It was an eventful week for indications of the real economy’s (waning) soundness. At 15.2 million annualized, January vehicle sales were the weakest since October 2005 (that followed more than a year of very strong sales). A larger-than-expected increase in weekly initial unemployment claims (356k) pushed continuing unemployment claims rose to the highest level (2.785 million) since late 2005. The ABC/Washington Post weekly Consumer Comfort index sank a notable 6 points this week to negative 33, the lowest reading since the early nineties.
Importantly, this week’s Federal Reserve survey of senior bank-loan officers provided confirmation both that bankers have become much more cautious in lending and that borrowers have lost enthusiasm for taking on more debt. Moreover, any indication of general tightening of bank Credit takes on major significance today due to the seizing up and breakdown of Wall Street finance. Inarguably, what erupted last year in subprime has now evolved into a broad-based and severe Credit tightening. Notably, 80% of banks tightened Credit for commercial real estate lending and better than a third tightened commercial and industrial (C&I) Credit. It is worthwhile excerpting directly from the Fed’s survey:
“In the January survey, significant numbers of domestic respondents reported that they had tightened their lending standards on prime, nontraditional, and subprime residential mortgages over the past three months; the remaining respondents noted that their lending standards had remained basically unchanged. About 55% of domestic respondents indicated that they had tightened their lending standards on prime mortgages, up from about 40% in the October survey. Of the thirty-nine banks that originated nontraditional residential mortgage loans, about 85% reported a tightening of their lending standards… compared with about 60% in October…”
“About 60% of domestic respondents…indicated that demand for prime residential mortgages had weakened over the past three months, and 70% of respondents…noted weaker demand for nontraditional and subprime mortgage loans over the same period… About 60% of domestic respondents indicated that they had tightened their lending standards for approving applications for revolving home equity lines… Regarding demand, about 35% of domestic banks…reported that demand for revolving home equity lines of credit had weakened over the past three months.”
“About 10% of respondents -- up from about 5% in…October -- reported that they had tightened their lending standards on credit card loans… About 30% of respondents noted that they had reduced the extent to which such loans were granted to customers who did not meet credit-scoring thresholds… About 15% of domestic banks -- up from about 5% in…October -- indicated a diminished willingness to make consumer installment loans… About one-third of domestic banks -- up from about one fourth… -- reported that they had tightened their lending standards on consumer loans other than credit card loans… Regarding loan demand, about 35% of domestic institutions, on net, indicated that they had experienced weaker demand for consumer loans of all types…”
“About 80% of domestic banks reported tightening their lending standards on commercial real estate loans over the past three months, a notable increase from the October survey. The net fraction of domestic banks reporting tighter lending standards on these loans was the highest since this question was introduced in 1990…”
“In the January survey, one-third of domestic institutions…reported having tightened their lending standards on C&I loans to small as well as to large and middle-market firms over the past three months. Significant net fractions of respondents also noted that they had tightened price terms on C&I loans to all types of firms… Compared with domestic institutions, larger net fractions of U.S. branches and agencies of foreign banks reported having tightened lending standards and terms on C&I loans…”
With Wall Street’s securitization markets basically closed for business and even bank Credit Availability now tightening meaningfully, January’s collapse in the ISM Non-Manufacturing index should have been less of shock to the markets. After all, the services-based U.S. economy is primarily finance-driven, and our financial system is floundering.
The ISM Non-Manufacturing index unexpectedly sank 12.5 points to 41.9 (below 50 indicates contraction), the lowest level since October 2001. Expectations had the index slipping only a point or so to a still expansionary 53. Instead, New Orders dropped more than 10 points to 43.5, while the Prices component dipped ever so slightly to a disconcerting 70.7. Alarmingly, the Non-Manufacturing Employment index sank to 43.9, the lowest reading since the 43.9 registered in the month subsequent to the 9/11 terrorist attacks. This report corroborates the recent dismal jobs report, where “Service-Producing” job growth collapsed from December’s 143,000 (5-month average growth of 138,000) to January’s 34,000.
It is worth noting that, despite the bursting of the technology Bubble, the Non-Manufacturing index remained above 50 (at 50.7) through February 2001. But as Credit problems engulfed the corporate debt market, the Employment component proceeded to drop 6.4 points in 11 months to fall to 44.3 by early 2002. Remarkably – and indicative of breadth and severity of the unfolding Credit Crises – the Non-Manufacturing Employment index sank 7.9 points just last month. Meanwhile, the ISM Manufacturing Employment index declined 4.7 points in two months to its lowest level since September 2003. The Bubble Economy is now clearly suffocating from insufficient Credit. In particular, the unfolding Corporate Credit Crisis has begun to impact jobs, incomes and the overall economy.
It was, as well, an eventful week for indications of the soundness of the U.S. and global financial systems. On the inflation front, major commodities indices (including the CRB and the UBS/Bloomberg Constant Maturity) surged to record highs. Platinum jumped 7% this week to a record on tight supplies and power shortages in South Africa. Lead gained 5%. Copper jumped 7.5% (biggest gain in almost a year), increasing y-t-d gains to almost 16%. Palladium rose to the highest price since 2002. Sugar rose 5% on Friday, and I’d be remiss not to note crude’s 4% one-day surge.
But when it comes to spectacular moves, wheat takes the cake. Prices surged to yet another record high (up 30% y-t-d), as forecasts have U.S. stockpiles falling to the lowest level since 1948. Global supplies are said to be the lowest since 1978. Alarmingly, wheat increased the 30 cent daily limit in Chicago trading for five straight sessions, with Bloomberg reporting this week’s 16% gain as the “biggest in history.” Prices are now up 140% y-o-y. Along for the ride, soybeans rose 4% this week to a near-record ( U.S. inventories at 4-yr low), increasing one-year gains to 80%. Corn prices gained 2% (having doubled in the past two years), also trading at record highs. Production and inventory concerns saw coffee prices rise 5.8% this week to the highest level since 1999. Cocoa gained 3.8% this week (37% 1-yr gain).
The question remains: How much will the Chinese, Indians, Russians, American consumers and others be willing to pay for wheat and other vital commodities? For energy? For stores of value such as gold, silver and the other (increasingly) precious metals in an age of unregulated, unrestrained, unanchored, electronic-based, securities-based, and market-driven global “money” and Credit. With trillions of dollar liquidity sloshing vagariously around the global financial “system”, there is clearly more than ample high-octane inflationary fuel to destabilize markets for myriad essential things of limited supply. And, increasingly, there is talk of problematic margin calls and derivative-related issues impacting commodities trading conditions. The talk is of trading dislocations and nervous “bankers” pulling away from the financing of hedging activities in various markets. Or, in short, we are witnessing a precarious ratcheting up of Monetary Disorder – in a multitude of key markets and on a global basis.
At the Heart of Monetary Disorder, we have a leveraged speculating community increasingly on the ropes. January was a tough month for the hedge fund community. In particular, it appears the (over-hyped) “long/short” (holding both long and short positions) and (over-hyped) “quant” funds had an especially tough go of it. To begin the New Year, last year’s favorite stocks (i.e. technology, emerging markets, energy, and utilities) were hammered, while the heavily shorted sectors have significantly outperformed (i.e. homebuilders, banks, retailers, “consumer discretionary,” and transports). The yen and Swiss franc (currencies traders had shorted to finance higher yielding “carry trades”) have rallied. Even the dollar has rallied somewhat. Many speculators have been (caught) short commodities, having expected negative ramifications from the bursting of the U.S. Credit Bubble. Others have been caught over-exposed to emerging equities and debt markets. And, increasingly, it appears various trades throughout the complex corporate Credit arena have run amuck.
Friday, various indices of corporate credit risk moved to record highs, including the previously stalwart “investment grade” sector. Leveraged loan prices fell to record lows late in the week, as talk of further bank and hedge fund liquidations captivated the marketplace. While the status of the (“monoline”) Credit insurers is now a central focus, behind the scenes there is increasing angst at the prospect for a disorderly unwind of various leveraged trading strategies in corporate Credits and Credit derivatives. “Synthetic” CDOs (collateralized debt obligations) – pools of Credit default swaps and other derivatives – are especially vulnerable and problematic for the system. In short, the Corporate Credit Crisis took a decided turn for the worse this week. There is, with the economy sinking rapidly and the leveraged speculating community faltering abruptly, little prospect at this point for stabilization. The downside of the Credit Cycle is attaining overwhelming momentum.
The Wall Street punditry seems to go out of its way to get things wrong. The latest talk is that the market will simply look over the “valley” and begin focusing on a recovery from what will be, at worst, a brief and mild recession. The relative strong performance of the banks, retailers, homebuilders, and transports is accepted as confirmation of the bullish view. I’ll instead take the view that the recent major squeeze in the heavily shorted stocks and sectors is only further destabilizing and indicative of dynamics troubling to the leveraged speculating community and the Credit system more generally. “Hedges” have stopped working, creating a backdrop of angst and forced liquidations.
Despite last year’s subprime collapse and mortgage turmoil, the leveraged speculating community overall chalked up another stellar year of performance. Actually, the “community” in total likely boosted returns with bets against subprime and mortgage Credit more generally. Certainly, the hedge funds profited nicely from shorts on the financial and consumer sectors. Ironically, the initial stage of the bursting of the Credit Bubble proved a favorable backdrop for many of the major players and the community in general. The deluge of industry inflows ran unabated through much of the year, a crucial dynamic that masked rapidly developing fragilities and vulnerabilities. These flows were surely critical in supporting speculative trading positions away from the mortgage bust.
In particular, I believe the general backdrop delayed a problematic unwind of leveraged and highly speculative positions in corporate Credits (securities, derivatives and other “structured products”). Shorting mortgage-related Credit last year provided a convenient mechanism for hedging corporate Credit and equity market risk. Meanwhile, the combination of profitable (mortgage bust-related) shorts and hedges – in concert with industry fund inflows – emboldened the speculators to press their (huge) bets on technology, energy, the emerging markets, global equities, and other speculative Bubbles. The relative resiliency of the U.S. corporate Credit market and global markets through 2007 played a critical role in delaying impending economic and stock market adjustment.
Well, I believe the dam broke in January. The leveraged players were hit with losses from all directions. Their long positions were immediately slammed with simultaneous bursting Bubbles round the globe. Meanwhile, a rush to unwind positions led to upward pressure on the heavily shorted sectors, only compounding the leverage speculating community’s predicament. Last year fostered an extraordinary dynamic of ballooning “crowded trades,” and January saw the bursting of this multifaceted Bubble.
The leveraged speculating community has suffered the occasional tough month – last August providing a recent case in point. Each time, however, performance quickly bounced back. In true Bubble fashion, each quick recovery from a setback emboldened all involved; industry fund inflows not only never missed a beat – they accelerated. Yet a strong case can be made today that this (historic) Bubble has now burst – that last year was the “last gasp” before succumbing to New Post-Credit Bubble Realities. I don’t expect performance to bounce back, while I do foresee a flight away from the leveraged speculating now beginning in earnest. With “crowded trades” unraveling virtually across the board, marketplace risk is now escalating significantly for leveraged strategies in general. Systemic liquidity issues and dislocated market conditions have created an environment where there is seemingly no place to hide.
Importantly, a leveraged speculating community “unraveling” would prove a death blow for myriad sophisticated trading strategies and risk models, with enormous ramifications for systemic stability. There are unmistakable “Ponzi Dynamics” involved here worthy of a few Bulletins.
Going forward, I expect a foundering leveraged speculating community to be At The Heart of Deepening Monetary Disorder. The initial victims appear the fragile global equities market Bubbles and the U.S. Corporate Credit market. Forced deleveraging of hedge fund corporate debt and derivatives is in the process of creating a massive overhang of securities to sell, in the process profoundly curtailing Credit Availability and Marketplace Liquidity throughout. The ramifications for our finance-based Bubble Economy are momentous. As an economic and financial analyst (as opposed to “fear-monger”), I feel it is imperative to highlight that it is more “technically” accurate to categorize the unfolding scenario in the historical context of an economic “depression” rather than “recession.” This is certainly not shaping up as a short-term inventory-led economic adjustment or “mid-cycle” slowdown. Instead, we have now entered the very initial stages of what will likely prove a deep, prolonged and arduous adjustment to the underlying structure of our Credit and economic systems.
10 February 2008
8 February 2008
The Credit Crunch – In 2008 The Worst May Keep Getting Worse
By: Satyajit Das
2007 may come to associated with the start of the "big" credit crunch. 2008 has begun with a number of "unresolved" items. Hope of an early resolution seems to be fading. In the words of Lily Tomlin, the American comedian: "Things are going to get a lot worse before they are going to get worse."
The total level of sub-prime losses is still far from clear. Based on current trading levels of ABS indices, estimates of losses range between US$ 150 and 400 billion, not all of which has been written off to date.
Interest rates on large volumes of sub-prime mortgages – estimated at around US$ 900 billion are due to reset by end 2008. Interest rates and repayments will rise significantly. The impact on delinquencies and losses are unknown. The rate reset freeze plan (which has not been in the news since being announced) and its impact are also still unclear.
As America's mortgage markets began unravelling, economists initially pointed to sub-prime mortgages issued to low-income, minority and urban borrowers. Closer analysis reveals risky mortgages in nearly every corner of the USA. Analysis by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined US$1.5 trillion in high-interest-rate, high risk loans. The potential losses on these loans are unknown.
There are also emerging concerns in the US$915 billion credit card debt markets. Credit card providers are all boosting loan loss provisions. There is anecdotal evidence that cash strapped mortgagors are using credit cards to make mortgage payments. Analysts expect credit card delinquencies to increase if consumers unable to use home-equity lines of credit to pay off their credit card debt start running up higher card debt. A number of banks have begun to boost reserves against anticipated losses.
Financial institutions have already incurred losses of over US$100 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. The total amount to be re-intermediated by banks may be in the range of US$1 to 2 trillion. This will make substantial depends on bank liquidity and capital.
There are already signs that the major banks are hoarding liquidity in anticipation of the return of assets. They will also inevitably have to raise substantial amounts of capital. In the second half of 2007 commercial and investment banks raised US$83 billion in equity. This was an increase of more than 20% on the corresponding period in 2006.
Asset backed conduit vehicles and SIVs ("Structured Investment Vehicles") may need to sell assets as they breach their rules. Hedge funds face substantial redemption requests in the coming months. This will exacerbate the demands on bank capital and liquidity.
The credit issues have widened beyond banks, investors and hedge funds active in structured credit.
In the conventional mortgage market, Fannie Mae (Federal National Mortgage Association) and Ginnie Mae (Government National Mortgage Association) have recorded losses and been forced to raise capital. This suggests that the problems in the housing market are deep seated.
Mortgage insurers and monoline insurers have suffered serious collateral damage. A significant downgrade in the rating of insurers will be particularly damaging. It will affect around US$ 2.5 trillion of municipal bonds guaranteed by the insurers. It will also affect other bonds wrapped by the insurers. This may trigger further selling pressure and contribute to decline in prices as well as absorbing increasingly scarce liquidity.
There is already talk of a plan to re-capitalise the insurers. The sum being talked about is between US$15 and US$200 billion. It is not clear where the substantial amount of capital needed to recapitalise the banks and financial guarantors is going to come from.
The US$ 2 trillion of European pfandbrief or covered bond markets have also experienced liquidity problems.
The sub-prime model is also used for leveraged funding in private equity, infrastructure and commercial property financing.
US$300 billion of leveraged finance loans made by banks is still effectively "orphaned" - they can't be sold off. In late 2007, there were signs that the loan logjam was easing. Underwriters pointed to some sales of risky assets.
Caution is needed in interpreting these developments. Firstly, the sales only related to the less risky tranches and loans. The more risky exposures remain with underwriters for the moment. There are also concerns that some of the sales were not "genuine". The banks had provided the buyers with a variety of favourable terms including the ability to sell the loans back to them at a future date at a guaranteed price. Alternatively, MFN ("most favoured nation") clauses mean that the selling bank will need to compensate buyers if loans are sold at lower prices during an agreed time from the initial sale. Current prices indicate steep discounts will be needed to shift the paper to investors.
The crisis shows signs of spilling over into other markets. In Great Britain, Ireland, Spain, Australia and other markets strong house price appreciation similar to the US led to similar growth in mortgage and real estate lending. If economic growth slows and housing prices fall then similar problem may emerge in those economies as well.
There are already signs that there will be significant litigation against the banks. There may also be regulatory investigations and potentially prosecutions. State Street recently provided over US$250 million against future litigation claims. The total cost of all this is still unknown.
The financial elements of the credit crunch are becoming clearer - higher credit costs; lower availability of debt; forced de-leveraging of hedge funds and conduits/ SIVs; significant capital losses for financial institutions. The real economy effects will be slower to emerge. Higher credit costs and tighter credit standards will affect all business.
The US housing industry is badly affected with no immediate prospect of a quick recovery. The outlook for US house prices is poor. Growth forecasts for the US have already been lowered. The dreaded "R" word – recession – is now being talked about.
The fall in asset prices has "wealth" effects. Then there are employment and income effects. Wall Street has already issued "pink slips" by the thousands as banks and mortgage lenders shed staff. More will be issued in 2008 as the slowdown in the financial services business continues.
A slowdown in economic activity will affect many financial transactions. Corporations with significant debt face refinancing challenges. The shares of an Australian real estate firm – Centro – fell over 80 % as a result of difficulties in refinancing its short-term debt secured over commercial property, some of it in the US. Commercial property financing has slowed, the cost has risen significantly and terms have tightened affecting commercial property prices.
Private equity deals in recent years were predicated on a combination of a growing economy, cheap debt and a buoyant stock market allowing the quick resale of the company. Weaker earnings and more expensive debt could lead to losses and distressed sales over time. Recent private equity deals also face re-financing risk. Some US$ 150 billion of leveraged loans come due in 2008. Financial engineering techniques – toggles, pay-in-kind securities and covenant-lite (lack of maintenance covenants) structures – will delay the problem but probably cannot forestall the inevitable rise in defaults.
Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Since 2003, 42% of bonds of high yield bonds issues were rated B- or below. In the first 6 months of the year that percentage rose to around 50%. Some commentators believe that the losses of corporate bonds will peak between 10% and 20% leading to significant losses.
Warren Buffet once observed that: "it's the weak link that snaps you…in financial markets, the weak link is borrowed money." In the present credit crisis, all companies and business models reliant on debt – especially cheap and abundant debt - look vulnerable.
The real economy effects will feedback into the financial markets. A weaker economy are likely to see higher levels of actual defaults. This may set off new phases of the crisis.
CDS contracts used to hedge credit risk have significant documentation and operational problems. If actual defaults in markets increase and the contracts do not function as intended then there would be additional complexity. A significant volume of CDS contracts is with hedge funds and other investors secured by collateral agreements. The counterparty and performance risk of enforcing the contracts may be challenging. It is important to note that the structured credit market in its current form is substantially untested. If defaults rise and the CDS contracts prove to be difficult to enforce then bank exposures to losses may well much higher than anticipated.
Credit markets remain gloomy. Unlike their equity and emerging market cousins, they are waiting anxiously for "the shoes to fall", except it seems that the shoes are from Imelda Marcos' collection.
At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
2007 may come to associated with the start of the "big" credit crunch. 2008 has begun with a number of "unresolved" items. Hope of an early resolution seems to be fading. In the words of Lily Tomlin, the American comedian: "Things are going to get a lot worse before they are going to get worse."
The total level of sub-prime losses is still far from clear. Based on current trading levels of ABS indices, estimates of losses range between US$ 150 and 400 billion, not all of which has been written off to date.
Interest rates on large volumes of sub-prime mortgages – estimated at around US$ 900 billion are due to reset by end 2008. Interest rates and repayments will rise significantly. The impact on delinquencies and losses are unknown. The rate reset freeze plan (which has not been in the news since being announced) and its impact are also still unclear.
As America's mortgage markets began unravelling, economists initially pointed to sub-prime mortgages issued to low-income, minority and urban borrowers. Closer analysis reveals risky mortgages in nearly every corner of the USA. Analysis by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined US$1.5 trillion in high-interest-rate, high risk loans. The potential losses on these loans are unknown.
There are also emerging concerns in the US$915 billion credit card debt markets. Credit card providers are all boosting loan loss provisions. There is anecdotal evidence that cash strapped mortgagors are using credit cards to make mortgage payments. Analysts expect credit card delinquencies to increase if consumers unable to use home-equity lines of credit to pay off their credit card debt start running up higher card debt. A number of banks have begun to boost reserves against anticipated losses.
Financial institutions have already incurred losses of over US$100 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. The total amount to be re-intermediated by banks may be in the range of US$1 to 2 trillion. This will make substantial depends on bank liquidity and capital.
There are already signs that the major banks are hoarding liquidity in anticipation of the return of assets. They will also inevitably have to raise substantial amounts of capital. In the second half of 2007 commercial and investment banks raised US$83 billion in equity. This was an increase of more than 20% on the corresponding period in 2006.
Asset backed conduit vehicles and SIVs ("Structured Investment Vehicles") may need to sell assets as they breach their rules. Hedge funds face substantial redemption requests in the coming months. This will exacerbate the demands on bank capital and liquidity.
The credit issues have widened beyond banks, investors and hedge funds active in structured credit.
In the conventional mortgage market, Fannie Mae (Federal National Mortgage Association) and Ginnie Mae (Government National Mortgage Association) have recorded losses and been forced to raise capital. This suggests that the problems in the housing market are deep seated.
Mortgage insurers and monoline insurers have suffered serious collateral damage. A significant downgrade in the rating of insurers will be particularly damaging. It will affect around US$ 2.5 trillion of municipal bonds guaranteed by the insurers. It will also affect other bonds wrapped by the insurers. This may trigger further selling pressure and contribute to decline in prices as well as absorbing increasingly scarce liquidity.
There is already talk of a plan to re-capitalise the insurers. The sum being talked about is between US$15 and US$200 billion. It is not clear where the substantial amount of capital needed to recapitalise the banks and financial guarantors is going to come from.
The US$ 2 trillion of European pfandbrief or covered bond markets have also experienced liquidity problems.
The sub-prime model is also used for leveraged funding in private equity, infrastructure and commercial property financing.
US$300 billion of leveraged finance loans made by banks is still effectively "orphaned" - they can't be sold off. In late 2007, there were signs that the loan logjam was easing. Underwriters pointed to some sales of risky assets.
Caution is needed in interpreting these developments. Firstly, the sales only related to the less risky tranches and loans. The more risky exposures remain with underwriters for the moment. There are also concerns that some of the sales were not "genuine". The banks had provided the buyers with a variety of favourable terms including the ability to sell the loans back to them at a future date at a guaranteed price. Alternatively, MFN ("most favoured nation") clauses mean that the selling bank will need to compensate buyers if loans are sold at lower prices during an agreed time from the initial sale. Current prices indicate steep discounts will be needed to shift the paper to investors.
The crisis shows signs of spilling over into other markets. In Great Britain, Ireland, Spain, Australia and other markets strong house price appreciation similar to the US led to similar growth in mortgage and real estate lending. If economic growth slows and housing prices fall then similar problem may emerge in those economies as well.
There are already signs that there will be significant litigation against the banks. There may also be regulatory investigations and potentially prosecutions. State Street recently provided over US$250 million against future litigation claims. The total cost of all this is still unknown.
The financial elements of the credit crunch are becoming clearer - higher credit costs; lower availability of debt; forced de-leveraging of hedge funds and conduits/ SIVs; significant capital losses for financial institutions. The real economy effects will be slower to emerge. Higher credit costs and tighter credit standards will affect all business.
The US housing industry is badly affected with no immediate prospect of a quick recovery. The outlook for US house prices is poor. Growth forecasts for the US have already been lowered. The dreaded "R" word – recession – is now being talked about.
The fall in asset prices has "wealth" effects. Then there are employment and income effects. Wall Street has already issued "pink slips" by the thousands as banks and mortgage lenders shed staff. More will be issued in 2008 as the slowdown in the financial services business continues.
A slowdown in economic activity will affect many financial transactions. Corporations with significant debt face refinancing challenges. The shares of an Australian real estate firm – Centro – fell over 80 % as a result of difficulties in refinancing its short-term debt secured over commercial property, some of it in the US. Commercial property financing has slowed, the cost has risen significantly and terms have tightened affecting commercial property prices.
Private equity deals in recent years were predicated on a combination of a growing economy, cheap debt and a buoyant stock market allowing the quick resale of the company. Weaker earnings and more expensive debt could lead to losses and distressed sales over time. Recent private equity deals also face re-financing risk. Some US$ 150 billion of leveraged loans come due in 2008. Financial engineering techniques – toggles, pay-in-kind securities and covenant-lite (lack of maintenance covenants) structures – will delay the problem but probably cannot forestall the inevitable rise in defaults.
Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Since 2003, 42% of bonds of high yield bonds issues were rated B- or below. In the first 6 months of the year that percentage rose to around 50%. Some commentators believe that the losses of corporate bonds will peak between 10% and 20% leading to significant losses.
Warren Buffet once observed that: "it's the weak link that snaps you…in financial markets, the weak link is borrowed money." In the present credit crisis, all companies and business models reliant on debt – especially cheap and abundant debt - look vulnerable.
The real economy effects will feedback into the financial markets. A weaker economy are likely to see higher levels of actual defaults. This may set off new phases of the crisis.
CDS contracts used to hedge credit risk have significant documentation and operational problems. If actual defaults in markets increase and the contracts do not function as intended then there would be additional complexity. A significant volume of CDS contracts is with hedge funds and other investors secured by collateral agreements. The counterparty and performance risk of enforcing the contracts may be challenging. It is important to note that the structured credit market in its current form is substantially untested. If defaults rise and the CDS contracts prove to be difficult to enforce then bank exposures to losses may well much higher than anticipated.
Credit markets remain gloomy. Unlike their equity and emerging market cousins, they are waiting anxiously for "the shoes to fall", except it seems that the shoes are from Imelda Marcos' collection.
At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
31 January 2008
The Minsky Moment
Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact, he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the moneymen.
Many of Minsky’s colleagues regarded his “financial-instability hypothesis,” which he first developed in the nineteen-sixties, as radical, if not crackpot. Today, with the subprime crisis seemingly on the verge of metamorphosing into a recession, references to it have become commonplace on financial Web sites and in the reports of Wall Street analysts. Minsky’s hypothesis is well worth revisiting. In trying to revive the economy, President Bush and the House have already agreed on the outlines of a “stimulus package,” but the first stage in curing any malady is making a correct diagnosis.
Minsky, who died in 1996, at the age of seventy-seven, earned a Ph.D. from Harvard and taught at Brown, Berkeley, and Washington University. He didn’t have anything against financial institutions—for many years, he served as a director of the Mark Twain Bank, in St. Louis—but he knew more about how they worked than most deskbound economists. There are basically five stages in Minsky’s model of the credit cycle: displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy. The current cycle began in 2003, with the Fed chief Alan Greenspan’s decision to reduce short-term interest rates to one per cent, and an unexpected influx of foreign money, particularly Chinese money, into U.S. Treasury bonds. With the cost of borrowing—mortgage rates, in particular—at historic lows, a speculative real-estate boom quickly developed that was much bigger, in terms of over-all valuation, than the previous bubble in technology stocks.
As a boom leads to euphoria, Minsky said, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. During the nineteen-eighties, junk bonds played that role. More recently, it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid. (Investors who bought the newfangled securities would be left to deal with any defaults.) Then, at the top of the market (in this case, mid-2006), some smart traders start to cash in their profits.
The onset of panic is usually heralded by a dramatic effect: in July, two Bear Stearns hedge funds that had invested heavily in mortgage securities collapsed. Six months and four interest-rate cuts later, Ben Bernanke and his colleagues at the Fed are struggling to contain the bust. Despite last week’s rebound, the outlook remains grim. According to Dean Baker, the co-director of the Center for Economic and Policy Research, average house prices are falling nationwide at an annual rate of more than ten per cent, something not seen since before the Second World War. This means that American households are getting poorer at a rate of more than two trillion dollars a year.
It’s hard to say exactly how falling house prices will affect the economy, but recent computer simulations carried out by Frederic Mishkin, a governor at the Fed, suggest that, for every dollar the typical American family’s housing wealth drops in a year, that family may cut its spending by up to seven cents. Nationwide, that adds up to roughly a hundred and fifty-five billion dollars, which is bigger than President Bush’s stimulus package. And it doesn’t take into account plunging stock prices, collapsing confidence, and the belated imposition of tighter lending practices—all of which will further restrict economic activity.
In an election year, politicians can’t be expected to acknowledge their powerlessness. Nonetheless, it was disheartening to see the Republicans exploiting the current crisis to try to make the President’s tax cuts permanent, and the Democrats attempting to pin the economic downturn on the White House. For once, Bush is not to blame. His tax cuts were irresponsible and callously regressive, but they didn’t play a significant role in the housing bubble.
If anybody is at fault it is Greenspan, who kept interest rates too low for too long and ignored warnings, some from his own colleagues, about what was happening in the mortgage market. But he wasn’t the only one. Between 2003 and 2007, most Americans didn’t want to hear about the downside of funds that invest in mortgage-backed securities, or of mortgages that allow lenders to make monthly payments so low that their loan balances sometimes increase. They were busy wondering how much their neighbors had made selling their apartment, scouting real-estate Web sites and going to open houses, and calling up Washington Mutual or Countrywide to see if they could get another home-equity loan. That’s the nature of speculative manias: eventually, they draw in almost all of us.
You might think that the best solution is to prevent manias from developing at all, but that requires vigilance. Since the nineteen-eighties, Congress and the executive branch have been conspiring to weaken federal supervision of Wall Street. Perhaps the most fateful step came when, during the Clinton Administration, Greenspan and Robert Rubin, then the Treasury Secretary, championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Depression.
The greatest need is for intellectual reappraisal, and a good place to begin is with a statement from a paper co-authored by Minsky that “apt intervention and institutional structures are necessary for market economies to be successful.” Rather than waging old debates about tax cuts versus spending increases, policymakers ought to be discussing how to reform the financial system so that it serves the rest of the economy, instead of feeding off it and destabilizing it. Among the problems at hand: how to restructure Wall Street remuneration packages that encourage excessive risk-taking; restrict irresponsible lending without shutting out creditworthy borrowers; help victims of predatory practices without bailing out irresponsible lenders; and hold ratings agencies accountable for their assessments. These are complex issues, with few easy solutions, but that’s what makes them interesting. As Minsky believed, “Economies evolve, and so, too, must economic policy.” ♦
Many of Minsky’s colleagues regarded his “financial-instability hypothesis,” which he first developed in the nineteen-sixties, as radical, if not crackpot. Today, with the subprime crisis seemingly on the verge of metamorphosing into a recession, references to it have become commonplace on financial Web sites and in the reports of Wall Street analysts. Minsky’s hypothesis is well worth revisiting. In trying to revive the economy, President Bush and the House have already agreed on the outlines of a “stimulus package,” but the first stage in curing any malady is making a correct diagnosis.
Minsky, who died in 1996, at the age of seventy-seven, earned a Ph.D. from Harvard and taught at Brown, Berkeley, and Washington University. He didn’t have anything against financial institutions—for many years, he served as a director of the Mark Twain Bank, in St. Louis—but he knew more about how they worked than most deskbound economists. There are basically five stages in Minsky’s model of the credit cycle: displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy. The current cycle began in 2003, with the Fed chief Alan Greenspan’s decision to reduce short-term interest rates to one per cent, and an unexpected influx of foreign money, particularly Chinese money, into U.S. Treasury bonds. With the cost of borrowing—mortgage rates, in particular—at historic lows, a speculative real-estate boom quickly developed that was much bigger, in terms of over-all valuation, than the previous bubble in technology stocks.
As a boom leads to euphoria, Minsky said, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. During the nineteen-eighties, junk bonds played that role. More recently, it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid. (Investors who bought the newfangled securities would be left to deal with any defaults.) Then, at the top of the market (in this case, mid-2006), some smart traders start to cash in their profits.
The onset of panic is usually heralded by a dramatic effect: in July, two Bear Stearns hedge funds that had invested heavily in mortgage securities collapsed. Six months and four interest-rate cuts later, Ben Bernanke and his colleagues at the Fed are struggling to contain the bust. Despite last week’s rebound, the outlook remains grim. According to Dean Baker, the co-director of the Center for Economic and Policy Research, average house prices are falling nationwide at an annual rate of more than ten per cent, something not seen since before the Second World War. This means that American households are getting poorer at a rate of more than two trillion dollars a year.
It’s hard to say exactly how falling house prices will affect the economy, but recent computer simulations carried out by Frederic Mishkin, a governor at the Fed, suggest that, for every dollar the typical American family’s housing wealth drops in a year, that family may cut its spending by up to seven cents. Nationwide, that adds up to roughly a hundred and fifty-five billion dollars, which is bigger than President Bush’s stimulus package. And it doesn’t take into account plunging stock prices, collapsing confidence, and the belated imposition of tighter lending practices—all of which will further restrict economic activity.
In an election year, politicians can’t be expected to acknowledge their powerlessness. Nonetheless, it was disheartening to see the Republicans exploiting the current crisis to try to make the President’s tax cuts permanent, and the Democrats attempting to pin the economic downturn on the White House. For once, Bush is not to blame. His tax cuts were irresponsible and callously regressive, but they didn’t play a significant role in the housing bubble.
If anybody is at fault it is Greenspan, who kept interest rates too low for too long and ignored warnings, some from his own colleagues, about what was happening in the mortgage market. But he wasn’t the only one. Between 2003 and 2007, most Americans didn’t want to hear about the downside of funds that invest in mortgage-backed securities, or of mortgages that allow lenders to make monthly payments so low that their loan balances sometimes increase. They were busy wondering how much their neighbors had made selling their apartment, scouting real-estate Web sites and going to open houses, and calling up Washington Mutual or Countrywide to see if they could get another home-equity loan. That’s the nature of speculative manias: eventually, they draw in almost all of us.
You might think that the best solution is to prevent manias from developing at all, but that requires vigilance. Since the nineteen-eighties, Congress and the executive branch have been conspiring to weaken federal supervision of Wall Street. Perhaps the most fateful step came when, during the Clinton Administration, Greenspan and Robert Rubin, then the Treasury Secretary, championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Depression.
The greatest need is for intellectual reappraisal, and a good place to begin is with a statement from a paper co-authored by Minsky that “apt intervention and institutional structures are necessary for market economies to be successful.” Rather than waging old debates about tax cuts versus spending increases, policymakers ought to be discussing how to reform the financial system so that it serves the rest of the economy, instead of feeding off it and destabilizing it. Among the problems at hand: how to restructure Wall Street remuneration packages that encourage excessive risk-taking; restrict irresponsible lending without shutting out creditworthy borrowers; help victims of predatory practices without bailing out irresponsible lenders; and hold ratings agencies accountable for their assessments. These are complex issues, with few easy solutions, but that’s what makes them interesting. As Minsky believed, “Economies evolve, and so, too, must economic policy.” ♦
29 January 2008
"America's Suicidal Statecraft" At the Bistro
You might be interested in the following extract from "America's Suicidal Statecraft" which went into print in November 2006 and was actually written some months earlier. At that time, the "bankers" - which includes the formal and less formal banks - were still in the midst of the Ponzi mania. For them, the world was still wonderful and if any of them gave a thought to crashes of any kind, it was hard to catch any sign of it.
The extract reads:
The credit-derivatives concept is new, dating from about 1997 with the launch of a financial product called Bistro (Broad Index Secured Trust Offering). It caught on and spread like wildfire to the $12.4 trillion market today. In a world already gorged on massive credit, Bistro and imitations of it allowed banks to expand their loans, sell the risk of default and so leave their reserves at the ready for more loans whose risk again could be sold on. Just how much expansion of credit the new derivatives have created which would never otherwise have existed, we do not know, but $12 trillion must have allowed a lot.
A worrying feature is that we do not know where the risk of these loans – made almost certainly on the basis of significantly reduced borrower quality – has now settled. Further innovations are already on the drawing board: derivatives of derivatives and “derivatives cubed”. One observer says that “the whole credit derivatives world has exploded at such a dizzy pace that nobody is exactly sure where the loan risk has gone. Have all the investors who have bought credit derivatives contracts checked the fine print to see what losses they could sustain? Does anybody understand the chain reaction that might be triggered by such losses? Could the world’s trading system cope? And what would happen to those hedge funds that have been jumping into the credit derivatives world?” 8
In July 2006, Gabriel Kolko put the credit-derivatives market much higher: “The credit derivative market was almost nonexistent in 2001, grew fairly slowly until 2004 and then went into the stratosphere, reaching $17.3 trillion by the end of 2005.” He then put the question, “What are credit derivatives?” and answered it by saying that “The Financial Times' chief capital markets writer, Gillian Tett, tried to find out, but failed. About ten years ago some J.P. Morgan bankers were in Boca Raton, Florida, drinking, throwing each other into the swimming pool, and the like, and they came up with a notion of a new financial instrument that was too complex to be easily copied (financial ideas cannot be copyrighted) and which was sure to make them money. But Tett was highly critical of its potential for causing a chain reaction of losses that will engulf the hedge funds that have leaped into this market… Nominally insurance against defaults, [credit derivatives] encourage far greater gambles and credit expansion. Enron used them extensively, and it was one secret of their success, and eventual bankruptcy with $100 billion in losses. They are not monitored in any real sense, and two experts called them ‘maddeningly opaque.’ Many of these innovative financial products, according to one finance director, ‘exist in cyberspace’ only and often are simply tax dodges for the ultra-rich. It is for reasons such as these, and yet others such as split capital trusts, collateralized debt obligations, and market credit default swaps that are even more opaque, that the IMF and financial authorities are so worried.”
One of the interesting and, again, highly disturbing features of credit derivatives is that their trading processes tend to be primitive. Deals seem to be recorded with pen and paper – and one imagines on cramped and overwritten shirt-cuffs – while hedge funds and banks scramble to improve their credit-derivatives trading systems by spending hundreds of millions of dollars in aggregate on suitable information technology. As reported by the London Financial Times on 16 August 2006, “Credit derivatives are tools that let investors place bets on whether bonds or loans will default. The industry is estimated to have $17,000bn of total outstanding contracts…and the sector has doubled in size every year since 2002. This growth has taken institutions by surprise and forced them to handle deals with small levels of support staff. A recent survey from the International Swaps and Derivatives Association showed that one in five credit derivatives trades by large dealers in 2005 contained mistakes and many suffered settlement delays.”
All of this sharpens the picture of a financial industry in the dollar size of its deals as big as or bigger than anything in financial history, being conducted by unmonitored institutions and dealers, with staffs that are largely inexperienced and, as the Financial Times puts it, with “sloppy back-office procedures [that] could cause serious damage.” The financial magnitudes they handle are indeed so great that they could, it seems, precipitate a global crash of unprecedented proportions; yet they are being run with some of their procedures apparently comparable with those of a church-fête bingo game.
James Cumes
The extract reads:
The credit-derivatives concept is new, dating from about 1997 with the launch of a financial product called Bistro (Broad Index Secured Trust Offering). It caught on and spread like wildfire to the $12.4 trillion market today. In a world already gorged on massive credit, Bistro and imitations of it allowed banks to expand their loans, sell the risk of default and so leave their reserves at the ready for more loans whose risk again could be sold on. Just how much expansion of credit the new derivatives have created which would never otherwise have existed, we do not know, but $12 trillion must have allowed a lot.
A worrying feature is that we do not know where the risk of these loans – made almost certainly on the basis of significantly reduced borrower quality – has now settled. Further innovations are already on the drawing board: derivatives of derivatives and “derivatives cubed”. One observer says that “the whole credit derivatives world has exploded at such a dizzy pace that nobody is exactly sure where the loan risk has gone. Have all the investors who have bought credit derivatives contracts checked the fine print to see what losses they could sustain? Does anybody understand the chain reaction that might be triggered by such losses? Could the world’s trading system cope? And what would happen to those hedge funds that have been jumping into the credit derivatives world?” 8
In July 2006, Gabriel Kolko put the credit-derivatives market much higher: “The credit derivative market was almost nonexistent in 2001, grew fairly slowly until 2004 and then went into the stratosphere, reaching $17.3 trillion by the end of 2005.” He then put the question, “What are credit derivatives?” and answered it by saying that “The Financial Times' chief capital markets writer, Gillian Tett, tried to find out, but failed. About ten years ago some J.P. Morgan bankers were in Boca Raton, Florida, drinking, throwing each other into the swimming pool, and the like, and they came up with a notion of a new financial instrument that was too complex to be easily copied (financial ideas cannot be copyrighted) and which was sure to make them money. But Tett was highly critical of its potential for causing a chain reaction of losses that will engulf the hedge funds that have leaped into this market… Nominally insurance against defaults, [credit derivatives] encourage far greater gambles and credit expansion. Enron used them extensively, and it was one secret of their success, and eventual bankruptcy with $100 billion in losses. They are not monitored in any real sense, and two experts called them ‘maddeningly opaque.’ Many of these innovative financial products, according to one finance director, ‘exist in cyberspace’ only and often are simply tax dodges for the ultra-rich. It is for reasons such as these, and yet others such as split capital trusts, collateralized debt obligations, and market credit default swaps that are even more opaque, that the IMF and financial authorities are so worried.”
One of the interesting and, again, highly disturbing features of credit derivatives is that their trading processes tend to be primitive. Deals seem to be recorded with pen and paper – and one imagines on cramped and overwritten shirt-cuffs – while hedge funds and banks scramble to improve their credit-derivatives trading systems by spending hundreds of millions of dollars in aggregate on suitable information technology. As reported by the London Financial Times on 16 August 2006, “Credit derivatives are tools that let investors place bets on whether bonds or loans will default. The industry is estimated to have $17,000bn of total outstanding contracts…and the sector has doubled in size every year since 2002. This growth has taken institutions by surprise and forced them to handle deals with small levels of support staff. A recent survey from the International Swaps and Derivatives Association showed that one in five credit derivatives trades by large dealers in 2005 contained mistakes and many suffered settlement delays.”
All of this sharpens the picture of a financial industry in the dollar size of its deals as big as or bigger than anything in financial history, being conducted by unmonitored institutions and dealers, with staffs that are largely inexperienced and, as the Financial Times puts it, with “sloppy back-office procedures [that] could cause serious damage.” The financial magnitudes they handle are indeed so great that they could, it seems, precipitate a global crash of unprecedented proportions; yet they are being run with some of their procedures apparently comparable with those of a church-fête bingo game.
James Cumes
27 January 2008
Nolan on the crisis
Credit then really began to flow. Greenspan’s assurances came at a critical juncture for the fledging Wall Street securitization marketplace; for Michael Milken, Drexel Burnham and the junk bond market; for private equity, hostile takeovers and the leveraged buyout boom; for the fraudulent S&L industry and for many banks’ commercial lending operations. While it sounds a little silly after what we’ve witnessed since, there was a time when the eighties were known as the “decade of greed.”
When the junk bonds, LBOs, S&Ls, and scores of commercial banks all came crashing down beginning in late-1989 to 1990, the Greenspan Fed initiated an historic easing cycle that saw Fed funds cut from 9.0% in November 1989 all the way to 3.0% by September 1992. In order to recapitalize the banking system, free up system Credit growth, and fight economic headwinds, the Greenspan Federal Reserve was more than content to garner outsized financial profits to the fledgling leveraged speculator community and a Wall Street keen to seize power from the frail banking system. Wall Street investment bankers, all facets of the securitization industry, the derivatives market, the hedge funds and the GSEs never looked back –not for a second.
In the guise of “free markets,” the Greenspan Fed sold their soul to unfettered and unregulated Wall Street-based Credit creation. What proceeded was the perpetration of a 20-year myth: that an historic confluence of incredible technological advances, a productivity revolution, and momentous financial innovation had fundamentally altered the course of economic and financial history. The ideology emerged (and became emboldened by each passing year of positive GDP growth and rising asset prices) that free market forces and enlightened policymaking raised the economy’s speed limit and increased its resiliency; conquered inflation; and fundamentally altered and revolutionized financial risk management/intermediation. It was one heck of a compelling – alluring – seductive story.
But, as they say, “there’s always a catch”. In order for New Age Finance to work, the Fed had to make a seemingly simple – yet outrageously dangerous - promise of “liquid and continuous” markets. Only with uninterrupted liquidity could much of securities-based contemporary risk intermediation come close to functioning as advertised. Those taking risky positions in various securitizations (especially when highly leveraged) needed confidence that they would always have the opportunity to offload risk (liquidate positions and/or easily hedge exposure). Those writing derivative “insurance” – accommodating the markets’ expanding appetite for hedging - required liquid markets whereby they could short securities to hedge their risk, as necessary. There were numerous debacles that should have alerted policymakers to some of New Age Finance’s inherent flaws (1994’s bond rout, Orange Co., Mexico, SE Asia, Russia, Argentina, LTCM, the tech bust, and Enron to name a few). Yet the bottom line was that the combination of the Fed’s flexibility to aggressively cut rates on demand; ballooning GSE balance sheets on demand; ballooning foreign official dollar reserve holdings on demand; and insatiable demand for the dollar as the world’s reserve currency all worked in powerful concert to sustain (until recently) the U.S. Credit Bubble - through thick and thin.
Despite his (inflationist) academic leanings and some regrettable (“Helicopter Ben”) speeches as Fed governor, I do believe Dr. Bernanke aspired to adapt Fed policymaking. His preference was for a more “rules based” policy approach of setting rates through some flexible “inflation targeting” regime, while ending Greenspan’s penchant for kowtowing to the markets. Today, it all seems hopelessly naïve. Inflation is running above 4%, while the FOMC is compelled to quickly slash the funds rate to 3%. And never – I repeat, never – have the financial markets been more convinced that the Federal Reserve fixates on stock prices while is permissive when it comes to inflationary pressures. Today, the contrast to the ECB and other global central banks could not be starker. The Fed has climbed way out on a limb, and it is difficult at this point to see how they regain credibility as inflation fighters or supporters of the value of our currency. It is not only trust in Wall Street-backed finance that is being shattered.
The greatest flaw in the Greenspan/Bernanke monetary policy doctrine was a dangerously misguided understanding of the risks inherent to their “risk management” approach. Repeatedly, monetary policymaking was dictated by the Fed’s focus on what it considered the possibility of adverse consequences from relatively low probability (“tail”) developments in the Credit system and real economy. In other words, if the markets (certainly inclusive of “New Age” structured finance) were at risk of faltering, it was believed that aggressive accommodation was required. The avoidance of potentially severe real economic risks through “activist” monetary easing was accepted outright as a patently more attractive proposition compared to the (generally perceived minimal) inflationary risks that might arise from policy ease. As it was in the late 1920s, such an accommodative (“coin in the fuse box”) policy approach is disastrous in Bubble environments.
The Fed’s complete misconception of the true nature of contemporary “inflation" risk was a historic blunder in monetary doctrine and analysis. To be sure, the consequences of accommodating the markets were anything but confined to consumer prices. Instead, the primary - and greatly unappreciated - risks were part and parcel to the perpetuation of dangerous Credit Bubble Dynamics and myriad attendant excesses. Importantly, the Fed failed to recognize that obliging Wall Street finance ensured ever greater Bubble-related distortions and fragilities – deeper structural impairment to both the financial system and real economy. In the end, the Fed’s focus on mitigating “tail” risk guaranteed a much more certain and problematic “tail” – a rather fat one at that.
Fundamentally, the Greenspan/Bernanke “doctrine” totally misconstrued the various risks inherent in their strategy of disregarding Bubbles as they expanded – choosing instead the aggressive implementation of post-Bubble “mopping up” measures as necessary. They were almost as oblivious to the nature of escalating Bubble risk as they were to present-day complexities incident to implementing “mop up” reflationary policies. “Mopping up” the technology Bubble created a greatly more precarious Mortgage Finance Bubble. Aggressively “mopping up” after the mortgage/housing carnage in an age of a debased and vulnerable dollar, $90 oil, $900 gold, surging commodities and food costs, massive unwieldy pools of speculative global finance, myriad global Bubbles, and a runaway Chinese boom is fraught with extraordinary risk. Furthermore, the Fed’s previously most potent reflationary mechanism - Wall Street-backed finance – is today largely inoperable.
I’m not going to jump on the criticism bandwagon and excoriate Dr. Bernanke for his panicked 75 basis point inter-meeting rate cut. From my vantage point, the “wheels were coming off” and I would expect nothing less from our increasingly impotent central bank. Yet it is silly to blame today’s mess on recent indecisiveness. The Fed has not been “behind the curve,” unless one is referring to the “learning curve.” The unfolding financial and economic crisis has been More than 20 Years in the Making. It’s a creation of flawed monetary management; egregious lending, leveraging and speculating excess; unprecedented economic distortions and imbalances on a global basis. And I find it rather ironic that Wall Street is so fervidly lambasting the Fed. For twenty years now the Fed has basically done everything that Wall Street requested and more.
It is also as ironic as it was predictable that Alan Greenspan - Ayn Rand “disciple” and free-market ideologue - championed monetary policies and a financial apparatus that will ensure the greatest government intrusion into our Nation’s financial and economic affairs since the New Deal. Articles berating contemporary Capitalism are becoming commonplace. I fear that the most important lesson from this experience may fail to resonate: that to promote sustainable free-market Capitalism for the real economy demands considerable general resolve to protect the soundness and stability of the underlying Credit system.
And, speaking of the Credit system, some brief market comments are in order. Stocks generally rallied this week, yet it was a backdrop that provided little comfort that the system has begun to stabilize. Sure, the banks rallied 10%, the homebuilders 20%, the retailers 7%, the transports almost 7%, and the restaurants 5%. One could easily assume that the bears were squeezed and leave it at that. There are, however, surely more complex and problematic dynamics at work. Notably, many of the favorite sectors were hit this week – the utilities, technology and biotechs all posted notable weakness. Coupled with this week’s extreme volatility, I will assume that the huge “market-neutral” and “quant” components of the leveraged speculating community have suffered even greater losses so far this month than those from last August. It is also worth noting that some important Credit spreads have diverged markedly, most notably many corporate, junk and commercial MBS spreads have widened as dollar swap spreads have narrowed. The spectacular Treasury melt-up must also be causing havoc for various strategies, ditto the recently strong yen and Swiss franc.
I’ll stick with the view that an unfolding breakdown in various trading models and hedging strategies is at risk of precipitating a crisis of confidence for the leveraged speculating community. I suspect hedge fund trading was much more responsible for chaotic global securities markets this week than a rogue French equities trader. There is, unfortunately, little prospect for markets to calm down anytime soon. There is no quick or easy fix to any of the myriad current problems – seized up securitization markets, sinking housing prices, faltering bond insurers, counterparty issues, a crisis in confidence for “Wall Street finance”, or acute economic vulnerability - to name only the most obvious. Again, they’ve been More than 20 Years in the Making.
When the junk bonds, LBOs, S&Ls, and scores of commercial banks all came crashing down beginning in late-1989 to 1990, the Greenspan Fed initiated an historic easing cycle that saw Fed funds cut from 9.0% in November 1989 all the way to 3.0% by September 1992. In order to recapitalize the banking system, free up system Credit growth, and fight economic headwinds, the Greenspan Federal Reserve was more than content to garner outsized financial profits to the fledgling leveraged speculator community and a Wall Street keen to seize power from the frail banking system. Wall Street investment bankers, all facets of the securitization industry, the derivatives market, the hedge funds and the GSEs never looked back –not for a second.
In the guise of “free markets,” the Greenspan Fed sold their soul to unfettered and unregulated Wall Street-based Credit creation. What proceeded was the perpetration of a 20-year myth: that an historic confluence of incredible technological advances, a productivity revolution, and momentous financial innovation had fundamentally altered the course of economic and financial history. The ideology emerged (and became emboldened by each passing year of positive GDP growth and rising asset prices) that free market forces and enlightened policymaking raised the economy’s speed limit and increased its resiliency; conquered inflation; and fundamentally altered and revolutionized financial risk management/intermediation. It was one heck of a compelling – alluring – seductive story.
But, as they say, “there’s always a catch”. In order for New Age Finance to work, the Fed had to make a seemingly simple – yet outrageously dangerous - promise of “liquid and continuous” markets. Only with uninterrupted liquidity could much of securities-based contemporary risk intermediation come close to functioning as advertised. Those taking risky positions in various securitizations (especially when highly leveraged) needed confidence that they would always have the opportunity to offload risk (liquidate positions and/or easily hedge exposure). Those writing derivative “insurance” – accommodating the markets’ expanding appetite for hedging - required liquid markets whereby they could short securities to hedge their risk, as necessary. There were numerous debacles that should have alerted policymakers to some of New Age Finance’s inherent flaws (1994’s bond rout, Orange Co., Mexico, SE Asia, Russia, Argentina, LTCM, the tech bust, and Enron to name a few). Yet the bottom line was that the combination of the Fed’s flexibility to aggressively cut rates on demand; ballooning GSE balance sheets on demand; ballooning foreign official dollar reserve holdings on demand; and insatiable demand for the dollar as the world’s reserve currency all worked in powerful concert to sustain (until recently) the U.S. Credit Bubble - through thick and thin.
Despite his (inflationist) academic leanings and some regrettable (“Helicopter Ben”) speeches as Fed governor, I do believe Dr. Bernanke aspired to adapt Fed policymaking. His preference was for a more “rules based” policy approach of setting rates through some flexible “inflation targeting” regime, while ending Greenspan’s penchant for kowtowing to the markets. Today, it all seems hopelessly naïve. Inflation is running above 4%, while the FOMC is compelled to quickly slash the funds rate to 3%. And never – I repeat, never – have the financial markets been more convinced that the Federal Reserve fixates on stock prices while is permissive when it comes to inflationary pressures. Today, the contrast to the ECB and other global central banks could not be starker. The Fed has climbed way out on a limb, and it is difficult at this point to see how they regain credibility as inflation fighters or supporters of the value of our currency. It is not only trust in Wall Street-backed finance that is being shattered.
The greatest flaw in the Greenspan/Bernanke monetary policy doctrine was a dangerously misguided understanding of the risks inherent to their “risk management” approach. Repeatedly, monetary policymaking was dictated by the Fed’s focus on what it considered the possibility of adverse consequences from relatively low probability (“tail”) developments in the Credit system and real economy. In other words, if the markets (certainly inclusive of “New Age” structured finance) were at risk of faltering, it was believed that aggressive accommodation was required. The avoidance of potentially severe real economic risks through “activist” monetary easing was accepted outright as a patently more attractive proposition compared to the (generally perceived minimal) inflationary risks that might arise from policy ease. As it was in the late 1920s, such an accommodative (“coin in the fuse box”) policy approach is disastrous in Bubble environments.
The Fed’s complete misconception of the true nature of contemporary “inflation" risk was a historic blunder in monetary doctrine and analysis. To be sure, the consequences of accommodating the markets were anything but confined to consumer prices. Instead, the primary - and greatly unappreciated - risks were part and parcel to the perpetuation of dangerous Credit Bubble Dynamics and myriad attendant excesses. Importantly, the Fed failed to recognize that obliging Wall Street finance ensured ever greater Bubble-related distortions and fragilities – deeper structural impairment to both the financial system and real economy. In the end, the Fed’s focus on mitigating “tail” risk guaranteed a much more certain and problematic “tail” – a rather fat one at that.
Fundamentally, the Greenspan/Bernanke “doctrine” totally misconstrued the various risks inherent in their strategy of disregarding Bubbles as they expanded – choosing instead the aggressive implementation of post-Bubble “mopping up” measures as necessary. They were almost as oblivious to the nature of escalating Bubble risk as they were to present-day complexities incident to implementing “mop up” reflationary policies. “Mopping up” the technology Bubble created a greatly more precarious Mortgage Finance Bubble. Aggressively “mopping up” after the mortgage/housing carnage in an age of a debased and vulnerable dollar, $90 oil, $900 gold, surging commodities and food costs, massive unwieldy pools of speculative global finance, myriad global Bubbles, and a runaway Chinese boom is fraught with extraordinary risk. Furthermore, the Fed’s previously most potent reflationary mechanism - Wall Street-backed finance – is today largely inoperable.
I’m not going to jump on the criticism bandwagon and excoriate Dr. Bernanke for his panicked 75 basis point inter-meeting rate cut. From my vantage point, the “wheels were coming off” and I would expect nothing less from our increasingly impotent central bank. Yet it is silly to blame today’s mess on recent indecisiveness. The Fed has not been “behind the curve,” unless one is referring to the “learning curve.” The unfolding financial and economic crisis has been More than 20 Years in the Making. It’s a creation of flawed monetary management; egregious lending, leveraging and speculating excess; unprecedented economic distortions and imbalances on a global basis. And I find it rather ironic that Wall Street is so fervidly lambasting the Fed. For twenty years now the Fed has basically done everything that Wall Street requested and more.
It is also as ironic as it was predictable that Alan Greenspan - Ayn Rand “disciple” and free-market ideologue - championed monetary policies and a financial apparatus that will ensure the greatest government intrusion into our Nation’s financial and economic affairs since the New Deal. Articles berating contemporary Capitalism are becoming commonplace. I fear that the most important lesson from this experience may fail to resonate: that to promote sustainable free-market Capitalism for the real economy demands considerable general resolve to protect the soundness and stability of the underlying Credit system.
And, speaking of the Credit system, some brief market comments are in order. Stocks generally rallied this week, yet it was a backdrop that provided little comfort that the system has begun to stabilize. Sure, the banks rallied 10%, the homebuilders 20%, the retailers 7%, the transports almost 7%, and the restaurants 5%. One could easily assume that the bears were squeezed and leave it at that. There are, however, surely more complex and problematic dynamics at work. Notably, many of the favorite sectors were hit this week – the utilities, technology and biotechs all posted notable weakness. Coupled with this week’s extreme volatility, I will assume that the huge “market-neutral” and “quant” components of the leveraged speculating community have suffered even greater losses so far this month than those from last August. It is also worth noting that some important Credit spreads have diverged markedly, most notably many corporate, junk and commercial MBS spreads have widened as dollar swap spreads have narrowed. The spectacular Treasury melt-up must also be causing havoc for various strategies, ditto the recently strong yen and Swiss franc.
I’ll stick with the view that an unfolding breakdown in various trading models and hedging strategies is at risk of precipitating a crisis of confidence for the leveraged speculating community. I suspect hedge fund trading was much more responsible for chaotic global securities markets this week than a rogue French equities trader. There is, unfortunately, little prospect for markets to calm down anytime soon. There is no quick or easy fix to any of the myriad current problems – seized up securitization markets, sinking housing prices, faltering bond insurers, counterparty issues, a crisis in confidence for “Wall Street finance”, or acute economic vulnerability - to name only the most obvious. Again, they’ve been More than 20 Years in the Making.
24 January 2008
Soros calls it right
The current financial crisis was precipitated by a bubble in the US housing market. In some ways it resembles other crises that have occurred since the end of the second world war at intervals ranging from four to 10 years.
However, there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.
Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available. A bubble starts when people buy houses in the expectation that they can refinance their mortgages at a profit. The recent US housing boom is a case in point. The 60-year super-boom is a more complicated case.
Every time the credit expansion ran into trouble the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy. That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion. The system was so successful that people came to believe in what former US president Ronald Reagan called the magic of the marketplace and I call market fundamentalism. Fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest. It is an obvious misconception, because it was the intervention of the authorities that prevented financial markets from breaking down, not the markets themselves. Nevertheless, market fundamentalism emerged as the dominant ideology in the 1980s, when financial markets started to become globalised and the US started to run a current account deficit.
Globalisation allowed the US to suck up the savings of the rest of the world and consume more than it produced. The US current account deficit reached 6.2 per cent of gross national product in 2006. The financial markets encouraged consumers to borrow by introducing ever more sophisticated instruments and more generous terms. The authorities aided and abetted the process by intervening whenever the global financial system was at risk. Since 1980, regulations have been progressively relaxed until they have practically disappeared.
The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility.
Everything that could go wrong did. What started with subprime mortgages spread to all collateralised debt obligations, endangered municipal and mortgage insurance and reinsurance companies and threatened to unravel the multi-trillion-dollar credit default swap market. Investment banks' commitments to leveraged buyouts became liabilities. Market-neutral hedge funds turned out not to be market-neutral and had to be unwound. The asset-backed commercial paper market came to a standstill and the special investment vehicles set up by banks to get mortgages off their balance sheets could no longer get outside financing. The final blow came when interbank lending, which is at the heart of the financial system, was disrupted because banks had to husband their resources and could not trust their counterparties. The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever befor e. That made the crisis more severe than any since the second world war.
Credit expansion must now be followed by a period of contraction, because some of the new credit instruments and practices are unsound and unsustainable. The ability of the financial authorities to stimulate the economy is constrained by the unwillingness of the rest of the world to accumulate additional dollar reserves. Until recently, investors were hoping that the US Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realise that the Fed may no longer be in a position to do so. With oil, food and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an en d.
Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.
The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse.
The writer is chairman of Soros Fund Management
However, there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.
Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available. A bubble starts when people buy houses in the expectation that they can refinance their mortgages at a profit. The recent US housing boom is a case in point. The 60-year super-boom is a more complicated case.
Every time the credit expansion ran into trouble the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy. That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion. The system was so successful that people came to believe in what former US president Ronald Reagan called the magic of the marketplace and I call market fundamentalism. Fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest. It is an obvious misconception, because it was the intervention of the authorities that prevented financial markets from breaking down, not the markets themselves. Nevertheless, market fundamentalism emerged as the dominant ideology in the 1980s, when financial markets started to become globalised and the US started to run a current account deficit.
Globalisation allowed the US to suck up the savings of the rest of the world and consume more than it produced. The US current account deficit reached 6.2 per cent of gross national product in 2006. The financial markets encouraged consumers to borrow by introducing ever more sophisticated instruments and more generous terms. The authorities aided and abetted the process by intervening whenever the global financial system was at risk. Since 1980, regulations have been progressively relaxed until they have practically disappeared.
The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility.
Everything that could go wrong did. What started with subprime mortgages spread to all collateralised debt obligations, endangered municipal and mortgage insurance and reinsurance companies and threatened to unravel the multi-trillion-dollar credit default swap market. Investment banks' commitments to leveraged buyouts became liabilities. Market-neutral hedge funds turned out not to be market-neutral and had to be unwound. The asset-backed commercial paper market came to a standstill and the special investment vehicles set up by banks to get mortgages off their balance sheets could no longer get outside financing. The final blow came when interbank lending, which is at the heart of the financial system, was disrupted because banks had to husband their resources and could not trust their counterparties. The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever befor e. That made the crisis more severe than any since the second world war.
Credit expansion must now be followed by a period of contraction, because some of the new credit instruments and practices are unsound and unsustainable. The ability of the financial authorities to stimulate the economy is constrained by the unwillingness of the rest of the world to accumulate additional dollar reserves. Until recently, investors were hoping that the US Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realise that the Fed may no longer be in a position to do so. With oil, food and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an en d.
Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.
The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse.
The writer is chairman of Soros Fund Management
22 January 2008
Supkis on Money and Magic
Money and magic: they are like intertwined snakes. They have the same properties. One of the top tricks of all magicians is the ability to make things vanish in a flash or reappear suddenly out of nowhere. Money does this, too, and for the same effects. The Brothers Grimm in Germany collected odd fairy tales. One important one is called 'Godfather Death.'
A man's wife had a thirteenth child. The father knew this was a magical child so he sought out the most powerful godfather for him. God, himself, came and offered to be the child's guardian. 'No, you give to the rich and let the poor starve,' said the man [aren't peasants cynical?]. Then the Devil came with the same offer and added lots of gold, too. 'No,' said the man, 'You are a liar.' Then Death said he would make all men equal in the end.' The peasant agreed this was a good thing [being at heart, a revolutionary, eh?].
Death then said, 'Of course, I also control the source of all wealth and gold as well as life. I will make your son rich and powerful.' But even with Death guiding him and getting very wealthy, the boy grew up and decided he wanted more and more and more. He began to interfere with Death and one day, prevented Death from carrying off a princess. So Death carried him off, instead, to the rage and horror of the godson.
When Spain found the New World, all they wanted was the gold. There was lots of gold in the New World unlike the old world where it had been mined our sought for thousands of years and thus, harder to get. The vast gold wealth of the New World came at a terrible price. Most of the people living innocently in the midst of this metal, innocent stone-age people, were worked to death, died of disease. Then, to make more wealth, millions of innocent Africans were rounded up and shipped to this world to toil in the mines and fields, producing wealth. Their only reward was death.
As we see the world go through another vaporization of vast wealth, we must remember that the real wealth is right under our feet and is all around us in the form of Nature, Life and Love. Love is as infinite as Wealth but unlike Wealth, it is Life, not Death. The wife of the peasant in the old story here had lots of love and lots of life. The godson saved the Princess not because he loved her but because he lusted for her and that was why he was punished. He wanted her body and her powerful position. If he loved her, he would have asked Death to take him, not her. But he didn't want to do that.
We are going to see a scramble as everyone will grab at every possible physical thing they can as money vaporizes. This rush to Safety does not surprise me. I have had a very rough life. I went from jet setting around the world to hitch hiking due to no money. I have lived several times in mansions, one of which I bought with cash I earned, myself. I have lived on the streets. At one point, we all lived in a tent complex I built out of cast off building materials from the dump...for ten years!
Now I live in a beautiful house on a mountain which I designed and built mostly by myself. With my son assisting as much as he could as he grew up. I have seen money come and vanish. And it vanishes very fast! A great deal can turn into a great liability in a matter of hours in a crash. If we let easy gains go to our heads or swift losses drive us to despair, we are missing the truth of Life.
Life is living. Some readers may be mystified as to why I pointed out the distress of the mothers of Gaza on today, of all days. To me, they are a clear indication of what is important: children are dying. A muscular move is being made in the real world, not the magic world of mirrors in the stock markets. People are dying. In Kenya, an election was stolen and people are dying in riots and insurrections. In Burma, the priests were put brutally down while the world did nothing. Pakistan seethes and bombs go off. Around the world, workers are going hungry due to the sudden rise in oil and food prices. We must feel the mercy of the angels in all this, not fret about the magic money.
The people who mastered the magic formulas and who got ahold of the power levers that controls magic money making got greedy and silly about this and pushed all the levers to the 'Endless Wealth' level. They set the system to make infinite money, forgetting that this means Death will take over as always.
The history of bubbles is long and well-known for hundreds of years yet the very sophisticated and powerful people at the top of global society have decided yet again. to create bubbles and blow them up as much as possible. Tomorrow will bring ruin to many here in America. They will run to the rulers and hold out their hands and beg to be saved from the follies of the rulers. The rulers will go to Death and demand more gold, more power and more land. 'Make us gods!' they will order, sternly. And Death will flick a finger and more wealth will vanish. Poof.
Alas, the temptation to use the ultimate tool for wealth and power will rise before everyone's eyes. What does a bank robber, a Spanish conquistador, a Napoleon, a Hitler do when they need money? It is too tempting, too simple: kill someone who has something to steal. No one can steal anything from the US that we can't take back using our nukes, no one but...China.
And we can see the world is breaking in two. Instead of the usual money flow we are accustomed to over the last 50 years we have a new flow. It was initiated last July after the G7 nations chose to protect the Japanese 0.5% carry trade that is flooding the world with liquidity in the form of debts being piled all over the place. China called a halt to all this. They said, if the yuan must rise in value, so must the yen. This logic is all-important. But the G7 refused so China has begun a process of shutting down inflation, shutting down the financial machine of the world. They did this by raising interest rates, bank ratios and instituting severe economic curbs that are now hammering world monetary flows.
It doesn't take much to reset a system. In nature, a few degrees difference in the oceans or atmosphere can trigger vast ice sheets or tremendous warmth. Scientists call these changes 'flips' and the economic world 'flips' all the time. These resets or redirections are like when the earth suddenly shifts north and south polarities. This happens regularly on this earth. We are very near such a flip. We have no idea how this will impact nature or our machines. The earth also resets whole regions moving them suddenly many yards or even a mile in one split second. Huge waves can appear out of nowhere and wash away millions of people. Volcanoes can suddenly erupt of a meteorite strike a city. Or nuclear bombs can be launched without warning.
The Chinese simply changed their plans for their banking system. They wanted to negotiate a consensus for change and have the Bank of Japan, in particular, raise rates and the value of the yen. Everyone knows the dollar is worthless but all the central banks of all our trade partners who have surpluses with us have kept the dollar stronger than it really should be. The Chinese wanted to change this the proper way, everyone cooperating.
But the whole INVESTMENT world is addicted to the Japanese carry trade. The Chinese proposals last summer irritated these people who are also our rulers. They told China to go to hell. They imagine the Chinese can be cheated out of their funds and think that if China uses these funds to buy up the West, they will simply lose it if the wealth vanishes.
But magic money has very odd properties. If we wish to cheat the Chinese, the vanishing act will destroy us. The money will not be in the top hat when the magician reaches in but out pops Death in all his malicious gory glory. For the Chinese are not the Japanese nor the Germans. They have a huge military and nuclear bombs. China can't be penned in while we mock them as we rub our hands with glee over the idea of cheating them.
People forget that the US has enemies. People hate us. And we can't play magic money games which involves cheating our trade partners. We won't go home, laughing. They will follow us and do something nasty. The US thinks, our nukes will protect us but we can't rule the world as bankrupts and liars. Any more than Russia could under the communists.
A man's wife had a thirteenth child. The father knew this was a magical child so he sought out the most powerful godfather for him. God, himself, came and offered to be the child's guardian. 'No, you give to the rich and let the poor starve,' said the man [aren't peasants cynical?]. Then the Devil came with the same offer and added lots of gold, too. 'No,' said the man, 'You are a liar.' Then Death said he would make all men equal in the end.' The peasant agreed this was a good thing [being at heart, a revolutionary, eh?].
Death then said, 'Of course, I also control the source of all wealth and gold as well as life. I will make your son rich and powerful.' But even with Death guiding him and getting very wealthy, the boy grew up and decided he wanted more and more and more. He began to interfere with Death and one day, prevented Death from carrying off a princess. So Death carried him off, instead, to the rage and horror of the godson.
When Spain found the New World, all they wanted was the gold. There was lots of gold in the New World unlike the old world where it had been mined our sought for thousands of years and thus, harder to get. The vast gold wealth of the New World came at a terrible price. Most of the people living innocently in the midst of this metal, innocent stone-age people, were worked to death, died of disease. Then, to make more wealth, millions of innocent Africans were rounded up and shipped to this world to toil in the mines and fields, producing wealth. Their only reward was death.
As we see the world go through another vaporization of vast wealth, we must remember that the real wealth is right under our feet and is all around us in the form of Nature, Life and Love. Love is as infinite as Wealth but unlike Wealth, it is Life, not Death. The wife of the peasant in the old story here had lots of love and lots of life. The godson saved the Princess not because he loved her but because he lusted for her and that was why he was punished. He wanted her body and her powerful position. If he loved her, he would have asked Death to take him, not her. But he didn't want to do that.
We are going to see a scramble as everyone will grab at every possible physical thing they can as money vaporizes. This rush to Safety does not surprise me. I have had a very rough life. I went from jet setting around the world to hitch hiking due to no money. I have lived several times in mansions, one of which I bought with cash I earned, myself. I have lived on the streets. At one point, we all lived in a tent complex I built out of cast off building materials from the dump...for ten years!
Now I live in a beautiful house on a mountain which I designed and built mostly by myself. With my son assisting as much as he could as he grew up. I have seen money come and vanish. And it vanishes very fast! A great deal can turn into a great liability in a matter of hours in a crash. If we let easy gains go to our heads or swift losses drive us to despair, we are missing the truth of Life.
Life is living. Some readers may be mystified as to why I pointed out the distress of the mothers of Gaza on today, of all days. To me, they are a clear indication of what is important: children are dying. A muscular move is being made in the real world, not the magic world of mirrors in the stock markets. People are dying. In Kenya, an election was stolen and people are dying in riots and insurrections. In Burma, the priests were put brutally down while the world did nothing. Pakistan seethes and bombs go off. Around the world, workers are going hungry due to the sudden rise in oil and food prices. We must feel the mercy of the angels in all this, not fret about the magic money.
The people who mastered the magic formulas and who got ahold of the power levers that controls magic money making got greedy and silly about this and pushed all the levers to the 'Endless Wealth' level. They set the system to make infinite money, forgetting that this means Death will take over as always.
The history of bubbles is long and well-known for hundreds of years yet the very sophisticated and powerful people at the top of global society have decided yet again. to create bubbles and blow them up as much as possible. Tomorrow will bring ruin to many here in America. They will run to the rulers and hold out their hands and beg to be saved from the follies of the rulers. The rulers will go to Death and demand more gold, more power and more land. 'Make us gods!' they will order, sternly. And Death will flick a finger and more wealth will vanish. Poof.
Alas, the temptation to use the ultimate tool for wealth and power will rise before everyone's eyes. What does a bank robber, a Spanish conquistador, a Napoleon, a Hitler do when they need money? It is too tempting, too simple: kill someone who has something to steal. No one can steal anything from the US that we can't take back using our nukes, no one but...China.
And we can see the world is breaking in two. Instead of the usual money flow we are accustomed to over the last 50 years we have a new flow. It was initiated last July after the G7 nations chose to protect the Japanese 0.5% carry trade that is flooding the world with liquidity in the form of debts being piled all over the place. China called a halt to all this. They said, if the yuan must rise in value, so must the yen. This logic is all-important. But the G7 refused so China has begun a process of shutting down inflation, shutting down the financial machine of the world. They did this by raising interest rates, bank ratios and instituting severe economic curbs that are now hammering world monetary flows.
It doesn't take much to reset a system. In nature, a few degrees difference in the oceans or atmosphere can trigger vast ice sheets or tremendous warmth. Scientists call these changes 'flips' and the economic world 'flips' all the time. These resets or redirections are like when the earth suddenly shifts north and south polarities. This happens regularly on this earth. We are very near such a flip. We have no idea how this will impact nature or our machines. The earth also resets whole regions moving them suddenly many yards or even a mile in one split second. Huge waves can appear out of nowhere and wash away millions of people. Volcanoes can suddenly erupt of a meteorite strike a city. Or nuclear bombs can be launched without warning.
The Chinese simply changed their plans for their banking system. They wanted to negotiate a consensus for change and have the Bank of Japan, in particular, raise rates and the value of the yen. Everyone knows the dollar is worthless but all the central banks of all our trade partners who have surpluses with us have kept the dollar stronger than it really should be. The Chinese wanted to change this the proper way, everyone cooperating.
But the whole INVESTMENT world is addicted to the Japanese carry trade. The Chinese proposals last summer irritated these people who are also our rulers. They told China to go to hell. They imagine the Chinese can be cheated out of their funds and think that if China uses these funds to buy up the West, they will simply lose it if the wealth vanishes.
But magic money has very odd properties. If we wish to cheat the Chinese, the vanishing act will destroy us. The money will not be in the top hat when the magician reaches in but out pops Death in all his malicious gory glory. For the Chinese are not the Japanese nor the Germans. They have a huge military and nuclear bombs. China can't be penned in while we mock them as we rub our hands with glee over the idea of cheating them.
People forget that the US has enemies. People hate us. And we can't play magic money games which involves cheating our trade partners. We won't go home, laughing. They will follow us and do something nasty. The US thinks, our nukes will protect us but we can't rule the world as bankrupts and liars. Any more than Russia could under the communists.
Doug Nolan -- Past Strategies have turned infeasible.
The Credit system is today an incredible mess. Literally Trillions of securities, previously valued in the marketplace based upon confidence in the underlying financial guarantees, are now suspect. This has severely impacted marketplace liquidity. And perhaps tens of Trillions of Credit and other derivative contracts are now subject to very serious counterparty issues. Many players throughout the Credit market are now severely impaired and have lost the capacity to hedge against/mitigate further losses.
To be sure, Discontinuous and Illiquid Markets have Wreaked Bloody Havoc on “dynamic” trading strategies used commonly to hedge various risks. I don’t believe it is hyperbole to suggest that “dynamic hedging” (in particular shorting Credit instruments to provide the necessary cashflows to pay on Credit derivative contracts written) became the critical linchpin of contemporary Wall Street risk intermediation. Yet today the models behind so many strategies that have come to permeate “contemporary finance” have completely broken down; the strategies of thousands of financial institutions - big and small - have turned infeasible.
From a macro perspective, Wall Street Risk Intermediation has essentially crashed and the “risk markets” essentially “seized up.” Almost across the board, the major risk operators are moving aggressively to rein in risk-taking. The leveraged speculating community is in turmoil. The “quants” are in a quandary. Basically, the entire market today desires, at least to some extent, to reduce/mitigate/transfer Credit and market risk. Inevitably, however, when “the market” is keen to hedge there’ll be no one with the necessary wherewithal to take the other side of The Trade. I have so many fears I don’t even know where to begin, although I will say that I am less than comfortable these days discussing individual companies. Tonight the (brief) analysis will be in generalities.
There are scores of financial players – from small hedge funds to the major “money center banks” – with complex books of derivative trades that now have a very serious problem. These “hedged books” contain various supposedly offsetting risk exposures that, in there entirety, were to (through financial “alchemy”) have created a reasonable and manageable portfolio risk profile. But the breakdown in Wall Street finance has transformed these too often highly leveraged “books” into essentially unmanageable “toxic waste” and financial land mines.
First, correlations between various instruments have broken down (i.e. junk bond spreads widen while “dollar swap spreads” narrow). Second, the liquidity profile (hence pricing) of various sectors has diverged radically (i.e. agency MBS vs. “private-label” MBS/ABS) - with the Treasury market melt-up causing further destabilization. Third, with the breakdown in Wall Street’s “private-label” MBS market and the collapse in confidence in the “monoline” Credit insurers, liquidity has all but evaporated throughout huge cross-sections of the debt securities and related derivatives markets. This dynamic is fomenting dangerous counter-party risks and uncertainties. The capacity of a rapidly rising number of market participants to fulfill their obligations in various types of derivative and “insurance” contracts is in question.
Imagine you have a “hedged book” of securities and derivative – for example a portfolio of CDOs hedged with Credit Default Swaps (CDS) from one of the “monoline financial guarantors.” Today, the value of your CDO portfolio is declining while the “value” of your offsetting CDS hedge is impaired by the increasing likelihood of a default by the “monoline” (who provided the CDO default “insurance”). The reality is that the hedged position has broken down and risk now rises by the day. And, unfortunately, your options are decidedly limited - there is little if any liquidity to sell the underlying CDO. One could go into the market and attempt to buy additional protection, although in many cases the cost would be prohibitive. Besides, there’s today little assurance that counter-party risks wouldn’t emerge in the second hedge as well.
The Wall Street firms and many of the more sophisticated hedge funds run very complex “books” of securities and derivatives. The dilemma they face today is commensurate with the complexity of their strategies. Recent developments – in particular heightened marketplace illiquidity, rising probabilities of “monoline” defaults, dislocation in the CDS markets, and a breakdown in typical correlations between instruments/sectors/markets – makes the job of effectively comprehending, quantifying, analyzing and managing risk impossible. Do the managers, then, attempt the highly problematic task of recalibrating hedges based on current conditions (i.e. spiking hedging costs, likely counterparty defaults, and recent market correlations) and risk compounding the problem if market conditions begin to normalize? Is it feasible for these players to recalibrate hedges, knowing full well that our well-intentioned policymakers are destined to intervene clumsily in the marketplace?
It is difficult for me to believe the leveraged speculating community is not in serious jeopardy. It became all too commonplace to leverage illiquid (and difficult to price) securities, while even the previously liquid markets today barely trade. Few speculative Bubbles in history were as vulnerable to a “run.” None were remotely as gigantic or global in scope. This “community” today creates a systemic weak link on several fronts, certainly including the vulnerability to outsized losses and resulting redemptions instigating panic dynamics. Today, market illiquidity increases the likelihood that many funds will be forced to halt redemptions. This dynamic has commenced and it holds the potential to batter industry trust and confidence.
The leveraged speculators create various systemic risks. Their desire to hedge risk exposures – as well as seek speculative profits – during market turbulence has certainly exacerbated the Credit Crisis. During the cycle’s upside, their affinity for leveraging securities greatly amplified the liquidity bull run. Today, their selling/deleveraging/hedging foments liquidity crisis, fear and market dislocation. Importantly, the speculators are today keen to short stocks, sell futures, and purchase equity put options. The “hedge funds” have, after all, sold themselves as capable of minting money in any kind of market environment. This could prove a major systemic risk.
Leveraged speculator dynamics in concert with a Bursting Credit Bubble now places enormous stains on the stock market. Not only have faltering Credit Availability and Credit Marketplace Liquidity dramatically diminished the prospects for companies, industries and the general economy. Limited liquidity in the Credit market has also created a backdrop where those seeking to hedge (or profit from) heightened systemic risks have few places to go for relatively liquid trading outside selling stocks and equity index products. And sinking stock prices further aggravates the unfolding Corporate Credit Crisis, fostering only greater systemic stress and greater selling pressure. “Contemporary finance” is being exposed as a daisy-chain of interrelated weak underlying structures, unrecognized risks and acute fragilities.
To be sure, Discontinuous and Illiquid Markets have Wreaked Bloody Havoc on “dynamic” trading strategies used commonly to hedge various risks. I don’t believe it is hyperbole to suggest that “dynamic hedging” (in particular shorting Credit instruments to provide the necessary cashflows to pay on Credit derivative contracts written) became the critical linchpin of contemporary Wall Street risk intermediation. Yet today the models behind so many strategies that have come to permeate “contemporary finance” have completely broken down; the strategies of thousands of financial institutions - big and small - have turned infeasible.
From a macro perspective, Wall Street Risk Intermediation has essentially crashed and the “risk markets” essentially “seized up.” Almost across the board, the major risk operators are moving aggressively to rein in risk-taking. The leveraged speculating community is in turmoil. The “quants” are in a quandary. Basically, the entire market today desires, at least to some extent, to reduce/mitigate/transfer Credit and market risk. Inevitably, however, when “the market” is keen to hedge there’ll be no one with the necessary wherewithal to take the other side of The Trade. I have so many fears I don’t even know where to begin, although I will say that I am less than comfortable these days discussing individual companies. Tonight the (brief) analysis will be in generalities.
There are scores of financial players – from small hedge funds to the major “money center banks” – with complex books of derivative trades that now have a very serious problem. These “hedged books” contain various supposedly offsetting risk exposures that, in there entirety, were to (through financial “alchemy”) have created a reasonable and manageable portfolio risk profile. But the breakdown in Wall Street finance has transformed these too often highly leveraged “books” into essentially unmanageable “toxic waste” and financial land mines.
First, correlations between various instruments have broken down (i.e. junk bond spreads widen while “dollar swap spreads” narrow). Second, the liquidity profile (hence pricing) of various sectors has diverged radically (i.e. agency MBS vs. “private-label” MBS/ABS) - with the Treasury market melt-up causing further destabilization. Third, with the breakdown in Wall Street’s “private-label” MBS market and the collapse in confidence in the “monoline” Credit insurers, liquidity has all but evaporated throughout huge cross-sections of the debt securities and related derivatives markets. This dynamic is fomenting dangerous counter-party risks and uncertainties. The capacity of a rapidly rising number of market participants to fulfill their obligations in various types of derivative and “insurance” contracts is in question.
Imagine you have a “hedged book” of securities and derivative – for example a portfolio of CDOs hedged with Credit Default Swaps (CDS) from one of the “monoline financial guarantors.” Today, the value of your CDO portfolio is declining while the “value” of your offsetting CDS hedge is impaired by the increasing likelihood of a default by the “monoline” (who provided the CDO default “insurance”). The reality is that the hedged position has broken down and risk now rises by the day. And, unfortunately, your options are decidedly limited - there is little if any liquidity to sell the underlying CDO. One could go into the market and attempt to buy additional protection, although in many cases the cost would be prohibitive. Besides, there’s today little assurance that counter-party risks wouldn’t emerge in the second hedge as well.
The Wall Street firms and many of the more sophisticated hedge funds run very complex “books” of securities and derivatives. The dilemma they face today is commensurate with the complexity of their strategies. Recent developments – in particular heightened marketplace illiquidity, rising probabilities of “monoline” defaults, dislocation in the CDS markets, and a breakdown in typical correlations between instruments/sectors/markets – makes the job of effectively comprehending, quantifying, analyzing and managing risk impossible. Do the managers, then, attempt the highly problematic task of recalibrating hedges based on current conditions (i.e. spiking hedging costs, likely counterparty defaults, and recent market correlations) and risk compounding the problem if market conditions begin to normalize? Is it feasible for these players to recalibrate hedges, knowing full well that our well-intentioned policymakers are destined to intervene clumsily in the marketplace?
It is difficult for me to believe the leveraged speculating community is not in serious jeopardy. It became all too commonplace to leverage illiquid (and difficult to price) securities, while even the previously liquid markets today barely trade. Few speculative Bubbles in history were as vulnerable to a “run.” None were remotely as gigantic or global in scope. This “community” today creates a systemic weak link on several fronts, certainly including the vulnerability to outsized losses and resulting redemptions instigating panic dynamics. Today, market illiquidity increases the likelihood that many funds will be forced to halt redemptions. This dynamic has commenced and it holds the potential to batter industry trust and confidence.
The leveraged speculators create various systemic risks. Their desire to hedge risk exposures – as well as seek speculative profits – during market turbulence has certainly exacerbated the Credit Crisis. During the cycle’s upside, their affinity for leveraging securities greatly amplified the liquidity bull run. Today, their selling/deleveraging/hedging foments liquidity crisis, fear and market dislocation. Importantly, the speculators are today keen to short stocks, sell futures, and purchase equity put options. The “hedge funds” have, after all, sold themselves as capable of minting money in any kind of market environment. This could prove a major systemic risk.
Leveraged speculator dynamics in concert with a Bursting Credit Bubble now places enormous stains on the stock market. Not only have faltering Credit Availability and Credit Marketplace Liquidity dramatically diminished the prospects for companies, industries and the general economy. Limited liquidity in the Credit market has also created a backdrop where those seeking to hedge (or profit from) heightened systemic risks have few places to go for relatively liquid trading outside selling stocks and equity index products. And sinking stock prices further aggravates the unfolding Corporate Credit Crisis, fostering only greater systemic stress and greater selling pressure. “Contemporary finance” is being exposed as a daisy-chain of interrelated weak underlying structures, unrecognized risks and acute fragilities.
This Is It! buy Gold!!!!
Author: Jim Sinclair
Dear CIGAs,
All those that have joined our email list by adding their email address above received the following on Tuesday, October 23, 2007. Make sure information@jsmineset.com is added to your safe senders list if you are having problems receiving emails.
Nothing has changed. There is no fundamental basis for the US dollar and as Trader Dan noted, the technical factors are certainly quite short term.
This Is It!
Posted On: Tuesday, October 23, 2007, 2:11:00 PM EST
Author: Jim Sinclair
Dear CIGAs,
Many of you have asked what exactly I mean by “This is it,” so here it is in point form:
There is a rampant, serious financial problem with terminal potential and no practical solution hidden just outside of the public’s view (OTC Derivatives).
Because central banks have gotten so out of hand and political which cannot be controlled by investors or the man in the street, we need to adjust our actions so that each person takes on the responsibilities normal to central banks for their own finances.
Everything we buy is getting more expensive and many assets people have, other than gold, are losing value. Because of this credit is not a proper idea regardless of the weak dollar for the majority of people reading this.
Major financial institutions, Internet financial entities and banks operate without transparency where their derivative holdings are concerned. Losses the financial institutions are publishing are considered by media as having extinguished all the risk. I do not believe this. I believe they are still marked to model, only the model is moving slowly towards reality of worthlessness.
There is an acceleration of bankruptcy among financial institutions. This translates to the individual needing to act as their own financial institution by having their share investments in paper form, gold in their close possession with no one in-between and available cash. The individual must be their own bank and central bank as one has failed us and both may.
The savings rate in the US is negative while the expansion of credit is totally over the top.
Business is turning south so the US Federal Budget Deficit will move up exponentially.
The US dollar has become a bombed out and lost battle zone. There is nothing good anyone can say fundamentally about the US dollar.
Non US entities are fed up with financing the US consumer and US Federal activities. This is clear from the recent TIC report, which is now down trending.
Financial privacy is non-existent.
There is a model for exactly what is happening now and that is the Weimar Republic. Name war retributions as OTC derivatives and you begin to see the picture.
The US dollar has now made a clear indication of the final head and shoulders; the massive formation from the absolute top is breaking down.
Number 12 is the item that impacts all of the above because of the dollar’s technical position now beginning to reflect the dire fundamentals. This is it
This is it because you now have to perform not only as your own bank but also as your own central bank. This is it because the US dollar has completed a major head and shoulders bear formation, pulled back to the underside of the neckline and thereafter declining below the major support line drawn from the beginning of the big dollar bull under Chairman Paul Volcker. Volcker made the dollar and Greenspan gave it all back to Asia.
The dollar break below the recent and most important major, major support line drawn from 1980 to now is the fundamental basis which will push Gold to $1650. The US dollar is without any doubt in my mind is going to .7200, followed by .6200.
Ladies and gentlemen, prepare to defend yourselves.
Dear CIGAs,
All those that have joined our email list by adding their email address above received the following on Tuesday, October 23, 2007. Make sure information@jsmineset.com is added to your safe senders list if you are having problems receiving emails.
Nothing has changed. There is no fundamental basis for the US dollar and as Trader Dan noted, the technical factors are certainly quite short term.
This Is It!
Posted On: Tuesday, October 23, 2007, 2:11:00 PM EST
Author: Jim Sinclair
Dear CIGAs,
Many of you have asked what exactly I mean by “This is it,” so here it is in point form:
There is a rampant, serious financial problem with terminal potential and no practical solution hidden just outside of the public’s view (OTC Derivatives).
Because central banks have gotten so out of hand and political which cannot be controlled by investors or the man in the street, we need to adjust our actions so that each person takes on the responsibilities normal to central banks for their own finances.
Everything we buy is getting more expensive and many assets people have, other than gold, are losing value. Because of this credit is not a proper idea regardless of the weak dollar for the majority of people reading this.
Major financial institutions, Internet financial entities and banks operate without transparency where their derivative holdings are concerned. Losses the financial institutions are publishing are considered by media as having extinguished all the risk. I do not believe this. I believe they are still marked to model, only the model is moving slowly towards reality of worthlessness.
There is an acceleration of bankruptcy among financial institutions. This translates to the individual needing to act as their own financial institution by having their share investments in paper form, gold in their close possession with no one in-between and available cash. The individual must be their own bank and central bank as one has failed us and both may.
The savings rate in the US is negative while the expansion of credit is totally over the top.
Business is turning south so the US Federal Budget Deficit will move up exponentially.
The US dollar has become a bombed out and lost battle zone. There is nothing good anyone can say fundamentally about the US dollar.
Non US entities are fed up with financing the US consumer and US Federal activities. This is clear from the recent TIC report, which is now down trending.
Financial privacy is non-existent.
There is a model for exactly what is happening now and that is the Weimar Republic. Name war retributions as OTC derivatives and you begin to see the picture.
The US dollar has now made a clear indication of the final head and shoulders; the massive formation from the absolute top is breaking down.
Number 12 is the item that impacts all of the above because of the dollar’s technical position now beginning to reflect the dire fundamentals. This is it
This is it because you now have to perform not only as your own bank but also as your own central bank. This is it because the US dollar has completed a major head and shoulders bear formation, pulled back to the underside of the neckline and thereafter declining below the major support line drawn from the beginning of the big dollar bull under Chairman Paul Volcker. Volcker made the dollar and Greenspan gave it all back to Asia.
The dollar break below the recent and most important major, major support line drawn from 1980 to now is the fundamental basis which will push Gold to $1650. The US dollar is without any doubt in my mind is going to .7200, followed by .6200.
Ladies and gentlemen, prepare to defend yourselves.
18 January 2008
3 January 2008
Insight: Post credit bubble wealth transfer will beggar belief
By John Plender, chairman of Quintain
When financial market bubbles burst, a transfer of assets from the weak and undercapitalised to the strong and liquid invariably follows. The unprecedented scale of the credit bubble that burst last August suggests that the extent of the resulting wealth transfer will beggar belief.
The process is already well under way. So far, sovereign wealth funds have mopped up some $25bn worth of equity and debt in Citigroup, UBS, Merrill Lynch and Morgan Stanley. One of the safest predictions for 2008 is that this will lead to political friction of the beggar-thy-neighbour kind, with Western politicians complaining that their financial crown jewels are being sold for a song. Yet it is far from clear that the jewels are outright bargains.
In the long run it is admittedly hard not to believe that investing in an 11 per cent IOU in Citigroup with conversion rights attached represents good value. That said, it is possible that this and other comparable investments might be available on better terms at a later date. For while the immediate liquidity problems of the banks have been dealt with over the December 31 year end, more intractable difficulties remain.
A consequence of banks having set up off-balance sheet vehicles such as conduits and structured investment vehicles is that they are now having to put illiquid assets back on to the balance sheet under back-up agreements.
Those assets are piling up uncomfortably fast in relation to the banks’ ability to attract stable funding. They also put strain on bank capital just when dud assets are having to be marked-to-market under the eagle eye of auditors. After the experience of Enron, the Big Four firms are hell bent on providing a pro-cyclical twist to a dangerous financial downturn to protect their backs.
Meantime, a deterioration in credit quality is spreading from subprime mortgages across the financial system. The combined capital and liquidity constraint on the banks is in turn having a malign impact on the real economy where the banks will themselves induce a second round of asset transfers from weak to strong as they tighten lending conditions or put in insolvency experts, especially lower down the business scale.
A final problem is that until all the complex mortgage related structured products can be valued in a way that carries conviction, valuing banks will be a hazardous process. Much hitherto lucrative securitisation business may have gone for ever. The one certainty is that much more capital will have to be raised.
Then there is a currency question. To the extent that their investments in the west are unhedged, sovereign wealth funds take a big risk. There must be a fair chance that the dollar could weaken even further as financial unbalances in the US continue to unwind. There are few safe bets in currency markets, but in Europe the nearest thing to one is that sterling, attached to a debt-sodden UK economy afflicted with larger financial imbalances than the US, will sink. Those high growth economies of eastern Europe that have large current account deficits look similarly vulnerable on the currency front. So while there will be opportunities to buy these countries’ assets cheaply, the timing will be tricky.
For western politicians to complain about the loss of crown jewels is special pleading of a particularly invidious kind. For there is a marked similarity in what is happening today to what happened in the 1997-98 crisis in Asia. Then hot money from western banks exacerbated financial bubbles and inflation across the region. When the hot money pulled out, more stable western funds snapped up Asian assets on the cheap. Now official money from Asia and from the petro-economies has contributed to the western credit bubble. And the sovereign wealth funds are mopping up after the burst.
The significant difference is that the debacle in Asia was followed by truly appalling losses in output and employment whereas the US is merely at risk of recession rather than slump. Not only is hypocrisy an issue here. There is folly when people in current-account glasshouses throw protectionist stones.
When financial market bubbles burst, a transfer of assets from the weak and undercapitalised to the strong and liquid invariably follows. The unprecedented scale of the credit bubble that burst last August suggests that the extent of the resulting wealth transfer will beggar belief.
The process is already well under way. So far, sovereign wealth funds have mopped up some $25bn worth of equity and debt in Citigroup, UBS, Merrill Lynch and Morgan Stanley. One of the safest predictions for 2008 is that this will lead to political friction of the beggar-thy-neighbour kind, with Western politicians complaining that their financial crown jewels are being sold for a song. Yet it is far from clear that the jewels are outright bargains.
In the long run it is admittedly hard not to believe that investing in an 11 per cent IOU in Citigroup with conversion rights attached represents good value. That said, it is possible that this and other comparable investments might be available on better terms at a later date. For while the immediate liquidity problems of the banks have been dealt with over the December 31 year end, more intractable difficulties remain.
A consequence of banks having set up off-balance sheet vehicles such as conduits and structured investment vehicles is that they are now having to put illiquid assets back on to the balance sheet under back-up agreements.
Those assets are piling up uncomfortably fast in relation to the banks’ ability to attract stable funding. They also put strain on bank capital just when dud assets are having to be marked-to-market under the eagle eye of auditors. After the experience of Enron, the Big Four firms are hell bent on providing a pro-cyclical twist to a dangerous financial downturn to protect their backs.
Meantime, a deterioration in credit quality is spreading from subprime mortgages across the financial system. The combined capital and liquidity constraint on the banks is in turn having a malign impact on the real economy where the banks will themselves induce a second round of asset transfers from weak to strong as they tighten lending conditions or put in insolvency experts, especially lower down the business scale.
A final problem is that until all the complex mortgage related structured products can be valued in a way that carries conviction, valuing banks will be a hazardous process. Much hitherto lucrative securitisation business may have gone for ever. The one certainty is that much more capital will have to be raised.
Then there is a currency question. To the extent that their investments in the west are unhedged, sovereign wealth funds take a big risk. There must be a fair chance that the dollar could weaken even further as financial unbalances in the US continue to unwind. There are few safe bets in currency markets, but in Europe the nearest thing to one is that sterling, attached to a debt-sodden UK economy afflicted with larger financial imbalances than the US, will sink. Those high growth economies of eastern Europe that have large current account deficits look similarly vulnerable on the currency front. So while there will be opportunities to buy these countries’ assets cheaply, the timing will be tricky.
For western politicians to complain about the loss of crown jewels is special pleading of a particularly invidious kind. For there is a marked similarity in what is happening today to what happened in the 1997-98 crisis in Asia. Then hot money from western banks exacerbated financial bubbles and inflation across the region. When the hot money pulled out, more stable western funds snapped up Asian assets on the cheap. Now official money from Asia and from the petro-economies has contributed to the western credit bubble. And the sovereign wealth funds are mopping up after the burst.
The significant difference is that the debacle in Asia was followed by truly appalling losses in output and employment whereas the US is merely at risk of recession rather than slump. Not only is hypocrisy an issue here. There is folly when people in current-account glasshouses throw protectionist stones.
24 December 2007
Life after peak oil -- better for everyone!
Following an initial period of painful adaptation, we can live happily and healthily in a world with high energy costs
By Gregory Clark - Special To The Bee
Published 12:00 am PST Sunday, December 23, 2007
Oil prices have receded from their recent flirtation with $100 a barrel, but demand soars from China and India, rapidly industrializing countries with a massive energy thirst. The combination of increased demand, high prices and the prospect of an eventual peak in oil production, has caught Americans paralyzed between twin terrors: the fear that rampant consumption of oil and coal is irreversibly warming the Earth and the dread that without cheap oil our affluent lifestyles will evaporate.
Can't live with oil, can't live without it.
Study of the long economic history of the world suggests two things, however. Cheap fossil fuels actually explain little of how we got rich since the Industrial Revolution. And after an initial period of painful adaptation, we can live happily, opulently and indeed more healthily, in a world of permanent $100-a-barrel oil or even $500-a-barrel oil.
The first lesson of history is that cheap energy explains only a modest portion of our current wealth. We are now, as a result of the Industrial Revolution, 12 times richer than the average person in the pre-industrial world. Modern economic growth has been accompanied by huge declines in energy costs from exploiting coal and oil. A worker today can buy a gallon of gas with his wages from 20 minutes of work. Before the Industrial Revolution to buy the energy in a gallon of gas the English worker of the 1760s needed to work four hours.
As energy prices declined consumption rose. Currently in the United States we consume the equivalent in energy of six gallons of gas per person per day. In England in 1770 energy consumption (mainly coal) was equivalent to only 0.5 gallons of gas per day.
Many people think mistakenly that modern prosperity was founded on this fossil energy revolution, and that when the oil and coal is gone, it is back to the Stone Age. If we had no fossil energy, then we would be forced to rely on an essentially unlimited amount of solar power, available at five times current energy costs. With energy five times as expensive as at present we would take a substantial hit to incomes. Our living standard would decline by about 11 percent. But we would still be fantastically rich compared to the pre-industrial world.
That may seem like a lot of economic hurt, but put it in context. Our income would still be above the current living standards in Canada, Sweden or England. Oh, the suffering humanity! At current rates of economic growth we would gain back the income losses from having to convert to solar power in less than six years. And then onward on our march to ever greater prosperity.
The ability to sustain such high energy prices at little economic cost depends on the assumption that we can cut back from using the equivalent of six gallons of gas per person per day to 1.5 gallons. Is that really possible? The answer is that we know already it is.
The economy would withstand enormous increases in energy costs with modest damage because energy is even now so extravagantly cheap that most of it is squandered in uses of little value. Recently, I drove my 13-year-old son 230 miles round-trip from Davis to Chico, to play a 70-minute soccer game. Had every gallon of gas cost four hours of my wage, I am sure his team could have found opposition closer to home.
The median-sized U.S. home is now nearly 2,400 square feet, for an average family size of 2.6 people, almost 1,000 square feet per person. Much of that heated, air-conditioned and lighted square footage rarely gets used. Cities in the Central Valley, such as Elk Grove, that were developed in the world of cheap gas have sprawled across the landscape so that the only way to get to work or to shops is by car. Ninety-four percent of the inhabitants of Elk Grove drive to work. Sidewalks have disappeared in some locations.
Some countries in Europe, such as Denmark, which have by public policy made energy much more expensive, already use only the equivalent of about three gallons of gas per person. I have been to Copenhagen, and believe me the Danes are not suffering a lot from those the daily three gallons of gas they gave up.
But can we get down to 1.5 gallons without huge pain? We can see even now communities where for reasons of land scarcity people have been forced to adopt a lifestyle that uses much less energy – places like Manhattan, London or Singapore. Manhattan, for example, has 67,000 people per square mile. Kensington and Chelsea in London have 37,000 people per square mile. Housing space per person is much smaller, people walk or take public transit to work and to shop, and energy usage is correspondingly much lower, despite the inhabitants being very rich.
So the future after peak oil will involve living in such dense urban settings where destinations are walkable or bikeable, just as in pre-industrial cities (the city of London in 1801 had 100,000 inhabitants in one square mile). Homes will be much smaller, but instead of caverns of off-white sheet rock, we will spend our money in making much more attractive interiors. Nights will be darker. We will not have retail outlets lit up like the glare of the midday sun in Death Valley.
Such a lifestyle is not only possible it will be much healthier. We are not biologically adapted to the suburban lifestyle of Central California – lots of cheap calories delivered right to your seat in the SUV that shuttles you from your sofa at home, to your chair at work, to the gym where you try and work on your weight problem. It will also make aging more graceful. We now live as much in fear of losing our gas-fueled mobility as we age as we are of the Grim Reaper himself.
So life after peak oil should hold no terror for us – unless, of course, you have invested in a lot of suburban real estate.
By Gregory Clark - Special To The Bee
Published 12:00 am PST Sunday, December 23, 2007
Oil prices have receded from their recent flirtation with $100 a barrel, but demand soars from China and India, rapidly industrializing countries with a massive energy thirst. The combination of increased demand, high prices and the prospect of an eventual peak in oil production, has caught Americans paralyzed between twin terrors: the fear that rampant consumption of oil and coal is irreversibly warming the Earth and the dread that without cheap oil our affluent lifestyles will evaporate.
Can't live with oil, can't live without it.
Study of the long economic history of the world suggests two things, however. Cheap fossil fuels actually explain little of how we got rich since the Industrial Revolution. And after an initial period of painful adaptation, we can live happily, opulently and indeed more healthily, in a world of permanent $100-a-barrel oil or even $500-a-barrel oil.
The first lesson of history is that cheap energy explains only a modest portion of our current wealth. We are now, as a result of the Industrial Revolution, 12 times richer than the average person in the pre-industrial world. Modern economic growth has been accompanied by huge declines in energy costs from exploiting coal and oil. A worker today can buy a gallon of gas with his wages from 20 minutes of work. Before the Industrial Revolution to buy the energy in a gallon of gas the English worker of the 1760s needed to work four hours.
As energy prices declined consumption rose. Currently in the United States we consume the equivalent in energy of six gallons of gas per person per day. In England in 1770 energy consumption (mainly coal) was equivalent to only 0.5 gallons of gas per day.
Many people think mistakenly that modern prosperity was founded on this fossil energy revolution, and that when the oil and coal is gone, it is back to the Stone Age. If we had no fossil energy, then we would be forced to rely on an essentially unlimited amount of solar power, available at five times current energy costs. With energy five times as expensive as at present we would take a substantial hit to incomes. Our living standard would decline by about 11 percent. But we would still be fantastically rich compared to the pre-industrial world.
That may seem like a lot of economic hurt, but put it in context. Our income would still be above the current living standards in Canada, Sweden or England. Oh, the suffering humanity! At current rates of economic growth we would gain back the income losses from having to convert to solar power in less than six years. And then onward on our march to ever greater prosperity.
The ability to sustain such high energy prices at little economic cost depends on the assumption that we can cut back from using the equivalent of six gallons of gas per person per day to 1.5 gallons. Is that really possible? The answer is that we know already it is.
The economy would withstand enormous increases in energy costs with modest damage because energy is even now so extravagantly cheap that most of it is squandered in uses of little value. Recently, I drove my 13-year-old son 230 miles round-trip from Davis to Chico, to play a 70-minute soccer game. Had every gallon of gas cost four hours of my wage, I am sure his team could have found opposition closer to home.
The median-sized U.S. home is now nearly 2,400 square feet, for an average family size of 2.6 people, almost 1,000 square feet per person. Much of that heated, air-conditioned and lighted square footage rarely gets used. Cities in the Central Valley, such as Elk Grove, that were developed in the world of cheap gas have sprawled across the landscape so that the only way to get to work or to shops is by car. Ninety-four percent of the inhabitants of Elk Grove drive to work. Sidewalks have disappeared in some locations.
Some countries in Europe, such as Denmark, which have by public policy made energy much more expensive, already use only the equivalent of about three gallons of gas per person. I have been to Copenhagen, and believe me the Danes are not suffering a lot from those the daily three gallons of gas they gave up.
But can we get down to 1.5 gallons without huge pain? We can see even now communities where for reasons of land scarcity people have been forced to adopt a lifestyle that uses much less energy – places like Manhattan, London or Singapore. Manhattan, for example, has 67,000 people per square mile. Kensington and Chelsea in London have 37,000 people per square mile. Housing space per person is much smaller, people walk or take public transit to work and to shop, and energy usage is correspondingly much lower, despite the inhabitants being very rich.
So the future after peak oil will involve living in such dense urban settings where destinations are walkable or bikeable, just as in pre-industrial cities (the city of London in 1801 had 100,000 inhabitants in one square mile). Homes will be much smaller, but instead of caverns of off-white sheet rock, we will spend our money in making much more attractive interiors. Nights will be darker. We will not have retail outlets lit up like the glare of the midday sun in Death Valley.
Such a lifestyle is not only possible it will be much healthier. We are not biologically adapted to the suburban lifestyle of Central California – lots of cheap calories delivered right to your seat in the SUV that shuttles you from your sofa at home, to your chair at work, to the gym where you try and work on your weight problem. It will also make aging more graceful. We now live as much in fear of losing our gas-fueled mobility as we age as we are of the Grim Reaper himself.
So life after peak oil should hold no terror for us – unless, of course, you have invested in a lot of suburban real estate.
21 December 2007
The Catastrophist View
Peter Schiff is laughing at me. I’ve just asked him to entertain the following notion: that we dodged a bullet during August’s financial-market turmoil and, with the stock market bouncing right back from every dip, things might be okay. So why worry?
He stops laughing. “Why worry?” he asks. “Because we dodged a bullet but are about to step on a hand grenade.”
Sitting in a corner office of a nondescript building just off I-95 in Darien, Connecticut, Schiff, the president of brokerage Euro Pacific Capital, and author of Crash Proof: How to Profit From the Coming Economic Collapse, will spend the next hour spelling out a singularly pessimistic view of the American economy. And he will do so while exhibiting a curious juxtaposition unique to the bearish prognosticator: He speaks of disaster with a smile on his face. No, he’s not happy about our impending doom. But he is happy that people are finally taking him seriously.
Some people, anyway. The recessionary fears that were sparked by the global liquidity crisis in August have eased, largely because of a resilient stock market and a belief that the Federal Reserve’s interest-rate cut in September curtailed deeper losses. When Goldman Sachs invested in its own imploding Global Equity Opportunities hedge fund in August, calling it an “opportunity” and not a “rescue,” people laughed. Guess who laughed last? Goldman, which had reportedly enjoyed a $370 million gain on its $2 billion rescue by October. The optimists stay focused on stories like Steve Jobs’s next stroke of genius.
But Schiff, whom CNBC calls “Dr. Doom,” has not, as bears do when winter approaches, gone off to hide in a cave. Why not? Because every single one of the underlying economic factors that he has identified as cause for concern has worsened. And his is no longer a lone voice in the woods. If you don’t care to listen to a man nicknamed Dr. Doom, you can listen to people like former Federal Reserve chairman Alan Greenspan, esteemed bond-fund manager Bill Gross, or famed money manager Jeremy Grantham. They’re part of a growing chorus of voices that are saying many of the same things as Schiff.
Their bearish arguments come in many shapes and sizes, but here’s the basic one: The past five or six years have been deceptively fortunate ones for the U.S. economy. That’s because any troublesome developments—the surge in oil prices from $28 per barrel in 2003 to about $87 today, for example—have been papered over by rising home prices. Home equity has been used to buy flat-screen TVs, SUVs, and more homes. Wall Street bought up all this debt from lenders, thereby allowing them to lend more.
The softening of real-estate prices in most parts of the United States put a crimp in this system, but it hasn’t stopped it. The question is, what, if anything, will? What will bring on the apocalypse that Schiff and others believe is inevitable? They see it like this:
THREAT NO. 1
The Bottom Continues to Fall Out of the Housing Market
Manhattan’s gravity-defying real estate aside, it’s quite clear the nation is experiencing a genuine housing crisis. In August, pending home sales dropped 6.5 percent, and they currently sit at their lowest level since 2001. The National Association of Realtors conducted a recent survey that showed more than 10 percent of sales contracts fell through at the last moment in August, primarily owing to disappearing loan commitments from banks. The crisis will only deepen, when more borrowers see their adjustable-rate mortgages adjusted upward. There was a foreclosure filing for one of every 510 households in the country in August, the highest figure ever issued, and by one estimate, more than 1.7 million foreclosures will occur in the country by the end of 2008. That’s not just subprime borrowers: According to the Federal Housing Finance Board, while nearly 35 percent of conventional mortgages in 2004 used ARMs, some 70.7 percent of jumbo loans—those above $333,700 (the jumbo threshold in 2004; it’s now higher)—did too.
Historically, bond-market investors have been the boring counterparts to their equity-market brethren. But in his October Investment Outlook, famed bond investor Bill Gross was anything but. The managing director of money management firm pimco pointed out that the Federal Reserve is caught in a bind: It must continue to lower interest rates to ameliorate this burgeoning housing crisis, but in doing so, it “risks reigniting speculative equity market behavior, and … a run on the dollar.” (More on the dollar later.) Gross doesn’t have the answers but observes that the Fed is “in a pickle, and a sour one at that.” Worse yet, concerns that a rate cut might be inflationary actually caused bond yields to rise in the wake of the rate cut, something that doesn’t normally happen. The Fed’s influence, always overstated, might turn out to be nonexistent in a credit market that remains on edge.
Hedge-fund veteran Rick Bookstaber, the author of A Demon of Our Own Design, spells out a potentially disastrous scenario that could unfold regardless of what the Fed does: Continued foreclosures result in a further drop in housing prices, which results in further foreclosures, which result in a further drop in housing prices. Even for those of us not selling, reduced home values result in a reduced sense of security, which results in reduced consumption, which results in a slowing economy, which … you get the point.
Next: The derivatives-related meltdown, part II.
THREAT NO. 2
The Derivatives-Related Meltdown, Part II
Anybody who glances occasionally at the financial pages these days knows that mortgages issued to home buyers are packaged together (in a process called securitization) into a collateralized-debt obligation, or CDO. That’s what’s known as a derivative, a security whose value depends on the value of other securities. The price of the CDO, you see, is “derived” from the prices of the underlying mortgages. (It works with credit cards, too, or bank loans—any kind of debt will do.)
In principle, the idea of a CDO makes perfect sense. In buying $5 million worth of a CDO, an investor has essentially lent money to an entire portfolio of homeowners, instead of placing all his eggs in one basket, say, by funding a single $5 million mortgage. In the real-estate-crazy environment of the past decade, the CDO market took off like a rocket. But the buyers of these derivatives made a critical error—they confused the spreading of risk with the elimination of risk. A booming economy made this confusion not just possible but irresistible. With relatively few defaults in the first half of the decade, investment firms, including many hedge funds, came to see CDO returns as a sure thing and loaded up on them, often borrowing money to do so, taking on debt to buy debt and thereby setting up a potentially deadly chain reaction. The readiness of the secondary market to buy all these mortgages encouraged the lenders to run wild and lend to anyone who walked through the door, leading—inevitably, in retrospect—to a decline in loan quality. Analyst Christopher Wood of Asia-Pacific investment house CLSA succinctly defines the problem in his highly readable newsletter Greed & Fear: “[Securitization] has one fatal flaw, which will ultimately prove to be its undoing … it removes the incentive of those making the loan to worry about whether the loan is a good credit.”
Still, it all held together until mortgage defaults began to cut into the yields of these CDOs and holders looked to sell them, only to realize their value had slipped. Forced liquidations as a result of that “price discovery” were a primary factor in Bear Stearns’ hedge-fund calamity in August. And it’s not over yet: The aftershocks of the mortgage meltdown are still being felt, as banks such as Citigroup and Deutsche Bank announce multibillion-dollar write-downs.
Each time one of these write-downs has been announced, the market has had a curiously positive response, taking the news as a sign that the worst was over and the banks were cleaning up their books. But because these derivatives are linked to other debt, there’s no reason to be certain that trouble won’t bleed into other markets. Among other things, the liquidity crisis froze the market in structured investment vehicles (SIVs), a nifty bit of financial engineering that banks use to profit from the spread between short-term debt and long-term debt. No one yet knows how nasty these losses could turn out to be because SIVs are stashed, Enron style, off the books.
THREAT NO. 3
Consumers Run Out of Steam (and Take the Economy Down With Them)
The U.S. economy, for all its worldly sophistication, is driven by mall shoppers and late-night Amazon addicts—70 percent of the gross domestic product is accounted for by consumer spending, which is buttressed by debt. According to the Federal Reserve, total U.S. household debt was, as of August, $2.5 trillion—a 24 percent increase in the past five years. Total credit-card debt, including gas cards and the like, was $915 billion.
The willingness of consumers to keep spending and piling on debt in the midst of a slowing real-estate market is hailed on Wall Street as an act of patriotism, which Schiff considers perverse. Imagine, he suggests, that you ran into a good friend and asked him how he was doing. His reply: “I took out a third mortgage, maxed out my credit cards, and emptied out my kids’ college savings account so I could buy a bigger TV and a new car, and we’re going to Greece on vacation over the holidays. Things are great!” Schiff lets the idea sink in and then finishes the thought: “And we’re celebrating the fact that we’re doing this as a nation?”
Next: The dollar tumbles hard.
In a recent interview, John Santer, a district director of NeighborWorks America, a community-based nonprofit, pointed out that 43 percent of American households spend more than they earn each year, and fewer than six in ten have enough savings to last them three months if they were suddenly out of a job. So where’s the money coming from? From 1991 to 2005, Americans borrowed $530 billion against the value of their homes each year.
James Glassman, a senior economist at JPMorgan Chase, told a Tulsa, Oklahoma, luncheon crowd in early October that before 1985, consumer spending grew in line with income, but since that time, it’s grown half a percent faster on an annual basis. As a result, household savings, which once reached 10 percent of income, is now literally negative. “My guess is that in five years we’ll look back and realize … that the consumer we knew for twenty years is coming to an end,” he said.
Roger Ehrenberg, an ex–Wall Streeter and author of the financial blog Information Arbitrage, forecasts extreme financial pain. “You’ve got a weaker dollar, declining economic fundamentals, and a debt-strapped consumer—I’d call that a bad fact set,” he says. “Lay on top of that the mortgage problem and declining home values, and you can paint a pretty ugly picture.”
THREAT NO. 4
That the Rest of the World Decides They Don’t Need Us and the Dollar Tumbles Hard
The dollar is falling, possibly collapsing, depending on whom you talk to. The greenback has sunk close to its lowest point in the post-1973 floating-exchange-rate era, so low that it’s been overtaken by the Canadian dollar—affectionately known as the loonie—for the first time since 1976. How low will it go? When Alan Greenspan was asked by Lesley Stahl of 60 Minutes last month what currency he’d like to be paid in, his response was telling: “[The] key question … is, ‘In what currency do you wish to hold your assets?’ And what I’ve done is I diversify.” Translation: He isn’t betting on the dollar. And neither is the majority of Wall Street.
Here’s why catastrophists see that as a major problem: About 25 percent of our government debt is held by foreign governments, with the major holders being Japan ($610.9 billion), China ($407.8 billion), the U.K. ($210.1 billion), and our friends in the Middle East, the oil-exporting countries ($123.8 billion). When the current Fed chairman, Ben Bernanke, cuts rates to soften the housing blow for Americans, he also weakens the dollar by making dollar-based investments less attractive. And when the dollar weakens, so, too, does the value of these gigantic positions held by the foreign governments. At some point, they’re no longer going to tolerate the losses we inflict on them by lowering rates, and if that happens and they start dumping dollars, watch out for the peso.
The bulls will tell you that foreign governments understand the American economy is the key to global economic health, and that they’ll suck it up and take it when we devalue their debt. To which Schiff offers another analogy. Imagine if five people were washed up on a desert island: four Asians and an American. In splitting up their duties, one Asian says he’ll fish; another will hunt, another will look for firewood, and another will cook. The American assigns himself the job of eating.
“The modern economist looks at this situation and says the American is key to the whole thing,” says Schiff. “Because without him to eat, the four Asians would be unemployed.” The alternative: Without the American, the Asians might eat a little more themselves and even spend some time building a boat. This is happening as we speak: With the rise of the Chinese consumer class, the local citizenry is now spending, and the country is no longer totally dependent on exports. Which means they’re no longer totally dependent on us.
Readers of the financial press are surely familiar with the buzzword of the moment, decoupling. It’s used to describe how U.S.-Europe and U.S.-Asian trade relationships are becoming less dependent at the same time as European-Asian ties are growing. Most Asian nations, including China, are seeing more rapid growth in exports to Europe than to the U.S. And the U.S. now accounts for a declining share of European exports. The bearish interpretation: that the longtime global embrace of the dollar is loosening.
Next: We don’t see it happening because it’s a slow-motion train wreck.
THREAT NO. 5
That We Don’t See It Happening Because It’s a Slow-Motion Train Wreck
Last but not least, we can circle back to the Dow Jones Industrial Average making new highs in October—14,087.55 on October 1—offering hope that our equity portfolios will carry us through to the other side of whatever it is we’re on the wrong side of. Before addressing the fact that the equity market might just be clueless, there’s one last dollar-related point to make. The true value of a stock portfolio isn’t really its quoted worth in dollars—it’s what you could buy with that portfolio if you were to sell it.
Given that we as Americans don’t manufacture that much anymore (we’re a service economy!), we are largely talking about foreign-made goods, such as flat-screens from Korea or cars from Germany. Over time, if the dollar continues to slump, foreign manufacturers will raise prices to compensate for what they’re losing in the exchange rate. In that light, a Dow at 14,000 with the euro at $1.42 is really no different from a Dow at 13,000 with the euro at $1.33. (One reason the price of oil has risen so high is that it is quoted in dollars, and the sellers thereof have had to continually jack up the per-barrel price to maintain their own purchasing power at home and elsewhere.)
Still, a rising Dow is better than a falling Dow, and the bulls are piling into every rally. Which still doesn’t impress Jeremy Grantham, chairman of Boston-based money manager GMO, in the least. “The equity market is always slow to pick up on someone else’s crisis,” he says, referring to the turmoil in both the housing and fixed-income markets. “And so you’ve got a slow-motion train wreck that has to work itself through the system.”
How will it work itself through? Grantham points to the recent strength in profit margins, fueled by—you guessed it!—our plummeting savings rate, and says there’s nowhere to go but down. “If you start with an overpriced market and bring profit margins down, that’s more than enough to bring stock prices down,” he says. “It is the most certain mean-reversion in all of finance.” Grantham calculates that the U.S. stock market will have to fall by a full third before it gets to its “fair value.” At which point we will likely be in full-blown recession. And when that happens, Schiff says, we will see a country in downsizing mode, “selling the consumer goods we’ve been buying back to the Chinese. It will be one big, giant repossession.”
So assuming all this is true, that Schiff and his fellow doomsayers are right about the rotten core of the U.S. economy, how will this affect New York City? We’ve grown accustomed to the idea of our local economy, particularly the real-estate market, being inherently stronger than the nation’s and possibly immune to whatever woes strike the rest of America. Wall Street, after all, makes money on downs as well as ups, and the stampede of foreigners and foreign cash could, if anything, be aided by the weak dollar.
Last week, though, the argument against New York invincibility was implicitly made when Merrill Lynch announced a larger-than-expected write-down of $7.9 billion dollars in its third quarter alone, primarily due to losses in the credit markets. Numbers as large as that can paradoxically seem trivial due to the abstract nature of accounting—a “write-down” involves no movement of real-life cash, just a readjustment of some theoretical values—but here’s something nontrivial to consider: Merrill Lynch is one of the largest employers in New York City. While so far only a few Merrill bigwigs have been shown the door, it’s almost certain that a chunk of the company’s rank and file will soon follow. All told, New York–based financial companies had already announced more than 42,000 layoffs as of October, according to one study, and the pace could pick up through the end of the year. That’s people who won’t be bidding up new apartments, who won’t be going out to dinner five times a week, who won’t be testing the outer limits of their credit cards at Barneys. The downstream effects of this could be even more severe, as every Wall Street job is estimated to account for another 1.3 to 2 jobs, meaning that additional job losses could push 100,000.
Meanwhile, the public sector is feeling it, too. A recent report by Nicole Gelinas, published by the Manhattan Institute, forecast a budget deficit for New York City next year and predicted that Mayor Bloomberg, who enjoyed a string of budget surpluses until this year, will likely be forced to leave his successor with a double whammy: a deficit and a projected 50 percent increase in outstanding debt. Of course, the catastrophists could be dead wrong, as they have been for going on a decade now—but to them, it sure smells like the seventies all over again.
Next: Good-Behavior Bribes for the Poor?
He stops laughing. “Why worry?” he asks. “Because we dodged a bullet but are about to step on a hand grenade.”
Sitting in a corner office of a nondescript building just off I-95 in Darien, Connecticut, Schiff, the president of brokerage Euro Pacific Capital, and author of Crash Proof: How to Profit From the Coming Economic Collapse, will spend the next hour spelling out a singularly pessimistic view of the American economy. And he will do so while exhibiting a curious juxtaposition unique to the bearish prognosticator: He speaks of disaster with a smile on his face. No, he’s not happy about our impending doom. But he is happy that people are finally taking him seriously.
Some people, anyway. The recessionary fears that were sparked by the global liquidity crisis in August have eased, largely because of a resilient stock market and a belief that the Federal Reserve’s interest-rate cut in September curtailed deeper losses. When Goldman Sachs invested in its own imploding Global Equity Opportunities hedge fund in August, calling it an “opportunity” and not a “rescue,” people laughed. Guess who laughed last? Goldman, which had reportedly enjoyed a $370 million gain on its $2 billion rescue by October. The optimists stay focused on stories like Steve Jobs’s next stroke of genius.
But Schiff, whom CNBC calls “Dr. Doom,” has not, as bears do when winter approaches, gone off to hide in a cave. Why not? Because every single one of the underlying economic factors that he has identified as cause for concern has worsened. And his is no longer a lone voice in the woods. If you don’t care to listen to a man nicknamed Dr. Doom, you can listen to people like former Federal Reserve chairman Alan Greenspan, esteemed bond-fund manager Bill Gross, or famed money manager Jeremy Grantham. They’re part of a growing chorus of voices that are saying many of the same things as Schiff.
Their bearish arguments come in many shapes and sizes, but here’s the basic one: The past five or six years have been deceptively fortunate ones for the U.S. economy. That’s because any troublesome developments—the surge in oil prices from $28 per barrel in 2003 to about $87 today, for example—have been papered over by rising home prices. Home equity has been used to buy flat-screen TVs, SUVs, and more homes. Wall Street bought up all this debt from lenders, thereby allowing them to lend more.
The softening of real-estate prices in most parts of the United States put a crimp in this system, but it hasn’t stopped it. The question is, what, if anything, will? What will bring on the apocalypse that Schiff and others believe is inevitable? They see it like this:
THREAT NO. 1
The Bottom Continues to Fall Out of the Housing Market
Manhattan’s gravity-defying real estate aside, it’s quite clear the nation is experiencing a genuine housing crisis. In August, pending home sales dropped 6.5 percent, and they currently sit at their lowest level since 2001. The National Association of Realtors conducted a recent survey that showed more than 10 percent of sales contracts fell through at the last moment in August, primarily owing to disappearing loan commitments from banks. The crisis will only deepen, when more borrowers see their adjustable-rate mortgages adjusted upward. There was a foreclosure filing for one of every 510 households in the country in August, the highest figure ever issued, and by one estimate, more than 1.7 million foreclosures will occur in the country by the end of 2008. That’s not just subprime borrowers: According to the Federal Housing Finance Board, while nearly 35 percent of conventional mortgages in 2004 used ARMs, some 70.7 percent of jumbo loans—those above $333,700 (the jumbo threshold in 2004; it’s now higher)—did too.
Historically, bond-market investors have been the boring counterparts to their equity-market brethren. But in his October Investment Outlook, famed bond investor Bill Gross was anything but. The managing director of money management firm pimco pointed out that the Federal Reserve is caught in a bind: It must continue to lower interest rates to ameliorate this burgeoning housing crisis, but in doing so, it “risks reigniting speculative equity market behavior, and … a run on the dollar.” (More on the dollar later.) Gross doesn’t have the answers but observes that the Fed is “in a pickle, and a sour one at that.” Worse yet, concerns that a rate cut might be inflationary actually caused bond yields to rise in the wake of the rate cut, something that doesn’t normally happen. The Fed’s influence, always overstated, might turn out to be nonexistent in a credit market that remains on edge.
Hedge-fund veteran Rick Bookstaber, the author of A Demon of Our Own Design, spells out a potentially disastrous scenario that could unfold regardless of what the Fed does: Continued foreclosures result in a further drop in housing prices, which results in further foreclosures, which result in a further drop in housing prices. Even for those of us not selling, reduced home values result in a reduced sense of security, which results in reduced consumption, which results in a slowing economy, which … you get the point.
Next: The derivatives-related meltdown, part II.
THREAT NO. 2
The Derivatives-Related Meltdown, Part II
Anybody who glances occasionally at the financial pages these days knows that mortgages issued to home buyers are packaged together (in a process called securitization) into a collateralized-debt obligation, or CDO. That’s what’s known as a derivative, a security whose value depends on the value of other securities. The price of the CDO, you see, is “derived” from the prices of the underlying mortgages. (It works with credit cards, too, or bank loans—any kind of debt will do.)
In principle, the idea of a CDO makes perfect sense. In buying $5 million worth of a CDO, an investor has essentially lent money to an entire portfolio of homeowners, instead of placing all his eggs in one basket, say, by funding a single $5 million mortgage. In the real-estate-crazy environment of the past decade, the CDO market took off like a rocket. But the buyers of these derivatives made a critical error—they confused the spreading of risk with the elimination of risk. A booming economy made this confusion not just possible but irresistible. With relatively few defaults in the first half of the decade, investment firms, including many hedge funds, came to see CDO returns as a sure thing and loaded up on them, often borrowing money to do so, taking on debt to buy debt and thereby setting up a potentially deadly chain reaction. The readiness of the secondary market to buy all these mortgages encouraged the lenders to run wild and lend to anyone who walked through the door, leading—inevitably, in retrospect—to a decline in loan quality. Analyst Christopher Wood of Asia-Pacific investment house CLSA succinctly defines the problem in his highly readable newsletter Greed & Fear: “[Securitization] has one fatal flaw, which will ultimately prove to be its undoing … it removes the incentive of those making the loan to worry about whether the loan is a good credit.”
Still, it all held together until mortgage defaults began to cut into the yields of these CDOs and holders looked to sell them, only to realize their value had slipped. Forced liquidations as a result of that “price discovery” were a primary factor in Bear Stearns’ hedge-fund calamity in August. And it’s not over yet: The aftershocks of the mortgage meltdown are still being felt, as banks such as Citigroup and Deutsche Bank announce multibillion-dollar write-downs.
Each time one of these write-downs has been announced, the market has had a curiously positive response, taking the news as a sign that the worst was over and the banks were cleaning up their books. But because these derivatives are linked to other debt, there’s no reason to be certain that trouble won’t bleed into other markets. Among other things, the liquidity crisis froze the market in structured investment vehicles (SIVs), a nifty bit of financial engineering that banks use to profit from the spread between short-term debt and long-term debt. No one yet knows how nasty these losses could turn out to be because SIVs are stashed, Enron style, off the books.
THREAT NO. 3
Consumers Run Out of Steam (and Take the Economy Down With Them)
The U.S. economy, for all its worldly sophistication, is driven by mall shoppers and late-night Amazon addicts—70 percent of the gross domestic product is accounted for by consumer spending, which is buttressed by debt. According to the Federal Reserve, total U.S. household debt was, as of August, $2.5 trillion—a 24 percent increase in the past five years. Total credit-card debt, including gas cards and the like, was $915 billion.
The willingness of consumers to keep spending and piling on debt in the midst of a slowing real-estate market is hailed on Wall Street as an act of patriotism, which Schiff considers perverse. Imagine, he suggests, that you ran into a good friend and asked him how he was doing. His reply: “I took out a third mortgage, maxed out my credit cards, and emptied out my kids’ college savings account so I could buy a bigger TV and a new car, and we’re going to Greece on vacation over the holidays. Things are great!” Schiff lets the idea sink in and then finishes the thought: “And we’re celebrating the fact that we’re doing this as a nation?”
Next: The dollar tumbles hard.
In a recent interview, John Santer, a district director of NeighborWorks America, a community-based nonprofit, pointed out that 43 percent of American households spend more than they earn each year, and fewer than six in ten have enough savings to last them three months if they were suddenly out of a job. So where’s the money coming from? From 1991 to 2005, Americans borrowed $530 billion against the value of their homes each year.
James Glassman, a senior economist at JPMorgan Chase, told a Tulsa, Oklahoma, luncheon crowd in early October that before 1985, consumer spending grew in line with income, but since that time, it’s grown half a percent faster on an annual basis. As a result, household savings, which once reached 10 percent of income, is now literally negative. “My guess is that in five years we’ll look back and realize … that the consumer we knew for twenty years is coming to an end,” he said.
Roger Ehrenberg, an ex–Wall Streeter and author of the financial blog Information Arbitrage, forecasts extreme financial pain. “You’ve got a weaker dollar, declining economic fundamentals, and a debt-strapped consumer—I’d call that a bad fact set,” he says. “Lay on top of that the mortgage problem and declining home values, and you can paint a pretty ugly picture.”
THREAT NO. 4
That the Rest of the World Decides They Don’t Need Us and the Dollar Tumbles Hard
The dollar is falling, possibly collapsing, depending on whom you talk to. The greenback has sunk close to its lowest point in the post-1973 floating-exchange-rate era, so low that it’s been overtaken by the Canadian dollar—affectionately known as the loonie—for the first time since 1976. How low will it go? When Alan Greenspan was asked by Lesley Stahl of 60 Minutes last month what currency he’d like to be paid in, his response was telling: “[The] key question … is, ‘In what currency do you wish to hold your assets?’ And what I’ve done is I diversify.” Translation: He isn’t betting on the dollar. And neither is the majority of Wall Street.
Here’s why catastrophists see that as a major problem: About 25 percent of our government debt is held by foreign governments, with the major holders being Japan ($610.9 billion), China ($407.8 billion), the U.K. ($210.1 billion), and our friends in the Middle East, the oil-exporting countries ($123.8 billion). When the current Fed chairman, Ben Bernanke, cuts rates to soften the housing blow for Americans, he also weakens the dollar by making dollar-based investments less attractive. And when the dollar weakens, so, too, does the value of these gigantic positions held by the foreign governments. At some point, they’re no longer going to tolerate the losses we inflict on them by lowering rates, and if that happens and they start dumping dollars, watch out for the peso.
The bulls will tell you that foreign governments understand the American economy is the key to global economic health, and that they’ll suck it up and take it when we devalue their debt. To which Schiff offers another analogy. Imagine if five people were washed up on a desert island: four Asians and an American. In splitting up their duties, one Asian says he’ll fish; another will hunt, another will look for firewood, and another will cook. The American assigns himself the job of eating.
“The modern economist looks at this situation and says the American is key to the whole thing,” says Schiff. “Because without him to eat, the four Asians would be unemployed.” The alternative: Without the American, the Asians might eat a little more themselves and even spend some time building a boat. This is happening as we speak: With the rise of the Chinese consumer class, the local citizenry is now spending, and the country is no longer totally dependent on exports. Which means they’re no longer totally dependent on us.
Readers of the financial press are surely familiar with the buzzword of the moment, decoupling. It’s used to describe how U.S.-Europe and U.S.-Asian trade relationships are becoming less dependent at the same time as European-Asian ties are growing. Most Asian nations, including China, are seeing more rapid growth in exports to Europe than to the U.S. And the U.S. now accounts for a declining share of European exports. The bearish interpretation: that the longtime global embrace of the dollar is loosening.
Next: We don’t see it happening because it’s a slow-motion train wreck.
THREAT NO. 5
That We Don’t See It Happening Because It’s a Slow-Motion Train Wreck
Last but not least, we can circle back to the Dow Jones Industrial Average making new highs in October—14,087.55 on October 1—offering hope that our equity portfolios will carry us through to the other side of whatever it is we’re on the wrong side of. Before addressing the fact that the equity market might just be clueless, there’s one last dollar-related point to make. The true value of a stock portfolio isn’t really its quoted worth in dollars—it’s what you could buy with that portfolio if you were to sell it.
Given that we as Americans don’t manufacture that much anymore (we’re a service economy!), we are largely talking about foreign-made goods, such as flat-screens from Korea or cars from Germany. Over time, if the dollar continues to slump, foreign manufacturers will raise prices to compensate for what they’re losing in the exchange rate. In that light, a Dow at 14,000 with the euro at $1.42 is really no different from a Dow at 13,000 with the euro at $1.33. (One reason the price of oil has risen so high is that it is quoted in dollars, and the sellers thereof have had to continually jack up the per-barrel price to maintain their own purchasing power at home and elsewhere.)
Still, a rising Dow is better than a falling Dow, and the bulls are piling into every rally. Which still doesn’t impress Jeremy Grantham, chairman of Boston-based money manager GMO, in the least. “The equity market is always slow to pick up on someone else’s crisis,” he says, referring to the turmoil in both the housing and fixed-income markets. “And so you’ve got a slow-motion train wreck that has to work itself through the system.”
How will it work itself through? Grantham points to the recent strength in profit margins, fueled by—you guessed it!—our plummeting savings rate, and says there’s nowhere to go but down. “If you start with an overpriced market and bring profit margins down, that’s more than enough to bring stock prices down,” he says. “It is the most certain mean-reversion in all of finance.” Grantham calculates that the U.S. stock market will have to fall by a full third before it gets to its “fair value.” At which point we will likely be in full-blown recession. And when that happens, Schiff says, we will see a country in downsizing mode, “selling the consumer goods we’ve been buying back to the Chinese. It will be one big, giant repossession.”
So assuming all this is true, that Schiff and his fellow doomsayers are right about the rotten core of the U.S. economy, how will this affect New York City? We’ve grown accustomed to the idea of our local economy, particularly the real-estate market, being inherently stronger than the nation’s and possibly immune to whatever woes strike the rest of America. Wall Street, after all, makes money on downs as well as ups, and the stampede of foreigners and foreign cash could, if anything, be aided by the weak dollar.
Last week, though, the argument against New York invincibility was implicitly made when Merrill Lynch announced a larger-than-expected write-down of $7.9 billion dollars in its third quarter alone, primarily due to losses in the credit markets. Numbers as large as that can paradoxically seem trivial due to the abstract nature of accounting—a “write-down” involves no movement of real-life cash, just a readjustment of some theoretical values—but here’s something nontrivial to consider: Merrill Lynch is one of the largest employers in New York City. While so far only a few Merrill bigwigs have been shown the door, it’s almost certain that a chunk of the company’s rank and file will soon follow. All told, New York–based financial companies had already announced more than 42,000 layoffs as of October, according to one study, and the pace could pick up through the end of the year. That’s people who won’t be bidding up new apartments, who won’t be going out to dinner five times a week, who won’t be testing the outer limits of their credit cards at Barneys. The downstream effects of this could be even more severe, as every Wall Street job is estimated to account for another 1.3 to 2 jobs, meaning that additional job losses could push 100,000.
Meanwhile, the public sector is feeling it, too. A recent report by Nicole Gelinas, published by the Manhattan Institute, forecast a budget deficit for New York City next year and predicted that Mayor Bloomberg, who enjoyed a string of budget surpluses until this year, will likely be forced to leave his successor with a double whammy: a deficit and a projected 50 percent increase in outstanding debt. Of course, the catastrophists could be dead wrong, as they have been for going on a decade now—but to them, it sure smells like the seventies all over again.
Next: Good-Behavior Bribes for the Poor?
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