Credit Crunch Leaves No Debt Market Unscathed

Anyone who has paid even a wee bit of attention to the business press no doubt has gotten the message that there is a world of hurt in the debt markets. But both optimists and skeptics might wonder: is there an element of reporting fallacy? Are there sectors that are OK but have gone unnoticed because reporters focus on train wrecks?

An article by Paul Davies in the Financial Times describes how widespread the pullback has been:

Global debt issuance collapsed in the first quarter as the credit crunch took its toll on new deals in all sectors from structured finance and riskier high-yield bonds and loans right up to sturdy investment-grade corporate debt, according to new data.

Total debt market volumes were $1,030bn in the first quarter, a 48 per cent drop compared with the same quarter a year ago, while total syndicated loan market volumes were $599.bn, a 47 per cent drop versus the same period last year, according to Dealogic, the data provider.

The numbers illustrate how the withdrawal of liquidity from the world's debt markets in the wake of the turmoil that began in the US mortgage markets has affected everything from the safest corporate borrower to the most risky private equity backed leveraged buy-out deal.

Structured finance markets, which cover mortgage-backed bonds and complex products such as collateralised debt obligations, unsurprisingly suffered the worst contractions.

Globally, new deal volumes of just $81.5bn were 89 per cent less than the first quarter of 2007. This volume was the lowest since the first quarter of 1996.

The outlook for bankers' jobs in this sector was also put under a cloud with news that revenues generated by structured finance were the lowest since the third quarter of 1995, when a fraction of today's armies of professionals worked in the field.

Bankers and analysts said the outlook for most areas of the debt markets remained fairly bleak for the next quarter and probably the rest of the year.

Suki Mann, credit strategist at SG CIB, said that the investment grade companies in Europe, which have been least immediately harmed by the credit crisis so far, would continue to shy away from issuing new debt while markets remained so rocky.

"We think corporates can continue to hang on," he said. "Their liquidity position remains quite strong and banks in Europe continue to lend on a bilateral basis."

Within the loan markets, the leveraged loans that fund private equity buy-outs saw the biggest declines with volumes down 84 per cent to just $46.9bn worldwide compared to the first quarter of 2007.

Paulson's Cosmetic, Cynical Financial Regulation "Reform"

Why is it that the media feels compelled to take pronouncements from government officials more or less at face value? By now, they ought to know that if someone from the Bush Administration is moving his lips, odds are it's a lie.

Today's object lesson is the so-called financial services regulatory reform plan announced by Treasury Secretary Hank Paulson. Both the Journal and Times treat his proposals as significant. Their headlines, respectively: "Sweeping Changes in Paulson Plan," and "Treasury’s Plan Would Give Fed Wide New Power."

There is less here than meets the eye, and what is here is guaranteed not to be implemented during the remaining months of the Bush presidency. And that of course is precisely the point of this exercise. Appear to be doing something and dump the mess in the lap of your successor.

To the details. Remember where we are: we've had years of misguided confidence that investment banks could be left to their own devices, that the wonders of the originate-and-distribute model meant Things Were Different This Time. Specifically, the powers that be believed that risks were so widely spread and diversified that the financial system was now much more resistant to systemic shocks. We've seen what a crock that idea was.

So although no one has come up with a detailed reform plan, it's clear that the old model is badly tarnished. Since we have demonstrated that losses from investment banking risk-taking will be socialized, curbs need to be put on them. Otherwise, the very presence of a put to the government will guarantee untoward speculation and poor allocation of capital. In addition, continued taxpayer funded rescues of institutions with egregiously well-paid staff would eventually result in bankers' heads on pikes.

A number of ideas have been proposed: tougher capital requirements; restrictions on the use of off-balance sheet entities; driving more trading on to exchanges; limiting the risk-taking of institutions that are big enough to be systemically important (say allowing them to risk only a certain portion of capital in hard-to-value, volatile, or illiquid products); pro-cyclical capital charges; addressing poor incentives; improving transparency and disclosure.

But would any of the measures proposed by Paulson have prevented our crisis-in-motion? No.

What Paulson offered up instead what a plan for some consolidation of financial services industry regulatory oversight. This isn't useless; it would help prevent regulatory/supervisory arbitrage and allow for more consistent implementation of any new regulation. But to pretend that bureaucratic consolidation is tantamount to reform is dishonest. But the New York Times parrots the Administration's story line:

The proposal is part of a sweeping blueprint to overhaul the nation’s hodgepodge of financial regulatory agencies, which many experts say failed to recognize rampant excesses in mortgage lending until after they set off what is now the worst financial calamity in decades.

In reality, the biggest single culprit was a lack of willingness of major regulators, in particular the Fed, to intervene in a securitization process that, as long as it beefed up housing prices, was seen to be virtuous. A secondary factor was that the Federal government, largely through favorable court rulings, has for the most part stripped states of the power to regulate financial services firms. Yet many states have been far more aggressively pro-consumer than the Feds; usury laws, now gutted, existed only at the state level, as did the tougher versions of predatory lending laws. Ironically, had the states been more in the driver's seat (which is a less rather than more consolidated regulatory approach), the mortgage crisis might have been severely blunted (it might not have been attractive to design and market the more aggressive subprime products if they would have been permissible only in certain states). But the Federal government has long had a regulatory bias that favors industry profits over consumer protection.

Yes, as we'll detail, Paulson did add a couple of bells and whistles that were a slight nod to the need to reform. But some had already been served up (and we had deemed them wanting); one is severely misguided.

To the guts of the Paulson program. From the Journal:

Mr. Paulson's plan will include merging some agencies, such as the Securities and Exchange Commission with the Commodity Futures Trading Commission, while broadening the authority of others, such as the Federal Reserve, which appears to be a winner under the proposal. Mr. Paulson is expected to recommend that the central bank play a greater role as a "market stability regulator," with broader authority over all financial market participants.

Mr. Paulson is also expected to call for the Office of Thrift Supervision, which regulates federal thrifts, to be phased out within two years and merged with the Office of the Comptroller of the Currency, which regulates national banks. One reason is that there is very little difference these days between federal thrifts and national banks.....

In addition to some of the short- and medium-term changes, Treasury officials have also designed what they believe to be an "optimal structure" of financial oversight. It would create a single class for federally insured banks and thrifts, rather than the multiple versions that now exist. It would also create a single class of federally regulated insurance companies and a federal financial-services provider for other types of financial institutions.

A market stability regulator, which would likely be the Fed, would have broad powers over all three types of companies. A new regulator, called the Prudential Financial Regulatory Agency, would oversee the financial regulation of the insurance and federally insured banks. Another regulator, the Business Regulatory Agency, would oversee business conduct at all the companies.

Note also that the SEC would be merged with the Commodity Futures Trading Commission.

"Market stability regulator" is a dangerous bit of Newspeak. This is code for the fact that the Fed's role as chief bailout agency will be formalized. And when Japanese regulators there spoke about promoting market stability, that meant protecting industry incumbents, usually by somehow limiting competition and therefore improving profits.

And this program sounds as if it is replacing a hodgepodge now fractured by type of institution (thrifts vs. national banks vs. securities firms) with a smaller number of regulators that will be fragmented functionally. The idea of the Business Regulatory Agency is utter hogwash. How do you oversee business conduct separate and apart from supervisor audits? This agency is bound to be toothless, which is probably the point. And if I read this correctly, we will have the new Prudential Financial Regulatory Agency and the Fed (n the cases of banks with significant trading operations)regulating the same institution, which can lead to either overlapping mandates (which generates conflicts) or supervisory gaps.

Now to the elements that involve some bona fide regulation. Again from the Journal:

A key part of the blueprint is aimed at fixing lapses in mortgage oversight. Mr. Paulson plans to call for the creation of a new entity, called the Mortgage Origination Commission, according to an outline of the Treasury Department's plan, which was first reported by the New York Times. This new entity would create licensing standards for state mortgage companies. This commission, which would include representatives from the Fed and other agencies, would scrutinize the way states oversee mortgage origination.

Also related to mortgages, Mr. Paulson is expected to call for federal laws to be "clarified and enhanced," resolving any jurisdictional issues that exist between state or federal supervisors. Many of the problems in the housing market stemmed from loans offered by state-licensed companies. Federal regulators, too, were slow to create safeguards that could have banned some of these practices.

We had noted before that the merit of mortgage licensing idea depended not on the licensing standards itself (do you really think making brokers take courses and sit an exam is going to lead to better behavior?) but on the standards for conduct, monitoring procedures, and enforcement. Paulson hasn't mentioned any of those. Similarly, it isn't clear how deeply the federal authoriites can get into interfering with, um, overseeing the states on mortgage origination. Since deeds are recorded locally, and contracts are a state law matter, Washington's influence may be limited.

In keeping with notion that the Fed is underwriting the financial system, the Paulson plan gives lip service to the idea the the central bank should have enhanced regulatory powers. However, the proposals are remarkably vague. From the executive summary:

First, the current temporary liquidity provisioning process during those rare circumstances when market stability is threatened should be enhanced to ensure that: the process is calibrated and transparent; appropriate conditions are attached to lending; and information flows to the Federal Reserve through on-site examination or other means as determined by the Federal Reserve are adequate. Key to this information flow is a focus on liquidity and funding issues. Second, the PWG should consider broader regulatory issues associated with providing discount window access to non-depository institutions.

This says the Fed should be able to send inspectors into an institution once it has started propping it up. That is tantamount to shutting the barn gate after the horse is in the next county. The Fed should be supervising any institution that it might have to bail out, period. And the idea that the Fed can effectively examine an organization that it hasn't previously overseen is utter bullshit. Do you think the Fed has any ability to monitor Bear?

Despite its overly generous warm-up, the New York Times does point out the many shortcomings of this plan:

While the plan could expose Wall Street investment banks and hedge funds to greater scrutiny, it carefully avoids a call for tighter regulation.

The plan would not rein in practices that have been linked to the housing and mortgage crisis, like packaging risky subprime mortgages into securities carrying the highest ratings.

The plan would give the Fed some authority over Wall Street firms, but only when an investment bank’s practices threatened the entire financial system.

And the plan does not recommend tighter rules over the vast and largely unregulated markets for risk sharing and hedging, like credit default swaps, which are supposed to insure lenders against loss but became a speculative instrument themselves and gave many institutions a false sense of security.

Congress would have to approve almost every element of the proposal....Mr. Paulson’s proposal is likely to provoke bruising turf battles in Congress among agencies and rival industry groups that benefit from the current regulations.

And the real kicker:

The bulk of the proposal, however, was developed before soaring mortgage defaults set off a much broader credit crisis, and most of the proposals are geared to streamlining regulation.

In other words, this isn't even rearranging the deck chairs on the Titanic; it's keeping the ship on full throttle with a only slight change in course.

Links 3/29/08

Oregon man stripped by Craigslist looter The Register

My Very Own Risk-Based Repricing Experience Adam Levittin, Credit Slips. A law professor who studies the credit card industry has his own mini-horror story and recounts several ways the bank's procedures violate applicable laws.

Study sees Microsoft brand in sharp decline IDG News Service

Nationwide predicts first annual fall in house prices since 1990s property crash Guardian

Valuation, Frayed Nerves and Liquidity Roger Ehrenberg

Lehman May Be Victim of Fraud Wall Street Journal

Stop the Mortgage Bailout NationalBubble. As readers know, your humble blogger is of the view that trying to shore up asset prices that are not supported by cash flow is bound to fail and will divert resources from better ways to deal with the fallout of the credit crisis. This site does a good job of making the economic considerations accessible to non-economists and is orchestrating measures to oppose bailouts. Hat tip Cactus at Angry Bear.

High prices spark fresh gold rush in California Financial Times

Antidote du jour:

SEC Gives Permission to Fudge Mark-to-Market

The US is acting more and more like a banana republic with every passing day. One of the characteristics of a banana republic is that it puts out flattering-to-the-point-of-being-unreliable data about its economy and important institutions.

Alert reader James Bianco pinged us about a new SEC release today and Floyd Norris of the New York Times' commentary on it, "If Market Prices Are Too Low, Ignore Them," Norris, who is usually pretty understated, disapproved of one of the items in the SEC letter, as do we.

Most readers probably know that accounting rule FAS 157 became effective as of January 1 of this year. It requires companies, subject to certain restrictions, to classify financial assets as Level 1 (easily valued by reference to market prices), Level 2 (doesn't trade actively, but similar enough to actively traded assets that can be valued in relationship) and Level 3 (known in the trade as "mark to model" or "mark to make believe"). Some financial firms opted to comply with FAS 157 early, which led to quite a few investment banks revealing that the value of their Level 3 assets exceeded their net worth.

In the last couple of months, there has been increased worry that mark-to-market accounting leads to the operation of a destructive "financial accelerator." As prevailing values go down, banks have to lower the value of their holdings. This leads to a direct hit to their net worth, which will lead them to contract their balance sheets, either by withholding credit or selling assets. More sales in a weak market lead to further declines in the prices of financial instruments, leading to more writedowns and sales of inventory.

Funny how no one had a problem with mark-to-market when asset prices were rising. The process in reverse leads to mark-to-market gains, higher net worths fueling balance sheet growth and credit expansion, which led to more demand for financial assets. That gives you higher securities prices which least to more mark-to-market gains. Sounds like a bubble, doesn't it?

The SEC's solution for the contractionary version of this dynamic is simple: ignore those market prices if they are too ugly. From the release:

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale (boldface ours).

Quite a few observers had argued that the windups of SIVs and the failure of hedge funds, and even Bear Stearns, would be a good thing because they would force price discovery of assets that are normally illiquid and/or hard to value. That in turn would resolve a great deal of uncertainty of what bank and hedge fund positions were really worth.

But now the SEC has given banks and brokers a huge out. No matter how small or easily absorbed by the market a forced sale might be (think of a hedge fund hit by a margin call), a financial institution can ignore the price realized. In fact, they get to determine what trades constitute a forced sale. As Norris dryly notes:

Some people on Wall Street think that nearly every sale today is a forced sale. There are entire categories of collateralized debt obligations where most, if not all, of the trades, occur because a holder has received, or expects, a margin call.

Moreover, we've seen plenty of unintended consequences, or worse, backfires, as regulators intervene trying to alleviate the credit crisis. Banks have been reluctant to extend credit to each other precisely because they don't trust their creditworthiness. That's tantamount to saying they already don't trust their public financial statements, since according to their public filings, virtually all major financial institutions have more than the required statutory capital.

So this move, to stem the balance-sheet-shrinking impact of mark-to-market accounting in a falling price environment, may further undermine liquidity. Companies will less able to judge whether their published financials are telling the whole story, And where the numbers are in doubt, rumors are taken more seriously.

Now in fairness, the entire letter wasn't a gimmie to the securities industry. Entities that report Level 3 exposures have to talk about them at great length:

To paraphrase Winston Churchill, it has been said that mark to market accounting is the worst form of financial accounting except for all the others that have been tried. But it looks like we are going to try them anyhow.

Bloomberg Pronounces Hope for Subprimes Based on Single Deal

An article by John Berry at Bloomberg, "Fed Actions Defuse Subprime ARM Rate Reset Bomb," is extraordinarily misleading, claiming that a Fed paper based on a single pool of MBS issued by New Century in 2006 shows that subprimes will work out much better than conventional wisdom says.

Let' s start with Berry:

Many analysts and public officials have said that foreclosures of subprime adjustable-rate mortgages would soar this year as owners' monthly payments jumped when interest rates reset to a higher level.

Not only is that unlikely to happen, this year's resets of earlier vintages of subprime mortgages may even reduce some payments that increased in 2007.

The reason? The index to which many ARMs are tied is the six-month London inter-bank offered rate, or Libor, and that rate has fallen from more than 5.3 percent last fall to about half that level....

Unfortunately, most of the defaults and foreclosures that have wreaked havoc in financial markets haven't been due to resets so far. Many borrowers simply bought a house or condo they couldn't afford unless bailed out by rising prices, and lower rates alone won't help them much.

Still, the big drop in Libor means there likely will be many fewer foreclosures than there would have been....

A new report, ``Understanding the Securitization of Subprime Mortgage Credit,'' by economists Adam B. Ashcraft and Til Schuermann of the New York Federal Reserve Bank, published this month, provides a wealth of detail about subprime mortgages. Much of its information is based on a pool of such mortgage-backed securities issued by New Century Financial in June 2006.

All but 12 percent of the loans in the pool were ARMs, either the so-called 2/28 or 3/27 variety. That is, they carried a fixed-initial rate for two or three years, respectively, so the former will first reset in June.

The average initial rate for the loans was 8.64 percent, set when the six-month Libor was 5.31 percent, according to the report. It was a teaser rate in the sense that once resets began, the interest rate would be based on Libor plus a spread of 6.22 percentage points.

Now the interesting thing is that the authors of the paper stress that they investigated only one pool used to illustrate how subprimes work and to try to understand how the product turned out to work so badly. The abstract and executive summary make no reference to the economics of subprimes. The abstract:

In this paper, we provide an overview of the subprime mortgage securitization process and the seven key informational frictions that arise. We discuss the ways that market participants work to minimize these frictions and speculate on how this process broke down. We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending. We present the key structural features of a typical subprime securitization, document how rating agencies assign credit ratings to mortgage-backed securities, and outline how these agencies monitor the performance of mortgage pools over time. Throughout the paper, we draw upon the example of a mortgage pool securitized by New Century Financial during 2006

Fed economists no doubt would know better than to use on one pool of MBS issued by one issuer in one month for an economic when there are vastly more comprehensive data sources that are designed for precisely that sort of analysis. And a quick look at one suggests that Berry's conclusions are quite a stretch.

The American CoreLogic databases as of March 2007 contained 38 million mortgages. Their extraordinarily detailed analysis of 8.4 million ARMS originated between 2004 and 2006 showed only 9.1 % with initial interest rates of 8.5% or higher (note that the paper claims an average of 8.64%)

There were more mortgages ate 2% and below (1,1 million) than above 8.5% (770 thousand). Without throwing in the intermediate levels, it's obvious that the weighted average is well below 8.64% (the level in the New Century pool, which gave Berry the notion that there wouldn't be much reset shock). Similarly, a March 2007 (admittedly now dated) paper by Chris Cagan deemed ARMs with initial rates of 6.5% or higher as not-very-vulnerable to reset shock.

ARMs with low introductory rates were never intended to reset; the assumption was that the would refinance. And recent pools are running at unheard-of rates before reset, with monthly default rates of 3.5%, which equates to a 34.8% cumulative default rate over three years. Thus the performance of later subprimes is horrendous independent of the issue of resets.

Finally, while Libor was a popular index for setting the reset rate, it's far from the only benchmark. Others include the 11th District Cost of Funds rate, the Prime rate, the Monthly Treasury Average rate, the Constant Maturity Treasury rate. And some of these have not been affected by the Fed's cuts:



Note that while prime has fallen, its level is not much below what it was in 2005 and 2006, which were the heaviest years for origination of dubious subprimes (while the 2007 vintage is worse in terms of quality, the volume issues was lower than in the two preceding years):

Chinese Avoiding Dollar as Invoicing Currency

Once sign of the move away from the dollar as reserve currency that we've noted before is the shift away from its use as an invoicing currency in commercial transactions. The Financial Times provides another example, namely, that Chinese exporters are avoiding the dollar:

Rising numbers of Chinese exporters are shunning the US dollar or devising ways to offset the impact of the falling currency as they confront rising labour and raw material costs at home.

According to Alibaba.com, the online company that matches Chinese suppliers with international buyers, the vast majority of their almost 700,000 Chinese suppliers no longer use dollars to settle non-US transactions in order to minimise foreign exchange risk.

"They are moving to euros, pounds, Australian dollars or even quoting prices in renminbi," David Wei, chief executive, told the Financial Times. Moreover, he added, prices quoted in dollars were now often valid for just seven days compared with the 30-60 days common previously.

The dollar has long been the currency of choice for Chinese and other exporters around the world. However, the impact of its recent weakening has led exporters to begin questioning its place as the de facto world currency.

The renminbi, which western governments have long alleged is undervalued, thus giving Chinese exporters an unfair advantage, has appreciated 6.7 per cent against the US dollar in the past six months. Economists expect it to rise 10-15 per cent against the dollar in 2008 and it is expected to rise a further 10 per cent in value this year, according to Qing Wang, economist at Morgan Stanley China. He warned that pace could quicken to more than 15 per cent should inflation in China, already running at a high level, continue to climb.

Quanzhou Leething Garment & Knitting, a Chinese men's underwear factory, said it had started encouraging clients to pay in euros instead of dollars in November. While the Chinese currency has appreciated against its US counterpart in recent months, it has moved little against the euro. Orders placed in US dollars are now subject to having their prices adjusted according to the latest exchange rate just prior to shipping, said a company spokeswoman.

Dongguan Wang Cai Garment, based in the southern Chinese province of Guangdong, exports mainly to Europe and quotes prices in US dollars but this year began updating their quotations every week.

Other companies have taken more unusual approaches, such as setting their own exchange rates and, therefore, in effect raising prices.

Xiao Zheng, chairman ofDongguan City Shima Toys in southern China, said its price quotations were valid for three months but were calculated based on an exchange rate of Rmb6.6 to the dollar.

With the official exchange rate at Rmb7.01 to the dollar yesterday, this in effect raised prices 5.8 per cent.

"We are thinking about renewing our quotations every other month and we are also going to offer quotations in euros very soon," Mr Xiao said.

Bruce Rockowitz, president of the trading arm of global supply chain company Li & Fung, said many Chinese companies still favoured US dollars because "everybody is used to using [that currency]. But it all comes out in the price."

William Fung, managing director of Li & Fung said international buyers would have to accept higher export prices from China, especially for goods such as toys that are largely made only in the country.

"The final result is they will buy at a higher price, but at lower volumes," he said. Mr Fung added that retailers are mitigating the effects of higher costs by locking in proprietary, or exclusive brands, which in turn allows them to charge higher prices to consumers.

Lack of Arbitrage Producing High Futures Prices for Ag Commodities

Reader notice: a bit terse in our own commentary due to (grr) internet outage...

A New York Times article, "Odd Crop Prices Defy Economics," discusses the fact that there have been frequent disparities between cash and futures prices in some agricultural commodities since 2006. While this pattern has never taken place before and experts blame it on new entrants such as hedge funds, the failure to arbitrage against the cash market price is mystifying.

From the Times:

Economists note there should not be two prices for one thing at the same place and time. Could a drugstore sell two identical tubes of toothpaste, and charge 50 cents more for one of them? Of course not.

But, in effect, exactly that has been happening, repeatedly and mysteriously, in trading that sets prices for corn, soybeans and wheat — three of America’s biggest crops and, lately, popular targets for investors pouring into the volatile commodities market. Economists who have been studying this phenomenon say they are at a loss to explain it.

Whatever the reason, the price for a bushel of grain set in the derivatives markets has been substantially higher than the simultaneous price in the cash market.

When that happens, no one can be exactly sure which is the accurate price in these crucial commodity markets, an uncertainty that can influence food prices and production decisions around the world.....

“We do not have a clear understanding of what is driving these episodic instances,” said Prof. Scott H. Irwin, one of three agricultural economists at the University of Illinois at Urbana-Champaign who have done extensive research on these price distortions.

Professor Irwin and his colleagues, Prof. Philip T. Garcia and Prof. Darrel L. Good, first sounded the alarm about these price distortions in late 2006 in a study financed by the Chicago Board of Trade. Their findings drew little attention then, Professor Irwin said, but lately “people have begun to get very seriously interested in why this is happening — because it is a fundamental problem in markets that have generally worked well in the past.”

Market regulators say they have ruled out deliberate market manipulation. But they, too, are baffled....

The mechanics of the commodity markets are more complex than selling toothpaste, however. The anomalies are occurring between the price of a bushel of grain in the cash market and the price of that same bushel of grain, as determined by the expiration price of a futures contract traded in Chicago.

A futures contract is an agreement to deliver a specific amount of a commodity — 5,000 bushels of wheat, say — on a certain date in the future. Such contracts are important hedging tools for farmers, grain elevators, commodity processors and anyone with a stake in future grain prices. A futures contract that calls for delivery of wheat in July may trade for more or less for each bushel than today’s cash market price. But as each day goes by, its price should move a bit closer to that day’s cash price. And on expiration day, when the bushels of wheat covered by that futures contract are due for delivery, their price should very nearly match the price in the cash market, allowing for a little market friction or major delivery disruptions like Hurricane Katrina.

But on dozens of occasions since early 2006, the futures contracts for corn, wheat and soybeans have expired at a price that was much higher than that day’s cash price for those grains.

For example, soybean futures contracts expired in July at a price of $9.13 a bushel, which was 80 cents higher than the cash price that day, Professor Irwin said. In August, the futures expired at $8.62, or 68 cents above the cash price, and in September, the expiration price was $9.43, or 78 cents above the cash price.

Corn has been similarly eccentric. A corn futures contract expired last September at $3.36, which was a remarkable 55 cents above the cash price, but the contract that expired in March 2007 was roughly even with the cash price.

“As far as I know, nothing like this has ever happened in the corn market,” said Professor Irwin.

Wheat futures had been especially prone to this phenomenon, going back several years. Indeed, the 2007 study by Professor Irwin and his colleagues concluded that wheat price distortions reflected a “failure to accomplish one of the fundamental tasks of a futures market.”

And while the situation improved sharply for wheat futures in Chicago late last year, it deteriorated for futures traded in Kansas City. And it has gotten worse for corn and soybeans, Professor Irwin said. Many people have a theory about why this is happening, but none of them seem to cover all the available facts.

Mary Haffenberg, a spokeswoman for the CME Group, which owns the Chicago Board of Trade, where these contracts trade, said the anomalies might be a temporary result of “a lot of shocks to the system,” including sharp increases in worldwide food demand, uncertainty about supplies and surging commodity investments.

Veteran traders and many farmers blame the new arrivals in the commodities markets: hedge funds, pension funds and index funds. These investors and speculators, they complain, are distorting futures prices by pouring in so much money without regard to market fundamentals.

“The market sends a sell signal, but they don’t sell,” said Kendell W. Keith, president of the National Grain and Feed Association. “So the markets are not behaving the way they otherwise would — and the pricing formula for the industry is a lot fuzzier and a lot less efficient than we’ve ever seen.”

Representatives of the new financial speculators dispute that. Their money has vastly increased the liquidity in the futures markets, they say, and better liquidity improves markets, making them less volatile for everyone.

And, as Professor Irwin noted, if new money pouring into the market has been causing these distortions, they probably would be occurring more consistently than they are.

Some experienced commodity analysts think the flaw may be in the design of the contracts, said Richard J. Feltes, senior vice president and director of commodity research for MF Global, the world’s largest commodity futures brokerage firm. If futures were settled based on a cash index, it would eliminate these odd disparities, Mr. Feltes said.

Ms. Haffenberg at the CME Group said cash settlement had “not been ruled out,” but it raised the question of finding the appropriate cash index. Other modest contract changes are awaiting approval of the futures trading commission, she said.

“We are continuing to have industry meetings to discuss what we need to do,” she said. “But we want to be careful, before we undertake any changes, that above all, we don’t do any harm.”

Moreover, defenders of the exchange’s current contract design note that these widely used agreements have gone largely unchanged for some time — and yet, have only begun to display this odd and inconsistent behavior in the last few years.

Some economists are exploring whether some unperceived bottlenecks in the delivery system explain what is going on. But traders say that such bottlenecks would eventually become known in the market and prices would adjust. Professor Irwin, whose research is continuing, said there might not be a single explanation for the price distortions.

Markets may simply be responding to the uneven impact of new financial technology, which allows more money to flow in and out, and to investors’ growing but fluctuating appetite for hard assets.

“Those factors may be combining to create this highly volatile environment for discovering prices,” he said. “But for now, that is pure conjecture on my part.”

What is not happening in these markets is equally mysterious. Normally, price disparities like these are quickly exploited by arbitrage traders who buy goods in the cheap market and sell them in the expensive one. Their buying and selling quickly brings the prices back into balance — but that is not happening here.

“These are highly competitive markets with very experienced traders,” he said. “Yet they are leaving these profits alone? It just doesn’t make sense.”

Links 3/28/08

Grr. Verizon was down, hence the dearth of posts compared to normal.....

CBPP on Income Concentration ataxingmatter. It continues to get worse.

Interview with Dr. Steven Keen Itulip. Some juicy items, including:


and this:

Ben Bernanke famously said that, “If we do actually find ourselves in a deflation we can take comfort in the fact that the logic of the printing press will restore inflation.” Returning to the hose in the river analogy the most recent instance to refute that is what happened in Japan in 2001 or 2002, the Japanese monetary authorities increased base money by over 25% in one year. Now you’d expect that to restart the endogenous credit system and create some inflation and have solved the problem. In fact a year after that 25% growth in broad money the rate of inflation in Japan was negative once more. The rate of deflation actually rose from minus 0.5% to minus 1% in wholesale price terms, so this isn’t something that can be addressed merely by growing the money supply. That’s what scares me because that’s the policy that monetary authorities have committed themselves to.

The Most Important Article You Probably Didn’t Read This Week Jeff Matthews Is Not Making This Up

Warning on plastic's toxic threat BBC

Canadian ABCP investors bullied Diane Francis

Antidote du jour:

"India’s love affair with gold tarnishing"

As the goldbugs load up on gold futures, one of the main buyers of physical gold in pulling back. From the Financial Times:

As India’s voracious appetite for gold wanes, producers of the precious metal are taking heed.

Indian consumers buy about 25 per cent of the world’s gold, the vast majority of which is imported, making the country the largest market for the metal.

Globally, investors have poured into gold, seeking refuge from the deflating dollar...

But with the recent volatility in gold prices, which have hit more than $1,000 per troy ounce, investors have become nervous and sales of gold in India have fallen sharply. Demand for gold in India plummeted 64 per cent year-on-year in the fourth quarter after growing 40 per cent in the first three quarters of last year.

According to James Burton, chief executive of the World Gold Council, the global miners’ group, in the first half of 2007 India was on track to buy more than 1,000 tonnes of gold for the year, but demand “tailed off at the end of the year”, as gold prices rose. Jewellers in India have been particularly hard hit and tell of subdued sales as consumers baulk at high prices. Even families of marrying couples, traditionally obliged to drape newlyweds in the precious metal, are passing on family heirlooms instead of buying new gold.

The slowdown has added urgency to talks in New Delhi this month between Indian officials and the heads of the world’s largest gold producers, including Barrick Gold, AngloGold Ashanti, and Goldfields and Newmont, about exploration of India’s untapped domestic resources.

The country has been unable to attract enough investment to survey, explore and mine for gold because of unattractive policies, such as the requirement of separate licences for each step of the process and uncertainty about procedures for transferring mining rights.

Miners of precious metals and stones are permitted foreign direct investment of 100 per cent under Indian law. But layers of red tape and ambiguous policies have deterred foreign interest.

That could be about to change.

Subbarami Reddy, India’s mining minister, is spearheading policy efforts to attract more foreign gold miners. This month, Mr Reddy presented a new mining policy to parliament intended to reduce bureaucracy and safeguard investor interests. It would “encourage investing heavy capital in exploration for gold and diamonds,” he said.

The new guidelines aim to shorten the time it takes for mining leases to be granted to between six and 12 months; the current process can take years. Investment would be made easier, paperwork reduced and prospecting companies would automatically get a mining licence. “Prospecting and mining shall be recognised as independent activities with transferability of concessions playing a key role in mineral sector development,” a document presenting the new policy to parliament said.

India’s handful of gold mines produce about 2.5 tonnes of the metal each year, a fraction of the country’s annual consumption of about 800 tonnes. It is unclear how much gold India could yield, although Mr Reddy has alluded to possible domestic reserves of 25,000 tonnes.

Gregory Wilkins, chief executive of Canada’s Barrick, the world’s largest gold producer, agrees that the new policies outlined are a step in the right direction. “The government is doing a good job of creating a favourable investment climate,” he said.

However, the guidelines failed to address the issue of royalties. State governments are demanding a move to value-based royalties on minerals from a flat rate, potentially eroding miners’ margins. Officials from New Delhi and the states have yet to agree on how royalties would be charged. Parliamentary approval could come quickly, says Ajay Mitra, India managing director for the World Gold Council. But how the mining policy would be implemented remains unclear.

Quelle Surprise! Credit Card Delinquencies Rising

A report by Credit Sights, as recounted by Research Recap says that credit card delinquencies are increasing, but not to the degree where there is any threat to the performance of credit card ABS pools. Unlike Fitch, which expects the historical relationship between credit card defaults and unemployment to continue (they normally track each other closely), Credit Sights flags the possibility that lenders may see a change in that pattern this cycle.

From Research Recap:

In a new survey of US credit card Asset-Backed Security collateral performance, CreditSights finds and that pool performance has deteriorated significantly over the course of the last eight months. “Despite that deterioration, however, credit card ABS collateral delinquencies are still well within the normal historical range, and the ratings on credit card ABS senior tranches appear to be safe for now.”

While issuance and excess spread levels do help to offset concerns about rising delinquencies, we find some worrying evidence that delinquencies are rising more rapidly than what might have been historically normal given recent trends in unemployment.

“We would grant that the most recent unemployment data have been surprisingly low, so in the coming months we may simply see unemployment rise, validating the recent steep rise in delinquencies. But if something else is going on, especially if there has been some structural change in the behaviour of credit card borrowers that has made them more likely to default than they historically would have been given current economic conditions, then credit card ABS bondholders may have a more bumpy ride ahead than they might have expected.”


Stripping out master trusts which did not exist in 2001, CreditSights finds that most master trusts are approaching their mid-2001 delinquency levels, and one (the MBNA/BofA trust) is now well above that mid-01 level. Only the Discover master trust is still enjoying delinquency rates well below its 2001 levels.

“Combining all six of the older credit card ABS master trusts’ delinquency rates into a simple average of the six, we find that average delinquency rates have jumped sharply over the last eight months, from an index reading of just under 70 (where the delinquency rate index stood at 100 as of May 2001) to a reading of 89.5 today. While that leaves average delinquency rates below their mid-2001 levels, and still well below the record index reading high of 114 in Early 2002, the increase since July 2007 has still been severe. It took 21 months - from April 2004 to January 2006 - to get this index level from just over 90 to just under 70. It has taken only eight months, however, for the index to jump from just under 70 back to around 90.”

Cayne Throws in Towel on Bear Sale

From Bloomberg:

Bear Stearns Cos. Chairman James ``Jimmy'' Cayne sold his shares in the firm prior to a shareholder vote on the company's pending takeover by JPMorgan Chase & Co.

Cayne sold 5.6 million shares at $10.84 a piece on March 25 on the New York Stock Exchange, according to a regulatory filing today. Bear Stearns spokesman Russell Sherman had no comment on why or to whom Cayne sold his shares.

Robert Shiller Makes Bogus Defense of Financial Innovation

Before I put my buzz saw to work, let me make a few things clear. First, I have a good deal of respect for Robert Shiller's work. Anyone who was willing to tell Greenspan in 1996 that he ought to be worried about asset bubbles has a good deal of foresight. Second, I am a fan of Project Syndicate; I've featured many of its articles. Third, I am not opposed to financial innovation per se (although that term is so all-encompassing as to get in the way of useful discussion, and the term "innovation" has such positive connotations as to put critics on the back foot).

However, Robert Shiller's Project Syndicate article, "Has Financial Innovation Been Discredited?" can only charitably be interpreted as incredibly sloppy, but since this is an area where he claims expertise, it must be deemed to be intellectually dishonest.

Let's go through it:

Skeptics of financial liberalization and innovation have been emboldened by the crisis in the world’s credit markets that erupted in mid-2007, when the problems with sub-prime mortgages first appeared in the United States. Are these skeptics right?....

The entire sub-prime market is largely a decade-old innovation – the word “sub-prime” did not exist in any language before 1994 – built on such things as option adjustable-rate mortgages (option-ARM’s), new kinds of collateralized debt obligations, and structured investment vehicles. Previously, private investors in the US simply did not lend to mortgage seekers whose credit history was below prime.

First, option ARMs are not a subprime product; they were targeted to prime borrowers (see here and here from the esteemed Tanta). This is a striking error from a supposed expert on housing markets. Second, financial innovation does not equal "securitization of subprimes" which is what his second paragraph implies. CDOs frequently contain heterogeneous assets; many CDOs contain only corporate bond exposures.

Back to Shiller:

But, while it does sometimes appear that the current crisis is due, at least in part, to financial innovation, financial-market liberalization has been shown to be a good thing overall.

A study published in 2005 by economists Geert Bekaert, Campbell Harvey, and Christian Lundblad found that when countries liberalize their stock markets, allowing them to operate freely without government intervention, economic growth rises by an average of one percentage point annually. The higher growth tends to be associated with an investment boom, which in turn seems to be propelled by the lower cost of capital for firms.

This is a misrepresentation of the Bekaert, Harvey, and Lundblad paper. I am pretty certain the article in question is "Growth Volatility and Financial Liberalization." I will be generous and assume that he did not get past the abstract, which uses the term "equity market liberalization." However, when you read the paper, it analyzes opening financial markets in a development economic context, and the primary focus is on increasing receptivity to international capital, not on lowering regulatory standards. This is the question the paper is seeking to answer:

Is the cost to a country for opening its financial markets to foreign portfolio investment increased economic volatility?

Other quotes to show its emphasis and conclusions diverge from what Shiller implies:
.

...there is an extensive literature on the benefits of international risk sharing. This literature explicitly recognizes that open capital markets lead to international risk sharing, which should improve welfare....Our study contributes to this debate by testing directly whether consumption growth volatility changes after financial liberalization. If there are genuine benefits to international risk sharing, we expect to observe reduced consumption growth volatility....

And consider this:

A substantial interaction analysis shows that countries with relatively large government sectors and developed banking sectors experience significant reductions in volatility but countries with poor investor protection experience significant increases in volatility (boldface ours).

So to the extent this article discusses regulation of markets in the manner Shiller implied, it found that greater investor protection, i.e., regulation, was beneficial.

Note also that per our post earlier today, Dani Rodrik disputes the conclusions of this paper, that financial liberalization is good for developing countries.

And in any event, extending conclusions from equity markets, which by nature are speculative, to credit markets, where investors expect to get their principal back, is also quite a stretch. Ditto applying work on developing markets to mature economies.

Back to Shiller:

.....The US is one of the world’s most financially liberal countries. Its financial markets’ high quality must be an important reason for America’s relatively strong economic growth. Indeed, given a very low savings rate and high fiscal deficit over the past few decades, the US might otherwise have faced economic disaster.

This discussion is pretty confused. "Markets" covers a multitude of sins. Public equities and bonds are in fact highly regulated, as are exchange traded derivatives. It's when you get into certain OTC markets that things can get wild and woolly. And the notion that US financial markets are "high quality" is no longer widely accepted. Foreign buyers have compared our mortgage products to China's toxic toys.

Although the SEC's enforcement isn't what it used to be, the basic framework of regulations hasn't changed dramatically; indeed, measures like Rule FD and decimalization were forced on the industry. A 1993 Harvard Business Review article by Amar Bhide, "Efficient Markets, Deficient Governance," makes observations that still ring true:

Without a doubt, the US stock markets are the envy of the world. In contrast to markets in countries such as Germany, Japan, and Switzerland, which are fragmented, illiquid, and vulnerable to manipulation. US equity markets are widely respected as being the broadest, most active, and fairest anywhere. The Securities and Exchange Commission strives mightily to keep it that way.....

US rules protecting investors are the most comprehensive and well enforced in the world....Prior to the 1930s, the traditional response to panics had been to let investors bear the consequences......The new legislation was based on a different premise: the acts [the Securities Act of 1933 and the Securities and Exchange Act of 1934] sought to protect investors before they incurred losses.

Bhide describes the three main approaches: detailed description of the company, its financial performance, and the securities offered, with requirement for extensive periodic disclosure; measures to bar insider trading; rules against market manipulation.

Bhide discusses at some length that extensive regulations are needed to trade a promise as ambiguous as an equity on an arm's length, anonymous basis. In hindsight, it may be that the halo effect of America's successful equity markets facilitated the sale of dodgy debt instruments.

To Shiller again:

In 2000, Stewart Mayhew, Assistant Chief Economist at the US Securities and Exchange Commission’s Office of Economic Analysis, surveyed the extensive literature on this topic. Mayhew concluded that it is rather difficult to tell whether derivative markets worsen financial-market volatility, because their creation tends to come when existing financial markets already are more volatile, or can be predicted to become so. Moreover, he found that there is no evidence that derivative markets create volatility in underlying cash markets; in fact, they may even reduce it.

The effect on underlying financial markets’ volatility may not even be the right question to consider in deciding whether to permit new derivative products. The right question is whether these products are conducive to economic success and growth.

Here, Mayhew concludes that new derivative markets clearly increase the liquidity and quality of information in existing financial markets. And it is this liquidity and quality of information that ultimately propels economic growth.

First, it's revealing that Shiller cites a dated paper to support his position. Mahew's paper did indeed look at research on options and futures markets to a wide variety of cash markets. However, these were all exchange traded markets.

Shiller conveniently ignores the elephant in the room: the systemic risk posed by OTC derivatives. We have a $45 trillion credit default swaps market, for instance, which has the potential for large-scale counterparty failure. Indeed, some observers think that the risk of cascading CDS losses was the reason the Fed rescued Bear Stearns and was willing to pony up such a large credit facility (Bear was a large CDS protection writer, the side of the transaction susceptible to default).

And his comment that " liquidity and quality of information that ultimately propels economic growth" is unadulterated financial services industry bullshit. Economic growth is a function of demographic growth and productivity growth. Perhaps Shiller can make a case that liquidity and high quality financial market information produce higher productivity growth. Merely asserting it doesn't make it so.

Shiller again:

The sub-prime crisis has exposed serious problems that we must address. For example, we need stronger consumer protection for retail financial products, stricter disclosure requirements for new securities, and better-designed vehicles for hedging risks.

Some of the innovations associated with the sub-prime crisis – notably option-ARM’s, when extended to borrowers who couldn’t handle them – seem to have little redeeming value. But others – those involved with the securitization of mortgages – were clearly important long-run innovations, because they can help spread risks better around the world.

The first paragraph is more or less motherhood and apple pie, although it isn't clear what he means by "better designed vehicles for hedging risk"

In the second, he gets it wrong again on option ARMs. They were around long before subprimes, and they are a perfectly fine mortgage when sold to its proper market, which is fairly narrow. Some private banks offered them in the 1980s, if not sooner, to investment bankers. They are perfect for people who have low salaries and high bonuses. The product fits their cash flows: low monthly commitment with discretionary additional paydowns when the big money arrives. Those users don't suffer the negative amortization that can make the product so damaging.

Shiller once more:

So, we should not slow down financial innovation in general. On the contrary, some of the fixes that result from the sub-prime crisis will probably take the form of still more innovation, further increasing the sophistication of our financial markets.

This gets back to the disingenuous idea that regulation is tantamount to stifling innovation. But now distrust of opaque structures, poor underwriting standards, and unreliable credit ratings is so high that it is naive to think that many investors will have appetite for complexity absent tougher regulation. Preserving innovation is far down the list of concerns these days. Merely keeping the wheels from coming off the financial system will be a considerable accomplishment.

The Failure of Finance

Two loosely related and thoughtful posts today point up some of the ways that the fundamental frameworks of how participants think about and relate to financial markets are breaking down. Note that this development is separate from the fact that financial institutions look pretty wobbly. Instead, these two writers, Roger Ehrenberg and Cassandra, highlight two different, but fundamental ways that investors' mental models about markets are under serious strain.

This is a more troubling issue than might be obvious. It is very unnerving to have core assumptions proven wrong, or at least not as reliable as you thought. This repudiation of widely-held beliefs (starting with the cliche "safe as houses") is going to produce dislocations that will feed into institutional stress.

Ehrenberg and Cassandra attack this phenomenon from very different vantage points. Ehrenberg discuses how some of the assumptions underlying much of modern finance have failed; Cassandra, although also taking a similarly analytical starting point, about how gains and losses are usually distributed in market, focuses on how the recent disruptions are likely to lead to radical changes in investor behavior, namely revulsion towards financial assets.

When I started out in the securities industry (1980) stocks were regarded as speculative. Investors still recalled how people had been wiped out in the Crash, how it had taken until 1954 for the Dow to return to its 1929 levels. The 1950s and 1960s had been good times for stocks, but again, the 1970s showed them to be losers once again. Investor Peter Lynch said that stocks were the best investment when the public regarded them as risky, and most speculative when they were widely regarded as safe. The idea that equity investing could be perilous is still deemed antique in many circles, but the grind of credit contraction will erode the faith in most financial assets.

This is a long post because both authors have worthwhile observations. I encourage you to read both their views. Cassandra's observations also shed light on the inflation vs. deflation debate, which has been gnawing at me.

First, "(Dis)continuous Time Finance" from Ehrenberg:

I grew up in a time when markets were considered to be "continuous.".... Liquidity was presumed to be available. And while markets could and did gap due to an event, new information, etc., it could and would clear with transactions taking place at the new level. The financial markets, through price discovery in the presence of liquidity, conveyed valuable information that could be used for both security selection and asset allocation. The field of financial economics, as such, was predicated upon the existence of bids and offers and, therefore, liquidity. And this phenomenon was assumed to persist across time.

But this is not the world I observe today; quite the contrary. Price movements are not only discontinuous, but the notion of liquidity across time as traditionally assumed simply does not exist. Something has happened to rock the prevailing academic paradigm. Have the experiences of the past six months essentially blown a hole through the heart of modern financial theory?

.....consider what Merton said back in 1987 as it relates to capital markets:

The conscious motivation for creating a capital market is to provide the means for financial transactions. However, an objective consequence of this action is to produce a flow of information that is essential for all agents' decision-making, including that of those agents who only rarely transact in the market.

You see, the problem is that without transactions it is hard to get information, and without information it is hard for people to transact. We are caught in this Catch-22, the Fed's prescription for which is injecting hundreds of billions of dollars into the financial system. And while this creates money, it does not necessarily create liquidity in the instruments for which no bids are available. Why? Because potential investors are sorely lacking information, either intrinsic to the securities or extrinsic in the form of observable market prices. This is partly due to the complexity of the instruments in question, the structured asset-backed market and related derivatives. And while this problem is not intractable, it is easy to imagine that getting sufficient information to make educated bids will take quite some time.

Another problem is that an element of liquidity was predicated upon the faith and belief in the ratings system. A AAA-rated security was available for purchase by trillions of investment dollars, AA-rated fewer trillions, A-rated hundreds of billions, and so on. But now that we've seen tens of billions of AAA-rated securities marked like junk, the very foundations of the institutional investment model have been shaken. Trust has been shattered. No trust, no liquidity..... we can't and don't live in a riskless world. The problem is that too many investors and market intermediaries thought we did. This was telegraphed by the historically low levels of volatility during the latter part of 2006 and into early 2007.

Today we live in a world fraught with risks that we barely understand, risks that modern financial theory doesn't have great answers for. A new model is needed that incorporates the effects of discontinuity as an outgrowth of, among other things:

Complexity - structured securities, derivative instruments;

Interdependency - widely disseminated holdings that can pollute portfolios globally, hundreds of trillions in counterparty exposures;

Intermediary errors - ratings that don't reflect the risks, financial institutions with weak control environments and poor risk management practices; and

Bad actors - originators, underwriters, traders and managers with mis-aligned motives.

....Our models and academic frameworks needs to be robust enough to handle these occurrences and to provide a model for maintaining liquidity, price discovery and information dissemination. Based upon today's market action we've got a long way to go.

Cassandra's post, "Liquidity Tug-o-War??" is quite long; I've omitted her colorful and insightful analysis to focus on her conclusions. She starts by discussing the until recently ever-rising tide of liquidity and notes:

....understand that one will lose half the value of the paper every four to six years, despite the tamer prevailing rate of so-called inflation as measured by government officials and apologists for unfettered liquidity creation. Such a reality is sufficient for those with such paper to avoid its accumulation by (a) spending it immediately (b) converting it to other stores of value (c) borrowing it in order to do 'a' or 'b' or both above....

Even if your view of the real, as opposed to nominal inflation rate isn't quite that dire, foreign holder of the dollar have seen those kinds of losses. Back to Cassandra:

And so credit growth, fueled by rising asset prices and ever-more confident lenders, is likewise positively skewed. Like the first skaters testing the ice, they proceed slowly, whereupon confident of its integrity based solely upon the fact that they remain above the surface of the icy waters, signal to the others that all is fine in slippery Golconda. Of course this is overly simplistic. There are in reality many forces at work: agent vs. principal issues; keeping up with the jones'; and all manner of behavioural biases that serve to reinforce the alledged prudence of one's herd-like actions and penalize the questioning of the same, for no one benefits from caution, not least the individual. At least until the edifice is too large for its foundations. There are of course limits to how many can safely glide upon an ice-sheet of certain thickness. Exceeding such threshold limits results in rapid fat-tailed catastrophe with no recourse. Eschewing analogies, revulsion destroys credit and collateral values in vast quantities. It crushes the price of core asset values in real estate and equity, and cremates securities that use these assets as collateral. The size of core asset value destruction in our present case being measured perhaps, ultimately, in the double-digit trillions....

But mega-revulsions do more. They scar the psyche, irrespective of whether by natural consequence of falling in under the weight of the edifice, or in response to man-made pressure such the Volcker's Saturday night massacre. Our current predicament is the former, the result of multiple attempts to prevent recession over the years, with diminishing marginal returns to the priming almost guaranteed that much of the investment would of marginal quality and ultimately wasted. Lenders, accustomed to lognormal distributions begin to rework risk under more symmetrical regimes. They reduce existing leverage to save powder and prepare for worse to come, much like the body will warm the trunk at the expense of the extremities. And like the body they do this not as opportunists but in self-preservation. Ray Dalio's Bridgewater in their latest research report makes the following points:

The financial market unraveling is, as we've described, 'the Big One". What we have meant by this is that the implications of the last six months will impact how the financial system will work for years. Both directly and indirectly (through the literal profits and incomes associated with the financial sector) and indirectly (through the benefits of credit creation) the economy is more reliant upon the financial sector than ever. The virtuous circle of easy credit and rising asset prices leading to increased consumption and therefore increased incomes has been fueling the economy for so long that it has been taken for granted. The reverse of this cycle will have profound implications for the economy, and we have only just begun to see those implications upon the real economy.

It is a natural and logical reaction. This is what the beginning of a cascade feels like, and one that only will end with the eventual uprightness and sustainable leverage atop the system, corresponding levels of consumption related to output, and asset values that are either reasonably well-discounted or known, at the very least, to have stabilized in the longer-term. We are not there yet, and every bank - whatever their domicile - knows this, hence are reticent to lend except to all but the most creditworthy, and on terms that provide more than just compensation for there remains a reasonable probability that price discovery continues in a direction that erodes one's margin of safety. Falling asset prices, in turn, kills the speculative animal spirits. Why build a new shopping mall when the existing ones can be had for less than the cost of new construction? Time shares will trade at hilarious distances below where they were sold in the primary market. And banks, flush with assets recently foreclosed have no appetite to project-lend when they are recently - involuntarily - long the last cycles excesses. Again the chain of dependencies numerous and complex, but the end result is the same: more destruction in collateral values and hence both liquiidity and the supply of dollars.

The remedy for this is clear. Rapi