Thursday, August 30, 2007

East For Income, West For Wealth (and Dow 100.000)

Fed Chairman Bernanke just re-iterated that the Fed is "prepared to act" and urged Fannie Mae and Freddie Mac to step in and help resolve the mortgage difficulties "if able". All these stern words of market succor while S&P 500 is a mere 6% off its all time highs and after being up an almost uninterrupted 100% in the past 5 years. Why? Is the Federal Reserve now a Guardian of The Dow, as well as the sleepless watchdog of US commercial banking?

In a word, yes. This what the once proud institution has succumbed to: being a carnival barker for the hedge fund and private equity interests that now dominate markets, not only in the US but the whole world. But, once again, why? Because asset prices, shares in particular, are now the "be all" and "end all" of the global economy. Income generation as a way to prosperity has been savaged in the West by the pittance wages of the 1.2 billion Chinese ex-peasants, not to mention the mere hundreds of millions of other assorted Asians and near Asians. And let's not forget another 1 billion Indians...

The die has been cast: The Economy of The East is based on labor income and The Economy of The West is asset wealth. And just as it was unthinkable in years past for incomes to go down in any given year, it is now absolute anathema for asset prices to drop. It is not only a reason of national importance, but of global balance: we in the West buy lots of their cheap goods, they buy our expensive assets. This is a balance resting on the knife edge of market performance, a global financial accord that is rapidly overtaking entrenched perceptions established decades ago in Bretton Woods.

How is it maintained? By a series of algorithms that are pushed, stretched and if need be kicked into constantly spewing out buy orders for all manner of securities, regardless of fundamentals and it all boils down to one simple parameter: momentum. Buy because the market is up and going higher, period. All the rest is fancy footwork pour epater les bourgeois. Roughly eighty percent of all transactions in US equities are now done by hedge funds, 15 percent by other institutions and a minute 5% by individuals. The name "hedge fund" has long become an oxymoron because they no longer "hedge" anything and they merely follow the latest fashion in trading, which right now is "quantitative strategies". There are exceptions, of course, but the great majority just follow the exact same fake rabbit around the dog track.

It all became exceedingly clear in the recent market drop, when hedge funds reported incredible losses (some lost 30% in one month), from a mere correction, however sudden. Everyone was on the same side: long risk, short volatility, short yen and all leveraged to the maximum.

So the Fed promptly pushed the "panic" button, though it did not wish to appear doing so. First it cut the Discount Rate to show resolve and then (very, very quietly) permitted the large banks with brokerage subs (Citi, JP Morgan, et al) to lend an astonishing $25 billion each of what is clearly depositor money to their said subsidiaries, so that they could in turn provide it to their customers in trouble (i.e. hedge funds). Not only that, but as we have already seen, those "customers" were often nothing more than in-house hedge funds and SIV's.

Does anyone recall that this is exactly how large banks got into the deepest possible trouble in 1929? They kept lending depositor funds to the broker call loan market (i.e. margin), which then simply evaporated within two days. Just like today's margin loans, ABCP's, the yen carry and all other types of financial leverage bets, they did it because the rates were higher than regular loans and could be demanded back within a day or two. Safe until proven poisonous.

Mr. Bernanke surely knows all this - he is, after all, a professor who has written two books on the subject of Fed operations during that period. He is apparently resolved that unlike 1929 no "liquidity need" shall go unmet on his watch to cause anything approaching a significant correction, no matter what the eventual consequences. And what may those consequences be?

Well, if Ben's Balloon Emporium keeps pumping more and more helium into the market it will certainly levitate. And there will be no ill effects, save perhaps a shrilly voice from gulping too much He, because...let's see... if each Chinee were to buy just $10.000 worth of US stocks...(gulp, gulp) by golly mate, that's twelvvve treeeellion dzollarz worth! And why stop there? The oil sheikhdoms are good for another 10 trillion, at least, and then you have the Indians and the Russians (gulp, gulp) - holy cow, Dow 100.000 heeeere vve come!


  1. "if Ben's Balloon Emporium keeps pumping more and more helium into the market it will certainly levitate"
    Ehmmm...yes, that's called inflation.

  2. What BB is trying to do is to prevent a major credit correction that would result in asset deflation. Save the market, is the rallying cry. I believe he will fail because the underlying fundamentals are just not there, as there weren't for the dotcom and comms bubbles. Credit/debt is ultimately supported by the income generated to properly service it, not by the continuous appreciation of collateral.

    All those hedge funds and private equity funds are merely pumping up collateral prices - not operating incomes...


  3. I am French. The term "hedge fund" was used very often for many years in the press here. But it is only two days ago that I discovered the meaning of "hedge" in hedge fund. Thanks to wikipedia. I was astonished. A real hedge fund should never loose more than a few percents. Will all those hedge fund managers who failed be fired?
    Arnould (Paris, France)

  4. Re: "hedge" funds

    The term "hedge" has ceased meaning that decades ago. It now officially means "highly speculative and leveraged" fund.


  5. Hi Hellasious,

    I appreciate your input a lot as always.

    May I put a question that you raised partly :
    "Are the current STOCK markets significantlyh inflated directly via cheap credit (carry trade, unsafe leverage offered by WS banks)?"

    If that is the case, a 1929-alike event is boiling. Possibly within a quarter.

    I catch that your opinion is clearly that they are definetely credit-fed.

    A very close friend of mine - high ranking in one the top market derivative maker (a bank) tells me. NO, DEFINITELY NOT.

    He maintains that the link is indirect. Which I, of course, do not believe and read your blog.


    Is the carry trade directly feedy stock market trade (my feeling is yes), is cheap FED money getting poored straight into equity-trafficking funds?

  6. In the comments section hellasious wrote:

    "the underlying fundamentals are just not there..."

    Ding ding ding, we have a winner!

  7. Dear Hellasious,
    " Credit/debt is ultimately supported by the income generated to properly service it, not by the continuous appreciation of collateral"....SO TRUE !! i suggest then that disposible personal income be increased immediately by 5 %. it will reverse the relationship between capital and labour remuneration and allow consumers to service their debt, and consume. sounds good no ? but how can we do it ????

  8. I agree with your comments about hedge funds not hedging and driving the market up. But it is possible that we are now seeing the apex of the hedge fund boom, before the big flame-out. There are just two sources of hedge fund capital (investors and margin suppliers) and both may be pulling back. Hedge funds always have been terrible investment structures, relative to alternatives.

    There is a big problem with your theory about east and west. It assumes that investors will stop viewing the stock market as a discounting mechanism for future earnings. If the West isn't producing much, Western companies won't earn much. Capital will flow to other global regions and companies where P/Es are not more than 2X earnings growth.

    Never forget that hedge funds can turn on a dime, so they all start to move from the long to the short end of the market simultaneously. If hedge fund liquidity dries up at the same time mountains of money go net short, the market will melt.

  9. Hedge funds are suppose to match investments that offset (hedge) risk, such as a long position and a short position in the same industry. But lately, the index of the "long/short" hedge funds has had correlations with the stock market as high as 0.80. So, I tried to figure out why. The answer isn't that they forgot to hedge. Some of these hedge funds did a good job offsetting risk. But they used so much leverage that they look a lot like long common stocks. For example, if you have hedged out risks so that you only have 20% of stock market risk, but you leverage the fund four times, then you now have 80%.

    Some hedge funds have worked harder to get access to more (and more) leverage than they have worked to attract investor capital.

    I think those days are over. There isn't much difference between the commercial paper SIVs use and the prime broker loans that most hedge funds use. In both cases, they are backed by risky assets.

  10. Are the current STOCK markets significantly inflated directly via cheap credit (carry trade, unsafe leverage offered by WS banks)?

    Yes, no, I mean maybe.....

    The really insane leverage in the equity markets was driven by private equity groups. But, private equity got snuffed out before it really got rolling (thank goodness). Companies were starting to leverage up their balance sheets to fend off the PE firms.

    From what I can see, the leverage has been concentrated in the MBS, ABS, CDS markets. A 2-7% drop was all that was needed to collapse some hedge funds trading in these markets. That would suggest leverage of around 20 to 1.

  11. Thanks for the explanations.

  12. For your edification. Read the piece at the bottom of the page by the former banker.

  13. Re: are stock markets leveraged directly?

    In my view all financial markets now form a continuum, mainly because of the explosive growth in credit default swaps. Through them credit markets look to equity markets and vice versa, in a feedback loop that kept inflating, until it popped. Thus leverage in the bond market found its way, or in any case affected stocks.

    I hope I'm being clear - if not let me know and I will do a longer reply.


  14. Dear Edwardo,

    Thanks VM for the link. It was very informative, indeed. I agree with the writer, particularly with the way banks and other credit institutions are managing reported earning through loan loss provisions and reserves. I have seen this occur at several banks.


  15. Can we hope with high probability that the LBO outfits will find themselves credit squeezed and bankrupt?

    In the 1923 Weimar experience, the industrialists who did the same thing were bankrupted as soon as easy credit was terminated. They could not meet their debt service obligations.

    Any chance this will happen to the LBO outfits now?

  16. They're gonna inflate via the FHA loan buy outs.

    How can we make money on this one?

    Where are the smart minds when the money gates open?

    What do FHA victims (as they are victims, right?...sold a bill of goods by shysters who now get bailed out, both of them, as the borrowers come home to mama, and the lenders get their money back!!) really need?

  17. Comments about Oil Price Rise Causes Global Shift in Wealth:High oil prices are fueling one of the biggest transfers of wealth in history. Oil consumers are paying $4 billion to $5 billion more for crude oil every day than they did just five years ago, pumping more than $2 trillion into the coffers of oil companies and oil-producing nations this year alone.The consequences are evident in minds and mortar: anger at Chinese motor-fuel pumps and inflated confidence in the Kremlin; new weapons in Chad and new petrochemical plants in Saudi Arabia; no-driving campaigns in South Korea and bigger sales for Toyota hybrid cars; a fiscal burden in Senegal and a bonanza in Brazil. In Burma, recent demonstrations were triggered by a government decision to raise fuel prices.


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