How To Pull a Rabbit Out of a Hat

Increasing numbers of foreclosures, among other things, have created financial havoc in the credit markets. Writedowns in asset valuations have necessitated increasing loss reserves, and credit availability is tightening in the context a higher likelihood of insolvencies at the personal, corporate, and governmental levels. One of the first public policy attempts to deal with this was to create a Super Bailout Fund in the attempt of establishing a fictional floor on valuations of financially impaired assets.

Apparently, the next public policy foray into establishing a floor on impaired assets is the proposed freeze on resetting ARM interest rates. The number of actual mortgagees this would actually help appears to be small; the number of mortgagees who would actually be deserving of help is even smaller. Moreover, numbers I have read suggest that even if this plan were able to be cost effectively implemented in a timely way, over 50% of these mortgagees would likely be in financial distress within several years later. In a deteriorating economy, likely to be in recession, and a projected continued decrease in property values, it is reasonable to ask where the soundness is in this policy prescription.

As I alluded to in an earlier post, it appears that the real benefits accrue to the troubled institutions at the root of this episode in financial folly. After thinking further about this, it becomes apparent that the deterioration in the asset values of the CDO’s, MBO’s, etc arises from the increased numbers of non-performing loans. If these loans, and mortgages, can be restructured to appear to be performing loans, voilà, we have created a floor in the valuation of the derivative assets, and at least a temporary slow down of the financial hemorrhage. On the plus side perhaps this at least buys some time to either come up with some other more effective solutions, or at least to think up another charade to defer the day of reckoning to someone else’s watch. Whether this buys time to allow accountable parties to fade into the sunset, or it buys time to reconstruct a seriously damaged financial system is an open question. Judging, however, from the fat severance packages we have seen some of those bearing responsibility walk away with, with relative impunity there is likely to be at least a good portion of the former.

Sub Prime Freeze Helps Whom?

We should be clear about one thing, the proposed rescue plan for struggling ARM homeowners, is primarily directed at slowing down the collapse of beleaguered financial institutions. The inputs for the plan were heavily influenced by those institutions most impacted. The veneer of beneficent social policy suggesting that these homeowners would be significantly helped does not appear to be supported by the evidence. An article in the Financial Times[1] cites a Barclays analysis that only 12%, or 240,000 homeowners would be helped by this freeze. It is patently obvious that this proposal amounts to nothing more than an additional attempt to bailout institutions whose imprudent actions lead to this set of circumstances.

Aside from the theoretical issues such as violation of contract law, establishing a precedent for the institutionalization of moral hazard (the Governmental Put, if you will), and State sanctioned erosion in the one primary concept serving as the foundation of the US, and consequently the global financial system, trust and faith in established US property rights, there is the question of equitable treatment of economic players. If we consider the context for the current economic calamity, it arose through the generation of incredibly huge profits for the players in these schemes. What appears to be being proposed is that, under the guise of the threat of global economic collapse, the policy response should be to reduce the consequences of the imprudent actions of the players who have benefited so handsomely. To make the pill easier to swallow, the sugar coating is spun to be the benefit to the “homeowners”.

As I’ve alluded to before, in other blog contributions, it is dubious as to whether “homeowner” is an appropriate term when little or no equity exists. Moreover, even if we granted the dubious theoretical justifications for the implementation of such a plan, the operational practicality of implementation is unlikely to be accomplished in a timely and cost effective manner.

It is interesting to note that in the last few days, eminent analysts, economists, and commentators, whom I’ve regularly viewed as having sober, well-reasoned opinions, even if I did not agree with all of them, appear to be becoming infected with a contagion of panic. Paul Krugman’s opinion piece uses words like “spooky”, in Robert Shiller’s Bloomberg interview several days ago I felt I heard an undertone of panic, and in Nouriel Roubini’s blog he appears to be appealing to ad hominem type support for his arguments by such statements as

“Thus only folks who are so blinded by their free markets fundamentalism and opposition to any government intervention in market failures would be so obfuscated by their ideological blinders that they would realize that this plan –however modest and partially faulty and incomplete – implies a better market-oriented resolution and much lower losses to private investors than a disorderly and “mission impossible” case-by-case workout of millions of actual or threatened mortgage defaults.”

This, in itself, is a good indication of how serious this issue is.

Ryan Darwish
Author of The Emperor’s Clothes: A Mosaic Look at the Megatrends Affecting Your Financial and Investment Decisions
[1] Financial Times, Bush Faces Subprime Loan Freeze Opposition, December 7, 2007.

US Dollar Fate

Gazprom May Switch Oil, Gas Sales to Rubles as Dollar Weakens
By Dan Lonkevich
Nov. 29 (Bloomberg) -- OAO Gazprom, the world's largest natural-gas exporter, may start selling its crude and gas production in rubles rather than dollars and euros after the U.S. currency weakened.
``We are seriously thinking about selling our resources in rubles,'' Alexander Medvedev, Gazprom's deputy chief executive officer, told reporters today in New York. He didn't give a specific timeline for the decision.
The switch would happen ``sooner, rather than later,'' Gazprom Chief Financial Officer Andrei Kruglov told the same gathering of reporters.
To contact the reporters on this story: Dan Lonkevich in New York at dlonkevich@bloomberg.net .
Last Updated: November 29, 2007 14:04 EST
It is interesting to note that a primary concern other countries have with the drop in the US dollar relative to their currency is the fear that their trade export position, and consequently,thier export driven ecomonies would suffer. In the case of Gazprom, referenced above, considering repricing in rubles rather than US dollars signals a perception of the decreasing significance of ruble strengthening relative to the dollar. It suggests when the demand is relatively inelastic for an export, such as energy, the concern about the likelihood of decreased exports is diminished. Moreover, it is somewhat of a two edged sword. As the ruble strengthens the purchasing power, and consequently the real wealth of ruble holders increases. It is a win on two fronts, increased purchasing power and increased accumulation through continued export driven growth.
Absolutely brilliant. Wait until some of the other petro powers catch on to this.
Ryan Darwish
Author of The Emperor's Clothes: A Look at the MegaTrends Affecting Your Financial and Investment Decisionshttp://www.investmentmegatrends.com/

Economic Decoupling

Nouriel Roubini, an eminent global economist, has made the point that if the US experiences an economic slowdown, other countries, such as China, would also experience a slowdown because our economies are dependent upon one another.[1] This is known as being coupled together. There has been ongoing discussion which suggests the alternative hypothesis, that economic decoupling has occurred, and the rest of the world is not economically dependent upon the US anymore.

While there are many well made points in Roubini's, as usual fine analysis, I believe there is something lacking in several respects. The idea of decoupling is contextualized as a black and white issue; either other countries have decoupled, or they have not. The preponderance of evidence, a posteriori, is that those other countries now have more developed economies, and by extension greater internal, as well as intra-regional, demand. The statement “"For now it is clear that it is still the case that when the US sneezes the rest of the world gets the cold.” may be an overstatement. I see little evidence to support this conjecture. It appears more likely that a more accurate representation would be "the rest of the world gets something between a sniffle and a cold". Whether the rest of the world gets more of a cold than a sniffle remains to be seen.

I see several possible mitigating factors which were not mentioned in this analysis. One factor would be how rapidly US demand deteriorates relative to geo-specific, intra-regional, and country specific internal demand increasing. Another factor are those elephants in the living room known as sovereign wealth funds, and country specific economic stabilization funds. It is no secret that a number of countries who have been beneficiaries of petro-dollar and trade surplus dollars have strategically identified the risk of a US slowdown. It may be a gross under-estimation of the intelligence of these entities to assume that they have not factored in contingency planning. Considering the infra-structure build-out needs of these emerging economies, a hypothetical alternative to being dragged down by a declining US economy would be to redeploy surplus reserves, and/or borrowing capacity, to developing, for example, their economic and physical infrastructure such as roads, telecommunications, environmental cleanup, etc. The US, in fact, presents a model of such an endeavor during the early 20th Century with the Civilian Conservation Corp. A major difference, nowadays, is that the US is financially broke, while these other emerging economies are relatively financially flush.

Ryan Darwish
Author of The Emperor’s Clothes: A Mosaic Look at the MegaTrends Affecting Your Financial and Investment Decisions
http://www.investmentmegatrends.com/

[1] http://www.rgemonitor.com/content/view/228535/85/

A Hard Landing or Stagflation?

Predicting a "hard landing" recession is not much more than making the observation that the horse is already out of the barn. It is also an intellectual hedge, to not go too far out on the limb, from making the observation that what we are facing is not just an economic "hard landing", but a period of stagflation. Looking at escalating food and energy costs, while not core items in "Fed Think", are certainly core items in living. Moreover, the pervasiveness of the dependency of the pricing of other goods on the production and availability of food and energy, suggests a very ugly outlook. This is compounded by increasing demand in the context of supply limitations for these items. It begs the question to hold the position that a slowing economy will dampen the demand for these goods. Externalities such as weather, geopolitical unrest, and strategic hoarding of vital resources, at the very least, cast doubt upon the premise of decreased demand because of slow, or recessionary, economic growth.

Author of The Emperor's Clothes; A Look at the Megatrends Affecting Your Financial and Investment Decisions
www.investmentmegatrends.com

The Current Financial Crisis and its Likely Outcome

As the current credit market crisis continues to unfold, it goes from bad to worse. Credible commentaries are now emerging in the mainstream press citing estimates as high as $500 billion(1) of losses that financial institutions may incur before it runs in course. It is unclear to me what the actual implications will be of a systemic loss of this magnitude, and indeed, since none of us has a perfect crystal ball, it can only be the subject of conjecture and speculation. That there will be an increase in insolvencies, massive economic displacement, and economic restructuring is appearing to be more and more a given. We appear to be at a global economic watershed point. If history is any guide, previous bouts of monetary folly have resulted in hyperinflationary environments, followed by collapse(2). In the past, however, there was relative economic containment because of the absence of the degree of globalization and economic integration we currently have in the world, with the exception, possibly, of the Great Depression era. In any event, an economic crisis of the magnitude we are currently facing, quickly becomes a political crisis. In considering possible strategies which may be attempted, short of the transparent charade recently proposed of the SIV Super Bailout fund, it appears the corner strategy will be monetization of the debt through hyperinflation. Indeed, we have already seen the evidence of this occuring, and it is well known that it is not a peripheral strategy for Ben Bernanke.

If we assume, for purposes of discussion, that this is the direction in which economic history will move, it becomes useful to consider some of the implications of this scenario for asset deployment purposes. While there is a great deal of discussion regarding the demise of the US dollar, it is often followed by considering other currencies as a safe harbor refuge. This may be a false sense of security. Considering that one of the reasons for the US dollar's problem is the lack of monetary discipline because of the fiat nature of the currency, the same problem exists with other currencies. There appears to be an inherent instability with a fiat monetary system. Consequently, in my opinion, it is a mistake to believe that other currencies might be anything other than a temporary refuge.

Let us also consider the question of debt. The initial reaction is to want to minimize indebtedness in a financial crisis. This may well, generally, be the prudent course to take. However, as circumstances amoung market participants differ, holding a fixed liability during a time of hyperinflation can become an asset as long as the ability to service the debt remains in place. For example, if I have a mortgage of $300,000, a hyperinflationary environment will reduce the value of that liability, in real terms, while at the same time possibly increasing the value of that asset in nominal terms. If I have a fixed mortgage payment of $1,500 per month which I can continue to service, a hyperinflationary environment may reduce that nominal figure in real terms, ie adjusted for inflation.

Let us also consider assets which might best retain or increase in value. It seems clear, and current market behavior suggests there is growing recognition of this, that assets which have a real use value, such as commodities, energy, food, water, etc. will continue to be in growing demand. At the same time, the constraints on the supply of these resources continues to grow. Economics 101 would suggest that a highly probable way to successfully deploy assets would be to own assets which are in growing demand and diminishing supply.

Traditonally, institutional creditors would be the one's to lose big time in inflationary environments. Nowadays, these institutions also appear to be some of the biggest debtors.


(1) Banks Face $100 Billion of Writedowns on Level 3 Rule, John Glover Nov. 7 (Bloomberg)
(2) Manias, Panics, and Crashes, A History of Financial Crises, Charles Kindleberger.

Moral Hazards and Free Riders

"High concentrations of money and power provide trigger points for economic calamity that can be brought about by relatively few individuals or institutions. The potential harm which can arise from acts of malfeasance represents a moral hazard in our investment environment. Some financial theorists would argue that this risk is “priced in” to our investments so that what we invest in is fairly valued with respect to its risks. I see little sound rationale to accept this point of view. Risks that can be perceived and quantified can perhaps be priced in to arrive at an estimate of fair value for an investment. Many risks, such as the moral hazard of malfeasance, cannot be effectively quantified. The media, institutional, and governmental approach to representing these types of risks to the general investor seems to be to marginalize these risks. This approach gives a false sense of security and the impression that these risks are non-significant. This may be necessary to manage the perceptions of the general investor and retain confidence in the financial markets. From the perspective of the individual, this approach breeds complacency where there should be vigilance in the wise management of one’s assets."

Excerpt from: The Emperor's Clothes: Megatrends Affecting Your Financial and Investment Decisions
http://www.investmentmegatrends.com/

Financial Magic or The Disappearing Elephant Act

When a financial system is based solely upon the faith people have in it, maintaining this faith becomes of paramount importance. In the absence of sound financial and economic policy, maintaining people's faith in the system becomes the politics of spin management where public policy reduced is to a confidence game.

The problems in the global credit markets, wrought by overzealous financial institutions, taking advantage of imprudently lax credit standards, are throwing a wrench in the spokes of the global economic and monetary systems, particularly in the United States. The latest proposal to try to manage this potentially monumental financial crisis is the creation of what, in my opinion, should be called a super bailout fund. This is essentially a fund, created by a consortium of banking institutions, that can be used to dump assets into when they believe there is not an acceptable alternative buyer. Wouldn't it be nice if, whenever we wanted to sell something and couldn't find a buyer that would pay what we wanted, we could just create a fictional buyer to take the asset off our hands.
One of the best analyses I've seen on this subject was done by economist Nouriel Roubini, and can be found at his blog http://www.rgemonitor.com/blog/roubini/220816.
The timing of putting this plan together is interesting. This push was reported to occur last weekend. Interestingly enough at least three major banks report earnings this week. Citibanks presentation of its dismal result are already known, with a decline in profit of 57%. It looks like quite a bit of spin managment going on here, in order to keep the confidence of potential new money boosted. From accounts I've read this fund will be seeking new money coming in to it. An interesting bit of financial sleight of hand; create a buyer to support a price on suspect assets and we now have a market pricing mechanism, then suck in new money until the real solvency issues cause it to implode.

Valuation Issues

The key metric in being able to evaluate an investment is knowing what it is worth. With a publicly traded investment such as a share of common stock, there is ongoing price disclosure generated by prices offered, and the prices accepted by a multitude of buyers. Reoccuring episodes of irrationality and over exuberance suggest that this may not be the perfect method of determining the true value of a given security. However, since what a willing buyer will pay a willing seller is the final arbitor of current value, the transparency of price disclosure by the market forces of the multitude at least has the merit of establishing a more level playing field as a starting point. Indeed, some financial theorists argue that markets are efficient to the extent that current prices determined by market forces are an accurate representation of true value. Be that as it may, an entirely different issue arises when investments are illiquid. Alternatively, if the value is determined by reference to a valuation model, this may contain self-serving, or otherwise erroneous assumptions.

For example, one of the problems, recently creating turmoil in the global financial markets, has been the valuation of Collateralized Mortage Obligations(CMO). When subprime mortgages are bundled together and packaged with other mortgages, assumptions need to be made about such things as the default rates of these mortgages. With a minimal history of these mortgages, there is also minimal information about default rates. Nonetheless, this had not stopped trillions of dollars of these securities from being created, and consequently being valued by, at best, an arbitrary method, and at worst a self-serving procedure of malfeasance. Consequently, when these valuations were challenged by the real market conditions of defaulting mortgage holders, these valuations became glaringly inadequate.

The latest example, after a litany of tens of billion of dollars of losses being claimed by the likes of Bear Stearns, Citigroup, Merrill Lynch, Deustche Bank, and having the Central Banks of the world pump $500 billon into the global banking system to try to avert a global financial catastrophe, is Ellington Capital Management, a $5.2 billion debt-focused hedge fund which recently announced it had restricted withdrawals from its fund because of the difficulty of valuing the securities in its portfolio. Along the same line, a Wall Street Journal article(Pricing Tactics Of Hedge Funds Under Spotlight, October 6, 2007) cites academic research findings which show that hedge fund managers sometimes "cherry pick" valuations to give a more positive appearance.

The bottom line is that these shenanigans, under the guise of free market capitalism, are anything but champions of free market capitalism. At core, these tactics erode the strength of a vital and strong economic system by distorting the efficient allocation of capital based upon fundamentally sound information.

Latest Delusional Market Behavior

The latest "sugar rush" to keep the market pumped has been the implicit promise of Big Daddy Fed coming to the rescue of the United States' economy and financial system. The concept of lowering interest rates to make credit, and consequently liquidity, more available is an idea which would have more play in an environment where solvency issues were not the context in the background.

The chorus of more sober voices highlighting the serious underlying economic issues are, as usual, being drowned out in favor of the voices of hyperbole espousing more faith based investing themes such as "stocks always go up in the long run", the worst of the credit crisis in behind us, etc. These spinnings, by and large, invite a "trust me" perspective in the absence of a more evidentiary decision process.

What remains largely unsaid is that we appear to be at the later beginning stages of a collapsing housing market, rather than at the end stages. The consequences are likely to be felt in job losses, decreased consumer demand, and increasing insolvencies and foreclosures. These latest exhuberances of the financial markets are likely to end poorly after having sucked in a multitude of additional naive investors impressed by its glitter.