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

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

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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

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

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

The Russians are Coming

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

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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"

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?

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

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!

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

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)

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)

*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

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