Phorgy Phynance

It’s official.

On September 22, 2007, I said in Bye bye dollar (emphasis added)

I wasn’t particularly excited about the surprise 50 bps cut in both target and discount rates for the general long-term prospects of the US economy, although on a selfish level it was certainly good for my career stability. As far as I’m concerned, it is open season for Bernanke bashing. Greenspan bashing has been accelerating as well. Besides, if things really get bad with the USD, we’ll just move to Hong Kong or something

One of the things that I learned from Al Wojnilower was that the US economy could certainly keep chugging along for as long as the USD was the world currency. As he liked to repeat often, having the USD as the dominant world currency is like having an “American Express card with no limit”. One of the things that keeps the USD as the world’s currency is its position in sovereign reserves as well as the fact that oil is priced in USD. As far as I can see, both of these factors are beginning a worrisome decline.

With sovereign reserves continuing to diversify away from USD and Saudi Arabia refusing to cut rates in lock step with the US marks a real turn in the outlook for the USD dollar, and consequently the ability of the US economy to continue chugging along.

Then on October 31, 2007, I said in Xie xie ni Bernanke (emphasis added)

Financial Armageddon points to the Reuters article:

Worried about inflation? Just wait

where he argues that deflation is the next big worry. I have to humbly disagree. Sort of.

I do agree that financial asset prices are due for a massive correction, but the economy is made of more than just financial assets. Financial assets will see deflation, but physical assets will see inflation.

During the “New Economy”, financial assets have soared in value and I believe, like Jeremy Grantham, that financial assets throughout the globe have experienced a bubble.

Like I’ve said in a comment or two on Panzner’s blog, during past corrections in the financial sector, China and India were absorbing inflationary pressures. That structural shift is what will make this time different. Today, China and India are net exporters of inflation and loose monetary policy in the US will create domestic inflationary pressures that have no where to go this time.

This is the rift I saw between physical and financial assets when David Richards asked me what I thought about the markets back in December of 2006. That rift has been partially corrected with the rise in commodity and energy prices since then, but I think there is a long way to go before things are neutral. As usual, things usually will not reach a nice equilibrium and stay there. Inertia will carry it through neutral and beyond. Significantly beyond.

Wow. When I first began voicing my opinion about the Fed and monetary policy in a public phorum, it didn’t take long for me to be drawn to some papers by Anna Schwartz. On July 3, 2007, when I was asked what I would have done if I was in charge of monetary policy, I said:

If I were in charge from 2000-2007, I probably would have surrounded myself by smart people like Anna Schwartz, who wrote this gem (in 2002)

Asset Price Inflation and Monetary Policy

Abstract:

It is crucial that central banks and regulatory authorities be aware of effects of asset price inflation on the stability of the financial system. Lending activity based on asset collateral during the boom is hazardous to the health of lenders when the boom collapses. One way that authorities can curb the distortion of lenders’ portfolios during asset price booms is to have in place capital requirements that increase with the growth of credit extensions collateralized by assets whose prices have escalated. If financial institutions avoid this pitfall, their soundness will not be impaired when assets backing loans fall in value. Rather than trying to gauge the effects of asset prices on core inflation, central banks may be better advised to be alert to the weakening of financial balance sheets in the aftermath of a fall in value of asset collateral backing loans.

Now, she takes both Greenspan and Bernanke to task in this scorching article at the Telegraph:

Anna Schwartz blames Fed for sub-prime crisis

The high priestess of US monetarism – a revered figure at the Fed – says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. “The new group at the Fed is not equal to the problem that faces it,” she says, daring to utter a thought that fellow critics mostly utter sotto voce.

“They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence,” she told The Sunday Telegraph. “There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for,” she says.

That is a great article and although I should probably be a little more dignified that proclaiming “Bernanke sucks”, it is good to know that Anna Schwartz is also not a particularly big fan of those at the Fed right now.

A while back, I was sitting in a meeting with some bankruptcy attorneys that were helping the investment group understand some new bankruptcy laws. After the meeting, I asked one of the attorneys a pretty open-ended question that tends to get surprisingly honest answers:

In the long term, what is your biggest concern for the US economy?

Her answer was immediate and without hesitation:

I can’t see how the US is going to be able to afford healthcare costs for the coming wave of retiring babyboomers.

Not exactly what I was expecting her to say, but the apparent honesty left an impression on me. That is one of the reasons why, when I began voicing my gloomy opinions for the coming credit crisis (even though I’m an optimist!), I said some fairly radical things.

I’ve quoted part of the discussion here when I first learned of the amount of US debt held outside the US.

Looking out over the horizon, say 10 years or more, it was hard to imagine the US being able to pay its obligations. On July 26, Aaron Brown said:

I’ve never understood the argument that foreign ownership of treasuries is a threat to the US. If everyone who didn’t like me lent me money, I’d be happy. I’d be even happier if I got to pay them back with paper I wrote myself. In the 60’s and 70’s, the US sold a lot of debt to foreigners and inflated its way out of repayment. In the 00’s, the US sold a lot of debt to foreigners and devalued its way out of repayment. But people keep lining up to buy more. I don’t see that changing.

I admire Aaron a LOT. He is super knowledgeable AND super helpful. He has uncanny patience and is willing to walk even thick-skulled people like me through technical explanations. What he is suggesting above is that when the US’ obligation become unmanageable, we can simply inflate our way out of it. Sure. That is one solution, but when your obligations are both internal and external, inflating your way out of an obligation to a retired senior citizen doesn’t seem to be the most politically correct thing to do.

What is an alternative?

I suggested that, since much of the US’ obligation is to its retiring senior citizens as well as foreign debtors, one solution would be for the US to default on its external debt *gasp*

Here is my direct quote on July 26:

I’m not sure I’m so enthusiastic about the idea of inflating your way out of foreign debt obligations. That wouldn’t be so great for the domestic economy. Something like what Russia did, i.e. a flat out default, as crazy as it sounds, is seeming like more of a possibility to me though.

The deep and insightful comment from Skillionaire followed:

Eric, I’ve been disagreeing with your views for the past couple of days in this thread, but I believe with this statement you might’ve officially gone off the deep end with this apocalypse stuff you’ve been pushing.

To which I replied:

The good thing about these phorums is that they have time stamps. Sure, today the idea seems crazy. It’ll probably seem crazy for the next 5 years or more. Ten years? Anything is possible. We’ll see. Care to wager on it?

Wager: Within the next 10 years, i.e. before July 26, 2017, a major news source will carry a headline indicating the US may default on a foreign debt obligation.

No one took me up on it It’s only been 5 months, but the first cracks in the long term credit quality of US sovereign debt has surfaced

This is from the Financial Times

Moody’s warns on US sovereign rating

The US is at risk of losing its top-notch triple-A credit rating within a decade unless it takes radical action to curb soaring healthcare and social security spending, Moody’s warned on Thursday. The warning over the future of the triple-A rating – granted to US government debt since it was first assessed in 1917 – reflects growing concerns over the country’s ability to retain its financial and economic supremacy. It could also further pressure candidates from both the Republican and Democratic parties to sharpen their focus on healthcare and pensions in the run-up to November’s presidential elections. Most analysts expect future governments to deal with the costs of healthcare and social security and there is no reflection of any long-term concern about US financial health in the value of its debt.

I’ll repeat, I don’t see any real threat of a US sovereign default in the next 5 years, which is probably beyond the horizon of most investors and so might be considered irrelevant. But 10 years? 15 years? 20 years?

Last Wednesday, I gave my call for monetary policy in the US and Eurozone

The Fed SHOULD hold rates, but I’ve lost all faith in the fed and they are just puppets for Wall Street.

My call:
ECB holds at 4%
Fed drops to 4%

So I was a bit shocked when the Fed only dropped rates 25 bps. I would have preferred 0 bps, but if you’re going to cut, cut enough to make some impact. A cut of 50 bps makes more sense the 25 bps even though if they had brains it would have been 0 bps, i.e. either do something or not. Don’t be a wet noodle.

So Bernanke doesn’t want to be Greenspan, eh? That much is clear. He is trying every tool in the chest other than lowering the Fed rate, but how on earth is this global bank bailout going to do anything other than bailout some new found buddies on Wall Street?

You should not really be surprised. After all, they are just as human as you and I. I’m probably better educated than most in the Fed anyway (as scary as that may sound).

Here is my advice to Helicopter Ben. The sooner you realize that some on Wall Street deserve to be insolvent, the better. Hold rates where they are (or even raise rates). Trashing the dollar isn’t really in anyone’s interest. Let the inevitable recession come over us. We’ll live. Trust me. We’ll even come out on the other side stronger. Leaner. Meaner. Greener.

The 0% APR on Al Wojnilower’s American Express Card is about to expire and we’re likely not going to be able to roll over into a new one. But that’s alright. This country is still full of smart innovative people. Even if/when Citigroup defaults on its first interest payment, we’ll get through this. In every Econ 101 book I’ve ever glanced at (and tossed back on the shelf in fright), you see the words “business cycle”. It is natural. Recession are natural. Embrace it. Don’t let complacency take us beyond the point of no return. Make us work for a living. Don’t let us expect to be able to hold a job if we’re not giving 110% of our effort to be cost effective employees. We’re in a global competition with some super smart, super aggressive entrepreneurs and innovators in China and India, yet we’re feeding our lazy kids into diabetic obesity. This competition cannot be won through politics or military strength, it has got to be won through hard work, creativity, and dedication.

Ok. Why did I go off on that rant again?

Go USA!

Whenever I read about “subprime contagion”, I feel frustrated. When you get the flu, does the runny nose cause the muscle aches? No. Just because the runny nose came first doesn’t mean the flu can be described as “runny nose contagion”. The subprime mess was just the first symptom to appear in the bursting of a general credit bubble. The corporate high yield market saw very similar aggressive loan covenants. Commercial real estate. Emerging markets. You name it. We’ve been in the midst of a general fixed-income bubble since our friends at the Fed decided to keep rates far too low for far too long.

Think about this. Back in 2005, we were worried about the CDS market reaching $17 TRILLION notional. That is a HUGE number. But the notional amount is not indicative of overall exposure because of hedging, right?

If you want to see a perfect hedge, visit a Zen garden.

What is that number today? More like $45 TRILLION. That is insane. An entire new insurance industry has basically assumed that corporate defaults do not exist anymore. Not only that, a “hedge” can turn into naked exposure at the flip of a switch, i.e. what happens when the entity you bought insurance from no longer exists?

When I get a chance, I hope to start posting some more mathematical analysis of what’s going on (since that’s what I’m good at). For example, a primer on Leverage Mathematics 101 (which is partially complete) followed by Hedge Mathematics 101 would be a good start. In risk management, “hedging” basically means “let’s buy(sell) some similar securities so that we have more capital to buy other stuff.” In other words, hedging allows you to leverage yourself more.

Here is an article that may help spread the word, i.e. it’s not about subprime:

Straight Talk on the Mortgage Mess from an Insider

However, I would go even further. The truth is the current mess is not even about mortgages. Here is the word we should all be thinking about, “Fixed Income Bubble”.

Just a quick note from MarketWatch before I hit the sack…

17 reasons America needs a recession

Here are some of my thoughts on the subject.

Good night and have a Happy Thanksgiving!

Market turmoil is still quite fascinating to me and I still believe the current environment will be one for the history books and I’m still trying to take as much as I can from this learning experience.

My professional work experience is in fixed income. For two years, I was very “plugged in” to the markets and was meeting regularly with some of the greatest thinkers out there, but now I’m more of a pure “quant” and most of my news comes from blogs, web news, etc. Unfortunately, I’m not yet spending as much time with the traders as I’d like (but that should change soon I hope). Most of the major news sources, e.g. Bloomberg, seem to concentrate more on equity markets than credit and fixed income. I pay more attention to the Dow now than ever before. That is why I am so perplexed by the stock market. I thought stocks were supposed to be easier than bonds, i.e all the smart guys are in fixed income, right?

So while the credit markets seem to be imploding, stocks are doing just dandy. Maybe people are taking cues from the market cheat sheet?

Anyway, I’ve blabbered quite a bit on this blog (and at my former employer) expressing my opinion of CDOs. I even managed to upset quite a few people while expressing my opinions as well. No regrets though. I’m happy to have this hugely public diary, both here and on NP, to later look back and see how I did in regards to thinking events through. Occasionally, I still like to poke my nose in over at NP and I see kr is still giving out the occasional nugget. Here is one of his latest:

A few thoughts:
- If you took all the writedowns at a single med-to-large bank rather than seeing them across the street, you could have reduced that entity’s equity to ZERO. For instance, MER has only something like USD54bn of mkt cap and USD39bn of book equity.
- If the view is that there will be another round of writedowns in the same amount as Q3 then you will have banks desperate to raise equity (i.e. it is not just the monolines). Who would buy that equity right now? Prince Alwaleed for example has floated his own holdings so I see him more as seller than buyer for example. I don’t see guys like JC Flowers or Cerberus well positioned for this job – in retrospect, even Barclays/RBS have not been with respect to ABN, as can be seen by the action in their share price and cost of jr capital.
- Another possibility would be the downgrade to BBB like the Japanese banks, with all the implications that brings with it. I.e. serious change in business model. That has contagion and macro effects. One example is that flow trading of financials has cost people a lot.
- I think investors will call foul on the FAS157 Level-3 assets, and it will hit guys like GS seriously as their L3 reporteds are a big multiple of their mkt cap.
- There was a funny comment in this month’s BBG mag about “nobody really knows how desks are hedging the CDO assets.” That is bull – the answer is that most people were NOT HEDGING AT ALL, BECAUSE THEY COULDN’T. Stuff was originated to sell, and the exit has vanished, or, it was originated to live forever on a trading book even though people tried to avoid saying that, and there is no decent MTM approach so instead banks are showing huge volatility, mostly to the downside.
- Implications of SIV / CDO / CP demise are pretty vast. There seem to be an increasing amount of trade receivables on the market, b/c there are no conduits to fund them… means corp cost of cap is going up in unexpected areas.

My hunch is that the fed cuts on the 11th b/c liquidity is dropping again, especially with year-end. It is out of control – specifically Ben’s control. It looks like political support for the various subprime fixes has stalled. What I think is that liquidity of all things financial (i.e. non-corporate) is going to get weaker and cause a full-on crisis for a market-traded institution. The talk about Citi cutting their div is one tremor, trading activity in Barclays is another, and the fact that even AFTER all the reported loss numbers, people still don’t feel comfortable, is yet another.

I think vols are still cheap, maybe looking to buy some.

All the while I was complaining about CDOs, I was coming at it from the angle of a “quant”, i.e. thinking about how to model CDOs and how those models are used in risk management, asset allocation, etc. Too bad I didn’t understand more about the legal/accounting aspects of CDOs. The term everyone has now heard of is SIV. I was blabbering about off balance sheet leverage and fair value accounting, but didn’t realize that the entire CDO market was (to a jaded eye) a big play on accounting in addition to the obvious play on ratings agencies. If I had known about SIVs, I might have been able to do more to help some who may have now lost a lot of money. Maybe not. That’s all in hindsight. But what am I missing now? Where is the next weakest link? How are corporations hiding off balance sheet debt? Has anyone looked at “Level 3″ assets in corporate, i.e. non-financial, balance sheets? Are they as scary as the big banks?

I’ll say it again… this is not a subprime issue. Subprime contagion does not explain the current environment. Subprime was just the first to blow. We are experiencing the blowup of a global fixed income bubble. In fact, some would say we’re experiencing a general global asset bubble.

Who’s going to get hurt? Financial institutions for sure. Anyone who depends directly on the value of paper assets.

Who’s going to win? People whose wealth depends on physical assets.

I’ve already lost all hope in Bernanke. He is not going to let his monicker “Helicopter Ben” go by the wayside in a “time of need”. Bernanke is going to lower rates and weaken the USD until oil exporters are forced to break the peg to the USD and inflation skyrockets. I predict that all these gloom mongers about home prices dropping by 30% will turn out to be wrong in nominal terms even if they are correct in real terms. In other words, home owners are going to be saved by the dropping value of the USD. All those on Wall Street who were so gleeful every time rates dropped are suddenly going to feel the pain when the value of their paper securities go up in smoke.

Watch out for the “happy stage of inflation”, i.e. wage increases. It will be interesting to see what the world will look like when oil is priced in EUR and the USD is no longer the world currency. Fortunately, I still have faith that we’ll come out of the current mess stronger as a country, but there will certainly be pain felt at the higher end of the wealth spectrum.

I’m actually ironically optimistic about the outlook for suburban and rural economic development. A weaker dollar will make outsourcing less attractive. That will bring manufacturing jobs back home. I can imagine a boon in suburban and rural development. Just imagine if communities developed decent broadband via fiber-to-the-home/business. Suddenly, there will be attractive jobs and living standards in affordable places.

Maybe a weak dollar is what this country needs, i.e. a good kick in the pants. Pain is the best teacher, right?

[Edit: PS, the title of the post was inspired by a great article on Financial Armageddon, but I never got around to explaining why, but have a look and it might be obvious.]

I just wanted to take a moment to say thank you to Mr Bernanke and the FOMC. I work in finance and these rate cuts are really great for my career sustainability. Without you’re gifts to the markets (at the expense of the USD, the long-term US economic health, and those who were responsible enough to actually save money instead of gambling), I don’t know what I’d do. I’m just glad that when this irresponsible monetary policy finally catches up to you that I have the option to move to Hong Kong. That reminds me, I need to kick my Mandarin lessons into high gear

Bernanke han bun!! Bu hao!

What is the Fed going to do on September 18?

With the latest news coming from the NFP report, I think even the staunchest opponents to a rate cut are starting to capitulate. Except me!

I still think the Fed should hold tight and resist the pressure to lower the rate. Sure, that would likely lead to a recession, but the alternative is worse in my opinion. In fact, I don’t even think recessions are all that bad. They are “normal”. What is not normal is flooding the markets with cash every time there is some expectation of a slowing economy. For the past 7 years, that has worked out because China, India, and other nations were able to absorb inflation as they exported deflation.

Things are different now. China is no longer exporting deflation as they begin to deal with their own inflationary pressures. Meanwhile, Europe continues to see inflationary pressures. I’m not too surprised the ECB decided not to raise rates in light of liquidity fears, but think they’re doing a good job keeping the focus on inflation.

Lowering the rates now will not necessarily help, as Roubini so eloquently pointed out, this is not merely a liquidity crisis, but a credit/solvency event as well. Throwing money at a turning credit cycle will only delay the inevitable. Ask Japan about that.

Recessions are not always bad and I, for one, would welcome the strength of leadership it would take to accept that. The longer term risks that would be exacerbated by a rate cut should be weighed heavily. Bernanke has navigated in such a way that I can only admire so far, but a rate cut now would be quite disappointing to me. Economic Darwinism is the only way to longer term prosperity. Complacency has been the downfall of more than one empire and we risk going further down that road. Pain is the best teacher. Ok. That is enough with the cliches for now