Wednesday, May 21, 2008

A Conservative For Obama

I really enjoy it when I find honest conservatives, linking sincere market analysis to Obama's ideas, of a better way forward. There's still a little hope for us that more will discover the merits of Hyman Minsky's Heinz 57 capitalism's truly fundamental, and profound, yet simple, analyses...
Other great links to Minsky ideas, and others promoting them: Pimco
Pimco Archives
JPRI, Marshall Auerback
Here's another important paper, from the BIS, everyone should read; "A History of Deflation": Link
Here's an eye opening warning from Sybil...

Government Failed, Not The Market

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

As commentators have come to realize the depth of the economic mess in which the United States is now mired, an increasingly loud theme of their wailings is that the free market has failed, so that we need more government regulation and state control. One expects the Democratic Presidential candidates to take this view (though Barack Obama is mercifully mild on the subject) but we hear it also from John McCain, nominally a Republican. The truth is quite the opposite: the free market has not failed, in the US over the last few decades it was never properly tried. Time after time, bedrock principles of a free market economy have been violated by the corrupt and overblown US government.

The most fundamental way in which free market principles have been violated, central to the entire course of the US economy over the last 13 years, is monetary policy. Economic theory is based on money, the unit of measurement, being fixed in value so that its fluctuations do not affect purchase and sale decisions. It is well known that in the Weimar Republic hyperinflation of 1923 or the Latin American periodic hyperinflations, the economic system does not work properly, because price signals are not properly transmitted through the monetary mechanism and consumers are forced to modify their behavior to take account of the quirks in money. The average apartment-dwelling German consumer of 1923 did not intrinsically need a wheelbarrow, but was forced to buy one anyway to carry his money if he wanted to go shopping, since Diners Club had not yet invented the credit card.

In the United States since 1995, the Federal Reserve has increased the broad money supply -- whether measured by M3, disgracefully discontinued by the Fed in March 2006, or by the St Louis Fed’s Money of Zero Maturity (MZM) -- almost 4% per annum faster than the growth rate of nominal GDP. The true potential increase in money-generated activity may well have been somewhat greater than that, because new and more efficient payment mechanisms, PayPal and the like, have been introduced during that 13 year period – thus one would expect the velocity of money, its ability to generate economic activity, to have increased. This money supply increase was wholly artificial, generated by actions of government, notably former Fed Chairman Alan Greenspan’s bizarre 1993 decision to cease targeting the money supply in forming monetary policy. It had nothing whatever to do with the market.

Wall Street, the Fed and the Clinton and Bush administrations would claim that, since inflation has been modest during the period, the market’s price mechanism has not been distorted and no harm has been done. But that is of course unmitigated twaddle. Because of global outsourcing through the Internet and modern telecoms, consumer prices have not risen much (though more than is admitted by the Bureau of Labor Statistics, more on which later) but we have been subjected to a series of asset bubbles. First stocks soared in the late 1990s to levels entirely unjustifiable on any reasonable valuation mechanism, with even the Dow Jones Index of 2000 being more than double its proper level. That had happened previously in history, in 1929 in the United States (though 1929’s overvaluation was less egregious) and in 1989-90 in Japan; in both cases it had resulted in a severe economic downturn, the one unprecedented in its depth, the other unprecedented in its duration.

In the US after 2000, the solution was to expand the money supply still further, overriding the market’s natural deflationary corrective mechanisms by forcing real interest rates down to well below zero. That, allied to the “creativity” of the housing finance sector produced a boom in housing that was unprecedented in the United States. When that in turn led to disaster, the Fed over-expanded money supply yet again, and produced a commodity bubble that has pushed the oil price up by 50% in eight months, and is now threatening the entire fabric of the world economy, as well as potentially starving millions of the Third World’s impoverished. While the poor may starve, the rich, either asset owners or, as on Wall Street and in corporate top management, asset manipulators, have done very well indeed from cheap money – much better than they should have done in a truly free market.

These three highly damaging excesses, the stock bubble, the housing bubble and the commodities bubble, all utilized the mechanisms of the free market, but their underlying cause was a government policy: the Fed’s excessive monetary expansion over a 13 year period. Since Jean-Claude Trichet took over the European Central Bank from Wim Duisenberg in late 2003, the ECB has joined in excessive expansionism, pushing euro M3 up by 8.3% annually compared with a 4.3% annual rise in nominal eurozone GDP, the same 4% annual excess of monetary expansion as in the United States. The Bank of Japan, the People’s Bank of China and the Reserve Bank of India have also pursued excessively expansionary monetary policies. International reserves of foreign exchange increased by almost 17% per annum in the decade to December 2007, almost treble the increase in nominal global GDP. The current global inflation was thus inevitable; it is likely to get substantially worse.

The excesses of the housing bubble and the especially damaging nature of the subsequent housing finance collapse were also due to government, in this case misguided regulation. Fannie Mae and Freddie Mac, those tottering behemoths of the housing finance market, should not exist in a free market system. Their superfluous quasi-government guarantees of housing finance led to the advent of securitization, a pernicious Wall Street product that separated the origination of home loans from their ownership. The interest rate ceilings of the 1970s, followed by the partial cack-handed deregulation of the sector in the 1980s, led to the collapse of the savings and loans, destroying the local system of housing finance that has worked well in other countries and worked perfectly adequately in the US before the 1970s. However it was bank capital regulations, and the loophole that allowed banks to create minimally capitalized special purpose vehicles to hold securitized home mortgages, that produced the subprime bonanza and subsequent collapse. Again, all were actions of government, to which the free market simply reacted.

As an indication that the innovations in housing finance were not driven by a true free market, the cost of home loans increased from an average of 108 basis points above 20 year mortgages in 1972-78 to 122 points above that average in 2000-06. If an innovation increases the price of a product to the consumer, we can be certain that the innovation, like the CAFÉ automobile fuel economy standards of the 1980s, was directed by government, not the market.

To operate properly, the modern free market needs accurate economic statistics. Before 1900, the economy operated satisfactorily without such statistics, though swings in the business cycle were more extreme since planning for inventory and capital expenditure was more difficult. Lack of statistics thus has a cost, but only a moderate one. Much larger than the cost of no statistics, however, is the cost of inaccurate statistics that are nevertheless regarded by the market as credible. Those can produce distortions lasting many years, including excessive consumption and excessive asset price inflation. The short term effect of dishonest statistics may be positive, like that of embezzlement (which increases GDP through the multiplier effect until the victim discovers his loss.) However the long term effect in destruction of both value and confidence is far greater and more prolonged; indeed in some respects it may be permanent.

We can thus blame the government for significant economic distortion over the last decade, through its falsification of inflation figures. The Boskin Commission of 1996 allowed the government to “adjust” inflation figures by taking account of “hedonic” effects, by which supposedly products improved in quality in ways not captured by inflation calculations. The example always given was the tech sector, in which processing power doubled every 18 months. Thus following Boskin US price indices were adjusted to take account of that doubling, being rebased every year in order to take account of each subsequent year’s progress in processor power. There are three problems with this. First, doubling processor power does not anything like double the benefit one gets from a computer; the computers of today are at most twice as “hedonic” as those of 1998, not 64 times as hedonic as predicted by their increase in processing power. Second, the annual rebalancing allows the price benefits in the tech sector to be repeated every year, as though computers were now available for $5. Third, the Boskin methodology took no account of the costs imposed on consumers through technology, for example the negative hedonic effect of automated telephone help lines, which appear deliberately designed to maximize the time wasted and minimize the probability of getting the consumer’s problem solved.

(As an aside, US taxpayers and the economy generally dodged a bullet when the Presidential candidacy of former New York mayor Rudy Giuliani collapsed. Not only was his chief foreign policy advisor Norman Podhoretz, author of “World War IV – the long global struggle against Islamofascism” -- think for a moment of the budgetary effect of that approach to security policy -- but his chief economic advisor was Michael Boskin. Phew!)

The Boskinized price indices are thus downward biased, probably by about 0.8%-1% per annum, thus saving the government trillions of dollars on social security payments for the unfortunate elderly. As well as ripping off old folk, this has caused a number of distortions. Since nominal GDP is known, real GDP growth rates are distorted upwards by the same amount as price indices are distorted downwards. Likewise, productivity growth figures are also distorted upwards – the “productivity miracle” relied upon by Fed Chairman Alan Greenspan for his misguided monetary policy was a mere statistical fiction. With such distortion it is little wonder that the voting public has come to suspect published economic growth figures, or to assume that even more of such growth has gone to “the rich” than is actually the case.

The price index distortion has since January 2008 grown even worse, through the use (or more probably misuse) of seasonal adjustments, by which “unadjusted” price indices are smoothed for seasonal effects, providing a supposedly more accurate picture of consumer price inflation. Such seasonal adjustments are ignored in setting social security and bond indexation – there is thus no further cash fraud against the public. However adjustments have been used to produce spuriously low consumer price inflation figures, certainly in March and April 2008, thus propping up the stock market and appearing to justify the Fed in its manic loosening of monetary policy.

March’s consumer price index was adjusted down by 0.6%, from 0.9% to 0.3%, while April’s was adjusted down by 0.4%, from 0.6% to 0.2% -- both “adjusted” figures were greeted by the stock market with a sharp upward move. In the ten years to 2007, no seasonal adjustment has ever exceeded 0.3%, plus or minus; the probabilities that the March and April seasonal adjustments were randomly arrived at by the same method as those of the last decade were thus 0.18% and 2.3% respectively (so the probability of two such anomalies in successive months was 0.0041%, about 1 in 25,000.) If the raw March and April figures are adjusted by the average March and April seasonal adjustments of the last decade, consumer price inflation in those two months averaged 7.4% per annum. Needless to say, neither the bond market, where 10-year Treasuries yield 3.9%, nor the stock market, within 10% of its overblown all-time high, comes close to reflecting this. Again, the losses and poor investment decisions caused by this massively false market are due to the government, not market failure.

There are many other “market failures” which are in reality due to government manipulation. Real wage rates for low-skill US employees have dropped sharply in the last 30 years, primarily due not to globalization and free trade but to government’s failure to enforce immigration laws, which has led to excessive low-cost illegal immigrant wage competition. The shortage of graduate engineers is due to the H1B visa program, which lets in floods of engineers but not lawyers – so the average earnings of a young graduate lawyer are more than twice those of an equivalently qualified young graduate engineer. Distortions in agriculture policy are notoriously the result of government meddling, reportedly about to get worse with the new $300 billion farm bill. (It is however not true that all of the world’s high food prices are caused by US ethanol subsidies – an even more important cause is excessively lax US and global monetary policy.) The number of lobbyists in Washington has more than doubled since 2000 – so consequently has the level of wasteful earmarks and destructive special interest legislation. McCain’s “cap and trade” environment proposal would open up a huge new arena for government favor-shopping – and do almost nothing to reduce carbon emissions, even were such a reduction desirable (Obama’s proposal is somewhat more market-oriented.)

Don’t let anybody tell you in this election season that the “market has failed.” In the United States since about 1995, it has never been allowed to operate properly.

Wednesday, May 14, 2008

The Strange Tale of the Bare-Bottomed King

I am re-posting this tale from Pimco's Bill Gross, to show you how correct the bears, have been all along. The article's forcast was and is right on. Check it out, and be sure to read the post of Auerback and Dialynas, I posted yesterday. They're on the money. It's going to be a very interesting world, when the "Bears" will be, or are, required to re-educate the "Bulls."

Bill Gross
The Strange Tale of the Bare-Bottomed King

They say never sell America short and with good reason. Any country whose equity market has been able to crank out 6.8% real returns annually over the past century stands as a formidable obstacle for any speculator willing to bet the “don’t come” line. The odds of winning a long-term wager laid against the U.S. “house” have been about as bad as heading out to the track and betting on your favorite color of jockey silks. Even when the bear gets his facts right, the timing and the wait often spell his doom; the “house” has more chips, especially a house with reserve currency status like the U.S., so a wager must be done prudently in order to conserve capital for that prospective rainy day.

Our recent PIMCO Secular Forum, held over a 3-day period in mid-May, discussed this cautionary and historical framework within the context of a U.S./global economy that clearly had begun to resemble a casino, but nonetheless appeared to have ample chips or reserves to keep the game going for awhile. Speakers such as Michael Dooley, conceptualizer of the current Bretton Woods II arrangement, and Jonathan Wilmot of CSFB, presented their bullish and in some cases bearish arguments for economic growth and investment returns over the next 3-5 years. Over 100 PIMCO professionals actively participated in the discussions and decision-making, which by its heritage has a long-term secular orientation. In the end, while the gambling metaphor and betting against the house advice was more than apropos, we chose instead to weave our tale around the story of the Emperor who had no clothes and the solitary boy who in his innocence cried out that this sovereign was indeed – naked. Not wanting to sell America short just yet however, and being mindful of our country’s dynamic past and the lessons that its history inevitably has taught wayward doubters, we decided to modify the parable just a tad. We agreed that the U.S. was indeed King of the World and was indeed outfitted in a grand set of clothes. Biggest economy, most powerful military, best universities, highly productive, freest capital markets, bearer of the world’s reserve currency status – these are all characteristics that describe our current King, and any little boy or bear who shouts that they can’t see them is close to blind. So our monarch has some spiffy threads indeed. Still, after analyzing not only the U.S. in 2005, but the global kingdom that it rules, we had legitimate concerns as to how well those threads were put together. They look good, but can they hang tight without shredding during a storm, or will they come undone, leaving our ruler bare-bottomed in the wind? The answer, we decided, was dependent on the quality of the cloth and its stitchery – how well they were put together – and of course, the probability of a storm epitomized in our cartoon by the terrier of Coppertone fame. But lest we give too much away in this reality–show fairytale let us recap the past and begin as they say at the beginning.

Secular Review and Current Update

One day sometime in the early 21st century, there was a global economy that was growing at what appeared to be a decent enough rate but which was suffering from a strange malady – something economists describe as a lack of “aggregate demand” – in essence an inability to make use of available global capacity to produce. Now that was a condition that most citizens could hardly comprehend because mankind’s desires/demands appear to forever be insatiable. We always want more of everything so how could there ever be a lack of “aggregate demand” in this magic kingdom? The historical textbook example of this malady probably first appeared during the depression of the 1930s when what Keynes labeled as capitalism’s “animal spirits” were so dampened that corporations and consumers sat out the dance, preferring to hide their money in a mattress instead of risking it in a transaction during a deflationary spiral. In their place, government became the buyer of last resort. The world’s most recent example has unfolded in Japan over the past decade, but scores of other instances now abound centering around either 1) mercantilistic or 2) demographic secular influences. The mercantilistic draining of global demand has its most recent origins in the Asian crisis of nearly a decade past when South Korea, Malaysia, and others left themselves exposed to the seemingly whimsical liquidity injections – then withdrawals – of global bankers and investors. Whispered vows of “never again” placed an increasing emphasis on exports/production as opposed to imports/consumption and the result was massive increases in Asian and selected emerging country reserves as the U.S. current account deficit helped build the war chests shown in Chart I.

“If you don’t have enough reserves it can cost you a lot. We learned that (in the late 90s),” ex-Korean official Hong-choo Hyun warned recently. Asia’s mattress in the past few years, then, has taken the form of massive recycling of reserve surpluses into U.S. Treasuries instead of reinvestment in infrastructure or government sponsored business ventures. To make this arrangement possible, a fixed currency in China and “dirty floating” currencies in the bulk of Asia have mirrored an image reminiscent of the Bretton Woods era of reserve management during which the U.S. dollar was fixed to gold and the remaining currencies were fixed to the dollar. Our new arrangement is being labeled Bretton Woods II even though the dollar no longer has any such anchor and currencies such as the Euro are free to float. China itself is expected to institute a freely floating currency within the context of existing WTO plans during the next 3-5 years, but for now, BWII and its currency fix is standard operating procedure.

Supporters of this process such as Forum speaker Dooley, argue that its informal yet semi-regulated structure is helping to generate sufficient global demand for goods and services by flowing money from those countries that want to produce (Asia) to countries that still want to spend (the U.S.), and they have a point. Yet to focus on currently attractive global growth rates under the umbrella of Bretton Woods II misses the broader and overarching point. The global economy needs more consumers, but because of prior financial crises and advancing demographic influences that focus on savings for retirement, shown in Chart II, the primary willing spenders reside in the U.S.

Newly prosperous emerging market countries are the world’s natural deficit countries – instead they are building surplus reserves. Together this combination of American shoppers and Asian/emerging market/European savers are exchanging dollars, and goods and services in what for now appears to be an OK arrangement for both parties. But because it is so consumption one-sided, there are risks – increasing risks – that this apparent equilibrium is rather unstable and may at some point tip over. Unless Asia and Europe can join the consumption party, there may come a time when the U.S. Viagra wears off. Because of Bretton Woods II, the recycling of reserves into U.S. Treasuries has allowed Americans to finance their imports at exceedingly attractive interest rates. Yields on U.S. Treasuries and corporates may be as much as 100 basis points below prior equilibrium levels, so if the U.S. is King, then we undoubtedly have purchased for ourselves a fine set of clothes on cheap credit. The new threads, however, have been secured on the back of rapidly increasing debt, resulting in a 6% of GDP balance of trade deficit, and that debt has been extended to consumers only because of asset appreciation in the financial and housing markets. Can this King continue to reign over a seemingly prosperous yet imbalanced global and U.S. economy?

We advised in prior pages that the King’s clothes and their ability to cling to his bod were dependent on two things – the quality of the stitchery and the potential for a storm. Let’s put ourselves first of all in the role of royal seamstress to get a behind-the-scenes look at how these clothes have been put together. We acknowledge once more that the finest cloth has been purchased due to productivity advances, leading technologies, superb higher education, free-flowing capital markets, and a military dominance that allows the U.S. to exert its will in supranational agencies such as the U.N., World Bank, IMF, and the WTO. But in recent years, America’s growth has been stitched together more from the iron fist of government policies than the invisible hand of a dynamic free enterprise economy. (In a world deficient in aggregate demand, the case for free markets and the invisible hand grows weaker as PIMCO’s Paul McCulley has pointed out.) Its budget surpluses of the late Clinton years are a distant memory due to tax cuts and Iraq-related defense expenditures. Without them however, and the resultant deficits, our recovery from the stock market “bubble popping” of 2001 might never have occurred. In turn, reflationary monetary policies of global central banks, especially our Federal Reserve, have fostered a low nominal and much lower still real interest rate environment that has remarkably failed to stimulate normal domestic investment as in prior business cycles. Instead it has led to higher levels of U.S. consumption due to housing appreciation/equitization which have provided the ability to buy goods with money that can only be described as near “costless.” Without this government intervention, which in some ways is reminiscent of the 1930s depression – differing for the time being primarily in its earlier and more efficient implementation – the U.S. and global economy might be sinking instead of floating.

What’s New

But there are limits, both fiscal and monetary, and the monetary limit – what we will describe on the next few pages as the “Pump,” as well as our recognition of the still developing Bretton Woods II policy arrangement – stand as PIMCO’s primary 2005 additions to our ongoing secular outlook. While Bretton Woods II is odds-on in PIMCO’s book to be with us during the bulk of our 3-5 year secular timeframe, and therefore continue the 100 basis point interest rate subsidy to our financial markets, there undoubtedly are risks that must be monitored. It isn’t prudent for U.S. citizens to continue to expect to consume 6% more than they produce, nor is it rational for investors to expect foreign central banks – primarily the Chinese and Japanese – to invest that 6% surplus and other direct investment monies into the U.S. Treasury market forever. At some point it comes undone, either through a massive revaluation and dollar decline, a Treasury buyer’s boycott, or a whimpering U.S. consumer beaten down by the cost and/or amount of their burgeoning leverage – much of which is housing related. Geopolitical risks abound as well with North Korea, Taiwan, and Iran serving as potential flash points. Since the Bretton Woods II arrangement currently seems to satisfy giver and taker, consumer and maker, it should survive for a few years. Cross those fingers, though.

Because that conclusion nearly mandates a continuation of our artificially low U.S. and global interest rates fostered at the expense of the yield insensitive Chinese and Japanese Bretton Woods II (BWII) “cartel,” it might seem that all we as bond investors have to do is to head for the bar to get a tall cool one. But that would neglect the potentially reflationary impact of this artificially low yield environment. Surely, near 0% real short-term rates here and abroad have got to stimulate an inflationary resurgence. Au contraire. China has opted into BWII for one reason only – to employ hundreds of millions of unemployed workers in its interior. And it is those same workers, requiring only 5-10 cents per U.S. wage dollar that have kept inflation competitively low nearly everywhere in the global economy. What inflation we do have – 3% in the U.S., 2% in Euroland, 0% in Japan – is due to asset inflation – higher commodity prices, higher housing prices, and higher stock prices – creating artificial wealth and immediate purchasing power through what we described at our Secular Forum as the “Pump.” In some secular stretches, real, not artificial wealth is generated by productivity surges and the advancement of new technologies. The 1990s was such an example, but during the past five years wealth has come more from finance-based miracles than those based on productivity.

Nearly everyone knows that oil prices, housing prices, and even stock prices are up in the past few years and in some cases spectacularly. Not everyone knows why. Enter the “Pump.” The pump in its purest sense – sans the risk premium, and the P/E, P/Rents multiple changes of stock and home prices – can best be explained via the price action of a good old inflation protected Treasury, a 5-year maturity TIPS shown in both yield and price terms in Chart III.

This asset has been “Pumped” over the past 4 years to the tune of 14% price appreciation by the low interest rate policy of Alan Greenspan. Its 4% real yield has been lowered to 1% real yield with a resultant 14% price pop. That increase is reflective of the wealth creation pump for more well known asset classes – our homes, our stocks, our corporate bonds with their CDO structures and so on, except in these cases, the asset pop has been more than 14% because they are risk assets and in many cases levered ones.

Now this concept of the “Asset Pump” (which in combination with fiscal deficit spending and associated tax cuts has been the primary U.S. induced policy to keep consumption up and the recovery going) is important to understand because it gives us a strong hint about our economic and investment future and allows us to describe our King’s seamstress as having done a rather poor job of sewing. That seems evident because her creations have been put together not based on savings and domestic investment but on finance-based consumption fed from asset appreciation based on the Pump.

Future finance-based consumption, however, is limited by our ability to keep pumping lower and lower yields, which in the past have led to higher and higher TIPS, home, stock, and associated asset prices. Let me do the TIPS math for you and then you can draw the implications for other asset classes. The 14% 5-year TIPS capital gain over the past few years that Alan Greenspan has been able to manufacture probably can only go up by 5 more points, because a 0% real yield for a 5-year maturity TIPS serves as a practical limit that investors will tolerate during deflationary, and most low inflationary environments. A 5-year TIPS moving lower in yield from 1% to 0% goes up 5 points. Even if the Fed continues to “Pump,” then, we are ¾ of the way complete in terms of the Fed’s ability to continue to stimulate asset prices, because its 21st century journey started at 4%, we are now at 1%, and 0% is the practical limit. That doesn’t mean that the housing “bubble” can’t keep going because it likely will if the Fed “Pumps” real yields closer to 0%. But there are limits, and we are heading down the home stretch of this U.S. race towards prosperity based on asset price appreciation.

Our point on the “Pump” then, is to suggest that in combination with a globalized free trade-based economy exhibiting a surfeit of cheap Asian labor, it will be difficult to generate U.S. inflation higher than our current 3% even if interest rates fall further. If 3% inflation is all we can get from the past 5-years’ asset inflation, it’s hard to believe that we get more from what’s left. The potential to reflate via interest rates is nearly over. We draw the same conclusion for Euroland and Japan. Japan, of course, is the primary example of how 0% nominal yields can fail to generate any inflation whatsoever, is it not? Continued disinflation not reflation, then, will rule our fragile future kingdom, with the potential for 1-2% CPI prints in most years between 2006 and 2010 throughout much of the global economy. Readers may remember our past few years’ Secular Forum descriptions of the tug-of-war between disinflation and reflationary forces. We have proclaimed a winner based on our observation of massive fiscal and monetary global stimulation described above, the limited inflationary response, and the lack of further ammunition. Long live our disinflationary King.

Investment Implications

The risk to bond markets going forward, therefore, will not be from having too much high quality duration, but too little. The demand for Treasuries should continue at high levels from foreign central banks due to the continuation of Bretton Woods II and from private global bond investors who will sense no threat from accelerating inflation over our secular 3-5 year timeframe. In addition, as our Secular Forum speaker Olivia Mitchell described, private and public sector pension fund changes are underway which will likely mandate increased allocations to long-term bonds in order to accommodate many nations’ demographic surge towards old age and retirement. The change is even further advanced in Euroland based on UK and Dutch pension accounting modifications. If we had to forecast (and we do), we believe a range of 3 - 4½% for 10-year nominal Treasuries will prevail during most of our secular timeframe and that yields on Euroland bonds will be slightly lower due to their structural unemployment problems, disinflationary incorporation of new Central and Eastern European countries into their existing family of nations, and more growth-inhibiting demographics. This bullish scenario is not without its risks, be they geopolitical, trade, oil, or internal budget popping related in the U.S. or Euroland. In addition, anything that threatens BWII or resembles a “helicopter money” monetary response described by Ben Bernanke could ultimately be bond market destructive.

Furthermore, the inherent leverage throughout the global financial system will pose a danger to risk-oriented markets (stocks, high yield debt, CDO structures, real estate) as owners gradually realize their returns can no longer be pumped anywhere near double-digit expectations. Whether this can be accomplished gradually as central bankers maintain or happen quickly as others believe is an important question, and points to the potential storm referred to in previous pages. We would suggest that although financial innovation and derivative products allow for diversification and a spreading of risk across more market players, the increased liquidity of our modern day system has also allowed for increased leverage, quicker exits, and therefore more systemic, system-wide risk. If institutional and retail investors in levered products become increasingly disenchanted with quarterly/annual returns, an unwind of levered structures could take place even in the face of continued economic growth, much like we’ve seen in recent weeks.

Well our reality-based fairytale must now come to a close. The one reality we are sure of is that we at PIMCO are most fortunate to be entrusted with the management of your assets. The responsibility, while heavy, is the reason we are in business. Thank you. As to happy endings in the global economy and financial markets? Well some assets – high quality bonds, and certain commodities in limited supply among them – may continue to do well; other risk-oriented holdings can be pumped only a little bit further. And then? Well, given appropriate steps from government policymakers that attempt to rebalance our decidedly imbalanced global economy, we can still continue to prosper, but as with most fairytales, the wicked witch lurks. For now we at PIMCO will be content to acknowledge our reigning King’s clothes, the poor quality of the stitchery, and the partial exposure of his bare-bottom displayed on our front cover. Stay tuned in future years. This may yet turn into a reality show that resembles not the Coppertone Girl but Uncle Sam with a crown on his head and not much else to show for his/our years of profligate consumption based upon Bretton Woods II and the leveraging of near costless finance.

William H. Gross
Managing Director

Tuesday, May 13, 2008

Libor Set for Overhaul as Credibility Is Doubted

And the "shadow banking system" squeaks and groans a bit more...
As an extra related series, check out Sybil Star's links.
Here's an older article of Marshall Auerback's everyone should read; Link It is certainly still pertinent.
This article by Karol Gellert should also be read by everyone. It may be old, but very pertinent.
And finally for the real truth: Auerback, Gross and Dialynas

Libor Set for Overhaul as Credibility Is Doubted (Update1)

By Ben Livesey and Gavin Finch

May 13 (Bloomberg) -- The benchmark interest rate for at least $347 trillion of derivatives and 6 million U.S. mortgages is set for its biggest shakeup in a decade on concern that banks misquoted their true borrowing costs.

``We have not run away or hidden from the need for reform or the need for review'' of ``serious issues'' in the U.K. financial-services industry, British Bankers' Association Chief Executive Officer Angela Knight said at a hearing of a parliamentary committee in London today. The BBA is set to announce the results of its most far-reaching review of the way it sets the London interbank offered rate in a decade on May 30.

The association, an unregulated London-based trade group, is under pressure to show that Libor is reliable following complaints by investors that financial institutions weren't telling the truth about their funding costs after rising mortgage defaults contaminated credit markets and drove up borrowing costs.

While the association set the one-month dollar Libor rate at 2.72 percent on April 7, the Federal Reserve said banks paid 2.82 percent for secured loans later that day. Secured loans typically yield less than unsecured debt.

``The Libor numbers that banks reported to the BBA were a lie,'' said Tim Bond, head of global asset allocation at Barclays Capital in London. ``They had been all along. The BBA has been trying to investigate them and that's why banks have started to report the right numbers.''

April Warning

Libor rates jumped after the association said April 16 that any member banks found to be misquoting rates will be banned. The cost of borrowing in dollars for three months rose 18 basis points to 2.91 percent in the following two days, the biggest increase since the start of the credit squeeze last August. The one-month rate climbed 14 basis points, the most since November.

The cost of borrowing in dollars for three months should be as much as 30 basis points, or 0.30 percentage point, higher than the current rate, Citigroup Inc. said in a report last month.

Banks are understating borrowing costs on concern they will be perceived as ``weakened'' by the credit turmoil that forced financial companies to record $323 billion of losses and credit- markets writedowns, said Peter Hahn, a fellow at the London- based Cass Business School.

``Since the credit crunch, it's something that appears to have been manipulated,'' said Hahn, a former managing director at Citigroup. ``We are in an extraordinarily delicate confidence time where a small event can shatter things quite easily.''

Review Brought Forward

The BBA accelerated its annual review of Libor to assess if there's a fault with how the rate is computed, if it reflects ``difficult markets'' or is ``giving the right answer, just one that people don't want to hear,'' Knight said yesterday.

``Libor has stood the test of two decades,'' she said at today's parliamentary committee hearing. While the association has contacted all the member banks to investigate Libor ``volatility,'' the swings in the rate are ``hardly surprising'' amid the credit turmoil, Knight said.

The association has submitted a report based on discussions with member banks to its independent Foreign Exchange and Money Market Committee, which is carrying out the review of Libor, said Brian Mairs, a spokesman for the BBA in London.

The banking group, which represents Citigroup, HSBC Holdings Plc and 14 other lenders, asks members each morning to say how much it would cost them to borrow from each other for 15 different periods ranging from a day to a year in dollars, British pounds, euros and eight other currencies.

BIS Report

The Bank for International Settlements said in a March report some lenders were manipulating the rates to prevent their borrowing costs from escalating. The system still worked as it was meant to do as the credit crunch began in the middle of last year, the Basel, Switzerland-based BIS said.

Libor is used to guide banks in setting rates on most adjustable-rate mortgages. It's also the benchmark for the $1.2 trillion of interest-rate swap contracts traded every day worldwide, according to the BIS.

``Libor is a proxy for the effective rates of the economy,'' said Rav Singh, an interest-rate strategist at Morgan Stanley in London. ``Libor eventually feeds into the economy. There's so much on the back of the Libor problem. There are structured products, all the swaps and then there are the hedging positions.''

Fed Cuts

To ease the credit crunch, the Fed cut rates seven times, created three lending facilities to help both banks and securities firms obtain funds and backed the takeover of Bear Stearns Cos., which was on the verge of collapse. In all, the central bank made more than $600 billion available to lenders and allowed Wall Street firms to borrow money overnight at the same so-called discount rate charged to commercial banks. Fed Chairman Ben S. Bernanke provided $29 billion of financing to back JPMorgan Chase & Co.'s bailout of Bear Stearns in March.

Bank representatives declined to say what recommendations they are making to change Libor.

HSBC and HBOS Plc spokesmen declined to comment, as did Bank of America Corp. spokesman Scott Silvestri. Barclays, Royal Bank of Scotland Group Plc, Lloyds TSB Group Plc also declined to comment. Deutsche Bank AG spokesman Ronald Weichert wasn't immediately able to comment.

``I can confirm that along with the other 15 members of the BBA, as happens every year, we have been in consultations,'' said Richard Bassett, a London-based spokesman for WestLB AG. Rabobank Groep NV spokesman Anthony Arthur wasn't immediately available for comment.

Spokesmen for Mitsubishi UFJ Financial Group Inc. and Norinchukin Bank Ltd. weren't immediately available. A Royal Bank of Canada spokeswoman said it had discussions with the BBA as part of consultations with all Libor panel members and awaits the association's recommendations.

To contact the reporters on this story: Ben Livesey in London; Gavin Finch in London at

Thursday, May 08, 2008

The 12 Steps to a Financial Disaster

We caught wind of a recent analysis from Professor Nouriel Roubini of the Stern School of Business at New York University. Nouriel has become known for his rather clear clarion calls that the housing bubble would lead to a credit crisis and possibly much worse. He has been one who has been on CNBC and was in the clear minority early last year, but now no one is laughing.

John Mauldin's Outside the Box posted the Nouriel details for us on how a worse case scenario would develop. "We both hope this does not develop. It can be avoided, but realistic investors need to know what to look for to make sure we are not going there. I like Nouriel's work, as it pull's no punches. You can go to RGE Monitor at to see his regular work, which is geared to institutions. Like this letter, he offers Outside the Box analysis, which I think you will find useful." The Rising Risk of a Systemic Financial Meltdown:

The Twelve Steps to Financial Disaster
by Nouriel Roubini

Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January? It is true that most macro indicators are heading south and suggesting a deep and severe recession that has already started. But the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting.

To understand the Fed actions one has to realize that there is now a rising probability of a "catastrophic" financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown.

That is the reason the Fed had thrown all caution to the wind - after a year in which it was behind the curve and underplaying the economic and financial risks - and has taken a very aggressive approach to risk management; this is a much more aggressive approach than the Greenspan one in spite of the initial views that the Bernanke Fed would be more cautious than Greenspan in reacting to economic and financial vulnerabilities.

To understand the risks that the financial system is facing today I present the "nightmare" or "catastrophic" scenario that the Fed and financial officials around the world are now worried about. Such a scenario - however extreme - has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.

Start first with the recession that is now enveloping the US economy. Let us assume - as likely - that this recession - that already started in December 2007 - will be worse than the mild ones - that lasted 8 months - that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households - whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession.

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use "jingle mail" (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders' stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005
through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages - already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.

Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing - rather than reducing systemic risk - and making the credit crunch global.

Third, the recession will lead - as it is already doing - to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.

Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package - short of an unlikely public bailout - is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.

Next, the downgrade of the monolines will lead to another $150 of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses - and potential runs - on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines' downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.

Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead - with a short lag - to a bust in non-residential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.

Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors' panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide - an institution that was more likely insolvent than illiquid - has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks' bankruptcies will add to an already severe credit crunch.

Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans - a good chunk of which were issued to finance very risky and reckless LBOs - is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone - not avoid - such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions.

Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD - or recovery given default - rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen.

While on average the US and European corporations are in better shape - in terms of profitability and debt burden - than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection - possibly large institutions such as monolines, some hedge funds or a large broker dealer - may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.

Ninth, the "shadow banking system" (as defined by the PIMCO folks) or more precisely the "shadow financial system" (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that - like banks - borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don't have direct or indirect access to the central bank's lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system - stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.

Tenth, stock markets in the US and abroad will start pricing a severe US recession - rather than a mild recession - and a sharp global economic slowdown. The fall in stock markets - after the late January 2008 rally fizzles out - will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008.

Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.

Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dryup of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates - TED spreads, BOR-OIS spreads, BOT - Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors' risk aversion - will massively widen again. Even the easing of the liquidity crunch after massive central banks' actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds - about $80 billion so far - will be unable to stop this credit disintermediation - (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe.

A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties - driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities - will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch.

In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century. Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question - to be detailed in a follow-up article - is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response - monetary, fiscal, regulatory, financial and otherwise - is coherent, timely and credible. I will argue - in my next article - that one should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis."

We thank John Mauldin for making the Professor's thesis available. John can be reached at: Powered by Joomla! Generated: 8 May, 2008, 12:15

Sunday, May 04, 2008

Derivatives the new 'ticking bomb'

Derivatives the new 'ticking bomb'
Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen

ARROYO GRANDE, Calif. (MarketWatch) -- "Charlie and I believe Berkshire should be a fortress of financial strength" wrote Warren Buffett. That was five years before the subprime-credit meltdown.

"We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

That warning was in Buffett's 2002 letter to Berkshire shareholders. He saw a future that many others chose to ignore. The Iraq war build-up was at a fever-pitch. The imagery of WMDs and a mushroom cloud fresh in his mind.

Also fresh on Buffett's mind: His acquisition of General Re four years earlier, about the time the Long-Term Capital Management hedge fund almost killed the global monetary system. How? This is crucial: LTCM nearly killed the system with a relatively small $5 billion trading loss. Peanuts compared with the hundreds of billions of dollars of subprime-credit write-offs now making Wall Street's big shots look like amateurs.

Buffett tried to sell off Gen Re's derivatives group. No buyers. Unwinding it was costly, but led to his warning that derivatives are a "financial weapon of mass destruction." That was 2002.

Derivatives bubble explodes five times bigger in five years

Wall Street didn't listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:

Sarbanes-Oxley increased corporate disclosures and government oversight

Federal Reserve's cheap money policies created the subprime-housing boom

War budgets burdened the U.S. Treasury and future entitlements programs

Trade deficits with China and others destroyed the value of the U.S. dollar

Oil and commodity rich nations demanding equity payments rather than debt

In short, despite Buffett's clear warnings, a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession.

Data on the five-fold growth of derivatives to $516 trillion in five years comes from the most recent survey by the Bank of International Settlements, the world's clearinghouse for central banks in Basel, Switzerland. The BIS is like the cashier's window at a racetrack or casino, where you'd place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:

U.S. annual gross domestic product is about $15 trillion
U.S. money supply is also about $15 trillion
Current proposed U.S. federal budget is $3 trillion
U.S. government's maximum legal debt is $9 trillion
U.S. mutual fund companies manage about $12 trillion
World's GDPs for all nations is approximately $50 trillion
Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
Total value of the world's real estate is estimated at about $75 trillion
Total value of world's stock and bond markets is more than $100 trillion
BIS valuation of world's derivatives back in 2002 was about $100 trillion
BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion

Moreover, the folks at BIS tell me their estimate of $516 trillion only includes "transactions in which a major private dealer (bank) is involved on at least one side of the transaction," but doesn't include private deals between two "non-reporting entities." They did, however, add that their reporting central banks estimate that the coverage of the survey is around 95% on average.

Also, keep in mind that while the $516 trillion "notional" value (maximum in case of a meltdown) of the deals is a good measure of the market's size, the 2007 BIS study notes that the $11 trillion "gross market values provides a more accurate measure of the scale of financial risk transfer taking place in derivatives markets."
Bubbles, domino effects and the 'bad 2%'

However, while that may be true as far as the parties to an individual deal, there are broader risks to the world's economies. Remember back in 1998 when LTCM's little $5 billion loss nearly brought down the world's banking system. That "domino effect" is now repeating many times over, straining the world's monetary, economic and political system as the subprime housing mess metastasizes, taking the U.S. stock market and the world economy down with it.

This cascading "domino effect" was brilliantly described in "The $300 Trillion Time Bomb: If Buffett can't figure out derivatives, can anybody?" published early last year in Portfolio magazine, a couple months before the subprime meltdown. Columnist Jesse Eisinger's $300 trillion figure came from an earlier study of the derivatives market as it was growing from $100 trillion to $516 trillion over five years. Eisinger concluded:

"There's nothing intrinsically scary about derivatives, except when the bad 2% blow up." Unfortunately, that "bad 2%" did blow up a few months afterwards, even as Bernanke and Paulson were assuring America that the subprime mess was "contained."
Bottom line: Little things leverage a heck of a big wallop. It only takes a little spark from a "bad 2% deal" to ignite this $516 trillion weapon of mass destruction. Think of this entire unregulated derivatives market like an unsecured, unpredictable nuclear bomb in a Pakistan stockpile. It's only a matter of time.

World's newest and biggest 'black market'

The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco's bond fund king Bill Gross said "What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August." In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't "figure out" the world's $516 trillion derivatives.

Why? Gross says we are creating a new "shadow banking system." Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions.

BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic "shadow banking system" that has become the world's biggest "black market."

That's crucial, folks. Why? Because central banks require reserves like stock brokers require margins, something backing up the transaction. Derivatives don't. They're not "real money." They're paper promises closer to "Monopoly" money than real U.S. dollars.

And it takes place outside normal business channels, out there in the "free market." That's the wonderful world of derivatives, and it's creating a massive bubble that could soon implode.

Comments? Yes, we want to hear your thoughts. Tell us what you think about derivatives: as "financial weapons of mass destruction;" as a "shadow banking system;" as a "black market;" as the next big bubble dangerously exposing us to that unpredictable "bad 2%."

Saturday, May 03, 2008

The Great Depression 2008 - It can't happen to us....can it?”

The Great Depression 2008 - It can't happen to us....can it?” By: Andy_Sutton

Webster's defines complacency as “1.satisfaction or contentment 2. smug self-satisfaction” There is probably not a better word to describe the current state of perception with regard to economic and financial malady. I had an interesting conversation the other night about exactly this topic and the individual I was speaking with had an overriding belief that we cannot suffer economically simply because the current generation is not prepared to deal with it. While I certainly agree with the latter assertion, the former continues to baffle me. I am certainly not prepared to deal with a lengthy hospital stay as the result of a horrific car crash, but that alone doesn't cloak me in immunity from having an accident. The reasoning is so broken and flawed, yet it is often all we get in terms of a perception of what is going on.

This disconnect begets a discussion of why exactly it is that society has chosen to believe itself to be immune from bad things. It is odd in itself that when you talk to individuals, they seem to be acutely aware of many of the challenges facing us, but when you put all the individuals together and create a society, we act as though the party will indeed last forever. We are certainly dealing with a situation in which the intelligence of the whole is by far less than the sum of all its parts. Here's a little bit of déjà vu for you, compliments of Wikipedia:

“ In the 1920s, Americans consumers and businesses relied on cheap credit, the former to purchase consumer goods such as automobiles and furniture and the later for capital investment to increase production. This fueled strong short-term growth but created consumer and commercial debt. People and businesses who were deeply in debt when price deflation occurred or demand for their product decreased often risked default. Many drastically cut current spending to keep up time payments, thus lowering demand for new products. Businesses began to fail as construction work and factory orders plunged.”

Sound familiar anyone? See any price deflation going on? The Wilshire 5000 has only lost about 2.5 TRILLION dollars in value in the last two months or so. What about the loss in home equity? Another trillion or two? Who knows, but I think you get the point. We are seeing almost to the final utterance the same play we saw unfold in 1929. Were those folks any more prepared for the Great Depression than we are today? I'd argue that while they were perhaps a bit better equipped to provide for their own sustenance that American society in the 1920's was as complacent as we are today. When the realization of history's coup de grace hits, we will be caught as unaware as our ancestors were back in 1929.

Here are some other examples of what Alan Greenspan likes to call ‘irrational exuberance' in the 1920's:

"We will not have any more crashes in our time."

John Maynard Keynes in 1927 (The authenticity of this one is a little suspect) DOW ~ 175

"There will be no interruption of our permanent prosperity."

Myron E. Forbes, President, Pierce Arrow Motor Car Co., January 12, 1928 – DOW ~ 200

"There may be a recession in stock prices, but not anything in the nature of a crash." - Irving Fisher, leading U.S. economist, New York Times, Sept. 5, 1929 – DOW ~ 375

"All safe deposit boxes in banks or financial institutions have been sealed... and may only be opened in the presence of an agent of the I.R.S." - President F.D. Roosevelt, 1933 – DOW ~ 65

Tuesday morning we received news that according to the Institute of Supply Management, the service portion of our economy underwent a significant contraction during the month of December. This is alarming given the fact that December is normally one of the busiest times of the year. Even still, a trip past the local mall provides a busy scene. People are streaming in and out, carrying boxes and bags of imported trinkets to their imported cars. They will then use imported gasoline to drive to their home, the mortgage of which is likely to be owned by a foreign investor. Yet the average American citizen sees nothing wrong with this picture. Or could it be that they don't even see the picture at all? The media has certainly been playing the role of absentee informant in recent years, choosing to focus on such insipid topics as Britney Spears' latest rehab stint rather than the important business at hand.

Here now, are some quotes from this generation's 2007 and 2008:

“It is encouraging that inflation expectations appear to be contained,” Fed Chairman Ben S. Bernanke – Testimony to Congress – March 28 th , 2007 – DOW ~ 12,500, Headline CPI-U ~ 2.8% Y/Y

"As I think you know, I believe very strongly that a strong dollar is in our nation's interest, and I'm a big believer in currencies being set in a competitive, open marketplace," - Henry Paulson – Secretary of the Treasury – USDX ~ 81.50

““We are making history. What has passed the Congress in record time is a gift to the middle class and those who aspire to it in our country.” House Speaker Nancy Pelosi on the $168 Billion tax ‘rebate' while the middle class is spending their Wal-Mart Christmas gift cards on food and other necessities.

They're making history all right. Too bad it will end up being the WRONG kind. How can we ever hope to focus the population on the urgency of our current predicament when our leaders are willing to make it worse by handing our freebies, bailing out those who willingly make poor investment choices and telling us everything can be ‘free' if we'll only pull their lever on election day?

Or am I putting the cart in front of the horse? Perhaps a contrarian opinion might be that our leaders are giving the public exactly what it wants. In either case, I am quite certain that our state of unpreparedness will not constitute a free pass from the negative effects of a recession or a retraction of any of the financial excesses we've enjoyed over the past few decades.

By Andy Sutton

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. His firm, Sutton & Associates, LLC currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar. For more information visit