Risk models - incredibly precise and dangerously wrong

The following excerpt comes from Why Banks Failed The Stress Test which is a document authored by Andrew Haldane, Executive Director for Financial Stability at the Bank of England and echoes several of my own comments on the danger of the financial models that have been overly relied upon by risk managers.

Risk managers are of course known for their pessimistic streak. Back in August 2007, the Chief Financial Officer of Goldman Sachs, David Viniar, commented to the Financial Times: “We are seeing things that were 25-standard deviation moves, several days in a row” To provide some context, assuming a normal distribution, a 7.26-sigma daily loss would be expected to occur once every 13.7 billion or so years. That is roughly the estimated age of the universe.

A 25-sigma event would be expected to occur once every 6 x 10124 lives of the universe. That is quite a lot of human histories. When I tried to calculate the probability of a 25-sigma event occurring on several successive days, the lights visibly dimmed over London and, in a scene reminiscent of that Little Britain sketch, the computer said “No”. Suffice to say, time is very unlikely to tell whether Mr Viniar’s empirical observation proves correct.

Fortunately, there is a simpler explanation – the model was wrong. Of course, all models are wrong. The only model that is not wrong is reality and reality is not, by definition, a model. But risk management models have during this crisis proved themselves wrong in a more fundamental sense. They failed Keynes’ test – that it is better to be roughly right than precisely wrong. With hindsight, these models were both very precise and very wrong.

Latest in toilet humour from Ryanair

Feb. 27 (Bloomberg) -- Ryanair Holdings Plc, Europe’s biggest discount airline, may charge passengers to use toilets on its planes, adding to fees already imposed for beverages, stowed baggage, airport check-in and preferential boarding.

I wonder if you will be able to pay with a credit card.

Arthur C Clarke on prediction

Arthur C. Clarke is best known for one of his so-called Laws relating to prediction which is
Any sufficiently advanced technology is indistinguishable from magic.

There are two others that I like even more

The only way of discovering the limits of the possible is to venture a little way past them into the impossible.
For every expert there is an equal and opposite expert.

Silent fear is mounting

Over the last few days I have been surprised by the number of investment professionals, to whom I have spoken, who have been making similar remarks to the following broad sentiments.

I'm starting to get scared about the way things are evolving.

Maybe we're close to some kind of tipping point where the transfer of liabilities into the public sector and the need for massive ongoing Treasury funding could just be more than is actually feasible.

There are erratic movements taking place across asset classes that are not in line with previous inter-market correlations.

Government are not being transparent about the extent of the bailouts and the general public don't have a clue as to the magnitude of the banking crisis.

And for those who work for well-known financial brands one of the more common qualifications when expressing such concerns runs along the lines "Of course I'm keeping pretty quiet about all of this and not sharing my anxieties with too many colleagues."

Even vultures need reassuring in today's markets

There is an interesting article in the New York Magazine this weekend illustrating that even vulture investors, who are normally most cheerful when they have an opportunity to prey on those who have fallen on hard times, are getting just a teeny bit apocalyptic.

Here is just a short excerpt from the piece:

V: I heard this yesterday: The top five U.K. banks have $10 trillion of assets and their GDP is only $2.13 trillion. The whole country could fall into the ocean. The top five U.S. banks represent only about 60 percent of GDP by comparison. The other thing is a survey that I just read about in the Times. Over six in ten Americans think that someone in their household will lose their job in the next year. That means six in ten people won't buy anything other than basics. The economy comes to a full halt even worse than now.
NYM: That means the other four out of ten better be out there buying Gucci. You're not losing your job. Are you buying any Gucci? Taking vacations? Leasing a new Mercedes?
V: I'm still taking vacations and renting a summer house but I ain't buying anything. Credit-default swaps scare me too much. For the banks, their portfolios of second-lien loans is terrifying and nobody, including the government, wants to talk about it. The banks carry them at par and have hundreds of billions of dollars of them. We just bought some at 33 cents on the dollar in the market. If they turn out to be worth 33, every bank would collapse.

Reading this article caused me some concern for V - the vulture investor - and I thought it wise to provide him some reassurance during these difficult times.

The good news for him is that, despite his remark that UK banks have "assets" that are five times the nation's GDP, there's much less need to worry now on that score at least. Under the Asset Protection Scheme announced late last week the UK government will be insuring 90% of the losses incurred on the most risky assets. And the banks will be paying for this insurance too - well paying may not be exactly the best word - they are going to issue non voting shares to the government equal to around 2-4% of the amount insured. There that should teach them to be more careful next time.
The really neat thing is that even when the new shares are issued for converting the government's preferred to common and with the banks paying for the insurance in shares as well, and with RBS being owned up to 95% by Her Majesty's government on behalf of its citizens, the Chancellor has categorically assured the markets that contrary to what some rotten bad apples have suggested, the banks will not, in fact, be nationalized. After all of these reassurances from its government one can be sure that UK taxpayers will now be sleeping much more soundly at night - especially, if they are also following the advice that the vulture investor is currently giving to his colleagues, to keep gold bars and shotguns under their beds.

Euro collapse - unthinkable of course...

This article may well be dismissed as alarmist by all of the very same smart people who were adamant that the sub-prime crisis could not conceivably crash the financial system. It is not that the opinion is necessarily correct but having it articulated so clearly by someone with these credentials suggests that it is not "unthinkable"

Feb. 27 (Bloomberg) -- Hayman Advisors LP, the firm that earned $500 million betting on the U.S. subprime mortgage-market collapse, says Europe’s monetary union is about to fall apart.

Richard Howard, a managing director for global markets at Dallas-based Hayman, said Germany may opt to shore up its own economy, Europe’s biggest, rather than bail out fellow euro nations such as Austria, Italy and Spain as their banks sag under the weight of bad debts. That might lead to defaults and compel Germany to renounce the euro, he said.

“People said subprime could never blow up but it did and now they’re saying the exact same thing about the eurozone,” said Howard. “There’s no stopping what is now a downward spiral.” He declined to discuss his investments.

Hayman joins a growing number of investors seeing the possibility of a breakup of the $12 trillion euro bloc, conceived more than 10 years ago to cut unemployment, tame inflation and create a rival to the dollar. Societe Generale SA said this week Germany may refuse a bailout in an election year. ABN Amro Holding NV said Feb. 17 the crisis is “Europe’s subprime.”

US Dollar - the safe haven currency

UUP, which allows a bullish trade on the US dollar against a collection of major currencies is in a clear buy channel. While resistance is to be expected at the top of the channel indicated, there is a good chance that global investors are becoming increasingly convinced that the US dollar is the world’s worst currency - apart from all of the rest.

US Treasury yields have turned

While I am no longer outright bearish on the banking sector I am becoming more concerned that the risk transference that has been heralded by the Asset Protection Scheme (or should that be Scam) announced in the UK yesterday and which may have some echoes in the moves being made for Citigroup (C) in the US are negative for all issuers of Treasury paper.

Gilts in particular need to be watched for signs of a buyer’s strike and although the US government has even bigger fish to fry - the US Treasury market has the benefit that it is underpinned by the global reserve currency.

Not that I am seriously proposing this, but the nightmare meltdown scenario that just could evolve is a surging dollar, an even more bullish market in gold and other strategic commodities, and an outright buyer’s strike which affects the most indebted nations first and eventually hits US Treasuries. Just for reference the chart of the yield on five year maturities is showing that the trend is now clearly upwards.

That is a conceivable risk that must now be contemplated and not just dismissed as scare-mongering. Thinking the unthinkable has proven to be a better conceptual strategy over the last year than thinking that smart financial engineers had successfully provided a safety net under capital markets by distributing risk through structured products and securitizations.

US Banking Index may have a sustainable bottom

The UK government is trailblazing with a sweetheart deal to ring fence those much celebrated "toxic assets". Why is this relevant to the US Banking index (BKX) - I have been commenting for some time that - much as it is counter-intuitive - the US banks may finally be putting in a sustainable bottom.

That’s the good news - the bad news is that although they may have stopped going down - and they have gone down on an epic scale - and even though they may enjoy some nice quick bounces, the ground they now have to try to recover is staggering.

And this is in a financial environment which could take many years, to put it optimistically, to see anything like the supportive conditions and growth potential that resembles those seen in the earlier years of this decade.

RBS - a fiasco

Several pundits and journalists in the UK media have covered in depth the ludicrous position that Her Majesty's taxpayers now find themselves in with respect to RBS. The bank has been granted a sweetheart deal via the Asset Protection Scheme with even more cash to be injected which could take the public interest to 90%+, but because of the issuance of B shares which do not readily convey voting rights, the government is still trying to maintain that the bank is not nationalized and remains in the private sector.
One of the saddest aspects of the whole cock up is the fact that the red top media in the UK is looking at the wrong story. Sir Fred and his egregious pension arrangement is a sideshow compared to the enormity of the possible losses that the current generation of taxpayers, and several other generations to come, could be liable for if the "troubled assets" are even half as toxic as many believe them to be.
One wants to say more about the whole sorry mess but it has a tendency to increase my blood pressure so I shall leave it there.

Treasury Secretary Geithner -is the job too big for him?

It's a trade-off decision for Mr. Obama - would he look bad if he hangs Geithner out to dry too early or even worst if he allows Geithner to go in front of the world's media on an ongoing basis and continue to disappoint and convey the sense that the job is too big for him. Hard decision for a new President to make especially when people are losing confidence and getting angrier with every new trillion dollar commitment.
I suspect that contingency plans for a replacement are well under way.

Large number fatigue - $Half Trillion - nice one from Royal Bank of Scotland

I do hope that I am not alone in still being shocked by the Royal Bank of Scotland announcements this morning.
What is most shocking is that so much complacency and large number fatigue is setting in, that even when Alistair Darling admitted during a radio interview that just RBS alone needs to have insurance on almost half a trillion dollars worth of troubled assets, the interviewer took that number in his stride and then went on to another fairly innocuous question for the Chancellor.

Why didn't the watchdogs bark?

In the UK yesterday Lord Turner, the chairman of the Financial Services Authority (FSA), was interrogated by the Treasury Select Committee and repeatedly asked to explain why the FSA was asleep at the wheel during the last several years which coincided with the heyday of banking incompetence. The members of the Committee were trying to find out why the FSA failed to follow warnings and take appropriate regulatory action, even when those warnings came from senior people working within banks which are now nationalized, and Lord Turner could only point to a "philosophy" which discouraged such surveillance.
So, according to Britain's senior financial regulator, we can blame a "philosophy" for the UK's domestic version of the global financial meltdown. And just to underline the magnitude of this colossal incompetence, just today it has been acknowledged by Chancellor Alistair Darling that UK citizens will be insuring against losses of almost half a trillion dollars worth of troubled assets on the books of just one bank, Royal Bank of Scotland. Her Majesty's taxpayers already have a 70% stake in this bank and further assistance of £20 billion above the insurance just mentioned will take the stake to approximately 80%, although the Chancellor obstinately refused to say that this amounted to nationalization. For US readers the semantics of this should be reflected upon when contemplating what kinds of ingenious fig leaves the US government is searching for to justify a likely stake by the US government in Citigroup (C) of perhaps as much as forty percent.
But to return to Lord Turner's reasoning it appears that a "philosophy" can be blamed for a banking system built on structured finance which became ever more incomprehensible, and for the squadrons of smart and well armed bankers who sold trillions of dollars worth of contractual claims that virtually no-one understands and which lie at the heart of the gaping black holes in banks' balance sheets. But the consequences of this "philosophy extend even further. It was also cited as the reason why a bloated bureaucracy of regulatory watchdogs not only failed to bark but who, in fact, saw it as their role to look the other way when any intruders or whistle-blowers appeared on their doorstep to disrupt their tranquility.
Not mentioned by Lord Turner, but noted by many commentators, including this writer, the primary motivation behind the "philosophy" to which he kept alluding yesterday, was a carefully crafted policy of "light touch" (i.e. non-existent) regulations which were primarily designed to promote London and its City culture as the friendliest onshore center for all kinds of financial engineering shenanigans, tax avoidance and favorable to those seeking to maximize the benefits of, to use the new buzzwords, "jurisdictional arbitrage".
While writing this piece I am listening to a fascinating radio discussion about the cultural background to T.S. Eliot's The Wasteland which was written in the early 1920's. Situating this great work in the history of ideas reminds us that all cultures have a prevailing philosophy or ideology and that before and during the period that Eliot created his masterpiece the world had to confront the nationalism that had lead to The Great War, the philosophy of Karl Marx which inspired the Russian Revolution of 1917 and a feudal and aristocratic mindset that manifested itself in imperial grandeur and the servility of millions in the name of God, King and country.
Putting the current global crisis into a longer term perspective, Lord Turner's feeble appeal to a "philosophy" of cultural complacency towards financial risk management may provoke very strong feelings of anger that this should never have been allowed to happen.
But, at the moment at least, the consequences of the light touch philosophy and the market fundamentalism about which George Soros has articulated well, has been confined to the write-off of trillions of dollars worth of phony wealth, admittedly with all of the associated misery from people losing jobs, homes and businesses, but, this is in stark contrast to the tens of millions of innocent young men who lost their lives fighting two World Wars in defense of the prevailing philosophies of nationalism and other ideologies of communism and fascism.
Let us hope that the largest cost to be borne by the world economy as a result of the stupidity, greed and cronyism of the financial and political technocrats, can remain in the domain of paper wealth destruction and that it does not extend, as it did several times in the 20th Century, to a loss of human lives on an epic scale.

S&P 500 declines - 1929-31 and 2008-?

Bespoke Investment are experts at presenting statistical data on the markets and I shall quote an excerpt from a recent article which can also be found here

There have now only been two periods in the history of the S&P 500 where the index declined more than 50% from an all-time high -- 1929 and now. In the first chart below, we highlight the percentage change from the S&P 500's most recent all-time high to its current level, along with the change from the 1929 all-time high over the same number of days. Although the front-page headline in the WSJ today is "Stocks Drop to 50% of Peak," the S&P 500 was actually down 50% from its peak back in November. It just recently hit the 50% threshold again.

What is ominous about the first chart is that only four trading days separate the first time that the S&P 500 went 50% below its all-time high. Ultimately in the bear that started in 1929, the S&P 500 dropped a whopping 86.19% from its all-time high. This low occurred 679 trading days after the all-time high was reached, or about two years and nine months. The current decline has lasted one year and four months.

Ukraine and Latvia - both junk credits

Bloomberg has reported that Ukraine's credit rating has been cut to CCC+
Ukraine’s credit rating was cut two levels by Standard & Poor’s, a day after Latvia was downgraded to junk, because political turmoil poses growing risks to the country’s International Monetary Fund loan.

The long-term foreign currency rating was lowered to CCC+, seven levels below investment grade, the rating company said in an e-mailed statement. Ukraine’s rating is now the lowest in Europe and on a par with Pakistan. S&P left Ukraine’s outlook negative, indicating it may reduce the ratings further.

German sovereign debt - CDS rates rising sharply

Ambrose Evans Pritchard who is one of the most astute financial journalists reporting on the global financial crisis has a very interesting piece today about the increase in the CDS rates for Gereman sovereign debt

“German CDS spreads are going massively higher. German bank exposure to Eastern Europe, although less than Austria, is still very high. The markets have started to price in a de facto bail-out of Eastern Europe and they think that Germany that will have to pay the bill,” he said.

The rating agency Standard & Poor’s said in a report on Tuesday that the region was “shuddering to a halt”, with a number of countries were “crumbling under the weight of high foreign currency debt.” It is unclear whether they can roll over debts as Western banks retreat to their home market.

S&P said foreign debt is 115pc of GDP in Estonia, 103pc in Bulgaria, 93pc in Hungary, all far above danger level. “All the ingredients of a major crisis are in place,” said Jean-Michel Six, the group’s Europe economist.

Japanese yen stepping down the stairs

The hourly chart of the Japanese yen, as manifested in the exchange traded fund, FXY, is revealing a remarkable downward staircase pattern confirming the trend discussed here several times recently including a post from earlier this morning.

Inter-market correlations and strategies are morphing

A number of previously reliable inter-market correlations are starting to break down. Not only does yen strength no longer appear to be positively correlated with US equity weakness, in fact the converse or negative correlation is establishing itself. Yet another example is the normal inverse correlation between the spot price of gold and the strength of the US dollar. There has been a well documented tendency for strength/weakness in these two asset classes to move in a counter cyclical manner but there is mounting evidence to suggest that the relationship is transforming itself into one with a more positive correlation.

One could even cite the fact that during the decline in the equity markets over the last several weeks, US long term Treasuries are not demonstrating their more typical safe haven status as yields are no longer so readily moving inversely to the direction of prices in the broad equity market.
Could it be that these correlations are weakening, and in some instances going into reverse, exactly because the inter-market co-movements which were historically observed, and then used as a foundation stone for a variety of cross-asset trading strategies, are not being practiced by hedge funds to anything like the same extent today as they have been in recent years?
The fact that the correlations are morphing because of the declining role of the hedge funds will of course mutually reinforce the changes in such correlations and could make trading conditions even more unpredictable for funds that are using top-down quantitative strategies that attempt to exploit arbitrage opportunities between different asset classes.

Eligibility for inclusion in S&P 500 needs to be lowered

An interesting look at the market capitalization of the S&P 500 is provided in the following article
In the table, we summarize the number of stocks in each sector that currently do not meet the $3 bln market cap threshold to be eligible for inclusion in the S&P 500. In the Consumer Discretionary sector, over 40% of the stocks currently have market caps of less than $3 bln. For the index as a whole, nearly 27% of the stocks that are currently in the index would not be eligible for inclusion if they were being considered today.

Junk Bonds heading south again

The chart for HYG, which tracks the high yield corporate bond market is looking vulnerable to a possible re-test of the lows seen last November and December as there seems to be no obvious signs of support since the break below two key moving averages over the last few sessions.

DAX index breaks below November low

The DAX index in Germany has now clearly taken out its lows from last November as has the CAC40 Index in France, although the UK’s FTSE still has some distance to go. It is worth pointing out that the German index still remains substantially above its 2003 lows while the FTSE could more easily revisit its 2003 lows and that is what I am expecting.
Meanwhile the problems I have alluded to in Eastern Europe continue to worry the bankers of western Europe.
Commercial banks in Germany’s immediate neighbor Austria have lent almost $300 billion to Eastern Europe, which is more than 70% of Austrian GDP. It has been estimated that even a 10% write-down could bankrupt the Austrian financial system. Meanwhile policymakers within the EU struggle with concerns emanating from the most troublesome eurozone economies - now becoming known as the PIGS i.e. Portugal, Ireland, Greece and Spain.
It is becoming uncomfortably likely that this could end in tears for the technocrats in Brussels.

What wave count?

The S&P 500 (SPX) closed at its lowest level for almost 12 years.

The long term monthly chart for this index covers a fifteen year period and suggests that technicians must struggle to find any obvious clues as to where the next level of support kicks in.

I showed the chart to a friend who knows nothing about technical analysis and the comment was that it looked like an obvious "M" pattern. Simple when you think about it.

Furthermore when dealing with monthly granularity patterns such as revealed in this chart it becomes rather obtuse to try to identify any kind of complex wave count based on any of the well known theories regarding such, especially Elliot Wave Theory.

In hindsight, which is always 20/20, it seems abundantly clear now that the double top in late 2007 with the subsequent failure in the summer of 2008 to break back above the 20 month moving average (the blue line on the chart) was a major sell signal.

Yen losing safe haven status

The relationship between the Japanese yen and the US stock market is changing quite significantly. Whereas the yen has been seen as a safe haven play where investors have parked funds when US asset prices, especially stocks, are declining the inverse now seems to be happening as the yen is falling in sync with declining US stock prices.

This has been observed in an article today from Bloomberg

“The yen appears to be losing some of its safe-haven status,” said Masanobu Ishikawa, general manager of foreign exchange at Tokyo Forex & Ueda Harlow Ltd., Japan’s largest currency broker. “Japan’s economic and political situation is poor.”

The correlation between the dollar-yen and the Nikkei 225 was minus 0.89 since Feb. 16 when a report showed Japan’s economy shrank at an annual 12.7 percent pace in the last quarter, the most since the 1974 oil shock. The relationship was positive 0.86 in the 12 months to Feb. 16. A reading of 1 would mean the two moved in lockstep.

“The correlation has broken down, because the drivers are now changing,” Stannard said. “Dollar-yen in particular will continue to move quite sharply higher.”

Demand for the yen as a haven also declined after U.S. financial regulators said yesterday they will begin examinations this week to determine if banks have enough capital. Citigroup Inc. and Bank of America Corp. jumped on the announcement even as the S&P 500 closed at the lowest level in 12 years.

Euro behaving poorly again

One of the commentators that I follow (and he shall remain nameless) made this comment in a newsletter this morning (Monday Feb 23rd)

It's Sunday night as I write this and one of the main catalysts for a potential market rally is occurring. The dollar is falling. Perhaps this is a first sign that the near-term panic may stay contained.

It is Monday afternoon when Morph is writing this and the euro is acting very erratically and the 15 minute chart of the FXE fund continues to support the notion that any sudden rallies by the Eurozone currency should be seen as good selling opportunities.

Soros on market fundamentalism

I watched an interview between George Soros and Bill Moyers over the weekend – you can find it on YouTube.
Soros was talking about the end of an era and the need for a complete overhaul of the financial system avoiding the errors of what he calls "market fundamentalism".
Let’s hope that those who are in a position to change the system do something to improve it – this is a unique opportunity.
Alas there’s always the danger that the politicians will pay lip service to the idea of setting up a new financial architecture etc. but secretly be hoping for this crisis to come and go and for the voters to forget about the reasons behind it as they look forward to the next bubble.

Citigroup - trades below $2

News regarding a further capital injection into Citigroup (C) that circulated late Sunday from an article in the Wall Street Journal appears to be providing some support in overseas markets.

The Hang Seng Index (HSI) in Hong Kong managed a three percent gain and most European markets are up between one and two percent in early trading on Monday morning. There has been no official acknowledgment of the exact nature of the Citigroup assistance and its effect on the capital structure but it will almost certainly involve the taxpayer downgrading its preferred to common with subsequent dilution.

In this writer’s view the capital being made available to this behemoth bank is quite mind boggling and shows an obstinate refusal to accept the obvious - this bank is insolvent and should be placed into some form of re-organization or nationalization or whatever other euphemism provides the necessary fig leaf.

As the hourly chart reveals, Citigroup (C) did manage to see a minor bounce off its low on Friday afternoon but still closed below the $2.00 level.

It is hard to see how any kind of short term government rescue plan is going to significantly alter the big picture which is one that resembles the futility of re-arranging the deckchairs on the Titanic.

Inverse tracker of dollar tracks the S&P 500

I am struck by the similar configuration and contours between the chart of the S&P 500 over the last few months and that for the exchange traded fund, UDN, which provides an inverse tracker to a broadly based dollar index. There is definitely a counter cylical trend emerging where as risk aversion increases and equities sell off so the dollar rallies and vice versa.
The Euro is benefiting from this trade in Europe this morning but as mentioned here recently there are some fairly profound structural problems confronting European monetary union and the euro, and it is a currency which would drop suddenly as capital flight by sovereign wealth funds surfaces again.

Gordon Brown and tinseltown

It was predictable but still rather nauseous to hear the UK Prime minister making comments Monday morning designed to position himself under the tinseltown halo from the success of Slumdog Millionaire and Kate Winslet at the Oscar ceremony.

Skin in the game - not according to Mr. Brown

Writing for an article in the Observer for Sunday February 22nd, 2009, the British prime minister has made a shocking proposal to boost his credentials for financial prudence. He has proposed that in the future no mortgages should be granted in the UK for more than 100% of the property value.
Whatever happened to the notion that in all deals one should have some skin in the game?

Future inflation - the thin end of the wedge

During a speech last week that was given by Paul Volcker, at Columbia University, the veteran central banker made some astute observations regarding the nature of the current economic/financial crisis and pointed towards a dual model for banking in the future. If you have the time to watch the speech it is worth it but here are some of the more salient points.

He discussed the notion that the exculpatory arguments now being given by many in the financial engineering community, that they were not to blame for the debacle that has arisen from their overly complex structured instruments because they were simply obeying orders from above. Volcker’s rejoinder to this was to cite the bogus Nuremberg Defense case presented by SS officers who claimed they were just following orders emanating from the Fuhrerbunker.

The obsessive predilection by banks for the originate and distribute model that accompanied the proliferation of securitized instruments during the last several years has brought with it an alarming breakdown in the customer relationship and retention culture that is vital to commercial banking.

The relaxation of the segregation between high risk/investment banking and the more routine matters of deposit taking, payment clearances and granting of commercial credits allowed the inherent dissonance, and opportunity for abuse, in the classical Principal/Agent conflict to return in a major way to the manner in which the large supermarket banks operated. In particular the credit ratings agencies were hopelessly compromised in this respect.

His final point, and the one which is perhaps the most important, was to contrast the role that a central bank is now being required to play in the current crisis with the more traditional role of a central bank which, he suggested, is to ensure price stability. There was an implied warning that the current mindset of throwing everything including the kitchen sink into a desperate effort to reflate the economy was also encouraging the view amongst some close to the current Federal Reserve that tolerating a little bit of inflation down the road is not such a bad thing.

Volcker who earned his credentials for taming rampant inflation in the late 1970's and early 80's has just cause to be alarmed. As he said towards the end of his speech there is a tendency for a little bit of inflation to turn into a lot of inflation, and going on record with such a reminder was perhaps the most useful part of his speech.

The speech was short on jargon and delivered in a calm manner with just a hint of irony and could unfortunately be easily overlooked by the glib, fast talking financial technocrats who presently hold sway in Washington. But one is reminded of the remark sometimes made about the judgments of bright young entrepreneurs and their cadre of advisers - it is always good to have some grey hair on the board - notwithstanding the fact that Mr. Volcker has very little even of that.

Switzerland - holes in their cheese and now their banks too

There is a provocative article about the possibility of Switzerland being threatened with bankruptcy and also having to join the Euro.
It is a sign of just how shock immune we are all becoming that I even had to question whether such an article would be worth reading. On balance I am not convinced by the reasoning given in the piece but it did coincide with other news about Swiss banks last week that adds another dimension to the story.
The author does not refer to the settlement between UBS and the US government in which potentially thousands of names who have held secret accounts with the Swiss bank would have to be released by UBS to the SEC and investigated for tax evasion.
This could have even larger long-term consequences to the Swiss economy than the troubles with Eastern European credits.
Anyway here is an excerpt from the piece:

Swiss banks have given billions of credit to Eastern Europe - now the customers cannot pay back the money. Switzerland is threatened with the fate of Iceland, says economist Arthur P. Schmidt.

In countries such as Poland, Hungary and Croatia, the Swiss franc has become an important currency. Thousands of households and small firms took out loans in Swiss francs, and not in the national currency zloty, forint, or kuna because of lower interest rates. In Hungary, 31 percent of all loans are in Swiss currency. Amongst household loans, they are almost 60 percent.

Now, the financial crisis has ended the era of cheap credit. As a result, Eastern European currencies are falling. At the end of September, one had to pay 46 francs for 100 Polish zlotys. Today it is 30 francs. That means more and more borrowers are having problems with interest payments and repayment. So the question is what effect this has on the Swiss financial marketplace. One who sees a dark future for Switzerland is economic expert Artur P. Schmidt. He believes that the Swiss franc is in danger because of the loans in Eastern Europe.
Switzerland, like Iceland, is threatened with a potential national bankruptcy. One consequence would be that the Swiss currency could fall massively in value — possibly even crash. Another would be that Switzerland’s credit rating would be massively downgraded. That would be a trauma for the country: Switzerland was always as a stronghold of stability. The franc could become an unstable soft currency. Then Switzerland would perhaps be forced to abandon the franc and take on the euro.

The last paragraph jumps through lots of "ifs" quite quickly to reach its conclusion.

Switzerland has enjoyed unusual benefits as a money center for many years in the smoke and mirrors world that is now starting to come apart and the reasons why bankers have had things relatively easy rested largely on secrecy and alleged prudence in financial management. The massive losses at UBS in all of the usual suspect securities and now the exposure to Eastern European problems suggests that the gnomes of Zurich may not have been much wiser than their counterparts in London and New York. Take away the secrecy assurance and quite a lot of the super-rich could decide that it's time to look elsewhere to park their money.

UK fast tracks quantitative easing - just in time policy for Treasury refunding season?

The following news report from Bloomberg shows that the UK financial establishment is getting more worried about the severity of the current recession. No wonder when they face, declining tax revenues, plenty of public support required for insolvent banks and a need to sell UK gilts to an ever increasing number of institutional investors and foreigners that may be losing their appetites.

Feb. 20 (Bloomberg) -- Bank of England Deputy Governor John Gieve said policy makers are trying to protect Britain from the threat of a decade-long slump similar to that experienced by Japan in the 1990s.

“Do we face a ten-year depression like Japan? That is a risk, and a risk that we and other policy makers are taking very seriously,” he said late yesterday after a speech at the London School of Economics. “It’s a serious risk but we are addressing it. There’s a huge amount of policy easing in the pipeline. I don’t think it’s inevitable.”

Separately it now appears that the Bank of England is fast tracking the move to quantitative easing - just in time for Treasury refunding season.

Is debasement of the currency inevitable?

The current mechanics of the world's credit system lack all credibility and morality and the only thing which is holding, what remains of it, together is the rule of law.
A questioner asked in a recent blog posting - How smart is it to place one’s total faith in contract-based assets that are denominated in a fiat currency?
One could easily answer - not smart at all.
But the way that the question is posed it runs two separate issues together that could be addressed separately.
Imagine for a moment that we did not have the "luxury" of debasing the currency because it was tied to a gold standard for example. As a society/economy we would then almost certainly have to face the question of how to dishonor contractual based claims on assets and IOU's within a proper legal context and framework of re-negotiation. A kind of collective or social bankruptcy process could be undertaken where assets/debts could be written down and re-structured, somewhat like a collective Chapter 11.
Governments would not like such an adult process to occur because it has the risk of revealing far too many skeletons in far too many closets to be put in full view of the public, who governments believe should be kept in the dark on such matters as much as possible.
But such a re-structuring or re-organization of existing debts and creditors would have to be seriously contemplated in the situation where the true value of existing obligations could not be easily inflated away.
Of course, in the world we actually inhabit, debasement of the currency - which is tenable precisely because it is a fiat currency with no inherent value of its own - is the way we will almost inevitably be going.

Bank of Japan nudging the yen down

I am particularly pleased with the call I made some weeks ago on pending weakness for the Japanese yen. At the time there were the beginnings of a topping pattern in the technicals but all of the commentators were still insisting that the Japanese currency was part of the safe haven matrix. Meanwhile the habitual dollar bears were proselytizing about the risks to the greenback and some were urging investors to seek out the relative safety of the yen.
It seems almost certain that the Japanese central bank is partly responsible for the drop as it tries to engineer a more favorable exchange rate for their exports.If that is so they will probably be targeting considerably lower levels.
The point marked by the arrow on the chart for the exchange traded fund, FXY, which tracks the yen, coincides with the 200 day EMA and seems feasible in the intermediate term.

Slow motion crash - getting even slower

The current market action is giving an even subtler dimension to the notion of a slow motion crash. The DJIA closed at its lowest level in more than six years and the financials continue to get pummeled but there seems to be a rather stoical and mild mannered response to it all. Part of the reason has to do with the way in which the Dow Jones is calculated

The Dow is a price-weighted index where the higher the stock price, the more it affects the index’s value. As many financial companies have plunged in value, the Dow is littered with sub-$10 stocks that have little impact. Consider that Bank of America (BAC), Alcoa (AA), Citigroup (C), General Motors (GM), and General Electric (GE) have a combined weighting of 2.9%. If all five were to go bankrupt the U.S. economy would be devastated, yet the Dow would fall only 220 points.

The S&P 500, which is market cap weighted is not quite at multi-year lows but a rendezvous with 750 looks almost inevitable. If that breaks I suspect that we could be looking at 680 in a hurry. Many learned analysts from a more fundamental perspective are making cases for 600 or thereabouts on the S&P 500 based on P/E ratios but the enigma at the moment is trying to make any kind of convincing case as to what the E part of the formula is going to be this year.

Branded staples - going, going gone

A week or so ago I commented that the consumer staples sector, as tracked by XLP, an exchange traded fund, was behaving poorly considering that it has traditionally been seen as a defensive play and likely to show relatively better performance during economic downturns.
A recent visit to my local supermarket provided plenty of evidence as to the reason for the lack of strength of the sector. There were various types of tomato ketchup on display and certainly not the most prominent was Heinz, chocolate bars are no longer the domain of Cadbury and Kleenex is not the type of tissue that was most in evidence. Generics are replacing branded products as price sensitive shoppers are spending more judiciously.
I began to think of how the goodwill attached to many product brands, as a result of the billions of dollars worth of advertising and marketing spent over many years, is starting to evaporate. Consumers seem less willing to pay for the supposed premium brands any longer - perhaps there are deeper cultural reasons at work as well as the necessity of saving money.
When major brands in the financial world are seen to be virtually worthless and when established businesses are falling like dominoes there is less belief in the sanctity of the traditional household names. If the labels can no longer be trusted then why pay a premium to buy Heinz 57 if all you want is some ketchup to put on your hamburger?

Not my problem guv

This was the cover to the album Crisis. What Crisis? by the group Supertramp from the 1970's. That era had its own set of calamities to deal with but the image resonates with the widespread complacency that many still have about financial disintegration and a planet which is approaching a tipping point (let's be optimistic and believe it hasn't got there yet) on a path to oblivion

Nice pets

With thanks to a blogger by the name of The Mole at SeekingAlpha. I made the comment in connection with the article.
Regarding the cartoon of the docile taxpayers I don't know whether to laugh or to cry.
Certainly the UK government is not finding the revenue being raised through taxation to be a laughing matter. It has been announced that in January 2009 the amount raised through general taxation was £7 billion less than January 2008.

UBS releases names - end of the road for Swiss banking secrecy?

According to Reuters there may be cracks developing in Swiss banking secrecy

UBS, the world's biggest bank to the rich, agreed late on Wednesday to pay a hefty $780 million fine and disclose the identity of some clients after U.S. investigators accused it of helping wealthy Americans to dodge taxes.

Some observers believed the deal opens cracks in the country's tough bank secrecy laws and could potentially undermine the $7-trillion global offshore banking industry.

President and Finance Minister Hans-Rudolf Merz defended the settlement said the principles of secrecy remained in place. He said UBS had had no choice but to settle the case to avoid criminal charges that could have threatened its existence and undermined Switzerland's economy.

"Bank secrecy will stay," Merz told a news conference.

"It became evident that if the American authorities would bring UBS to an indictment...the whole threat would have been falling also on our economy."

Switzerland does not consider tax evasion a crime, and Swiss law prohibits disclosure of client data or names unless the country's authorities believe the client has committed a serious crime such as money laundering or tax fraud.

The financial crisis is heaping added pressure on tax havens like Switzerland to stop helping the wealthy hide their money from the taxman as governments seek funds to pay for more spending.

Germany has said it wants Switzerland put on a tax haven blacklist and launched a probe last year into its nationals stashing assets in Liechtenstein.

Thousands of wealthy westerners avoid taxes by hiding assets in Switzerland and other offshore centers, and U.S. lawmakers say tax havens deprive Washington of $100 billion a year.

As suggested previously the Obama government seems to be ready to take on the issue of tax avoidance via havens such as Switzerland and parts of the Caribbean. This will create tensions in the relationship between the US and the UK which is probably the most favorably disposed jurisdiction in the G7 to maintaining the status quo for those who have an aversion to paying their fair share of tax.

Important to monitor the Nasdaq Composite

The two areas highlighted in yellow on the chart for the Nasdaq Composite reveal two attempts to break out to the upside from the pronounced triangular formation. Both efforts were short lived and we now confront a potential break down.

Far more than the charts for the S&P 500 and the DJIA, the chart for the Nasdaq suggests that a trading range dynamic is still in evidence for this index. Further weakness in the near term and a break below the 1440 level - the closing low on January 20th - would strengthen my opinion that the bullish camp are starting to lose heart at current levels.

Pharmaceuticals look vulnerable

A surge in selling emerged yesterday, in conjunction with a technically weak pattern following the recent break below all three key moving averages, on the chart for XPH which is an exchange traded fund tracking the pharmaceuticals.

Emerging Market Sovereing Debt is sinking

PCY, the sector fund which tracks Emerging Markets Sovereign Debt, slipped below key moving average support on a spike in volume.
Credit default swaps for many sovereign credits are widening and with the plight of the old Soviet bloc countries simmering away in the background this looks like a good sector to be short in coming sessions.

Could Warren Buffet turn into a long-term seller?

Even smart money is not looking so clever in the current market.
There was an interesting post this morning at SeekingAlpha about the recent under-performance of Warren Buffet's Berkshire Hathaway. The chart shows that so far in 2009 Buffet is down more than 17% and, perhaps more ominously, more than four percent below the level of the S&P 500.
Is it conceivable that Buffet could turn into a major seller if stocks break below the critical levels that they have reached.

Scrapping the Euro - hold on a moment

A comment was made at another blog site about the difficulties facing the Eurozone and makes the point

Another alternative thinking in the wake of this crisis would be to re-assess the long term workability of the Euro as a single currency for the EuroZone.....
The European Common Market is a great thing, the Euro is not so much of a success, lets face it! Different economies will always have different monetary and fiscal behaviours, making it impossible to come all under one regulating body

I think we should be careful not to be too cavalier about such matters.
It would be extraordinarily disruptive for the global financial system - not that it has been having a quiet time recently anyway - if the Euro currency was to unravel. This could see a capital flight like nothing we have seen yet. While the US dollar would be the initial beneficiary the longer term "unintended consequences" of current members of the monetary union going their own way would really see a flight to gold and other hard assets.

Utilities - no longer a pure defensive play

I recently suggested in my Daily Form Commentary that the utilities sector fund XLU, seemed vulnerable after breaking below a key moving average level and a key trendline. The Dow Jones Utilities was one of the worst performing indices yesterday with a 4.8% drop and underlines the fact that even traditional defensive plays are not working in a market which is lacking normal liquidity and the usual participation of institutional fund managers.

Japanese Yen - no longer part of the safe haven matrix

The Japanese yen is continuing its decline and one of the more interesting features of yesterday’s big sell-off (Feb 17th) was that the yen is losing its bid despite the fact that the other safe haven plays - the dollar, long term Treasuries and gold all rallied as fear returned to global capital markets.
If you are looking to trade the Japanese currency the exchange traded fund FXY, if you can short it, looks like it is targeting the 104 level.

Cricketers in awe of Stanford

One of the more amusing sights on the evening news bulletins in the UK was the sight of the most prominent men in British cricket - such a British sport - in awe of Sir Allen Stanford displaying a pile of dosh when trying to set up a new cricket tournament with big payouts to the players.
Not very gentlemanly - but there you go

Icelandic investment bankers becoming fishermen again

There could, to use the vernacular, be a "take away" proposition in the news that all of the smart young men in Iceland who a couple of years ago were investment bankers in their Armani suits have now returned to the more traditional Icelandic occupation - they're becoming fishermen again.

New financial architecture

There is an interesting article on SeekingAlpha about the ineffectual efforts of the G7 at their recent meeting in Rome and the even bigger challenge confronting the present day political leadership in really dealing with the ongoing financial crash.
The writer, Simon Johnson, poses the issue as follow:

But the real issue is that no one is yet ready to take on the deeper underlying problem - the political power structure of modern finance.

It's a good question to raise and one that we should be more focused on.
Just for starters some thoughts on the matter:

The financial technocracy that got us into the current crisis are absolutely the worst people to solve it. Not only are they in denial but their academic training, culture of cronyism and their intellectual toolkit are not up to the job.
What is required are structural changes to the financial architecture but that cannot happen as long as the focus is one of sticking band aids all over the current system.
Across the board asset write-downs and a legal moratorium on debt repayment covenants would be a good start while a new bi-modal banking system is allowed to develop with public sector funding initiatives to get them started.
One type of bank would be run like like an utility company. Nothing sexy, no corporate jets, relatively predictable income streams and no great surprises when they release their earnings statements.
The regulation of such banks could still fall primarily within the respective jurisdictions where they do most of their business and cross border financing would have to be supervised by an international regulator with supra-national deposit insurance etc.
The other type of bank which would handle what we, until recently, called investment banking should be separated into entirely different entities. The disclosure rules for any kind of ownership - equity or debt - would have to be rigorously and uncompromisingly blatant that only those who are prepared to engage in highly risky investments would be qualified to participate. Also another stipulation would be that all principals of said institutions would be paid primarily in equity in their firms and would need to keep the bulk of their wealth in such firms for a minimum of five years.
These new banks/shadow banks would be funded by the private sector through the global capital markets and all of them would have to be subject to a new global regulator. Any firm that entered into a counter party deal with another entity which operated without a specific license from this new global regulator would be immediately subject to having its license revoked and all of the principals of the firm violating this code of conduct would be banned from the securities industry.
The whole labyrinth of offshore tax havens, complex tax treaties etc would have to be cleaned up and most importantly under no circumstances should any taxpayer ever have to clean up the mess resulting from their inevitable misjudgments.

Hang Seng Index - breakout from triangular pattern

The Hang Seng Index (HSI) dropped by almost four percent in Tuesday’s session and this was closely matched by a similar fall in Shanghai. As suggested here recently there are bullish indications emerging from the Shanghai Exchange (SSEC) and undoubtedly there are institutional traders that will see pullbacks in this geographical sector as buying opportunities.
However the breakdown from the triangular pattern seen on the Hang Seng chart above, as well as another weak session on the Mumbai exchange in India, suggests that it caution with regard to venturing into emerging markets is still the prudent course.

Euro resumes its downtrend

After spending most of last week drifting the Euro is resuming, during early trading on Tuesday (Feb17), its downward trend against the US dollar.
The staircase pattern, which has been noted on the chart below, emerged after the abrupt rally in early December and the stepping down this staircase is proving to be the path of least resistance. Since the turn of the year the currency has consistently failed to make it back above its 20 day EMA (the blue line on the chart). The eurozone currency is now headed towards a test of fairly critical chart support at the $1.25 level. This level provided a robust limit to downside action in trading last November but there is an intraday spike down on the currency to the $1.20 level which was seen during the tumultuous trading of that period. A re-test of that level must be seriously considered and a failure at this level would be very bearish for the currency.
With mounting problems within Eastern Europe which is putting many European banks under pressure (in particular the Austrian banking system is highly exposed to failing credits in this region), the very weak GDP readings in Germany last week, the fact that there is even an ongoing discussion regarding the possibility of a debt default by the Irish government and growing signs that the Franco-German rapport is fraying at the edges, the currency will stay under pressure.

Grey haired men in grey suits not wanted at ITN News

In an article in the Guardian newspaper's G2 section on February 16th, 2009 a lady by the name of Daisy McAndrew, who appears to run ITN News, talked about the need she has for pundits to go on television to explain the current financial mess to her viewers. But she added they must not be grey haired men in grey suits.
I have sent a pledge to her to dye my hair and wear some funny clothes and perhaps then she would let me go on one of her shows.
More seriously, such blatant ageism should not be tolerated from a person in her editorial position.

Round two of our financial Götterdämmerung.

Just when politicians are trying to soothe us with upbeat forecasts about the impact of all of the numerous rescue plans and talk of the end of the crisis, there are new seismic rumblings on the horizon.

This is an excerpt from an excellent piece in the Daily Telegraph by Ambrose Evans-Pritchard

If mishandled by the world policy establishment, this debacle is big enough to shatter the fragile banking systems of Western Europe and set off round two of our financial Götterdämmerung.

Austria's finance minister Josef Pröll made frantic efforts last week to put together a €150bn rescue for the ex-Soviet bloc. Well he might. His banks have lent €230bn to the region, equal to 70pc of Austria's GDP.

"A failure rate of 10pc would lead to the collapse of the Austrian financial sector," reported Der Standard in Vienna. Unfortunately, that is about to happen.

The European Bank for Reconstruction and Development (EBRD) says bad debts will top 10pc and may reach 20pc. The Vienna press said Bank Austria and its Italian owner Unicredit face a "monetary Stalingrad" in the East.

Mr Pröll tried to drum up support for his rescue package from EU finance ministers in Brussels last week. The idea was scotched by Germany's Peer Steinbrück. Not our problem, he said. We'll see about that.

Stephen Jen, currency chief at Morgan Stanley, said Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay – or roll over – $400bn this year, equal to a third of the region's GDP. Good luck. The credit window has slammed shut.

Not even Russia can easily cover the $500bn dollar debts of its oligarchs while oil remains near $33 a barrel. The budget is based on Urals crude at $95. Russia has bled 36pc of its foreign reserves since August defending the rouble.

"This is the largest run on a currency in history," said Mr Jen.

The article is well worth reviewing, and, even if just part of what he claims is about to unfold in Eastern Europe and Russia, does take place this would overshadow the currently acknowledged banking crisis and create massive problems for the Eurozone economies and the ECB with knock on implications for the global financial system.

Financial meltdown blamed on risk models

The following is an extract from a useful article from the Financial Times

By Norma Cohen, Economics Correspondent

Published: February 14 2009 02:00

The failure of banks to count, manage and hedge their risks over the past decade is responsible both for the fantastic growth before 2007 and the crash that followed, according to the Bank of England's director for financial stability.....

The meltdown in money markets that followed the credit squeeze was an event that banks' risk models showed could happen only once in the lifetime of the universe - once every 13.7bn years - Mr Haldane said. Referring to economist John Maynard Keynes' rule of thumb that it is better to be roughly right than precisely wrong, he added: "With hindsight, those models were both very precise and very wrong."

Banking losses now "lie anywhere between a very large number and an unthinkable one", he said.

In pinpointing reasons why the systems banks use to gauge how big their losses could be under worst-case scenarios were so wrong, Mr Haldane noted that most are based on a very short-term view of the past. Mathematical models were based on economic events in a very narrow window of time, as short as 10 years, he said.

A further look back into history would have shown fluctuations in UK gross domestic product four times greater than that of the past 10 years, that of unemployment five times greater, that of inflation seven times greater and that of earnings 12 times greater.

Bankers also forgot to assume "network externalities" - the possibility that adverse events in, say, the mortgage market, might trigger a similar move in others. These effects would probably be multiplied across the entire financial system.

One comment that comes to mind is that the phrase "network externalities" sounds like it means something but I would suggest that it is not even as useful as "Acts of God" which lawyers have managed to insert in contractual law.

Mr Brown can't wait for the G20 meeting

The meeting of the finance ministers of the G7 in Rome ended with the usual bland communique about the need to coordinate actions, be vigilant about excess volatility in the currency markets and so on.
The next big meeting of global economists and politicians will be the enlarged forum of the G20 summit to be held in early April in London and hosted by the hapless Mr. Brown, the UK prime minister. More than any other world leader he is hoping to pull a rabbit out of the hat to save his own government and try to assuage the widespread perceptions regarding his bungling of the UK banking crisis. Increasingly the UK prime minister lacks any credibility and when pressed on reasons for the parlous state of the domestic banking system he waffles on about the global financial crisis and how no one could have seen it coming etc.
Several facts specific to the UK seem to have escaped Mr. Brown's narrow attention span.
Most obviously, the only major bank in the world to have seen an actual run was the UK based Northern Rock. Then there were the staggering losses announced last Friday by HBOS which underline the fiasco where the CEO who was at the helm during the piling up of those losses was Mr. Brown's appointee to be the number 2 at the UK's financial regulator, the FSA. It has also emerged that another key appointee that Brown wanted to bring into his "team" was attached for several years as a consultant to the principal bank in Liechtenstein which is the world's most secretive tax haven.
In the Alice Though The Looking Glass world we live in it is not surprising that a supposed left leaning social democrat government in the UK has created the most nauseous form of cronyism that has allowed bankers to bring the UK economy to its knees.

Don't spend too long on this one

Normally I wouldn't bother to draw attention to such drivel but there was a posting by Michael Lewis - the very clever chap who wrote Liar's Poker et al - on Bloomberg that is full of twisted thoughts that left me feeling a lot less interested in his comments in the future.
Just one of the many offensive comments is when he suggests that bankers

“identify exactly the sort of things that cause the average congressman to say “these Wall Street guys just don’t get it,” and do as many of them as possible.”

How does that contribute one iota to a better understanding of a serious cultural issue that needs to be dealt with in a slightly more grown up way than Mr. Lewis seems to be capable of?

We don't live in a Casino Economy

It is vital to dispel the notion that modern financial capitalism is best considered under the moniker of the Casino Economy.

Americans have been living in a casino economy for years. It's a style of life ingrained in the national psyche. But at the prospect of a long-term losing run they are getting frightened and angry, fast.

The above quote comes from the well known contributor to The Nation publication Alexander Cockburn

There are moments when movements in the capital markets are random and seem completely capricious but to think that the underlying dynamics of the market are as random as the spin of a roulette wheel is a convenient act of ignorance. I have always been struck by the fact that the root of the word ignorance is closely related to the act of ignoring. Ignoring is an act of casting one's mind away from something and not, as the word has come to mean in common parlance, a lack of knowledge about something.
To describe the global financial system as a giant casino is an act of shallow intellectual defiance but does not contribute to any real understanding of what is wrong with the system. There are clearly people who consistently gain from speculating in financial assets - on both the long and short side - but it would be wrong to see many of them as simply lucky gamblers.
If we choose to ignore the complexity of markets and give up on trying to understand their real dynamics - and to collapse the distinction between speculation and gambling - we postpone the day when informed debate will undermine the inertia of those who have positioned themselves within positions of power and influence to be the primary beneficiaries of that ignorance.

Getting junk debt away

According to Bloomberg - in a report on February 13, 2009 - "High-yield, high-risk bond sales almost tripled to $2.38 billion this week, the most in seven months, as borrowers took advantage of a rally in corporate debt to increase cash reserves and pay down credit lines."
This is perhaps even more remarkable since the article also pointed out that "Moody’s Investors Service predicts defaults will peak in November at a rate worse than in the Great Depression."

The New York-based ratings company this week raised its global default rate forecast to 15.5 percent over the next 12 months, up from last month’s estimate of 15.1 percent, or about three times the current rate. In the U.S., companies will miss their obligations at a maximum 16.4 percent rate in the fourth quarter, Moody’s predicted.

The major myth in classical economic theory

The major myth in classical Economics - which is largely attributable to Alfred Marshall and all of the supply and demand diagrams that are taught in Economics 101 - is that market systems seek out equilibrium. It results in the idea that the "normal" state for the economic system is to be in some kind of benign condition, guided by an invisible hand, which leads to the proper allocation of resources and an underlying cultural harmony.
A corollary to this mistaken theoretical foundation behind this pseudo-science is the view that severe financial disruptions are the result of exogenous shocks to the economic system.
Certainly there are wars, natural catastrophes etc which cannot be accommodated within a broad macro-economic theory but there is an inherent instability to the financial system which should be included as endogenous to our economy. Booms and busts are an inevitable consequence of of human nature which is largely motivated by passions of fear, greed and envy, and should be factored in on the ground floor to any all embracing explanation of the macro-economy.
If you are not familiar with him you may want to seek out the work of Hyman Minksy who has written with insight on the topic that the financial system is essentially unstable and not subject to analysis in terms of some simple rationality.

SPY - bulls couldn't wait to pull the trigger

Reviewing the hourly chart for SPY from yesterday (February 12th) there is a clear suggestion that bulls were waiting to pull the trigger as the index came down towards the January 20th lows. The fact that the volume kicked in before there was a real testing of that low suggests that we there is more of a trading range mindset prevailing at present rather than a concerted effort to properly test the possibilities of a new overall leg down.

Contrary to some people’s intuition I suspect that the reluctance to aggressively probe for evidence of game changing buying support at lower lows at this stage is actually an overall negative in the longer term outlook for US equities.

The great cultural blunder of the early 21st century.

Thought leadership in the financial innovations of the last twenty or so years has been mainly inspired by the work of practitioners in the world of highly sophisticated quantitative techniques such as astrophysics.
The unquestioned application of concepts and techniques from physics to finance – sometimes even called econophysics – will, in hindsight, be seen as one of the great cultural blunders of the early 21st century. It allowed those in possession of astounding levels of mathematical competence, almost certainly without malevolent intent, to hijack the interests of the financial elite who had control of almost limitless amounts of notion capital and who eventually became victims of their own hubris and ignorance. In other words these “Masters of the Universe”, to use the oft quoted phrase from Tom Wolfe, ignored the feelings of discomfort and dissonance that they had when they did not understand the nuances of highly complex financial instruments, but instead of erring on the side that such a situation contained high risk, they engaged in the wonderfully human trait of self deception and over-confidence in the face of uncertainty.

Banking - blowing away the cobwebs

The following parts of the banking system are now looking vulnerable as more and more public sector inspectors and accountants, many of whom have not had the opportunities to learn the dark arts of modern finance, shine lights on areas previously reserved for the high priests.

The mechanics of building derivatives on derivatives - all those remarkable instruments like CDO squared structured products. This is the stuff for which there is no market because no-one understands it never mind how to value it.

The offshore vehicles and structures that have been designed to avoid taxation and to hide the true beneficial ownership of many elaborate "investments".

The true value of the assets on a balance sheet after applying real world write-downs as opposed to mark to rosy scenario models.

The quality of the legal framework that underpins a lot of structured products may not be as robust as it should be.

The bonus and incentive schemes that bankers have devised to reward themselves may be even more egregious than has so far come to light. And the extent to which future commitments have been made contractually may require some messy litigation and re-negotiations.

There are almost certainly a large number of class action lawsuits that will occupy the attention of top managers within the banks for years to come.

Latest news from Tim Geithner - he has an idea for a concept for a plan

The rescue of the US (and global) economy is in script development. Latest news from the US Treasury is that there is an idea for a concept for a plan. Stay tuned - they'll get back to us when they've got something a bit more sketched out.
Watching Mr Geithner I was struck by the fact that the man looked like he needed someone to throw him a lifebelt - drowning in a tsunami of bad assets.
Judging by the way the markets reacted Tim doesn't appear to have the X-Factor

Tim Geithner - is he part of the problem or the man with the solution

In an otherwise thoughtful blog posting about the issues that the Geithner proposals need to address there were these rather worrying couple of sentences.

"I’ve talked over the past few days with people with extensive financial market experience, with journalists who’ve covered every angle of this story, and with academics who think about these issues all day and night. And I’ve had remarkably similar conversations with each."

The most remarkable characteristic shared by a lot of academics, many senior bankers and most in the financial media is to be found in the often quoted - "Who could have seen this crisis coming?"

It was a form of groupthink that created the intellectual environment conducive to a serious underestimation of risks attached to complex securitisations and alas while the same group of thought leaders are at the helm there is unlikely to be a structural solution to the problem

Long term US Treasury yields and a rush for the exits

The fact that the 10 year Treasury note yield has been moving up steadily since the completion of window dressing operations at the end of 2008 suggests that institutional bond holders, as well as foreign governments are standing aside despite the best efforts of the Fed to directly influence (and talk down) long term rates.
My suspicion is that there is a nagging anxiety developing amongst the big bond players that the inflation genie is out of the bottle. No-one can be sure when the first signs will really manifest themselves (e.g. a sudden big upturn in commodity prices) but more managers are sensing that it will be better to be ahead of the crowd when everyone wants to head for the exits at the same time. That dynamic alone could become self-fulfilling and pose yet a further credibility issue for US policymakers.

Selling the brain drain story to politicians and financial journalists

The London Sunday Times (Feb 8, 2009) had a piece called End of the Line for the Piggy Banks which included the following comment made by the journalist on the piece.

Without bonuses the big banks face suffering from a brain drain.

This statement shows just how worthwhile it has been for the City folks to engage PR agencies like Brunswick to sell this bogus argument to the financial media and political class.
Let's focus on the financial engineers for the moment (although similar arguments would apply to other bankers in client relations and institutional sales)
Where else are these brainy people going to go to make the ridiculous amounts that they were (and still are in the UK at least) paid by the investment banks?
Just how brainy are these people that nearly brought about a systemic financial meltdown? - and who knows in the fullness of time that meltdown still might be in our future.
If you read interviews with some of the "quants" that are largely responsible for black hole financial engineering most of them readily confess that they could never have made anything like the money they have made on Wall Street or at Canary Wharf if they were doing what their skills were alternatively suited for i.e. teaching other brainy people to have similarly questionable quantitative skills.

Week ahead for markets is the most important in a generation - not again surely

The following blogger's comment seems just a teeny bit overstated

I believe this week may be the most important week in U.S history, economically anyway.... The govt. will make a decision on whether or not to borrow 800billion dollars of tax payer money to create jobs....
If it doesnt work?................. complete collapse and failure. There are no second chances with this kind of money. It either works or it doesn't and there's no turning back. Lets pray there all right about this. If there not and it doesn't work, will go into depression...if were not there already.

Reminds me of the story of the boy who, playfully cried wolf so often that when a real wolf showed up on his doorstep everyone ignored his cries for help assuming it was another prank.
Needless to say the wolf had a good meal.

No more bonuses for bankers - we'll get back to you on that

Why cannot the Brown government in the UK bring itself to actually say no to bankers' bonuses. Instead, as announced this morning, they are going to set up a government review which will take a year to report on the issue, and which is being chaired by someone who has lots of cosy friendships and shared interests with precisely the people who stand to lose the most from a proper inquiry - the bankers themselves and other City "professionals".
One of the Labour government's real weaknesses (but this is not a partisan issue because the previous lot thought the same way) is that it has totally bought into the fears spread by the City and their spin doctors that if things are made hard for the bankers and hedge funds they will all emigrate en masse to Switzerland or Monaco.
That fallacious argument is behind the "light touch" regulations fiasco which has helped to bring the UK economy to being so vulnerable in the current crisis and overly dependent on the financial services sector which seems unlikely to see another heyday any time soon.

Buy and hold? Are you sure you want to do such a thing?

There is a very interesting article in The New York Times dated February 6th by Floyd Norris

The author takes a long term look at the S&P 500 and considers some of the least rewarding time periods to have been invested in the market - including the 1930's and also the 1970's and comes to the following rather startling conclusion

There has never seen a 10-year stretch as bad as the one that ended last month. Over the 10 years through January, an investor holding the stocks in the S.& P.’s 500-stock index, and reinvesting the dividends, would have lost about 5.1 percent a year after adjusting for inflation

For years the supposedly smart investment gurus - the wise men of finance - along with the large mutual fund companies like Fidelity as well as the Personal Finance pages of the broadsheets were telling us that the right way to approach investment was Buy and Hold.

As I have been suggesting for a long time, the current financial malaise has highlighted how much we are all on our own when it comes to making sense (and profit) in today's markets and business environment.

One can forget about any protection or prudent stewardship from bodies like the SEC, FSA, credit ratings agencies, government regulators and most financial advisers. Even more importantly we should forget most of the common sense notions that many of us have been taught about how the economy works, how banks operate and how governments and central bankers know how to manage financial crises.

The stark truth is that more than ever we are all on our own and need to retrain our instincts in order to survive and successfully navigate through the labyrinth of smoke and mirrors that will thwart the best efforts of the unwary

Catastrophes abound - it's all just a bit too apocalyptic

I shall begin with the following excerpt from the latest posting from Peter Schiff which can be found at SeekingAlpha and I suspect elsewhere.

This week President Obama claimed that failure to pass his economic stimulus bill will have catastrophic consequences for the U.S economy. The reality is the catastrophe will be far greater with his plan then without it. If the trends of January and early February of 2009 continue, the rug will be completely pulled out from beneath the U.S. economy, and the full cost of the President's "economic depressant package" will be apparent to all.

If foreign capital does not continue to pour into Treasuries, interest rates and consumer prices in the U.S. will soar. At that point, we will finally be confronted with the real crises that I have long predicted. When the day of reckoning arrives our policy response will be critical. If we continue on the course our new President has mapped out, the catastrophe will far exceed the scope of any he hoped to avoid.

So if Obama is right we get a catastrophe but if Schiff is right we get a catastrophe - but it sounds like the Schiff catastrophe is even more catastrophic.

Calm down dear it's only the economy stupid.

I find all this talk about catastrophes just a teeny bit over the top. It seems like everywhere one turns another meltdown is looming with another forecast of Armageddon. Nothing sells like excess and it reminds me of the other kind of hyperbolic superlatives that can be found in popular TV shows like X-Factor where everything is described as "Absolutely Fantastic" and "I absolutely loved it".

Why do so many people find it necessary to use strings of overblown terminology to draw attention to things?

On the subject of Seeking Alpha I am finding it increasingly hard to take this site seriously and did not post a comment to Schiff's article because to say anything adverse about the man is guaranteed to trigger an avalanche of abusive counter comments.

Also the most popular item at the SA site at the moment is from a chap who says that he has a "bad feeling" about the market at the moment. It has brought about 5o comments most of which are about as penetrating as the author sharing his feelings with us.

Bad Bank is a Bridging Facility

Optimists - and ultimately who can afford not to be - could argue that the Bad Bank construct is nothing but a large scale bridging facility to better times when asset prices return to much loftier levels. Of course all of the interest which has been accruing during the interim has to be capitalized and added on to the requisite level at which the holder of the bad assets (i.e. the taxpayers) becomes whole again.
If, however, the bad assets remain in the private sector and valuation is based on shorter time frame accounting principles - mark to market for example - then suspicions about the insolvency of the holders of the bad assets will remain.
If the holder of the bad assets is the public sector where inter-generational accounting seems to be now presumed then a much more lenient form of valuation accounting - such as hold to maturity - becomes feasible and insolvency issues go away because in the inter-generational long term we're all dead.

Marginal propensity to provide viable collateral

Keynesian theory has some interesting propositions regarding the multiplier effect and its relation to two key issues involving propensities at the margin. The key idea is the marginal propensity to consume (MPC) which in simple terms reflects the incremental appetite for consumption given an increase in income. The starting out point for Keynes was that MPC would be less than one in that we would not spend all of an additional (say) $100 in income but decide to save perhaps $10 and therefore our MPC would be 0.9. Looked at in another way our marginal propensity to save would be 10% or 0.1 which of course expressed in another way is 1-MPC.
Looking at today's economy perhaps what would be useful is a concept which could be called the Marginal Propensity to provide Viable Collateral (MPVC). In a nutshell this is what is in extremely short supply at present and which apart from other obvious reasons having to do with previous bad lending practices and distressed bank balance sheets, inhibits an imminent economic recovery.
There are several big picture issues that play directly into the MPVC:

The de-leveraging which is taking place across the financial spectrum as existing collateral values are collapsing which leads to further selling from margin calls in a nasty deflationary spiral.

The fact that many firms and households have exhausted whatever viable collateral they have and are effectively not able to qualify for new loans

There is an over-capacity of supply in many areas of the economy which suggests that there is a lack of new opportunities for new entrepreneurs that may have some access to equity and viable collateral but see an absence of medium term demand for their proposed business offering.

Increased scrutiny and regulation from the public sector will make the qualification of the viability of collateral that much harder. Also credit ratings agencies have been so discredited that there is little faith in the assessment of creditworthiness and most potential lenders prefer to be ultra conservative.

The real consequence of the deflationary asset spiral that the global economy is moving towards is that the MPVC is close to, if not already, at zero.

Build it and they won't come to Dubai

Build it and they will come - not any more in Dubai it seems.
Watching the clip I was struck by the number of cliches used to promote the condos that no one seems to want. "Favored by the international jet set" was just one.
Trouble is many of those jet-setters have never even set foot in their condos - having bought them off plan and now nursing large losses. Hard to have too much sympathy for them though

US government- guarantor of last resort

Would it be better to nationalize the banks, create a bad bank for all of the impossible to value assets or provide an insurance scheme whereby the public sector absorbs the losses if things turn very sour?
Perhaps we will get a combination approach but what I think we are going to get when Mr. Geithner delivers his plan next week is an emphasis on the insurance option.

On the surface an Insurance solution appears to get around the hard question of what the assets are actually worth - nobody really knows now - but the insurance proposal allows that valuation to be postponed into the indefinite future.
Beneath the surface it is more insidious to the taxpayer because if no-one knows what the true value is, the US government, in its capacity as the guarantor of last resort, is in effect providing an unlimited commitment to absorb whatever losses could ultimately be sustained

Stimulus, Savings and Cruel Ironies

Lots of discussion regarding the likely impact of the Obama stimulus package mentions the Keynesian multiplier effect.
In very simple terms the multiplier effect can be quantified as 1/marginal propensity to save. It follows that the higher the percentage that goes into the denominator (the marginal propensity to save) the lower the actual multiplier value

The effectiveness of any stimulus has to reckon with the fact that there is a trend developing - as evidenced by recent reports regarding consumer credit contraction - that people are saving more in the Keynesian sense which is that less of their income is being used on current consumption.

The cruel irony or paradox is that the virtue of thrift will diminish the impact of the stimulus package. It will prolong the recession but arguably on the other side of this recession the US economy may have the benefit of a larger pool of genuine savings again.
The even more cruel irony is that this new private pool of savings would be at great risk of evaporation if the re-inflation scenarios being touted by many come to pass.
But as readers who have seen the "Life of Brian" will recall we should perhaps take our inspiration from the song "Always Look on the Bright Side of Life"