The Connection Between CDS and Swine Flu

Before you roll your eyes in desperation and think "this guy will pin everything on credit derivatives", hold on and read a bit more than the post's title.

Remember the post on correlation (gamma, γ) and how the simplistic way in which it was used by Wall Street financial engineers to calculate predicted loan "mortality" rates created the huge trouble in the securitization business (CDO, CLO, CPDO, SIV, etc.) - it being the proximate cause of the current global financial crisis? Well, the entire mathematical theory was lifted, warts and all, from epidemiology, i.e. the study of how communicative diseases (mostly viral in nature) spread.

Funny how the world works, eh?

Them's Not Grapes

Anyhow, I must also observe that we in financial markets seem to not be taking the swine flu situation seriously enough. The World Health Organization just went to Level 5 (out of 6) on its pandemic alert scale and we are just whistling past the graveyard, if you allow me the rather macabre simile.

Mexico is now officially shutting down its economy, telling everyone to stay home for five days. Infection is spreading fast to other countries, NYC is quickly becoming the US flu epicenter and.. what? We are acting as the villagers who think the wolf won't decimate the flock because previous avian flu and SARS alarms proved to be false. Three's the charmer, maybe?

I do not claim any knowledge of medical science; in fact, for those not familiar with Wall Street and London's City denizens, I should point out that we are rather pathetic when it comes to knowledge beyond our blinking screens. We simply encapsulate our existence in a self-created and self-perpetuated virtual existence of charts, graphs and numerical tables, thinking they tell all.

We do vacation in exotic (i.e. poor) locales - but always cocoon within the walls of five star resorts, sampling the local cuisine and whatever "culture" the resort manager allows to filter through during thematic "nights". The only sights of reality we get come as flickering images outside windows of speeding, air-conditioned taxis to and from airports. Oh yes, by and large we are a rather boorish lot. There are exceptions, but there are very few, trust me.

So, I am getting increasingly worried that the financial world, in its lack of real world understanding, is dismissing swine flu too easily and too lightly.

I fervently hope to be proven wrong very quickly.

The Crisis, Part Two (Plus Addendum)

View everything that has happened so far in the global economy as The Crisis, Part One. What is still to come is Part Two - and it's going to be worse. Why? Because we are going to get slammed with the effects of rapidly rising unemployment where it hurts most: consumption makes up 70% of GDP. No job, no spending.

Look at the chart below (click to enlarge): employment (blue line) is dropping at the fastest rate in 60 years. Meanwhile, total population is still rising at over 1% per year.

And here's the government's increasingly pressing Keynesian dilemma: borrowing trillions to salvage the financial sector from its own perfidy makes it all that harder to go on a public spending program to boost jobs and incomes in a counter-cyclical fashion.

But isn't all this new "bail-out money" created by the Fed and Treasury going to eventually find itself in the pockets of Mr. and Mrs. Average Joe? No, it won't - and AIG is the perfect example why: the $182.5 billion in public money it received to cover its CDS-related losses was immediately recycled back into the Wall Street trough. Goldman Sachs, JP Morgan, et. al. are not exactly hurting and in no way contributing to balanced income re-distribution. Even if Wall Street bonuses are "slashed" by 50% (and they most certainly aren't) it still means a huge chasm in income disparity.

Let's see things for what they are, right now:

1. Until 2008 tens of millions of American Average families supplemented their increasingly insufficient wages and salaries by borrowing. They didn't do so to buy into a Rich and Famous lifestyle, but to continue the American Dream middle class existence they inherited from their parents. A modest house, a nice car, college, medical care, a bit of vacation. This package, unfortunately, became unaffordable as real incomes stagnated; so household debt soared, instead.
2. The debt bubble blew out of all proportion and finally burst. All that so-called innovative finance did with its inumerable alphabet derivative contraptions was to mask reality and keep the party going for just a bit longer.
3. Households cannot borrow as before and cannot resume consuming at their previous pace. Thus, GDP will continue to drop until it gets in balance with the carrying capacity of earned incomes.
4. Since the government is not currently providing Keynesian fiscal stimulus to the real economy this process will be drawn out and unemployment will continue to rise.
5. Higher unemployment will quickly hit even those sectors of the economy that have - so far - mostly escaped serious damage: consumer staples, discount retailers, healthcare, etc. For example, look at the huge overperformance of McDonalds shares (MCD) vs. banks (BKX).

McDonalds (black) vs. US Banks (yellow)

Bottom line: our previous economic "growth" was a debt-induced mirage and has now disappeared. Current global economic policy measures are aimed almost 100% at salvaging the bankrupt and discredited (literally) financial sector. This will prove a huge and costly policy mistake that will quickly backfire as the real economy continues to adjust downward to its "natural", lower debt state.

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Consumer Confidence addendum (April 29, 2009)

The Conference Board yesterday announced that its reading of consumer confidence for the month of April jumped a very significant 13.2 points, from 26 to 39.2. On the face of it, this sounds very encouraging - until we dig a little deeper: the rise was almost entirely due to a jump in the Expectations Index, up almost 20 points. The Present Situation Index was almost unchanged, as were other sub-indexes that measure current business conditions and job prospects. Hope dies last?

As I said in the previous post [scroll down, see point (b)] we are in the midst of a manufactured feedback loop that is aiming to boost peoples' morale. The stockmarket's recent performance is a big factor in all of this, no doubt. An entire generation of Americans (and plenty of others, too..) has grown up with the religious belief that green "up" arrows on the Dow scrolling below their CNBC screen is - somehow - a good thing for them, even if they own zero stocks and bonds.

For them, I suggest they should instead look at this chart, below: continued claims for unemployment insurance as a percent of the civilian labor force, i.e. the real economy, right now. Unfortunately, it doesn't look good; if we reach the 5% level of 1975, then we are looking at an additional 2 million continuing benefit claimants, on top of the record 6.1 million currently.

And if things get significantly uglier (remember, "worst crisis since 1929"?), say to the tune of 8%, then we will have to deal with 12.5 million people claiming unemployment benefits. Truly ugly.

So, if the real economy doesn't turn around in the current quarter there will be hell to pay; from a psychological perspective alone, dashed expectations are very powerful negative motivators that will induce people to really go into their shells.

And that's when the Crisis will go into its most virulent, Part Two phase. Just in time for the swine...

Greens, Shoots And Leaves

Recently Chairman Ben said he was seeing "green shoots" in the US economy. I immediately thought of Lynne Truss's wonderful book "Eats, Shoots & Leaves" and, thus, the title for today's post.

To wit, for several weeks now my thesis on the global economy has been as follows:

• (a) Markets would stage a significant bounce on the back of massive monetary intervention to rescue the financial sector and preventing a repeat of the banking collapse that led to the Great Depression. This has already happened; the S&P 500 index is now up 30% from the bottom reached a bit over a month ago. More significantly, the BKX index of US banks is up 102%.
  

BKX and SPX Comparative Chart

• b) By indirectly pointing back to markets, politicians and opinion makers would steer popular opinion towards the view that the worst is over and that a recovery is coming soon. This process is under way right now. I am already observing subtle changes in the language used by media: e.g. economic "downturn" instead of "crisis".
  

• c) But the real economy is no longer driven by finance. The borrow-spend-inflate Permagrowth model has been bankrupted and can no longer function as the fat "tail" that wags the rest of the "dog", the real economy where jobs and earned incomes are generated. In fact, we can say that America has killed its vital manufacturing dog and is now left with just a stumpy, trampled-upon finance tail. Within just ten years we have lost 5 million manufacturing jobs, a scary 30% of the total.
  

• d) This means that unless the administration immediately, radically and massively re-focuses its attention on creating a Sustainable real economy, the rally in stocks will soon fizzle and the green shoots will be revealed to be nothing more than the figments of the market's forward-looking imagination. This shift in focus is, unfortunately, NOT happening yet.

• e) Putting it another way, we need to create a whole new "green" dog and we need to do it right away. The finance tail should be heavily groomed, cleaned, shortened and regulated before it is allowed to attach itself to this new dog. Green New Deal is an excellent report on the origins of the triple debt, climate and resource crises and what may be done to overcome them.

If we don't immediately refocus our efforts to the REAL economy by working towards the creation of a sustainable future, then all we're going to achieve with the current massive bailouts is what is implied in the post's title: A bit of a relief rally in financial markets, quickly followed by a pile of poop and then, bye-bye economy.

I will close by recommending a very relevant book: Herman Daly's "Beyond Growth - The Economics of Sustainable Development" is a densely written and densely argued treatise. Published in 1996, no one can accuse its author for being a Green/Sustainability parvenu; the arguments are all the more relevant today. Read it.
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Addendum

The International Swaps and Derivatives Association (ISDA) just announced the results of its semi-annual survey; at the end of 2008 CDS notional amounts outstanding have dropped significantly to "just" $38.6 trillion.

Data: ISDA

The Christmas Bunny

I hope your Easter was a pleasant one - so onwards with Christmas..

I am not at all an expert in the retail/merchandising business, but I do know that consumption makes up 70% of GDP in the US (and the EU) and that Christmas is the single most important season. Last Christmas caught most retailers with bigger inventories than they could move, resulting in big discounts and losses. You can bet they're going to be very careful this year not to repeat the same mistake.

I am not sure when wholesalers and retailers start placing firm orders with manufacturers for the next holiday season. But whenever it is, it's going to be a pretty good early indicator - positive or negative - for the "real" economy, even if only of the Permagrowth variety.

Personally, I don't expect things to look good because inventories have swelled incredibly fast vs. sales. Inventory to sales ratios have jumped at the fastest rate in at least 17 years (see chart below - click to enlarge), so I presume order activity is going to be very guarded, to say the least.

Inventory to Sales Ratio - Total Business

If any readers are familiar with the order cycle and/or in possession of relevant data please share..

Another possible early indicator of international manufacturing and trade activity is charter rates for containerships. So far, they look downright awful (see chart below - click to enlarge).

HAX Index (see here for explanation)

Pig Money vs. Real Money

Just about everyone thinks that all money is the same, that a dollar is a dollar. But that's just not so: like the pigs in Orwell's Animal Farm some money is "more equal" than others, i.e. it has more power and significance in the real economy outside finance. But, unlike in the story, today's money pigs are actually the weakest amongst money animals.

That's a particularly important distinction to understand today, when bailout "money" is going around in the tens of trillions causing much consternation and/or glee to hyper-inflationists and goldbugs. Even worse, it is causing many of us to scream "social injustice" at the top of our lungs, but for the wrong reason.

Why?

Because for the most part bailout money consists of book-entries to replace other book entries that have been deleted in the deflationary credit destruction of the current crisis. Let's call such funny money Pigs (after the pink color of $5 bills in Monopoly, you understand..). And, as we well know, porcines don't fly.

Pigs, in fact, don't fly

Such bailout Pig money stays mostly put on banksties (i.e. balance sheets) and like its bacon buddies it doesn't go for much activity. It doesn't produce any wages and salaries, spending or investment in productive assets because, unlike "real" money, it doesn't get loaned out. It's there today to plug holes left by yesterday's loans gone sour, not to make new ones. One could say that Pigs are there to be seen and heard (oink, oink), not to do anything useful.

Why am I saying all this? Because I hear a lot of activists complaining that this kind of piggish money should instead go towards social programs and/or the real economy. That's almost delusionary, I'm afraid.. Does anyone think that $13 trillion dollars (latest bailout count) could be absorbed by the real economy so fast? Or that so much RealMoney(tm) could in fact be created, if anyone was crazy enough to get it circulating in the first place? No way.

We should simply forget that this kind of money is... money. Let's just imagine it as pigs around the trough.

Hmm.. I wonder what should we call the real stuff? Greenbacks? Thalers? Denarii?

A NOTE ON READER COMMENTS

In recent weeks this blog has come under increased attention from various advertisers who use the Comments section to pollute the otherwise pristine thought environment of readers' comments, i.e. we're getting lots and lots of comment spam :(. I have thus started using comment verification (the gobbledy-gook you type to enter a comment) and comment moderation (for comments entered on posts older than a certain number of days).

This may be a bit annoying for regular readers but it absolutely necessary. I recently had to manually clean up hundreds of such porn, game and Chinese merchandiser ads, one by one no less, because Blogger does not (yet) provide a block delete function.

If your comment is held up for a day or two while I notice and approve it, I'm sorry but we live in a digital age... Hopefully the pests will give up pretty soon. They are already down to just a few a day.

The Debt Mining Industry

Before today's post, a nod to regular readers "dink" and "Debra" who mentioned a Renaissance painting of a couple in fancy dress oblivious to the looming storm brewing behind them. Dink could not remember it and Debra could not immediately identify it, but I can.

The Tempest, oil on canvas by Giorgione, c. 1505 (Galleria dell’Accademia, Venice)

On with today's subject..

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The mining industry is notorious for its terrible environmental record. Not only do mining operations pollute during the extraction period, runoff from tailings, open pits and dumps continues to do serious damage for decades after the mine is closed. In many cases the pollution will continue forever. Reclamation obligations are set out in the original pemitting process but they are often prefunctory and far from comprehensive enough to restore the environment to its original state.

But even so, some mining companies just take the valuable ores out and then declare bankruptcy, leaving behind a mess for the local communities to deal with. Needless to say, the owners and directors of the mining companies don't live "downstream" of their mess.

The same happened with the debt industry: the entire food chain that evolved around it - brokers, originators, packagers, servicing companies, lawyers, investment bankers, rating agencies, hedge funds, private equity firms - flourished mightily as the rich loan seams were mined to exhaustion. As the mine started drying up, new extraction methods were dreamed up and applied to a clueless population, to eke out potential interest streams and to stuff them into ever more opaque "vehicles". Regulators? C'mon... we're talking Bush administration here, with the de-regulation process having already started in the Clinton years by the likes of Greenspan (blinded by technology), Rubin (financial industry insider) and Summers (insufferable know-it-all wonderboy).

Liar loans, NINJAs, Alt-As, CLOs, junk bonds - a whole panoply of toxic debt was chopped up, mashed into amorphous chunks and fed into even more opaque CDOs, CPDOs, SIVs, synthetic CDOs.. Credit swaps were brought in and used like arsenic in gold mining: they made possible the extraction of "value" from even the poorest quality source rock, like sub-prime mortgages.

And then the debt mine finally went stone "dry" - as all resources ultimately do when they are squeezed mercilessly be they mines, oil wells or fisheries - leaving behind a whole lot of of aptly-named toxic waste to pollute the global village. But the vastly enriched mining company operators most definitely do not reside anywhere near the disaster zones they created, geographically, or income and wealth-wise.

The financial industry's bonus system of pay is (was, hopefully) based on immediate results and guaranteed that no care was taken to safeguard the future viability of the debt that was being mined. As an executive, I can tell you that the attitude in the business has always been "what have you done today". Heavy emphasis on today, quickly forgetting yesterday and entirely disregarding what effects our current actions may cause tommorrow.

It's no coincidence, then, that the last decade has produced income and wealth disparities not seen in the US since the robber baron era. The richest got ultra rich while everyone else remained stuck in the doldrums. According to the latest Survey of Consumer Finances (pdf file) conducted by the Federal Reserve, in 2007 the top 10% in the income percentile earned on average eight and a half times as much as the middle 40-60%: $400,000 annually versus only $47,000. By contrast in 1992 the top 10% earned five and a half times as much. The disparity has widened dramatically - and keep in mind that this is in constant 2007 dollars (see chart below, click to enlarge).

Income By Percentile

Likewise for wealth. Average net worth for the top 10% exploded upwards more than doubling to $4,000,000 while the "bottom" 90% went nowhere.

Net Worth by Percentile

Isn't it amazing? Nine out of ten American families, 90% of the population, is plainly in the relative "bottom". Literally, in the pits!

And here's the amazing part: because of what we are doing right now, i.e. saving the financial industry and the entire associated food chain from its own toxic waste, there is a real prospect that this "bottom" 90% of Americans will shoulder the vast portion of the salvage cost.

I say only "prospect" instead of "certainty" because things may and, indeed, should turn out differently. After banks are stabilized and markets thaw out (signs are there already) it is imperative that the Obama administration does the following:

a) Kill the shadow banking system - it's already withered, anyway. Start by once again distinguishing between regular banks and investment banks, i.e. re-imposing a modern version of the Glass-Steagall Act that was abolished by the Clinton administration. Strengthen the regulatory powers of all relevant public institutions (SEC, OCC, FRB, etc.).

b) Demand that shareholders and creditors assume the burden of keeping their financial companies afloat as public money is gradually withdrawn. This means capital injections in the form of new share issuance (i.e. likely dilution for existing shareholders) and accepting debt rollbacks/haircuts (i.e. losses for creditors). The objective is to reduce the legacy costs of the current Fed and Treasury operations to the taxpayer (i.e. the 90%) to the greatest extent possible.

Paradigm Shift Now!

I just read an article in Reuters about what President Obama should do to get the economy "back on a solid footing". Here's their analyst's advice: "...convince Americans to spend now and save later.." Wow! Talk about living in a shelterd past under a shaped Shrub..

Yeah, sure - let's all go shopping in the face of adversity; and this will boost GDP, jobs, income, asset prices and - of course - the ability to borrow ever more to keep the Permagrowth cycle going for ever and ever. Some analysts' thoughts never break free from Groundhog Day, do they? - no, scratch that: most analysts never do. Their exhortations to spend, spend, spend (more accurately: borrow, borrow, borrow) are based on the religious conviction that the world knows no physical boundaries, that resources are supplied as needed because we just demand them. It's only a matter of Adam Smith setting appropriate scarcity prices by His Invisible Hand, don't you know?

How ludicrous!

But, you know what? Forget the big picture for a moment. Let's just only look at the personal saving rate. Does anyone have any doubt that saving less and less, until America's households began to liquidate savings to consume, was a major underlying cause of the current crisis?

Oh, but I forgot: the New Economy and technology will save us. More strawberries and cream will appear just because we sell more tickets to Wimbledon through the Internet. Truckloads of lumber and pails of nails shall materialize at building sites because the house was designed by AutoCAD instead of pencil and paper. Ahuh..

And dollars will rain down from helicopters to pay for all these, people merrily collecting them in baskets (or is it wheelbarrows?) to exchange for such trifles as food, clothing, fuel and shelter. Oh yes, and spaghetti grows on trees, so if you believe any of the above just "place a sprig of spaghetti in a tin of tomato sauce and hope for the best".

But if you do not, do the exact opposite of what Ms. Emily Kaiser (the Reuters analyst) suggests. Save now because the borrow-spend-grow paradigm is shifting fast. How do I know? Because Mr. Obama says so, and he is the President of a country that accounts for a quarter of the world's consumption. Here's what he just said during his trip to Europe:

"In order for growth to be sustainable, it can't be based on speculation, it can't be based on overheated financial markets or overheated housing markets, or U.S. consumers maxing out on their credit cards, or us sustaining nonstop deficit spending as far as the eye can see. The whole point is to move from a borrow-and-spend economy to a save-and-invest economy."

Listen to the man. Oh and I trust that Michelle is not planting spaghetti trees in the back of the White House, either...

Reasoning By False Analogy

Ignoring current reality while drawing false lessons from history can be very dangerous. Just ask the French generals who overlooked rapid advances in mechanized warfare after World War One and built the Maginot Line, instead.

"World's Greatest Fortifications Guard France" - Modern Mechanix (1934)

This kind of action by backward example is called reasoning by false analogy and can lead to highly unexpected, nasty results. In World War Two it took Guderian's highly mobile blitzkrieg a mere six weeks to bring France to its knees; German tanks simply bypassed the static Line.

Today, the Fed and Treasury are institutionally scarred by - and scared to death of - the deflation monster which devoured the US economy during the Great Depression. Responding to the current crisis, they are throwing up vast walls of public money to surround failing private financial institutions, intending thus to prevent the monster from entering and mauling the real economy. That's a dangerous fallacy.

I agree that preserving the public's trust towards financial institutions is important; no one wants a repeat of 1930's bank runs and closures. But that's not enough - not by a long shot. What ails the economy today is completely different from what sickened it during the Great Depression and requires radical surgery, instead of massive doses of vitamin C.

Let's start with the diagnosis.

Today's problem is a rapid and accelerating depletion of the Earth's biosphere caused by the one-two combination punch of increased activity by a rising population. In plain language, more people wanting more "stuff".

This "illness" is aggravated by two relatively recent developments:

• The adoption of dogmatic free-market ideology by the entire world. This is a false analogy tragedy because Adam Smith's invisible hand can no longer regulate a resource-limited world of 7 billion inhabitants, since it cannot exact the proper price for "common" goods like topsoil, water and a temperate climate. It's like this: scientific thought has advanced by quantum leaps, while "dismal" economists are still religiously adhering to the teachings of a gentleman who died in 1790, one hundred and fifteen years before Albert Einstein published his special theory of relativity.*

• The creation and explosive misuse of credit derivatives like CDOs and CDSs provided an illusion of financial innovation, causing a vast expansion of debt versus income. Instead of financial innovation, however, all that happened was the ruinous mispricing of credit risk.

Data: FRB Z1 Release

The faster rate of biosphere degradation is firmly connected with the explosion of debt, since the latter enabled an inordinate acceleration of consumption and thus usage of resources and higher pollution.

Let's go back to the Fed and Treasury. Yes, it is likely that current initiatives will succeed in flooding the system with dollars; after all, it's just (fiat) money. And, yes, it is likely that they will thus engineer a "thaw" in money and credit markets and probably in equities, too. But if that's all the government does, then the cheer will be short-lived.

If we myopically focus on mere GDP boosting via renewed lending and consumption, then we will quickly suffer from a whiplash as the real economy continues to deteriorate, weighed down by the "external" biosphere costs that we have so far ignored in our global accounting books.

I don't know how soon we could, or should, declare a partial "victory" against credit market troubles. But I do know that if we do so and then rest on our laurels in the belief that we have successfully avoided the worst, then that would be our worst mistake. Because what we need, instead, is a radical break from our conventional growth-at-all-costs groupthink, a declaration of war against black energy, massive investments in green energy and organic food and, yes, a serious re-think of our current pension schemes that depend entirely on Permagrowth.

We've got to stop digging massive financial trenches and start building lots of solar, wind and organic farms.

Otherwise, best be on the lookout for the panzers.

...and oh,

P.S. I am personally much more impressed and touched by the message provided by Michelle Obama's planting of an organic vegetable garden in the White House than just about anything done by Bernanke, Geithner and Co.


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* For historical context, in Smith's time stealing goods valued over 40 shillings carried a mandatory death sentence.

CDSs Crash Land On Planet Gamma

In the preface to a previous post I mentioned the concept of correlation, denoted by the Greek letter γ (gamma). There is an excellent Wired magazine article by Felix Salmon that goes into significant detail on how a simplistic and short-sighted approach to correlation "sunk" Wall Street's CDO industry and precipitated today's crisis - or at least was its proximate cause. I highly recommend reading it.

Today, a bit more on my current view that correlation madness has ran its course and will fizzle back into obscurity.

First, a bit of background: I have in the past posited that CDSs are responsible for the lightning speed with which the crisis has spread from real estate to money, credit, equity and commodity markets. In chemistry terms, credit default swaps catalyzed a financial critical reaction, making it run faster and more destructively. They turned what could have been a severe - but otherwise normal - crisis into a runaway market meltdown.

[Note: Some think that all financial derivatives are bad - this is simply not so. According to the Bank for International Settlements as of June 2008 there were $683 trillion in nominal value of over the counter derivatives outstanding (OTC: not traded on regulated exchanges). Seventy five percent were interest rate swaps, forward rate agreements and foreign exchange swaps, i.e. run-of-the-mill instruments used in the daily operation of bank treasury departments. But the $57 trillion in CDSs are another species altogether.]

It was the newly created CDS market that provided the "toxic" structured product manufacturers (CDO, CDO squared and cubed, CPDOs, etc) with the ability to use and abuse low correlation values, and thus vastly expand the amounts of highly rated (AAA and AA) marketable tranches they could create. For example, a low gamma of +0.2 for a pool of mortgages would allow 70% of the pool to go into the AAA tranche, while a gamma of +0.5 would allow only 50% (all numbers hypothetical).

Once it was shown that actual correlation was higher when the real estate bubble burst, all hell broke loose. Every trader in the money and credit markets started plugging higher assumed correlation values into their spreadsheets, resulting in higher presumed risk and thus lower prices for everything from CDOs and equities to government bond spreads. The loop fed back into itself via - what else? - the CDS market, which now produced even higher gamma values. In other words, after a point the crisis was not only self-made but self-sustaining, too.

Understanding this "technical" cause of the current financial crisis leads us to conclude that part of the damage done to some credit and equity markets is pretty much artificial, i.e. not due to underlying economic fundamentals. That's why I have been saying recently that things are overdone on the downside.

The way out of this hole is pretty obvious, to me at least: use a modicum of common sense in evaluating risk and not exclusively arcane mathematical formulas that end up in the GIGO dustbin. In gamma terms, just as +0.2 was way too low for reality then, a gamma of +0.8 may be way too high now.

There are other necessary steps, too:

1. Reduce the nominal amount of CDS outstanding. Demand that every major counterparty comes to a "netting conference", where they will be required to drill down to the final customer level.
2. List all remaining positions on regulated exchanges that provide central clearing, position and margin limits, tight regulation and better transparency. This is harder than it sounds for the single name business (i.e. CDSs written on individual companies or entities) but should be very doable for the index business which constitutes a large portion of CDSs in existence.
3. Have all new business conform to standard futures exchanges policies that already exist regarding customer risk and disclosure, margin, position limits, etc.

I am pretty sure that all of the above are getting some attention from market participants, regulators and even some market-savvy politicians. And this is - partly, at least - why we are currently experiencing a rally in equity and credit markets. Let's call it a "relief rally" for now and leave it at that...

PS: In view of the above, I agree with FASB's recent ruling on mark to market.

Margin Debt, Again

Just one chart today- on margin debt once again (click to enlarge).

Data: NYSE

As of 2/2009 margin debt is down 55% from the top reached in mid-2007. More importantly, in my view, is the whipsaw speed with which the plunge occurred: from an annual rise of +67% to a drop of -48% in just 20 months. That's unprecedented in at least 50 year and shows how fast greed turned into fear.

What does it mean? As always, there are two interpretations:

a)The Titanic is sinking and people are wise to abandon it en masse before it drags them into a watery grave or,
b)The only ones remaining on board are experienced seamen who will manage to save the boat and profit handsomely from the salvage.

As always, everyone has to make up his/her own mind: Should I Stay Or Should I Go?

On Markets: Five Laconic Points

1. Financial markets have discounted a grim global future similar to the Great Depression. Just look at share prices or credit spreads. Speculators have switched heavily to shorting.
2. However, this is NOT the 1930s - no gold standard, more international financial and political co-operation, better understanding of monetary economics.
   
3. In combating the crisis the Fed and Treasury have provided, loaned or guaranteed $13 trillion in new funds - equivalent to nearly 100% of US GDP. This enormous peacetime economic intervention is completely unprecedented in size and scope. It will have an effect.
   
4. Therefore, we won't repeat the Great Depression. Not even close.
5. Therefore, markets have over-discounted on the downside.

5a. Maybe the post should be titled Five Monty Python Points? "Snap snap, grin grin, wink wink, nudge nudge, say no more??