Initiative Blog

Fred Hickey on Government Speak

2010-04-22T07:51:00.005-04:00

Reminding us of the fragility of the current u.s. political economy

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"What Irritated me the most about the health care debate was the sham argument that it would somehow reduce the nation's deficit. The history of these giant entitlement programs is clear. After adjusting for inflation, Medicaid now costs 37 times more than it did at its launch, way, way beyond the original projections. Medicare cost nearly eight times what Congress had initially forecast. Social Security -- all you need to know is that there's absolutely no money put aside for the pensions promised to the baby boomers just beginning to retire. All the money that I've put into the Social Security system (and I pay both the employee and employer contributions) for more than thirty years supposedly to finance my retirement is gone, used to fund the pensions of others who have come before me. Indeed, this year there will not even be enough 'pay-as-you-go' receipts to cover the year's Social Security outlays, forcing the government to borrow an estimated $28 billion to fund the payouts

" Yet the House Speaker Nancy Pelosi had the nerve to declare last month that, "Over the life of this (health care) bill, it will create 4 million new jobs and cut the deficit by 1.3 trillion dollars." House majority leader Steny Hoyer: "In truth it is the biggest deficit reduction bill any of us will have an opportunity to vote on in this congress and indeed other congresses as well." What kind of turnip truck do they think we fell off of?

"All these savings will supposedly be created by adding 32 million currently uninsured Americans essentially to the poorly functioning Medicaid program. I guess eventually the program may grow enough to add 4 million more bureaucrats to the government's payroll, but the new jobs won't come from the private industry. Caterpillar (and a long list of other private companies) recently came out with estimates of their additonal first-year costs. Giant manufacturer (and exporter) Caterpillar forecast their costs would increase by $100 million; and noted that it could 'ill-afford cost increases that place us at a disadvantage versus our global competitors'

"The saddest part about the 'Decade from Hell' is that we didn't learn anything from it. We're losing manufacturing jobs because our companies are non-competitive. Our solution: make them less competitive. The country is burdened by enormous debts. Our solution: spend (mostly waste) record amounts of money and pile on even more government debt. The social safety nets are woefully underfunded. Our solution: massively increase entitlement benefits. We don't save any money. Our solutions: Drive interest rates to zero, drastically increase tax rates on investments and encourage more consumer spending (cash for clunkers, ect.). The Fed continually creates debilitating asset bubbles: The solution - create some more

"We have been deluding ourselves for years. Our spendthrift policies would have led to an earlier crisis if not for the willingness of foreigners to fund our follies, thanks to the U.S. dollar's position as the world's reserve currency. When many of the biggest lenders (Chinese, Russians, and others) began to hesitate recently, reducing their U.S. Treasury holdings, a new source of funding was required to avoid a funding crisis. That's when the Fed stepped in this past year by monetizing the debt, directly (through $300 billion of U.S. Treasury Securities purchases) and indirectly (with over $1.4 trillion of mortgage purchases). I find it utterly preposterous that just a few weeks ago Fed Chairman Bernanke told Congress: "We're not going to monetize the debt" as the Fed has been doing exactly that through its 'quantitative easing' money printing operations for more than a year. There can be no sugar-coating this. Our government leaders are not telling us the truth."

Is it all just a Ponzi scheme? - Eric Sprott & David Franklin

2009-12-31T03:53:00.001-05:00

Is it all just a Ponzi scheme?
By: Eric Sprott & David Franklin
In our May/June Markets at a Glance, "The Solution…is the Problem", we discussed how
much debt the US government would need to issue in order to balance the budget for
fiscal 2009. We calculated they would need to sell $2.041 trillion in new debt - or almost
three times the new debt that was issued in fiscal 2008. As a thought experiment, we
separated all the various US Treasury owners and asked our readers whether each group
could afford to increase their 2009 treasury purchases by 200%. In the end, we surmised
that most groups couldn’t, and prepared our readers for the worst.
Almost seven months later, however, nothing particularly bad has happened on the US
debt front. There have been no failed auctions, no sovereign defaults, no downgrades of
debt and no significant increase in rates…not so much as a hiccup in the treasury market.
Knowing what we discussed this past June, we have to ask how it all went so smoothly.
After all – it was pretty obvious there wasn’t enough buying power to satisfy the auctions
under ‘normal’ circumstances.
In the latest Treasury Bulletin published in December 2009, ownership data reveals that
the United States increased the public debt by $1.885 trillion dollars in fiscal 2009.1 So
who bought all the new Treasury securities to finance the massive increase in
expenditures? According to the same report, there were three distinct groups that bought
more than they did in 2008. The first was "Foreign and International Buyers", who
purchased $697.5 billion worth of Treasury securities in fiscal 2009 – representing about
23% more than their respective purchases in fiscal 2008. The second group was the
Federal Reserve itself. According to its published balance sheet, it increased its treasury
holdings by $286 billion in 2009, representing a 60% increase year-over-year.2 This
increase appears to be a direct result of the Federal Reserve’s Quantitative Easing
program announced this past March. Most of the other identified buyers in the Treasury
Bulletin were either net sellers or small buyers in 2009. While the Q4 data is not yet
available, the Q1, Q2 and Q3 data suggests that the State and Local governments and
US Savings Bonds groups will be net sellers of US Treasury securities in 2009, while
pension funds, insurance companies and depository institutions only increased their
purchases by a negligible amount.
So who was the third large buyer? Drum roll please,... it was "Other Investors". After
purchasing $90 billion in 2008, this group has purchased $510.1 billion of freshly minted
treasury securities so far in the first three quarters of fiscal 2009. If you annualize this rate
of purchase, they are on pace to buy $680 billion of US treasuries this year - or more than
seven times what they purchased in 2008. This is undoubtedly the group that made the
US deficit possible this year. But who are they? The Treasury Bulletin identifies "Other
Investors" as consisting of Individuals, Government-Sponsored Enterprises (GSE),
Brokers and Dealers, Bank Personal Trusts and Estates, Corporate and Non-Corporate
Businesses, Individuals and Other Investors. Hmmm. Do you think anyone in that group
had almost $700 billion to invest in the US Treasury market in fiscal 2009? We didn’t
either. To dig further, we turned to the Federal Reserve Board of Governors Flow of
Funds Data which provides a detailed breakdown of the owners of Treasury Securities to
Q3 2009.3 Within this grouping, the GSE’s were small buyers of a mere $5 billion this
year;4 Broker and Dealers were sellers of almost $80 billion;5 Commercial Banking were
buyers of approximately $80 billion;6 Corporate and Non-corporate Businesses, grouped
together, were buyers of $11.6 billion, for a grand net purchase of $16.6 billion.7 So who
really picked up the tab? To our surprise, the only group to actually substantially increase
their purchases in 2009 is defined in the Federal Reserve Flow of Funds Report as the
"Household Sector". This category of buyers bought $15 billion worth of treasuries in
2008, but by Q3 2009 had purchased a whopping $528.7 billion worth. At the end of Q3
this Household Sector category now owns more treasuries than the Federal Reserve
itself.8
So to summarize, the majority buyers of Treasury securities in 2009 were:
1. Foreign and International buyers who purchased $697.5 billion.
2. The Federal Reserve who bought $286 billion.
3. The Household Sector who bought $528 billion to Q3 – which puts them on
track purchase $704 billion for fiscal 2009.
These three buying groups represent the lion’s share of the $1.885 trillion of debt that was
issued by the US in fiscal 2009.
We must admit that we were surprised to discover that "Households" had bought so many
Treasuries in 2009. They bought 35 times more government debt than they did in 2008.
Given the financial condition of the average household in 2009, this makes little sense to
us. With unemployment and foreclosures skyrocketing, who could afford to increase
treasury investments to such a large degree? For our more discerning readers, this
enormous "Household" investment was made outside of Money Market Funds, Mutual
Funds, ETF’s, Life Insurance Companies, Pension and Retirement funds and Closed-End
Funds, which are all separate reporting categories.9 This leaves a very important question
- who makes up this Household Sector?
Amazingly, we discovered that the Household Sector is actually just a catch-all category.
It represents the buyers left over who can’t be slotted into the other group headings. For
most categories of financial assets and liabilities, the values for the Household Sector are
calculated as residuals. That is, amounts held or owed by the other sectors are subtracted
from known totals, and the remainders are assumed to be the amounts held or owed by
the Household Sector. To quote directly from the Flow of Funds Guide, "For example, the
amounts of Treasury securities held by all other sectors, obtained from asset data
reported by the companies or institutions themselves, are subtracted from total Treasury
securities outstanding, obtained from the Monthly Treasury Statement of Receipts and
Outlays of the United States Government and the balance is assigned to the household
sector." (Emphasis ours)10 So to answer the question - who is the Household Sector?
They are a PHANTOM. They don’t exist. They merely serve to balance the ledger in the
Federal Reserve’s Flow of Funds report.
Our concern now is that this is all starting to resemble one giant Ponzi scheme. We all
know that the Fed has been active in the market for T-bills. As you can see from Table A,
under the auspices of Quantitative Easing, they bought almost 50% of the new Treasury
issues in Q2 and almost 30% in Q3. It serves to remember that the whole point of selling
new US Treasury bonds is to attract outside capital to finance deficits or to pay off existing
debts that are maturing. We are now in a situation, however, where the Fed is printing
dollars to buy Treasuries as a means of faking the Treasury’s ability to attract outside
capital. If our research proves anything, it’s that the regular buyers of US debt are no
longer buying, and it amazes us that the US can successfully issue a record number
Treasuries in this environment without the slightest hiccup in the market.
Perhaps the most striking example of the new demand dynamics for US Treasuries
comes from Bill Gross, who is co-chief investment officer at PIMCO and arguably one of
the world’s most powerful bond investors. Mr. Gross recently revealed that his bond fund
has cut holdings of US government debt and boosted cash to the highest levels since
2008.11 Earlier this year he referred to the US as a "ponzi style economy" and
recomended that investors front run Uncle Sam and other world governments into
government debt instruments of all forms.12 The fact that he is now selling US treasuries
is a foreboding sign.
Foreign holders are also expressing concern over new Treasury purchases. In a recent
discussion on the global role of the US dollar, Zhu Min, deputy governor of the People’s
Bank of China, told an academic audience that "The world does not have so much money
to buy more US Treasuries." He went on to say, "The United States cannot force foreign
governments to increase their holdings of Treasuries… Double the holdings? It is
definitely impossible."13 Judging from these statements, it seems clear that the US cannot
expect foreigners to continue to support their debt growth in this new economic
environment. As US consumers buy fewer foreign goods, there are less US dollars
available for foreigners to purchase future Treasury securities. Foreigners are the largest
source of external capital that can be clearly identified in US Treasury data. If their
support wanes in 2010, the US will require significant domestic support to fund future debt
issuances. Mr. Gross’s recent comments suggest that their domestic support may already
be weakening.
As we have seen so illustriously over the past year, all Ponzi schemes eventually fail
under their own weight. The US debt scheme is no different. 2009 has been witness to
spectacular government intervention in almost all levels of the economy. This support
requires outside capital to facilitate, and relies heavily on the US government’s ability to
raise money in the debt market. The fact that the Federal Reserve and US Treasury
cannot identify the second largest buyer of treasury securities this year proves that the
traditional buyers are not keeping pace with the US government’s deficit spending. It
makes us wonder if it’s all just a Ponzi scheme.

Lesson: If you borrow, borrow a crapload

2009-09-29T17:00:00.006-04:00

"Some US numbers have been bothering us for a while. If commercial property has dropped in value by something like 40% in the past two years, and if most of the financings of the past five years were tightly priced at higher values (as they were), then where are the bankruptcies that should be stirring up the financial waters? We have written before (September 3) about the long lag before commercial real estate problems become obvious because leases are renegotiated over many years, and our charitable view was that the lack of current problems was a function of this time-lag. However, the story of Tishman Speyer Properties LP and its investment in the Stuyvesant Town-Peter Cooper Village property in New York, the largest real estate transaction in US history, has woken us up. Its looming bankruptcy implies that the credit departments in the major banks were seeing more problems than were apparent to the average reader of the Wall Street Journal. An independent appraisal placed the value of this property at less than 40% of its purchase price. We remembered that the John Hancock Building, the premier office tower in Boston, was sold at less than 50% of its previous purchase earlier this year. So why aren’t there any rumblings in credit-land? It seems that the banks are not doing anything. “They don’t ask and we don’t tell them’” a leading property owner told us with a drink in his hand. He continued that almost all of his properties were in technical default, but that the banks wouldn’t want to press him on them. In fact he was in a powerful position as he could threaten to stop paying, forcing the bank to recognize the problem. As a result deals are being rewritten and problems are getting pushed out to the future. As a result, defaults are avoided and losses are deferred."

Cost of Education vs. Income over time

2009-09-15T00:34:00.005-04:00

This is pretty crazy if you think about it...

Manifesto to invest/live by

2009-08-24T10:31:00.001-04:00

Q2 2009 Letter from Elliot Management:

"To this, we say maybe... and maybe not. Our job, as stewards of Elliott’s capital, is not to choose one of the big possibilities (including, among other things: renewed collapse; recovery starting now; double-dip recession; recovery co-existing with a continued downturn in commercial real estate and then an inflation crisis) and aggressively position Elliott’s portfolio accordingly. Rather, our job is to preserve capital and to make some money on a consistent basis regardless of which scenario (or crazy combination of several) actually comes to pass. That is the really tricky part, because significant differences exist between them.

We have a number of positions which are progressing in their own timeframes and processes, not related to anything else in our book. We actively look for such uncorrelated situations, and we think that type of position is more of a primary focus for us than for most other hedge funds. Other positions that we own have a variety of risks which are impacted by what is happening in global financial markets. We hedge these risks either internally, with similar assets, or externally, by single assets, indices or derivatives. We will try not to lock ourselves into a rigid set of macro assumptions, attempt to control our own destiny to the extent we can, and do the best job possible on the “knowable” part of the equation (analysis and research). This is the “secret” to our longevity and consistency, even though we view it as the well-worn and time-tested contents of a broad and deep tool chest, which always come in handy but whose value is most vivid in tough times like these."

Great Quote

2009-08-24T10:21:00.002-04:00

You could contrast this perspective with China's economic policy of 保八

Robert Kennedy on his campaign trail for the US presidency on March 18, 1968:

"We will find neither national purpose nor personal satisfaction in a mere continuation of economic progress, in an endless amassing of worldly goods. We cannot measure national spirit by the Dow Jones Average, nor national achievement by the Gross National Product. For the Gross National Product includes air pollution, and ambulances to clear our highways from carnage. It counts special locks for our doors and jails for the people who break them. The Gross National Product includes the destruction of the redwoods and the death of Lake Superior. It grows with the production of napalm and missles and nuclear warheads.... It includes... the broadcasting of television programs which glorify violence to sell goods to our children. And if the Gross National Product includes all this, there is much that it does not comprehend. It does not allow for the health of our families, the quality of their education, or the joy of their play. It is indifferent to the decency of our factories and the safety of our streets alike. It does not include the beauty of our poetry, or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials... the Gross National Product measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America -- except whether we are proud to be Americans."

Nice reminder of the folly of modern finance

2009-08-10T09:29:00.006-04:00

John Mauldin's Aug 7th newsletter (GO! must read!):
http://www.2000wave.com/article.asp?id=mwo080709

Awesome excerpt:

"The EMH also teaches us that opportunities will be fleeting as someone will surely try to arbitrage them away. This, of course, is akin to the age old joke about the economist and his friend walking along the street. The friend points out a $100 bill lying on the pavement. The economist says, "It isn't really there because if it were someone would have already picked it up".

Sadly these simple edicts are no joking matter as they are probably the most damaging aspects of the EMH legacy. Thus the EMH urges investors to try and forecast the future. In my opinion this is one of the biggest wastes of time, yet one that is nearly universal in our industry. Pretty much 80-90% of the investment processes that I come across revolve around forecasting. Yet there isn't a scrap of evidence to suggest that we can actually see the future at all."

The undue focus upon benchmark and relative performance also leads Homo Ovinus to engage in Keynes' beauty contest. As Keynes wrote:

"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the price being awarded to the competitor whose choice most nearly corresponds to the average preference of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees"

This game can be easily replicated by asking people to pick a number between 0 and 100, and telling them the winner will be the person who picks the number closest to two-thirds the average number picked. The chart below shows the results from the largest incidence of the game that I have played - in fact the third largest game ever played, and the only one played purely among professional investors.

The highest possible correct answer is 67. To go for 67 you have to believe that every other muppet in the known universe has just gone for 100. The fact we got a whole raft of responses above 67 is more than slightly alarming.

You can see spikes which represent various levels of thinking. The spike at fifty reflects what we (somewhat rudely) call level zero thinkers. They are the investment equivalent of Homer Simpson, 0, 100, duh 50! Not a vast amount of cognitive effort expended here!

There is a spike at 33 - of those who expect everyone else in the world to be Homer. There's a spike at 22, again those who obviously think everyone else is at 33. As you can see there is also a spike at zero. Here we find all the economists, game theorists and mathematicians of the world. They are the only people trained to solve these problems backwards. And indeed the only stable Nash equilibrium is zero (two-thirds of zero is still zero). However, it is only the 'correct' answer when everyone chooses zero.

The final noticeable spike is at one. These are economists who have (mistakenly...) been invited to one dinner party (economists only ever get invited to one dinner party). They have gone out into the world and realised the rest of the world doesn't think like them. So they try to estimate the scale of irrationality. However, they end up suffering the curse of knowledge (once you know the true answer, you tend to anchor to it). In this game, which is fairly typical, the average number picked was 26, giving a two-thirds average of 17. Just three people out of more than 1000 picked the number 17.

I play this game to try to illustrate just how hard it is to be just one step ahead of everyone else - to get in before everyone else, and get out before everyone else. Yet despite this fact, it seems to be that this is exactly what a large number of investors spend their time doing.

Amen to this

2009-05-06T13:09:00.001-04:00

Unafraid In Greenwich Connecticut
Clifford S. Asness
Managing and Founding Principal
AQR Capital Management, LLC

The President has just harshly castigated hedge fund managers for being unwilling to take his administration’s bid for their Chrysler bonds. He called them “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout.”

The responses of hedge fund managers have been, appropriately, outrage, but generally have been anonymous for fear of going on the record against a powerful President (an exception, though still in the form of a “group letter,” was the superb note from “The Committee of Chrysler Non-TARP Lenders,” some of the points of which I echo here, and a relatively few firms, like Oppenheimer, that have publicly defended themselves). Furthermore, one by one the managers and banks are said to be caving to the President’s wishes out of justifiable fear.

I run an approximately twenty billion dollar money management firm that offers hedge funds as well as public mutual funds and unhedged traditional investments. My company is not involved in the Chrysler situation, but I am still aghast at the President’s comments (of course, these are my own views, not those of my company). Furthermore, for some reason I was not born with the common sense to keep it to myself, though my title should more accurately be called “Not Afraid Enough” as I am indeed fearful writing this… It’s really a bad idea to speak out.

Angering the President is a mistake, and my views will annoy half my clients. I hope my clients will understand that I’m entitled to my voice and to speak it loudly, just as they are in this great country. I hope they will also like that I do not think I have the right to intentionally “sacrifice” their money without their permission.

Here’s a shock. When hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back. However, they know, or should know, they take the risk of not being paid back. But if such a bad event happens, it usually does not result in a complete loss. A firm in bankruptcy still has assets. It’s not always a pretty process. Bankruptcy court is about figuring out how to most fairly divvy up the remaining assets based on who is owed what and whose contracts come first.

The process already has built-in partial protections for employees and pensions, and can set lenders’ contracts aside in order to help the company survive, all of which are the rules of the game lenders know before they lend. But, without this recovery process nobody would lend to risky borrowers. Essentially, lenders accept less than shareholders (means bonds return less than stocks) in good times only because they get more than shareholders in bad times.

The above is how it works in America, or how it’s supposed to work. The President and his team sought to avoid having Chrysler go through this process, proposing their own plan for re-organizing the company and partially paying off Chrysler’s creditors. Some bond holders thought this plan unfair. Specifically, they thought it unfairly favored the United Auto Workers, and unfairly paid bondholders less than they would get in bankruptcy court. So, they said no to the plan and decided, as is their right, to take their chances in the bankruptcy process. But, as his quotes above show, the President thought they were being unpatriotic or worse.

Let’s be clear, it is the job and obligation of all investment managers, including hedge fund managers, to get their clients the most return they can. They are allowed to be charitable with their own money, and many are spectacularly so, but if they give away their clients’ money to share in the “sacrifice”, they are stealing. Clients of hedge funds include, among others, pension funds of all kinds of workers, unionized and not.

The managers have a fiduciary obligation to look after their clients’ money as best they can, not to support the President, nor to oppose him, nor otherwise advance their personal political views. That’s how the system works. If you hired an investment professional and he could preserve more of your money in a financial disaster, but instead he decided to spend it on the UAW so you could “share in the sacrifice”, you would not be happy.

Let’s quickly review a few side issues.

The President’s attempted diktat takes money from bondholders and gives it to a labor union that delivers money and votes for him. Why is he not calling on his party to “sacrifice” some campaign contributions, and votes, for the greater good? Shaking down lenders for the benefit of political donors is recycled corruption and abuse of power.

Let’s also mention only in passing the irony of this same President begging hedge funds to borrow more to purchase other troubled securities. That he expects them to do so when he has already shown what happens if they ask for their money to be repaid fairly would be amusing if not so dangerous. That hedge funds might not participate in these programs because of fear of getting sucked into some toxic demagoguery that ends in arbitrary punishment for trying to work with the Treasury is distressing. Some useful programs, like those designed to help finance consumer loans, won’t work because of this irresponsible hectoring.

Last but not least, the President screaming that the hedge funds are looking for an unjustified taxpayer-funded bailout is the big lie writ large. Find me a hedge fund that has been bailed out. Find me a hedge fund, even a failed one, that has asked for one. In fact, it was only because hedge funds have not taken government funds that they could stand up to this bullying.

The TARP recipients had no choice but to go along. The hedge funds were singled out only because they are unpopular, not because they behaved any differently from any other ethical manager of other people’s money. The President’s comments here are backwards and libelous. Yet, somehow I don’t think the hedge funds will be following ACORN’s lead and trucking in a bunch of paid professional protesters soon. Hedge funds really need a community organizer.

This is America. We have a free enterprise system that has worked spectacularly for us for two hundred plus years. When it fails it fixes itself. Most importantly, it is not an owned lackey of the oval office to be scolded for disobedience by the President.

I am ready for my “personalized” tax rate now.

Testimony on AIG Portfolio Firesales

2009-04-15T08:32:00.004-04:00

The implications of all this is baffling

---

Sunday, March 29, 2009
Posted by Tyler Durden at 6:35 PM
Zero Hedge is rarely speechless, but after receiving this email from a correlation desk trader, we simply had to hold a moment of silence for the phenomenal scam that continues unabated in the financial markets, and now has the full oversight and blessing of the U.S. government, which in turns keeps on duping U.S. taxpayers into believing everything is good.

I present the insider perspective of trader Lou (who wishes to remain
anonymous) in its entirety:

"AIG-FP accumulated thousands of trades over the years, all essentially consisted of selling default protection. This was done via a number of structures with really only one criteria - rated at least AA- (if it fit these criteria all OK - as far as I could tell credit assessment was completely outsourced to the rating agencies).

Main products they took on were always levered credit risk, credit-linked notes (collateral and CDS both had to be at least AA-, no joint probability stuff) and AAA or super senior portfolio swaps. Portfolio swaps were either corporate synthetic CDO or asset backed, effectively sub-prime wraps (as per news stories regarding GS and DB).

Credit linked notes are done through single-name CDS desks and a cash desk (for the note collateral) and the portfolio swaps are done through the correlation desk. These trades were done is almost every jurisdiction - wherever AIG had an office they had IB salespeople covering them.

Correlation desks just back their risk out via the single names desks - the correlation desk manages the delta/gamma according to their correlation model. So correlation desks carry model risk but very little market risk.

I was mostly involved in the corporate synthetic CDO side.

During Jan/Feb AIG would call up and just ask for complete unwind prices from the credit desk in the relevant jurisdiction. These were not single deal unwinds as are typically more price transparent - these were whole portfolio unwinds. The size of these unwinds were enormous, the quotes I have heard were "we have never done as big or as profitable trades - ever".

As these trades are unwound, the correlation desk needs to unwind the single name risk through the single name desks - effectively the AIG-FP unwinds caused massive single name protection buying. This caused single name credit to massively underperform equities - run a chart from say last September to current of say S&P 500 and Itraxx - credit has underperformed massively. This is largely due to AIG-FP unwinds.

I can only guess/extrapolate what sort of PnL this put into the major global banks (both correlation and single names desks) during this period.
Allowing for significant reserve release and trade PnL, I think for the big correlation players this could have easily been US$1-2bn per bank in this period."

For those to whom this is merely a lot of mumbo-jumbo, let me explain in layman's terms:
AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam.

In simple terms think of it as an auto dealer, which knows that U.S.
taxpayers will provide for an infinite amount of money to fund its ongoing sales of horrendous vehicles (think Pontiac Azteks): the company decides to sell all the cars currently in contract, to lessors at far below the amortized market value, thereby generating huge profits for these lessors, as these turn around and sell the cars at a major profit, funded exclusively by U.S. taxpayers (readers should feel free to provide more gripping allegories).

What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner's (and thus the administration's) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

For banks to proclaim their profitability in January and February is about as close to criminal hypocrisy as is possible. And again, the taxpayers fund this "one time profit", which causes a market rally, thus allowing the banks to promptly turn around and start selling more expensive equity (soon coming to a prospectus near you), also funded by taxpayers' money flows into the market. If the administration is truly aware of all these events (and if Zero Hedge knows about it, it is safe to say Tim Geithner also got the memo), then the potential fallout would be staggering once this information makes the light of day.

And the conspiracy thickens.

Thanks to an intrepid reader who pointed this out, a month ago ISDA published an amended close out protocol. This protocol would allow non-market close outs, i.e. CDS trade crosses that were not alligned with market bid/offers.

The purpose of the Protocol is to permit parties to agree upfront that in the event of a counterparty default, they will use Close-Out Amount valuation methodology to value trades. Close-Out Amount valuation, which was introduced in the 2002 ISDA Master Agreement, differs from the Market Quotation approach in that it allows participants more flexibility in valuation where market quotations may be difficult to obtain.
Of course ISDA made it seems that it was doing a favor to industry participants, very likely dictating under the gun:

Industry participants observed the significant benefits of the Close-Out Amount approach following the default of Lehman Brothers. In launching the Close-Out Amount Protocol, ISDA is facilitating amendment of existing 1992 ISDA Master Agreements by replacing Market Quotation and, if elected, Loss with the Close-Out Amount approach.

"This is yet another example of ISDA helping the industry to coalesce around more efficient and effective practices, while maintaining flexibility," said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. "The Protocol permits parties to value trades in the way that is most appropriate, which greatly enhances smooth functioning of the market in testing circumstances."

And, lo and behold, on the list of adhering parties, AIG takes front and center stage (together with several other parties that probably deserve the microscope treatment).

So - in simple terms, ISDA, which is the only effective supervisor of the Over The Counter CDS market, is giving its blessing for trades to occur
(cross) below where there is a realistic market bid, or higher than the offer. In traditional equity markets this is a highly illegal practice.
ISDA is allowing retrospective arbitrary trades to have occurred at whatever price any two parties agree on, so long as the very vague necessary and sufficient condition of "market quotations may be difficult to obtain" is met. As anyone who follows CDS trading knows, this can be extrapolated to virtually any specific single-name, index or structured product easily. In essence ISDA gave its blessing for below the radar fund transfers of questionable legality. The curious timing of this decision and the alleged abuse of CDS transaction marks by and among AIG and the big banks, is striking to say the least.

This wholesale manipulation of markets, investors and taxpayers has gone on long enough.

Cool U.S. Household Debt/Savings Charts

2009-03-25T11:48:00.004-04:00

"Wealth can only be accumulated by the earnings of industry and the savings of frugality" - John Tyler

Courtesy of Nomura:

Good Read on AIG Bonuses

2009-03-25T09:10:00.003-04:00

March 25, 2009
Op-Ed Contributor
Dear A.I.G., I Quit!

The following is a letter sent on Tuesday by Jake DeSantis, an executive vice president of the American International Group’s financial products unit, to Edward M. Liddy, the chief executive of A.I.G.

DEAR Mr. Liddy,

It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context:

I am proud of everything I have done for the commodity and equity divisions of A.I.G.-F.P. I was in no way involved in — or responsible for — the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage.

After 12 months of hard work dismantling the company — during which A.I.G. reassured us many times we would be rewarded in March 2009 — we in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials. In response to this, I will now leave the company and donate my entire post-tax retention payment to those suffering from the global economic downturn. My intent is to keep none of the money myself.

I take this action after 11 years of dedicated, honorable service to A.I.G. I can no longer effectively perform my duties in this dysfunctional environment, nor am I being paid to do so. Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid. Having now been let down by both, I can no longer justify spending 10, 12, 14 hours a day away from my family for the benefit of those who have let me down.

You and I have never met or spoken to each other, so I’d like to tell you about myself. I was raised by schoolteachers working multiple jobs in a world of closing steel mills. My hard work earned me acceptance to M.I.T., and the institute’s generous financial aid enabled me to attend. I had fulfilled my American dream.

I started at this company in 1998 as an equity trader, became the head of equity and commodity trading and, a couple of years before A.I.G.’s meltdown last September, was named the head of business development for commodities. Over this period the equity and commodity units were consistently profitable — in most years generating net profits of well over $100 million. Most recently, during the dismantling of A.I.G.-F.P., I was an integral player in the pending sale of its well-regarded commodity index business to UBS. As you know, business unit sales like this are crucial to A.I.G.’s effort to repay the American taxpayer.

The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money. I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of A.I.G.-F.P. because of those losses. In this way I have personally suffered from this controversial activity — directly as well as indirectly with the rest of the taxpayers.

I have the utmost respect for the civic duty that you are now performing at A.I.G. You are as blameless for these credit default swap losses as I am. You answered your country’s call and you are taking a tremendous beating for it.

But you also are aware that most of the employees of your financial products unit had nothing to do with the large losses. And I am disappointed and frustrated over your lack of support for us. I and many others in the unit feel betrayed that you failed to stand up for us in the face of untrue and unfair accusations from certain members of Congress last Wednesday and from the press over our retention payments, and that you didn’t defend us against the baseless and reckless comments made by the attorneys general of New York and Connecticut.

My guess is that in October, when you learned of these retention contracts, you realized that the employees of the financial products unit needed some incentive to stay and that the contracts, being both ethical and useful, should be left to stand. That’s probably why A.I.G. management assured us on three occasions during that month that the company would “live up to its commitment” to honor the contract guarantees.

That may be why you decided to accelerate by three months more than a quarter of the amounts due under the contracts. That action signified to us your support, and was hardly something that one would do if he truly found the contracts “distasteful.”

That may also be why you authorized the balance of the payments on March 13.

At no time during the past six months that you have been leading A.I.G. did you ask us to revise, renegotiate or break these contracts — until several hours before your appearance last week before Congress.

I think your initial decision to honor the contracts was both ethical and financially astute, but it seems to have been politically unwise. It’s now apparent that you either misunderstood the agreements that you had made — tacit or otherwise — with the Federal Reserve, the Treasury, various members of Congress and Attorney General Andrew Cuomo of New York, or were not strong enough to withstand the shifting political winds.

You’ve now asked the current employees of A.I.G.-F.P. to repay these earnings. As you can imagine, there has been a tremendous amount of serious thought and heated discussion about how we should respond to this breach of trust.

As most of us have done nothing wrong, guilt is not a motivation to surrender our earnings. We have worked 12 long months under these contracts and now deserve to be paid as promised. None of us should be cheated of our payments any more than a plumber should be cheated after he has fixed the pipes but a careless electrician causes a fire that burns down the house.

Many of the employees have, in the past six months, turned down job offers from more stable employers, based on A.I.G.’s assurances that the contracts would be honored. They are now angry about having been misled by A.I.G.’s promises and are not inclined to return the money as a favor to you.

The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats — even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.

So what am I to do? There’s no easy answer. I know that because of hard work I have benefited more than most during the economic boom and have saved enough that my family is unlikely to suffer devastating losses during the current bust. Some might argue that members of my profession have been overpaid, and I wouldn’t disagree.

That is why I have decided to donate 100 percent of the effective after-tax proceeds of my retention payment directly to organizations that are helping people who are suffering from the global downturn. This is not a tax-deduction gimmick; I simply believe that I at least deserve to dictate how my earnings are spent, and do not want to see them disappear back into the obscurity of A.I.G.’s or the federal government’s budget. Our earnings have caused such a distraction for so many from the more pressing issues our country faces, and I would like to see my share of it benefit those truly in need.

On March 16 I received a payment from A.I.G. amounting to $742,006.40, after taxes. In light of the uncertainty over the ultimate taxation and legal status of this payment, the actual amount I donate may be less — in fact, it may end up being far less if the recent House bill raising the tax on the retention payments to 90 percent stands. Once all the money is donated, you will immediately receive a list of all recipients.

This choice is right for me. I wish others at A.I.G.-F.P. luck finding peace with their difficult decision, and only hope their judgment is not clouded by fear.

Mr. Liddy, I wish you success in your commitment to return the money extended by the American government, and luck with the continued unwinding of the company’s diverse businesses — especially those remaining credit default swaps. I’ll continue over the short term to help make sure no balls are dropped, but after what’s happened this past week I can’t remain much longer — there is too much bad blood. I’m not sure how you will greet my resignation, but at least Attorney General Blumenthal should be relieved that I’ll leave under my own power and will not need to be “shoved out the door.”

Sincerely,

Jake DeSantis

Cool quotes of the day

2009-03-11T11:32:00.002-04:00

"I don't know the bottom. I mean, if I knew the bottom, you know, I wouldn't have to look up 10-Ks and do all that stuff, I'd just buy the S&P 500 at the bottoms"
- Warren Buffett, CNBC interview Mar 9, 2009

"There are no such things as absolute values, independent of the subjective references of erring men. Judgments of values are the outcome of human arbitrariness. They reflect all the shortcomings and weaknesses of their authors."
- Ludwig Von Mises, Bureaucracy

Mundus vult decipi, ergo decipitatur

2009-03-09T21:43:00.002-04:00

Quote of the day, courtesy of Marc Faber and his genius March 2009 issue of Gloom, Boom & Doom Report. None so captures the past and present state of affairs so succinctly and accurately. Of the truths that the world would rather ignore--the fact that our fragile world remains ever so such, and yet the fleeting solutions and seducing words of amateur gods ring through the hearts of men; the discord mistaken for profundity.

Yep... thats pretty much it!

This made my day... courtesy of a jolly salesman from one of our Swedish bank coverages

2009-03-06T08:43:00.004-05:00

Sent as what I presume to be as a metaphor for the markets these days? haha.

--

4. Ragnarok - Viking Mythology to prepare for the worst winters and wars and the renewal that follows.

http://en.wikipedia.org/wiki/Ragnar%C3%B6k#Etymology http://en.wikipedia.org/wiki/Ragnar%C3%B6k

The long nights and the short, dark days followed fast upon each other, and as the time drew near when summer would come again men's hearts grew light with hope once more. Each day they looked into the sullen skies, through which clouds of snow were whirling, and said to each other, "To-morrow the summer will come;" but when the morrow came no summer came with it. And all through the months that in other days had been beautiful with flowers the snow fell steadily, and the cold winds blew fiercely, while eyes grew sad and hearts heavy with waiting for a summer that did not come. And it never came again; for this was the terrible Fimbul-winter, long foretold, from which even the gods could not escape. In Jotunheim there was joy among the frost-giants as they shouted to each other through the howling storms, "The Fimbul-winter has come at last." At first men shuddered as they whispered, "Can it be the Fimbul-winter?" But when they knew it beyond all doubting a blind despair filled them, and they were reckless alike of good or evil. Over the whole earth war followed fast upon war, and everywhere there were wrangling and fighting and murder. It hardly snowed fast enough to cover the blood-stains. Mothers forgot to love their little children, and brothers struck each other down as if they were the bitterest enemies.

Three years passed without one breath of the warm south wind or the blossoming of a single flower, and three other years darker and colder succeeded them. A savage joy filled the hearts of the frost-giants, and they shook their clenched hands at Asgard as if they had mastered the gods at last. On the earth there was nothing but silence and despair, and among the gods only patient waiting for the end. One day, as the sun rose dim and cold, a deep howl echoed through the sky, and a great wolf sprang up from the underworld and leaped vainly after it. All day long, through the frosty air, that terrible cry was heard, and all day the giant wolf ran close behind, slowly gaining in the chase. At last, as the sun went down over the snow-covered mountains, the wolf, with a mighty spring, reached and devoured it. The glow upon the hills went out in blackness; it was the last sunset. Faint and colourless the moon rose, and another howl filled the heavens as a second wolf sprang upon her track, ran swiftly behind, and devoured her also. Then came an awful darkness over all as, one by one, the stars fell from heaven, and blackness and whirling snow wrapped all things in their folds. The end had come; the last great battle was to be fought; Ragnarok, the Twilight of the Gods, was at hand.

Suddenly a strange sound broke in upon the darkness and was heard throughout all the worlds; on a lofty height the eagle Egder struck his prophetic harp. The earth shook, mountains crumbled, rocks were rent, and all fetters were broken. Loke shook off his chains and rushed out of his cavern, his heart hot with hate and burning with revenge, the terrible Fenris-wolf broke loose, and out of the deep sea the Midgard-serpent drew his long folds toward the land, lashing the water into foam as he passed. From every quarter the enemies of the gods gathered for the last great battle on the plain of Vigrid, which was a hundred miles wide on each side. Thither came the Fenris-wolf, his hungry jaws stretched so far apart that they reached from earth to heaven; the Midgard-serpent, with fiery eyes and pouring out floods of venom; the awful host of Hel with Loke at their head; the grim ranks of the frost-giants marching behind Hrym; and, last of all, the glittering fire-giants of Muspelheim, the fire-world, with Surt at the front.

The long line of enemies already stretched across the plain when Heimdal, standing on the rainbow bridge, blew the Gjallar-horn to call the gods. No sooner had Odin heard the terrible call to arms than he mounted and rode swiftly to Mimer's fountain, that he might know how to lead the gods into battle. When he came, the Norns sat veiled beneath the tree, silent and idle, for their work was done, and Ygdrasil began to quiver as if its very roots had been loosened. What Odin said to Mimer no one will ever know. He had no sooner finished speaking than Heimdal blew a second blast, and out of Asgard the gods rode forth to the last great battle, the golden helmet and shining armour of Odin leading the way. There was a momentary hush as the two armies confronted each other, and then the awful fight began. Shouts of rage rose from the frost-giants, and the armour of the fire-giants fairly broke into blaze as they rushed forward. The Fenris-wolf howled wildly, the hosts of Hel grew dark and horrible with rage, and the Midgard-serpent coiled its scaly length to strike. But before a blow had been struck the shining forms of the gods were seen advancing, and their battle-cry rang strong and clear across the field. Odin and Thor started side by side, but were soon separated. Odin sprang upon the wolf, and after a terrible struggle was devoured. Thor singled out his old enemy, the Midgard-serpent, and in a furious combat slew him; but as the monster died it drew its folds together with a mighty effort and poured upon Thor such a deadly flood of venom that he fell back nine paces, sank down and died. Frey encountered Surt, and because he had not the sword he had given long before to Skirner, could not defend himself, and he too was slain. The dog Garm rushed upon Tyr, the sword-god, and both were killed, Tyr missing the arm which he lost when the Fenris-wolf was bound.

And now the battle was at its height, and over the whole field gods, monsters, and giants were fighting with the energy of despair. Heimdal and Loke met, struggled, and fell together, and Vidar rushed upon the wolf which had devoured Odin, and tore him limb from limb. Then Surt strode into the middle of the armies, and in an awful pause flung a flaming firebrand among the worlds. There was a breathless hush, a sudden rush of air, a deadly heat, and the whole universe burst into blaze. A roaring flame filled all space and devoured all worlds, Ygdrasil fell in ashes, the earth sank beneath the sea. No sun, no moon, no stars, no earth, no Asgard, no Hel, no Jotunheim; gods, giants, monsters, and men all dead! Nothing remained but a vast abyss filled with the moaning seas, and brooded over by a pale, colourless light. Ragnarok, the end of all things, the Twilight of the Gods, had come. (My Comments: This is not the end of the story. It is just the end of the beginning. Fear is as old as human life)

Saving Capitalistic Banking From Itself - Paul McCulley

2009-02-20T09:25:00.001-05:00

gr8 simple read on banking/finance 101, the magnification of economic/market cycles by credit, and the role of government

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/GCB+February+2009+McCulley+Saving+Capitalistic+Banking.htm

郎咸平：巴菲特的成功奥秘是能耐得住寂寞

2009-02-13T12:32:00.000-05:00

郎咸平：巴菲特的成功奥秘是能耐得住寂寞
2009年02月12日来源：经理人

全球股市疯狂跳水，被称为“股神”的巴菲特正大刀阔斧地开始他的抄底之旅。然而根据权威调查显示，巴菲特在这场金融危机中并不是隔岸观火，他自己的损失竟高达163亿美元，名列美国股市十大输家排行榜第三位。该如何看待这位损失惨重的“股神”呢？

巴菲特并不神奇

　　巴菲特信奉长期投资策略，但这个投资策略必须寄托在长久稳定的股市之上才可能赚钱。所以不要看他在这一刻损失163亿，而是要看这50年来能够赚多少钱。你也不要跟他最高点做比较，而是跟他原始投资做比较，你看他能赚多少钱。他是一个看长线的人，因此就不能以短线损失多少来评判。

　　我相信，只要这次金融危机顺利解决，股票市场恢复正常，他一定大赚一笔。而这也是他会在这个时刻大量买进的原因。如果真像他所预期的会反弹的话，说不定他又是赚钱最多的人。

　　其实，巴菲特懂的这些有关投资的东西，美国每一个商学院出来的人都懂。在美国教MBA，只有两个学校是案例教学，一个是哈佛，一个是维吉尼亚大学，除了这两个大学之外其他大学都不是案例教学，根本不谈案例的，而且所有的其他大学所用的教材都是一样的，用的习题都是一样的，标准答案也都是一样的。

　　因此美国每一个MBA学生学出来后，他所懂的东西都是一样的。所以巴菲特懂的东西和别人都是一样的，他所聘用的金融分析师水平也是跟我的学生一模一样的。

　巴菲特不相信神话

　　他所以能赚钱，和我们一般人的不一样之处，在于这个人耐得住寂寞。估算出真实价值后，他一定等到股市大跌他才进场，等到这家公司股价大跌才会进场。而且他非常务实，从来不相信神话，从来不相信高科技。这里所谓高科技是金融方面的高科技，比如说对冲基金，比如说IT互联网，比如说投资银行的财富神话，他统统不信。他只相信可口可乐，他只相信通用电气。因为这些传统的公司用数学模型来算是最准确的，这种数学模型是算不了高科技的，算不了投资银行的，甚至算不了对冲基金，只能算传统行业，因此他一生都把他的钱投资在传统行业。

巴菲特具有超人的耐心与执着，同时具有当机立断的另一面。在金融危机袭来时，雷曼兄弟公司向巴菲特求援，他不为所动，但当高盛把电话打过来，正喝着樱桃可乐的巴菲特只用了一刻钟就敲定了50亿美元的投资计划。

　　巴菲特到底是怎样看待企业？这些看法又如何影响他的投资决策呢？

　　他不会去买IT、对冲基金。实际上他是对的—IT的泡沫多了，投资银行的财富神话也破灭了，对冲基金的神话也爆破了。他这次买了很多股票，包括美林银行、通用电气、高盛、比亚迪汽车，甚至还有日本的一家工具制造商，这些都是传统公司。

　　他为什么这个时候买呢？他认为，1932年7月8日道琼斯指数创了新低，但是到了第二年的3月，罗斯福就任总统之后，这个指数马上上涨30%。而且纵观 20世纪，虽然美国经历过两次世界大战，经济大萧条，多次金融崩溃，但是道琼斯指数由最初的66点攀升到11497点。组成道琼斯指数的都是传统企业，他买的就是以道琼斯指数为主的传统企业。他笃信，长期之下，道琼斯指数一定是向上走，因此现在就是进场的好时机，将来一定会回弹。

　　你明白巴菲特成功的奥秘了吗？

Man Up! Hedge-Fund Man's Advice for Wall Street: Michael Lewis

2009-02-13T09:03:00.001-05:00

Man Up! Hedge-Fund Man's Advice for Wall Street: Michael Lewis
2009-02-13 05:01:00.700 GMT

Commentary by Michael Lewis
Feb. 13 (Bloomberg) -- Before I quit my job trading bonds for my former Wall Street employer and set up my first hedge fund, I thought long and hard.
I stared at the ceiling every night, unable to sleep, and asked myself, over and over, many difficult questions. For
example: "How sincerely do I want to grow my net worth from $10 million to $100 million?" And: "How much pleasure might be had from the envy of others?"
One question I didn't ask myself, however, was "What will I do if people off Wall Street try to take away my money?" It just never crossed my mind. I assumed they'd know better.
Clearly they don't.
Everywhere I turn I hear people who know nothing about Wall Street complaining about how much Wall Street people get paid -- as if a few million at the end of the year is excessive as opposed to the barest necessity. Barack Obama's rant about bonuses I can understand: The guy never recovered from passing up Goldman Sachs Group Inc. to become a community organizer.
What's more disturbing -- what has provoked me to the point where I am willing to take extremely valuable time away from shorting Spain to write a column for Bloomberg -- is that people on Wall Street are actually paying attention to what people off Wall Street think.

Crime Against Nature

In the past year I've witnessed more crimes against financial nature committed than in the previous 20 combined:
former Merrill Lynch & Co. traders writing op-eds for the New York Times questioning Wall Street's right to bonuses; Wall Street CEOs afraid to show their faces in Davos: Wall Street firms canceling their boondoggles in Las Vegas out of concern for appearances; former investment bankers telling journalists how much happier they are having more time to spend with the family.
It's gotten so bad that Michael Moore, saying how encouraged he has been by financiers who have written to him, is now mass e- mailing Wall Street employees in search of even more guys who want to confess their sins to his cameras.
Even as I write I am watching the eunuchs now posing as Wall Street CEOs bend over backward before some congressional committee to prove that the operation was a success, and they are now well and truly without testicles.
John Mack swore that he and everyone else at Morgan Stanley have only a secondary interest in money -- that the guys at Morgan Stanley love to bank so much that if necessary they'd do it for free. Vikram Pandit went out of his way to apologize for ordering up a single corporate jet. "I get the new reality,"
he said.

Get It

No, Vikram, you don't. You think the new reality is cowering and simpering before elected officials so that they'll quit being mean to you and maybe even let Tim Geithner give you more money.
The new reality is that you need to grow a pair. Here's how:

-- Play the hand you've been dealt rather than the hand other people insist that you hold.
Pandit and Mack and the rest have completely swallowed "the people's" line that because they've taken taxpayer money they are somehow now required to care how "the people" feel about them.
Think about this. Some fool comes along and gives you $15 billion, no strings attached. The fool doesn't own you. You own him. Mack needs to stand up and say, "We at Morgan Stanley are pleased by your investment. Now, if you ever want to see a dime of it back, go away.
We'll call you if we need you."

Thain's Right Idea

John Thain had the right idea: The minute these numb nuts started to meddle in his affairs he demanded a $10 million bonus after spending $35,000 on an antique commode. Thain's mistake was his last-second failure of nerve. The minute he was exposed in the newspapers he panicked like a 6-year-old caught trying to steal an extra cookie. Which brings me to my second point:

-- Don't allow yourself to feel guilty.
America is supposedly outraged by your behavior. See America's outrage and raise it. "You blame Wall Street for this financial crisis?"
Ken Lewis might ask, as only Ken Lewis might.
"I'm not the guy who walked away from the house he bought but can't afford. I'm not the guy who reneged on his debts. All I did was make it possible for you ingrates to live large, like me."
Having established this pose of righteous indignation (poor people should be thanking Wall Street for agreeing to have anything at all to do with them) seek opportunities to extend it.

Guilt Kills

For instance, John Thain might point out that the thoughts he had while admiring his commode paid for the thing many times over and so he wished only he had spent even more money on the thing. Vikram Pandit might insist that Citi Field not only remain Citi Field but that Citi's subprime-mortgage traders should throw out every first pitch. Lloyd Blankfein might demand further compensation from the Treasury for allowing former Goldman employees to spend so much valuable time on the public's business.
The main point is that guilt is financially counterproductive. To combat yours you need to identify exactly the sort of things that cause the average congressman to say "these Wall Street guys just don't get it," and do as many of them as possible.
Which brings me to my third and final point:

-- Embrace your manhood.
We've all been hearing a lot lately about the dangers of testosterone. A preposterous idea is gaining traction: that the problem with Wall Street is that it is run exclusively by men.
News flash: Wall Street always has been run exclusively by men.
If this crisis is worse than previous ones it may be because, for the first time in financial history, women were let in. Remember Erin Callan, Zoe Cruz, Sallie Krawcheck?
Some of this advice is, I realize, ahead of its time. Most of it is counterintuitive. But if you step back from your situation you'll see that it requires a radical re-think. Above all, you need to keep on paying yourself as much as you can.
No one really liked you when you were making $45 million a year.
How do you think they'll treat you when you're poor?

(Michael Lewis, author of "Liar's Poker," "Moneyball,"
"The Blind Side" and the fictitious hedge-fund man, is a columnist for Bloomberg News. The opinions expressed are his and hedge-fund man's
own.)

For Related News and Information:
More on Financial Crisis: NI CRUNCH BN More Lewis columns: NI LEWIS For more of the credit crunch: CCRU For more about banks:
BANKS For more columns: NI COLUMNS BN For the top editorial
menu: OPED

Interesting idea from that article... now that I think about it

2009-02-10T17:00:00.007-05:00

The stimulus in place within China (and also applies in principle to other parts of the world) fails consider the consequences of not allocating credit into the private domestic sector as a result of excess government spending/borrowing, which will crowd out any real recovery and structural changes in the Chinese economy to sustain wage growth and domestic consumption. This happened both during policy tightening in the last few years (which inadvertently directed excess private capital towards an overheating stock/property market as a result lack of private credit for domestic industry) and the loosening going on right now (2trln out of 4trln must be from banks). This economist's pretty acrimonious with failed policies of the Chinese government, but he gets it, which is sometimes all that matters! (保8 is China's misguided mantra of protecting an 8% GDP growth with public infrastructure spending, this passage is preceded by passages on the dual-economy--private vs. public--and the misallocation of capital which results... interesting read!). Frankly, im surprised the government lets him publish such scathing attacks on Chinese economic policy :) Good for him, stickin' it to the man

--

"对于2009年政府的4万亿救市工程我想从目的、行动跟手段三方面做一个全面的评估。首先看一看4万亿的资金用途，你们都知道大部分是中西部的基础建设，对于这个用途，我是赞同的，因为它讲的非常明确，目的是为了增加中西部人口的就业量，如果达到这个目的，那在中西部投资完全可以理解，如果你认为这个目的可以达得到，如果为了这个目的保8也可以做得到，但是我要提醒的是，你的副作用是什么？如果要在中西部创造8%的GDP增长需求，同时大量雇佣中西部人口这个我相信做得到，可是我要提醒的是，你能不能够承受副作用，因为金额太大了， 2009年之后能不能筹到4万亿都是未定之数，包括我本人在内都比较怀疑，除非你印钞票，由于9月份开始我们已经和欧美工商链条挂钩，所以从今年开始各级政府财政收入将大幅下滑，这是不可争辩的事实，如果财政收入大幅下滑，你如何筹集4万亿这本身就是一个疑问。
　　可是按照原先规划，中央政府出一万多亿，地方政府出一万亿以及银行融资两万亿，我对于地方政府能够出一万亿我本身就表示怀疑，中央政府能不能出一万亿我也表示怀疑，但是对于银行挪出两万亿我不太怀疑。宏观调控的第一个管道就是在银行的运作之下，它将从民营经济收回大量流动性打给地方政府，从事基础建设。因此它的结果就是民营经济更萧条，这就是代价。同理可推，如果你要从银行拿出两万亿融资，或者是政府直接发债卖给银行，其必然结果就像刚刚讲的第一个管道一样，从民营经济抽出两万亿资金打给地方政府从事中西部的基础建设，如果这个推论是正确的，那么你的代价就很清楚了，你要维持保8，以及中西部就业量所付出的副作用，以及代价就是民营经济更萧条，倒闭更多，失业更严重。

　　我认为目前保8本身都是错的.我国是一个根本不该看GDP增长的国家，真正看GDP的是美国，因为美国都是民营企业.我们呢？我们保8是什么结果？那就是透过钢筋、水泥硬堆起来保8，而且代价就是民营经济更萧条，更贫穷.这就是我们保8，保10的代价，保8，保10的应该是美国。所以目前你问我郎教授具体怎么做？这个不用操心，首先把资源用做于民生相关的民营经济，就是放弃保8，藏富于民。
　　如果我把4万亿投资基础建设，是一锤子买卖，建完了就失业了，那怎么办？再建第二台，再就业，建完以后又失业了，那怎么办？做回头拆第一条，一拆又就业了，拆完以后又失业了，又拆第二条，所以搞了半天你建了两条，拆了两条，老百姓是全民就业，最后什么事都没有干，结果啥事都没有干，这就是基础建设。
　　4万亿投资在民营经济有什么好处呢？就是滚雪球，如果你能把民营经济投资营商环境改善了，你大量投资他，他赚的利润是最重要，当企业赚了利润之后会进行转投资，这样赚更多的钱聘更多的劳工，给他们更多的薪水，然后再进行转投资，从而产生所谓滚雪球的效应。一个国家的富裕，我告诉各位，是靠利润，而不是高GDP的增长率。"

四大泡沫冲击2009中国经济-郎咸平

2009-02-09T15:55:00.002-05:00

Gotta love these Chinese economists telling it like it is. Especially the part about borrowing to buy cars

--

四大泡沫冲击2009中国经济

　　首先想给各位讲两个资料，第一个就是为什么从08年11月份开始，我们深圳和广东地区对外的贸易，或者出口订单大幅下跌，为什么是11月？另外，1月 7号联想开始重组，你认为联想只是一个简单的重组吗？这是这一家公司进入09年之后一个极其悲观的信号，或者叫做一叶知秋。

　　2006年开始股市泡沫、楼市泡沫什么原因？你真的以为是由于我们经济发展更成功了，老百姓更富裕了，所以我们有更多的钱炒楼、炒股就造成泡沫吗？这个说法就是流动性过剩的解释，而且也是由于垄断性过剩，促发了这几年宏观经济调控的解释。但你们在2006年所看到的泡沫现象根本就不是由于经济发展更成功了，老百姓更富裕了，所以有更多的钱炒股、炒楼，也就是说不是流动性过剩.怎么办？那我可以告诉你，这几年宏观调控基本都是存在缺憾的。

　　从2008年8月份开始，中央政府做了180度大转弯，推出了新一轮的宏观调控，其实中国经济这几年从来没有过热，一些部门是过热的，就是和地方政府推动GDP有关的部门是过热的，其他的部门尤其是民营经济基本过冷。我国经济目前最大的问题，就在于2006年之前，我国制造业已经陷入危机，这就反映在了股市泡沫、楼市泡沫。我认为2006年股市、楼市泡沫的原因，是因为我国投资营商环境05年急剧恶化，这样大量做制造业的不做了，就炒股、炒楼，所以我跟他们观点不同，他们认为是流动性过剩，我认为是制造业的回光返照。

　　我们中国的问题是除了我们所面临的金融海啸之外，我们还有一个别人没有的问题，就是我们有第二个危机，叫做制造业危机。而制造业危机最佳的表现，就是 2006年股市泡沫、楼市泡沫，本质就是告诉你制造业出了最大的问题，所以当时我们整个市场一片火热，对危机我们是缺乏认识的。

　　金融海啸是因为破坏了资本主义的灵魂

　　很久很久以前的美国充满信托，那个时刻掌握了资本主义的灵魂，有一群信用卓越的借款人去借款买房子，这些人不但信用卓著，更主要是他有信托责任。如果他还不起钱他不会借，这就是他的信托责任，他找到了中介，中介也充分发挥信托责任努力收集他的材料，包括税单、收入证明等等的。这个审核通过之后再交给银行做审核，银行继续审核，也是发挥自己的信托责任，等到一切都通过以后，就把一万美金借给这个人买房子。我们中国很多银行就到此结束，每个月等着坐收利息，可是美国不一样，美国的金融活动，大概就是这个时候才真正开始。也就是从银行开始所延伸出来的所有金融工具，我们就把它称为衍生性的金融工具。

　　他把一万块债券卖出去，卖给美国政府的事业单位，包括房地美跟房利美，他们就是通过证券化帮美国老百姓买房子，或者卖给美国的证券公司，这些机构买到一万块债券之后会做什么？房地美跟房利美为例，他们就切成市场证券，就叫做证券化，每张是一千美元，加在一起就是一万美元，这些机构买了一万块债券之后，就把它转换成为10张债券加在一起还是一万块，这个债券就是衍生性的金融工具。

　　所以请注意，原先只是1万块债权，后来就变成10张债券，再加上10张保单，一下多了20张衍生性金融工具，还不止如此，这些证券公司还把这些债券和其他的金融工具挂钩，包括美国的股市，或者国债，或者公司债一起挂钩。我们举个例子吧，你怎么挂钩，你和股票市场挂钩，假如今天估值是1万点，如果明天涨到1万5千点，他就给你50%的回报，当然扣很高的手续费，如果跌了，你不用付钱出来，他就把债券利息给你，这种方式很容易做到，就是利用所谓的看涨跌捆绑方式。捆绑之后又创造出一倍、两倍、五倍、十倍、五十倍、上百倍的衍生金融工具，因此创建出一个伟大繁荣的美国金融市场，产品种类非常丰富，不但孕育了一个伟大的市场，同时孕育了一个伟大的华尔街，创造了华尔街神话。

　　请各位注意，这一切的基础，就在于那一个人按时付利息，整个链条都不会产生问题，而维系整个链条的基础就是信托责任。可当你这个体系缺乏信托责任之后的结果,就是从此以后，次级债给这么庞大的美国金融市场加上了一个可怕的因素，叫做三聚氰氨。由于丧失信托责任，而给整个金融体系加上了三聚氰氨，这就是金融海啸.根本不是那么简单因为次级债，你把事情看的太简单了。当你碰到三聚氰氨的时候，你怎么想？你根本就不能理解，怎么会有这种人呢？为了赚钱而害死婴儿的，在人类历史是上绝无仅有的。

　　所以你就对牛奶开始丧失信心，就不喝牛奶了，牛奶工业全线崩溃.同理可推当美国人或者欧洲人发现他们的牛奶里面也有三聚氰氨，所以他们也不喝牛奶，他们的牛奶工业从此以后完全崩溃,他们的牛奶就是这个庞大的美国金融市场。当他们发现他们庞大的金融市场当中有三聚氰氨之后，他们就对他们的金融体系，对他们的牛奶丧失信心，结果他们不喝牛奶，而美国的金融体系将像我们牛奶工业一样全线崩溃，而金融体系崩溃的结果，就是资本主义的全线崩溃，就是这么简单，因为你破坏了资本主义的灵魂。破坏的结果就是资本主义的全线崩溃，所以事情才会这么严重。

　　斩断工商链条设立防火墙

　　什么叫做工商链条？简单的讲所谓的工商链条就是，当一个部门发生危机以后，如果这个政府不帮助这个部门，那就一定会产生多米诺骨牌的效应，这个话讲的不清楚，所以我就把这个链条套在美国身上，我相信你就理解了。如果美国政府这一次不出面救市，是什么结果？那就是第一张骨牌是美国金融体系的崩溃，如果你不救市，那么将冲击第二张骨牌，造成美国人信心的丧失，再冲击第三张骨牌，消费全面下降，再冲击第四张骨牌，企业破产，再冲击第五张骨牌，失业，再冲击第六张骨牌，消费下降，从而形成消费下降的恶性循环。

　　我们在06年所碰到的楼市泡沫跟股市泡沫，其实就是工商链条的第二张骨牌。第一张骨牌是什么？那就是从05年到06年所开始的，我国制造业所面临的投资营商环境急速恶化，大量资金不做制造业，拿出来炒楼、炒股了，从而冲击第二张骨牌，形成股市泡沫，楼市泡沫。 2、3年之前政府误判,使得第二张骨牌倒下，形成股市泡沫。那么由于制造业回光返照，就造成了第三张骨牌，就是楼价下跌，就造成09年的全面停顿。由于是回光返照，所以第四张骨牌一定倒下，那就是08年你们所见证的一切，就是制造业的倒闭。第五张工商链条就是失业，如果第五张还不斩断，那第六张出来了。

　　当把这一切换成工商链条之后，你发现这一切都是可以避免的，我们有三个误判，第一张骨牌是政府的误判，误判的结果造成整个工商链条的全面崩塌。而第二张骨牌倒下，使得中小股民误判，使得地产商误判，误判的结果一定要付出代价，这一切都可以避免，你设想一下2、3年之前我们政府就能运用现在的四大手段，还有电器的以旧换新，渠道的强化，等等这些政策，如果在三年之前推出，这一切都不会发生，第二张骨牌也不会倒下，就不会有股市泡沫、楼市泡沫，既然第二张不倒下，第三就不会倒下，这一切都可以避免，只是三个误判，是误判就一定要付代价。

　　国有化是什么意思？只是一个手段，目的就是为了斩断工商链条，设立防火墙。而国有化是一个有效的手段，我请每一位回到我们的国企改革，一直到现在的银行改革，你知道我们最大的错误是什么吗？那是我们把手段当目的,为了民营化而民营化，这就是错误的。其实民营化也好，国营化也好，这只是手段，你要选择一个最有效的手段，我不管你是国营，或者是民营，都无所谓，目的是什么？目的就一定要为老百姓创造财富，目的要藏富与民。所以我们希望我们政府能够汲取这一次教训，要了解国企改革本身是对的，问题是你的目的是什么？银行改革本身也是对的，问题你的目的是什么？你千万不要把手段当目的，这就是我要透过这个演讲所呼吁的，这一次透过国有化成功地斩断了工商链条，设立了防火墙非常好。

　　四个泡沫

　　我今天要讲四个泡沫，四个泡沫给我们整个经济冲击之大，我们从09年开始会一一享受到，第一个泡沫是股市泡沫，第二个泡沫是楼市泡沫，第三个泡沫就是泡沫消费，我相信你是第一个听到有人这么说，吸收掉我们35%的过剩产能竟然是泡沫消费，你知道其中危机有多大吗？因为只要是泡沫就一定会破裂，只是时间的问题。

　　所谓的泡沫消费简单讲，借钱来做的消费全部都是泡沫消费。美国人靠借钱从事泡沫消费，请你们猜一下美国人借钱来消费，这个钱借了多少，占GDP的比重多少？美国人借钱占GDP的比重高达95%，你能相信吗？这么可怕。

　　相对而言，我们中国人借的钱少得多，我们中国是一个有传统美德的民族。我们只借了13%，美国人是我们的7倍，高负债消费，为什么借钱消费叫做泡沫消费？我们中国人很多很富裕，还可以用现金买汽车，这在美国人看来是疯狂的，难以想象的，我们看他傻，他们看我们更傻。因为美国人穷，他没有现金，他都花了，借钱的原因是因为没有现金，因此要把未来很多薪水都透过借钱的方式拿到今天来花，就是泡沫消费，泡沫消费的本质意义就是把未来该花的钱都在今年花了，所以就叫做泡沫消费。

　　美国人如何从事泡沫消费？美国银行接给A去买汽车，所以这是泡沫消费，因为他借钱买汽车，然后美国银行把一期债券卖给投资人取出一千块，再借一千块给 B去投资买冰箱，再拿一千块债券借给债权人，然后又拿这个债券借给第三个人买电脑，所以他唯一的功用就是从投资里那里取回三千块钱，借给A和B、C进行泡沫消费。而中国透过政府的两项政策，第一就是拉动GDP，使得消费比例达到35%，第二个政策由于招商引资，使产能扩大到GDP的30%，就是我们一半的产能靠着三千的泡沫所吸收的。那么你慢慢看出危机了，就是我们全国对于出口的误判，误判什么呢？我们没有把它当成三千块的泡沫消费，我们把它当成一个常态，我们甚至简单认为美国、欧洲的消费需求上升，所以我们拼命建仓，拼命扩仓，错误是一样的，因为泡沫消费一旦爆破，就像楼市跟股市一样很难起来了。

　　当银行借一千块给A去买汽车以后，他们把这个债权拿在手里不想借给其他人了，为什么不想借呢？因为有三聚氰氨，他就一千块钱抠在手上坐收利息，所以到 11月份美国政府说明什么问题呢？就是美国的泡沫消费由过去三千块跌到了11月份的一千块。美国政府希望拿出8千亿美金里面一千亿借给投资人，请投资人拿一千亿里面的一千块钱向银行收购汽车债权，然后希望银行拿这一千块借给B买冰箱，然后拿一千块冰箱的债权卖给投资人，投资人拿美国政府一千亿里面的一千块钱给银行。希望透过这种借款借给投资人一千亿的方式激活消费市场，否则就冻结了，激活的目的就是让美国人有一千块的泡沫消费变成三千块的泡沫消费。你只要跟从事出口有关的行业，10月份你的出口订单大幅下滑，原因就是中国工商链条透过35%的过剩产能跟美国的工商链条紧密的挂钩在一起了。

　　我在08年年初就说过10月份之后情况急转直下，这是我当时的言论，我当时判定到年底的时候这就是结果。所以这两个管道一旦遇到三聚氰氨使得泡沫消费从三千块变成一千块，第二道防火墙漏水，原因是因为三大汽车公司问题，就像一刀插在我国工商链条的第一张骨牌。这就是你所见到的2009年的开始。

　　所以为什么1月7日联想开始重组，本身已经不是联想是不是要重组了，而且联想现象要使得各位来宾值得警惕，因为他是必然结果，懂得我的意思嘛，这就是我们学到的第三个泡沫。

　　后面还有第四个泡沫， 05年、06年开始，我国制造业所面临的投资营商环境急速恶化，从而冲击第二张骨牌.按照分析，有四大重要原因，以及无数小原因，四大重要原因，第一国家通货膨胀所引发的成本上升；第二个原因，人民币汇率的升值；第三个原因劳动合同法；第四个原因宏观调控的误判，再加上其他一些小原因都是误判，但是太多了，所以我挑四个比较重要的。第一个就是通货膨胀所引发的成本问题，这个是我今天跟大家谈的第四个泡沫。

　　我透过这个场合告诉你一个新的思维，那就是国际通货膨胀的原因是国际金融资本的操作。国际金融资本这20、30年给亚洲各国造成灭顶式的冲击，而且我觉得我们对它的理解是非常肤浅的。毛泽东说的一句话是对的，帝国主义的本质是不会变，今天的帝国主义是以国际化为前导，金融为后盾，他的目的都是一样的。

　　其实我听很多人讲说，我们的经济马上会复苏，我希望他来听听我的演讲，看看日本人，看看亚洲这些国家，看看越南，你再来发言也不迟，请大家多学习一些别国的经验，如果你还有那么一点认识，请你注意，日本的工业基础比我们强多少倍，你知不知道，他都扛不住金融海啸。

　　一个真正以赚钱为目的的国际金融炒家，他赚钱你都不知道为什么。比如建行最大股东是谁？外资股东是谁？美国商业银行，美国银行在07年下半年声明，说次贷危机他们受到重大损失，但是建行的上市让他们赚到1300亿，也就是我们全国13亿老百姓每一个人都付出了100块.因为建行上市的定价权是由国际金融资本所掌控的，这个比什么都重要，你千万注意。一旦取得定价权，它的目的就是石油价格从70块涨到147块，这是算计中国，然后跌到35，这是算计俄罗斯。2009年，普京跟他们还有一场博弈，鹿死谁手，我的水平有限，我不知道，但是我会告诉你们他们将如何博弈，在这次炒作之下，中国应该损失几千亿美金，俄罗斯也损失5千亿美金，在去年9月份的时候，我给上海宝钢上课，我就告诉宝钢，你不要把泡沫当成常态，这是第四个泡沫，叫做国际通货膨胀的泡沫，我请各位注意，今天讲了四个泡沫，你一定要铭记在心，不要用正常的供需原理做判断.

　　第一个泡沫，股市泡沫使得中产阶级倒掉；第二个楼市泡沫使得我们地产行业从09年真正走入冬天，09年开始如果没有大量新建楼盘，你能想象他的冲击多大；第三个是消费泡沫，使得我们占了35%有关的GDP出口制造业陷入全面的困境；第四个泡沫国际通货膨胀的泡沫使得我国和能源相关的产业陷入前所未有的冬天，请你注意这四个泡沫的冲击有多大，大部分的产业都被冲击到了，假设一种情况，如果事先我们就能够有判断，不要误判的话，我们今年情况不至于如此之被动。

　　如何理解中国制造业投资营商环境恶化

　　我告诉各位如何理解中国制造业投资营商环境恶化，第一个叫做国际通货膨胀的泡沫；第二是人民币汇率的升值；第三是《劳动合同法》的误判；第四是宏观调控的误判，连续误判。

　　通货膨胀，叫做国际金融资本，或者叫做国际金融炒家的操纵.我们企业家目前还停留在产业资本的水平.请你记住我一句话，产业资本的思维碰到金融资本所设下的金融战之后，你唯一的可能就是全败。你总认为第一要确保原材料来源，第二要确保你的市场能够销售出去，这就是我们产业资本的简单思维。如果你还停留在产业资本的水平，那你的下场就很凄惨，如果你的对手是金融资本的话，你会被杀的体无完肤。

　　我们这个国家有35%的过剩产能要靠出口来吸收，既然是过剩产能要靠出口吸收，所以出口减掉进口，那一定是贸易顺差，是常态，而且很多工厂进口原材料以后简单加工出口，所以在这种结构之下成为一种必然，就像在去年11月份跟12月份，我们经济已经走下坡之后，出口大跌，比如说11月份出口下跌 2%，12月份出口下跌接近3%，而进口11月份下跌17%，12月份下跌21%，进口下跌的速度远远大于出口下跌的速度，这就是35%过剩产能必然的结果。那是什么结果，人民币就升值，到12月份还升值，我佩服你的勇气，是什么时代，你还敢让人民币升值，我们前一阵子连续贬值5天，被美国一吓不敢贬了。各位懂我的意思吧，有些事是只能说不能做的。而且我们出口这么衰退了，你没有想到人民币现在是全世界最强势的货币，你知道吗？美金在涨，人民币涨的还多，最强势的货币就是人民币，我们出口这么衰退了，你还保持这么强势的增值，我不知道该说你什么，我只有四个字，无话可说。

　　第三个《劳动合同法》又是误判，《劳动合同法》本身意义我觉得是很重大的，这点我们凭良心讲确实是，因为透过国家的立法，透过人大的立法来保护弱势群体本身是值得钦佩的，问题是你错了，到最后形成三输的局面，企业输、劳工输，政府最后买单跟着输，因为第一缺乏论证，第二缺乏试点。

　　第四个宏观调控的误判，这个请大家注意，我这几年就我一个人到处呼吁宏观调控是错的，当然没人听，一直到08年8月份才整个转过来，对中央政府这种态度转变我也给予正面的评价，至少转过来了,政府最近也提出很多的检讨，我觉得这个非常好.为什么会误判？误判的原因只有一个，那就是他认定中国所看到的人民币汇率的上升，股市泡沫、楼市泡沫、通货膨胀他们发生的原因就是认为日本当时是一样的.从表现现象来看，日本当时和我们06年、07年是一样的，可那是日本，他是因为流动性过剩，银行信贷太过泛滥，但是我们中国不是，我们中国就是我讲的工商链条的第一张骨牌，他是由于什么原因呢？是由于投资营商环境急速恶化。可是当政府误判之后。认为是流动性过剩，因此宏观调控的目的就是收回流动性，方法之一提高利率，收回流动性；之二提高银行存款准备金率，收回流动性，而且进行了几年。到了07年年底中央经济工作会议召开，宣布两防，当时我那时候还是比较不成熟，我心急如焚，我到处演讲，到处呼吁政府不能两防，一定要帮助制造业，当然没人听，想自己也多事。你看看到最后还是改过来了，为什么呢？这一切都来源于两个字误判。误判的结果透过三个管道对我国的宏观经济产生重大影响，大家注意听。

　　第一个管道在宏观调控的压力之下，银行从民营企业部门大量收回流动性，打给地方政府从事基础建设去了，就是GDP工程去了，这就是为什么四五年宏观调控下来，我国的广义货币增长率和信贷规模增长率依然维持在16—18%的高峰，依然没有减少，这是为什么？因为钱都去了公共建设部门，这就是为什么这么高的信贷规模增长率，而在座各位民营企业家享受不到实惠的原因，就是因为整个社会流动性产生了逆流转现象，从民营企业转到了公共建设部门，因此根本就不是流动性过剩，而是流动性移转的问题，从而使得民营经济开始萧条，而公共建设部门开始膨胀，这就是我所说的二元经济，和公共建设有关部门是过热的，民营企业大部分是过冷的，我们这么多年就是二元经济。

　　第二个管道在宏观调控的压力之下，配合上了前面的成本、汇率、《劳动合同法》等等压力，使得民营经济部门更不想干了，结果就是从民营制造业拿出大量应该投资在制造业钱不投资，打到过热部门炒楼、炒股去了，从而造成第二个管道流动性由过冷部门逆流转到过热的部门，而使得过冷的部门更冷，过热的部门更热。

　　请你注意，这三个管道毫无例外的都使得这个社会的流动性，过冷的部门更冷，过热的部门更热，这就是07年当政府提高利率，或者存款准备金率，当天的股价都是上升的，而且从无例外，一般都不能解释，一般宏观调控股价应该下跌，为什么上升呢？而且每一次都是上升的，原因就是提高利率的结果，使得更多民营制造业资金进入股票市场，造成股价上升，所以二元经济才能解释这种奇怪特殊的现象.

　　我们的楼市也是二元经济的产物，根据一些学者做的研究，发现深圳资金炒地产资金7%是外资，其中6%是港澳台资金，只有1%是真正的外资，93%都是内资，什么意思？那就是我07年所说的，深圳房价为什么上升这么快？因为深圳企业倒闭数目应该是越来越多。这就是当时所谓的奇怪推论，也就是深圳房价翻几翻的缘故。制造业资金流入楼市的结果通常是进入高档楼盘，所以高档楼盘价格拉高之后，附近中低档楼盘随之水涨船高。所以真正有泡沫的是中低档楼盘，而不是高档楼盘，这种现象就很可怕，由于高档楼盘拉抬速度过快，使得后续大量资金竟然慢慢进入了整个结构错乱的房地产市场，就是以中高档楼盘为主，这个现象是非常让人遗憾的。所以今天我跟大家演讲的，这种楼价上涨的后果使我们地产商产生误判，误判的结果，是大量资源被这种高档楼盘，或者中高档楼盘所锁定，大量资源进入这种楼盘，一旦萧条之后，使这种楼盘产生严重的供过于求的现象，而农民工这样的弱势群体根本买不起，你再怎么跌还是买不起，因为我们整个房地产资源就误导到了结构性的扭曲上面去了，那就是以中高档为主，加上政府提倡的经济适用房和廉租物，这样造成的差距就更大，实际上真正的农民工还是买不起。这就是绝对扭曲式的超额供给，这种超额供给更可怕。11月份开始的金融海啸威胁，使得地产商的资金链变得非常紧张，结果就是09年开始由于误导到这个行业，使得 09年开始的地产没有大面积的新楼盘推出，没有大面积的新楼盘重新开始构建，这个就非常危险，现在不是楼价跌不跌的因素，而是09年政府要如何刺激大面积的构建地产。否则这个冲击是不可想象的，这就是09年的地产危机。地产危机来源就是我刚才讲的，这里是超额供给，这里是超额需求，两个没有连在一起。如果你这么理解房地产市场跟股票市场，你会发现这两个市场的驱动因素就是二元经济，你只要把二元经济彻底理解了，未来的股价、楼市走势非常容易判断。

　　对于2009年政府的4万亿救市工程我想从目的、行动跟手段三方面做一个全面的评估。首先看一看4万亿的资金用途，你们都知道大部分是中西部的基础建设，对于这个用途，我是赞同的，因为它讲的非常明确，目的是为了增加中西部人口的就业量，如果达到这个目的，那在中西部投资完全可以理解，如果你认为这个目的可以达得到，如果为了这个目的保8也可以做得到，但是我要提醒的是，你的副作用是什么？如果要在中西部创造8%的GDP增长需求，同时大量雇佣中西部人口这个我相信做得到，可是我要提醒的是，你能不能够承受副作用，因为金额太大了， 2009年之后能不能筹到4万亿都是未定之数，包括我本人在内都比较怀疑，除非你印钞票，由于9月份开始我们已经和欧美工商链条挂钩，所以从今年开始各级政府财政收入将大幅下滑，这是不可争辩的事实，如果财政收入大幅下滑，你如何筹集4万亿这本身就是一个疑问。
　　可是按照原先规划，中央政府出一万多亿，地方政府出一万亿以及银行融资两万亿，我对于地方政府能够出一万亿我本身就表示怀疑，中央政府能不能出一万亿我也表示怀疑，但是对于银行挪出两万亿我不太怀疑。宏观调控的第一个管道就是在银行的运作之下，它将从民营经济收回大量流动性打给地方政府，从事基础建设。因此它的结果就是民营经济更萧条，这就是代价。同理可推，如果你要从银行拿出两万亿融资，或者是政府直接发债卖给银行，其必然结果就像刚刚讲的第一个管道一样，从民营经济抽出两万亿资金打给地方政府从事中西部的基础建设，如果这个推论是正确的，那么你的代价就很清楚了，你要维持保8，以及中西部就业量所付出的副作用，以及代价就是民营经济更萧条，倒闭更多，失业更严重。

　　我认为目前保8本身都是错的.我国是一个根本不该看GDP增长的国家，真正看GDP的是美国，因为美国都是民营企业.我们呢？我们保8是什么结果？那就是透过钢筋、水泥硬堆起来保8，而且代价就是民营经济更萧条，更贫穷.这就是我们保8，保10的代价，保8，保10的应该是美国。所以目前你问我郎教授具体怎么做？这个不用操心，首先把资源用做于民生相关的民营经济，就是放弃保8，藏富于民。
　　如果我把4万亿投资基础建设，是一锤子买卖，建完了就失业了，那怎么办？再建第二台，再就业，建完以后又失业了，那怎么办？做回头拆第一条，一拆又就业了，拆完以后又失业了，又拆第二条，所以搞了半天你建了两条，拆了两条，老百姓是全民就业，最后什么事都没有干，结果啥事都没有干，这就是基础建设。
　　4万亿投资在民营经济有什么好处呢？就是滚雪球，如果你能把民营经济投资营商环境改善了，你大量投资他，他赚的利润是最重要，当企业赚了利润之后会进行转投资，这样赚更多的钱聘更多的劳工，给他们更多的薪水，然后再进行转投资，从而产生所谓滚雪球的效应。一个国家的富裕，我告诉各位，是靠利润，而不是高GDP的增长率。

　　怎样面对2009年

　　我前面已经跟各位谈了很多09年中国经济的现况跟展望,我们09年应该有什么样的心态？我跟各位做一个提醒，我们的企业家只有个人的辛勤奋斗历程，我们普遍缺乏萧条的洗礼，而且中国改革开放30年不管怎么讲还是比较成功的，因此你们没有经历过真正意义上的大萧条。这就是各位长期保持乐观的原因，我就想拿各位的心态和香港的四大天王做一个比较，香港四大天王，包括李嘉诚、李兆基等，他们除了和你们一样有个人奋斗历程之外，他们还经历过各种形势的中小萧条，当然他们也没有经历这么大萧条，就凭这一点差别，就使得这四家上市公司，和我们有着本质的差别。他们很多都是做地产的，他们应该是我国大型地产公司的几十倍，上百倍那么多而资本负债比率我们是100—300%，他们只有20%。而且不是平均20%，每一家都是20%，这个特别难能可贵。

　　我曾经私下问过四大天王里面的一位，我说你这个人这一生有成就的哲学思想是什么？他告诉我两个字，这两个字就是保守，保守是这个人成功的关键。我又问他第二句话，我说你手下这么多公司，不可能每家公司都看，到底注重什么呢？他回答的是这样子，他最重视稳定的现金流，什么叫做稳定的现金流？按照我们对他的研究结果显示，他们透过两个方法做到的，而且四大天王一模一样，这一点我感到万分震惊，第一叫现金打底，第二叫做项目对冲，透过这两个办法达到稳定的现金流。

　　什么叫做现金打底呢？举一个例子。我以李兆基的地产公司为例，我把恒基兆业公司过去20、30年资料做了分析，我发现恒基地产公司在过去五年是负现金流，也就是5年他的资金链是断裂的，但是他没有倒闭，请问各位如果你的资金链断裂的话，你能够支撑多长时间？而他为什么可以撑过五年，我分析的结果是他手上有两个资产非常有意思，一家叫做煤气，一家叫做租赁，这个煤气跟租赁的现金流都是稳定上升，所以虽然地产开发的现金流有5年是负的，可是当我把地产开发的现金流加上煤气的现金流，加上租赁的现金流，加在一起之后，过去20、30年没有一年是负的，统统是正的，这叫做现金流打底。

　　所以我希望在这个场合，能够把这两个心态一个是保守，一个是稳定的现金流这两个金玉良言送给在座各位，但是我告诉你，这个时候稳定的现金流来不及了，你也不可能在短期内创造出项目的对冲，也很难创造出所谓现金流的打底，你唯一能做的就是保守心态下的三大指标，低负债，高现金流，停止投资，至少这是目前李嘉诚做的.

　　中长期你应该做什么？以我们广东为例，你想想中国工商链条第一张骨牌碰到了四大国内冲击之后，为什么这么不抗压，比如成本汇率，《劳动合同法》，宏观调控等等的，那你为什么不可以提升价格呢？你提升价格不是卖的更好嘛，为什么我们广东省制造业从去年开始一大片倒闭，而你不能提高价格？

　　这也是我跟各位讲的第二个观点:定价.在很久以前，当中国经济要发展的时候，美国已经决定了未来的战略，那就是进入了产业链的战争时代。也就是 09年开始你们所面临的这一切不是产品对产品，也不是公司对公司，更不是行业对行业的竞争，而是一个前所未有的产业链对产业链的战争.你真的认为我们中国是制造业大国吗？我告诉你，真正的制造业大国不是中国，是美国.而美国产业链战争最高指导原则，就是把整条产业链一切为二，把价值最低的放在了中国和其他经济欠发达国家.而制造有三大特色，第一破坏环境，第二浪费资源，第三剥削劳工，他不想要。他要的是制造业以外的其他六大环节，包括产品设计、原材料采购、订单规划，商品运输、产品零售、终端，六加一就是整条产业链.

　　为什么你不能提价呢？因为产业链当中定价权是掌握在六，而不是一，所过欧美各国依然掌握着定价权，这就是我今天要告诉各位的。我们这些产业资本的水平走到今天，被金融资本市场给算了，你和美国资本市场相比，还缺了定价权，所以你是做什么败什么.在这种产业链的战争之下，再加上金融战，你可以想象到我们的企业遭受多大的压力。我们为什么有这么多大学生失业，因为真正需要大学生的是六，一是不需要大学生的.因为你是六加一的一，他不需要这么多大学生，我们连这一点都没有看清楚，就搞教改，扩招，结果让很多大学生失业，为什么失业呢？因为搞不清楚六加一.

　　所以我认同政府所谓的产业转型，可是政府所谓的专业转型不是在一里面下工夫，像联想一样，为什么今天演讲告诉你1月7号联想已经宣布要重组，因为联想收购IBM本身我在三年前就批判过他，那就是错的，为什么错？你还是在一里面下工夫，到最后一定回付出代价，他1月7号已经付了。

　　我们犯的最大错误就是在一里面下工夫。而真正该提高生产力的方法，包括传统行业，包括高科技不是抛弃传统行业，而是希望传统行业以及高科技行业都能够从一进入到六加一的整合，这样子你才能提高生产力。你要走上六加一高效整合之路，就是你目前短期之内保有元气，而中长期走入六加一的最高战略指导思想。那么在金融方面有没有可能？我认为在可预见的未来，我们中国人没有机会，但是产业方面的定价权我认为我们从中国开始做还有这个机会。

　　今天已经不再是所谓的金融危机的问题，而是已经严重的波及到实体经济，在这个时刻我建议你，你在短期之内要保留元气，在一定时期之内求生存，留下大量以现金为主的资源，准备一两年之后再出发，而再出发的目的，不是叫你炒楼、炒股，而希望各位以产品为中心，做六加一的整合，而且以龙头企业为推动力量，这是你两年之后做的事情.

I dig this suggestion!

2009-01-16T09:27:00.002-05:00

lovingly ripped off from Market Vertigo by Cliff Draughn

"The third risk I foresee for Obama's administration is the continued thought process of "too big to fail." Whether it is financial services, autos, transportation, etc., the "top-down" approach of providing more and more taxpayer dollars to weak corporations is ill-advised. In my opinion, if you're using taxpayer dollars, then either nationalize the company or let it fail. And, if you nationalize the company then wipe out the bond holders and shareholders, replace the management and board, sell the good assets to qualified buyers, and then and only then, have the taxpayers eat the remaining deficit. With the current "bailout system" we are merely trying to sustain the status quo, which penalizes those banking institutions that did not make bad decisions while at the same time rewarding poorly managed institutions by handing them taxpayer money. Until you put the stimulus money back in the hands of the private sector (i.e., the individual) you're fighting today's housing/mortgage fires with a garden hose. The bailout funds need to be distributed to the homeowners, not the banking and lending institutions. Banks currently taking the government TARP money (our tax money) are adding it as capital to their balance sheets and then sitting on the funds in anticipation of further losses, rather than lending back into the system. Obama should follow the laws of nature: if you have a herd of animals and some become sick, get rid of the sick. Why continue sustaining the sick animals that will eventually die anyway and at the same time risk the entire herd? A prime example of propping up the status quo occurred in December of this year when Treasury Secretary Paulsen made the unilateral decision to guarantee $306 billion of CitiGroup's assets. The guarantee was in addition to the $25 billion Citi had already received in TARP funding. The $306 billion "guarantee" was not part of TARP and was extended without Congressional approval! $306 billion is equal to what our government spent in 2007 for the departments of Agriculture, Education, Energy, Homeland Security, Housing and Urban Development, and Transportation combined. (The Economist) Unfortunately, the only money makers to come out of TARP and the proposed stimulus bill, in my opinion, will be the lobbyists, the legislators (imagine, with our taxpayer money, the campaign contributions to be received!), and a few "selected" legal, accounting, and infrastructure firms."

The Daily Pfennig cracks me up!

2008-12-19T12:45:00.003-05:00

"As reported by the Wall Street Journal...

"Obama's economic team is crafting a stimulus package to send to Congress of $675 billion to $775 billion over two years, according to transition officials. The transition team has conveyed the figures to Capitol Hill, where the package is likely to grow as it works its way through the House and Senate. Obama aides hope to keep the package below the trillion-dollar mark, as they fear being accused of adding too much to the country's long-term budget deficit."

I laugh! As if! As if $775 Billion "won't add too much to the country's long-term budget deficit"! I give up... I really do... The Gov't thinks we are all BUFFOONS! They really do, folks... They are taking us as village idiots, thinking that if they keep it below $1 Trillion, we "won't notice"! "

- Chuck Butler

Yes yes, i agree, as if we don't have enough debt already. I think its funny that people consider us now as Japan in the 90s--that we can spend money/buy bad assets/subsidize losses like they did and create a softer landing. The only difference is our TEN TRILLION DOLLAR DEBT!!! (vs. their 1 trillion reserve--and China's 1.7trln...) Plus, most of these are apparently gonna be mostly on infrastructure when construction workers will probably only make up appx 1/5th of the unemployment coming up (the rest being in finance, retail, leisure/lodging, health/education--don't see them picking up a shovel even if there's a job to do so with). None of this will help solve America's structural problems in its real economy. These short-sighted policies is making my head hurt.

Uh oh... joint FX reserves in Asia to ease USD dependence

2008-10-24T08:40:00.007-04:00

just another incremental step, wonder what they are gonna fill it with? If China/Japan is serious about diversifying out of U.S. treasuries and/or live in a banking/financing world less dependent on the US, it would make sense to do it now while they are still making money on it while deleveraging and unwinding of USD carry is artificially inflating demand (after this is all over, it will be impossible to sell treasuries at 2% for a long long time!)

If the USD didn't have reserve currency status...

2008-10-21T20:24:00.006-04:00

(here comes a stream of consciousness) We'd be fucked. Argentina announced the nationalization of private pension funds today in order for the government to fund its external debt obligations coming due. It must be pretty hard being a pensioner/retiree there today--having your hard earned life savings be put towards buying government debt on a currency that is at best going to be severely debased by the time the crisis blows over and at worst a complete zero by the time Kirchner government is done with it. All because you can't roll over and refinance the debt you've once borrowed from other countries... life sure is tough for an emerging market

Now why isn't the U.S. government suffering the same fate? People are willing to keep buying our bonds to the point where 2% nominal and negative real yields is totally acceptable. The fashionable interpretation of this is that the dollar is actually considered a "safe haven" investment, that this is only because people believe foreigners flock to our currency because its solid, backed by a 14trn dollar economy and the most liquid capital markets in the world. I would love to see if this is the case... if there were some way to pool together the data on the actual demand for dollars out there--and whether we could break it down into real demand vs. short covering (foreigners having buy back the USD to repay eurodollar debt that they can't find refinancing for, or americans themselves bringing money home as international asset prices collapse and the dollar strengthens)... because why anyone would want to accept such absurd yields--on a currency that will most definitely have to be debased should the financing spigot from the likes of China and Japan ceasees--is beyond me. The party is coming dangerously to an end... and at some point, the trillion dollar nationalization programs and investment programs on assets that are likely to be worth much less then they are at "a little less than held to maturity" (in the words of Bernanke...), along with a NEW stimulus package in the works will seem dauntingly impossible as a sensible form of collateral to our creditors. The pyramid scheme goes way beyond wall street--the united states of america is, in a way, the biggest subprime issuer there is. And it's only allowed to function to the extent that "lending standards" of creditor nations are lax, and its in their interest to keep us borrowing because their concern may not ever be the realization on the repayment of our principal, but on the perpetual fees and interest garnered in the form of unsustainable account surpluses on their books (the only difference being that they haven't somehow securitized these and moved them off balance sheet into obscure investment vehicles to be sold to dumb money... maybe even back to americans!). But its scary to see moods changing in Beijing, Tokyo the Eurozone, with voices calling out for a massive revision of the Bretton Woods system--and a call for the diversification from U.S. treasuries (which, if they are serious about they should do it soon while yields are still at 2%). If we are moving to a basket of currencies, or maybe back to the gold standard, it will NOT be fun for America. Real interest rates are going to balloon, and our currency is going to have to be severely debased in order to repay our obligations--that will be the doomsday scenario, and contrary to popular belief in a deflationary environment going forward, we actually have hyperinflation and a great big kick in the balls to teach us a lesson that's going down in history books--never spend beyond your means, educate yourself and work hard, save and invest. However disappointing, this is most likely the inevitable scenario anyway as the current international financial system as we know it is broken. How Nixon managed to make everyone drop out of the Gold standard because we can't repay our debt is beyond me (maybe something that involved having lots of nuclear bombs and the world's most sophisticated military at the time). It was diabolically genius, but something I doubt we can pull off again (what are we going to use as the next fake reserve currency that we can print as much as we want?). But today we still have King Dollar, and the music keeps on playing... and people can arguably love it as the best store of value there is around the world, for which as a country we can get unlimited financing for even in the worst of times. Sadly, it doesn't change the fact that foreigners are slowly coming around to the realization that unbridled anglo-saxon finance and the bretton woods system is broken, that its done much to encourage an unsustainable disequilibrium in the macroeconomic picture of the world (with the U.S. severely bloated on useless consumption and the Asians fooled by the possibility of sustainable economic growth from purchases by a customer that could potentially never be able to pay for any of his buying) owes its origins to a fiat money serving as reserve currency--a store of value that's supposed to be relatively permanent. I've pretty much accepted that the U.S. won't be a comeback kid as it was after the 70s, and that there won't be a cent of left in social security institutions by the time i retire. Unless we have a new economic paradigm or a technological/business landscape change that could match the industrial revolution in output growth and launch us back into profitability as a nation, everything essential to a well functioning financial/social system is bankrupt... pensions, medicare, social security. We won't go as far as to take people's retirement accounts and 401k's to fund our nation's obligations quite yet... but what are we going to do, really, when China and Japan says screw you?

Okay, that's my bearish rant--excess liquidity (i.e. stupid money) will take a while to come back--this massive systematic deleveraging we have today will go on for quite some time. Pick your poison: 1.) slow death by japan-esque decade long deflation and economic recession, or 2.) massive inflation and output loss to end it quickly, so we can get back on our feet and quit dragging it on?

I like to think of myself as an optimist. When this is all over, we will be fine. We do indeed have the world's largest economy of 14 trillion (peak cycle output though?), relatively the most efficient/fair legal system, and the world's most liquid capital markets on the backs of those two giants. So hopefully our politicians still play it cool, come up with the right kind of regulations targeting excess levered risk taking (not blanket regulations hampering financial innovation), spend as little money as possible doing it, and get over the hope that we'll actually make money out of this crisis (cuz we won't, not by buying mortgaged assets at close to held to maturity value, which is most likely the value that our banks are still carrying them for on their balance sheets, and can't sell for less unless we suffer more write-downs leading to more equity injections). I sure hope the government doesn't botch it up yo!

Say hi to your mother for me aite?

McCulley: Paradox of Deleveraging

2008-07-28T12:54:00.001-04:00

Haven't read anything this cool in a while!

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCBF+July+2008.htm

Best satire I've read all year.

2007-12-26T02:44:00.000-05:00

The Economist

Staying at the top
Mao and the art of management

Dec 19th 2007

Books on management tend to define success in the broadest possible terms—great product, happy employees, continuous improvement, gobs of profits, crushed competitors. Even when words such as “excellence” and “success” are omitted from the title, they are often implicit. A case in point is the book which many would say defined the genre, Alfred Sloan's “My Years with General Motors”, published in 1963 when GM was still an iconic company and Sloan correctly acknowledged as the architect of the well-run, decentralised, global corporation.

But focusing on how the best produce the best has its limits. Most managers, after all, do not stitch an industrial triumph from a vast bankrupt junkyard, as Sloan did. They do not delight their customer, crush competitors and create vast wealth. They struggle. They stumble.

Where is the book for them? Who can help the under-performing, over-compensated chief executive fighting to survive intrusive journalists, independent shareholders and ambitious vice-presidents who could do a better job? Where is the role model for the manager who really needs a role model most—the one who by any objective measure of performance cannot, and should not, manage at all?

An obvious candidate is Mao. Yes, he was head of a country, not a company. But he self-consciously carried a business-like title, “chairman”, while running China from 1949 until dying in office in 1976, having jailed, killed, or psychologically crushed a succession of likely replacements and therefore created the classic business problem: a succession void. He thought of himself as, in his own words, an “indefatigable teacher” and the famous “Little Red Book” drawn from his speeches is packed with managerial advice on training, motivation and evaluation of lower-level employees (cadres); innovation (“let a hundred flowers bloom”); competition (“fear no sacrifice”); and, of course, raising the game of the complacent manager (relentless self-criticism).

Mao still has at least a symbolic hold over the Chinese economy, even though it began to blossom only after death removed his suffocating hand. His portrait is emblazoned on China's currency, on bags, shirts, pins, watches and whatever else can be sold by the innumerable entrepreneurial capitalists that he ground beneath his heel when in power. No other recent leader of a viable country (outside North Korea, in other words) is so honoured—not even ones that did a good job.

It was not a nurturing management style that won Mao this adulation. According to Jung Chang's and Jon Halliday's “Mao, the Unknown Story”, admittedly an unsympathetic portrait, he was responsible for “70m deaths, more than any other 20th-century leader”. But why stop at the 20th century? In Chinese history, only Emperor Qin Shi Huang, who started building the Great Wall (in which each brick is said to have cost a life), was competition for Mao; and since the population was much smaller then, Mao is likely to have outdone him in absolute numbers.

Botched economic policies caused most of the carnage. Deng Xiaoping, Mao's successor, turned the policies, and eventually the economy, around. Yet he does not even merit an image on a coin.

The disparity between Mao's performance and his reputation is instructive, for behind it are four key ingredients which all bad managers could profitably employ.

• A powerful, mendacious slogan

Born a modestly well-off villager, Mao lived like an emperor, carried on litters by peasants, surrounded by concubines and placated by everyone. Yet his most famous slogan was “Serve the People”. This paradox illustrates one aspect of his brilliance: his ability to justify his actions, no matter how entirely self-serving, as being done for others.

Psychologists call this “cognitive dissonance”—the ability to make a compelling, heartfelt case for one thing while doing another. Being able to pull off this sort of trick is an essential skill in many professions. It allows sub-standard chief executives to rationalise huge pay packages while their underlings get peanuts (or rice).

But Mao did not just get a stamp from a compliant board and eye-rolling from employees. He convinced his countrymen of his value. That was partly because, even if his message bore no relation to his actions, it expressed precisely and succinctly what he should have been doing. Consider the truth and clarity of “serve the people” compared with the average company's mission statement, packed with a muddle of words and thoughts tied to stakeholders and CSR, that employees can barely read, let alone memorise.

Deng Xiaoping's slogan, which he used in his campaign to revive the economy, had similar virtues. “Truth from facts” is a sound-bite that Sloan would have loved and every manager should cherish, but you won't find it chiselled on a Chinese wall. It doesn't have the hypocritical idealism of Mao's version—nor was it pushed so hard.

• Ruthless media manipulation

Mao knew not just how to make a point but also how to get it out. Through posters, the “Little Red Book” and re-education circles, his message was constantly reinforced. “Where the broom does not reach”, he said, “the dust will not vanish of itself.” This process of self-aggrandisement is often dismissed as a “personality cult”, but is hard to distinguish from the modern business practice of building brand value.

Yet within China economic growth was pathetic and living conditions were wretched. So why did a vast list of Western political, military and academic leaders accept the value of Mao's brand at his own estimation? Even Stalin, no guileless observer, believed in and, to his later regret, protected Mao. The brand-building lesson is that a clear, utopian message, hammered home relentlessly, can obscure inconvenient facts. Great salesmen are born knowing this. Executives whose strategies are not delivering need to learn it.

Chief executives are not in a position to crush the media as Mao did. Nevertheless, his handling of them offers some lessons. He talked only to sycophantic journalists and his appeal in the West came mainly from hagiographies written by reporters whose careers were built on the access they had to him.

The law constrains the modern chief executive's ability to imitate Mao's PR strategy. Publicly listed companies have to publish information, rather than hand it out selectively. But many, within bounds, emulate Mao's media management; others, determined to control information about them, are delisting. Burrow beneath laudatory headlines on business and political leaders, and it becomes clear that the strategy works.

• Sacrifice of friends and colleagues

“Who are our friends? Who are our enemies? This is a question of first importance,” Mao wrote. Sloan agreed. He worried that favouritism would come at the expense of the single most valuable component of management: the objective evaluation of performance.

Mao had a different goal: he did not want people too close to him, and therefore to power; so being Mao's friend often proved more dangerous than being his enemy. One purge followed another. Promotions and demotions were zealously monitored. Bundles of incentives were given and withdrawn. Some demotions turned out well. Deng Xiaoping's exile in a tractor factory may have helped him understand business, and thus rebuild the economy, but that was an unintended benefit.

This approach makes sense. Close colleagues may want your job, and relationships with them may distract you. Mao's abandonment of friends and even wives and children seemed to be based on a calculation of which investments were worth maintaining and which should be regarded as sunk costs. Past favours were not returned. According to Ms Chang and Mr Halliday, a doctor who saved his life was left to die on a prison floor after being falsely accused of disloyalty. Mao let it happen: he had other doctors by then.

Enemies, conversely, can be useful. Mao often blamed battlefield losses on rivals who were made to suffer for these defeats. The names of modern victims of this tactic will be visible on the list of people sacked at an investment bank after a rough quarter; the practitioners are their superiors, or those who have taken their jobs.

• Activity substituting for achievement

Mao was quite willing to avoid tedious or uncomfortable meetings, particularly when he was likely to be criticised. But maybe that helped him avoid getting bogged down. From the Anti-Rightist Movement of the late 1950s to the Great Leap Forward, a failed agricultural and industrial experiment in the early 1960s, to the Cultural Revolution in the late 1960s, Mao was never short of a plan.

Under Mao, China didn't drift, it careened. The propellant came from the top. Policies were poor, execution dreadful and leadership misdirected, but each initiative seemed to create a centripetal force, as everyone looked toward Beijing to see how to march forward (or avoid being trampled). The business equivalent of this is restructuring, the broader the better. Perhaps for the struggling executive, this is the single most important lesson: if you can't do anything right, do a lot. The more you have going on, the longer it will take for its disastrous consequences to become clear. And think very big: for all his flaws, Mao was inspiring.

In the long run, of course, the facts will find you out. But who cares? We all know what we are in the long run.

Calculating Inflation

2007-11-18T14:09:00.000-05:00

The John Mauldin newsletter this week makes me wanna go "Anarchy burger! Hold the government..." (just like the good old punk rock days, pat on the back for those who know what I'm talking about, although this might be too old school and before they wuz cool HAHA)

It's intriguing to read things from those who have been around in the markets long enough to comment on how the "good old days" differs from the "brave new world". John Mauldin is always very good at this, and he does it like a true straight-talking Texan who never tries to bedazzle an audience with unnecessary detail and technical language. There's a reason why poor people have been finding it harder and harder to survive in this country while official statistics continue to suggest nothing out of the ordinary. This article is fly, and it will teach you a thing or two about the obfuscation in government statistics (Inflation figures emphasized)... especially if you are contrarian, and perhaps by nature are disinclined to believe politics and politicians, then it will make you quite dandy, and gives you something to be politically incorrect with at dinner parties and cocktails.

That one paragrapher, about shifting from the fixed basket arithmetic calculation of CPI, to the variable basket geometric calculation--and the relationship between that decision and how much politicians wanted to lower social security and welfare payment burdens... sure seems to make sense!

--

How do You Spell Stagflation?
November 16, 2007
By John Mauldin

How do You Spell Stagflation?

I wrote this summer that it was likely that we would see inflation as reported in the Consumer Price Index rise dramatically in the fourth quarter. This is due to the very low year over year comparison numbers of last years fourth quarter. We got the CPI numbers yesterday, and we did indeed see a rather uncomfortable rise in inflation, just as I predicted. "Headline" inflation is at 3.5% over the last 12 months, well above anybody's comfort level, and "core" inflation (inflation without food and energy in the numbers) is at 2.1% over the same period.

It is likely to look worse in the coming months, at least in the statistics. To see why, let's go the table below from the Bureau of Labor Statistics who creates the CPI.

The monthly numbers are the index for inflation. Since the base is from 1982-84, we can see that sometime last year prices doubled over the last 25 years. But it certainly feels like it has been more. We will look at how those numbers are created in a minute, and whether we can attach much credulity to them.

Now, here is what to notice in the table. The number for December is the same as the number for October. Since the beginning of this year we have seen a steady rise almost every month. If you assume inflation is running at 2%, this would mean that the November number would yield a 3.8% inflation rate and would be closer yet to 4% for December.

If you extrapolate the inflation of the past two months for the next two months, that would take inflation slightly over 4% as we go into the next two Fed meetings. Yes, we all know the Fed prefers to look at core inflation, but at some point you do have to pay attention to the headline number.

Today, in a speech in New York, Federal Reserve Governor Randall Kroszner said policy makers probably won't need to reduce interest rates further to help the economy weather a "rough patch" in the coming year.

"The current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate," Kroszner said. Data consistent with such growth "would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate."

The risks are roughly balanced between inflation and growth in his opinion. However, futures prices still suggest that the market expects an 84% chance of a rate cut at the December 11 meeting.

Cooking the Inflation Books

Just for the record, I want to state that I know as does nearly everyone else who pays attention to the CPI statistics that they are bogus. They do not reflect the real world that you and I, gentle reader, live in. So, while it may look like I take them at face value, I do so only because the Fed pays attention to the number, (nod, nod, wink, wink) and makes policy based upon it. So, let's look at how the calculation of the CPI has been politicized and how much of a difference it makes, and then go on to the expectation for statistical inflation in the near future.

John Williams writes an excellent monthly letter on all types of government statistics called the Shadow Government Statistics at www.shadowstats.com. One of the things he points out that during the Clinton administration, the way the BLS calculates inflation was changed. He calculates his own inflation number using the old pre-Clinton inflation model. Using that methodology suggests that inflation is at 7%. And if you use other methods, inflation might even be substantially higher. Look at the chart below.

Since the CPI is used to calculate the increase in Social Security payments and a host of other items, calculating inflation is important. I the early 1990s the arguments in the press was that inflation was over-stated. Michael Boskin, chief economist in the first Bush administration and Alan Greenspan were among the chief proponents for a new methodology of accounting for inflation.

Quoting Williams: "Up until the Boskin/Greenspan agendum surfaced, the CPI was measured using the costs of a fixed basket of goods, a fairly simple and straightforward concept. The identical basket of goods would be priced at prevailing market costs for each period, and the period-to-period change in the cost of that market basket represented the rate of inflation in terms of maintaining a constant standard of living.

"The Boskin/Greenspan argument was that when steak got too expensive, the consumer would substitute hamburger for the steak, and that the inflation measure should reflect the costs tied to buying hamburger versus steak, instead of steak versus steak. Of course, replacing hamburger for steak in the calculations would reduce the inflation rate, but it represented the rate of inflation in terms of maintaining a declining standard of living. Cost of living was being replaced by the cost of survival. The old system told you how much you had to increase your income in order to keep buying steak. The new system promised you hamburger, and then dog food, perhaps, after that.

"The Boskin/Greenspan concept violated the intent and common usage of the inflation index. The CPI was considered sacrosanct within the Department of Labor, given the number of contractual relationships that were anchored to it. The CPI was one number that never was to be revised, given its widespread usage.

"Shortly after Clinton took control of the White House, however, attitudes changed. The BLS initially did not institute a new CPI measurement using a variable-basket of goods that allowed substitution of hamburger for steak, but rather tried to approximate the effect by changing the weighting of goods in the CPI fixed basket. Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting. The Boskin/Greenspan benefit of a geometric weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price.

"Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third."

Then to confuse the process even more, the BLS uses something called hedonics, from the root word hedonism. Essentially, the adjust the price of an item based on the "pleasure" or increased value you get. Thus, they don't price automobiles based on the sticker price, but on what you get for your money. If the manufacturers load in more items like new electronics or anti-locking brakes that were not standard the year before that means you are getting more value for your dollar, so therefore the price in terms of inflation goes down even though you may be paying the same or even more to get out of the car show room.

The same is true for computers. We clearly get more power every year, so for the BLS the price of computers are going down, although it seems to me that the price I pay for a top of the line computer is about the same as it was five or ten years ago.

If the government mandates an additive to gasoline that costs 10 cents more, that is not included in the inflation numbers, because we get a new, improved gasoline that pollutes less. Supposedly the pleasure of breathing cleaner air reduces the costs to our pocket book, or something like that.

My health insurance costs have tripled over the last ten years, and I know that is the experience of many of my readers. Yet, the BLS has medical costs rising by less than 50% for the last ten years. Their data suggest the cost of housing has risen by about 30% over the last ten years. Again, that is not the experience of many of my readers.

Social Security expenses are $657 billion per year. If Williams is right (and I think he is) that under the old methodology that expenses would have risen by a third, then that means we are spending $200 billion a year less. Add $200 billion to the deficit. And then watch politicians panic.

I am not one to suggest conspiracy, but if the CPI reflected the real world, the US government would be spending far more money on Social Security and a host of other pension programs. The crisis we will be experiencing in about 8 years would have already hit us. Thus, there was an incentive for leaders to find economists who could argue for new, more "progressive" methods for calculating inflation. Notice that this was done by the BLS without any protest from Congress.

None of this was done behind closed doors. The BLS, to its credit, is extremely open about how it calculates CPI, and you can get an enormous amount of detail on their web site about prices of things like tomatoes in very part of the country going back for decades.

But the way we calculate the CPI is not going to change. No administration will want to go back and add in an extra 4-5% a year to Social Security and other government pension programs. So, let's return to the prospects for a rise in the CPI in the near future, which will have policy implications for the Fed.

Gaming the Producer Price Index

On Wednesday, we got the Producer Price Index. After the above notes on the CPI, it will probably not come as a surprise that there may be some problems with the PPI. The PPI rather oddly has the price of energy going down in October. PPI is important, as it is in indication of the trend of inflation in consumer prices in the future.

As friend Bill King notes:

"Since June, BLS has energy prices declining in all three PPI stages: finished, intermediate and crude. For June finished energy goods the index is 160.9, for October 159.5; the intermediate prices are 179.9 vs. 178; for crude it's 238 vs. 232.9. BLS has energy prices DOWN 3.64% since July!!

"Oil has rallied from ~$75 to the mid-90s since July 9. Over the same period, gasoline has rallied from $1.95 to $2.35; heating oil has rallied from $2.15 to $2.55; natural gas has fallen from $8.50 to $8.25."

That means that inflation in the PPI numbers may be less than the table below, which is bad enough. Notice the increase in the change of year over year inflation in the index over the last 8 months.

Another table shows "core" PPI, without energy and food, and you find that core PPI is flat. Again, we are seeing almost all of the real inflation in food and energy. But with a falling dollar, do we expect food and energy prices in the US to fall as well, since much of the price of food and energy is determined on international markets?

Consumer Spending is Up, but then Again, It May Be Down

Headline consumer spending came in up 5.2% year over year, which suggest a very respectable growing economy. But retail sales were only up 0.2% in October, which is below inflation. In other words, retail sales fell in October in real terms. But digging deeper into the numbers, we find a problem. Remember food and energy. As Greg Weldon points out, it is unlikely that US consumers bought 16% more gasoline than they did last year. The increase in spending for gasoline was all related to price. Ditto for food.

John Williams says the same analysts who want to use core inflation should also use core retail sales. And if you take out food and energy from retail sales, you find consumer spending to be flat in October. There were multiple categories like home furniture, music, electronic games, etc that were in outright declines. Most interestingly, online sales actually dropped last month. Annual sales growth dropped to its lowest number in years.

FedEx warned today that its earnings would be down due to fewer shipments and higher energy costs. The number of containers coming into the US is down. Retailers are expecting a very modest Christmas season.

So, we come to the question: Is the economy slowing and thus the Fed will cut, or is inflation rising which will force the Fed to sit tight?

A Two Dimensional Problem

I recently spent some time with the very brilliant Columbia Professor Graciella Chichilnisky (the economist whose work created the carbon credit markets, among other things). We got to talking about the problems the Fed is facing, and she gave me a very interesting insight from a paper she had written a few years back. I am going to try and re-create it, though I am sure I will take some of the potency away in trying to put it in my simple terms.

Assume that you have an individual living in a two dimensional world. For them there is only length and width, but no height. Then let's draw a line between two exactly opposite points above and below that two dimensional world and connect them with a line. At the precise point where the lines meet in the two dimensional world, to the individual in that world, it appears that both points are exactly the same. Two things which would clearly be opposite to anyone living in a three dimensional world would be equal in a two dimensional world.

The Fed faces a problem something like that. They are living in a two dimensional world, working with two dimensional tools (they can cut rates or raise them) but the problems they face are multi-dimensional.

If they cut rates, the dollar will fall and import prices rise, and it will also likely have negative effects on food and energy prices. If they do not cut rates, the markets will simply throw up as it will interpret that as a Fed which is not concerned about a slowing economy.

Not cutting rates risks an economy that could easily slip into recession due to a growing risk of a credit crisis turning into a credit crunch. Usually, that means that inflation will fall. Usually, but not always.

The Fed is faced with a problem I predicted four years ago in this letter and in Bull's Eye Investing, as the Fed dramatically eased monetary conditions in an effort to fight deflation. In a word, stagflation. That terrible moment in time when an economy slows (is stagnant) yet inflation is high, limiting the monetary authority's ability to act.

With a clearly slowing economy, a credit crisis, and rising inflation, they have no good and clear choices. Whatever they do is likely to create problems in a multi-dimensional real world. I still think they cut, as core inflation is still close to their comfort zone. But if core inflation starts to rise, they will have to act. Or at least should.

Saudi Justice

I usually avoid controversial matters, other than economics and finance, but I came across a story which I think deserves attention. It seems that a 19 year old young lady in Saudi Arabia was gang-raped by six armed men. They got between one and five years in prison. Because she was in a car with a man who was not related to her, she was given a sentence of 90 lashes. Because she appealed and a higher court ordered another trial, the court then more than doubled the sentence to 200 lashes.

"A court source told the English-language Arab News that the judges had decided to punish the woman further for 'her attempt to aggravate and influence the judiciary through the media.'" Her lawyer had his credentials removed for defending her. This is simply barbaric. It is an affront to any civilized thoughtful person. Where are the protests? Are we to believe that the Saudi royalty condones such acts?

http://www.breitbart.com/article.php?id=071115145104.rykb7bub&show_article=1Ifanyone

I hope that other writers will use this in their letters.

New York, Toronto, Europe and Thanksgiving

This week I had to take a quick one day trip to Toronto. Changing my ticket ended up costing me six times the original round trip ticket. To add insult to injury, I got in a taxi at the Toronto Airport. It used to cost about $50 Canadian dollars to get a ride to downtown. The price has risen to $60 and then throw in a $10 tip. A few years ago, this would cost me about US$35. Today it was $70. I offered the taxi driver 3 twenty dollars bills and a tip, but he pointed out that the exchange rate made my US$60 only worth about Canadian $55. Sigh.

I am going to have to go to New York again in a few weeks to attend the Minyanville BBQ picnic and charity fundraiser. South African business partner Prieur du Plessis will be there, but I am going because his wife Isabel has demanded my attendance. And a European trip late in January is shaping up.

There will be no Thoughts from the Frontline letter next week, as it is Thanksgiving, and I am going to take the day off and spend it with the kids. They are all seven coming back home. I know that it will not be too far into the future when they are going to get scattered and having them all under one roof at the same time is something to be savored. I will make prime and smoke turkey, with mushrooms and all the fixings. I do so love Thanksgiving. Friends and family, food and Cowboys football, great wine and laughter. It just doesn't get any better.

I hope those of me readers in the US have a good Thanksgiving as well. Have a great week.

Your thinking about how the world will change analyst,

John Mauldin
John@FrontlineThoughts.com

Wall Street's House of Debt

2007-11-02T14:28:00.001-04:00

The Bear's Lair: Level 3 Decimation? By Martin Hutchinson October 29, 2007 Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.com There's a mystery on Wall Street. Merrill Lynch last week wrote off $8.4 billion in its subprime mortgage business, a figure revised up from $4.9 billion, yet Goldman Sachs reported an excellent quarter and didn't feel the need for any write-offs. The real secret of the difference is likely to be in the details of their accounting, and in particular in the murky world, shortly to be revealed, of their "Level 3" asset portfolios. Both Merrill and Goldman have Harvard chairmen - Merrill's Stan O'Neal from Harvard Business School and Goldman's Lloyd Blankfein from Harvard College and Harvard Law School. Thus it's pretty unlikely their approaches to business are significantly different - or is a Harvard MBA really worth minus $8.4 billion compared with a law degree? (The special case of George W. Bush may be disregarded in answering that question!) We may be about to find out. From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks' balance sheets. The new accounting rule SFAS157 requires banks to divide their tradable assets into three "levels" according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks' own models. Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman's capital of $36 billion. In an extreme situation therefore, Goldman's entire existence rests on the value of its Level 3 assets. The same presumably applies to other major investment banks - since they employ traders and risk managers with similar educations, operating in a similar culture, they probably have Level 3 assets of around twice capital. The former commercial banks Citigroup, J.P. Morgan Chase and Bank of America may have less since their culture is different; before 1999 those institutions were pure commercial banks and a substantial part of their business still lies in retail commercial banking, an area in which the investment banks are not represented and Level 3 assets are scarce. There has been no rush to disclose Level 3 assets in advance of the first quarter in which it becomes compulsory, probably that ending in February or March 2008. Figures that have been disclosed show Lehman with $22 billion in Level 3 assets, 100% of capital, Bear Stearns with $20 billion, 155% of capital and J.P. Morgan Chase with about $60 billion, 50% of capital. However those figures are almost certainly low; the border between Level 2 and Level 3 is a fuzzy one and it is unquestionably in the interest of banks to classify as many of their assets as possible as Level 2, where analysts won't worry about them, rather than Level 3, where analyst concern is likely. The reason analysts should worry is that not only are Level 3 assets subject to eccentric valuation by the institution holding them, but the ability to write up their value in good times and get paid bonuses based on their capital uplift brings a temptation that few on Wall Street appear capable of resisting. Both Goldman Sachs and Merrill Lynch are reported to have made profits of more than $1 billion on their holdings of Level 3 assets in the first half of 2007, for example, profits on which bonuses will no doubt be paid at the end of their fiscal years. Given that we have had five good years on Wall Street, years in which nobody has known the amount of Level 3 assets on banks' balance sheets, and no significant media waves have been made questioning their valuation methodologies, it would not be surprising if many banks' Level 3 assets had become seriously overstated, even without any downturn having occurred. When Nomura Securities sold its mortgage portfolio and exited the US mortgage business in this quarter, it took a write-off of 28% of the portfolio's value, slightly above the 27% of the portfolio that was represented by subprime mortgage assets. Were Goldman Sachs's Level 3 assets similarly value-impaired, it would result in a $20 billion write-off, more than half Goldman's capital, leaving the bank severely damaged albeit probably still in existence. Defenders of Goldman Sachs and the rest of Wall Street will insist that less than 27% of their level 3 assets are represented by subprime mortgages yet that is hardly the point. Subprime mortgages, estimated to cause losses of $400-500 billion to the market as a whole, though only a fraction of that to Wall Street, have been only the first of the Level 3 asset disasters to surface. There is huge potential for further losses among assets whose value has never been solidly based. These would include the following: * Mortgages other than subprime mortgages. With the decline in house prices accelerating, the assumptions on which even prime mortgages were made are being exposed as fallacious. As house prices decline, debt to equity ratios increase, and for mortgages with an original loan-to-value ratio of 90% or more quickly pass the 100% at which a mortgage becomes uncovered. If the value of conventional mortgages decline many securities related to them, currently classed as Level 1 or 2 assets, will become un-marketable and descend into Level 3 * Securitized credit card obligations. $915 billion of credit card debt is currently outstanding, the majority of it securitized, and its default rate is likely to soar as the full effects of the home mortgage market's crack-up spread to the credit card area. The risks in Level 3 portfolios derived from this asset class arise particularly in the areas of complex derivatives and manufactured assets based on credit card debt pools. * Leveraged buyout bridge loans. After a hiccup in August, the market in these has reopened recently, although around $250 billion of them still remains on banks' balance sheets. The value of a leveraged buyout bridge loan that has failed to find a pier to support the other end of the bridge is very dubious indeed, even though these loans are being carried in the books at or close to par. As the value of underlying assets declines and the cash flow fails to match debt payments, the deterioration in credit quality of these loans will accelerate. * Asset backed commercial paper. The amount of asset backed commercial paper outstanding has dropped from $1.2 trillion to $900 billion in the last three months. This financing structure was always unsound; it was basically a means of removing the assets backing the commercial paper from bank balance sheets, and always faced the problem of a severe mismatch between asset and liability duration. The $100 billion vehicle intended to rescue this market has found a mixed reception to say the least. It is likely that as credit conditions deteriorate, the assets underlying ABCP vehicles will increasingly find themselves on bank balance sheets, where they will prove to be almost completely unmarketable. * Complex derivatives contracts. Even simple interest rate swaps and currency swaps caused large losses in the last significant credit tightening in 1994, although most of those losses were suffered by Wall Street's customers rather than Wall Street itself. The more complex transactions that have been devised during the last twelve giddy years are much more likely to prove impossible either to sell or to hedge. Goldman Sachs reported that in the third quarter of 2007 its profits on derivatives used for hedging more or less matched its losses on subprime mortgages. It is likely in reality that the bulk of those profits were incurred through model-based write-ups of value on contracts that were within the Level 3 category - after all, Goldman's Level 3 assets increased by a third during the quarter. It's not much good shorting to match a long position you don't like if your hedging shorts prove to be impossible to close out. * Credit Default Swaps, the global outstanding value of which in June 2007 was $2.4 trillion, according to the Bank for International Settlements. These are a relatively new instrument, the efficacy of which has not been tested in a downturn. It appears likely that the value in banks' books of their Level 3 credit derivatives contracts bears no relation whatever to reality. As discussed above, the incentives have been all in favor of inflating it. The capital underlying Wall Street, at the top, is not all that large - a matter of a few hundred billion. Given the piling of risk upon risk that has been engaged in over the last few years, and the size of the losses in the mortgage market alone that seem probable - my own estimate last spring of $980 billion looks increasingly likely to be somewhat below the final figure - it appears almost inevitable that in a bear market in which liquidity dries up and investors become skeptical, Wall Street's capital will be wiped out. Only the commercial banks like Wachovia and Bank of America whose investment banking ambitions have been largely thwarted and portfolios of Level 3 rubbish are correspondingly lower are less likely to disappear. Given the size of the overall figures involved and the excessive earnings that Wall Street's participants have enjoyed over the last decade, a taxpayer-funded bailout of Wall Street's titans would seem politically impossible, however loud the lobbyists scream for it. In the long run, that is probably a blessing for the US and world economies.

Some bearish thoughts on bearish views

2007-10-24T23:41:00.000-04:00

Seems these days, investors can't get enough of gold. Who can blame them, look at any gangbuster chart of gold in terms of the dollar and its hard not to jump on the bandwagon. Especially if there are bearish geniuses spelling out exactly how an impending doom of the global economy might play out--and very convincingly too.

Therefore, it's always nice to read a refreshing piece or two that run counter to the overwhelmingly articulated arguments to own gold. I'm still pretty bullish on Gold myself--and still a believer in very inflationary times ahead, but these days I have been catching a few sneezes here and there curing my conviction hours--not because I don't think America and the American economy is going to be pretty gloomy in the next decade or so, but because of the sheer volume of liquidity that has been piling into gold, commodities, ect... THINKING IT'S AN ATTRACTIVE HEDGE/ALTERNATIVE TO THE MARKETS! The talks of a supercycle that is driven by demand from the likes of BRIC and other emerging markets seems old news, and is actually very accepted now among the investment community, maybe too fast too soon. So while you have the bulls calling for stock markets to be quite alright, you have the bears calling for a rush to safety in precious metals and secular growth commodities (secular only if China keeps up). In other words... everything is up! bulls and bears (shorts excluded) both party! unbelievable! And it's times like these, I get agnostic. There's simply too much money out there still!

Call me a party-pooper, but if (1) liquidity leaves this area--i.e. China slows down or (2) Bernanke grew balls and started targeting excess money supply at the expense of economic growth, then I think there could be a severe correction in not only asset prices, but also the things that are supposed to be "safe" havens for investors--Gold included. Bulks, basic metals, cyclicals, softs (maybe not this one, a story for another time) will do even worse.

The following article tells it well, with a specific focus on Gold. In a nut-shell, it's important to focus again on the Bernanke factor. If, again, he grew balls--ignored politicians and wall streeters like a central banker should in the first place, and raised rates and somehow manage to start a tradition of inflation-fighting, money supply targeting Fed, we will see some serious issues in the Gold call. The market is already pricing in that Bernanke isn't the type of guy that is serious about controlling inflation at the expense of offending wall street and the government (which might be a dangerous assumption since we arguably don't know much about his ultimate policy stance yet, outside the one time liquidity injection he gave that was necessary to prevent a complete banking crisis, and the snippets of being another Alan Greenspan--what investors want to believe). Nobody took Paul Volcker's words seriously at first when he said he's going to focus on fighting inflation (as you'll read about in the following article)... Bernanke said the same things along those same lines once or twice, but nobody is taking that seriously so far--so it's yet to be seen.

Meh... its too late at night. I don't even know sometimes why I focus on these macro things since everything that's ever made me money in my short and humble investing career has mostly been unsystematic, business specific, microeconomic positions. But hey, what can you do, I guess it's too interesting to avoid :D I can't wait until everything is cheap again.

Anyway, without further ado, here is that refreshing look on Gold

--

FORECASTS & TRENDS E-LETTER
Gary D. Halbert
October 23, 2007

Why I’m Taking Profits In Gold Now

IN THIS ISSUE:

1. My History With Precious Metals

2. The Precious Metals Crash Of January 1980

3. Why I’m Selling My Gold Coins Now

4. I’m Not Bearish On Gold

5. Pros And Cons Of Investing In Gold

6. Gold Exchange Traded Funds Revisited

Introduction

As discussed last week, the response to our recent Reader Survey was much larger than we expected, and we received tons of comments and suggestions. Interestingly, many of you asked me to write about precious metals from time to time. The timing was excellent, since I sold most of my gold coins last week when gold prices topped $760.

The last time I made a sizable investment in gold coins was back in 1998 and 1999 when gold was around $300 per ounce. At that time, I purchased a large number of uncirculated American Gold Eagle coins. I also bought several bags of circulated silver coins, also known as “junk silver.” I have been sitting on them ever since, until now.

Obviously, gold and silver prices have risen substantially since 1998/99, especially in the last two years, and most especially in the last three months as prices spiked higher. Many analysts believe precious metals prices will rise much more in the months and years to come. There are plenty of predictions of $1,000 gold, and maybe they’re right. But in the pages that follow, I will tell you why I sold all but my core holdings of precious metals now. I’ll also tell you a little about my history with precious metals. I think you will find it an interesting discussion.

We will also revisit the subject of exchange traded funds in gold. There are currently two gold ETFs, and they have become a very popular way to participate in the movements in gold prices without having to own the physical metal.

My History With Precious Metals

After getting my Masters degree in 1975, I went to work for Continental Grain Company, one of the largest grain and agribusiness companies in the world. After less than a year, I became a broker in the company’s commodities futures division in their Dallas branch office. Specifically, I was what was called a “hedging broker.”

In a relatively short period of time, I developed a large clientele which consisted mainly of grain elevators, commercial feedlots, cotton gins and many large farmers. Most of my clients were located in Texas, Oklahoma, Louisiana and Arkansas. My clients were not in the futures markets to speculate; rather, they used the futures markets to “hedge” the value of their inventories of whatever commodities they dealt in or produced so as to protect their profit margins.

I actually taught most of them how to do it. In 1977, I wrote a manual entitled “Hedging – Can You Afford Not To?” which explained in layman terms how the complicated process of hedging in the futures markets works. With all of these clients, I quickly became one of the largest producers in the company by the ripe old age of 25 or 26.

What does this have to do with precious metals, you’re probably asking. I’m getting there. It was also in 1977 that I was introduced to The Bank Credit Analyst. At that time, BCA was predicting that inflation was going to get out of control, and that precious metals prices, and tangible assets in general, were going to go through the roof in the next few years.

Of course, I was writing about BCA’s forecasts in my newsletter, even back in those days, and most of my clients agreed that inflation was going to be a big problem in the next few years. They wanted to know how they could make money from this trend. I had always urged my clients not to speculate in futures on the commodities they dealt in or produced. But in this case, we were talking about precious metals futures – gold, silver, platinum, etc.

In 1978, most of my clients loaded up on gold and silver futures at a time when gold was below $200 and silver was below $6. As most of us remember, inflation ran rampant in the last few years of the 1970s, and precious metals prices soared just as BCA had predicted. By late 1979, gold had reached $650, and silver had soared above $30.

My clients were making a killing, and I was a hero. As noted above, I had a lot of clients, and with all the market positions we had on - hedge positions and speculative positions - my daily printout of all accounts and all positions stretched the entire length of our large office suite.

But BCA Killed The Party In Late 1979

You may recall that Paul Volcker became Fed chairman in August of 1979, with a mandate to get inflation under control. Initially, there was a widespread consensus that Volcker was not going to take any significant actions to bring down inflation, what with Jimmy Carter in the White House. However, by late 1979, BCA thought otherwise.

Shortly after Volcker took over at the Fed, he talked about implementing a new monetary policy. Rather than targeting interest rates, as had been done for years, he was going to target the growth in the money supply. Volcker believed that if he squeezed the money supply, interest rates would rise and eventually choke off inflation. And he basically said he didn’t care how high interest rates had to go to get the job done.

As noted above, few believed Mr. Volcker’s words. But BCA did. In their November and December 1979 monthly reports, the BCA editors made it very clear that they believed Volcker was dead serious. They warned in chilling terms (at least for me) how they believed interest rates were going to soar, and how that could lead to a serious recession.

Most importantly they adamantly advised readers to liquidate all positions in precious metals, tangible assets and other inflation hedges immediately.

I was stunned to say the least! My clients and I were having so much fun, after all. And we were all very convinced that inflation would not be brought under control. I anguished for several days about what to do. My clients certainly didn’t want to get out of their inflation hedges. But in the end, I decided to take BCA’s advice, as much as I hated to. By the end of December 1979, I had sold out every single position in gold and silver for every client but one. That one client got so mad at me he transferred his account to another brokerage firm.

When I liquidated all of these large positions, gold was in the area of $650, and silver was around $35. Well, gold went on to soar to near $850 and silver to $50. I didn’t look so smart then, but no one complained that we got out a little early, especially after what happened in January 1980 – but I’m getting ahead of myself.

My branch manager was thrilled because of the huge volume of commissions this unloading of metals positions generated. A couple of days after the liquidation was done, my manager came into my office and asked, “When are you going to buy it all back?” I replied, “We’re not, we’re done.” He was shocked, once he realized I was serious.

In the ensuing days, the manager talked to me on several occasions, trying his best to get me to put all my clients back in these trades. I refused, even though the precious metals were still exploding on the upside. Growing weary of his efforts to get me to put my clients back in the market, I finally responded with something like the following (paraphrasing):

Look, this has been an historic run in the precious metals, which aren’t even my area of specialty; thanks to BCA, we got to ride most of this huge move; we made a lot of money for my clients and for the company, and you and me. We’re done.

When I first got in to the commodities business, I heard an old saying that always made sense to me: ‘There’s some for the bulls, some for the bears, but there’s none for the hogs’. What a great saying! I repeated it to my commission-hungry manager, and he never asked me again. Good thing.

The Precious Metals Crash Of January 1980

After soaring to all-time record highs of $850 in gold and $50 in silver, the precious metals markets collapsed in the last half of January 1980. You may recall that the Hunt brothers of Dallas had driven the price of silver through the roof. But as silver futures prices were exploding to $50 per ounce, the New York Comex Exchange arbitrarily raised the margin requirement to hold futures contracts in silver. That signaled the peak.

Silver futures plunged from $50 to below $17 in less than a month! Silver futures were locked “limit down” for 21 consecutive days, meaning that no one could unload their positions. A move from $50 to $17 was a $33 swing, and on a 5,000-ounce silver futures contract, that move represented a $165,000 loss in value. Margin calls were huge, and several large brokerage firms were rumored to be in trouble.

At the same time, gold collapsed from around $850 to below $500 in less than a month. Gold was also limit down for a couple of weeks. To this day, that was the single most violent move in commodities that I have ever seen. Many speculators were wiped out. Fortunately, I got all of my clients out a month earlier. Talk about dodging a bullet! Perhaps this helps explain why I have valued BCA’s opinions for all these years.

Why I’m Taking Profits On My Gold Coins Now

As you probably know, precious metals prices have been on a tear for the last couple of years, and especially in the last few months. Gold has risen from below $450 in late 2005 to above $760 as this is written. Silver prices have soared from around $7 to above $14 per ounce in the last two years, although prices are slightly below $14 as this is written.

On Wednesday of last week, I decided to take profits on all but my core holdings of gold coins. For better or worse, I called the coin dealer I use (Camino Coin) and locked in the price on my Gold Eagles when spot gold was around $760. Gold prices have dropped back a bit since then, but it will not surprise me if gold prices continue to move higher for a while longer.

So why did I decide to sell last week? To begin with, I have been thinking about selling for a couple of months now, what with the sharp rise in gold prices just since August. Most analysts believe that precious metals prices are soaring due to expectations for a significant rise in inflation. Oil prices are at all-time record highs, and precious metals often track the price of oil to some extent. As noted above, there are analysts who now predict that gold will hit $1,000 per ounce on this move, and maybe they will be correct.

However, as I have discussed in recent E-Letters, the latest inflation numbers have been tame, even as oil prices have soared to record highs near $90 per barrel at one point last week. The Consumer Price Index (including food and energy) rose only 0.3% in September and was down 0.1% in August. For the last 12 months, the CPI is up 2.8%, and the trend is down. The “core” CPI is up only 2.1% over the last 12 months. That is hardly runaway inflation.

Meanwhile, BCA has maintained for several months that US inflation will surprise on the downside over the next year or so. What with the US and global economies slowing down, BCA expects the core rate of inflation to remain tame, or actually decline, in the months ahead. In a Special report issued last week, BCA had the following to say about inflation:

“The cyclical tendency of the world economy is leaning toward disinflation or deflation, not inflation. The reason is simple” The bursting of the U.S. real estate bubble is a deflationary shock whose disinflationary impact will continue to be felt in the global economy… This is because asset price deflation often precedes a period of economic weakness, which in turn restrains the business sector’s pricing power.

In short, BCA expects overall inflation to surprise on the downside over the next year, despite soaring oil prices and the increases in food prices.

The tame inflation rates over the last few months are, in part, what led the Fed to cut interest rates on September 18, and it may do so again on October 31. I don’t think the Fed would be cutting rates if it believed that inflation is going to be a problem in the near-term.

I’m Not Bearish On Gold

For the gold bulls in our E-Letter audience, please note that my selling of my gold coins does not mean that I am bearish on gold, although I do believe it is overbought in the near-term. In fact, the long-term supply/demand fundamentals still look quite encouraging. Demand continues to rise, especially from China, and there have not been any major new discoveries of gold in the last couple of years.

There are a number of other factors that have the potential to impact the price of gold in the future. I have discussed these factors in previous E-Letters, and have updated them below as they are just as relevant to the future price of gold as they were back then:

1. Gold is a good store of value during times of uncertainty, and there is definitely no shortage of uncertainty in the world today. In fact, you could call gold the “currency of global uncertainty,” in that, as a general rule, the greater the geopolitical tensions, the more investors tend to buy gold.

2. Gold is considered by many to be a hedge against inflation. I noted above that BCA does not feel that inflation will be a factor in the short-term. However, that doesn’t mean that inflation will never again be an issue. As Baby Boomers retire and the government is forced to borrow to fund Medicare and Social Security, both interest rates and inflation have the potential to rise in the long-term.

3. Although I do not believe that gold reacts to supply and demand in exactly the same way that many other commodities do (see #4 below for more about this), you cannot discount the fact that exploration was down during the period of low gold prices and gold mining companies have had to play catch-up in the last few years, and this has helped push up the price of gold.

4. As I have written before, another reason why gold does not always react to supply and demand forces the same way that many other commodities do is because gold has a hybrid nature. While it is a commodity used by many industries, it is also a currency maintained in large reserves by many countries, central banks and individual investors. As a result, the price of gold is often dictated more by its relative value to currencies rather than on a strict supply/demand basis.

Accordingly, the slide in the value of the US dollar over the last few years has been bullish for the price of gold. If the US dollar experiences a continued decline, this might provide additional upside potential for gold prices.

Obviously, these are not all of the reasons to be bullish on gold, but they are some of the major factors that I keep on my radar screen in relation to the yellow metal, in addition to the supply/demand fundamentals. The point is that there are several factors that are favorable for a continued increase in the price of gold. But you never know. What is clear is that gold prices are at a 28-year high, despite the fact that the US and global economies are slowing down.

Reasons To Be Cautious

Just as there are reasons to be bullish about the price of gold, there are equally valid reasons to be cautious about running headlong into a major gold investment at this point in time.

1. As noted above, gold prices in the US have tripled since the low around $255 in 1999, including periods of time when prices moved virtually straight up. The spike up in prices since late August has sent gold prices from $650 to $760. That suggests to me that the market is ripe for a pullback at any time. Furthermore, gold has heavy overhead resistance (a technical term for selling pressure) from $750 to the all-time high around $850.

However, there have also been significant pullbacks in the price of gold, such as in 2006, and that’s another negative. Gold prices typically fall off a cliff after a sharp run-up, rather than gently trending downward. This extreme volatility can be disconcerting to many investors.

2. Most analysts believe that the US dollar will continue to fall for at least another year. That may well be true, but keep in mind that the dollar is already down apprx. 20%. If for any reason the dollar stabilizes, or begins to rise, that could take a lot of the wind out of gold’s sails.

3. Another thing to keep in mind is that the run-up in gold prices prior to late 2005 was largely a US phenomenon. If you look at gold prices in Euros, you will see that gold prices in that currency were generally flat during much of the big rise in US gold prices prior to that time because the Euro has strengthened relative to the dollar. So, the relative value of gold as an investment sometimes depends in part on what kind of money you have in your pocket.

More recently, however, it is important to note that gold has experienced a bull market even in other international currencies. Click on this LINK to see a chart of gold prices in various currencies since 2003.

4. Contrary Opinion. More often than not, I am a contrarian, meaning that I don’t like to buy when everyone else is buying (or short when everyone else is shorting). Right now, the bullish consensus on gold is very high, as evidenced by the stampede into the new gold ETFs over the last couple of years (more on this below).

5. As prices have continued to rise, gold producers have begun to ramp-up production. As noted above, they may be playing catch-up at present, but at some point increased supplies may adversely affect gold prices. It is also important to note that most of the gold that has ever been mined continues to exist. As prices rise, some of this gold will find its way to the markets. I’m sure you’ve seen the TV commercials for companies that will buy your gold watches, rings, etc. If enough of this “scrap” gold makes its way to the markets, it could help hold down the price.

6. As I have written in recent weeks, the US economy is clearly slowing down, and the odds of a recession have increased. The global economy is slowing down as well. Historically, weakening economies lead to decreased demand for gold and other metals.

As the above pros and cons illustrate, there are many reasons to invest or not invest in gold. For those of you who do want to include gold as a part of your overall diversified portfolio, the question then becomes how to make the purchase.

Gold Exchange Traded Funds Revisited

As I discussed earlier, there are various obstacles to owning physical metals. Obviously, there is the storage issue – you must have a safe place to hold your precious metals, and this can be expensive. There is also the issue of insurance, which is not cheap. Then there is the shipping issue, unless you trade with a local dealer, which frequently will not have the best prices. Typically, you will need to ship your coins or bullion via registered mail, which I found has gone up substantially in the last 10 years.

I know there are some of you who will prefer to keep your gold in a safe deposit box at the bank. For others, however, there are relatively new gold Exchange Traded Funds (ETFs) that address many of the disadvantages of buying, storing and selling physical gold. If you want to participate in the movements in gold prices, I think ETFs are a good way to do it.

In late 2004, I discussed at length the then new gold exchange traded fund (ETF), StreetTracks Gold Trust (NYSE: GLD). Since then, we have seen the introduction of the iShares Comex Gold Trust (ASE: IAU), which is also an ETF. These funds have become very popular for those who wish to participate in movements in the gold market, either long or short.

There are advantages and disadvantages to trading these ETFs in gold. One of the most obvious advantages of the gold ETFs is that they solve the shipping, insurance and storage problems associated with investments in physical gold bullion or coins. Some of the other advantages of this new way to own gold are as follows:

1. Dealer markup is no longer a problem, in that there is no spread between bid and ask prices. There may be transaction costs associated with purchasing and selling these ETFs, but there is no premium to be paid.

2. The gold ETFs are listed on the New York Stock Exchange and the American Stock Exchange, so they are liquid and can be bought or sold any time the market is open and trading. In addition, the gold ETFs may be “shorted” if an investor believes the price of gold will fall.

3. In the past, many institutional investors were precluded from owning gold because of the costs related to buying, selling, and storing the physical gold. The gold ETFs allow these investors to have an undivided interest in gold, but without all the hassles.

4. Gold mining stocks, a popular way to play the gold market, are often significantly overvalued or undervalued, relative to the price of gold for various reasons, and are typically extremely volatile. Because the gold ETFs closely track the price of gold, they have become a popular alternative to gold mining stocks.

Unfortunately, there are still some disadvantages to investing in these gold ETFs. Perhaps the most obvious is that it is not physical gold. For those investors who want to own gold as a store of value in case of emergency, having an undivided interest in gold sitting in a London or Nova Scotia vault will provide little or no comfort. Those investors who want to run their fingers through their gold hoard will still have to buy physical gold, and deal with the storage, shipping and other hassles involved.

Other disadvantages of the new gold ETFs are:

1. As I have written a number of times, the price of gold is very volatile and can move suddenly and without warning. The gold ETFs do not change this characteristic of gold, but at least they offer a way to quickly trade out of a gold position without the hassles of selling physical coins or bars – on the days the markets are open, of course.

2. The success of the gold ETFs likely contributed to the rise in gold prices over the last few years. As large sums of money have flowed into these gold funds, the ETFs have had to buy more and more physical gold on the open market. This buying almost certainly contributed to the upward pressure on the price of gold, and may continue to do so as long as the demand for these ETFs continues to grow.

Of course, the reverse will also be true whenever gold prices start to decline and investors start to sell their shares in these gold ETFs. In that case, the funds will have to sell physical gold on the open market, and this could exacerbate price declines.

3. While shares in the gold ETFs are considered to be securities, the IRS classifies these shares as “collectibles” for tax purposes. This means that long-term gains will be taxed at a higher 28% rate reserved for collectibles, rather than the 15% rate for other types of investments.

The points above do not represent a complete discussion of the advantages and disadvantages of gold ETFs. Be sure to read the prospectus carefully before you invest. However, the gold ETFs can be a good way to participate in the price movements in gold without having to own physical precious metals.

Other ways to deal in precious metals are e-gold.com and e-bullion.com. Both of these are electronic Internet currency facilitators backed by gold or other precious metals. E-gold Ltd., a Nevis corporation, states that it is:

“100% backed at all times by gold bullion in allocated storage. Other e-metals are also issued: e-silver is 100% backed by silver, e-platinum is 100% backed by platinum, and e-palladium is 100% backed by palladium. e-gold is integrated into an account based payment system that empowers people to use gold as money. Specifically, the e-gold payment system enables people to Spend specified weights of gold to other e-gold accounts. Only the ownership changes - the gold in the treasury grade vault stays put.”

Apparently, e-gold and e-bullion have become popular as a form of international payment, as well as an investment medium. How popular, I don’t know. I must emphasize that I have never used e-gold or e-bullion, so I cannot recommend these services.

Conclusions

There is an old saying in the commodities markets that “the solution to high prices is high prices.” This probably sounds strange but generally speaking, when commodities prices rise significantly, production increases and demand decreases. This combination usually results in lower prices at some point.

While I don’t profess to know what gold prices will do in either the short-term or the long-term, I simply decided to take some profits on my gold investment, based largely on how much prices have increased over the last two years, and especially in the last few months. So it will not surprise me if we see a pullback in gold prices just ahead.

And finally, while I have sold my speculative position in physical gold, I still maintain my core holdings in precious metals, and I still have exposure to gold via our futures funds and certain of our Absolute Return Portfolios.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

Stephen Roach Explains It All... Again... For the Last Time... Maybe?

2007-10-22T22:15:00.000-04:00

Like all bearish geniuses, Stephen Roach--many bleak reports later--explains it all again in his most articulate/convincing piece yet. So maybe he is finally right this time, not just in theory but also in timing. Just be glad you didn't start shorting everything frothy when he first started this spiel... unless you have been, in which case, hope that this is subprime/credit issue is the final stroke of the matador in the heart of that raging bull... or, at the very least, a blunt to knock some sense into the current economic arrangement of our times.

Enjoy, read, and absorb every bit. Hope you guys enjoy, I certainly did :D

--

A Subprime Outlook for the Global Economy
By Stephen S. Roach

After nearly five fat years, the global economy is headed for trouble. This will come as a surprise to policy makers and investors, alike-most of who were counting on boom times to continue.

At work is yet another post-bubble adjustment in the world's largest economy - this time, the bursting of America's massive property bubble. The subprime fiasco is the tip of a much larger iceberg - an asset-dependent American consumer who has gone on the biggest spending binge in the modern history of the global economy. Seven years ago, the bursting of the dot-com bubble triggered a collapse in business capital spending that took the US and global economy into a mild recession. This time, post-bubble adjustments seem likely to hit US consumption, which at 72% of GDP, is more than five times the share the capital spending sector was seven years ago. This is a much bigger problem - one that could have grave consequences for the US and the rest of the world.

There is far more to this story than a potential downturn in the global business cycle. Another post-bubble shakeout poses a serious challenge to the timeworn inflation-targeting approach of central banks. It also presents the body politic with a fundamental challenge to its tolerance and, in many cases, encouragement of a new asset-dependent strain of global economic growth. Subprime spillovers have only just begun to play out - as has the debate this crisis has spawned.

Game Over for the American Consumer

The American consumer has been the dominant engine on the demand side of the global economy for the past 11 years. With real consumption growth averaging nearly 4% over the 1996 to 2006 interval, US consumption expenditures currently total over $9.6 trillion, or 19% of world GDP (at market exchange rates).

Growth in US consumer demand is typically powered by two forces - income and wealth (see Figure 1). Since the mid-1990s, income support has lagged while wealth effects have emerged as increasingly powerful drivers of US consumption. That has been especially the case in the current economic expansion, which has faced the combined headwinds of subpar employment growth and relatively stagnant real wages. As a result, over the past 69 months, private sector compensation - the broadest measure of earned labor income in the US economy - has increased only 17% in real, or inflation adjusted, terms. That falls nearly $480 billion short of the 28% increase that had occurred, on average, over comparable periods of the past four US business cycle expansions.

Lacking in support from labor income, US consumers turned to wealth effects from rapidly appreciating assets - principally residential property - to fuel booming consumption. By Federal Reserve estimates, net equity extraction from residential property surged from 3% of disposable personal income in 2001 to nearly 9% by 2005 - more than sufficient to offset the shortfall in labor income generation and keep consumption on a rapid growth path. There was no stopping the asset-dependent American consumer.

That was then. Both income and wealth effects are now coming under increasingly intense pressure - leaving consumers with little choice other than to rein in excessive demand. The persistently subpar trend in labor income growth is about to be squeezed further by the pressures of a cyclical adjustment in production and employment. In August and September 2007, private sector nonfarm payrolls expanded, on average, by only 52,000 per month - literally one-third the average pace of 157,000 of the preceding 24 months. Moreover, this dramatic slowdown in the organic job creating capacity of the US economy is likely to be exacerbated by a sharp fall off in residential construction sector employment in the months ahead. Jobs in the homebuilding sector are currently down only about 5% from peak levels despite a 40% fall-off in housing starts; it is only a matter of time before jobs and activity move into closer alignment in this highly cyclical - and now very depressed - sector.

Moreover, the bursting of the property bubble has left the consumer wealth effect in tatters. After peaking at 13.6% in mid-2005, nation-wide house price appreciation slowed precipitously to 3.2% in mid-2007. Given the outsize overhang of excess supply of unsold homes, I suspect that overall US home prices could actually decline in both 2008 and 2009 - an unprecedented development in the modern-day experience of the US economy. Mirroring this trend, net equity extraction has already tumbled - falling to less than 5.5% of disposable personal income in 2Q07 and retracing more than half the run-up that began in 2001. Subprime contagion can only reinforce this trend - putting pressure on home mortgage refinancing and thereby further inhibiting equity extraction by US homeowners.

With both income and wealth effects under pressure, I don't see any way saving-short, overly-indebted American consumers can maintain excessive consumption growth. For a US economy that has drawn disproportionate support from a record 72% share of personal consumption (see Figure 2), a consumer-led capitulation spells high and rising recession risk. Unfortunately, the same prognosis is likely for a still US-centric global economy.

Don't Count on Global Decoupling

A capitulation of the American consumer spells considerable difficulty for the global economy. This conclusion is, of course, very much at odds with notion of "global decoupling" - an increasingly popular belief that depicts a world economy that has finally weaned itself from the ups and downs of the US economy.

The global decoupling thesis is premised on a major contradiction: In an increasingly globalized world, cross border linkages have become even more important - making globalization and decoupling inherently inconsistent. True, the recent data flow raises some questions about this contention. After all, the world seems to have held up reasonably well in the face of the slowing of US GDP growth that has unfolded over the past year. But that's because the downshift in US growth has been almost exclusively concentrated in residential building activity - one of the least global sectors of the US economy. If I am right, and consumption now starts to slow, such a downshift will affect one of the most global sectors of the US. And I fully suspect a downshift in America's most global sector will have considerably greater repercussions for the world at large than has been the case so far.

That's an especially likely outcome in Asia - the world's most rapidly growing region and one widely suspected to be a leading candidate for global decoupling. However, as Figure 3 clearly indicates, the macro structure of Developing Asia remains very much skewed toward an export-led growth dynamic. For the region as a whole, the export share has more than doubled over the past 25 years - surging from less than 20% in 1980 to more than 45% today. Similarly, the share going to internal private consumption - the sector that would have to drive Asian decoupling - has fallen from 67% to less than 50% over the same period.

Nor can there be any mistake as to the dominant external market for export-led Asian economies. The United States wins the race hands down - underscored by a 21% share of Chinese exports currently going to America. Yes, there has been a sharp acceleration of intra-regional trade in recent years, adding to the hopes and dreams of Asian decoupling. But a good portion of that integration reflects the development of a China-centric pan-Asian supply chain that continues to be focused on sourcing end-market demand for American consumers. That means if the US consumer now slows, as I suspect, Asia will be hit hard - with cross-border supply chain linkages exposing a long-standing vulnerability that will draw the global decoupling thesis into serious question. A downshift of US consumption growth will affect Asia unevenly. A rapidly growing Chinese economy has an ample cushion to withstand such a blow. Chinese GDP growth might slow from 11% to around 8% - hardly a disaster for any economy and actually consistent with what Beijing has tried to accomplish with its cooling-off campaign of the past several years. Other Asian economies, however, lack the hyper-growth cushion that China enjoys. As such, a US-led slowdown of external demand could hurt them a good deal more. That's especially the case for Japan, whose 2% growth economy could be in serious trouble in the event of a US demand shock that also takes a toll on Japanese exports into the Chinese supply chain. While less vulnerable than Japan, Taiwan and South Korea could also be squeezed by the double whammy of US and China slowdowns. For the rest of Asia - especially India and the ASEAN economies - underlying growth appears strong enough to withstand a shortfall in US consumer demand. But there can be no mistaking the endgame: Contrary to the widespread optimism of investors and policy markers, the Asian growth dynamic is actually quite vulnerable to a meaningful slowdown in US consumption growth.

A Subprime Dollar

This constellation of forces could prove especially vexing for the US dollar. Currencies are, first and foremost, relative prices - in essence, measures of the intrinsic value of one economy versus another. On that basis, the world has had no compunction in writing down the value of the United States over the past several years. A broad dollar index, which measures the US currency relative to those of most of America's trading partners, is off about 20% from its early 2002 peak. Recently, it has hit new lows against the euro and a high-flying Canadian currency, likely a harbinger of more weakness to come.

Sadly, this depreciation of the US currency is not surprising. Because Americans haven't been saving in sufficient amounts for a long time, the United States must import surplus savings from abroad in order to grow. And it has to run record balance of payments and trade deficits in order to attract that foreign capital. The United States current account deficit - the broadest gauge of America's imbalance in relation to the rest of the world - hit a record 6.2% of gross domestic product in 2006 before receding slightly in the first half of this year. America must still attract some $3 billion of foreign capital each business day in order to keep its economy growing.

Economic theory is very clear on the implications of such huge imbalances: Foreign lenders need to be compensated for sending scarce capital to any country with a deficit. The bigger the deficit, the greater the required compensation. The currency of the deficit nation usually bears the brunt of that compensation. It then follows that as long as the United States fails to address its saving problem, its large balance of payments deficit will persist and the dollar will keep dropping.

The only silver lining so far has been that these adjustments to the US currency have been orderly - declines in the broad dollar index averaging a little less than 4% per year since early 2002. Now, however, the possibility of a disorderly correction is rising - with potentially grave consequences for the American and global economy.

A key reason is the mounting risk of a recession in America. As noted above, the bursting of the subprime mortgage bubble - strikingly reminiscent of the dot-com excesses of the 1990s - could well be a tipping point. In both cases, financial markets and policy makers were steeped in denial over the risks. But the lessons of post-bubble adjustments are clear. Just ask economically stagnant Japan. And of course, the United States lapsed into its own post-bubble recession in 2000 and '01. Sadly, the endgame could be considerably more treacherous for the United States than it was seven years ago. In large part, that's because the American consumer is now at risk. Consumption expenditures currently account for a record 72% of the gross domestic product - a number unmatched in the annals of modern history for any nation.

This buying binge has been increasingly supported by housing and lending bubbles. Yet, as also stressed above, both of these bubbles are now in the process of bursting - an outcome which could put US consumer demand under considerable pressure. That will make it exceedingly difficult for the United States to avoid a recession.

Fearful of that possibility and the additional Fed easing it implies, foreign investors are becoming increasingly skittish over buying dollar-based assets. The spillover effects of the subprime crisis into other asset markets - especially mortgage- backed securities and asset-backed commercial paper - underscore these concerns. As a result, foreign appetite for America's complex and opaque financial instruments is likely to be sharply reduced for years to come. That would choke off an important avenue of capital inflows, putting more downward pressure on the dollar.

The political winds are also blowing against the dollar. In Washington, China-bashing is the bipartisan sport du jour. New legislation is likely that would impose trade sanctions on China unless it makes a major adjustment in its currency. Not only would this be an egregious policy blunder - attempting to fix a multilateral deficit with more than 40 nations by forcing an exchange rate adjustment with one country - but it would also amount to Washington taxing one of America's major foreign lenders.

That would undoubtedly reduce China's desire for United States assets, and unless another foreign buyer stepped up, the dollar would come under even more pressure. Finally, the more the Fed under Ben Bernanke follows the easymoney, market-friendly Alan Greenspan script, the greater the risk to the dollar.

Why worry about a weaker dollar? The United States imported $2.2 trillion of goods and services in 2006. A sharp drop in the dollar makes those items considerably more expensive - the functional equivalent of a tax hike on consumers. It could also stoke fears of inflation - driving up long-term interest rates and putting more pressure on financial markets and the economy, exacerbating recession risks. Optimists may draw comfort from the vision of an export-led renewal arising from a more competitive dollar. Yet history is clear: No nation has ever devalued its way into prosperity.

So far, the dollar's weakness has not been a big deal. That may now be about to change. Relative to the rest of the world, the United States looks painfully subprime. So does its currency.

The Failure of Central Banking

The recent chain of events is not an isolated development. In fact, for the second time in seven years, the bursting of a major asset bubble has inflicted great damage on world financial markets. In both cases - the equity bubble in 2000 and the credit bubble in 2007 - central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of an unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy.

This sorry state of affairs can be traced to developments that all started a decade ago. Basking in the warm glow of a successful battle against inflation, central banks decided that easy money was the world's just reward.

America's IT-enabled productivity resurgence in the late 1990s was the siren song for the Greenspan-led Federal Reserve - convincing the US central bank that it need not stand in the way of either rapid economic growth or excess liquidity creation. In retrospect, that was the "original sin" of bubble-world - a Fed that condoned the equity bubble of the late 1990s and the asset-dependent US economy it spawned. That set in motion a chain of events that has allowed one bubble to beget another - from equities to housing to credit.

Yet bubbles always burst. And when that happened to the equity bubble in 2000, central banks threw all caution to the wind and injected massive liquidity into world financial markets in order to avoid a dangerous deflation. With globalization restraining inflation and real economies recovering only sluggishly in the early 2000s, that excess liquidity went directly into asset markets.

Aided and abetted by the explosion of new financial instruments - especially what is now over $440 trillion of derivatives worldwide - the world embraced a new culture of debt and leverage. Yield-hungry investors, fixated on the retirement imperatives of aging households, acted as if they had nothing to fear. Risk was not a concern in an era of open-ended monetary accommodation cushioned by a profusion of derivativesbased shock absorbers.

As always, the cycle of risk and greed went to excess. Just as dot-com was the canary in the coalmine seven years ago, subprime was the warning shot this time. Denial in both cases has eerie similarities - as do the spillovers that inevitably occur when major asset bubbles pop. When the dot-com bubble burst in early 2000, the optimists said not to worry - after all, Internet stocks accounted for only about 6% of total US equity market capitalization at the end of 1999. Unfortunately, the broad S&P 500 index tumbled some 49% over the ensuing two and a half years and an over-extended Corporate America led the US and global economy into recession. Similarly, today's optimists are preaching the same gospel: Why worry, they say, if subprime is only about 14% of total US securitized mortgage debt? Yet the unwinding of the far broader credit cycle, to say nothing of the extraordinary freezing up of key short-term financing markets, gives good reason to worry - especially for over-extended American consumers and a still US-centric global economy.

Central banks have now been forced into making emergency liquidity injections - including a rare intra-meeting cut in the Fed's discount rate that was then followed by a 50 basis point reduction in the overnight lending rate. The jury is out on whether these efforts will succeed in stemming the current rout in still overvalued credit markets. While tactically expedient, these actions may be strategically flawed in that they fail to address the moral hazard dilemma that continues to underpin asset-dependent economies. Is this any way to run a modern-day world economy?

The answer is an unequivocal "no." As always, politicians are quick to grandstand and blame financial fiduciaries for problems afflicting uneducated, unqualified borrowers. Yet the markets are being painfully effective in punishing these parties. Instead, the body politic needs to take a look in the mirror - especially at the behavior of its policy-making proxies and regulators, the world's major central banks.

It is high time for monetary authorities to adopt new procedures - namely, taking the state of asset markets into explicit consideration when framing policy options. Like it or not, we now live in an asset-dependent world. As the increasing prevalence of bubbles indicates, a failure to recognize the interplay between the state of asset markets and the real economy is an egregious policy error.

That doesn't mean central banks should target asset markets. It does mean, however, that they need to break their one dimensional fixation on CPI-based inflation and also pay careful consideration to the extremes of asset values. This is not that difficult a task. When equity markets go to excess and distort asset-dependent economies as they did in the late 1990s, central banks should run tighter monetary policies than a narrow inflation target would dictate. Similarly, when housing markets go to excess, when subprime borrowers join the fray, or when corporate credit becomes freely available at ridiculously low "spreads," central banks should lean against the wind. The current financial crisis is a wake-up call for modern-day central banking. The world can't afford to keep lurching from one bubble to another. The cost of neglect is an ever-mounting systemic risk that could pose a grave threat to an increasingly integrated global economy. It could also spur the imprudent intervention of politicians, undermining the all-important political independence of central banks. The art and science of central banking is in desperate need of a major overhaul.

The Political Economy of Asset Bubbles

There may be a deeper meaning to all this. It is far-fetched to argue that central banks have consciously opted to inflate a series of asset bubbles - and then simply deal with the aftershocks once they burst. At work, instead, are the unintended consequences of a new and powerful asset-led global growth dynamic that is very much an outgrowth of the political economy of growth and prosperity.

This outcome reflects the confluence of three mega-trends - globalization, the IT revolution, and the provision of retirement income for aging workers. Globalization has injected a powerful new impetus to the disinflation of the past quarter century - facilitating a cross-border arbitrage of costs and prices that has put unrelenting pressure on the pricing of goods and many services, alike. At the same time, IT-enabled productivity enhancement - initially in the United States but now increasingly evident in other economies - has convinced central banks that there has been a meaningful increase in the non-inflationary growth potential in their respective economies. Finally, rapidly aging populations in Japan, Europe, and the United States are putting pressure on plan sponsors - public and private, alike - to boost investment yields in order to fund a growing profusion of unfunded pension and retirement schemes.

A key result of the interplay between the first two of these mega-trends - the globalization of disinflation and IT-enabled productivity enhancement - has been a sharp reduction in nominal interest rates on sovereign fixed income instruments for short- and long-term maturities, alike. Lacking in the yield to fund retirement programs from such riskless assets, investors and their fiduciaries have ventured into increasingly riskier assets to square the circle. That, in conjunction with the ample provision of liquidity from inflation- relaxed central banks, has driven down yield spreads in a variety of risky assets - from emerging-market and highyield corporate debt to mortgage-backed securities and a host of other complex structured products. In an era of spread compression and search for yield, the rising tide of ample liquidity covered up a profusion of jagged and dangerous rocks. As the tide now goes out, the rocks now get uncovered. The subprime crisis is a classic example of what can be unmasked at low tide.

The same set of forces has had an equally profound impact on the investment strategies of individual investors. Lacking in traditional yield from saving deposits and government bonds, families have opted, instead, to seek enhanced investment income from equities and, more recently, from residential property. This has created a natural demand for these asset classes that then took on a life of its own - with price increases begetting more price increases and speculative bubbles arising as a result. As long as inflation-targeting central banks remained fixated on their well-behaved narrow CPIs, there was little to stand in the way of a powerful liquidity cycle that has given rise to a multi-bubble syndrome.

In the end, it is up to the body politic to judge the wisdom of this arrangement - essentially, whether the inherent instability of increasingly asset-dependent and bubble-prone economies is worth the risk. Lacking a clear feedback mechanism to render such a verdict, it falls to the world's central banks - the stewards of economic and financial stability - to act as proxies in resolving this problem. This is where the problem gets particularly thorny. It takes a truly independent central bank to take a principled stand against the systemic risks that may arise from the pro-growth mindset of the body politic and act to "take the punchbowl away just when the party is getting good" - to paraphrase the sage advice of one of America's legendary central bankers, William McChesney Martin. Yet as recently retired Fed Chairman Alan Greenspan concedes, "I regret to say that Federal Reserve independence is not set in stone."

Greenspan's confession underscores the important distinction between two models of the central banker - those who are truly politically independent and those who are more politically compliant. The United States has had both types. I would certainly put Paul Volcker in the former category; amid howls of protest, his determined assault against the ravages of double-digit inflation was conducted at great political risk. Yet in the end, he held to a monetary policy that was fiercely independent of political pressures. By contrast, Arthur Burns, who I worked for in the 1970s, was highly politicized in his decisions to avoid the wrenching monetary tightening that a cure for inflation would eventually require. The market-friendly stance of Alan Greenspan - and the asset-dependent US economy it spawned - was more consistent with the model of the complaint central banker who was very much in sync with the pro-growth mindset of the body politic. Greenspan's memoirs are as much about politics as economics - underscoring his much stronger sense of the interplay between these two forces than a more independent central banker might otherwise perceive.

Yet Greenspan's basic point is well taken: It is not easy for any central banker to do unpopular things - especially if he happens to be a political animal operating in a highly charged political climate. But that's where I would draw the line. With all due respect to Alan Greenspan, the truly independent central banker was never supposed to win political popularity contests. I would be the first to concede, however, that it will take great political courage to forge the new approach toward monetary policy that I am advocating. But it can be done - as exemplified by the legacy of Paul Volcker.

In the end, it will undoubtedly take a crisis to provide central banks with the political cover they believe they need to broaden out their mandate from the narrow dictums of CPI-based price stability. Who knows if such a crisis is now in the offing? But with the credit cycle unwinding at the same time that Washington is turning protectionist and the overly-indebted American consumer is in trouble, the wisdom of condoning asset-dependent, bubble-prone economies may finally be drawn into serious question.

A Subprime Prognosis

How all this plays out in the global economy in the years immediately ahead is anyone's guess. I have long framed the tensions shaping the outlook in the context of "global rebalancing" - the need of a lopsided world economy to wean itself from a US-centric growth dynamic. A partial rebalancing now appears to be at hand - likely to be led by the coming consolidation of the American consumer. That is painful but good news for those of us who have long worried about the destabilizing risks of a massive US current account deficit. But a more complete global rebalancing is a shared responsibility - one that must also be accompanied by an increase in domestic demand from surplus-saving economies elsewhere in the world. To the extent that doesn't happen - and, as underscored above, that remains my view - then a asymmetrical rebalancing dominated by slowdown in US consumer demand should take a meaningful toll on global growth.

For a world economy that has been on close to a 5% growth path for nearly five years, that points to nothing but downside over the next 1-2 years. It's always hard to pinpoint the magnitude of such a shortfall with any precision, but I would not be surprised to see world GDP growth slip down into the 3.5% to 4% range at some point in 2008. Interestingly enough, such a downshift would only take global growth back to its post-1970s trend (3.7%). While that's hardly a disaster, it would still represent approximately a 25% slowing from the world's recent heady growth pace. Such an outcome could prove especially troublesome for the earnings optimism still embedded in global equity markets. The silver lining of such a prognosis would be likely cyclical relief on the inflation front - providing support for sovereign bonds.

But, as I have attempted to underscore above, the issues shaping the medium-term prognosis for the global economy go far beyond a standard call on the business cycle. America's asset-dependent growth paradigm is finally at risk. And with those risks comes the potential for collateral damage elsewhere in a still US-centric global economy. Dollar risks are especially problematic but so, too, is the collective wisdom - or lack thereof - of central bankers and politicians who have allowed the world to come to this precarious point. Policymaking and politics remain driven purely by local considerations. Yet the stresses and strains of a globalized world demand a much broader perspective. A new approach is needed - before it's too late.

Inflation is sad for anyone who is not invested in assets

2007-10-19T16:35:00.000-04:00

Tell this to the eggheads at the Fed who only focus on "core" CPI and PCE. How convenient it'll be for them to use core numbers as excuse to lower rates again! For a nation who hates China and pokes fun at their 5-6% inflation numbers, it looks like we won't be that far behind soon. Bernanke needs to grow some balls, Volcker style, and let investors and wall street suffer a bit and reign in money supply--by allowing asset prices to deflate and financial markets to deleverage, unlike his intellectually shaky & social climbing predecessor.

http://news.yahoo.com/s/ap/20071019/ap_on_bi_go_ec_fi/stretching_paychecks_8;_ylt=AsYlhRzO9vVNlgdE9lcciG8E1vAI

GLA/U CN Equity

2007-10-18T09:51:00.000-04:00

Global Alumina... F-yeah!!! gonna get ready for a m-fing bidding war yeah!!! (to the tune of team america)

The Russians are Coming

2007-10-16T21:15:00.000-04:00

The people at Stratfor writes some of the most mindblowingly detailed analysis of geopolitical matters that I've the fortune of reading. This week's analysis on the consequences of America's royal f-up in the middle east and the coming regional alliances/conflicts that will play out independent of US wants is definitely worth reading and pondering on. Plays out like Final Fantasy XII doesn't it? Guess who the Rozzarians are :D

This made me stop outside my apartment with my blackberry so I could finish reading it. Usually, I just scroll through things very fast as I enter the building but NOT THIS TIME! One day, I swear I am going to get mugged or hit by a bus--but that's a story for another time! HAHA

--

The Russia Problem

By Peter Zeihan

For the past several days, high-level Russian and American policymakers, including U.S. Secretary of State Condoleezza Rice, Secretary of Defense Robert Gates and Russian President Vladimir Putin's right-hand man, Sergei Ivanov, have been meeting in Moscow to discuss the grand scope of U.S.-Russian relations. These talks would be of critical importance to both countries under any circumstances, as they center on the network of treaties that have governed Europe since the closing days of the Cold War.

Against the backdrop of the Iraq war, however, they have taken on far greater significance. Both Russia and the United States are attempting to rewire the security paradigms of key regions, with Washington taking aim at the Middle East and Russia more concerned about its former imperial territory. The two countries' visions are mutually incompatible, and American preoccupation with Iraq is allowing Moscow to overturn the geopolitics of its backyard.

The Iraqi Preoccupation

After years of organizational chaos, the United States has simplified its plan for Iraq: Prevent Iran from becoming a regional hegemon. Once-lofty thoughts of forging a democracy in general or supporting a particular government were abandoned in Washington well before the congressional testimony of Gen. David Petraeus. Reconstruction is on the back burner and even oil is now an afterthought at best. The entirety of American policy has been stripped down to a single thought: Iran.

That thought is now broadly held throughout not only the Bush administration but also the American intelligence and defense communities. It is not an unreasonable position. An American exodus from Iraq would allow Iran to leverage its allies in Iraq's Shiite South to eventually gain control of most of Iraq. Iran's influence also extends to significant Shiite communities on the Persian Gulf's western oil-rich shore. Without U.S. forces blocking the Iranians, the military incompetence of Saudi Arabia, Kuwait and Qatar could be perceived by the Iranians as an invitation to conquer that shore. That would land roughly 20 million barrels per day of global oil output -- about one-quarter of the global total -- under Tehran's control. Rhetoric aside, an outcome such as this would push any U.S. president into a broad regional war to prevent a hostile power from shutting off the global economic pulse.

So the United States, for better or worse, is in Iraq for the long haul. This requires some strategy for dealing with the other power with the most influence in the country, Iran. This, in turn, leaves the United States with two options: It can simply attempt to run Iraq as a protectorate forever, a singularly unappealing option, or it can attempt to strike a deal with Iran on the issue of Iraq -- and find some way to share influence.

Since the release of the Petraeus report in September, seeking terms with Iran has become the Bush administration's unofficial goal, but the White House does not want substantive negotiations until the stage is appropriately set. This requires that Washington build a diplomatic cordon around Iran -- intensifying Tehran's sense of isolation -- and steadily ratchet up the financial pressure. Increasing bellicose rhetoric from European capitals and the lengthening list of major banks that are refusing to deal with Iran are the nuts and bolts of this strategy.

Not surprisingly, Iran views all this from a starkly different angle. Persia has historically been faced with a threat of invasion from its western border -- with the most recent threat manifesting in a devastating 1980-1988 war that resulted in a million deaths. The primary goal of Persia's foreign policy stretching back a millennium has been far simpler than anything the United States has cooked up: Destroy Mesopotamia. In 2003, the United States was courteous enough to handle that for Iran.

Now, Iran's goals have expanded and it seeks to leverage the destruction of its only meaningful regional foe to become a regional hegemon. This requires leveraging its Iraqi assets to bleed the Americans to the point that they leave. But Iran is not immune to pressure. Tehran realizes that it might have overplayed its hand internationally, and it certainly recognizes that U.S. efforts to put it in a noose are bearing some fruit. What Iran needs is its own sponsor -- and that brings to the Middle East a power that has not been present there for quite some time: Russia.

Option One: Parity

The Russian geography is problematic. It lacks oceans to give Russia strategic distance from its foes and it boasts no geographic barriers separating it from Europe, the Middle East or East Asia. Russian history is a chronicle of Russia's steps to establish buffers -- and of those buffers being overwhelmed. The end of the Cold War marked the transition from Russia's largest-ever buffer to its smallest in centuries. Put simply, Russia is terrified of being overwhelmed -- militarily, economically, politically and culturally -- and its policies are geared toward re-establishing as large a buffer as possible.

As such, Russia needs to do one of two things. The first is to re-establish parity. As long as the United States thinks of Russia as an inferior power, American power will continue to erode Russian security. Maintain parity and that erosion will at least be reduced. Putin does not see this parity coming from a conflict, however. While Russia is far stronger now -- and still rising -- than it was following the 1998 ruble crash, Putin knows full well that the Soviet Union fell in part to an arms race. Attaining parity via the resources of a much weaker Russia simply is not an option.

So parity would need to come via the pen, not the sword. A series of three treaties ended the Cold War and created a status of legal parity between the United States and Russia. The first, the Conventional Armed Forces in Europe Treaty (CFE), restricts how much conventional defense equipment each state in NATO and the former Warsaw Pact, and their successors, can deploy. The second, the Strategic Arms Reduction Treaty (START I), places a ceiling on the number of intercontinental ballistic missiles that the United States and Russia can possess. The third, the Intermediate-Range Nuclear Forces Treaty (INF), eliminates entirely land-based short-, medium- and intermediate-range ballistic missiles with ranges of 300 to 3,400 miles, as well as all ground-launched cruise missiles from NATO and Russian arsenals.

The constellation of forces these treaties allow do not provide what Russia now perceives its security needs to be. The CFE was all fine and dandy in the world in which it was first negotiated, but since then every Warsaw Pact state -- once on the Russian side of the balance sheet -- has joined NATO. The "parity" that was hardwired into the European system in 1990 is now lopsided against the Russians.

START I is by far the Russians' favorite treaty, since it clearly treats the Americans and Russians as bona fide equals. But in the Russian mind, it has a fateful flaw: It expires in 2009, and there is about zero support in the United States for renewing it. The thinking in Washington is that treaties were a conflict management tool of the 20th century, and as American power -- constrained by Iraq as it is -- continues to expand globally, there is no reason to enter into a treaty that limits American options. This philosophical change is reflected on both sides of the American political aisle: Neither the Bush nor Clinton administrations have negotiated a new full disarmament treaty.

Finally, the INF is the worst of all worlds for Russia. Intermediate-range missiles are far cheaper than intercontinental ones. If it does come down to an arms race, Russia will be forced to turn to such systems if it is not to be left far behind an American buildup.

Russia needs all three treaties to be revamped. It wants the CFE altered to reflect an expanded NATO. It wants START I extended (and preferably deepened) to limit long-term American options. It wants the INF explicitly linked to the other two treaties so that Russian options can expand in a pinch -- or simply discarded in favor of a more robust START I.

The problem with the first option is that it assumes the Americans are somewhat sympathetic to Russian concerns. They are not.

Recall that the dominant concern in the post-Cold War Kremlin is that the United States will nibble along the Russian periphery until Moscow itself falls. The fear is as deeply held as it is accurate. Only three states have ever threatened the United States: The first, the United Kingdom, was lashed into U.S. global defense policy; the second, Mexico, was conquered outright; and the third was defeated in the Cold War. The addition of the Warsaw Pact and the Baltic states to NATO, the basing of operations in Central Asia and, most important, the Orange Revolution in Ukraine have made it clear to Moscow that the United States plays for keeps.

The Americans see it as in their best interest to slowly grind Russia into dust. Those among our readers who can identify with "duck and cover" can probably relate to the logic of that stance. So, for option one to work, Russia needs to have leverage elsewhere. That elsewhere is in Iran.

Via the U.N. Security Council, Russian cooperation can ensure Iran's diplomatic isolation. Russia's past cooperation on Iran's Bushehr nuclear power facility holds the possibility of a Kremlin condemnation of Iran's nuclear ambitions. A denial of Russian weapons transfers to Iran would hugely empower ongoing U.S. efforts to militarily curtail Iranian ambitions. Put simply, Russia has the ability to throw Iran under the American bus -- but it will not do it for free. In exchange, it wants those treaties amended in its favor, and it wants American deference on security questions in the former Soviet Union.

The Moscow talks of the past week were about addressing all of Russian concerns about the European security structure, both within and beyond the context of the treaties, with the offer of cooperation on Iran as the trade-off. After days of talks, the Americans refused to budge on any meaningful point.

Option Two: Imposition

Russia has no horse in the Iraq war. Moscow had feared that its inability to leverage France and Germany to block the war in the first place would allow the United States to springboard to other geopolitical victories. Instead, the Russians are quite pleased to see the American nose bloodied. They also are happy to see Iran engrossed in events to its west. When Iran and Russia strengthen -- as both are currently -- they inevitably begin to clash as their growing spheres of influence overlap in the Caucasus and Central Asia. In many ways, Russia is now enjoying the best of all worlds: Its Cold War archrival is deeply occupied in a conflict with one of Moscow's own regional competitors.

In the long run, however, the Russians have little doubt that the Americans will eventually prevail. Iran lacks the ability to project meaningful power beyond the Persian Gulf, while the Russians know from personal experience how good the Americans are at using political, economic, military and alliance policy to grind down opponents. The only question in the Russian mind pertains to time frame.

If the United States is not willing to rejigger the European-Russian security framework, then Moscow intends to take advantage of a distracted United States to impose a new reality upon NATO. The United States has dedicated all of its military ground strength to Iraq, leaving no wiggle room should a crisis erupt anywhere else in the world. Should Russia create a crisis, there is nothing the United States can do to stop it.

So crisis-making is about to become Russia's newest growth industry. The Kremlin has a very long list of possibilities, which includes:

Destabilizing the government of Ukraine: The Sept. 30 elections threaten to result in the re-creation of the Orange Revolution that so terrifies Moscow. With the United States largely out of the picture, the Russians will spare no effort to ensure that Ukraine remains as dysfunctional as possible.
Azerbaijan is emerging as a critical energy transit state for Central Asian petroleum, as well as an energy producer in its own right. But those exports are wholly dependent upon Moscow's willingness not to cause problems for Baku.
The extremely anti-Russian policies of the former Soviet state of Georgia continue to be a thorn in Russia's side. Russia has the ability to force a territorial breakup or to outright overturn the Georgian government using anything from a hit squad to an armored division.
EU states obviously have mixed feelings about Russia's newfound aggression and confidence, but the three Baltic states in league with Poland have successfully hijacked EU foreign policy with regard to Russia, effectively turning a broadly cooperative relationship hostile. A small military crisis with the Balts would not only do much to consolidate popular support for the Kremlin but also would demonstrate U.S. impotence in riding to the aid of American allies.

Such actions not only would push Russian influence back to the former borders of the Soviet Union but also could overturn the belief within the U.S. alliance structure that the Americans are reliable -- that they will rush to their allies' aid at any time and any place. That belief ultimately was the heart of the U.S. containment strategy during the Cold War. Damage that belief and the global security picture changes dramatically. Barring a Russian-American deal on treaties, inflicting that damage is once again a full-fledged goal of the Kremlin. The only question is whether the American preoccupation in Iraq will last long enough for the Russians to do what they think they need to do.

Luckily for the Russians, they can impact the time frame of American preoccupation with Iraq. Just as the Russians have the ability to throw the Iranians under the bus, they also have the ability to empower the Iranians to stand firm.

On Oct. 16, Putin became the first Russian leader since Leonid Brezhnev to visit Iran, and in negotiations with the Iranian leadership he laid out just how his country could help. Formally, the summit was a meeting of the five leaders of the Caspian Sea states, but in reality the meeting was a Russian-Iranian effort to demonstrate to the Americans that Iran does not stand alone.

A good part of the summit involved clearly identifying differences with American policy. The right of states to nuclear energy was affirmed, the existence of energy infrastructure that undermines U.S. geopolitical goals was supported and a joint statement pledged the five states to refuse to allow "third parties" from using their territory to attack "the Caspian Five." The last is a clear bullying of Azerbaijan to maintain distance from American security plans.

But the real meat is in bilateral talks between Putin and his Iranian counterpart, Mahmoud Ahmadinejad, and the two sides are sussing out how Russia's ample military experience can be applied to Iran's U.S. problem. Some of the many, many possibilities include:

Kilo-class submarines: The Iranians already have two and the acoustics in the Persian Gulf are notoriously bad for tracking submarines. Any U.S. military effort against Iran would necessitate carrier battle groups in the Persian Gulf.
Russia fields the Bal-E, a ground-launched Russian version of the Harpoon anti-ship missile. Such batteries could threaten any U.S. surface ship in the Gulf. A cheaper option could simply involve the installation of Russian coastal artillery systems.
Russia and India have developed the BrahMos anti-ship cruise missile, which has the uniquely deadly feature of being able to be launched from land, ship, submarine or air. While primarily designed to target surface vessels, it also can act as a more traditional -- and versatile -- cruise missile and target land targets.
Flanker fighters are a Russian design (Su-27/Su-30) that compares very favorably to frontline U.S. fighter jets. Much to the U.S. Defense Department's chagrin, Indian pilots in Flankers have knocked down some U.S. pilots in training scenarios.
The S-300 anti-aircraft system is still among the best in the world, and despite eviscerated budgets, the Russians have managed to operationalize several upgrades since the end of the Cold War. It boasts both a far longer range and far more accuracy than the Tor-M1 and Pantsyr systems on which Iran currently depends.

Such options only scratch the surface of what the Russians have on order, and the above only discusses items of use in a direct Iranian-U.S. military conflict. Russia also could provide Iran with an endless supply of less flashy equipment to contribute to intensifying Iranian efforts to destabilize Iraq itself.

For now, the specifics of Russian transfers to Iran are tightly held, but they will not be for long. Russia has as much of an interest in getting free advertising for its weapons systems as Iran has in demonstrating just how high a price it will charge the United States for any attack.

But there is one additional reason this will not be a stealth relationship.

The Kremlin wants Washington to be fully aware of every detail of how Russian sales are making the U.S. Army's job harder, so that the Americans have all the information they need to make appropriate decisions as regards Russia's role. Moscow is not doing this because it is vindictive; this is simply how the Russians do business, and they are open to a new deal.

Russia has neither love for the Iranians nor a preference as to whether Moscow reforges its empire or has that empire handed back. So should the United States change its mind and seek an accommodation, Putin stands perfect ready to betray the Iranians' confidence.

For a price.

"Marking to Model"

2007-10-16T11:44:00.000-04:00

Keep this in mind while we frolic in the alchemy of finance :)
http://money.cnn.com/2007/09/06/magazines/fortune/eavis_level3.fortune/index.htm

Macquarie the Pyramid Scheme?

2007-10-16T11:15:00.000-04:00

w0wz0rs, this is some smart/twisted shiznit... it's a skeptic's paradise (to the tune of coolio) :D

http://money.cnn.com/2007/09/17/news/international/macquarie_infrastructure_funds.fortune/index.htm

Mandelbrot is a genius

2007-10-08T13:01:00.000-04:00

1.) Volatility clusters; price movements concentrate and are non-independent
2.) Prices leap, not glide--i.e. are non-continuous
3.) In trading "time" is flexible and non-interval

Yup, I now officially have no faith in modern finance theory.

Oh Caaanada... parity with USD at last!

2007-09-21T00:18:00.000-04:00

Ooooh yeah, 1 Canadian dollar now buys more than 1 USD--so much for making fun of Canadians!

Canada kicks ass... especially their currency--oh what fun it is to have a budget surplus and a currency so correlated with basic materials, natural resources, and mining.

Just look at the appreciation! This is awesome for anyone that has a lot of their investments/holdings in Canadian dollars. (i.e. my Roth IRA... weeee!)

This will hurt Canadian exports to the U.S. though--paper and forestry products, gas, and any other manufactured products whose cost curve is based on the loonie. But that's a story for another time... I just wanted to express my excitement at this monumental event! Let's see if it lasts (and with the way the U.S. has been handling fiscal and monetary policies, and with inflationary pressures in basic materials, it should!)

I was too lazy to write this so someone else did it for me

2007-09-20T10:03:00.000-04:00

Fears of dollar collapse as Saudis take frightBy Ambrose Evans-Pritchard, International Business Editor
Last Updated: 8:39am BST 20/09/2007

Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East.

China threatens 'nuclear option' of dollar sales
Ben Bernanke has placed the dollar in a dangerous situation, say analysts
"This is a very dangerous situation for the dollar," said Hans Redeker, currency chief at BNP Paribas.

"Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," he said.

The Saudi central bank said today that it would take "appropriate measures" to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg.

As a close ally of the US, Riyadh has so far tried to stick to the peg, but the link is now destabilising its own economy.

The Fed's dramatic half point cut to 4.75pc yesterday has already caused a plunge in the world dollar index to a fifteen year low, touching with weakest level ever against the mighty euro at just under $1.40.

There is now a growing danger that global investors will start to shun the US bond markets. The latest US government data on foreign holdings released this week show a collapse in purchases of US bonds from $97bn to just $19bn in July, with outright net sales of US Treasuries.

The danger is that this could now accelerate as the yield gap between the United States and the rest of the world narrows rapidly, leaving America starved of foreign capital flows needed to cover its current account deficit - expected to reach $850bn this year, or 6.5pc of GDP.

Mr Redeker said foreign investors have been gradually pulling out of the long-term US debt markets, leaving the dollar dependent on short-term funding. Foreigners have funded 25pc to 30pc of America's credit and short-term paper markets over the last two years.

"They were willing to provide the money when rates were paying nicely, but why bear the risk in these dramatically changed circumstances? We think that a fall in dollar to $1.50 against the euro is not out of the question at all by the first quarter of 2008," he said.

"This is nothing like the situation in 1998 when the crisis was in Asia, but the US was booming. This time the US itself is the problem," he said.

Mr Redeker said the biggest danger for the dollar is that falling US rates will at some point trigger a reversal yen "carry trade", causing massive flows from the US back to Japan.

Jim Rogers, the commodity king and former partner of George Soros, said the Federal Reserve was playing with fire by cutting rates so aggressively at a time when the dollar was already under pressure.

The risk is that flight from US bonds could push up the long-term yields that form the base price of credit for most mortgages, the driving the property market into even deeper crisis.

"If Ben Bernanke starts running those printing presses even faster than he's already doing, we are going to have a serious recession. The dollar's going to collapse, the bond market's going to collapse. There's going to be a lot of problems," he said.

The Federal Reserve, however, clearly calculates the risk of a sudden downturn is now so great that the it outweighs dangers of a dollar slide.

Former Fed chief Alan Greenspan said this week that house prices may fall by "double digits" as the subprime crisis bites harder, prompting households to cut back sharply on spending.

For Saudi Arabia, the dollar peg has clearly become a liability. Inflation has risen to 4pc and the M3 broad money supply is surging at 22pc.

The pressures are even worse in other parts of the Gulf. The United Arab Emirates now faces inflation of 9.3pc, a 20-year high. In Qatar it has reached 13pc.

Kuwait became the first of the oil sheikhdoms to break its dollar peg in May, a move that has begun to rein in rampant money supply growth.

Bearish Gibberish (still in the works)

2007-08-24T20:12:00.000-04:00

Alright! Some free time off work! Whew… time to let some stuff off my chest! I was gonna write a week ago… but you know what they say: the hardest part is getting started. Aint that the truth!

Well I feel vindicated… all my previous babbling of a possible doom that I dare not predict the timing of… but still…

First of all… more currently… what? What’s all this talk about current market situations reflecting a “classic bank run”—long term assets’ inability to meet short-term liquidity needs? If only it were that easy! What about the actual quality in these long term assets? If they were actually sound investments it would be easy to restore confidence… but the fact of the matter is that nobody knows where these assets are anymore, or who the guarantors are, and what they should be priced at. All this talk about the markets gaining confidence again due to renewed liquidity injections... by the Fed, by Bank of America… ho ho ho… with all that bad debt underwritten in the past few years, do markets really think that everything can be solved by banks making a little bit of market here, and asset managers writing down just a couple billion there? The potential amount of bad money created by bad debt multiplied by bad leverage over the past couple of years is laughable! (laughable because there’s not much else to do) And for those still holding on to a glimmer of hope that not 100% of the securitized/packaged/voodooed debt will default and thus sound assets will prop up the desire and liquidity to own these things once they are cheap enough… hold fast hope, cuz it doesn’t really take a genius to figure out that some residual quality will still be worth something—but it is the sheer sell down resulting from not knowing where that residual quality is that will give us, hopefully, a great secular bear market where bitter people like me can pick up assets for cheap. Woohoo! (I really should hide my enthusiasm on wanting the markets to tank… badly tank… tanking to the historical bear markets of 15-20% earnings yield businesses… and stay there for three years to give enough time to load up the value truck HA HA HA!)

And with that, I’d like to rant some more about current developments and outlooks of the financial markets of our times

--

The Contagion

You hear people talking about a financial contagion… what is it? Two contagions actually: greed and fear! That’s what it is… and its roots are in the emotions, pure and simple. Money really is just a reflection of thoughts and processes that’s, after all, only in our heads. So this contagion is more like a parasite that’s been stuck in the butt of mankind for eons—an extension of a gamut of complicated biological responses to adverse stimulation, the most basic reactions to pleasure and pain. And the two reflexively work off of one another to create a complicated web of cause and effect events that the many see as isolated and linear when they are anything but.

I think it’s funny when talking heads on CNBC start speaking about the contagion like it just crept up on us, as if it were a silent killer or a disease—none thinks about the possibility that these sort of things are unavoidable, that there is a world after the contagion has done what it is supposed to do, and that the losses suffered by the greater many will also create opportunities for a braver few. In a way, the masses will sway as they’ve always swayed—with the crowd and thus the reason for the term masses.

The great greed/fear contagion of the late 1990s to early 2000s taught us a lesson that we’re quick to forget. Of course, the greed contagions of today came in the form of cheap money and cheap loans for businesses/consumers alike wanting to make wealth out of thin air (inelastic goods speculation—say—land/houses, assets, derivatives on assets, transactional profit from writing derivatives on assets). And the fear contagion will come from not knowing the unknown… and what’s the unknown? You guessed it… complicated structured products on structured products on structured products that nobody knows how to price without a mega computer calculating a billion probability trees (and even then, it’s just a computer model… can you really trust a—computer ROBOT? *shifty eyes*) I want to show you pictures, but alas, I choose words as my medium like a true babbler! Any investment newsletter writer can bore you with charts of consumer savings (or lack thereof), house prices, subprime originations, CDO originations, aggregate money supply, inflation, risk/return spreads, implied volatility, asset wealth to income ratio (and what happens when asset wealth dissipates in a down market)… but I challenge YOU! Reader, to seek these things out yourself! The truth—or the absence of such in this random world of ours—will set you free but you must seek on your own! That, and... I’m too lazy/time constrained to copy and paste all that info. But if I was retired with a billion dollars maybe. HAHA.

And its funny to think that markets will quite possibly see two consecutive downturns in just a single decade when modern finance theory, structured products and derivatives is supposed to have made the markets permanently safer and risk premiums and earnings yield on equity investments permanently lower is… well… ironic. And what a dropkick in the face for those who think human nature and markets on an aggregate level can be tamed! Managed maybe, but tamed? Baloney! Financial contagions after a prolonged period of excess good times are very much a part of nature as—get ready for some obnoxious metaphors—(1) forest fires when too many trees are preserved in the wildlife regions of Midwestern U.S. (2) earthquakes when a period of long calm create unseen but pent up friction and pressure in the geology (3) wars after long periods of peace where populations grow to the point where resources (where productivity of use does not increase) are fought over between groups (4) any smarty-pants critical state ubiquity theory applicable. New financial innovations only give a sense of abolishing the inevitable, the inevitable of eternal recurrence (any Nietzsche fans out there?)…regression to the norm, and a whole lot of curve hugging volatility in between.

Where is the Excess Liquidity?

So back to the part where claims were being made… saying, modern financial theory and financial innovations are making markets permanently safer and liquidity readily available where necessary. In monetarist-speak, that just means: too much money is chasing too few assets, and excess leverage and velocity in the money system has been tinkering with otherwise rational risk perception! I’ve always liked them monetarists.

Economics 101 will tell you that money is created mostly from the lending system. Where banks have a certain amount of reserve from deposits, and can lend out money with that so long as there’s no “run”, and the lent out money in turn becomes deposits and reserves at another financial institution which lends out a portion of that money and the process continues.

Finance 103 will tell you that now a days, that the process of money creation can be expedited through creating avenues where banks can lend where none existed. Derivatives, asset backed securitization, receivables financing, to name a few—all to serve the purpose of driving the cost of debt lower by guaranteeing the lender that there is “something” that backs up the value of the loan just in case of borrower default. Today these things are so complicated (but if you have an hour or two on your hands you can still figure them out pretty easily…) that it’s beyond the purpose of this ramble to go into them in too much detail. All you need to know is they are based on probability theory. Every single last one of these quant valuation metrics… all probability and no pragmatism!

The lower the interest rate goes and the more financial innovations out there, the “looser” the money supply. So excess liquidity isn’t rocket science… it’s just extra money! (with or without extra value to back it up) Ever wish to yourself: man I wish I could have all the money I ever need? Well, excess liquidity is what happens when just that happens! Just on an aggregate level s’all.

But leverage works both ways. Money creation also leads to money destruction when no value is behind the paper. We learn that very early on… Finance/Econ 101! Excess liquidity can turn into excess contraction in the blink of an eye, and it can all start with writing-off of certain assets, and margin calls from brokers ect, and perfectly good assets can get sold, and perfectly bad assets will have no market and no pricing—and BAM! You get a nice big drop (which I’m still waiting patiently for but cannot help but get giddy trying to hurry it on)

Just call excess liquidity what you will… stupid money! That’s what it really is. And you know it when there’s a plethora of jobs in the finance field! The Chinese have a funny people’s anecdote. It talks about work habits in Japan, China, and America as compared to rowing crews in a race. The Chinese have everyone rowing, but nobody shouting out “1! 2! 1! 2!” To keep the rhythm, since there’s so many workers and no real leaders the boat doesn’t go anywhere. The Japanese have one guy shouting and everyone else rowing so they ultimately win. And the Americans—funny big nosed pink skinned people—everyone on the boat is a supervisor/investor, and no rowers to boss around! But you can always hear them talking loudly about where to invest and how to find the best rowers HAHA! Well that’s exactly what happens in an environment of excess money—Just look at what goes into earnings of the S&P! If you saw a big chunk generated by the finance industry, then that’s just what’s happening! (Consumer spending related sectors is the other major portion, which requires blabbling about later on)

Ponzi Finance

The term “ponzi finance” was coined by a famed 20-th century economist Hyman Minsky. You might have heard of talking-heads mention the words “Minsky moment” every once in a while—and poor Hyman Minsky died without ever knowing that his works would be famous… anyway. The ponzi finance he’s talking about is the excesses that financial worlds tend to turn into whenever a prolonged period of stability and prosperity takes shape. In a conservative period, we’d start out with “hedge finance”, which means debt is borrowed only when interest and principal obligations can be repaid in every period. Then we get a little crazy and start “speculative finance”, where debt must constantly be rolled over and refinanced and income only pays at best the interest portion of debt. Lenders usually are reluctant, but since the firm generates such a “stable and predictable stream of cash flows”, I guess they really don’t care so long as someone else could refinance this firm later in the future. “Ponzi finance” is the kraziest, with a K… and that’s when income flows of a firm or in aggregate will not cover even interest cost, and a firm must constantly be creative in order to convince lenders to keep throwing money. In modern times, Ponzi finance can be thought of as many things… and mainly cuz lenders these days don’t really give a hoot about borrower income not being able to cover interest, since they can just readily sell it to someone else through securitization and necromancy… and let me tell ya, ponzi finance is only possible when there is an excess supply of ready liquidity to chase returns.

When you think about it, the financial community really doesn’t create value—finance measures risk and return, allocates value accordingly, but doesn’t actually do the work needed to create the value, that’s the job of entrepreneurs, executive managers, politicians (NOT! I just put that there to see if you’re still paying attention. HAHA) So when there is an excess supply of “financing” available and quite a few entrepreneurs and sound companies, they’re all going to chase it like no tomorrow, and its supply/demand really—quite elementary no?

Back to Ponzi financing… so every once in a while, you will have pseudo-entrepreneurs come out during these times, and promise a certain rate of return that sounds just spectacular and makes you giddy—let’s say, subprime mortgage originators and private equity extra-extra-premium LBOs. The underlying business/asset? Pure crap. But do investors pay attention in a time of ponzi finance, that though the asset itself is worth nothing, the interest payments it seems to promise, and the potential that the investor themselves can package these loans up and sell them to someone else before anybody knows anything is wrong, now grasshopper, that is what we call a MORAL HAZARD—musical chairs, hot hands should stay in elementary schools, and that’s when society should have outgrown these ideas that you can crowd out someone else before you yourself gets hurt!

The subprime and dubious LBOs are underwritten to the public, and the bankers knew exactly what was being sold/invented/brewed-in-the-witches-pot, but they don’t care—they have the transaction fees in hand… a nice stream of income on the backs of other people’s ignorance. Arguably, an ignorance created by buying off the rating agencies (not blatantly, of course, but where do you think ratings agencies get their “revenue growth”?)

But can you really blame financiers for this… or the pseudo-entrepreneurs? In a world where money is awash, what do you do to make money unless you get creative? During excess liquidity periods—I just want to sleep all day long and complain about how nothing is cheap… cuz that’s how I roll. And people would say to me “Ming, you’re old school, think about all the productivity gains and the future”, and I reply “What… I don’t get it”. I do get it! I just don’t even wanna explain myself to someone stricken by the greed contagion, cuz there is no explaining it without getting severely rebuked by rhetorical acrobatics that only sound smart when loud and angry (and I’m a lover, not a fighter!)

Stat-arb Fund Blowups

The only hedge funds that makes headlines these days are the ones that have blown up (except Citadel, who makes headlines by buying up something that blew up), and the strategies that were employed by these funds are none other than, you know it! Statistical arbitrage funds! Whose quantitative valuation models (which all it is, is factors based on financial models, correlation, beta, momentum, ect. and a truck load of probability trees) feeds orders into a computerized trading model.

I don’t claim enough brilliance to already know what these models are (and frankly I don’t really care to know since they sure proved their worth! HAHA!), but ever since the beginning of my short and humble career as a money-shuffler I’ve been suspicious of these quantitative trading models—or just trading based on beta, correlation, and treating tickers not as underlying businesses, but as stochastic movements that somehow can quantified in math. Of course, there is a WHOLE LOT of merit to this method of making money, and I’m sure those that understand it fully could lead very fulfilling P&L books in their careers, however, there’s gotta be safer ways to make money. HAHA! It’s sort of ironic if you think about it. The more “hedged” and “neutral” you are, the less safe in a panic! And you can bet it’s the panics that make or break money managers! As can be seen in the fall of LTCM. Contrast that to the success of the likes of Warren Buffet to keep their principal even in times of turmoil. Well, it’s really not that hard—keep cash! And/or keep companies with at least >12% stable cash yield! And no leverage voodoo!

Cuz the fact of the matter is, it doesn’t matter if you make 10% gains every year for the past 10 years on 10x leverage, if you lose 61.5% on the 11^th year, you will lose ALL your gains… but investors and prime brokers probably won’t wait around until that happens, anything that gets close to 20% will get you a margin call or a redemption, which forces you to sell good quality assets at bargain prices to meet withdraws—and set off a chain reaction of losses and margin calls, and that’s what happened to some of these funds, and if you lose more than 61.5%? Tough! LTCM style… but to be fair, LTCM was levered some 100x? That’s just insane… So we have all these LTCM copycats who aren’t as hardcore as LTCM, but nevertheless suffer because of indiscretion and assuming markets are efficient/rational all the time.

To put it on a more extreme example suppose you make 10% every year for ONE HUNDRED YEARS (as in, your best and brightest son from your third mistress took over the business after you died), Oh man, you’re a genius, you’ve multiplied the equity portion of investors’ money by a factor of 13780.6x, anyone that invested just 72.57 bux in your fund would have become a millionaire after 100 years (or their children… this is before inflation which makes returns actually worse). And suppose they had their families stay with your son for money management, but suppose your son got a little carried away, and instead of having leverage 5x, with 1/3 in cash as a buffer, he carried leverage to 25x, and invested all the cash reserves in market neutral strategies? And when a market sell-off came to be, none of the brilliantly structured derivatives would trade, so he’s forced to sell off high quality assets for cheap to meet margin calls. And when that wasn’t enough because you’re levered TWENTY-FIVE TIMES, The entire equity portion of the fund gets wiped out on asset write-downs when finally a market is made on the brilliantly structured derivatives, except they only now sell for 18 cents on the dollar! The billions you’ve created over your career was destroyed instantly by your third mistresses’ son. Aint that a drag! HAHA! (but I guess you don’t care since you were dead by the time this happened! HAHA)—

Of course, people don’t have an extreme time-horizon like the one mentioned above, most people just want to make money as quickly as possible, and run for the hills (who doesn’t?) And that can be seen with returns chasing in many instances over the past five years or so even after the LTCM debacle, people still look at markets as if it were alchemy, with a way to make money any time all the time, when in fact it takes much more (or less, depends on how you look at it) than probability models to correctly price something. And in five short years for many of these funds, look what happened?

Some people will tell you that these irrational events occur 1/1000000^th of the time, but that’s where the hubris of science gets it wrong. Statistic lies, and often, because of the dangerous assumption that probability models reflect real life. When’s the last time anyone actually questioned the normal/log-normal curves? The only curves I care about in life are my beautiful girlfriend’s! HAHA! In all seriousness now… it actually seems that ten standard deviation events actually occur with a three standard deviation frequency. Ever read “The Masque of the Red Death” by Poe? It’s kinda like that! You can’t ever prevent that one guy that nobody paid attention to, and disaster strikes at your party more often than you can imagine!

Something Bearish This Way Comes

I give up, I can’t hide my giddiness… I don’t know why I get so worked up thinking about a huge crash—and you might ask “Ming… people are going to lose their jobs, their families are going to lose jobs, and you might not see stock market gains for ages! How is this in any way good for you?” To that, I say… I dunno! Haha, I can’t explain it. It’s not schadenfreude, if you think it is. I get very miserable reading articles about people losing their homes, and anecdotes on families shoved with mortgage papers in fine print that they could not understand but trusted their mortgage brokers to take care of them (you’d sooner trust a drug dealer!), and its heartbreaking to have to hear about people losing their jobs, and prospects of a worse time to come makes people scared, and how helplessness might be the best way to describe the state of mind in many people. And maybe it’s the little bit of sympathy left in me… or pity, whatever it is, but pity sure never helps anybody! People are hurt, but the reason why they are hurt in the first place was because of all the things I’ve been blabbing about! Speculative excess! And perhaps, one could unclog the pipes of hindsight, and ask just what it is that brought about people’s ability to purchase their homes in the first place, and what industry hath god wrought—mortgage brokers and real estate agents out to make a quick underwriting buck. I wouldn’t say the homeowners deserved it, or that all this unemployment now serves the mortgage industry right… ok ok who am I kidding… that’s exactly what I’m saying! Homeowners heard and trusted what they wanted to believe in, being able to afford a home on measly income and somehow the rest will take care of itself. Mortgagers wanted to believe that homeowners could repay the bill eventually, and that they were doing a service by giving people a home to live in (and if you could do that and write the loan to someone else, and forget that you were cheating both your clients and investors with the help of your bankers… then blessed are those who can forget).

The drawbacks of such thinking? Well, where do I start? It goes back to the problem of money creation, asset inflation, and a speculative spiral driven upwards. If you could write mortgages, sell these mortgages, use the proceeds to buy land/build houses, and write more mortgages to sell, and all the meanwhile (1) house prices go up and homeowners are eager speculators themselves (2) financial institutions love you because you give them bundled assets to sell (3) ratings agencies love financial institutions because they give them bundled products to rate (4) investment managers love these products because its free alpha, and eats these and pretty much everything else they can use leverage on (5) banks love investment managers for outperforming and give them more leverage for cheap, they also notice the general rise in the wider financial markets and starts providing financing for cheap to anyone that comes to them with a model to make money (6) everyone feels an asset inflation bliss, and assume eternally low volatility and default rates in pricing models.

Of course, that was yesterday… and it wouldn’t be strange then to walk down the street and see people happy, and all the wall street people bustling trying to make deals happen, especially since WACC is so low (because default premiums are gone, and the more debt you have, the lower your cost of acquisition, and the bigger/badder deals you can get), and business school students applying for jobs in real estate, private equity, and M&A banking, thinking “damn look at these fat bonuses”. Now people are starting to worry about the prospects of such futures. And the last panic of July 2007 sure was a really big rock tossed in the middle of lake placid, with a big splash—traders and fund managers everywhere shell shocked at just how close we all got to a complete financial meltdown. But now that the ripples have faded a bit, with the fed injecting that much needed liquidity, and confidence being restored in markets as some M&A deals continue to get announced… people might come out of their hiding holes… but they’ll probably be quick to go back in sirs! Cuz the show isn’t over yet!

Optimism remains, as it always has and always will be, and thoughts of utopia will never escape the human mind so long as it benefits rational self-interest—hope, my dear friends, that the fed will lower rates and bail out the indiscretion of financial markets… and we can blame others for such mistakes—after all, it’s not us that wrote the mortgages, it’s not us that caused the excess liquidity… or is it? The lines get blurry from here—after all, the Fed bailed out financial markets pretty hard the last time stock markets came crashing down, that gave an environment of easy money which could be argued to have caused the bubbles of today. And the rampant currency problems that we are already beginning to experience, (too many US dollars! And the foreigners are beginning to see!) and the fact that if it weren’t for the Chinese disinflation, we’d see some serious price increases in every day things. But that’s a story for another time!

Anyway, this optimism should prove short lived, and if history is any guide (and it usually is, except in the case of risk in quantitative models… HAHA) And although macroeconomic forecasting is a fool’s game, one can see the doubts and the moods manifest themselves… and whenever mood manifests themselves, there’s usually a great show. Just like how you wouldn’t see a movie that has no mood… you wouldn’t want financial market participants to be solid and sure all the time either (cuz then prices don’t vary, and people don’t panic sell!) I used to say “what’s inevitable is not always imminent”, but now, it sure is starting to get just a little bit more imminent every day—which is cool! Since everything seems to be falling into place… and what the bulls called “normal” we bears called “excess”, so now… we sure hope that the great normalization will kick in soon enough! And we just might start to see things cheap again.

The Boy Who Cried “Ease”! Inflation and Currency

But all this talk about this possible ease by the fed to bail the financial markets out is making everyone giddy with greedy eyes again. “Renewed liquidity will save us”, “Bernanke is watching the markets closely and will help us all in the end”, and my favorite “if I was the Fed, I’d sure lower them in light of what’s happening” (thank heavens you’re not! HAHA) The possibility of an ease is there, of course… any time a financial system is on the brink of collapse, the central bank must do its job and provide enough liquidity and money to at least support pricing/market making. But before we all get giddy and say “everything’s fine! Bernanke and the rest of the gang will be sure to fix this mess and we’ll be back on our feet again”, let’s take a closer look at what’s implied in loose monetary policy and bailouts of speculative excess from here on.

It’s hard being a central banker. No, it really is. Many people in the finance field don’t give these guys enough credit… and many talk with conviction and foresight as if they could do the jobs themselves… “oh look at this chart, oh look at this statistic, it only makes sense if the Fed does this”, and many would put good money on directional bets of where they think fed will take interest rates in the next meeting (my heart aches just thinking about it… I’m like Mr. Crabs from Spongebob Squarepants, why do you have to throw away a perfectly innocent little dollar?) And it’s always been my conviction that sometimes—actually, most of the time, the more you know about something, the more you think you know about it—and the more you think you know, the more you actually don’t know. All the data lying in front of you, and piece them together in some form or fashion and you can usually get something that makes sense in an abstract world but not at all in the real world. But I digress… the point is, Fed-watching is a whole lot like bird-watching… one should do it for vicarious intellectual fun, not for hairy chested, ego-on-the-line, table pounding. After all, you can’t influence how the birds will fly, and you can’t influence the way the Fed will act. But most people don’t prescribe to that philosophy, and being a central banker is tough because of just that—a whole lot of pressure from the outside people that think they know what they are talking about. It takes Bernanke a whole lot to sit there in a committee hearing, and get questions like “why do you want the value of the American people’s homes to go down?” while being shown a chart of the drastic drop in home prices (if you know what I’m talking about, then you must be an avid watcher of C-SPAN! Get a life! No… I’m just kidding, kudos to you for actually seeking the epistemology behind market noise!). Let the birds fly, I say! They know what they should do better than you!

At this point, a whole lot of people are reaching the consensus that the Fed will ease in the next meeting, and they are clamoring for it as if it is a necessity rather than a grace. Future markets, after all, are already pricing that possibility fully in the S&P futures markets. Most are foaming at the mouth at every “hurt growth”, “losses exceed the most pessimistic of forecasts”, “financial stress beyond mortgage market”, and of course “will act as needed to stem impact of market turmoil” as signs of an impending decision to lower rates. After all, if the Fed isn’t going to rescue the markets, who will? Like a knight in shining armor fighting back the dragon of bankruptcy; wielding the shield of monetary policy to block out the fires of financial meltdown… bad metaphor? You betcha! HAHA. But alas, I choose a bad metaphor for a reason, for an unrealistic literal outlook deserves nothing more! As if the Fed could stop impending disaster single-handedly! And once the crisis is over everyone can enjoy excess liquidity and stable yields again—with princesses, kings, and investment bankers and all… happily ever after? How nice… but of course, there’s always phrases like “Fed responsibility is not to protect investors” that people like to ignore… if the knight in shining armor does not fight the dragon, who will?

It wouldn’t be a stretch to say that the Fed has accommodated the markets quite a bit over the past decade or so… and has literally been the white knight that bailed out many instances of speculation gone wrong. With buying LTCM, and the tremendous easing after the tech bubble burst and September 11, all to create the liquidity necessary to prop up markets. For all those who don’t know… liquidity in this case means nationalizing bankrupt financiers, and dropping interest rates so low that people can’t help but borrow their hearts out to invest in asset markets (houses being the vehicle of choice). This has in turn rescued us from what could have potentially been an even worse bursting of the stock market bubble six-seven years back… and bulls cheered the quick recovery as sheet genius on part of Alan Greenspan, and bears jeered the bail out and mega-easing as a sign of an impending politicization of the central bank—and precedents that would bring about the doom of capitalism. Whatever one wants to believe, the reality of the situation is that the central bank is indeed political in nature, and to think that the bank can act independent of the representations of the American people is pish-posh! It just so happened that at the time, the majority of the American people actually participated in the asset markets as investors, so the central bank really could not sit back and watch the show while people were losing their retirement and life savings. Not to mention… in 1998, LTCM was a couple hundred billion dollars in the financial system, and that wasn’t exactly small change—and for that money to suddenly disappear overnight because of margin calls would have caused such a de-leverage effect that the we would have surely seen something worse.

So it’s a matter of how badly things get this time around (and from the looks of it, it could get pretty darn bad), and we bears can clamor all we want: “just let it be Bernanke!”, “the speculators deserve their pain!” The reality of the situation is that a melt-down is really no good for a well-functioning society—especially when people’s hard earned homes are involved—and the fact that it wouldn’t only be the speculators and the loud-mouthed bulls that would suffer from an impending financial doom (since leverage is everywhere!), we think twice about wasting time and wishing for impending doom… The media is already full of stories of poor American 40-50 somethings that have just bought their house, but now cannot meet interest payments because of blah blah blah, it would be unpatriotic now to not do something about a possible crash. “The Fed would only be doing their job if they bailed the markets out again—its only right because America needs help.”

So all this bearish talk about “artificial money” and “excessively low interest rates” being morally wrong and anti-capitalistic—don’t be surprised if it comes back again!

Oh, and keep in mind that a measely 25 bps or 50 bps ease will not change anything—if the Fed eases, it will have to be a consecutive ease like the one Greenspan undertook in the first few years of the millennium to bring sexy back to the markets!

Short-term monetary policy is nothing that one can predict. And I wanna make it clear that there is no way to call what the Fed will do in their next meeting September. But one thing is clear, whether they ease or raise, in the long-run, any decision would have its long-lasting effects in inflation and the integrity of the American dollar. While an ease might give financial markets crying “gimme a hit!” the much needed narcotic in a time of withdraw symptoms, and might even bring back a nice renewed rally—it’ll come at the expense of those that do not participate in capital investments. That’s another reason why being the Fed is hard… do you throw the bunny at the hyenas, or do you throw the bunny at the wolves? Either way, the bunny is dead… but you have to pick how it dies. So put on the gloves: currency or economy? Inflation or unemployment?

Yes… and all that money that’s being spent over there in the wars on terrorism, and all the currency account deficits that we’ve been running—that’s gonna come back to us one of these days. When China stops exporting disinflation as their currency strengthens and as European consumption and their own consumption strengthens, and when these foreigners no longer trust investments in America, we will see a flood of U.S. dollar selling, and we will have inflation-o-rama! That’s my story and I’m stickin’ to it! And if the Fed starts a series of interest rate eases, then they should know that would only exacerbate the consequences of the inevitable: dollar selling, import inflation, excess money supply. But does that mean they will choose to protect the integrity of the dollar and prevent inflation at the expense of short-term agony? Hard to say! Again, do you heed to the hyenas, or do you heed to the wolves?

And like a boy that cried “ease!”, one day the wolves (metaphorically, inflation) will actually come out—and by that time, the central bankers would not come and save the boy (the days of Paul Volcker returns), and the wolves will have their day, with a boy that has been grotesquely fattened by the rice-bowl of planned capitalism and artificial disinflation for way too long! Look at him run, with all that jiggly fat! That looks almost as bad as me when I run! HAHA!

Consumerism and Its Discontents

Economic Data as a Lagging Indicator

Macroeconomic Forecasting: A Fool’s Game

Zen and the Art of Value Investing

Of Bulls and Matadors, and Why A Bear Market Would Completely Kick Ass

The Inevitable is Imminent! (hopefully)

2007-08-10T09:41:00.000-04:00

*Die Walküre – Richard Wagner plays*

So the house of cards (dubious debt) is finally getting ready to crumble as expected. Quants and leveraged financiers can't expect to make all the money all the time :) The show’s not over yet folks! Let’s hope the Fed doesn’t ruin our fun with a bailout :D I want cheap assets!

$ amt of ARM resets—in billions USD:

Macro-view funnies

2007-07-19T05:15:00.000-04:00

HAHAHA
ahhh... the vagaries of macroeconomic prediction

hedgefolios.com: You know you are a Permabull when……

· each time the market declines you declare it a “healthy pullback”

· sideways moves are actually just the market “taking a breather” or a “pause”

· missing earnings estimates is ok as long as management confirms next quarter’s guidance

· bad guidance is ok as long as last quarter’s earnings beat estimates

· you criticize any analyst that downgrades your stock from “Strong Buy” to “Buy”

· you applaud poor economic results as good for the market because this time they will cause the Fed to stop raising rates

· any negative market commentary is evidence of a huge “wall of worry” that the market needs to go higher

· you plead that a 10% decline is a “great buying opportunity”

· you blame any market decline on short sellers who just don’t understand

· oil declines to $60 and you expect that will cause the market to head higher

· oil increases towards $70 and you point out how the market has been able to absorb higher oil prices

· you quote the cliches “history repeats itself” for positive things and “it’s different this time” for negative ones

· an inverted yield curve doesn’t concern you at all…

---

bigpicture.typepad.com: You Know You are a Permabear When…

· Each time the market rallies, you declare it an “unhealthy sign of speculative excess”

· The great majority of chart patterns always appear to be either rallies in a bear market or an imminent major top.

· CNBC asks you to appear as balance to the optimistic Bull guests.

· Good economic results are bad for the market – it will cause the Fed to keep raising rates; bad economic results are bad for the market -- its proof of the coming recession;

· You worship at the alter of the holy trinity: Roach, Fleckenstein and Kass;

· Sideways moves are actually just “setting up the market for the next down leg”

· You still rail against Nixon for taking the US off the gold standard;

· Your colleagues think you should become a fixed income portfolio manager.

· All the anecdotal evidence you see reveals excessive bullishness;

· You have trouble sleeping when you take a long trade.

· You refer to the 1987 crash, and the NASDAQ collapse of 2000, as "the good 'ole days." Bonus factoid: The LTCM debacle actually made you money.

· You have a ready "tulip-bulb" joke to use at all times.

· On days when gold prices drop, it's due to a government conspiracy;

· When gold prices rise, it's because central banks have finally lost control of manipulating the gold market. Either that, or the masses have finally figured out their fiat currency is just paper.

· If gold drops again the next day, see #1.

· The move from Dow 7,000 to Dow 11,000 has “just been short covering”

· When companies make quarterly earnings estimates, its bad because a) its already built it, and b) its evidence of earnings management. Missing earnings, on the other hand, is bad, because, well, its bad.

· Your website links to Marc Faber (The Gloom, Boom & Doom Report), Grant's Interest Rate Observer, and the Ludwig von Mises Institute.

· You criticize any analyst that upgrades a stock from “Strong Sell” to “Sell”

· The Yield Curve Inversion is a sure sign of the coming recession; As the inversion flattens, however, you note out how negative higher 10 Year Yields are for stocks;

· Positive market commentary is evidence of “complacency” and proof that the market must go lower;

· Any 10% rise in an stock is a “great shorting opportunity;”

· You blame market rallies on ignorant bulls “who just don’t understand;”

· The market is trading at 5 times earnings with a 5% yield -- and you are calling for the “next leg down”

· Strong economic data is proof that the BLS/BEA is politically fixed -- weak economic data shows how much the economy is slowing;

· You short anything that is in your parents' retirement portfolio – and are determined to outperform.

· You insist that Robert Prechter is just misunderstood

Science rules

2007-06-28T18:10:00.000-04:00

Finally, biology and engineering combine to make... biological robots!
http://www.reuters.com/article/topNews/idUSN2832706120070628?feedType=RSS

Economic Epiphany in an Easy to Read Chart

2007-06-14T17:47:00.000-04:00

This chart is from a really cool book called Ahead of the Curve written by Joseph H. Ellis on the vagaries of economic prediction (no oxymoron intended). The book is very well written... brilliant even. One of the coolest concepts in there is something called asymmetrical circular causality. But he can explain that better than I can. Check it out!

Okay, well, if you're too lazy to check it out here's a good summary, written by the author:

* Personal income - largely wages and salaries - is the primary driver of consumer spending, by far the largest sector in the economy. Credit and borrowing play a role, but if we can identify the most important indicators of spending power through wages, we have a shot at forecasting consumer spending.

* Uptrends and downtrends in consumer spending drive advances and declines in manufacturing and services.

* In turn, the capital spending sector of the economy, which includes companies' spending on plants and equipment, follows, like clockwork, the trend set by production and services, and consumer spending before them.

* These three sectors of economic activity - consumer spending, industrial production and services, and capital spending - represent the core of corporate profits produced in the United States, so the dependence of corporate profits on consumer spending is also clear.

* The stock market, which advances and declines as a sensitive predictive mechanism reflecting corporate profits, is therefore also tied closely to consumer spending at the front end of the cycle. This makes it easier to understand the sequencing of the stock market in this chain of cyclical events, with major stock market advances and declines tending to occur at similar points in successive cycles.

* Because business hire or fire workers based on the respective rise or fall of sales and profits, employment - jobs - follows rather than leads the economy. Mastering this fact is one of the core hurdles in overcoming emotional but erroneous reactions to economic news.

"In other words, consumer spending is dominant in the economy as a whole to such an extent that it is, by itself, the sector that cyclically determines the direction of the overall economy. This being the case, carefully monitoring overall consumer spending - or, even more significantly, forecasting the direction of consumer demand - is the key that unlocks effective forecasting for most other developments and sectors in the economy."

Financial and Economic Cycles: A Short Story

2007-05-15T07:07:00.001-04:00

A lighthearted note today... speculating on a hypothetical situation in a hypothetical world... where asset prices are going up-up and the perceived risks are going down down since its beginning. Let's call this hypothetical world: Omicron Ceti III (OC for short--star trek nerds will appreciate this), where a certain two groups of people interact in an imaginary economy, and establish economic exchange involving money. There were two clans in this world: The Klings and the Fergies.

The Klings were a nomadic hunter-warrior tribe before coming to OC. Honorable, proud, and sticklers for tradition, they are a hardworking people who have left their birthplace due to climatic changes and other acts of nature which forced them to find new sources of subsistence. The Klings were a very numerous people as women bore many children and men were prolific fathers. This eventually put strains on the environment when all their game were extinct. They had to move somewhere as many people were starving and had no food to eat.

The Fergies were in early stages of establishing agricultural surplus and an elementary economy before their coming to the OC. They have pride in their abilities to think beyond what's given in nature, and were superior to the Klings in education, intellect, and organization. They were also very resource minded and frugal, mainly because they were greedy. They established a very sophisticated system of social organization, and did not breed much and deliberately controlled breeding with complex systems of religion that promoted chasity. They wanted to conserve nutrients in their farmland and be frugal with what they know to be limited economic resources. They lived a rich life with a high standard of living per capita. Unfortunately, their military strengths were no match for a neighboring clan who has decided to invade them, and thus their trek to OC to find a new place where they can be left alone.

When the Klings and the Fergies met up in OC when both tried to settle in the land, the two chieftains who led the people at the time agreed to establish a democracy of equals, with the rule of law and property. The Klings were very impressed with Fergian knowledge of agriculture and political economy, and the Fergies needed badly the Kling dedication and experience with the "grunt work" and not to mention war-like activities to acquire and defend territory. Thus, generations have passed, and eventually both the Klings and the Fergies settled down and both called OC home. But of course, due to the Fergies previous intellect and experience with economic activities, and also due to their shrewdness and greed, they soon acquired significantly more wealth than the Klings. After a period of two generations, the Fergies were only 5% of the population, but controlled most of OC's vast amount of wealth and property. By then the economy has gotten relatively advanced. Not only were there a basic food and services industry that the people originally needed to survive, but tastes for consumer discretionary, finance, real estate, luxury goods, and the likes have also popped up on the backs of high population growth and a healthy labor market. Of course, it was mostly Fergies who had the bulk of the wealth to enjoy these amenities. Naturally, the Klings were unhappy with this, as their people were working very hard, but none could ever make as much as the Fergies. As the economy developed, up went the prices of assets such as land, shelter, and raw materials used to create the goods and services, and this meant it was very difficult for Klings to get in on the action with seemingly very meager wages. One day, a whole lot of Klings gathered and signed an official petition for a fairer distribution of wealth, and they protested and complained during a democratic council that the Fergies were guilty of manipulation and conspiracy to undermine the Kling people. This was the first time that the two groups of population had such problems since their founding.

Sensing danger of popular unrest, the democratic council tried very hard to figure out a solution. Around the same time, a secret committee of business and financial industry titans of the Fergie race convened in a secret meeting to try and figure out what to do to keep the Klings happy. The Fergies knew that the Klings were generally a proud and stubborn bunch who could in no way compare to the Fergie intellect and instinct for wealth accumulation, but they also did not think that this was a crime. These Fergies didn't look down upon the Klings, for they also needed the vast number of labor resources that the Klings provide for their civilization. They also realize that a Kling could kick a Fergie's butt any day in a physical match, which makes them dangerous if the Klings ever became politicized. The Fergie committee thought long and hard about what to do, and how to make the Klings feel richer without having to give up their own property and wealth that they've worked so long and hard to accumulate. But they just couldn’t figure it out, would they really have to give away their hard earned money and property in order to keep the social fabric from tearing apart?

Just then, a deus ex machina came and saved the day. A peaceful people known as the Chins sailed to OC from afar, with a caravan full of goods. They were very interested in opening up trade with OC, and the best part of it is that all they asked for in return for the ship full of goods were common shiny pebbles that were plenty to be found on a beach nearby. Apparently, where the Chins came from, these pebbles are very valuable.

The Fergies quickly capitalized on this opportunity and called in an emergency session with the democratic council on the island. The Fergies promised to fix the problem of income inequality by changing the money supply from the current rare gemstones to pebbles, and make available many assets in due time that Klings could purchase with these pebbles. The community built a 10 ft, heavily guarded wall outside of the beach, and established the first central bank in the OC. Of course, none of the Klings were smart enough to figure out what was going on, and the Fergies funneled enough pebbles into the pockets of Kling politicians to keep them happy enough to allow the Fergies to be the ones that controlled this seemingly endless beach full of pebble money. When the bank opened, all was welcomed to exchange their gemstones for these pebbles at a set rate of 50 pebbles per gemstone. The population quickly did so.

Trade with the Chins quickly heated up, and a vast surplus of goods and services were soon imported from the distant homelands of the Chins. A complex system of banking and finance sprang up as a result, where paper representing ownership of pebbles soon began circulating in the two-world economy. The Chins soon also incorporated bank-notes from the Fergies as a part of their currency back home, though they’ve always kept it tucked away as the Fergies didn’t export what they didn’t already have back home. The only thing that the Chins ever really wanted from the OC were the seemingly ubiquitous shiny pebbles and notes representing claims to these pebbles.

Soon, the food of goods from the Chins created a disinflationary effect on the economy of the OC, and the Klings, whereas before they could not afford the luxuries that the Fergies have enjoyed, quickly snatched up goods at cheap prices. The opening to foreign trade had allowed Fergie business owners to shift their production to low-cost foreign countries, outsourcing jobs once held by Klings. There were some complaints regarding job-loss, but in general, society in a very content state-of-being, everyone could purchase price-deflated consumer goods for cheap, and no one was hungry.

Of course, the Fergies who have outsourced labor overseas to the land of the Chins quickly found themselves able to earn very handsome margins on the products they shipped back home. Branded goods and services soon appeared, and an entire fashion and glamour industry sprang up on the backs of high selling prices. Voluptuous females, Kling and Fergie, paraded the catwalks and appeared in newly printed media advertising the new crowning consumerism, and urging the nouveau riche to splurge pebbles on luxury goods made widely available and affordable.

This worked pretty well for a while. The Klings were happy consumers, and could purchase more than they ever thought imaginable. And due to the flexibility of the Fergie dominated central bank, which has increasingly injected more and more pebbles and claims to pebbles into the money supply to pay for goods imported from the Chins, the Klings were able to enjoy very beneficial financing terms. They soon bought their own homes with very little down payment and mortgage debt with very little money down, low interest rates, and a terms of twenty-plus years. Despite the fact that more and more jobs were being shifted to the land of the Chins, in aggregate this was no problem because enough jobs were being created in the real estate, finance, and consumer retail industries in the OC to off-set job losses in hard-asset businesses. Nobody really worried about “real wages”, because inflation didn’t exist in this world of endless cheap Chin goods. Of course, all this prosperity have kick-started asset prices even more, and prices in the local stock exchange—once very illiquid and with only Fergie participation—has become very trendy among the new middle class Klings. Everyone was happy to see their home prices appreciate, and everyone was ecstatic when the value of their portfolios went up steadily day by day. This has created even more confidence in consumer spending, and the Klings were enjoying the seemingly unlimited wealth that the new banking/financial system created. Meanwhile, behind the scenes, the Fergie central bankers and central bank chairman Ulan Bluespan made sure that the system created enough pebbles and pebble denominated debt to sustain this asset inflation and the consumption binge.

And meanwhile, the Chins were increasingly worried that the pebbles and notes claiming pebbles would soon depreciate in value. After all, their economy is now flooded with pebbles, and they have been recently suffering a serious bout of deflation with more and more manufacturing capacity coming online with the easy pebbles available. However, the seemingly insatiable demand of the OCs were simply too profitable to ignore (at least in terms of what they thought was profit… more and more pebbles and pebbles denominated notes). Plus, the OCs were seen by the Chins as an economically and politically superior group of people. The Fergies, on the backs of a prosperous economy, had encouraged out-of-work young Klings to join in a new military expansion program—in the name of all that is good and just: freedom, liberty, and the pursuit of happyness. Over time, this military expansion program had lead to overseas expeditions known as freedom fights, and this showed off the OC economic and military might to the rest of the world, which significantly helped in the credit ratings of the OC central bank in the eyes of Chins and an increasing number of other societies.

All this has served to greatly increase the Klings satisfaction with the Fergie banking administration. Although the Fergies did not necessarily create real income equality, there was a standard-of-living equality that greatly satisfied the large Kling population, whom can now be largely considered “middle class”. At the same time, however, nominal income disparity widened further, as the original many Fergie asset owners, and a few Nouveau riche Klings accumulated an ever-increasing share of society’s wealth, so much that they had no idea what to do with it except to invest further into more assets and/or use them to flip stocks.

Abstract artists, once considered economically despicable in both the proud warrior-like Kling species and the practical Fergie race were soon making a good living tapping paint on a canvas and making random stories of feelings and heartbreaks. A canvas with three red dots were fetching on the market for as high as five hundred million pebbles. This mirrored the increases in securities markets and maybe even more.

However, the Fergies soon realized that this economic miracle would not be forever, and they soon started thinking about the downside to all this. The more they thought, the more they began to hedge themselves. The consumption binge and the seemingly endless asset inflation would grind to a halt if any trouble with the belief in the value of the pebble would come into question… but so long as the Chins and other nations impressed with the OC’s economic and military might were willing to take these pebbles and finance whatever account deficits and a growing national debt, and keep these in their foreign reserves and treat them as legal tender for possible future purchases, then the OC would be fine, and this binge would continue on and on. But all good things must end, and the fact remains that these pebbles were once just pebbles on a beach, and they hold no real value what-so-ever, and that sooner or later, there would be doubts to the real value of the OC pebble, and what goods and services that it might bring to the holder. The Fergies know this, and they are devising methods to try and shift the risk away from themselves.

Finally, the greediest among the Fergies would devise a method to enrich themselves one last time and still guarantee they would still come out alright. So, with a natural instinct for profit, and ever at a loss in finding ways to make money and keep money to themselves, the Fergies have devised very intricate financial innovations. The first of these innovations was asset securitization. The Fergies geniously devised a plan to extend even more credit to households that were not living the OC dream yet (they call this subprime pebble loans), and packaging these loans into fixed income securities called Mortgage Backed Securities. They also extended numerous loans to new start-up companies created by young, educated, and optimistic Kling entrepreneurs, and packaged the cash-flows to those and sold them off as Asset Backed Securities and Collateralized Debt Obligations. The Fergies loaned to whoever they could, and transferred the risk of default and asset depreciation to the investing public (whom by now are in a frenzy of asset purchases and speculation), and pocketed billions of pebbles worth of transaction fees and brokerage fees. Second, they began marketing various derivative instruments and packaged fixed income instruments to foreigners—in particular, the Chins, who were not as sophisticated as the Fergies in coming up with financial innovations, but were nevertheless eager to invest due to the strength of the OC pebble on the international currency exchanges. Third, the Fergies began to encourage leveraged products, as diminishing investment returns and low risk-return spreads plagued the rabidly greedy investors. This leverage allowed Fergies to pocket even more fees as they package ever increasing debt and sell them off to the public. As long as asset prices appreciated more than the interest on any of these loans that the Fergies made, then the investors were golden. Fourth, the Fergies began to create even more fervor among markets by organizing Private Equity funds, where they garner billions and billions of pebbles from investors, and take public assets private on the bank of billions of dollars in bank loans often at 20 – 30% premiums, and then IPOing these private equity funds back to the public at and even more mark-up.

Among all the frenzy in the markets, and everyone buying into the belief that the new financial innovations that the Fergies devised making investments permanently safer and more liquid, asset prices kept going up for a while. The Fergies have long gotten out of the game, while the Klings keep flipping and the Chins keep hoarding assets.

One day, out of the blue, the Chins decided that they now had enough pebbles and pebbles denominated debt to last them ad infinitum, so they started buying OC hard assets themselves (much like the Japanese did during their market bubble). The Klings also started selling these assets, and pretty soon, there was a rush of Klings wanting to sell and pocket their gains. Asset prices went down a bit, and margins on loans were called, and securitized products began losing some of their collateral. In other words, minor events and tremors in the system, and the subsequent asset price declines soon triggered several critical states in the economy. Those that had houses on subprime pebble loans began receiving rates that were beyond their payment capability, and they defaulted. Loans made on the backs of company products and equity securities were increasingly being called in. Klings and Foreigners across the board began losing money, and buying interest was taken out of the system by quite a bit.

And the Fergies central bank, in attempt to fix the problem, pondered two possible scenarios: lower borrowing costs, which will inject excess liquidity even more and support asset prices, but nevertheless will induce foreigners to sell pebbles, and will probably resulted in a run by the Chins on the existing pebble currency, where inflation hidden in years of disinflationary consumer products will finally kick in. Or, do nothing, which will create total illiquidity, where asset prices continue to tumble and across the board losses will occur with much of the value of pebble denominated assets wiped out—not to mention all the derivative products that were written to the public. Either way, however, the Fergies come out fine, due to their shrewd transfer of risk to the public, and their ability to buy back cheap assets when the markets tank.

Fergies 1, the rest 0. By now, the gems that were originally the money supply replaced by pebbles are now worth 600 pebbles per 1 gem. And the economy of OC is being plagued with an extended period of stagflation.

What will the Fergies think up next?

Complex Theory and Power Laws, With Philosophical/Economic Implications

2007-05-12T22:40:00.001-04:00

An artist's depiction of fractals in complexity/chaos theory

These are concepts set out to replace linear causality. Instead of event A causing a response called event B, events A, B, C, D and so on act as either points, planes, or spatial objects, with or without mutual exclusivity, push and pull in tandem or in flux or with mutual influence but not to the full extent, either cause some other group of events to occur, cancel themselves out, or somewhere in between.

I suppose that's where things get complicated (thus, complex theory, what a cool name), but it is certainly a concept more befitting of economics than linear algebra--and not just economics either, but maybe existence itself too. Of course that's beyond what I'm trying to do in a blog entry. But what's amazing about complex theory is its scope of application, in back-testing of what's happend in the past, in understanding how we got to where we are now, and in setting a framework for any sort of art in predicting the future. After all, to make an example of a commonly known process: evolution, the beginnings of life were once considered humble and quite easy to understand. Now, to define life itself as an academic pursuit would take years of not decades of categorical work. As the theory goes, single celled organisms divided itself and combined with other organisms to form living beings planet earth is teemed with today. First with simple structures and organelles to sustain itself and reproduce--a cell wall to house cytoplasm, a nucleus to shelter chromosome, mitochondria to generate energy, and some endoplasmic reticulum to distribute resources. Then on to sexual reproduction and combination with the genetic codes of other cells to create intergenerational adaptation and evolution through the shared replication of superior genes. Then, as cells moved beyond being isolated phenomenons, vessels of massive size are created to house groups of cells who have found ways to co-exist under mutually beneficial arrangements--we can think of these as plants and animals at any given stage of evolutionary complexity. Some remain very simple as rudimentary genomes find no reason to evolve beyond what is necessary to survive in a simple, unchanging environment--phytoplankton, algae, and various other microorganisms. Some, in order to exploit changing circumstances and power over other organisms evolved into a complex entanglement of organs and biological fluids working together for the goal of common survival and reproduction. And some of these organisms even evolved an executive cell group created solely for the purpose of intellectual thought called the brain. And it didn't end there. Intellectual thought (at least only in humans on this planet) quickly became a means for what was once cellular organisms to go beyond biological fluids and structures, to create social interaction, common history, civilization as we know it recorded in the form of knowledge--the rise and fall of empires, the evolution of media and the press, religion, economics, politics, and most recently the creation of the most complex web of virtual ideas known as software. And who knows what the future holds. But what's clear to scientists and philosophers is that each stage of evolution and change can be traced and graphed as according to a secret order, and the magnitude and timing of each tipping point or critical state could be related back to a statistical power law. Changes of a certain magnitude will happen less likely the bigger these changes themselves are. The frequency of such revolutions in biology, science, knowledge, ways of thought will happen statistically less—as according to a power law, with some physicists and scientists pointing to a factor of four times as likely or not as likely. But these critical states of change happen in natural phenomena, and it gets quicker and more complicated with every branch of development expanding ever rapidly. It took longer for single-celled organisms to go from asexual reproduction to sexual reproduction, than for a moth to develop chameleon-like skin as according to their environment to avoid predators (a process that takes only a couple of generations, each lasting a couple of years). By the same token it took much longer for man to develop and pass on agriculture and basic technologies to the next generation, than for modern innovation to take a foothold in everyday life (remember the most daunting advancements in technology and social organization came about in the 19th and 20th century). This example of evolution, and the frequency of critical turning points in its progress (the second derivative), is just one of what modern intellectuals can attribute to complex theory and power laws--which, as the trend of our scientific times has determined, the origins of virtually everything on this planet, hardware and software, can be ascribed.

As any model goes, it serves very well as a framework for organizing and back-testing data collected on historical data and developments. Simple and seemingly linear progressions would start very easy, but accelerate into multifaceted networks of causality weighing on one another and create systems of stable equilibrium that expand infinitely. This is mathematically beautiful (I personally think so). You could look at the development of anything with a new perspective, from evolution as we've just mentioned, to the development of our current government (from townhouse meetings to national democracy to national committees and agencies to bureaucratic glut), the great monotheistic religions (from simple beginnings of monotheism to Judaism to the crucifixion of Christ and the spread of 'the word' by Paul to the arrival of Mohamed and the thereafter split between Sunni and Shia to the splits in Christendom of Eastern Orthodoxy, Catholicism, Coptic Christianity, Protestants, Evangelicals, and the arrival of Islamic fundamentalism), to why one should do well early on in school (from As in math, science, and english, to an A in subjects derived from these subjects, history and economics for example, and then knowledge of each subject in detail, which is virtually every subject from the beginning ones, and the detrimental effects of having to catch up if full understanding of simple origins of such knowledge is not achieved) to categories in science, politics, economics, philosophy, you name it. And all knowledge and existence could be related to a tree, with which metaphorical branches spawn even more branches, and it doesn’t stop. Sometimes branches get old and die, in existence and in knowledge, and when branches wither and fall from the tree the other branches fall with it—like an act of god or maybe the inability for the environment to support certain phenomena or without the environment going head-to-head against its very existence. And thus a web is disturbed. The example would be like a tiny moth going extinct due to an external factor such as human intervention to control their population, leading to certain smaller birds of prey unable to feed their young, leading to tree-dwelling mammals unable to find birds eggs as a source of food, and larger predators unable to secure a steady supply of these mammals as prey, and extinction occurs at the top of the food chain more often than the bottom, ect. Sometimes branches continue their upward and outward growth, far outpacing what its original host had intended, due to its prolific potential as a basis to develop offspring—knowledge, for one, has several of these: monotheism, mathematics, literature and philosophy, or even the more modern ones such as the Einstein’s theory of relativity, Darwin’s theory, game theory, critical state ubiquity (the most recent). Sometime knowledge could be destroyed or rarified in human knowledge, and rendered antiquated and useless—such as geocentric theory, medieval treatment of lunacy through exorcism, Zoroastrianism, countless languages from extinct tribes of people, and the list goes on.

To put it in a nut-shell, "complex theory" serves to describe an underlying order to what seems to be the complete chaos of modern day life, by first ascribing the origins of any categorical phenomenon under consideration and then, with a model--either scientific or philosophical, slowly branching out these origins and fitting more modern manifestations under these models, and be able to explain their evolution or destruction and the prospects of the “branch” going forward. The "power law" describes the speed and the frequency at which the branching out occurs—for example, outlining the occurrence of earthquakes and its statistical frequencies according to their magnitude—the famous Gutenberg-Richter theorem, or the accumulation of wealth being defined as being a certain power of more or less frequency as the amount of wealth increases or decreases by a certain factor in the individuals of a population, or just the normal curve under any statistical study delineating the expected normal occurrences spread across standard deviations—with events getting rarer as sigma grows.

Anyway, that was quite a bit of description, but hopefully one can see the implications that these theories can have on economic development, whether macro or micro, and the relevant policy or investment decisions might be derived from understanding such models. But, as any model, it's very good for hindsight. We should keep in mind the adage "Models do not provide answers, they only serve to detail questions". So what would this theory tell us in the world of finance and economics? Could we use something like this to learn more about how the world of practical matters such as money, employment, social security, empire building, etc.

Let’s leave that for another time.

Just another suggestion, pick up these books, they are insane and make you go "holy shit this kicks ass" with every page:

Ubiquity - Mark Buchanan, Deep Simplicity - John Gribbins, The Selfish Gene - Richard Dawkins

They may mention finance/economics only seldomly, but the concepts and simple truths delineated in the pages is something that everyone in perhaps every profession would benefit to know.

Fortune Favors the Bold?

2007-05-09T01:14:00.001-04:00

These spreads are pitiful (yields of riskier credit securities compared to treasuries)...

In a nutshell, this chart shows how much investors of debt securities demand back in terms of yield. This chart relates a nice picture back to us regarding the general sentiments regarding risk, and how much return should compensate for that risk. The relationship of credit-spreads between what is considered "risky" and "riskless" shows very well the risk-reward expectations of the investing public. Basically the yellow and the red line compare how much "extra" return is expected when investing in securities other than the completely riskless U.S. treasuries market (the bonds issued by the U.S. government). Why does this picture scare me?

1.) People are no longer afraid of credit risk, expecting a measly 1% spread for barely investment grade securities and a little under 2% for emerging market sovereigns (usually considered pretty risky, but given the fact that "emerging market" has become a buzzword for growth and riches now-a-days, nobody really thinks about default or non-payment). With the easy availability of credit default swaps (derivative instruments that allow an investor to completely diversify out of default risk--provided the counter-party does not double-default... but who knows?) brunting the bulk of the uncertainties with investing in instruments of dubious integrity.

2.) To get the return required for yield hungry U.S. investors, institutions and money managers (alright alright, mostly hedge funds...dammit) have been using substantially higher leverage to capture ever decreasing returns. If you think credit spreads are bad, you should see how much people are willing to pay for equities these days (15-20x earnings on normalized businesses not unusual!) But yeah, here's a picture of how much hedge funds are levered. Prime brokers (firms who execute trades, lend money, and provide various other financial and administrative services to investment funds) have been literally giving money away since late 2003. Who can blame them? Money grew on trees as we were coming out of the tech bubble, all that extra cash needed to go somewhere, the new wonder-kids of finance at hedge funds are 'good' at making money all of a sudden because everything is going up, and the fees on these borrowings are not half bad.

3.) The justification for this complete negligence of investment sense is the circular argument that derivatives and credit default swaps has permanently made financial markets safer and more liquid, when the wide availability of these derivatives were a product of a secular bull-market driven by the wide availability of money supply in the first place. A paradox of the chicken and the egg is here. When I think about it, it makes my head hurt, because... first of all... would derivatives and credit default swaps be so easy to finance if it weren't for the fact that volatility was low and asset prices were perceived as sound? Second of all... would asset prices be sound and leverage/money be so easily dished out if it weren't for the fact that derivatives and credit default swaps has created "permanently" less risk and much more trading and liquidity? So, look at the two charts below... is it the chicken or the egg?

If I'm brilliant enough to call what's supposed to happen next as a result of this non-sense, I would be making millions of dollars right about now (if not billions)... I don't claim I know what's going on, but I do know that somebody has to be getting the short end of the deal. When there's a winner that has diversified away all his/her default risk and volatility risk, somebody else is taking it on--even if that somebody else has diversified that risk away themselves, then that somebody else's somebody else will be the one brunting the blow. Even if it comes full circle, somebody will probably have to default if things get bad enough.

I just wanna see what happens in a bear market, when liquidity suddenly dries up and trading grinds to a slow. When everyone wants to sell, you can bet this scenario of permanently lower volatility/risk/returns, higher leverage, and the happy-go-lucky world of record-high dow closings and never-ending LBO/M&As will be less enthusiastic.

Fortune doesn't favor the bold these days, it favors everybody. Virgil wouldn't be quite as poignant on courage if he saw what's happening today. Bankers winning on fees and investment funds winning on returns forever and ever seems like a utopia, but utopias are never quite so economically viable--for an extended period of time anyway.

How Loose Monetary Conditions (not economic) Affect Stock Market Returns, and Why I'm Still A Bear

2007-05-04T02:14:00.000-04:00

Before I begin a long-winded thought jot-down that was long before due regarding my views on the economic and investment outlook that I personally hold regarding the future, I'd like to say right now that I am not assigning any time-line to when I think my views would come to pass. Any economic view on the market, despite the potential inevitability that views suggest, are by no means ever imminent--as the market is still after-all a voting machine that is run by human psychology rather than the fundamental truths that might be of consequence. I've been bearish on the state of the U.S. economy and stock market for a while now, but that doesn't necessarily mean I want the stock market to fall, and for people to lose their jobs, or for America to lose its economic supremacy in time. What I am is worried, and I worry because I need to know where money can be made in the finance world if making money was the cause of a lot of fundamental disequilibriums in the first place. The problem of excess liquidity (I'm probably one of very few on the street that think excess liquidity is a problem rather than a solution) have weighed heavily on real returns, and the illusion of capital gains are paid on the backs of an unending quest to build capacity in Asia and the ebullient view of a neverending consumer binge that drives what it means to be American today. Nevermind the fact that the performance of the S&P has been caused mainly by the rise of financial stocks and consumer stocks, and nevermind the reason that much of the core growth in corporate earnings actually came from abroad in the form of a weakened dollar. The question that must be addressed is how America's chronic deficit spending, and the economic liberalization of the previous Greenspan regime effected our futures as investors and every day citizens going forward. And why we should be worried about a potential pitfall in investing in America if things go unaddressed. Difficulties in curbing inflation (i.e. things getting more expensive and our retirements getting more difficult) will be the challenge of the Fed and central bankers around the world as they try and figure out how this financial frenzy of today will affect money supply and velocity, where people give three cheers for M&A activity that make little to no sense simply because it drives stock returns, and where the wealthy simply give money away to anybody with a business plan for a (fill in the blank) fund. One can cite countless deals that have happend over the last few years done by private equity or investor consortiums that have investment yields thinner than Victoria's Secret models, and how if wealthy people really wanted to throw away money they might as well throw away money at kids starving around the world rather than down a black hole of greed and expectations comforted only by the scant hope that maybe someone else will buy the investment at a higher price (because, there's enough liquidity, duh).

Before anything, here's a very interesting piece courtesy of Marc Faber of the GBD Report and John Paul Koning of Pollitt & Co in Toronto:

The Zimbabwe Stock Exchange is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they've already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicice. Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability.

As for capital improvements, there is little incentive on the part of companies to invest their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe's policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms like banker Old Mutual, hotel group Meikles Africa, and mobile phone firm Econet Wireless. It is the only place to go. Thus the 12,000% year over year increase in the Zimbabwe Industrials.

Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions and not changes in GDP. New money gets spent or invested. In Zimbabwe's case, because there are no alternatives, it is stocks that are benefiting.

This sort of thinking can be applied to the stock markets in the Western world too. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock marekts over the preceding twenty-five yeras has been created by a vastly increasing money supply, and how much is due to actual wealth creation. Perhaps stock prices have increased faster than goods prices for the last twenty-five years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency.

This example really hit me, it describes a whole lot of what's going on around the markets in a more extreme manner. The emphasis in bold is mine, and what it's suggesting hints at how any investment return--viewed in absense of a perspective on the general monetary conditions of an economy--is at best illusory and at worst stupid. One might view the 12,000% returns in Zimbabwe industrials as very attractive, but in light of the horrible inflation and the lack of general investment options to preserve capital enough for a meal the next day is scary. Of course, the current inflation in the United States might be viewed as benign in comparison to much of the developing world (some 2.0%+ annualized), and compared to the 20%+ returns in the S&P500 over the last year or so this is a very good deal for anyone that has gotten into the markets, for their wealth in real dollar terms have increased by quite a bit.

But what does it really mean to hold wealth? What is money? To the average joe, the more money the better, and the more things money can buy, the merrier, if only everybody in the world could have money then every problem we have would go away. This is a fantasy not far off from what perhaps 95% of the population would agree with. However, for economists and interested investors, this is far from true. Economics 101 would tell you that if everyone in the world could make fast money, and build wealth in nominal dollars, and have a fatter bank account that grows day by day for some reason or another--with the awesome money their mutual fund managers and their mutual fund manager's fund managers makes--then there would be a case of increasing prices so that everybody loses purchasing value year after year and no "real" wealth is built at all. Certeris Paribus, $100 dollars that used to buy a coffee machine will now only buy a pack of coffee machine filters. Of course, the real world isn't ceteris paribus, but enough empirical evidence has already given us signs of danger that the next recessionary pressure we feel will surely be stagflationary, in consequence to lagging consumer spending, job loss, much higher commodity and raw material prices, and a weakening dollar. So we must ask ourselves is inflation truly under control? Prices in the United States have stayed stable, but any traveler can tell you that staying in other places around the world (developing economies excluded) have become much more expensive. Americans, as usual, are pretty complacent spending their evenings at home and not thinking outside of their own continents--but people really should be more concerned about the falling value of the U.S. dollar, and what implications on inflation it actually has at home.

While stock prices and house prices (until recently) have continued their upward climb slowly but confidently, driven primarily by the reflexive success of financial and consumer markets on the back of increasing asset prices that becomes its own grandpa, the rest of the world seems to have begun a bleek view on the fate of American status and the strength of the American Dollar (once pinnacled as the currency of dicipline and value preservation). A comparative glance at several currencies considered relatively "hard" against the dollar--meaning more fiscal dicipline and less monetary expansion--can tell you something about "true" inflation, in terms of how much it actually costs an American to live in the world (as opposed to his couch in surburbia).

How much Euros to buy one dollar

How much British Pounds to buy one dollar

How much Swiss Francs to buy one dollar

How much Austrailian Dollars to buy One Dollar

How much Korean Wons to buy One Dollar

For any of these foreigners to have invested in American assets in the last five years would have been difficult due to the falling to flattish real returns they would have earned on average (say in the S&P or treasury markets). The story of real inflation for Americans haven't hit home quite yet due to the still relatively cheap goods and cheap capital that is available in China and Japan, respectively. In China, manufacturing capacity and saturation have literally reached its limits, and the endless supply of labor have since cooled the price of consumed goods in America while under normal circumstances Americans would have certainly felt heat. But the China problem (the one that US politicians and economists keep talking about) might have found a solution yet--a gradual appreciation of its currency to reflect global norms and correct trade deficits.

The biggest draw back in the case of China is that, although "lowering our deficits to China" and "help save our jobs" sounds good to Americans now, the actual consequences will be dire in the form of much higher prices. China has acted as a cooling engine in world inflationary pressures in consumer goods (a cost that has arguably been passed on to increases in raw materials, energy, food and commodity prices that they are continuing to drive up), and this has enabled many societies around the world to live with relative comfort and still be frugal. Now I say Americans will feel heat, because while China has enabled a much cheaper manufacturing environment and thus cheaper goods to be enjoyed by everyone, Americans have been overspending even in light of this. A quick glance at the household savings rate and the household debt level (manifested primarily in credit cards, auto-payments, and mortgages) in Amerca will tell you the story:

But in light of these increasing pressures in actual finances of the consumer, it's still "okay" to buy the new playstation and the wii because the stock market or the value of the house is going to pay for it. The stock market, specifically, has continued its run over the last two years, and is coming closer to the levels reached in the Tech Bubble--only this time around, it's the consumer-spending-on-frothy-assets-and-financial-stocks-on-M&A Bubble as a result of easy credit expansion and the exponential growth in derivatives that "hedge-out" risk (provided that nobody defaults). A self-reinforcing phenomenon occurs here with two factors: (1) consumer spending and financial returns based on rising asset values (2) rising asset values based on increased consumer spending and financial returns.

Nominal S&P returns in the last 5 years

Nominal S&P returns in the last decade (tech bubble included in 2000)

Again, I repeat, foreigners (who fundamentally would view the dollar as an important consideration in investment decision making, and those more keen to inflationary pressure and American froth than we Americans) have seen little appreciation in the value of their investments if one were to adjust market returns in terms of their currency (look at the charts of dollar value of other currencies above). This tells a true story about the "real" wealth actually being built in the United States.

And the bit going around the market talking about how a "weak" dollar will help the American economy is declaring ignorance of the painful short-term effect of a continuing weak dollar. Namely, a slow-down in consumer spending, and a flatting and falling asset market that Americans pride itself on. Longer-term, the macroeconomy will adjust, and maybe we can see the United States actually making something "tangible" again in the future instead of just shuffling money and intellectual property, but nobody can predict when this long-run is. The case in point is that inflation in Ameica will hit sooner or later, and the factors have already been set in motion: (1) calls for a weaker Chinese Yuan that will increase consumer prices across the board (2) falling real estate prices and defaulting mortgages hurting consumer spending and financial returns over the next year or two (3) drying liquidity as capital loses value in the form of less trading, less M&A, and unwinding of the Yen carry-trade (4) yields too low to chase--which eventually but surely must happen unless the entire investment community collectively lose their minds.

All the money that's been spent in the Iraq War and the war against terrorism, and all of the money funneled into foreign central banks (such as China's and Japan's) will also play a role in increasing the money supply in the US. Although the velocity of these "eurodollars" are not enough to create rampant inflation in their current idle state, it would be interesting to see if any of them would make their way back into the states eventually as the dollar continues to weaken and money floods back to buy American goods. We would all be much poorer when that happens if we don't invest appropriately...

Whatever lessons this situation could tell us paints a picture of much uncertainty in the future. Stock prices will not increase forever, and macroeconomic conditions, although benign currently, are starting to slow. Making "real" money is difficult, but money in large doses as according to hedge funds and private equity funds still is performance since inflation doesn't hit that hard in its current manifestation. The investment outlook of any prudent investor should be one of caution as we move forward. Nobody can predict the timing of the unwinding of this seemingly stable disequilibrium (if it even unwinds in our career), but an investor can always protect against these events by going into foreign markets, and investing in sound businesses uncorrelated with the market at large that are cheap (something that calls for much more qualitative research in the microeconomic perspective). Just don't buy into the easy solution of investing in whatever grows that will most likely continue to grow so long as the economy is doing well and excess liquidity never stops.

w00t, that sure was long-winded. Probably would have tons of grammatical mistakes and concept left out if i were to go back to read it too... but that's my two cents, for whatever its worth (which will probably turn into one cent sooner than we think)

S&P is falling down... doo da... doo da...

2007-02-27T15:36:00.000-05:00

Yes! 3.0%+++ fall! Finally, some sense in the markets... could this be the beginning of cheap stocks again? :D *crosses fingers*