An Eternal Goldilocks

Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.

THE GLOBAL OUTSOURCING OF CREDIT ORIGINATION ACCOMPANIED BY BUYER WEALTH/SOPHISTICATION PERMITTING OPACITY IN SALES

Over the last 25 years, an incredible juxtaposition of intertwining financial circumstances through-out the globe, has permitted the myth of “An Eternal Goldilocks” Economy to Emerge and Thrive. Even now, after having recently skated closer to the edge of a measureless Financial abyss than imaginable, the myth, far from shaken in the foundation of a belief in infinity of continuity, twirls merrily on with perceived enhanced immunity from destruction.

To illustrate, to some extent, the strength of belief in the longevity of what some call a “Recovery,” others a “Boom,” I will state that until recently, when asked how long the “brief” instability seizing global financial markets might last; my reply had been that we “were in the first out of the 2nd half of the 1st inning.” I will introduce at this time, Satyajit Das, author of “Trader, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives” and someone better equipped to calculate the longevity of the ongoing Credit Crunch than this author. When asked the same question by an astute observer, “was the credit crisis was in what Americans would call the ‘third inning,” it evoked a gale of laughter. Brought back to the second or first inning (author’s initial choice), Das, who knows as much about global money flows as anyone in the world (there really is nobody because this assumes knowledge beyond the edge of the known universe), Das stopped chuckling long enough to suggest that we’re actually still in the middle of the national anthem before a game destined to go into extra innings, and it won’t end well for the global economy.

BACK IN YOUR GRANDFATHER’S DAY, BORROWERS (INDIVIDUALS,COMPANIES, GOVERNMENTS, INSTITUTIONS) IN NEED OF FUNDS WOULD GO A /SOME BANKERS/S AND WOULD AGREE TO BORROW, PAY INTEREST ON AND REPAY SOME MONEY. THOUGHTFUL OVERSEERS (OTHER BANKERS, GOVT’S, REGULATORS ETC.) WOULD MAKE SURE THE BANKERS HAD SOME SKIN IN THE GAME AS CAPITAL, AND REVERVES OR GOLD IN THE VAULT MAKING THE GAME SELF LIMITING AND THE GAME WAS ON

Humans would, as was/is their wont, try and beat the right way and some money would be lost often enough to keep the game straight but an eye, a tooth or a bunch of shekels lost pretty much made it all work. Those of us around long enough have seen the odd tooth scattered on the floor and taught some by loss. Ponzi and some folks close to the South Seas thing lost more, and a few lost all, but the lessons lasted awhile and things kept on. Even “The Pools” and the bankers they played with in the 1920’s got sufficiently hurt to correct.
HAD TO DO WITH LEVERAGE! COULD ONLY JUST GET SO MUCH OF IT.!

Might have found this out back in 1987 when Milken, Drexel, the Citi loans to Brazil, some nonsense called Canary Wharf and some more called Federated/Macy’s and RJR might have left a real large pile of teeth and a fair amount of skin out there. Fella called Greenspan (Up until then famous for certifying the soundness of a certain Arizona S&L) made Fedhead and stopped it all cold with the printing press! Worked like a charm. All the good loans had better margins, bunch of vulture guys got rich buying what the Govt had grabbed and we had the famous NON-EXISTENT Greenspan PUT (NOW BERNANKE PUT). By the way, he/BERNANKE is the author of the book told Greenspan how to do it!

Worked fine through the Mexican thing everybody remembers, worked good when the Siamese let the cat out of the bag. Even made Russia a democratic defaulter. Kept things going when the dotcom, telecom, bubble started to lose air long enough to let LOADS of Greenspan Put (RATE CUTS) and LIQUIDITY (Rubin printing press) get the better class of bubble going and this was a whole new kind of:

BANKING LIKE WE HAD NEVER SEEN BEFORE. NO NEED TO HAVE ANY SKIN IN THE GAME. NO NEED TO HAVE ANY WORRY ABOUT RISK OR DURATION. (Let guys like Das explain that kind of stuff.) WE HAD A BRAND NEW CENTRAL BANK . WHY WE DIDN’T EVEN HAVE TO PUT OUT THOSE SCARY NUMBERS CALLED MONEY SUPPLY USED TO CAUSE THOSE WALL ST TYPES FREEZE UP THEIR LIQUIDITY HOSES LIKE THEY GOT CAUGHT OUT IN THE COLD. WHY ALL YOU HAD TO DO WAS GET CONGRESS UP THE ANTE ON HOW HIGH FANNIE AND FREDDY COULD GO (DON’T FORGET THEM GOOD OLD FHLB’S!) AND THEY COULD PUSH ALL THE BONDS AND GUARANTEES YOU COULD NEED RIGHT OUT THE DOOR.!FED COULD JUST LET IT’S BALANCE SHEET GO TO SLEEP.

Didn’t take those geniuses down on Wall long to realize (particularly when they turned out to be a little tainted) that they didn’t need those GSE’s that much, just a bunch of PH’D’s. Seems like the big banks were still getting over the RJR’s, Canaries, Federated etc (And had a new crop from the Enron’s, Tycom’s etc. This Syndicated lending stuff wasn’t all it was cracked up to be. Nice fees but long tails. Why not go the way they and their PH”D’s had figured out to get rid of the pesky high credit score, low fee, doc-riddled mortgages. Do a bunch of M&A’s Buy-outs, Stock Buybacks etc. on the:

SAME WONDERFUL “TRANCHE” BASIS THAT WORKED WITH THE RMBS’S AND THE CDO’S AND CDO’s SQUARED IN THE MORTGAGE GAME! WHY, WHOOP De DOO, THE INDUSTRY COULD TRANCHE UP TRILLIONS WITH A NICE OPAQUE MIX OF SUB-PRIME (SHH, DON’T CALL IT THAT ANYMORE), ALT-A (ONLY A MORTGAGE BROKER KNOWS WHAT IT IS ANYWAY) STOCK BUYBACK’S (GIFT TO GET OURSELVES) M&A (Y’ALL EVER SEEN THE CHANGE OF CONTROL NUMBERS?) AND LEVERAGED PRIVATE EQUITY DEALS

So now we have got to the outsourcing of the Origination. Every peckerhead pumping gas can pump houses. Those who can’t can do the appraisals..

BETTER YET, ALL THOSE LENDERS CAN GO OUT AND ORIGINATE WITHOUT HAVING TO ANALYZE WHETHER THE DEAL PAYS. JUST MIX AND MATCH A FEW ALT-A AND SOME NICE CRE (WE HAVEN’T EVEN GOTTEN BACK TO THIS GOLDEN OLDIE FROM THE ‘80’S!) ALONG WITH SOME HEDGE FUND LEVERED BUY-OUTS, SLING THE WHOLE THING INTO A CDO (SQUARED< CUBED, what have you? And then GO SELL THE STUFF ANDS GET IT OFF THE BOOKS!

Then we hit the crème de la crème! Some of us can Remember when buyers of most things financial were individuals, then more and more mutual fund managers, a mix of “financial advisers” and other helpers named something like that. They did a few hundred, thousand, tens of thousands or maybe a couple million shares and bonds were sold ON A MARKET WHERE THE PRICES COULD NOW BE ASCERTAINED TO SOME DEGREE IN MILLIONS OR MODEST MULTIPLES THEREOF.

IT WAS VITALLY NECESSARY TO CHANGE THE DISTRIBUTION MECHANISM IF ROE’S ON THE STREET WERE TO BE HIGH ENOUGH TO NOT ONLY MAKE BILLIONAIRES BUT REACH THE ULTIMATE CASH-OUT, SELL THE HEDGE FUND MANAGEMENT COMPANIES/PRIVATE EQUITY PLAYERS TO THE UNSUSPECTING PUBLIC! THE MASSIVE GROWTH IN HEDGE FUNDS, THEIR ASSOCIATED LEVERAGE AND THE PRIVATE EQUITY WORLD ASSOCIATED WITH FINANCIAL ENGINEERING, STRUCTURED FINANCE AND THE ALPHABET SOUP OF “ONE-0FF” DEALS, CDO’S CPPI’S, SYNTHETIC CDS’S PLAYED RIGHT INTO THE GAME. THE ONLY BUYERS OF THIS STUFF (BEFORE THE “FUND OF FUNDS GOT THE DOOR OPEN WIDER) WAS THE LOOPHOLE IN THE SECURITIES LAWS FOR THE “QUALIFIED INVESTOR”. THIS NEARLY COUNTLESS POOL OF CAPITAL SIGNED A SHEET OF PAPERTHAT CERTIFIED THEY HAD SO MUCH THAT THEY DIDN’T NEED TO KNOW ANYTHING; THEY ALREADY KNEW IT ALL?THE DISTRIBUTION SYSTEM WAS NOW A FLOOD CHANNEL. NATURALLY, SINCE THE POTENTIAL BUYERS KNEW EVERYTHING, THEY KNEW THAT THOSE, LIKE THEMSELVES, WHO ALSO KNEW EVERYTHING WOULD BID AGAINST THEM AND DEALS GOT DONE AT LOFTIER AND LOFTIER LEVELS.

Some office building owner had seen these types of cap rates before and dumped. Some tree grove owner thought trees didn’t grow to the sky but houses might and dumped. Mostly the smartest guys in the room tried to sneakily outbid each other. The distribution flood channel was wide and deep.

THE UNITED STATES COULD ISSUE ALL THE PAPER IT WANTED TO AND THE REST OF THE GLOBE GOT WELL OVER 5 TRILLION IN RESERVES AND COULD BUY ANYTHING THE U.S. CONGRESS DIDN’T THINK MIGHT BE RELATED TO THOSE NASTY FOLKS W HAD GONE TO WAR WITH.

Then those people who should never have been sold houses in the first place found out they couldn’t even afford the electricity. SUB-PRIME STRUCK!

With a PH’D or two more, we might have noticed that the marvelous distribution system took a while to get all the whatever through the pipes. In the meantime, before it became a “tranche” of a synthetic insured enhanced cdo squared, the Damn stuff had to be stuck somewhere. The Wall St. Machine had invented some short term wampum called Commercial Paper years ago. Companies such as the Dow 30 with real cash flow and solid balance sheets leading to real AA ratings issued it and Treasurers and Trustees etc. bought it. It yielded a couple bps more. Not content with the few hundred billion that this quality of company could come up with, “The Street” simultaneously solved the “parking problem” for the whatever in the pipeline, but also created lots more money called:

Behold:asset backed commercial paper!

A few trillion of this stuff greased the distribution flood channel and the fees and bonuses flowed and eventually the super cdo or whatever took the end product.

ONLY ONE PROBLEM; A FUND OR TWO (REMEMBER MANLY, AUSTRALIA) WOULD UP OWNING SOME OF THIS STUFF WITH (SHH?!?!) SUBPRIME IN IT. WORSE YET, NOBODY COULD BE CERTAIN WHICH FUNDS AND WHAT BUYERS WERE WITHOUT CHAIRS. PRIVATE EQUITY IS CALLED PRIVATE FOR A REASON AND HEDGE FUNDS DON’T HAVE TO TELL YOU ANYTHING EXCEPT 2 AND 20 AND THEY CAN, WITHOUT WARNING IN MANY CASES, SAY: OH, BY THE WAY THERE ARE NO REDEMPTIONS THIS MONTH, YEAR OR CENTURY

And so we arrive at the present with a trillion or so of central bank “liquidity” injected (Do they use a syringe, ouch!) into the system, 50bps of Panic from the helicopters piloted by a famous speaker and the landscape littered with a few discovered and, probably, a few more undiscovered, non-redeeming, liquidating and otherwise indisposed funds.

PROBLEM SOLVED, RIGHT?

But that guy was saying we’re at “By the dawn’s early light” Whassup?

Let’s try and cut this credit thing up into chewable, if not digestible pieces and look at it from the most simple of angles.

DIGRESSING COMPLETELY AS THE WORD CHEW WAS USED IN THE PARAGRAPH ABOVE, I WILL PRATTLE ON ABOUT THE ADVICE ONCE GIVEN ME ABOUT A CERTAIN TYPE OF CREDIT: YOU ALL HAVE HAD A PIECE OR, IF NOT AND ARE UNDER AGE 25. WILL ONE DAY. MY MENTOR CALLED THIS GENRE OF CREDIT “MOOSEMEAT” WHEN QUERIED HOW ONE COULD TELL, HE REPLIED “THE MORE YOU CHEW, THE BIGGER IT GETS!”.

I could stop now and label the whole schmozzle moosemeat (technical term) but will press stupidly on.

Sub-prime is NOT the important part of the existing AND COMING Residential real estate crisis.

The Wall St. Journal finally seemed to half discover this in a Thursday, October 11 article where, amazingly enough, they still use the header “Sub-prime”! The problem is much more up-scale than the (forgive the word but it seemed so appropriate although may not yet have made the dictionary) “moniker” sub-prime. The WSJ, mixing and matching, interject the appellation “high-rate” occasionally in lieu of sub-prime. Since one of the areas they have listed under “The United States of Sub-prime” is Greater Miami with a mean price approaching the GSE minimum, they seem more than a little mixed up but, fortuitously, half discover, as mentioned above, that the real problem in total $ terms, in residential, is up the price road a piece and therefore much more humongous than the lowly subprime. The article and some better use of the research, although they DID go through 250 million mortgage records is the wanton failure in underwriting, as prolific in the McMansions as in the true sub-prime.

(Anecdote: an astute investor buys a run down (sub-prime) couple of shacks in Vidor, Texas (You find it-True story.) They pay less than 20M fix them up and sell one for 70M. Looks like a sale at 40 but maybe a rental at 300 per mo on the other. Loss, maybe but what’s the significance. You lose nationally $100 Billion on sub-prime. What is the significance. Most of the sub-prime origination chain loses more than the principal after Morgan Stanley and the like write off buying these things. Worst case, Congress or not, sooner or later, we slide most of it into the FHA, the GSE’s or your friendly home loan, maybe on a short sale, maybe a chapter buy.

NO, the worst is in the prime! There isn’t an acquaintance you have who didn’t go get a “second home” or two or three or did a cash-out refi and gone off and/or got into a specific performance suit on a condo that doesn’t flip. If it hasn’t happened where you live wait or admit home is in Flint, Michigan.- This brand of stuff, Alt A and Prime is in the million and way up level. At the bottom it is going to look, act and be worth subprime! One loss of a couple of million on a $3 million condo in the 60% range equals 30 subprimes and Congress will have a hard time getting Fannie and Freddie up to 4, 417,000! They are still building this stuff at a prodigious rate. Who are they going to sell to; each other?

We have genius Europeans in my small town buying like crazy. Miami at 40% off! When the $ drops another 30% as Gentle Ben takes rates to 2 or 1 and the Euro yields 4%, you think they won’t panic? The Venezuelans have the barrier beach and it looks like heaven at the moment. Last big buy here was when Castro sent all Cuba’s wealth to Brickell Avenue. One final question: who buys all the baby boomer’s 6/5’s on the shores of sunny Lake Michigan when they move to their retirement home. Pray for a continuing Chinese bubble! The new story in a lot of places is the short sale. No, this isn’t some bear pushing down a stock. It’s an about to be foreclosed homeowner finding a buyer 40% down from the mortgage owed and easily convincing the bank to take the cash and cancel the mortgage. Gets complicated if the seller gets a 1099 for the phantom gain but less so if he cash-out refie-ed high enough lately enough. Find a good attorney.

BUT THOSE IN RESIDENTIAL MAY BE IN THE SWEET SPOT. WHAT USED TO BE A GIANT TREE FARM IS NOW A LOT OF SUB-PRIMES. CONGRESS, THE GSE’S OR SOME MIXTURE MAY TAKE OUT SOME OF THE RESIDENTIAL BUT AT 4% CAP RATES WHERE DO WE FIND SAM ZELL; WAITING FOR THE 12% CAP RATE. WITH ALL THE HUNGRY BANKS NOW HAVING DIGESTIVE PROBLEMS OF THE ASSET BACKED COMMERCIAL PAPER VARIETY, WE NEED ANOTHER BERNANKE TRILLION OR AN FHA FOR THE COMERCIAL DEVELOPER.

Now remember all you good analysts, this is with a minuscule 4.7% unemployment rate. (Magnificent analyst Greg Weldon says the signs are malignant but we only seem to be hiring bureaucrats and those to take care of the sick bureaucrats when they find out what they have been hired to do.)

Interesting article in CFO magazine this issue. Of all things, they are talking about the “mythology” of the tallest building in the world; the idea that when a new highest or tallest is completed, it signals the end of an “up” economic era. Hell of an era. Shanghai will lose a lot of “face” as their World Financial Center was topped later by Taipei’s 101, well above the mainland city’s 1600 feet. The 1776 foot Freedom Tower at that height, if started, much less finished, might restore Manhattan’s luster but the winner will be the over 2000 foot Burj in Dubai. I remember opening a branch for what is now called Citi there in the early ‘60’s because we couldn’t get into Abu Dhabi where the oil was. The buildings (,ud) had central wind towers as air conditioning was yet to come and “industry” was syndicate smuggling ten tola bars of gold to Indian bride’s dowries. Great start for the world’s new possible greatest financial center. (Who knows, augur of new gold standard? Linking tallest building to idea of world’s Financial Center seems ludicrous in Dubai’s case but the Emirates may eventually make the case if NY drops the financial wrecking ball through its streets and the Chinese possible myth implodes. To quote the CFO: “So finance centers keep rising, popping up in new time zones like glittering trophies of financial nationalism. However, the substance behind such developments remains unclear. So has always been the stability of CRE lending and therefore the more normal “cap” rates than the current.

Running along, almost unseen in all the media glitterati and talking head noise about Peter Cooper/Stuyvesant Town and other ludicrous extensions of the value of a foot of dirt has been the ubiquitous accumulation of debt by otherwise seemingly sane corporations to “buyback shares,” There was a not too distant time when equity of a balance sheet was prized as proof of success rather than derided as proof of a CEO’s or Board’s inability to “Get it!” I challenge the financial asset community to come up with a net number for credit related to this phenomenon.

Yes, I know that an enormous amount of it is offset by the stock option exercise and concomitant increase in equity; but! How much of the stock so exercised winds up financed, not owned outright and represents credit extended on the collateral/worth of the company? With tax lawyers always one step ahead of the revenuers, it might be a big part of the jumps we see in the “Security” lending category.

In any event, casual and perfunctory as such analysis must be, the “buyback” game, as long as rates and accommodating banks were the wont, WAS AND STILL ON THE BOOKS< REALLY IS ONE HUMONGOUS PILE OF CREDIT> Now, extra credit question. How many of the lenders in these things did non-recourse because, in the long run, the market goes up? Probably our prudent lender corp would never think of such a thing!

WE HAVE SAVED THE BEST FOR LAST AS IT COMBINES THE VARIOUS ASPECTS OF WHAT HAS BECOME KNOWN AMONG SOME ASTUTE ANALYSTS WE KNOW AS THE “WALL ST THROUGH-PUT MACHINE!”

It doesn’t quite “through-put the whole magilla as evidenced by the high 20-30% growth in the balance sheets of the big or “bulge” bracket firms, and the still significant growth in others now including all kinds of foreign origin players as well as those multi-hundred billion or more what used to be called commercial banks.

All of the assets outlined above can (and have been) “financially engineered” into the end products spewing out of the “through-put” machine. (We will omit the quotation marks hereafter to save reader time.

THE REAL GAME FOR THE TRUE INSIDE PLAYERS, HOWEVER, HAS BEEN IN WHAT USED TO BE CALLED THE “LEVERAGED BUYOUT” May Drexel R.I.P. THE VERY RESPECTABLE TERM “PRIVATE EQUITY” AND/OR THE “IN CROWD” HEDGE FUNDS DON’T FLIP CONDO’S; THEY FLIP COMPANIES. RETURNS ARE MAGNIFICENT IN THE CREDIT ENVIRONEMENT WE HAVE HAD AND THE FEES EVEN MORE MUNIFICENT. TO QUOTE DOUG NOLAND OF PRUDNETBEAR, MOST FAMILIAR WITH THE PHENOMENOM,

THE ONLY PROBLEM IS THAT EACH SUCCEEDING YEAR REQUIRES MORE!!! CREDIT!!! OTHERWISE THE THROUGH-PUT MACHINE DELIVERS LESS PROFITS, ROE’S, “PERFORMANCE” AND THE “QUALIFIED INVESTORS” CALL THE INTERMEDIARIES THEY HIRE TO FIND THE “PLATFORMS” THAT PERFORM AND COMPLAIN THAT THEY DIDN’T!

THERE HAS BEEN A LOT OF KERFUFFLE (TECHNICAL TERM) ABOUT THE SUB-PRIME DISTURBANCE. WE DON’T PURPORT TO BE MORTGAGE/REAL ESTATE GUYS BUT COULD SEE IT COMING. THE MULTI-TRILLION ONE STILL WAITING IN THE WINGS IS THE PRIVATE EQUITY/HEDGE FUND GAME WHICH DIDN’T GET TO THE REQUISITE END GAME OF DUMPING ALL THIS STUFF BACK ON THE GENERAL PUBLIC IN A HOT MARKET AT A HIGH MULTIPLE! AS AN OLD COMMERCIAL LENDING GUY, WE WILL GO OUT ON A LIMB AND SAY THAT THE LEVERAGED DEALS WE SAW IN THE LAST FEW YEARS MADE MILKEN/DREXEL LOOK LIKE A MILQUETOAST. CASH FLOW AVAILABLE FOR DEBT SERVICE WAS RIDICULOUS, MUCH LESS THE CASH TO KEEP THE PLACE GOING AND SPRUCE IT UP FOR SALE TO THE HOI POLLOI (YOU FIGURE THIS ONE OUT)

WE WILL CLOSE WITH THE PROBLEM THAT THE PLAYERS HAVE BEEN DOING WHAT AN OLD GUY IN LONDON TOLD ME NOT TO TRY IN 1958-BORROW SHORT AND LEND LONG! THE SOURCES FOR MUCH OF THESE BALANCE SHEETS ARE OVERNIGHT OR NEAR OVERNIGHT LIABILITIES! THE WORLD HAS SEEN WHAT HAPPENS WITH A SMALL TAINT IN THE ASSET BACKED COMMERCIAL PAPER MARKET! DO WE HAVE ENOUGH DUMB HOLDERS FOR THEM NOT TO LOOK NOW!!! AT WHAT IS IN THEIR “MONEY MARKET MUTUAL FUNDS??? CAN BERNANKE MANUFACTURE A PUT FOR 3 TRILLION IN MUTUAL FUNDS. STAY TUNED IN FOR THE REST OF THE ANTHEM AND A PROTRACTED, FASCINATING GAME!

Towards A Cold War World

Towards a Cold War world
By Martin Hutchinson
September 17, 2007

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.com

It is now becoming clear that whether or not he relinquishes the presidency nominally, Vladimir Putin will remain in effective control of Russia for many years after 2008. In that event, his “spook” economic and political priorities, honed during his decades with the KGB, will doubtless rule Russian policy. Since Putin appears most comfortable in a cold war world, that is what we are likely to return to. It is not an attractive prospect.

In order to have a cold war, you need adversaries of approximately comparable strength. The West cannot have a cold war with Al Qaeda, which has neither the military nor economic strength to challenge it by conventional means. At the opposite extreme, the Soviet bloc was a worthy Cold War opponent, not so much because of its economy which was always fairly feeble, but because of its dedication to military might, which allowed it to punch far above its demographic or economic weight in world councils.

Putin is now trying to recreate the Soviet position. He has one major disadvantage: a population of only 141 million which is tending to decline. He has on the other hand an enormous advantage over the Soviet Union. That is intelligent exploitation of Russia’s immense energy resources in a period of high oil prices, not so much to confront the West directly, but to attract allies into a bloc that will be large enough and powerful enough to do so. A second minor advantage is that he is not ideologically compelled to defend an indefensible economic and political system. Allies who stand alongside Putin are not forced to adopt Communism, but can retain whatever bizarre political, economic and religious beliefs they already have, uniting only in hatred of the common adversary.

Had the West in general and the United States in particular not made several serious mistakes since 2000, Putin would not be in a position even to dream of realizing his disreputable ambitions. The 9/11 attacks differed only modestly in scale and not at all in kind from myriad previous terrorist attacks that had afflicted the Western world over the previous 30 years, while by chance largely sparing the United States. The IRA (which had considerable unofficial US backing) the Basque ETA, the PFLP, the PLO, Black September, the Japanese Red Army, Libya, the FALN (Puerto Rico), the Armenian Secret Army, the Soviet Union, the Medellin cartel and Kosovo, to make a partial list, all undertook terrorist incidents in Western countries killing more than 10 people in each over the 30 years after 1970.

Terrorism is an unfortunate and ineradicable danger of modern life. It is becoming clear that nothing in the 9/11 attacks justified selecting one particular group of terrorists and reorienting US foreign policy around it. By doing so, the United States tied its military forces down in Iraq and Afghanistan, allowed the various Islamic terrorist groups to consolidate and alienated potentially neutral countries such as Iran and leftist political groups throughout the West. Moreover, by focusing foreign policy so completely on “Islamofascist” terrorism, other challenges, notably those presented by Putin’s Russia and Hugo Chavez’s resource-controlling Venezuela, were neglected.

In 2001 a challenge by Putin’s Russia to the US would have been met by a united West and laughed off the international stage. Had President George W. Bush pursued the “modest” foreign policy on which he was elected in 2000 that would very likely still be the case. Instead, there is today a disgruntled element in the EU and elsewhere that regards Putin as less of a menace than Bush, while anti-US feeling in the UN and the EU has prevented effective blocking action in the ex-Soviet “near abroad” of Georgia, Ukraine and Kazakhstan. Beyond those countries, Putin has quite rich and potentially powerful allies in Iran and Venezuela. China is at best neutral and even in Japan opposition groups have taken to denouncing US policy. Even Putin’s nuclear buildup, renunciation of arms control, detonation of record-sized bombs and recreation of a Russian air force that may well be better in quality than the USAF have been met with little response.

Higher defense spending is a priority for the United States and still more for the EU, which has allowed its defenses to fall to pathetically low levels. Both the US and the EU have permitted defense procurement to become an incredible sinkhole of corruption, “industrial policy” and lobbying, while Putin’s Russia has spent resources in what is for governments an efficient manner. During the pacific 1990s, the Russian defense equipment sector fell far behind those of the West, but there is no question that under Putin it has been catching up fast

To take one example, the F-22 Raptor fighter aircraft was originally put out to tender in 1986, but the first aircraft was not delivered until 2003. The current estimate of its production cost is $361 million per aircraft. The Eurofighter Typhoon, a similar aircraft, was also 5 years late into production and costs $440 million per aircraft. The Russian PAK-FA, a derivative of the SU-47 Berkut, appears to be at least comparable or better in capability, is expected to come into service in 2010 and to cost $30 million per aircraft. The United States and the EU may have larger economies than Russia, but at anything like that cost differential, their economic advantage is negated. Thus it is a matter of urgency to de-fund the lobbying belt around Washington (let alone that around Brussels), strip down the military procurement process and compete on a level playing field against a lower cost, more efficient adversary.

One source of Russian efficiency has been competition. Putin’s people understand far better than the old Soviet bureaucracy how incentives and competition can be used to spur innovation. While defense production has remained in the state sector, competition between different agencies has deliberately been fostered, with substantial bonus payments to the management and staff of agencies that prove successful in an endeavor. Thus aircraft development, for example, occurs in both the Sukhoi and Mikoyan agencies. This produces a system considerably more efficient than the US defense procurement system, where the companies are largely private sector but competition between them is determined by who hires the best-connected lobbyists.

Outside the defense sector, a new cold war will bring challenges in energy. With Venezuela and Iran as allies, Russia will control a high proportion of the world’s oil supplies. Whereas today the Arab Middle East controls the majority of the world’s oil output, Venezuela’s Orinoco tar sands make it a much more important oil source over a 10-year time frame and Iran too will benefit from Russian technology and oil industry know-how. The old Soviet Union brought very little to its clients in terms of technological capability in fields outside defense. However Russia used the period of openness to Western influences well, modernizing its oil sector and bringing its technology up to cutting-edge levels. It is now unlikely that Russia will fall back since competitive forces have been maintained. Russia will use the energy supplies to which it has preferential access to influence policy in such oil-thirsty countries as China, and to browbeat customers in strategically important but politically feeble places such as the EU.

Globalization will go partly into reverse. Something like the old CoCom convention, which prevented sales of high technology equipment to the Soviet bloc, will need to be reinvented – its feeble successor, the Wassenaar Arrangement, has Russia as a member. High tech investment will be diverted to a large extent towards devising defense mechanisms against possible cyber-attacks. Barriers will be erected against takeovers by Russian state controlled behemoths. Indeed, such barriers could reasonably be erected against all takeovers by state-controlled companies, although this would be a little unfair to the admirable Temasek Holdings of Singapore (which in any case is more like an exceptionally well run and benign conglomerate than a state.) Trade will become somewhat less free, although the protectionist impulses thrown up by Cold War suspicion may be somewhat balanced by a geo-strategic need to play nice with Third World countries wishing to export to the US and Western Europe. Gross World Product growth will be lower than it might otherwise be, and more of it will be concentrated in unproductive defense and security sectors.

The one positive effect of a new Cold War might be in weeding out public sector waste in the US and Western Europe. Russian public spending is only 21% of GDP, below the US level and far below levels in the EU. The country runs a large budget surplus and its finances are further buttressed by soaring receipts from the 13% “flat tax” that Putin introduced when he came to office in 2001. While Russia has huge corruption and an overstuffed military, it wastes much less than the West in unproductive social spending, wasteful subsidies to agriculture and politically-directed “pork-barrel” projects. To accommodate higher defense spending without plunging its economies into recession, it is likely that the West will have to adopt a Russian – and in this respect, more capitalist – approach to its taxation system and public spending priorities.

Is there any way to prevent the escalation of this debilitating competition? Well yes, there is. The whole point of being capitalist is that one has good access to capital and uses it wisely. Russia, when given access to capital, tends to waste it, stashing it away in Swiss bank accounts and spending it on soccer clubs and call girls. However since 1995 Western central banks have used their almost unlimited ability to create money to make capital extremely cheap, in fact almost worthless as demonstrated by the huge number of insane dot-coms, vulgar oversized housing developments and megalomaniac empire-building takeover artists it has funded.

In recent years, this has also allowed the world economy to grow at a higher rate than is sustainable, raising the prices of energy, commodities and shipping ad infinitum. In other words, we have negated our advantage in capital availability and artificially enhanced Russia’s advantage in energy and natural resources.

The solution is thus quite simple – a prolonged period of much higher real interest rates, which will raise the value of capital. That will enhance our relative economic advantage and depress the price of oil and other commodities, thus forcing Russia and its satraps Venezuela and Iran into bankruptcy. A similar period of tight money and low commodity prices was instrumental in defeating the Soviet Union in the late 1980s – there is indeed a good case to be made that Paul Volcker did more to win the Cold War than Ronald Reagan! The process can be repeated now.

There are other ways of winning wars beyond mere armaments.

The Testosterone Threat: Sociobiology,National Security

The Testosterone Threat: Sociobiology,National Security and Population Control

This is what Valerie M. Hudson and Andrea M. den Boer argue in Bare Branches: The Security Implications of Asia’s Surplus Male Population. The book has circulated widely in academic and policy circles and its arguments have attracted the attention of media pundits as well as the CIA...

This is important. Everybody should read it, as our future is at stake over this very reality...

Black Holes & Revelations

Sean Corrigan is Chief Investment Strategist, Diapason Commodities Management, Lausanne & London.
“Glaciers melting in the dead of night/And the superstars sucked into the supermassive.”

Matthew Bellamy, Muse

“…If monetary policy has played a dominant role [in the recent benign financial conditions], the rise in inflation that has been observed recently in many countries and the likelihood of a further tightening of global monetary conditions suggest that the current episode of low interest rates and tight spreads could end quickly. This could have an adverse impact on interest rate sensitive sectors of the economy and lead to a withdrawal of liquidity from precisely those markets that have benefited the most from low interest rates.”

Malcolm Knight, BIS General Manager, June, 2007



To the casual observer, the recent behaviour of financial markets is surely a cause for wonder.

Trading volumes and M&A activity sets new records with every passing month; buy-out targets become more and more ambitious (and the leverage taken on to achieve them grows and grows); hedge funds proliferate and - no longer content to pick over such mundane assets as stocks and bonds - branch out into buying rare earth metals, art works, footballers and violins; emerging market equity indices trade on higher multiples than Western ones; US margin debt hits new records both outright and as a percentage of market cap despite a sputtering economy; equity mutual fund managers signal their endorsement of the view from the bucket shops by allowing liquid asset ratios to hit new lows.

Then there’s the increasingly bullet-proof mentality among risk takers who reacted to an emerging market fall in May 2006 by slashing positions so deeply across the board it took six months for some of them to recover the loss; who then responded to a mini-China crisis in February with not so much a flight- as a feint-to-quality that only took six weeks to shake off; and who then greeted the latest Shanghai shake-out with such a yawn that new highs had to wait less than six days from a sell off which lasted not a great deal more than six hours!

Finally, there’s the fact that emerging market and junk bond spreads, as well as CDS premiums, are hitting new lows even though the investment grade universe is tracking inexorably higher from the generationally low real and nominal yields set as recently as this year (e.g., in the case of the UK).

In fact, the key to understanding all these marvels – which are part of a wider phenomenon also made manifest in the record prices being set for drab Modernist daubings, French wines, Swiss watches, and all the other Hyper-Bling accoutrements of the nouveaux riches – and also the clue as to what may bring an end to this Bacchanalia is to be found in a careful re-reading of that last paragraph.

We say this because the great, gaudy merry-go-round to which we nowadays so precariously cling is powered by a vast surplus of credit which is being extended – not so much by banks who might, after all, be subject to some restraints on their lending activities, however notional - but by virtue of such exposures being floated off largely to an unregulated non-bank sector whose own liabilities the banks do fund, since they are theoretically fully-collateralized by the over-priced assets they have bought.

That the carousel spins so fast is because these non-bankers have also been instrumental in financing both the private equity boom and the knock-on flurry of acquisitions, spin-offs, and share buy-backs carried out by the nervous executives of vulnerable public companies. Their complicity has arisen both because the non-banks have participated actively in the LBO mania and because they have depressed yields and spreads in general (by writing ever cheaper insurance on ever more issued debt, if in no other way).

Like all good asset-collateral spirals, the volume of cash flooding into both institutional coffers and private pocket-books as a result of all this debt-based buying has left the recipients scratching around for places to re-invest their windfall and so - Hey Presto! – they have come to cultivate an avid taste for ‘alternative’ assets as replacements.

Apart from sounding impressively à la mode over the dinner table, this has meant in practice that they have rushed to buy stakes in the same private equity and hedge funds who initially relieved them of their former, more traditional holdings. Amazingly, this seems to take place in the expectation that the bought-out will enjoy greater future returns just because they have surrendered charge of their assets to the buyers-out (instead of exercising firmer shareholder control over the pre-existing management, in the first place), regardless of the damage wrought to the targets’ balance sheets and despite the eye-watering levels of fees involved in playing the game.

Thus refortified with ‘equity’ returned from those they have just borrowed to buy out, the non-banks can now go scoop up another fistful of assets, financing a hefty slice of the purchase with yet another slug of margin extended by their eager prime brokers.

Thus, the inflationary screw takes yet another turn to the cry of Come back, Signor Ponzi, all is forgiven!

To get a sense of the scale of but one aspect of all this, consider the findings of a recent Fitch Ratings survey which revealed that assets of ‘credit-oriented’ hedge fund had exceeded $300 billion as far back as 2005, since when CDS outstanding have doubled to $35 trillion, suggesting a substantial increase in the tally of those assets, too.

As the agency points out, even that sum represented a gross understatement of these funds’ influence since the typical financial leverage they employ is of the order of five to six. Moreover, on top of this figure of $1.8 trillion-and-counting, we must not forget to reckon with the extra economic leverage intrinsic to the fact that these funds also tend to concentrate their buying on the more risky tranches created much lower in the capital structure when loans are sliced, repackaged, and sold on by their originating banks.

Given that Fitch reckons that 60% of the trading volumes generated in the CDS market can be attributed to such funds, we can get a sense of the thinness of the ice upon which the whole bootstrapped edifice is being built.

But we mustn’t be too parochial here for, in addition to the internal distortions being wrought by the unholy alliance of hedge funds, LBO merchants, and prime brokers via securitization and through the use of structured products and derivatives, all of this has also brought about significant real world effects, far beyond the fairy tale realm of the financial markets themselves.

Though much of the world’s upsurge in economic activity (and the concomitant rise in commodity prices) these past five years has a genuine foundation in the modernisation of Asia and Eastern Europe, among others, there is also a large, if unquantifiable, overlay of that excessive or misplaced investment which has only arisen because the markets and the central bankers who oversee them have ensured that the real cost of financial capital has remained far too low for far too long.

Here it is that we see the first signs of danger, for, in a world which has come to define ‘risk’ as the avaricious angst that one could be missing out on a fabulous gain if one is not fully committed to the pot, the whole whirligig of financial speculation and industrial hyperactivity depends upon one thing and one thing only – non-threatening bond yields.

Here we must track back a little to set matters in context.

For well over eighteen months, it has been our view that the inflation genie has been fully let out of the bottle (taking ‘inflation’ in the misleading modern sense of a rise in a consumer price index which a central bank finds it hard to ignore) and that, as a result, we would see nominal short-term rates move successively higher, while real short-term rates lagged behind.

Then, we felt, there would be some weakness evident in some over-extended, interest-rate sensitive sector or other - and housing, thanks to the enormities of this cycle, was always a (sub) prime candidate to fulfil that role. Then, a pause for breath would ensue, that hiatus itself being taken as a sign that the next move in rates would inevitably be downwards, paradoxically setting the market up for another anticipatory move to the upside.

Absent a direct financial contagion from some parts of, e.g., the housing market (worries of which were certainly an accessory factor in the February wobble), we have also long contended that the heady mix of solid, secular and shaky, cyclical global growth would be sufficient to tide things over and would not let any material amount of slack back into the system - and that nor could it until the credit tap was further considerably tightened.

We have also argued that, due to the peculiarities of the energy market – a heady cocktail of the CB policy of ‘ex’-ing their price indices, the public ownership of oil & gas resources, and the politics of petrodollars – high fuel prices were acting as a monetary pump, not as a picket line to hobble output. Lo and behold, Brent crude is back at $70/bbl and we have been off to the races again, these past few months.

We further warned that the biofuel movement would have far-reaching effects, not just for commodity investors, but for the ordinary householder and – at length – for the central bankers anxious to keep his wards’ ‘inflation expectations contained’.

Finally, we thought that the balance of probabilities favoured a scenario where the move which broke the uneasy cease fire on rates would be up not down.

So far all of this has just about come true – though in a world riddled with self-installed vulnerabilities at every level, our fingers are still firmly crossed when we say so.

So far, the only thing missing is the next upward shift from the central banks which did go dormant, though New Zealand, for one, has gratified us. In Australia and Canada, we can see that the wider market (if not yet the monetary authority) has come round to our viewpoint, since futures are clearly pricing in such an imminent resumption. In the UK, Sweden, and the EU, too, where official rates have continued to rise, futures are, if anything marching further away from them as they do.

Ominously, too, the violent sell-off in Eurodollars has even begun to push the red months up above the funds rate and back towards a more normal premium which would signal the dispelling of the last lingering hopes of a cut. Additionally, the far end of the US curve is starting to resteepen with the differential between Fed funds and 10-year Libor, for example, moving from a negative 35bps in December (a six-year low) to an 11-month high of +48bps and, to cap it all, break-even inflation rates are also starting to move higher, not just Stateside, but in the EZ and the UK, too.

Finally, the sell-off has seen US T-notes at last break the downtrend which has capped the classic, long-term distribution built since the ’87 Crash, meaning Treasuries have joined the angry-looking charts for Bunds, Gilts, Canadas, Ozzies, et al.

Here, too, we could see another feedback come into operation – this time one far less helpful to the speculative herd – for rising long bond yields are likely to be viewed by central bankers as a sign that either their self-proclaimed anti-inflationary stance is being questioned or that the implied rate of return on capital has risen. Either way, bond yields could rise for fear of more CB tightening and the CBs could tighten more because bond yields are rising.

All it would need then would be for a little mortgage convexity to kick in, or for some other from of dynamic hedging on all that derivative product to take place, and we could see the asset-collateral spiral swirling rapidly into reverse.

If so, it is a matter of reasonable conjecture to suggest that, given the sheer mass of positioning involved – as well as the unfathomable interlinkages between its innumerable component parts - we could well see a good part of the present, self-supporting nebula of ‘liquidity’ rapidly vanish over the event horizon.

What price then the ‘global savings glut’ or the worldwide ‘asset shortage’ so beloved of US academia and how large a quota of disastrous malinvestment will be exposed once the impressive divide between the employment of means and the satisfaction of ends is no longer disguised by the anti-gravitational force of over-abundant credit?

(A version of this commentary originally appeared as part of the June monthly report for the Labarum fund)

Perpetual Cycle?

Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.

UNICYCLE, BICYCLE, CREDIT CYCLE OR PERPETUAL CYCLE?

The ridiculous starting phrase to this article above seems, to the author, in concert with the progression of what used to be known as, quite simply, the credit cycle. Put simply, business and consumers got frisky; the Fed raised rates/reserves, they got less frisky and the cycle restarted. We will refer to the bicycle as the point a couple of years ago when the Fed, consciously or unconsciously got the GSE’s in as augmentors of their interest rate cuts, liquidity expansions etc. Listening to (some) of the Fed, and (most) of the regulatory entities, it would now seem they yearn for something like the old Cycle. No Bicycle this time as the GSE’s are still mildly unable to find reliable numbers and some politicians actually think they should concentrate on median housing for those left out of the sub-prime bubble which was what they were created for in the first place.

How does a Perpetual cycle ensue if the Fed/Regulators etc. want a return to something new, but which brings about the result of the old cycle.? We have discarded the likelihood of the old cycle coming back to life after 17 Fed rate rises not only failed to stem the bubble, but a combination of either their amplification of money supply or

MORE LIKELY! A WHOLE NEW MONEY SUPPLY GENERATION CYCLIC MACHINERY INADVERTENTLY CREATED OUT OF THE U.S. PROPENSITY TO BORROW TO CONSUME FROM VIRTUALLY EVERY OTHER NATION ON EARTH.


If this is the case, there is a completely new set of players/machines at the helm! Even in the memory of some of the youngest is the parlous state of the rest of the world back in 1998. Now, in the aggregate, they have reserves over $5 Trillion. The Fed’s balance sheet of a paltry $1.8 Trillion shrinks in the shadow. The other new players, many of whom access greater or lesser parts of that $5 Trillions, the hedge funds at $1.3 Trillion (?) not including leverage, the private equity funds at much more than a trillion, depending on leverage and how you count or double count it, the mutual funds, still formidable at multi-trillions, even more if we throw in the money market funds, the investment banks having doubled into more than $3 Trillion.

All of these in the aggregate dwarf not only our fabled Fed but also the power of the rest of the central banks out there trying to realize they are operating in a different environment. (Remember though, those OTHER central banks are the guys with the $5 Trillion in reserves!). Talk about conundrum. Somewhere in here it is worth mentioning that the multiple needed to grow a dollar of GDP has moved from roughly 1-1 in the process to heading for $6 to 1 to produce the same dollar of GDP at the moment. Why and How? Credit Creation that is completely outside the traditional central bank/fractional reserve commercial bank/borrower mechanism that prevailed for such a long time.

Before getting into the details of how this phenomenon has come to pass, we would like to illustrate how fast this incredible world of non-bank credit creation is progressing. Yesterday, a financial executive I had mentioned CPDO’s to, e-mailed me asking what were CPPI’s. I had to profess ignorance and contacted a bunch of people smarter than me. I print below the amazing answer I received.

“Constant Proportion portfolio insurance (CPPI)”

Constant proportion portfolio insurance is a capital guarantee derivative security
that embeds a dynamic trading strategy in order to provide participation in the performance of a certain underlying asset. See also dynamic asset allocation. Note that the intuition behind the CPPI was adopted from the interest rate universe.

In order to be able to guarantee the capital investment, the option writer (option seller) needs to buy a zero coupon bond and use the proceeds to get the exposure he wants. While in the case of a bond + call case, the client would only get the remaining proceeds (or initial cushion) invested in an option, bought once and for all, the CPPI provides leverage through a multiplier. For example, say an investor has a $100 portfolio, a floor of $90 (price of the bond to guarantee his $100 at maturity) and a multiple of 5. Then on day 1, the writer will allocate 5 * ($100-90) = $50 to the risky asset and the remaining $50 to the riskless asset (The bond). The exposure will be changed as the asset performs and with leverage multiplied by 5 times the performance. (or vice versa). Same with the bond. These rules are predefined and agreed once and for all and for the life of the product. (All of the foregoing bad English from the writer of the definition not sender).

Two things stand out.
1. The CPPI is pretty much the same as the afore-mentioned CPDO except leverage can go up to 15x on the CPDO
2. The guys who re-invented the term portfolio insurance must have been in diapers (maybe still should be) in 1987 when portfolio insurance became a really dirty phrase!

All of this in aid of showing how complex the world of non-regulated credit creation has become. Another interesting statistic recently learned from a Financial Times article. Wall St/Hedge Funds etc. are proliferating Collateralized Debt Obligations or CDO’s. These are also fairly well known in the regulated Commercial/Investment Bank world inhabited by denizens like Citicorp. The regulated are in the Trillions. The Non-regulated-Private-Over the Counter- or basically opaque unknown CDO’s are also in the Trillions. Credit creation is truly beyond the ken of the world’s Central Banks.

How, in the opinion of the writer has all of this come to pass?
IF GIVEN THE OPPORTUNITY TO LEVERAGE WITH NO SKIN IN THE GAME (IF THE DEAL CRATERS, THE LENDER LOSES, YOU GO ON TO THE NEXT TRIUMPH/TRUMP?) AND INTEREST RATES GO TO A LEVEL WHERE THE MOST RAVENOUS OF LEVERAGE PLAERS (REAL ESTATE DEVELOPERS AND PRIVATE EQUITY, OR WHAT USED TO BE KNOWN AS LEVERAGED BUYOUT OPERATORS AFTER THEY ESCAPED THEIR PREVIOUS INVIDIOUS LABEL OF CONGLOMERATEURS) SLAVER AND DROOL , ENORMOUS AMOUNTS OF MONEY WILL BE BORROWED. THIS TIME, LOTS OF INGENIOUS DOCTORS OF PHILOSOPHY THOUGHT UP INCREDIBLE DEVICES TO BORROW OUTSIDE AS WELL AS INSIDE TRADITIONAL LENDING PARAMETERS!

When the now renowned Greenspan took interest rates to 0%, the horde was let loose. Pity the poor commercial banks and the GSE’s. They were in bad stead from the dot-com/telecom disaster and had to go into shipyard, opening the door for the Investment banks and the non-bank creations they had birthed to take off. The Brokers (Investment Banks) doubled and, as past readers know, the world of hedge funds, private equity funds, etf”s, venture capital and other non-regulated lending went wild. Since the successful, valiant effort of the hedge funds to face down the SEC on registration succeeded, there have only been estimations and gross numbers to give some idea of how much credit has been created out here in the unregulated world. In our previous missive, we came up with roughly 1½ times the amount to be found in the banking system or +/- $15 Trillion. That is only in the U.S. As we all know, numbers in much of the rest of the world are a flag of convenience rather than a certainty but that $5 Trillion in reserves from less than a trillion at the start of this run hints that the number must be at least the aggregate of the $25 Trillion combined in the U.S. before govt and agencies, if our hypotheses are anywhere in the ballpark.

All those who are research minded can go to the Bank for International Settlements website and get the numbers for the central banks scattered around the world. (Don’t put too much credence in the numbers of such worthies as Russia or China, much less Indonesia, but the sum total is truly dwarfed in any reasonable conclusion by the total non central bank balance sheets/credit out there in the non-regulated credit world. In terms of non-regulated U.S. credit (We are averse to using the word regulated even for the “commercial banks” in much of the rest of the planet) added to what we will, in the absence of the word “regulated” call “credit set loose by U.S. current account deficit,” in pools of Greed or ”CSLUSCAD” CREDIT, we have credit creation of humongous proportions. Recurrent rate raises by adventurous central banks in other parts of the world have had about the same effect in “CONTRACTING” money supply as has been the case so far in the U.S. That answer being slim to none and Slim went over the horizon.

To digress for a moment we look at the housing market in London. They raised rates there for a while and actually slightly slowed the housing bubble. Then they thought they had done enough. The creators of non-regulated credit are as ingenious (maybe more so) as the Wall St. creation machine and house prices began another precipitous ascent. They are raising rates again and house prices are going up even faster. CSLUSCAD credit is the answer to any pesky central bank that thinks it can get in the way of a Pool of Greed in full flight. Norway is sticking its neck out as the last unemployed Norwegian found two jobs and that Central bank actually thinks it should be responsible in monetary policy. Result so far, the Norwegian price index continues up led by housing prices.

A few weeks ago, we were privileged to hear a conference call by Larry Jeddlow of the TIS Group, Inc. that included slides he sent of the presentation. His thesis: “Investment Banks/Hedge Funds vs. Central Banks.” His conclusion: during the fall months, the central banks of the world were warning the CSLUSCAD crowd that they had gone too far in their headlong rush to lend; more recently (February/March) the warnings had gotten stronger. Therefore, credit/money (See the “Moneyness of Credit” by David Tice) growth was finally going to slow. There were actually a couple of mild warnings stuck in there by various Fed Presidents and Governors. Result, we have a Dow one day slide and Bernanke replays Greenspan’s 1987 performance (subtly), at least giving the CSLUSCAD crowd the “certainty” the Fed “PUT” is still in full force and effect. KKR is going to buy FirstData with no partners proving that those pesky investigators worried about collusion in the CSLUSCAD crowd are way off the mark. One possibility put forward in the aforementioned TIS Group presentation was “Property Derivatives.” While yet in their infancy, we actually found a four bank consortium writing a multi-hundred million play. Since the commercial property market dwarfs the commercial bond area that the CSLUSCAD players had run up to a reported $10 Trillion here in the U.S., the question we have been asking ourselves on where can a tens of trillions market be found to propagate the next bubble may have found an answer. Not at Sam Zell cap rates, however, as even the ridiculous spreads currently being accepted wouldn’t cut it in this proposed game. Who knows, this writer has been wrong before. If the private equity boys all go public, this kind of cash return on stocks is more the norm than the exception.

Continues at a frantic pace. The 4th Quarter Federal Reserve Z1 report is another clear indication that debt growth in the U.S continues at a frantic pace. Total Credit Market Borrowings running at an annualized rate of $3,567,000,000,000 (That is what it looks like in numbers instead of abbreviated Trillions. The admittedly slowing housing market cut back mortgage credit by several hundred billion but the U.S. CSLUSCAD more than made up the difference. (A decision on how to pronounce this newly created acronym is to leave the first S silent thus producing CLOOSCAD for anyone who wants to adopt it.)

What, if anything, will slow, halt or reverse this juggernaut (old name for battleship)? This observer, guided by mentors such as Doug Noland has resisted premature pronouncement of the end but is willing to hypothesize as such can always be dismissed as musings rather than predictions.

We are willing to agree with some rather astute financial analysts who have recently observed that the Credit Cycle (old version) has turned. The 1stData deal says the CSLUSCAD bunch are still at it. It is fairly evident from the slaughter in the world of sub-prime that the most egregious of “throughput” credit created by the alchemists on the Street has struck both the rock and the hard place. Early on the “throughput” crowd looked as though they might provide their own version of the Greenspan “Put” for this, their offspring but the wizened regulated banks seemed to have pulled that plug. Bubblevision or CNBC was just this morning babbling on about danger in the Alt A arena. M&T bank that thought it had found a niche there is looking at a New Century like hit for the day.

Another astute analyst we follow is fairly certain of a 2008 recession. Again, we are in agreement, at least for the United States. Happening to live in a state with the 2nd most ridiculous run-up in house prices over the last few years (California taking the crown in that race), we were perusing what goes for a local paper these days this morning. Even forewarned by our bear persuasion, we were still stunned by some data therein. Miami/Dade residents at the peak in 2005 extracted over 17% of their income from either home equity facilities or refinance/cashout mortgages. It was still running at 14.5% in the fourth quarter of 2006. While the average for the country peaked at about 10% in 2005 (Over $1 Trillion AND IS STILL HANGING IN THE 8.5% RANGE, ABOUT $900 BILLION+, THE PROFLIGACY IN south Florida has been amazing. With Chavez sending us floods of Venezuelans and the euro sending plenty of buyers from those countries, the real estate boom is lasting longer than anyone expected. Sign that the cycle has turned in the region, however, houses listed for sale doubled in the last year. One condo with 10 foot barbed wire fence ¾ of the way up 40 stories. Razor wire on top and dilapidated sign saying “All permits in place, for sale as is”. 48 cranes on the horizon in the Biscayne corridor. The ultimate end of the cycle will not be pretty.
Have an immediate relative who has found a nice business in the Florida keys. It isn’t worth it to an attorney in Key West to spend a day and 350 miles filing a chapter in Miami. Better to introduce the client to an attorney from Miami who can spend a day and file in a bunch. Business is booming. The papers are full of cruise ship ads offering deals. Like airlines, cruise ship guys have to order way in advance and capacity can quickly exceed demand. Even got an upgrade on a recent flight packed last year with spring-breakers. All this anecdotal.

Facts: C&I loan growth peaked at over 15% in mid 2006; now at 12.9%. Quarterly change in C&I loans March 2006-up $46 Billion, September $24 Billion. Mortgages in 2005, over $1.4 Trillion, 2006, just over $ 1 trillion. So, both consumer and C&I seem to have peaked. CRE is a subset of C&I and usually worse than C&I overall, both in the excesses and the whiplash when the cycle turns. Think about it; if the mortgage game based on refi/cashout and home equity lending really turns, a trillion could come out of income. Extreme to this generation’s thinkers but not beyond the realm of possibility. Home equity lending in the first quarter as measured by Asset Backed Securities issuance, is down some 35% so far this year. Conundrum: Year to date CDO issuance is running 38% ahead of last year.

WHAT ARE THEY PUTTING IN THESE THINGS AND WHO IS BUYING THEM AT THIS POINT IN THE CREDIT CYCLE? THE CSLUSCAD BOYS REALLY HAVE IMAGINATION!


All right, some data points which to this observer says the “old” credit cycle has turned. The conventional, regulated lenders are getting whatever mixed message the Fed less Bernanke seem to be sending out and the OCC is pretty clear that, particularly in CRE where they have been before, they want to dampen enthusiasm.

SO!THE ONE NECESSARY INGREDIENT FOR A CONTRACTION IN CREDIT(MONEY) CREATION IS STARTING TO HAPPEN IN THE REGULATED, CONVENTIONAL CREDIT CREATION MECHANISMS. !EXPLAIN THE 38% YEAR OVER YEAR GROWTH IN CDO’S! !EXPLAIN THE FIRST DATA ACQUISITION WITH THE CHUTZPAH TO GO IT ALONE ON KKR’S PART? THE ONE NECESSARY INGREDIENT THAT WE FORGOT TO MENTION ABOVE IS FEAR AND THAT IS OBVIOUSLY STARTING TO BUILD IN THE REGULATED, CONVENTIONAL CREDIT CREATORS BUT THE CSLUSCAD BOYS ARE APPARENTLY FEARLESS!

While our observations are agreeing with the TIS Group that the central banks around the globe and that the U.S. regulators (At least some of them) are starting to think that a dose of caution may need to be administered; is there a mechanism in place to enforce it with the CSLUSCAD gang?

At least so far in 2007, they seem to be ignoring any warnings. I am grateful to Doug Noland for having captured the following from the last week illustrating this.

1. Global debt issuance rose to $1.73 Trillion in the 1st quarter
2. Global mergers and acquisitions reached $1.130 Trillion, the busiest 1st quarter on record. The boom, driven by buy-out fever etc. rose 14% from the previous year’s record.
3. U.S. merger activity surged 21% in value year over year in the 1st quarter.
4. 1st quarter merger activity in the U.S. totaled $428 billion up from 2006’s record $352 billion.
5. U.S. companies sold $38.6 billion in high yield in the quarter, up from $29 billion the previous year.

NONE OF THE ABOVE SUGGESTS ANY FEAR OF CENTRAL BANKS IN THE CSLUSCAD GANG IN THE QUARTER AND, UNTIL SOMETHING OR SOME EVENT INSTILLS SOME FEAR INTO THIS TOTALLY FREE TO ROAM PARTY OF HIGH ROLLING DEAL MAKERS DRIVEN BY FEE INCOME AND BONUSES SUFFICIENT TO LEAD TO BELIEF IN INVINCIBILITY, LIQUIDITY/MONEY/WAMPUM OR WHATEVER THE ECONOMISTS WANT TO CALL IT WILL GROW AT THE 12% RATE IN THE U.S..; THE TEENS RATE IN EUROPE AND THE RIDICULOUS 20’S, 30’S AND EVEN 40 % RATES SEEN THROUGHOUT THE GLOBE.

Will inflation grow? According to John Williams of Shadow Government statistics, it already is in double figures. With rents being the owner equivalent rental income input for the Commerce Dept. it is even growing in the official statistics. Will the Fed raise rates to stop it? Who cares, we are funded in yen anyhow, so the long end of the curve is dependent on the Japanese Central Bank, a pillar of strength. Will a recession occur? Almost certainly and it will truly be a CONUNDRUM for Helicopter Ben as any cut while “Old Europe” continues to raise rates may avalanche the dollar. Sad to say, to use the Oriental sense of the word. “We live in interesting times!”

The Short Selling Bear...

Who Would Believe
by Doug Wakefield

Doug Wakefield is the president of Best Minds, Inc., a Registered Investment Advisor, and editor of the monthly newsletter The Investors Mind: Anticipating Trends through the Lens of History and author of Riders on the Storm: Short Selling in Contrary Winds. The following article was co-written with Ben Hill.


On January 2nd of 1900, the Dow Jones Industrial Average closed at 68. If you had told those living at that time that in one generation Americans would be driving automobiles and that the world would be looking back on a war in which the Allied Forces consumed 12,000 barrels of oil a day, who would have believed you? On September 3rd of 1929, the Dow closed at 381. If you had told those living at that time that on July 6th of 1932, the Dow would close at 44 – lower than its value on January 2nd of 1900 – who would have believed you?

After hitting 991 in January of 1966, thirteen years later, in August of 1979, the Dow closed at 885, and Business Week wrote a piece titled, “The Death of Equities.” If you had told those living at that time that the next generation would be surfing the web from their personal computers, who would have believed you? Who would have believed that median US home prices would go from $64,000, in 1979, to $257,000, in March of 2006?

On February 20th, 2007, the Dow closed at an all time high of 12,786. One week later, the Dow saw its worst one-day loss in 7 years (outside of 9/11). So, was February 27th a worldwide wakeup call for investors or just one more bump on the road to higher markets? While we wait to see what happens, we must contend with the fact that, collectively, we have a poor track record of foreseeing substantial changes in the future. Time and again, history shows the circumstances that have led to manias and the attendant aftermath of these episodes. In fact, the record is so replete, that we must consider how large of a role denial has played in financial history. The headlines and media coverage after Tuesday, February 27th, only serve to exemplify this trend.

In 2005, I dedicated five months to a topic that I think will be a historically significant in the near future and in generations to come. Though it has been around since the 1640s, little has been written on this topic. And, while many institutional players have had access to this tool through the hedge fund world, few people actually understand its value to investors. The topic? Short selling.

As recent events have caused some to consider the possibility that markets have a downside, I’ve decided to take this opportunity to revisit one of the managers that I interviewed for Riders on the Storm: Short Selling in Contrary Winds. As attested to by the Strunk Short Index, Robert B. Lang, Chairman and CEO of Lang Asset Management, is one of seven dedicated short-only managers in the US at this time.

I recently had the opportunity to ask Mr. Lang the following three questions:

Doug – Bob, dedicated short-sellers are extremely rare in our financial markets. Can you share some of your background and perhaps some of the experiences that led you to establish a short-only strategy?

Bob – I started in the business in 1959, have managed portfolios since 1964, and started my own firm in 1980.

I remember when the markets were bottoming in the mid 70s… I remember calling prospects and telling them P/E (price-to-earnings) ratios were down to 7 or 8, dividend yields were better than 6 percent, and that the market had likely bottomed so I thought it was a good time to start buying. There was absolutely no interest. Most people responded with something to the effect of, “I don’t want to touch the stock market. All its good for is losing people money.” Well, times have certainly changed.

Though, I have historically operated on the long side of the markets, during the latter part of the 1990s, I could tell that the activities on Wall Street were becoming much more speculative. Security analysts were no longer performing their traditional roles as independent thinkers. They would just take the information given to them by the companies they covered and parrot it. Also, since they had been given a boatload of options, many corporate executives were primarily interested in hyping their stock by making overly-optimistic predictions. To boost performances, mutual funds acted in ways that were not in the best interest of their fundholders. In short, Wall Street lost its way in a bullish tsunami. Since I had experienced multiple investment cycles and had witnessed how investors swing from greed to fear, it became apparent that a significant opportunity was developing for contrarians. That is, it was time to move to the short side of the markets.

Of course, since we are all products of our experience, and since most participants have only experienced stocks going up, a bearish view was, and is, extremely unpopular. Only a handful of investors understand the bigger picture. Stocks are subject to cycles.That is why long-term cycles occur.That is, one generation grows up with the understanding that stocks always rise. Finally, the market declines and a lot of people get hurt and the next generation look at stocks with contempt. So unless an individual investor is made aware of this pattern, they are inclined to go along with the current prevailing opinion. After the fact, that is once a decline unfolds, that decline becomes obvious in hindsight. But until then, most find it extremely difficult to “fight the crowd.”

Doug – Since most investors have no experience with short selling, can you give us some basic lessons on how short selling works?

Bob – Most investors buy stocks hoping that the price will rise.But short sellers, like Lang Asset Management, Inc, anticipate making a profit from declining prices.Expecting a drop in price, we sell the stock, and buy it back later at a lower price. The difference is our profit.
The natural question is: how can you sell a stock that you do not own?When you sell a stock short, the broker lends you the shares from a buyer, who previously approved such an arrangement.Later, when you buy the stock back (otherwise called covering), the broker returns the shares to the buyer, and all is settled.For example, you believe XYZ Corporation stock price is too high, so you instruct your broker to sell short 100 shares at $50. The broker borrows 100 shares from another account and “delivers” them to you, the short seller. As a short seller, you immediately sell the borrowed 100 shares at $50 per share, and $5,000, the proceeds from the sale, is credited to your account. If the stock were to fall to $30 a share, you might then decide to buy the 100 shares you borrowed back for a total of $3,000. You return the borrowed shares to the broker, and you make a $2,000 profit.

Of course the stock may go up instead of down. Suppose it goes to $60, and you decide to purchase in order to minimize your losses.You buy the shares back, and you have lost $1,000 ($5000-$6000). The net result is not all that different from a situation where you had bought the stock at $60 and watched it decline to $50.
Unless the broker “calls” the stock back because he must return the borrowed shares to the owner for some reason, there is no limit on the amount of time you may remain short. But, having a stock called away is a highly unusual situation which usually only occurs with stocks that have a low level of liquidity.There are a few stocks that the broker cannot obtain, and in such cases, you may not short that particular stock.

There are only a very few pure short sellers, probably measured in the single digits, versus many thousands of mutual funds and hedge funds.In my opinion, this endeavor requires a special aptitude, which is not easily transferable from the long side (without considerable experience).

Doug – How does the client benefit?

Bob – The same way one benefits if a stock rises. Most investors buy stocks hoping they will increase. The short seller makes a profit when the stock declines.When an overvalued market turns down, by definition most stocks decline, and portfolios that are short, increase in value. So, not only does the client not lose money, but by implementing this “hedging” strategy, he or she actually profits.Typically, as a measure of diversification, short selling is only done with a portion of a client's total assets.

Doug – Bob, I’d just like to thank you for taking the time to share your experience and knowledge with us today.
Unfortunately, millions of investors will never heed the words of Bob Lang or an article like this one. They continue to see warnings in their everyday lives, but take comfort in the fact that their friends and advisors are all doing the same thing. They ignore reality and trust theories that have worked well (for the last 3 decades) in an ever-expanding sea of credit. So why do most individuals, maybe even those reading this article, never take steps to protect their capital from a bear market?
In answering this question, I turn to a professor of geology at UCLA. As an evolutionary biologist, biogeographer, and Pulitzer Prize winning author, Dr. Jared Diamond addresses the “it can’t break” mindset in a story about individuals who live below a dam.

According to Diamond, attitude pollsters ask people who live downstream from the dam how concerned they are about the possibility of the dam bursting. Naturally, those that live further away from the dam are less concerned about the dam breaking that those that live closer to it. But shockingly, from a few miles below the dam, where one would assume the fear would be the greatest, as we approach the dam, the concern about the dam breaking falls off to zero. Why? Diamond notes that those that live closest to the dam, who are sure to drown if the dam breaks, must believe that the dam couldn’t break in order to preserve their own sanity. This ability to suppress or deny thoughts that cause us great pain is known as psychological denial. Diamond suggests that this behavior, common to individuals, could apply to groups as well.
The only way that investors will be able to take constructive financial steps before this credit cycle contracts, is to step outside of the powerful forces of the herd. From here, they can begin to address the unpleasant reality of that which is currently unfoldingand how we got here. Denial will only lead to unnecessary losses and increased pain.

Derivatives Bring Drama to Davos...

Derivatives bring drama to Davos
By Gillian Tett

Published: February 1 2007 02:00 | Last updated: February 1 2007 02:00

As Stephen Roach, chief economist at Morgan Stan-ley, moved around the debates on the world economy in Davos last week, he admitted that some of the discussions were distinctly bland. With the world economy growing steadily, de-bates about big economic themes lacked real drama.

However, in one area there was a raging debate: the role that the fast-growing derivatives sector may, or may not, be playing in distorting the cost of credit.

"We have just had a pretty lively discussion," Mr Roach said at a lunch to examine derivatives, attended by senior policy officials, economists and financiers. "In fact, this has probably been the fiercest argument I have had in Davos."

A cynic may suggest this reflects the fact that the global economy is so benign that policymakers now have the "luxury" of worrying about financial markets and esoteric instruments, as John Lipsky, the first managing director of the Internal Monetary Fund, put it.

Nevertheless, the focus on structured products does mark something of a departure for the Davos group, given that these issues have generally been ignored in previous years. The public and private meetings re-vealed sharp disagreement about three key points.

The first is whether regulators needed to worry about the fact that the structured finance and derivatives world is often opaque, particularly given the dominant role of unregulated hedge funds.

Optimists say this lack of transparency need not matter, since counterparties handling derivatives - such as investment banks - have a high incentive to monitor risks.

After all, as Andrew Crockett, now president of JPMorgan International and former head of the Bank for International Settlements, pointed out, investment banks do not want to suffer devastating losses.

However, pessimists poin-ted out that these banks were competing with one another to win business. Consequently, some banks "could be facing pressure to let their standards slip", as one regulator said.

Worse, the competitive climate may mean that banks lack the tools and the time correctly to monitor hedge funds - particularly since the instruments these funds are using can be opaque. That "makes it hard to see how much leverage is in the system", one policymaker said.

A second point of debate concerned the degree to which new products are dispersing risk across the financial system. In theory, senior officials pointed out, the proliferation of structured products should mean that credit risks were spread across a host of investors. Since this enabled investors to diversify their own risks, credit shocks could be absorbed easily.

But some policymakers suspect that banks might be re-acquiring risk via the back door because their investment arms are buying repackaged risk products or lending to hedge funds. "Banks have offloaded so many of their risks through hedge funds," said Michael Klein, co-head of investment banking at Citigroup. "But hedge funds have given some of this risk back."

While risk dispersal has helped the system weather shocks so far this decade, some policymakers fear that if a really big crisis were to hit, this dispersal might create a "contagion" effect. That could make a crisis worse, one regulator said.

But the third, related issue was how regulators should respond. Some observers said that policymakers needed to impose more oversight on hedge funds, private equity groups and over-the-counter markets. But others argued that this would be undesirable and impractical.

Meanwhile, the issue of legal authority poses a dilemma, as Stanley Fischer, governor of Israel's central bank, noted. For while banks such as the US Federal Reserve managed to quell the crisis at Long Term Capital Management in 1998, markets are now so international in scale that they cannot easily be controlled by any single authority. That made it hard to gather data in the short term but it also made unclear who had res-ponsibility for the system in a crisis, Mr Fischer said.

Policymakers are trying to deal with this in the Financial Stability Forum, a committee attached to the BIS.

"Every second month we meet in Basel and that is something which creates comfort for us," Jean- Claude Trichet, head of the European Central Bank, said.

One key point on which there was consensus was that more needed to be done.

Howard Davies, former head of the Financial Services Authority and now an academic, said: "We all know that the reality of the financial markets is that risk is being parcelled up and paced around. But international regulatory architecture is still organised as if the world had not changed. As a result, we have a regulatory architecture designed for a bygone age."