Tuesday, November 25, 2008

On the making and the unmaking of the Paradox of Deleveraging

Paul McCulley, Managing Director of PIMCO, the world's largest bond trading company yada yada yada, provides a highly useful public service by sharing his views on and understanding of the state and structure of the economy in words that are, for the most part, accessible to the feeble mind of a Guambat. The price of the education is to simply click on PIMCO's Content Archive and have a read. It's really good stuff, man.

Back in July of this year, he told us about the Paradox of Thrift, which is that what is good for the gooses is not always good for the geese. And currently, he takes a gander at the Paradox of Leveraging and a solution to it. Both of these, and especially when read together, have helped Guambat to experience a bit of perception of understanding the current financial crisis in the much larger context of both its making and its rehabilitation.

Guambat is likely to make a hash of the explanations, so you ought to read them in their entirety from the source, but here are some extracts that Guambat hopes will enlighten you if you are not inclined to click away, and then hopefully entice you to click anyway.

The Paradox of Deleveraging

For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

This principle is part of a whole range of macroeconomic concepts under the label of the paradox of aggregation: what holds for the individual doesn’t necessarily hold for the community of individuals. Understanding this paradox is absolutely vital to understanding macroeconomics and even more so to understanding what is presently unfolding in global financial markets.

[E]very levered financial institution – banks and shadow banks alike – decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense.

At the collective level, however, it has given us the paradox of deleveraging:... not all levered lenders can shed assets and the associated debt at the same time without driving down asset prices, which has the paradoxical impact of increasing leverage by driving down lenders’ net worth.

[M]onetary easing is of limited value in breaking the paradox of deleveraging if levered lenders are collectively destroying their collective net worth. What is needed instead is for somebody to lever up and take on the assets being shed by those deleveraging. It really is that simple.

As Keynes taught us long ago, that somebody is the same somebody that needs to step up spending to break the paradox of thrift: the federal government, which needs to lever up its balance sheet to absorb assets being shed through private sector delevering, so as to avoid pernicious asset deflation.

But levering up Uncle Sam’s balance sheet, to buy assets to break asset deflation resulting from the paradox of deleveraging still seems to be a foreign, if not a sinful proposition. [W]e hear endlessly that any levering up of Uncle Sam’s balance sheet to buy assets must be done in a way that “protects tax payers.” By definition, levering Uncle Sam’s balance sheet to buy or guarantee assets to temper asset deflation will put the taxpayer at risk – but will do so for their own collective good!

Conventional wisdom holds that when an economy faces a paradox of private thrift, it is appropriate for the sovereign to go the other way, borrowing money to spend directly or to cut taxes, taking up the aggregate demand slack. Indeed, that is precisely what Congress did earlier this year, sending out $100+ billion of rebate checks, funded with increased issuance of Treasury debt. Good ole fashioned Keynesian stuff!

Concurrently, conventional wisdom is struggling mightily with the notion that when the financial system is suffering from a paradox of deleveraging, the sovereign should lever up to buy or backstop deflating assets. But analytically, there is no difference: both the paradox of thrift and the paradox of deleveraging can be broken only by the sovereign going the other way.

The Paradox of Deleveraging Will Be Broken
[W]hat ailed Lehman was but a manifestation of what ailed, and ails the global financial intermediary system: the presumption that grossly levered positions in illiquid assets can always be funded, because those doing the funding will always assume the borrower is a going concern.

I submit, it was the loss of understanding of first principles that lies at the heart of the on-going paradox of deleveraging, which is the proximate cause of the on-going downward spiral of asset and debt deflation.

[T]he genius of banking, if you want to call it that, is simple: a bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is notionally of finite maturity, as short as one day in the case of demand deposits.

It’s the same alchemy that permits mutual funds to commit to next-day redemption at tonight’s NAV, even though all reasonable people know that a mutual fund – with the possible exception of a money market fund – could not possibly liquidate all assets on the wire tomorrow at tonight’s NAV marks. Systemically, it’s the illusion of liquidity, as so elegantly described by John Maynard Keynes:
"[T]he fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma.

So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organizing markets wherein these assets can be easily realized for money.”
Yes, liquidity for all at last night’s marks is an illusion. But for banks, unlike mutual funds, it’s not so much an illusion after all, for two simple reasons: banks have access to deposit insurance underwritten by fiscal authorities and to a discount window underwritten by the monetary authority (and one step removed, the fiscal authority). Thus, banks are unique institutions, providing a “public good:”
* Liquidity on demand at par for their depositors, because of the safety net underwritten by the sovereign, yet
* The ability to invest in longer-dated, more risky, not-always-at-par loans and securities, because the existence and credibility of the public safety net systemically renders the public’s ex post demand for liquidity at par below the public’s ex ante demand.
[A]nd since the sovereign providing the liquidity safety net is a de facto equity partner in the business, the sovereign quite rationally wants a say in how the business is run – the degree of leverage, corporate governance, risk management controls, etc. Kinda like I do when I pay the insurance premium on my 19-year old son’s car. Jonnie doesn’t like it, and neither do bankers.

Thus, both bankers and would-be bankers have, from time immemorial, sought to get the benefits of the sovereign’s liquidity safety net without shouldering the associated regulator nuisance.

Over the last three decades or so, the growth of “banking” outside formal, sovereign-regulated banking, has exploded, in something that I dubbed the Shadow Banking System. Loosely defined, a Shadow Bank is a levered-up financial intermediary whose liabilities are broadly perceived as of similar money-goodness and liquidity as conventional bank deposits. These liabilities could be shares of money market mutual funds; or the commercial paper of Finance Companies, Conduits and Structured Investment Vehicles; or the repo borrowings of stand-alone Investment Banks and Hedge Funds; or the senior tranches of Collateralized Debt Obligations; or a host of other similar funding instruments.

The bottom line is simple: Shadow Banks use funding instruments that are not just as good as old-fashioned sovereign-protected deposits. But it was a great gig so long as the public bought the notion that such funding instruments were “just as good” as bank deposits – more leverage, less regulation and more asset freedom were a path to (much) higher returns on equity in Shadow Banks than conventional banks.

And why did the public buy such instruments as though they were “just as good” as bank deposits? There are a host of reasons, not the least of which was lust for yield. But most fundamentally, Keynes again gives us the systemic answer (his italics, not mine):
“In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out quite so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely.

We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuations which are in no way relevant to the prospective yield. Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.

For if there exist organized investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence.
Thus investment becomes reasonably “safe” for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are “fixed” for the community are thus made “liquid” for the individual."
And so, Keynes provides the essential – and existential – answer as to why the Shadow Banking System became so large, the unraveling of which lies at the root of the current global financial system crisis. It was a belief in a convention, undergirded by the length of time it held: Shadow Bank liabilities were viewed as “just as good” as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by both the sovereign and the sovereign-blessed rating agencies.

Until, of course, convention was turned on its head, starting with a run on the ABCP market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization of Fannie and Freddie in July, and the actual death of Lehman Brothers in September 2008. Maybe, just maybe, there was and is something special about a real bank, as opposed to a Shadow Bank!

And indeed that is unambiguously the case, as evidenced by the on-going partial re-intermediation of the Shadow Banking System back into the sovereign-supported conventional banking system, as well as the mad scramble by remaining Shadow Banks to convert themselves into conventional banks, so as to eat at the same sovereign-subsidized capital and liquidity cafeteria as their former stodgy brethren.

The new conventional wisdom: levered capitalism is good, and made even better with a bit of socialism to protect the downside.

Like most of us, I’ve always had a separation in my mind between strictly capitalist activities and strictly public activities. Not that the demarcation is always clean. But it’s a useful way of thinking.

But you get the point: there is private enterprise and there is public enterprise. And then there is banking, a hybrid of the two. There is no way ‘round this, for good or bad, because fractional reserve banking depends upon the sovereign’s safety net against liability runs, a safety net that the private sector definitionally can’t universally supply. In this sense, the safety net is like national defense: we all need it, but since nobody individually has the incentive to pay for it, we collectively tax ourselves to pay for it.

[We] are now caught in the debt-deflationary pathologies of “the paradox of deleveraging.”6 Not everybody in the private sector can delever at the same time without creating a depression. Accordingly, the sovereign must go the other way, levering up the public balance sheet. And Washington has finally started to do so with appropriate vigor and enthusiasm.

It’s not a pretty picture. In fact, it’s repugnant, giving proof to the proposition that breaking the paradox of deleveraging does involve socializing the downside of previously profitable private sector activities.

If the sovereign must backstop a private sector activity that produces a public good, then the sovereign will, at least in a democracy, rightfully demand both bottom-up and macro-prudential rules to harness the greed that lubricates the invisible hand of capitalism.

Capitalism, and especially financial market capitalism, brought this outcome upon itself through greed and hubris. Capitalism is now re-grouping and learning how to play by new rules, which are still being written. And ultimately, I’m sure, capitalistic bankers will once again bend those rules in the pursuit of higher profitability. And that’s okay, I think. In the end, we really don’t want to turn our banking system into the [state Department of Motor Vehicles]. At the same time, we also don’t want our banking system to be nothing more than a betting parlor.

Or, in the famous words of Keynes again:
"When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

Monday, November 24, 2008

Leaving on a jet plane

There's so many times I've let you down
So many times I've played around
I tell you now, they don't mean a thing

I'm leavin' on a jet plane
I don't know when I'll be back again
Oh, babe, I hate to go.

-- [I'm] Leaving on a jet plane
Peter, Paul & Mary

With some cynically saying the Obama administration returns Kumbaya to the national stage, let us not forget Peter, Paul and Mary and the hootenanny days, because their jet plane song (let's all sing along) seems to have united even the Washington Post and FoxNews!

Here's FoxNews:
Obama economic advisor Austin Goolsbee criticized the auto industry for granting its executives multi-million dollar paychecks while the companies fell under.

"The fact that these guys flew in private jets to Washington, and it seemed like it was the first they heard of it: "what is your plan to restructure your companies?" They said, you know, "we'll have to get back to you." that was crazy," Goolsbee said on CBS' "Face the Nation."
Here's Dana Millbank in WaPo:
There are 24 daily nonstop flights from Detroit to the Washington area. Richard Wagoner, Alan Mulally and Robert Nardelli probably should have taken one of them.

Instead, the chief executives of the Big Three automakers opted to fly their company jets to the capital for their hearings this week before the Senate and House -- an ill-timed display of corporate excess for a trio of executives begging for an additional $25 billion from the public trough this week.

"There's a delicious irony in seeing private luxury jets flying into Washington, D.C., and people coming off of them with tin cups in their hands," Rep. Gary L. Ackerman (D-N.Y.) advised the pampered executives at a hearing yesterday.
Other voices were also chiming in from

Miami Herald:
You'd be hard pressed to find three guys more disconnected from Main Street and less qualified to talk about the plight of the average auto worker. According to The Washington Post, Wagoner's total compensation from GM last year was $15.7 million. Mulally collected $21.7 million from Ford.

When asked by Rep. Peter Roskam of Illinois if he'd be willing to cut his salary to $1 a year, as Chrysler's Nardelli has said he would do, Mulally replied: ``I think I'm okay where I am.''

Spoken like a true capitalist. Now give that man a big fat government bailout! As for Nardelli's benevolent offer to accept only a buck-a-year in compensation, he could surely afford it. In January 2007, he quit abruptly after six years as CEO of Home Depot Inc., where he'd been paid as much as $38 million annually.

Before leaving the company, Nardelli negotiated a ''retirement'' package worth $210 million, a stunningly obscene sum even in the surreal realm of corporate parachutes.

Nobody was asking that the CEOs apologize for their personal wealth and career successes. But when the corporation that rewards you so extravagantly is going down the toilet, a little humility and sensitivity is in order.

The generosity of Americans doesn't -- and shouldn't -- extend to sustaining the ethereal lifestyles of multimillionaires. Lots of executives fly private, but not to their own pity parties.

Bailouts are meant to save jobs, not corporate chariots.
Fox' Bill O'Reilly in Townhall.com:
Leaders of the three major American car companies showed up on Capitol Hill this week stating that if billions in government loans were not forthcoming, they would go bankrupt. And how did many of these executives get to Washington from Detroit? By private jet, of course.

They want charity from hardworking Americans who are getting pounded in a chaotic economy primarily caused by irresponsible businesspeople.

Both political parties are at fault, and we should tell them there will be no loans to private industry that uses private jets. The scam stops here.
Boston Herald:
Obama adviser David Axelrod says Congress is sending the right signal to the industry.

"I hope that they will come back to Washington in early December — on commercial flights — with a plan," he said.
Chicago Tribune:
This is not a good time to be Detroit, the city that put the world on wheels, and now the city whose corporate kingpins are begging Washington for a $25 billion bailout.

In fact, the timing couldn't be worse. All that pent-up public anger over gas prices, cars that get lousy mileage, autoworkers who get paid for not working and executives who fly on private jets and get fat bonuses while their companies suffer have come together to forcefully pose the question from public and Congressional critics: Why not let the whole rotten bunch of domestic automakers go belly up?
Meanwhile, the NYT looks back, not even as far as the Chrysler bail-out, which happened back in the days of dinosaurs when Guambat was in law school. Guambat was taking a corporation law class and his professor began one class with "Today we will discuss non-profit corporations and, no, I am not talking about Chrysler". The NYT only went back to the 1990's in this report:
Beginning in late 1993, the federal government contributed more than $1.25 billion to the [Partnership for a New Generation of Vehicles] program, an effort that began in late 1993 to make the automakers more competitive by assisting them in developing, by 2004, a prototype midsize sedan that would go 80 miles on a gallon of gas, with no loss of acceleration, size or carrying capacity.

The money that the industry is seeking now is not for research and development, as the partnership and a small successor program were. Congress has already approved $25 billion to finance an Energy Department program for car companies and their suppliers to retool factories for new fuel-efficient models. Detroit is also seeking additional loans in the form of working capital. But the history of federal help for Detroit is not good, experts say.

At the Natural Resources Defense Council, Roland Hwang, a vehicles expert, said the main effects of the program were to deflect pressure on Detroit to make cleaner and more fuel-efficient vehicles right away, and to prod Japanese manufacturers into speeding up their own efforts, which resulted in the Prius and other successful models.

Michael P. Walsh, an air pollution consultant who was in charge of efforts by the Environmental Protection Agency to limit vehicle emissions, said the research and development programs aided by Washington “were basically big failures in that they didn’t really force the industry to bring anything to the marketplace.”

Mr. Hwang said other policies could help the companies and move them in the right direction. The tax break of up to $4,000 per vehicle given to buyers of high-mileage hybrids is “as good as cash in the bank” for the car companies, he said.
It is interesting to point out that the automobile industry in the US was a big beneficiary of the recent stock market romp, and that the industry Executives didn't fly in to Washington offering to share in their unexpected and unearned windfall. Guambat posted from this story 2 years ago:
* The best stock rise for the year on the DOW was by a company who's rise was almost double the rise of the second best stock on the DOW.

* This stock went up 64.52% this year, and last year everyone was wondering if it would go bankrupt. This stock that went up 64.52% is a money losing company ... and it has been the most significant driver in the DOW reaching new highs! This same company's stock price has consistently made "lower tops and lower bottoms" since 2002 ... in other words, it is in a long term down trend.

* The stock's high on May 31st, 2002 was $68.17. At Noon yesterday, it was $31.87 ... a drop of 53.2% from May 2002, yet it is the best contributing stock to the DOW's rise this year by nearly a factor of 2 compared to the DOW's next best stock. By the way, the DOW is up 14.3% since its May 31st. 2002 monthly high.

* Oh ... one more tidbit. This company's second quarter Revenues were $53,669,000,000. and it still lost $3.37 billion dollars for the quarter with a -$5.97 EPS. And its reward for that performance was to be the #1 stock on the Dow Jones Industrials. (See GM's Earnings per Share chart and historical price chart below.)

* What company are we talking about? General Motors.

Much of GM's price increase was because of billionaire investor Kirk Kerkorian who owned 9.9 percent of GM shares and then considered raising his stake to 12 percent. This week Kerkorian signaled he would not acquire more stock. And, some of GM's rise centered around speculation whether a North American turnaround is really under way for General Motors ... or not.

If it turns out that Kirk Kerkorian really is giving up his interest in controlling GM, then that means he would sell this 9% of GM and the stock will once again move down to new lows.

The point of discussing all of this, is the new highs for the DOW and what effect GM's price had on it. By my calculations yesterday, if GM's poor EPS performance resulted in the price of the stock being at neutral (a zero % gain for the year), then the DOW's price yesterday would have been 11616 ... which would have meant the DOW never reached its "all time high".
But the problem is too big to ignore if not too big to fail, and the politicians are going to have to sit down and hammer out a deal of some kind, as noted in this story from far away New Zealand, as the whole world watches:
Senator Carl Levin, a Michigan Democrat, along with Republican Senators Kit Bond of Missouri and George Voinovich of Ohio are trying to broker an alternative that could provide bridge loans or a guarantee that the fuel-efficiency loan fund ultimately would be replenished.

Negotiators were discussing a scaled-down aid package of US$5 billion to US$8 billion to help the car makers survive through year's end. But it was unclear whether any progress could be made. Democrats strongly oppose letting the car companies tap into the energy loans for short-term cash-flow needs.

Now, if only I had a hammer ....

Value returns to stock market?

Guambat railed over the last several years at the seemingly absurd rise of the global markets, driven, he reckoned, but the creation of money by private equity and the cheap ass yen and the easy Greenspan credit regime. As prices were marked ever higher, Guambat failed to be convinced that value was keeping up.

Alas, that has appeared to be the case, at least in part confirmed by the following:

Hedge Funds Reduce Stock Holdings
"Hedge funds may have returned closer to their roots as 'hedged' investors, less dependent on market direction to produce returns, migrated away from the levered long strategies that many funds pursued during the upward-trending market of 2002 to 2006," [according to David Kostin, who leads Goldman's New York-based portfolio strategy team].

Net holdings of equities decreased to 17 percent from 47 percent a year ago. Hedge funds now own 3.5 percent of U.S. stocks, down from 4.5 percent in the third quarter, he said.
With only another 17% of equity holdings left to go in the hedge funds, perhaps momentum will subside and value will return to the stock markets.

Sunday, November 23, 2008

Felix Salmon has a Jimi Hendrix moment

Felix Salmon can answer yes to Jimi's "Are you experienced?".

Outing his own error, Felix noted that about a year ago he thought buying into Prince Alwaleed's hedge/private equity vehicle could be a good buy, but since then the price has dropped 55%. Said he,
Note to self: when a billionaire sells equity in his own investment prowess, that's normally a very good deal -- for him. For the schmucks who buy the shares, not so much.

Several months ago, in discussing how Blackstone was pulling off a similar scheme, Guambat related an old saw:
Guambat recalls roughly an old saw that goes something like, "when a man with experience meets a man with money, the man with experience ends up with the money and the man with the money ends up with an experience."

Commentors to Felix' post had similar thoughts.

Thursday, November 20, 2008

Have I got a preposition for you!

They aren't much mentioned any more, but long ago, Guambat remembers when "genuine synthetic pearls" were all the rage.

Not so benign but hidden in plain sight by equally dissonant language are "synthetic CDOs", which are now all the rage. At least, they are now causing a great number of people to rage about them.

To look at synthetic CDOs, first consider what a CDO is:
A CDO, most broadly, is a device that repackages the income from a pool of bonds, derivatives or other investments. A mortgage CDO might own pieces of a hundred or more bonds, each of which contains thousands of individual mortgages. Ideally, this diversification makes investors in the CDO less vulnerable to the problems of a single borrower or security.
Guambat recently had a post that touched on the current problems with synthetic CDOs, which were described as:
As opposed to regular CDOs, which contain actual bonds, synthetic CDOs provide income to investors by selling insurance against debt defaults, typically on a pool of a hundred or so companies or individual bonds.

banks, hedge funds and insurance firms around the world, used synthetic CDOs as a way to invest in diversified portfolios of companies without actually buying those companies' bonds.
Alan Kohler is an Australian financial commentator often mentioned in these posts. He describes how synthetic CDOs may restore banks around the world to their wealth and health, which would be a good thing.

But because for every winner there is a loser, this could be a very bad thing for people who bought these things for the yield they offered without regard to the risk they posed. Actually, the "without regard" part is only part right because in a great many cases they had no idea whatsoever what the synthetic part of the CDO was, if even they had any notion of a CDO to begin with, and to the extent that they understood anything at all, it was the non-synthetic AAA rating placed on things by ratings agencies run amok.

Let Alan tell us how this might all play out:

CDOs were invented by Michael Milken’s Drexel Burnham Lambert in the late 1980s as a way to bundle asset backed securities into tranches with the same rating, so that investors [code for fund managers playing with someone else's money, yours for instance] could focus simply on the rating [code for neglecting their own due diligence and relying blindly and purposefully ignorantly on ratings agencies] rather than the issuer of the bond [code for who gave a damn about what was in the stuff and if it was in any way credible?].

[In other words, CDOs were created to draw attention away from any thought about a return of capital, and mesmerize the market buyers (who usually got paid based on yields) with dreams of returns on capital.]

About a decade later, a team working within JP Morgan Chase invented credit default swaps, which are contractual bets between two parties about whether a third party will default on its debt.

In 2000 these were made legal [code for this stuff used to be illegal but somehow became not so], and at the same time were prevented from being regulated [code for free markets], by the Commodity Futures Modernization Act, which specifies that products offered by banking institutions could not be regulated as futures contracts.

This bill, by the way, was 11,000 pages long, was never debated by Congress and was signed into law by President Clinton a week after it was passed. It lies at the root of America’s failure to regulate the debt derivatives that are now threatening the global economy.

Anyway, moving right along – some time after that an unknown bright spark within one of the investment banks came up with the idea of putting CDOs and CDSs together to create the synthetic CDO.

Here’s how it works: a bank will set up a shelf company in Cayman Islands or somewhere with $2 of capital and shareholders other than the bank itself. They are usually charities that could use a little cash, and when some nice banker in a suit shows up and offers them money to sign some documents, they do.

That allows the so-called special purpose vehicle (SPV) to have “deniability”, as in “it’s nothing to do with us” – an idea the banks would have picked up from the Godfather movies.

The bank then creates a CDS between itself and the SPV. Usually credit default swaps reference a single third party, but for the purpose of the synthetic CDOs, they reference at least 100 companies.

They have a variety of twists and turns, but it usually goes something like this: if seven of the 100 reference entities default, the SPV has to pay the bank a third of the money; if eight default, it’s two-thirds; and if nine default, the whole amount is repayable.

For this, the bank agrees to pay the SPV 1 or 2 per cent per annum of the contracted sum.

Finally the SPV is taken along to Moody’s, Standard and Poor’s and Fitch’s and the ratings agencies sprinkle AAA magic dust upon it, and transform it from a pumpkin into a splendid coach.

The bank’s sales people then hit the road to sell this SPV to investors. It’s presented as the bank’s product, and the sales staff pretend that the bank is fully behind it, but of course it’s actually a $2 Cayman Islands company with one or two unknowing charities as shareholders.

It offers a highly-rated, investment-grade, fixed-interest product paying a 1 or 2 per cent premium. Those investors who bother to read the fine print will see that they will lose some or all of their money if seven, eight or nine of a long list of apparently strong global corporations go broke. In 2004-2006 it seemed money for jam. The companies listed would never go broke – it was unthinkable.

Here are some of the companies that are on all of the synthetic CDO reference lists: the three Icelandic banks, Lehman Brothers, Bear Stearns, Freddie Mac, Fannie Mae, American Insurance Group, Ambac, MBIA, Countrywide Financial, Countrywide Home Loans, PMI, General Motors, Ford and a pretty full retinue of US home builders.

In other words, the bankers who created the synthetic CDOs knew exactly what they were doing.

As one part of the bank was furiously selling loans to these companies, another part was furiously selling insurance contracts against them defaulting, to unsuspecting investors [code for spreading the risk via information arbitrage]

nobody has any idea how many were sold, or with what total face value.

It is known that some $2 billion was sold to charities and municipal councils in Australia, but that is just the tip of the iceberg in this country. And Australia, of course, is the tiniest tip of the global iceberg of synthetic CDOs. The total undoubtedly runs into trillions of dollars.

All the banks did it, not just Lehman Brothers which had the largest market share, and many of them seem to have invested in the things as well (a bit like a dog eating its own vomit) [code for greed makes you do silly things].

It is now getting very interesting. The three Icelandic banks have defaulted, as has Countrywide, Lehman and Bear Stearns. AIG has been taken over by the US Government, which is counted as a part-default, and Freddie Mac and Fannie Mae are in “conservatorship”, which is also a part default.

Ambac, MBIA, PMI, General Motors, Ford [code for, "are you sure you want to bankrupt the auto companies?"] and a lot of US home builders are teetering.

If the list of defaults – full and partial – gets to nine, then a mass transfer of money will take place from unsuspecting investors around the world into the banking system. How much? Nobody knows, but it’s many trillions.

The distress among those who lose their money will be immense. It will be a real loss, not a theoretical paper loss. Cash will be transferred from their own bank accounts into the issuing bank, via these Cayman Islands special purpose vehicles.

The repercussions on the losers and the economies in which they live, will be unpredictable but definitely huge. Councils will have to put up rates to continue operating. Charities will go to the wall and be unable to continue helping those in need. Individual investors will lose everything.

But for the banks, it’s happy days. Suddenly, when the ninth reference entity tips over, they will be flooded with capital. It’s possible they will have so much new capital, they won’t know what to do with it.

This is entirely uncharted territory so it’s impossible to know what will happen ....

If this scenario plays out, given the momentous consolidation in the banking industry, they will have to re-write the definition of "big bank".

But, at least the banks will be in the position of being able to lend again, and there will be no shortage of borrowers. As Ben Franklin didn't say, "ever a lender or a borrower be".

Tuesday, November 18, 2008

Left field slugger

As Guambat has often noted, he sees himself as a bit of a left field hitter: he sees an opportunity coming but swings too soon to get a good piece of it.

But whereas Guambat is such a poor left field hitter that he tends to foul out past the extreme left field foul line, some left field hitters manage to keep the ball on the in bounds side of the foul line, and hit it into the far left field stands for a home run.

One such slugger is John Hussman, of whom Guambat has on occasion admiringly spoken and cited.

The thing about Hussman is that he has, for the last several years to a decade, been extremely wary of the market conditions, as a quick review of the citations just mentioned reveal. So cautious has he been that many consider him to be leading bear voice, if not a perma-bear.

Guambat just considers him to be a left field slugger because, though he did miss the last and biggest spikes of the recent bull run because he hit to the left field ahead of the ball and arguably "got out" (well, got conservative in his holdings, anyway) too soon, he did also miss the crash that has caught so many bulls by the balls.

So now he's stepping up to the plate with a big bat and this time looking to hit a bull ball to left field. He's been "averaging in" to this idea for a little while, as you can see from his excellent weekly commentaries here.

The evolution of his thinking had taken shape by the time on October 20th when he wrote:
The best way to begin this comment is to reiterate that U.S. stocks are now undervalued. I realize how unusual that might sound, given my persistent assertions during the past decade that stocks were strenuously overvalued (with a brief exception in 2003). Still, it is important to understand that a price decline of over 40% (and even more in some indices) completely changes the game.

In 2000, we could confidently assert that stocks would most probably deliver negative total returns over the following 10-year period. Today, we can comfortably expect 8-10% total returns even without assuming any material increase in price-to-normalized-earnings multiples. Given a modest expansion in multiples, a passive investment in the S&P 500 can be expected to achieve total returns well in excess of 10% annually.

None of this is an argument that the market has necessarily registered either a near-term or a final bear market low.
He was warming to the idea in his November 10 report:
I continue to view stocks as somewhat undervalued, in that long-term investors can expect the S&P 500 to deliver total returns in the area of 10% annually over the coming decade. This is the largest expected return premium, relative to long-term Treasury yields, since the early 1980's.

These changes have significantly improved my views about market valuations and long-term return prospects, but I want to discourage any impression that stocks have “hit bottom” or that a new “bull market” is at hand. That sort of thinking isn't really helpful to investors, who should always be grounded in observable evidence (rather than trying to infer things like bottoms and turning points, which can only be identified in hindsight). Frankly, the idea of identifying those things in real time is wishful thinking. Investors should not rule out a continued bear market, or deeper lows, perhaps early next year (depending on the evolution of the economic evidence). Still, even in the context of a continued bear market, we may well observe a huge 25-35% trading range as evidence develops, pushing and pulling on the perceptions and expectations of investors. Better to be comfortable with uncertainty and thoughtfully adapt to observable evidence as it develops, rather than planting a flag in the ground and being trampled from both sides.
And his latest November 17th report puts his thinking in an historical context:
One of the fallacies about the recent financial turbulence is that the markets are in “uncharted territory” and that there are no historical precedents for the volatility, panic, or economic uncertainty that we've observed. To make statements like this is to admit that one has not examined historical evidence prior to the 1990's. The fact is that we've observed similar panics throughout market history. This decline has been deeper and more rapid than most, but that is largely a reflection of the rich valuation and overbought condition that characterized the market in 2007.

Sure, if U.S. unemployment is headed to 25%, as it did in the Great Depression, then stock prices might fall in half even from here, as they did by 1932. But this is important – even if stock prices were to fall further, it would not be because of earnings losses that would permanently impair the fundamental value of U.S. companies. Rather, if further losses emerge, it will be because of increases in risk premiums that will be associated with extremely high subsequent returns. Indeed, even though unemployment shot to 25% in 1932, the S&P 500 more than doubled in the year following the 1932 Depression low, and tripled off of that low within less than three years.

The handful of historical instances when stocks fell to 7 times prior record earnings were also points that were accompanied by 15-25% unemployment, 12% yields on commercial paper (as at the 1974 lows), or 15% Treasury yields (as at the 1982 lows). Similar data is unlikely in this instance

Meanwhile, it is notable that data that measure investor panic, such as risk-premiums and intra-day market volatility, already match historical extremes (1932, 1974, 1982, and 2002) – points where stock prices were not far from their lows even though negative economic news persisted for a longer period.

That's not to say that I believe stocks have “hit their lows.” We always have to allow for the market to move significantly and unexpectedly, and there is plausible downside risk from here. Our activity as investors is not to try to identify tops and bottoms – it is to constantly align our exposure to risk in proportion to the return that we can expect from that risk, given prevailing evidence.

Investors can get a good understanding of market history by examining a great deal of data, or by living through a lot of market cycles and learning something along the way. Only investors who have done neither believe that current conditions are “uncharted territory.” Veterans like Warren Buffett and Jeremy Grantham have a good handle on both historical data, and on the concept that stocks are a claim to a very long-term stream of future cash flows. They recognize that even wiping out a year or two of earnings does no major damage to the intrinsic value of companies with good balance sheets and strong competitive positions. Most importantly, these guys never changed their standards of value even when other investors were bubbling and gurgling about a new era of productivity where knowledge-based companies would make the business cycle obsolete, and where profit margins would never mean-revert. They knew to ignore the reckless optimism then, because they understood that stocks were claims on a very long-term stream of cash flows. They know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows. Stocks are not a claim on next quarter's or next year's earnings – they are a claim on an indefinite stream of future cash flows.

No thoughtful investor “calls a bottom” in the markets. Stocks are undervalued here, but they could decline further. Current market conditions are extremely compressed, to the extent that the market could soar by 30% even in the context of an ongoing bear market.

It is a typical market dynamic to have massive rallies toward prior levels of support, even within ongoing market declines. Once valuations are favorable, that tendency is even stronger, even in a weakening economy. Only the final panic decline of a bear market offers investors virtually no chance to get out on rebounds, but it is precisely that final decline that is recovered almost immediately in the subsequent bull market.

It's possible we've already seen the final panic of the current “bear market,” though we certainly wouldn't remove our hedges on that expectation. Given the slim prospects for an economic recovery in the near future, my impression is that regardless of what happens over the very near term, we'll observe an additional spate of weakness (possibly from higher levels) early next year as investors give up their remaining patience and decide –as they often do near the end of a bear market – that there's no way that the market or economy can recover, and that there is no “catalyst” that is capable of driving stocks higher.

It is important to establish exposure slowly, but long-term investors who ignore attractive valuations are not investors at all.

As I repeatedly noted when valuations were rich, gains in an overvalued market are generally not retained over the full market cycle. Likewise, weakness in an undervalued market tends to be temporary and impermanent. This distinction is essential. The main damage that investors can do to their financial security at this point would come from selling into steep but impermanent declines. Even in ongoing bear markets, once valuations become favorable, declines through prior levels of support are typically followed by advances back to that support. Remember that if and when things look frightening.

It is also important for investors to separate near-term earnings risks from long-term valuations. Earnings are more volatile than stock prices, and year-over-year fluctuations in earnings are not correlated at all with year-over-year fluctuations in stock prices. It is only over the long-term, when we examine stock prices versus the smooth trend of normalized earnings across multiple business cycles, that earnings really matter.

As a side note, do your best to filter out comments like “investors are moving out of stocks and into …” or “investors are selling into this decline” or “investors are buying into this rally.” On balance, investors do not sell shares, and they don't buy shares. Every share purchased is a share sold. The only question is what price movement is required to prompt a buyer and a seller to trade with each other. No money will come off the sidelines into stocks. No money will come out of stocks and onto the sidelines. All such talk is non-equilibrium idiocy. Keep in mind that the “market” consists of different traders with a variety of time-horizons, risk-tolerances, and analytical methods (e.g. technical, report-driven, value-conscious). It is helpful to think in terms of which group of individuals is likely to do what, and when. It is equally important to know which group of investors you belong to. As the old saying goes, if you're at a poker table and you don't know who the patsy is, you're the patsy.

John Hussman is an investor and not a trader, so, to some extent, reading his weekly reports is a bit like watching paint dry. But you are well advised to check in on his market commentary from time to time just for the education if not for the rush of animal spirits.

Saturday, November 15, 2008


It seems some elements of the Catholic church in particular has taken the pro-choice initiative to Obama, going so far as to penalize those who chose to vote for him. Sort of a pro-anti-pro-choice stance.

A Dallas Morning News blog pointed out
In a letter distributed at St. Mary's Catholic Church in Greenville, S.C., the Rev. Jay Scott Newman says parishioners who supported Barack Obama (or, as the priest put it, "Barack Hussein Obama") are putting their souls at risk if they receive Holy Communion before doing penance for their "cooperation with intrinsic evil" -- voting for a pro-choice candidate.

Meanwhile over on the Other Coast, an SF Bay area ABC news affiliate reported,
The Catholic Diocese of Sacramento is investigating an incident which took place before a mass last Sunday.

Elizabeth Castor was thrilled when Barack Obama won the presidency. The native of Kenya decided to decorate her SUV with his name and the word 'victory.'

"He went to the mic and said the owner of the grey SUV with the Obama signs has to move. "I felt humiliated."

Caster said Father Sebastian Meyer then followed she and her young son out to the parking lot and allegedly told her not to re-park, but to leave the church property.

"I couldn't believe what I was hearing," Caster said.

Some of the church leadership balks at taking on their own to fight the cause. In the California case, the report noted,
An official from the Sacramento diocese said an investigation was underway into what happened.

"It's not the church's place to criticize people for who they vote for," said Sacramento Catholic Diocese spokesman Kevin Eckery.

Bishops React to Priest who Told Obama-Supporting Catholics to Confess before Receiving Communion
A South Carolina Catholic priest who advised Obama supporters in his flock not to receive Communion before going to confession elicited polarized responses from the Catholic community - ranging from outrage at a misuse of authority to warm praise for championing Church teaching on abortion.

The article examined both sides of the debate, and alluded to other related articles:
Can Catholics Who Vote for Obama Still Receive Communion? http://www.lifesitenews.com/ldn/2008/jun/08061208.html

Special Report: Worthiness to Receive Holy Communion, General Principles

The www and blogoshpere is full of the debate as any quick search will reveal.

So don't expect much in the way of an Obama honeymoon period.

And while sitting on the supposed divide between church and state, there is this little imbroglio:

Preacher Appeals Sentence for Article Predicting God Would Smite Judge
An activist preacher in Michigan is appealing his sentence of up to 10 years in prison for writing an article predicting that God would smite the judge who oversaw his trial and conviction for paying patrons of a soup kitchen to vote.

The Rev. Edward Pinkney was sentenced in June to three to 10 years in jail for violating his probation in the voting case by making a threat against the judge

An ACLU brief in support of the motion (PDF) claims the sentence violates Pinkney’s First Amendment rights.

Sayeth the preacherman,
Judge Butzbaugh, it shall come to pass; if thou continue not to hearken unto the voice of the Lord thy God to observe to do all that is right; which I command thee this day, that all these Curses shall come upon you and your family, curses shalt be in the City of St. Joseph and Cursed shalt thou be in the field, cursed shall come upon you and your family and over take thee; cursed shall be the fruit of thy body. The Lord shall smite thee with consumption and with a fever and with an inflammation and with extreme burning. They the demons shall Pursue thee until thou persist.

Thursday, November 13, 2008

An "Obama effect"?

King Abdullah [of Saudi Arabia] organised [a] two-day conference in New York to promote a dialogue on religion and culture.

He told the meeting of world leaders that it was time to learn the lessons of the past. "Terrorism and criminality are the enemies of each and every religion and civilisation," he said, speaking through an interpreter.

"They wouldn't have appeared had it not been for the upset of the principles of tolerance."

When [Israeli President Shimon] Mr Peres took to the floor, he broke off from his prepared speech to address King Abdullah directly.

"Your Majesty, the king of Saudi Arabia," he said. "I was listening to your message. I wish that your voice will become the prevailing voice of the whole region, of all people. It's right. It's needed. It's promising.

"The initiative's portrayal of our region's future provides hope to the people and inspires confidence in the nations."

"I don't deny there are open and difficult questions, but if there is a will - as the Arabs are saying - there is a way. What was today demonstrated was the will. We know that we have to work for the way."
Peres lauds Saudi King peace plan

Sunday, November 02, 2008

You picked a fine time to leave us, Lucille