Tuesday, March 31, 2009

Neo At The Quantum Casino - Part III

Foreword to Part III

The Greek letter gamma (γ) is used in finance to denote correlation, the "connectedness" of two separate events. For example, if patient A dies of malaria, how likely is it that patient B will, too? If it is absolutely certain that he will, correlation is total and γ has a value of +1. If it is certain that he will not, then the two events are completely uncorrelated and γ has a value of -1.

Assigning proper correlation values is crucial in the design of tranched derivative products that contain many separate instruments. For example, CDOs structured from thousands of individual home mortgages, auto or student loans.

For an excellent story on correlation see this Wired magazine article: Recipe for Disaster: The Formula That Killed Wall Street by Felix Salmon.

It did not take Neo very long to become adept at dealing craps the Quantum Casino way. All he had to do was call the shots - just a split second before every gambler at his table had a chance to "see" how the dice lay. Neo's manipulation of perception created reality as he - and the Casino owners - wished it to be.

And in the Quantum Casino's version of reality almost every gambler got properly "skinned" the old-fashioned way: by regular and frequent swaps between greed and gloom.

Cartoon by KAL

Not content with swindling the same old geezers, Neo soon tired of the regular games and looked for added excitement. He designed a brand new game employing multiple variables that provided small, but regular, payoffs every time the variables did not align together - which was most of the time. But when they did converge everyone lost big, including their prior winnings. He called it The Correlation Game - and it proved to be a bonanza.

Neo realized that people loved repetition of familiar patterns - the herd mentality, he called it - and supplied it with gusto. He skillfully manipulated results and repeated gains to create a seemingly simple and profitable pattern - until he led everyone right over the edge, of course.

Not long thereafter, and based on the tremendous profits his new game racked up for Quantum Casinos, Inc., Neo was made a partner. His future was set.

The End


A few - very few - professionals have tried to explain how they "see" markets but their work is usually ignored or scorned by the "reality-based" community of professors, analysts and consultants who prefer deterministic theories, such as random portfolio, etc.

Here are two examples of really smart guys that "got it":
Needless to say, both individuals were extremely successful. In addition, Soros' premier hedge fund is named The Quantum Fund. A coincidence?

I will say it again: it is perception that shapes reality and not the other way around. Does this apply to today's crisis? Yes, it does. If we believe that "this is the biggest crisis since the Great Depression", then our belief will be realized because our behaviour will be altered to fit our preconception.

Therefore, one has to seriously wonder why all the smart analysts are crying oceans of tears for all the horrible things that are supposedly coming our way, while Neo (aka Fed, Geithner and Co.) are furiously pumping trillions of fresh dollars into the system.
P.S. From our This Is Just Too Good Of A Cheap Shot To Pass Up department:

Yes, she's back. Who? Goldman's strategist Abby Joseph Cohen has just said that US banks are "still not in the clear".

This is what I wrote about her in a post back in December 4, 2007.

"Abby Joseph Cohen of Goldman Sachs and 1999-2000 stock bubble infamy, just came out saying that the S&P 500 will climb to a record 1,675 by the end of 2008, extending the longest stretch of annual gains since the 1980s.

She is one of the best contrary indicators in the strategist camp. Back in 2000-01 I made a point of shorting every time she came out with a bullish hoo-hah. I think she stayed bullish until 2003 and then turned bear. Just in time."

S&P 500 was at 1,510 when she made that pronouncement and managed a 10 point rise over the next couple of days. It then went a whole lot lower, of course. The index is now at 798 and she thinks "it's not over", eh?

Well, I bet she's still the best contrary indicator around - and fervently hope Goldie keeps her on the payroll forever. And ever.

Wednesday, March 25, 2009

Neo At The Quantum Casino - Part II

Foreword to Part II

According to quantum physics, reality is a probabilistic wave function that collapses into fact only after we
observe it. For example, Schrodinger's cat is neither dead nor alive until we open the box and look inside. Thus, perception is everything.

Neo laughed at Fred's comment about Einstein. Though he himself had studied economics in college his roomate and closest friend was a Dane called Nils who, as it happened, was a physics student with a keen interest in quantum mechanics. Just like Niels Bohr, his famous compatriot .

After getting a crash course on the relative merits of uncertainty and the ERP paradox, he and Nils had spent countless nights debating the Copenhagen interpretation versus Everett's multiverse. So, yeah, Neo knew a thing or two about quantum physics.

Suddenly, he got it. Perception is everything, he chuckled to himself. Most people didn't even see the word Quantum next to Casino because all they cared about was gambling - they didn't bother seeing anything else other than "Casino, so they didn't.

He remembered his experience riding a bicycle to class every day. In one particular spot he had to go against traffic so he rode on the sidewalk, passing by a bus stop. There were usually a few people waiting there, most of them looking in the opposite direction from where he was coming - they were looking for the bus. The problem was that they were blocking his way, so he always rang the bell to warn them. But no one heard him - ever. No matter how close he was and how many times he rang the bell, there seemed to be only deaf people waiting for the bus.

The explanation was quite simple: they didn't expect to hear a biker from the opposite direction, so they didn't hear one. And since they didn't observe him, he simply did not exist - until he drew right next to them and asked politely to go through, causing the probability wave to collapse into the fact of his existence.

Neo also grasped what was happening with the blurry dice: the blonde croupier manufactured reality by announcing the throw. She forced everyone to see a three and four - or any other combination - and thus collapsing all other possibilities of the probability wave into the outcome she wanted.

"It's not a deterministic world, buddy" Neo remembered Nils telling him over and over again. "Reality is created by the way we see things and not the other way around".

Neo snapped out of his thoughts to see Fred smiling at him.

"I sense strongly that you are familiar with the theory of how we operate here.
Believe you me, there aren't many people with your ability. Most think the world exists independently of their perception of it. Well, like W.C. Fields said 'Never give a sucker an even break' - and we at the Quantum Casino surely don't. So, I have a proposal for you - do you want to hear it?"

Neo nodded yes.

"We'd like to offer you a"position at our training program, starting as a trainee croupier. The lady that brought you here is a graduate of the program - and her name is Claudia, by the way.
What do you say?"

Neo didn't have to think long. He accepted on the spot.

End of Part II

Monday, March 23, 2009

Neo At The Quantum Casino - Part I

One morning, young Neo Phyte woke up early. Feeling particularly frisky - and by his own admission in constant need of ready cash - he decided to try his luck at one of the gaming parlours that were recently opening up fast and furious in his town.

As he strolled down the street where most of them were located, he noticed for the first time that they all bore the same name: Quantum Casino. He puzzled about this momentarily but then quickly walked into one of the establishments, at random. He did need a new iPod rather desperately. But he little knew that his seemingly random choice was a harbinger of things to come.

Neo walked right past the loud cacophony of the one-armed bandits by the entrance. He was looking for what all the "How To" books claimed to be the best bang for his buck: craps. Players with proper understanding of the game and a quick head for odds stood a better chance there than, say, at the roulette wheel. Theoretically, anyway.

It didn't take him long to find some craps tables bunched together, though only a couple of them had lots of excited people around them with the rest standing almost empty. Neo thought he knew about this too: only a few tables were "hot" at any given time, and thus attractive for experienced gamblers, while the rest were "cold" and should be given a wide berth.

Elbowing through the crowd at the edge of the first hot table, Neo chanced a look at the croupier. She was a tall and attractive blonde, her tag curiously identifying her as GOD. But he had little time to think about it because right then, at the other end of the table, a man shook furiously, yelled "baby needs new shoes" and threw the dice in his general direction.

The red translucent dice rolled and gamboled on the green felt, turning this way and that in a constant whirl of forward motion. They raced to the wall of the table, bounced off and started to slow down, getting ready to settle on the faces which would determine the throw. Neo locked on them with his eyes, unconsciously trying to establish their final outcome but, naturally, found the motion too fast for the capacity of his optic nerves.

But even when the dice stopped completely, Neo could not immediately read them properly - they were still quite blurry. The effect lasted only a split second; the beautiful croupier announced "Lucky Seven" in her sonorous voice and the pair instantly resolved into a sharply defined three and four. The same thing happened again and again - Neo's focus remained just a tiny bit soft until she called the shots, whereupon the dice immediately snapped to high definition and the appropriate number combination.

Come Seven

The crowd roared with appreciation as a long string of sevens came in and brought large gains for the players. The table went from hot to scalding, and "baby" went from needing shoes to thirsting for sable coats and multi-carat rings. But just as the really big stakes were dreamily plopped down in anticipation of luxury yachts and Mediterranean vacation villas, the dice started resolving into ugly snake eyes and boxcars.

The table went cold quicker than a stand-up comedy club after the third bad joke in a row. Neo had not bet a dime - he was too bothered by his alternating blurry-sharp vision and the effect of the croupier's voice on the outcome of the dice. As the players quickly deserted the table with their wallets considerably thinner for their efforts, Neo saw the blonde croupier also leaving her post.

She headed for one of the service doors leading to the casino's backstage. Neo followed her and also went through, just one step behind. He tapped her lightly on the shoulder and she turned, smiling brightly. Before he could say a word, she spoke softly: "Follow me, please" she said and continued walking.

They moved silently down linoleum corridors illuminated in stark greenish fluorescent light, finally coming to a stop before a plain white door. The cheap plastic imitation brass plaque simply announced "Manager" and the croupier opened it without knocking first. "Fred, here's the Joe you saw on the closed circuit. I'm going on my coffee break now." She turned and started to leave but she stopped short, facing Neo. "Sorry about the Joe bit - what's your real name?"

"Ahh, it's Neo - but I couldn't help noticing that your own name is highly peculiar. I mean, what kind of weird name is GOD?" he asked.

"Well, Neo, it's nice to make your acquaintance. Speak to Fred here and he'll explain everything. I have only ten minutes for my break so I have to run now, but we'll be in touch, I'm sure". She gave him another of her dazzling smiles and walked off.

Neo looked inside at the sparsely furnished office. There was a man in a crumpled suit sitting behind an empty desk, his face lit by the ghostly light of monitors covering one entire wall. As Neo walked in, he rose to his feet and motioned him to a chair. "Please sit down, Neo is it? My name is Fred and I am the Manager of this Casino. Can I get you some coffee - or tea perhaps? It's still early and our chef does a great cheese danish, too, if you haven't had breakfast. I had a couple myself already, but I'll join you."

"No thanks, I'm not really hungry - but I'll have a double cappuccino if it's all right with you" said Neo as he sat down. After Fred had called for the coffee, Neo continued. "Say, what's this all about? You guys have a thing with names? Firstly, why are all the Casinos in this town named Quantum? And what's with GOD on her tag, anyway?" asked Neo, pointing with his thumb at the door.

"You noticed 'Quantum', eh?" chuckled Fred good-naturedly. "Very few actually do - almost everybody just sees 'Casino' and that says alot about people, doesn't it?" He waited for an answer, but Neo just bided his time quietly.

"Oh well, I guess I should also explain GOD" said Fred and opened his desk. He drew out a laminated card identical to the one worn by the croupier and put it on his desk. "How much do you know about quantum physics Neo? Schrodinger's cat, the bit about Einstein, God and dice - does it ring a bell? Look here" he said and offered the card, without waiting for the answer.

Neo reached over and picked it up, ignoring the question. Under "Quantum Casinos" and "Welcome My Name Is" in calligraphic script was printed "GOD" in large, spaced black bold letters. The card also bore a photograph, a bar code and some other numbers, all having to do with another employee, he assumed. "So what? Are all your employees named GOD? I don't get it".

"Look more closely young man", smiled Fred.

It was then that Neo saw the small lettering next to each capital.

God is Only a Dealer

"Yes, Neo. Albert Einstein was completely wrong. Not only does God play dice, he's also calling the shots".

End of Part I

Friday, March 20, 2009

Well, Sirs, I'm No Bagehot!

Our intrepid research assistants have been very busy. They found the following discarded document in the trash bins outside the Federal Reserve building in Washington DC. Apparently mislaid, it evaded the jaws of the shredder and is presented here for the first (and last) time.

(draft copy)

March 19, 2009

From: Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve

To Whom It May Concern

Dear All,

Let me start by pointing out that my name is Ben, not Bagehot and that this is the 21st century, not the 19th. For those not familiar with said gentleman's monetary policy admonitions, allow me a brief quote offered in his opus "Lombard Street":

"We must keep a great store of ready money always available, and advance out of it very freely in periods of panic, and in times of incipient alarm. Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic and enhances panic to madness."

You may be puzzled; after all, the Federal Reserve under my leadership has cut rates to zero and is constantly providing lakefuls of "ready money". So what is the difference between myself and Bagehot, you ask?

Simply this: while Bagehot advised lending freely and copiously during financial crises, he did so with the proviso that money should be directed only to temporarily illiquid institutions and under no circumstances to terminally insolvent ones, which should be allowed to fail, instead.

Well, ladies and gentlemen, let me assure you: I'm no Bagehot!

Thus, though I do rule money by near-absolute monarch fiat, I am not beholden to any notion of bygone Victorian monetary rectitude, such as the gold standard. My motto is Let No One Fail For Want of Bail. It is really a shame the government won't allow me to inscribe this above the entrance of the Federal Reserve Building in D.C., so I guess The Bernanke Exit must suffice - for now.

The Federal Reserve Building, Washington D.C.

In case you have not noticed (read my official biography), I grew up during the 1970's, a period of Keynesian economic theory apotheosis around the world. Even if a halo of Austrian neo-classicism may be discerned around me, what really matters right now is that I am a fully certified pilot of moneycopters (instrument rating). Such a development not even a genius of Bagehot's calibre could have predicted two centuries ago, let alone lesser lights today (I shan't mention names but you know who you are).

Therefore, let this missive act as a warning to all shorts, plungers, goldbubs, deflationists, doomers and acolytes of Wall Street declasse riffraf: I shall use all powers vested in me to smite you down. As for my erstwhile collegiate colleague from NYU, him of newfound fame and acclaim, I reserve a special bon mot from the 1975 rejoinder of President Ford to Mayor Beame of New York City: drop dead.

Sincerely Yours,

Ben (not Bagehot) Bernanke


And perhaps not unrelated to the above discarded memo (Taylor rule and all that), yesterday came news that continued claims for unemployment insurance reached a record 5.47 million, though not nearly as high as levels reached in the '70s and '80s when measured as a percentage of the labor force.

Thursday, March 19, 2009

The Fed Goes On A Long Trip

And then they went out - out on the yield curve, that is.

Yesterday the Fed announced it would buy as much as $300 billion in longer Treasury bonds (2-10 years and perhaps as long as 30 years) plus another $850 billion of mortgage securities in order to bring down rates at the far end of the yield curve and thus make borrowing cheaper for mortgage seekers and corporations looking to issue debt.

This is very unusual, as the Fed does not normally venture out beyond the immediate area of its purview, i.e. money market instruments with maturity of up to 12 months. There are two reasons it is doing so:
  1. The inverse of the Greenspan conundrum: long rates are stubbornly high despite near zero short rates. The spread between 10-year Treasurys and Fed funds is near record levels (see chart below, click to enlarge). The Fed wants to lower long rates so that household mortgage and corporate borrowing costs come down and the economy gets to carry a lighter debt-service burden. Refinancing is going to be a booming business for quite a while, I think.
  1. The Fed wants to replace "private" money destroyed by loan defaults with "public" money it creates itself, effectively out of thin air and at will. Mr. Bernanke has explicitly stated that he will use every tool at his disposal to avert further deflation in the economy and he means to be taken at his word.
Mr. Bernanke's bottom line, right now? Don't fight the Fed. Yes, he is saying, we screwed up with Lehman and sent you guys in the market the wrong message. You thought we were not willing to bear the cost of (your) foolishness and not firm enough to be "the enforcer" against the big egos of failing Wall Street CEOs. We did scare the pants and s(t)ocks off you, didn't we? We're truly sorry, but that's all done and finished now; all hands are on deck and the helicopter is already off the tarmac. Let's party - or else!

My bottom line, for market purposes? The same: Don't fight the Fed.

Wednesday, March 18, 2009

Lords of Finance, Today

Today, a "plug" for an excellent book written by an author who not only knows his financial history, he's a practising money man, too.

"Lords of Finance - The Bankers Who Broke The World" by Liaquat Ahamed. See the "Featured Book" Amazon button on the right or click on the link above.

Mr. Ahamed tells the story of the world's most powerful central bankers as they struggled to re-establish a Victorian financial ethos in a world forever changed by the Great War: Montagu Norman of Bank of England, Benjamin Strong of the NY Fed, Hjalmar Schacht of Reichsbank and Emile Moreau of Banque de France. Their short-sighted decision to re-impose the inflexible gold standard and its arcane foreign exchange and monetary policy mechanisms (which were previously abandoned during WWI) proved ruinous and ultimately precipitated the Great Depression.

From a Washington Post review :

The gold standard's role in the worldwide depression of the 1930s has been probed before, notably in Barry J. Eichengreen's scholarly "Golden Fetters" (1992). But Ahamed -- a hedge fund adviser, a World Bank veteran and a supple writer -- personalizes the story, exploring how insular relationships led to bad choices. Strong and Norman, for instance, became friends and gained each other's trust through lengthy correspondence. Strong used his influence to secure a loan for England, then prodded Norman to put England back on the gold standard. Norman, in turn, persuaded Strong to push down U.S. interest rates, helping to create the stock bubble that eventually burst in October 1929. When Strong died in 1928, his replacement became Norman's thrall and fell in lock-step with the emphasis on gold, extending the economic agony.

The purpose for bringing this up in today's blog is not out of intellectual curiosity for the financial history of a bygone era. Rather, it is to make clear that insistence on old dogma is highly destructive in the face of new economic realities. And in this context The Lords of Finance has a very important message for all of us, right now.

No, we are not threatened with going back to "that barbarous relic", as Keynes called the gold standard in 1924. Instead, our era's rapidly ossifying dogma is Permagrowth: the idea that we need to constantly grow our economies and fight GDP recessions with all tools at our disposal, fiscal and monetary. In my opinion, Permagrowth has "outgrown" its use and become but a relic of post-WWII groupthink, itself based on the erroneous application of Keynes' ideas.

Such dated orthodoxy is completely ineffective - probably even dangerous - in a world confronting challenges that could not be foreseen in 1944, when Permagrowth became the official religion during the Bretton Woods meeting. Climate change, habitat destruction and resource depletion were not on the radar screen then, not even as distant blips. But they certainly loom large now and demand our immediate attention.

Therefore, instead of futilely attempting to preserve the ancien regime, we should strive to develop a new global economic paradigm and the proper monetary model to fit with it.

This does not mean that we should plot a course that strives for maximum gain, even at the cost of maximum pain, as some suggest. This is not only unacceptable from a purely humanitarian viewpoint it is also impossible in today's modern democracies; voters will simply not stand for it. In any case, I am certain that the transition from Permagrowth to Sustainability can be accomplished without the inevitable social upheaval and massive degradation of living standards that is envisioned by some popular tent-revivalist doomers.

In fact, I strongly believe that the process of transition can serve as a secure foundation of continuous economic development for many decades to come (notice the absence of the word "growth"), replacing the current debt/asset/consumption vicious cycle.

What's my two cents worth of a contribution?

There is a missing link between the new Green Sustainability economic paradigm and the old monetary system, i.e. we cannot apply a new economic paradigm using an old money system. This is where my Greenback proposal comes in, a new way of creating "money" but one that is completely familiar and easy to implement for everyone involved, from consumers and businesses to financiers, central bankers and politicians. Even the day-to-day monetary policy tools are kept the same, though they have not been heavily used in some 25 years: direct targeting and control of money supply via open market operations.

"Late Edition" Post Script

Throughout my career I have had several magazine front covers framed. One is from BusinessWeek and shows a smiling cow jumping over the moon - naturally, it's about the stockmarket and is dated a few months before the 1987 Crash. Another comes from TIME and has the simple words "THE CRASH" in black, dated November 1987. Naturally, these two hang side by side.

And now, I think I have another addition for my collection. From the ever so subtle and tactful NY Post, comes today's "let's slam the barn doors shut after the (fat) cows have left" rage. We have our convenient scapegoat and we're going to milk her for all she's got - and then some.

Question: where was the mainstream press when the real looting was taking place?

Monday, March 16, 2009

CDS As Money In The Shadows

As of today I have changed the masthead of the blog to reflect my growing interest in monetary economics which, quite obviously to me, is at the very heart of the current financial crisis. There are certainly other critical influences shaping events (climate change, resource depletion and geopolitical tensions are foremost) but money clearly matters the most, day-to-day.

In fact, one could argue that every human activity ends up being factored into and reflected as money flows. If energy flow is the real (i.e. physical) manifestation of human activity, then money flow is its metaphysical - one could even say philosophical - equivalent. The funny thing about money is that, though it is ''unreal", even kids have a feel for it in daily transactions, whereas the "real" energy is completely nebulous in peoples' minds.

And yet, as befits any philosophic entity, few have a clue about what truly constitutes money - and this includes many so-called professionals. Most just think of money as currency in circulation: dollars, euros, yen and rubles in their pockets or in banks' vaults. Some take a further step and include deposits in banks, properly understanding them to be mere book entries. But it is very few who make the mental leap required to properly view debt as money - indeed, the very idea is antithetical to "common sense".

And yet, that's exactly what our current, fiat-issue money is. The acceptance of new debits (debt) by those willing to assume them creates equivalent new credits (money) and presto, new money is created out of, literally, faith. To paraphrase a familiar text:

Credo est fides omnipoténtem, factórem cæli et terræ, visibílium ómnium et invisibílium.
Credit is omnipotent faith, maker of heaven and earth, of all things visible and invisible.

I am sure that longtime readers of this blog are already familiar with all this stuff, Christian Credo in Latin and all. So I wrote the above as mere preamble to today's "out-of-the-box post".

Onwards, then..

The idea hit me as I was thinking more and more about CDS (credit default swaps) and their role in today's mess. I was quite surprised by Mr. Bernanke's repeated comments on how "angry" he was at AIG and their ruinous exposure to the CDS market. Now, a Fed chairman - the person most responsible for controlling our money - doesn't get "angry" in public, unless he has a very, very good reason and/or a serious point to make. To continue in the same vein as above, it's a bit like the Pope publicly denouncing one of his most important cardinals.


Because AIG and all other major CDS players did something very unorthodox, heretical even. They assumed monetary powers above and beyond those of a mere financial acolyte: they created money without having to submit to the prior omnipotent authority of the Fed.

I have previously discussed CDSs acting as phantom equity equivalents. But can they also be viewed as phantom money - indeed, very high-powered money? Yes, they can - and that's a key element to what has become known as "the shadow banking system".

The issuance of CDSs created obligations to pay pre-determined sums every year for, typically, five years - i.e. debts. They were created out of thin air and required no reserving at the Fed or anywhere else. There was no taxation, wage income, rents, mine output, oil wells or anything else tangible backing those debts. So what backed them? Faith, pure and simple. That's as close as we have ever come to creating the absolute faith-based financial instrument. The Dutch, those early tulip-bubblers, knew a thing or two about such instruments: windhandel they called it, or trading in wind.

A CDS Party Carried In The Wind
Flora's Wagon of Fools by Hendrik Pot (c. 1637)

There are several important observations and corollaries that can be drawn from viewing CDSs as uncontrolled money creation (see chart below). I will leave them to readers by posing this question: as CDS amounts outstanding now crash down through a combination of expiration, forced migration to regulated exchanges and negotiated settlement, what is the effect on money supply, the prospect for inflation/deflation and asset prices?

Data: ISDA

Friday, March 13, 2009

Race At Havoc House Bank

Banks are most definitely "it" in the stock market these days. Bloodbath is too modest a description for what happened to their shares in just 18 months: at its low last Friday the KBW index of US banks (symbol: BKX) was down a massive 85% from the high reached in mid-2007 (see chart below, click to enlarge).

KBW Index of US Bank Stocks

In almost every sense, the market has already discounted a 1930's type depression for the finance industry. For some financial institutions this is entirely just and rational. Given the ridiculous risks they took in lending and the massive leverage in their balance sheets (40x was not unusual), one did not have to be a prophet to predict the outcome. The government swooped in and took them over, effectively wiping out their shareholders (note: it may now be the turn of their bondholders to also get a severe haircut).

In the age of Prof. Bernanke's Flying Fiat Circus no financial edifice is to go down in flames if it poses a threat to its neighbours - period. (Is this the regulatory equivalent of the neutron bomb - kill the shareholders, save the structure?)

But what about those banks that are somewhat better positioned, being a bit further in from the edge of the precipice? The ones that didn't dive headlong into the NINJA/CDO/CLO/SIV/CPDO smorgasbord buffet? What are their prospects?

Yesterday I talked with a banker friend who works on the trading side and asked him his opinion on bank stocks. He was very sanguine: this is a balance sheet crisis, he said. It will take time and pain for banks to work down from 40-times leverage to around 10-times on their own - if ever. The "if ever" was a clear reference to the risk of a government takeover - a very real risk, as we well know.

And yet, as with any business, there are two elements to a bank's accounts: balance sheet and income statement. We are currently focusing very sharply on balance sheets, i.e. examining assets to judge if their current and potential toxicity is poisonous enough to knock banks out for good. But what about income statements?

Banks are pretty simple businesses: what they charge for loans minus what they pay for funds and expenses is their net interest margin (NIM) and it ought to be significantly higher than losses sustained from the loan portfolio. There are other sources of income, such as fees and prop trading, but the heart of a bank beats at its NIM.

So, let's look at margins; below are charts that attempt to provide a current picture.

First, the prime rate, the yield on BAA corporate bonds and the 30 year conventional mortgage rate minus one month AA financial commercial paper (click to enlarge). After a brief period of volatility late last year, margins are healthy once again - even "too" healthy if we judge by the BAA spread. This means that banks are making good money from performing loans.

Each bank's gross interest margin spread will be some combination of the above, given its particular mix of corporate, consumer and mortgage lending plus exposure to the yield curve (borrow short - lend long).

Another factor is how long will the Fed be willing to keep short-term rates at current historicaly low levels. With Fed funds at 0.20% and the various FRB "windows" wide open, banks can fund themselves at extremely low cost against all kinds of collateral. That's another "plus" for bank income statements - a rather big "plus", to put it mildly.

Bottom line? There's a race going on at Havoc House Bank. On one side of the account ledger the Bad Loan Demolition Squad is tearing down the balance sheet, whereas on the other side the Wide Margins Repair Team is furiously trying to patch things up through the income statement.

Who will prevail? There are a couple trillion dollars (at least) riding on the outcome and we all have wager slips on our hands, want them or not. But this is not really a fair race, if you think about it. The bookie is in on the "fix" and he's not going to let his chosen team lose - unless he runs out of time, of course.

Thursday, March 12, 2009

Contest Results... and More On CDS

Oh my! What a smart bunch y'all are!

Honestly, I am deeply honored to have such a highly inquisitive and creative readership. Putting it another way, your median IQ is well above the mean. You quickly figured out the main purpose of this "contest": to elicit ideas and engage in productive discussion, i.e. Hell knows Hell's answer, but there are more answers that are "more better". Hats off to all of you.

Therefore, I encourage all to take a look at yesterday's comment section for lots of interesting ideas. Who's the winner? That's a trick question - and always was. ALL OF YOU, OF COURSE!

Now, what's my answer? Many of you got it: gold standard then vs. fiat money now.

The implication is that today's crisis cannot evolve into a deep banking crisis that affects retail depositors - there are no bank runs in our future, unless the authorities really screw things up. And they haven't so far, we must give them that. I strongly believe that what turned the 1929 Crash and the recession that followed into a deep Great Depression was the inability of banks (and thus the entire economy) to operate under the tight constrictions of the gold standard. No wonder that Keynes called it a "barbarous relic" (as early as 1924).

Today the Fed is telling everybody willing to listen that it won't allow any (major) financial institutions to fail - and is doing so at the top of its lungs. A hundred billion? Done. Two hundred? No problem. A...trillion? Whatever it takes. You don't have to like this policy - just understand it

This should not be mistaken as setting the stage for hyperinflation, however. Instead, the Fed is acting as the financial system's Fire Department. It MUST prevent the fire from spreading and it MUST put it out as quickly as possible, using "all means at its disposal". At the same time, it MUST take care that all "flammable" material are properly looked after so that new fires don't break out elsewhere. In the FFD (Fed Fire Dept.) flood damage is considered a secondary danger, at least right now.

Which brings me to CDSs. In my opinion they are a major - very major - factor in this financial conflagration and the principal reason why the Fed and Treasury have had to act the way they did. Credit default swaps didn't cause the crisis (loose lending and asset bubbles did), but they are certainly making it much more difficult to deal with it (the mess at AIG being just one example). CDSs are acting as the virus of a highly contagious disease, cross-infecting parts of the finance community that thought they were dealing in vaccines, instead. Thus, we must quarantine and exterminate them. How?

This is where the Fed and Treasury come in - and the fiat nature of money. The stated policy of the authorities (or un-stated, but clearly understood) should simply be this: we shall operate so as to make 90+% of all CDS contracts (by market value) expire worthless. We shall force all participants to net down to the customer level (thus vastly reducing nominal amounts outstanding), we shall demand that both sides of the CDS (buyer and seller) post collateral based not only on the face amount but also on the market value of the contract, we shall force the rapid migration of the business - future AND existing - to properly regulated exchanges.

Of course, tweaking the technical aspects of the CDS market won't do the trick alone. It will take something much more powerful to send CDS buyers (i.e. those betting on the continuation and deepening of the credit crisis) into reverse mode. Let's use the bully pulpit - more appropriately, the bailout pulpit - but do it in a smart way. Don't use bailout money to pay the CDS buyers (as happened in the AIG case), but to convince them to sell their CDS as quickly as possible, thus setting off a rally in the credit market.

What should be the target? To get credit spreads down to reasonable levels ASAP. Actually, things are going in that direction, anyway, because the really smart money is already figuring out that Ben's Helicopter Brigade is not fooling around and really means business. Spreads for commercial paper are down from "nosebleed" to being merely "high" (see chart below, click to enlarge).

Chart: FRB

This does not mean that debtors and lenders should walk away scot-free, bailed out willy-nilly by the government. Far from it; corporate borrowers that cannot meet obligations should give up equity and lenders should accept painful haircuts. As for those involved in their CDSs they should be "gently" encouraged to settle amongst themselves. A skillful negotiator, armed with the Fed's and government's big sticks, should be able to quickly put the fear of God into all concerned.

We are living in very interesting times. Let's hope there are smart people out there who can appreciate the benefits of "boring", finance-wise.

Wednesday, March 11, 2009

Why It Is NOT The 1930's: Reader Contest

Today a Sudden Debt first: a reader contest.*

First, some background.

Comparisons to the Great Depression are rising to a deafening cacophony emanating from the financial pundit chorus. "Worst since.." is a common opening phrase and a standard qualifier for all commentators - be they economist, banker or politician. President Obama, who should really know better, is no exception.

But no matter how one views this crisis, there is at least one crucial difference between today and the 1930's which completely alters its nature, progress and likely outcome. It is so major and obvious that I am astonished that not more people have picked up on it. The folks at the Fed and Treasury are excepted, of course, but then again they are at the very heart of this difference, so they have an unfair advantage (that's a hint, by the way).

And this is what readers are kindly invited to fill in:


The major difference is: [.................................................]


For your guide, what I have in mind can be expressed in one well-crafted sentence, a short paragraph at most. You can then enlarge on it, of course, but it's not necessary to win the contest. Being master of this blog the decision on who is the winner(s) is mine and mine alone.

And what do you win? From the immortal Stones and the late great Otis Redding: Satisfaction and Respect.


Now, for some other thoughts and observations that have been swirling inside by perma-contrarian (markets dept.) brain:
  1. I just got an email from Amazon advertising 8 new books. Seven (88%) were about the financial crisis/meltdown/bad money/bubble, etc.
  2. Nouriel Roubini is an NYU economics professor whose pessimistic views were considered outrageously doomerish two years ago - and I heartily supported him. Today he is considered a guru, appears everywhere - US and foreign MSM included - and is even invited to Davos.
  3. Citibank went from being #1 bank in the world by market cap to #184.
  4. Several "friends" and acquaintances - the same ones that scorned me as a despicable short a year ago - are now advising me to short bank stocks and buy gold because TEOTWAWKI is upon us.
  5. The World Bank just announced that the entire world would go into a recession in 2009, the first time since WWII, and Warren Buffet said that "the economy has fallen off the cliff."
  6. And as far as I know, the proper authorities have not warned of the imminent impact of an asteroid the size of Manhattan. The sky is not falling on our heads and our little Gaul village is still safe.
Caelum non caput!

Finally, a new feature: below the fold you will find voting buttons to record your reaction to this post (and all others). It's only fair: if I inflict my views on y'all you have the right to judge without having to write comments. That's what we call swift justice!

Ave, omnia.


*Or is it second time around? I vaguely remember doing something similar a couple of years ago, but I may be wrong.

Monday, March 9, 2009

CDS: The Equity Connection Today

On November 29, 2007 I posted an entry titled "CDS: Phantom Menace". The following is an excerpt:

CDSs are equity substitutes carried at zero margin, masquerading as credit instruments. They create a feedback loop mechanism to equity markets that results in reducing volatility when things look good and increasing it when they don't. In other words, they work as risk amplifiers and not as risk attenuators.

... we have the potential for a financial viral disease of pandemic proportions. The CDS market is so new that it has never been tested on the downside of the credit/business cycle. We simply have no inkling of how it will behave under real life duress, when major credit events occur with increased frequency and magnitude.

I am not re-posting this to reap accolades for accurate prediction abilities. Rather, I want to stress two points relevant to today's situation:

a) All CDS trading counterparties are now - finally! - required to post margin, i.e. collateral. Furthermore, what was up to now a strictly OTC business is about to become significantly more organized and transparent through the involvement of established futures exchanges (ICE and CME are both vying for the business).

Thus, two of the major factors that previously allowed for unbridled speculation and opaque practices are being removed. That's a good thing, but it is definitely putting pressure on participants (and prices) in the short run.

b) CDSs acting in their role of phantom equity are now in reverse mode, causing substantial downward pressure on share prices - just as they artificially boosted share prices on the way up.

In my opinion, the two points taken together go a long way in explaining why CDS's for GE and Berkshire Hathaway are trading at puzzling levels, similar to those for much less creditworthy companies. For example, even though Warren Buffet's company has $25.5 billion of cash on hand and a AAA credit rating its CDSs "cost as much as those of KB Home, the homebuilder that lost money for seven consecutive quarters."

Things are just as bad for GE. "Sellers of credit-default swaps tied to the debt of General Electric Capital Corp. for five years yesterday demanded 16.5 percent upfront, in addition to 5 percent a year, according to broker Phoenix Partners Group. That means it costs $1.65 million initially and $500,000 annually to protect $10 million of obligations. The cost was $446,000 a year two weeks ago."

But at long last somebody is putting two and two together: CDSs create "phantom" short (or long) stock positions. From the same Bloomberg article:

"Because an average of just 1,550 Berkshire shares are traded on public exchanges, it’s difficult to borrow the stock to bet against the company through short sales.
So, speculators may be buying credit-default swaps to hedge against equity losses, said Backshall of Credit Derivatives Research. "

Obviously, this kind of trading is not restricted to shares with low trading volume - in fact, I believe the exact opposite is happening, given the opportunities for arbitrage and manipulation in CDS - equity spreads.

So, what am I trying to say here? Simply this: as CDSs were partly responsible for driving the stock market to unsustainable highs 18 months ago, likewise today they are causing technical downside pressure, unrelated to corporate performance and economic conditions "on the ground".

The finance tail is, once again and quite noticeably, wagging the economy dog. That's pretty dangerous stuff for a nation - and even a President - that remain in thrall of daily index gyrations.

Note: A reader already had a question which perhaps many of you share:

"Would it be possible for you to elaborate a bit further on how CDS put pressure on stock prices today?"


Here's one way:

Let's say you are a bank, insurance co. or hedge fund and have already sold CDSs (i.e. written credit insurance) in the past, on XYZ Motors debt. You now wish, understandably, to reduce your exposure.

You can:

a) Buy offsetting CDSs (not at all easy these days, very expensive and fraught with counterparty issues - remember, this is strictly OTC business still) and/or,

b) Short XYZ stock at an appropriate correlation ratio.

Even if you manage to accomplish all you need with option (a), whoever is selling you the CDS will need to hedge - assuming he's opening a new position and not closing an old one. Most likely hedge? Shorting XYZ stock.

The above example also applies if you are only doing "dynamic hedging" and not reducing overall exposure. Effect is the same, in the end - pressure on common stock of XYZ.

Come to think of it, there is a very intriguing aspect to this situation. If the current CDS mess is - somehow - quickly resolved on a comprehensive level (one example would be through migration of all the business, including open positions, to an established exchange and thus common clearing), then we are looking at lots and lots of short positions that may not be exactly necessary... .... .... fill in the blanks.

If you like what you read - DIGG It!

Sunday, March 8, 2009

Next Exit, Bernanke

Oh, how deliciously apropos are these news for a Sunday morning post.. I mean, really, you can't make this stuff up, folks..

It turns out that yesterday the good people of Dillon, S.C. invited their hometown hero Fed Chairman Ben Bernanke to speak at a ceremony naming a highway exit in his honor. Henceforth Exit 195 of Interstate 95 is to be officially known as the Ben Bernanke Exit. How uniquely American can one get? I mean, can anyone imagine the French dedicating anything - say the TGV railroad station in Lyon, where he was born - to Monsieur Jean-Claude Trichet, current president of the ECB? Sacre bleu!

Oh, never mind..

I expect that professional honors of any kind are rather thin on the ground for Mr. Chairman these days, so accepting local transportation-related alternatives may be the only way to satisfy the good professor's needs for ego boosters. Indeed, it takes gumption to "get angry" at the likes of AIG.

Still, it would be perfectly understandable if he had just traveled south for the day, enjoyed a bit of deep-fried chicken, okra and grits with pan gravy, plus the usual small-town shootin' the breeze and backslapping with old-time friends. Charming, even.

But, nooo..

Because Mr. Chairman instead chose this rather declasse event to make a major policy speech. "At the Federal Reserve", he proclaimed, "we will continue to forcefully deploy all the tools at our disposal as long as necessary to support the restoration of financial stability and the resumption of healthy economic growth."

Lock and load, Ben - or is that "start the rotors spinning, cap'n"?

On second thought, "The Bernanke Exit" may be exactly apropos for marking the end of our Permagrowth Era - prophetic, even. What better confluence of rapidly bygone symbolisms than a highway exit for gas-guzzlers named after the chief of a fiat currency?

Yep, you really can't make this up...

Saturday, March 7, 2009

Off The Cliff Goes The Coyote

There is no better illustration of the Rise and Fall of The Era of Finance than the chart below (click to enlarge). It compares the market performance of Citigroup stock with GM and the S&P 500 index. Citi is black, GM blue and S&P 500 yellow.

No further comment necessary.

Wile E. Coyote Hills

Friday, March 6, 2009

Market Cap- to-GDP Back At 1990 Levels

Caveat: The following is not meant as prediction, suggestion or inducement to any action. As always in matters of markets and personal finance, I offer no advice and strongly suggest you keep your own counsel.

US stock markets have taken it on the chin - and everywhere else, for that matter. Year to date the S&P 500 index is down a rather severe 26% - that's in just two months. And that's on top of a 38% drop during 2008, when measured from the high reached in May of that year. The total decline from the all time high reached in October 2007 now stands at -56%, bringing the index to levels last seen in 1996.

This has been repeated a million times already in the financial press and, quite importantly for popular mood followers, also in the regular media (you know, when the financial pages make it to the front page, etc. etc.). Nothing new there.

More interesting, however, is that total US stock market capitalization has plunged to 63% of GDP. That's a level not seen since 1990 (see chart below, click to enlarge).

  • You asked for it, so here is the Saturday Morning Addition: A longer-term version of the above chart (click to enlarge). Notice that it only goes to 2004. The current reading is intriguingly sitting right on top of the 85 year average - certainly much more in line with what one would term "reasonable". But markets are almost never characterized by sanity, so...

I am not going to interpret this - I'm keeping my own counsel, too. But feel free to provide comments as you see fit.

Oh, and here's the regular monthly update on the Monster Employment Index released yesterday. It managed to notch up a bit last month.

NOTE: Commenting is now "protected" by squiggly key word verification. Too much comment spam going on... I guess I must be happy to be so "honored".

Thursday, March 5, 2009

Thirty Cents On The Dollar

I know I am beating the deflation drum a bit too much, but it's important to record and understand what is happening, as it happens. Because, unlike those who still expect inflation to appear, I see it as being here already.

Unfortunately many people - too many - think deflation is just about consumer prices, i.e. lower prices at supermarkets and malls. They are making a fundamental mistake because they do not understand the direct link between debt, asset prices and our fiat money regime.


It's springtime in America and the flowers of deflation are blooming everywhere, from real estate and finance to industry. The latest example is yesterday's offer from Ford Motor Company to pay 30 cents on the dollar in order to retire $10 billion of its debt. That's debt destruction, but it is also money destruction since fiat money is nothing but debt.

As longtime readers know, I am an ardent advocate of exactly such actions, which I see as the only way to effectively reduce the pile of debt we have amassed over the past twenty plus years. The trick, however, is to do it without damaging earned income, i.e. wages for working people. With unemployment rising fast during a recession that's not an easy trick.

Of course, it's not like such deflationary events have not happened before; most recently we were threatened with one during the dotcom bubble burst in 2000-01. Followed by the 9/11 events, it caused serious panic in policy circles and precipitated the Late Great Real Estate Heave-Ho. Instead of grasping the opportunity to put the US economy in a sound footing Bush, Greenspan and Co. decided to just pump up another debt/asset bubble and prayed (literally) to Heaven.

We got Hell, instead. (Yes, yes, pun intended).

It is imperative that we do not repeat the same mistake. We are still trying to keep the clinically dead debt/asset economy alive by massive injections of new government debt, i.e. providing bailouts for banks and insurance companies. That's just replacing the private debt with public debt; but, in the end, it's the same old US economy that will have to bear it and service it. Can't be done, dammit!

Let's say it once more: let the debt die and focus instead on increasing earned income.

And that's precisely why we need a radically new fiscal/industrial policy, instead of more and more of the old monetary "fixes". We have to create new good, high-paying jobs to counterbalance the withering of the FIRE economy and to minimize - as much as possible - the pain from debt destruction.

Add to this mixture the negative factors of geopolitical dependency on crude oil and gas, plus resource depletion and environmental/climate degradation and the route forward is strikingly, even incredibly clear. Changing our energy regime from black to green in a massive and concerted way will quickly generate millions of new jobs and absorb trillions in new investment.

Net-net we may stand still or even retrench in classical GDP arithmetic - but that's old hat economics, isn't it? Here's just one way our current accounting is providing the wrong picture: where is the cost, the negative growth which results from massive habitat degradation? Economists hide behind the term "external cost", but that's plainly nonsense in a world of 7 billion souls ultimately aspiring to American-style living standards.

What if instead we subtracted from each nation's annual GDP growth $50 per metric ton of CO2 it emitted to the atmosphere? This is actually not a price I picked out of the hat. It is close to the top market price for European CO2 emission permits last year. Prices have since come down with lower economic activity but, if anything, I believe $50/ton underestimates the total negative impact (just think of health effects).

Here's a list for the top ten CO2 emitters, unfortunately dated back to 2004 (latest data available). It has changed significantly since then, mostly because of the growth in Asia.

That's a trillion dollars per year, right here.

So... where should our trillion dollar bailout money go, instead, eh?

Wednesday, March 4, 2009

What Is Deflation?

An extremely short entry today, prompted by the following comment from an anonymous reader:

Hell... stop the stupid hysteria about deflation. Thus far we're talking asset deflation. You can wax eloquent about deflation when we can fill a cart with groceries at the supermarket for $50, or when crude goes back to $10...

In a fiat currency monetary system asset deflation is actually all the deflation that matters and is the direct consequence of debt destruction (aka money destruction). Consumer price deflation, i.e. lower prices for goods produced by utilizing said assets, may or may not follow depending on the balance between lower costs for capital assets reducing production costs and the actual production of goods, i.e. how many units of goods are produced by the assets.

Asset deflation is the worst nightmare of modern-day central banks and governments, inured as they are to Permagrowth. In this light, it is quite easy to understand why we are currently witnessing a constant barrage of trillion-dollar bailouts for banks and other financial firms. They are simply at the nexus of the asset-debt-money structure.

Tuesday, March 3, 2009

More De-Leverage

The following data on CDS (Credit Default Swaps) amounts outstanding is not exactly fresh (latest available are from June 2008), but it is relevant to what was just announced by AIG - and apparently precipitated yesterday's steep drop in global equity markets.

Data: ISDA

The world's erstwhile largest insurance company lost a record-setting $61.7 billion in the last quarter. It comes as no surprise to yours truly that most of the losses were attributed to CDS contracts. Readers will recall that I have long been beating the drum on the terrible consequences of unchecked issuance of credit insurance. In a nutshell, I had pointed out that enormous CDS exposure would act as an accelerant to a financial meltdown, despite the frequent and voluble objections that "these are just notional amounts and the real exposure is much smaller."

Well... size does matter, ladies and gentlemen. Because the proviso, that little asterisk attached to or implied in all the objections to my warnings, was always the same: assuming counterparty risk is not increased. That's a bit like saying that cigarettes are completely harmless as long as you don't smoke them. Or, they are almost OK if you don't inhale.. As I am fond of saying, good luck with that (nonsense).

Reality has now hit us on the face like a baseball coming off a bat - and it has "Mfg. by CDS Industries, Inc." written all over it. Make no mistake: such derivatives, plus the second- and third- order artificial products manufactured from them, are the proximate cause for the seizure suffered by the FIRE economy. Simpy put, everyone is scared witless not only of their own but, most crucially, of everyone else's exposure to this stuff. That's counterparty risk, big time.

There's one silver lining, however: such derivatives are typically structured to last five years and we are already well into the second year of the crisis. Meaning, amounts outstanding - and the dangers associated with them - are coming down fast. There were nearly $8 trillion less CDS outstanding in mid-2008 than at the end of 2007, a 12% drop in six months. I am certain this process has accelerated sharply in the last nine months, as risk and leverage appetite has quite obviously turned into revulsion.

So, just like plunging margin debt (data in the previous post), the drop in CDS is a sure sign of rapid de-leveraging happening as we speak. I think its a very good sign, all things considered..

Now, if we could just get through the next year without any huge implosions... (note: I think we will).