The real purposes of a democratic society ...

A post by Jim Fitch of Some Assembly Required.

The real purposes of a democratic society cannot
be achieved by violence and destruction. George Kennan.

Balance Sheet: The housing market continues to deteriorate. Unemployment is rising. National retailers are seeking Chapter 11. The economy is slowing, if not in recession. Auto sales are non-existent. Americans have drastically cut their leisure travel. Based on this declining demand, the price of petroleum has fallen. Yet "Stocks Soar as Oil Plunges"

Housing Plan: When I bought my first house, the rule was 20% down and not more than 2.5 times primary income. Of course those ratios were based on years of experience, not modern economic theory.

Everything's Connected: The fighting between Georgia, Russia and South Ossetia doesn't have anything to do with the Baku-Tiblisi-Ceyhan pipeline, does it? Can't have an oil war and not invite the US. An all-out war between Russian and Georgia would be about as helpful to the world economy as the planned US/Iran conflict.

Pick A Number: How many investment houses will buy-back dubious paper, now that Citibank and Merrill Lynch have shown the way? (a) less than 5 (b) more than 9 (c) how many are there?

Nail, Horseshoe... Credit's crumble is starting to squash US consumer credit. If American plastic dissolves, there'll be nothing left but actual cash. No mortgages, no credit, no consumption. Imagine a world where people buy necessities for cash and save for everything else. 'Save' - it's an old timey word; look it up.

Identity Crisis: Wal-Mart: anti-union, biggest of big business, doggedly anti workers-rights, champion of healthcare-less cheap labor is now one of the largest givers to the Democratic Party. Wonder what they expect in return? Worse, what have they been promised?

Kill Yourself After Reading : The Bush administration drew up a response to Congress' questions about a new cybersecurity program, then redacted everything including what the program was designed to do, the names of the contractors who may or may not be working on whatever the program may be, and how much all this was going to cost. It did state, however, that the privacy of US citizens will be protected.

Prior Restraint: Displaying the courage that has become common in the US since 9/11, Random House has 'postponed indefinitely' publication of a novel about the Prophet Mohammed's child bride, fearing it could "incite acts of violence".

Bigger than a Breadbox: The US military is housing prisoners in cute little boxes, three feet deep six feet long and six feet high. The prisoners are checked frequently and revived when necessary.

Some Assembly Required reflects my somewhat cynical view of the world on a daily basis. Think of it as having coffee with a curmudgeon. Come visit; bring your own coffee.

Fight the Fed, Don't Fight the Fed, Baby

I followed a rather circuitous, unorthodox route to the little corner of Wall Street I occupy, so I don’t really know what goes on in all those big, glass-walled buildings that turns eager, bright-eyed young graduates of the finest schools into cynical, herd-following, careerists. But I imagine that early in orientation an avuncular veteran of the wars is trotted out to impart the wisdom of his years. Buy low, sell high. Bond yields up, bond prices down. Don’t fight the Fed.

The wisdom of that last saw is called into question when the events of this decade are scrutinized. Oh sure, the markets manage their reflexive, 3% jumps on the days when the Fed cuts, particularly when it goes 50 or 75 bps 40 minutes before the markets open after a long weekend, as has been its wont in the recent past. But viewed from a slightly longer term perspective, the Fed’s interest-rate setting power—note the distinction between that specific power and the myriad special “facilities” it has established over the last 8 or so months, where the Fed most certainly has had an impact—has become less and less effective over time.

Roughly since the bursting of the tech bubble, the credit markets have frustrated Fed policy at every turn, moving in opposition to the Fed funds. Stephanie Pomboy of MacroMavens refers to this as the broken lever. Below are two charts illustrating the Fed’s impotence, courtesy of MacroMavens.

And here’s a chart, courtesy of Jim Bianco of Bianco Research, showing the changes in rates across a broach spectrum of credit instruments, from before the Fed’s first rate cut last August, until now.




One could argue that the ineffectiveness of Fed interest policy today is simply a function of the old concept of pushing on a string, that the monetary transmission mechanism breaks down during a debt deflation/liquidity trap. You’ll get no argument from me; that’s definitely a big piece of the puzzle. But I think there’s another factor at work here as well.

At some point in the 1990s, Chairman Greenspan realized that he had a partner in the serial liquidity gushers he used to keep the economic expansion rolling ever onward. The GSEs and the entire shadow banking system that arose around them were all-too-willing accomplices in his effort to make certain that the liquidity pump was always primed. Initially, this must have been a seductively attractive realization: that Fannie, Freddie, and the Wall Street banks were only too eager to create credit by the truckload, allowing the Fed to save its bullets for the really dire moments.

But as interesting to ponder is the moment when Greenspan realized that he’d struck a deal with the devil, that servant had become master, Easy Al turned into Flaccid Al. Somehow in thinking about that turn of events, the image of the Sorcerer’s Apprentice from Disney’s Fantasia comes front and center, the shadow banking system turned into an unstoppable monster. Doug Noland of the Prudent Bear was the indispensable chronicler of these developments in his Credit Bubble Bulletin reports. His report from February 2004, The Curious Greenspan and the GSE, is a great one to look back at with the benefit of hindsight (Thanks, Fred). http://www.prudentbear.com/index.php/archive_menu?art_id=3130

In it, Noland goes so far as to speculate that Greenspan’s infamous endorsement of adjustable rate mortgages, spectacularly ill-timed to coincide with interest rate lows, was a desperate attempt to transfer the enormous interest rate risk sitting on the GSEs’ balance sheets to the individual homeowner. Talk about your unintended consequences! And talk about your irony, with the poor homeowner, or no longer homeowner, but still taxpayer, again on the hook, more directly this time, for Fannie and Freddie’s ill-conceived and overleveraged balance sheet risk.

The market has yet to come to grips with the thought that the Fed’s not in control here. The complacency about risk that a day like yesterday demonstrates (look at the VIX, look at the put/call ratio), with fear of missing a rally far greater than that of actually losing money, bespeaks a rather touching if naïve belief that the Fed’s got our backs. Does the Fed want to keep all the balls in the air? Without question. But that it can do so seems entirely questionable. Just as the shadow banking system came to overpower the Fed, so markets are big creatures, with minds of their own, and although they can sometimes be manipulated in the short term, over longer periods that’s not the case.

Or perhaps I give the market too little credit. Perhaps it has read its history, and recalls Bernanke’s speech at the Milton Friedman 90th birthday party gala. Referring to Friedman’s contention that it was bad (inappropriately tight) monetary policy that caused the Great Depression, Bernanke ended that speech with the following acknowledgement:

"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we [i.e. the Fed—SLF] did it. We're very sorry. But thanks to you, we won't do it again."

Ultimately, the Fed is no toothless tiger. The power of the printing press is the nuclear option sitting in its toolbox, and if Bernanke chooses to wield it, the market could certainly go much much higher. Take a look at Zimbabwe if you doubt me.

Antidote du Jour 8/9/08

Americans want cheap fuel....

This post is by Jim Fitch of Some Assembly Required.

Americans want cheap fuel, no matter what it costs.

Sign Here: JPMorgan, Citigroup, Morgan Stanley. The Usual Suspects. Now they want to take over all the pension funds. With Uncle Sam's help, blessing, and taxpayer backing. Sort of a consolation prize for not getting their hands on Social Security yet.

Another Shoe: AmeriCredit announced a net loss of $150 million for the quarter. The interesting part is that AmeriCredit's business is financing new car purchases, and loan originations were down 70% this year over last. Not so much the less lending, but the less buying.

The Road to Perdition: A group of wizards called the Counterparty Risk Management Policy Group III has unfolded the map to the future, where the financial collapse we're drowning in today will never be repeated. One little problem: the wizards are from Goldman Sachs, HSCB, JP Morgan Chase, Merrill Lynch, Morgan Stanley, Bank of America - everyone but Mozilo and he probably submitted a brief. If these guys can lead us to the promised land, just who was it that lead us into the desert?

Preferences : Pimco's Bill Gross says that by September Fannie and Freddie will issue preferred stock and the US Treasury will buy it. Mussolini said: "Fascism should more properly be called corporatism because it is the merger of state and corporate power."

Midnight Sun Oil: Norway, the most conservative producer in the North Sea oilfields, will likely end petroleum exports by 2030. Its larger fields are declining at 13% a year. This announcement is in line with predictions made by the Export Land Model. Recall that the UK went from their peak production to importer in less than 8 years.

Mauled: The retailers got beaten up wholesale in July; 60% have reported disappointing results and missed analysts (lowered) expectations. From Wal-Mart and JCPenny to Target, Kohls, A&F, and The Gap. And that's with the stimulus checks...

Some Assembly Required reflects my somewhat cynical view of the world on a daily basis. Think of it as having coffee with a curmudgeon. Come visit; bring your own coffee.

Summary of the FSA Investigation in HBOS Trading

Slow on the draw, I missed the Aug 1 release of FSA's Investigation into accusations that HBOS was torpedoed by hedge funds spreading malicious rumours. If you missed it too, FT-Alphaville has the detail here, but I'll save you the trouble and summarize it for you below.

10. Something went seriously wrong in the market that mid-March day in regards to HBOS share price moves.

9. Our research staff reconstructed the day's activity by looking at exchange time&sales, derivatives trades, emails, phone records, chat rooms, some internet porn (during our break) spoke with reporters, and consulted a psychic.

8. What we strikingly found out was that the stock price went down...a lot.

7. It was clearly the result of more sellers than buyers which made the HBOS price fall more than it would have if this hadn't been the case.

6. This was exacerbated by the fact the few people wanted to buy, and lots wanted to sell (or do nothing), following the manslaughter of Bear Stearns the week prior. In our view (as a non-regulator) this in entirely understandable.

5. Some of the selling was apparently caused by rumours of an unknown origin that were clearly malicious. If we ever catch them, we will hang them upside-down in the naughty-tree.

4. While in this instance, we didn't find any obviously guilty people as everyone had plausible excuses for their activity, nor did we find the so-called smoking gun, we did find a few computers that were culpable (the were Dell's apparently) as their algorithmic strategies sold when they saw others selling.

3. We DID confirm that when market participants are stressed and their nerves are frayed, rumours can have outsized impacts upon share prices.

2. Irrespective the outcome of this investigation, we will be watching you in the future. Watching is the operative word here, as it remains difficult to actually prove anything in such cases.

1. Most importantly, in order to deal with such situations in the future, we will be studying how to write better reports, and are resolved to improving our communication. This will give comfort to our constituency that they can safely remain here in London, and needn't move to Geneva.

Your pension is safe on Wall Street

Defined-benefit pension plans are famously a headache for the many firms that, once upon a time, offered them. Managing far-future liabilities related to employee career choices and life spans is far outside the core competence of nonfinancial firms. Pensions accounting is its own little universe, just like nightmares are. So doesn't it make sense to outsource the management of those plans to financial firms, whose bread and butter is managing assets to fund liabilities? And wouldn't it cut down on "moral hazard" if the firms managing the plans owned them, and were actually liable for any shortfalls?

A BusinessWeek article by Matthew Goldstein (hat tip to Calculated Risk commenter "synthetic-guarantee groupie") describes a proposal to do just that, transfer ownership of closed pension plans from Main Street firms that find them burdensome to Wall Street firms that see an opportunity. Why am I (along with the article's author) not entirely enthused?

The folks who brought you the mortgage mess and the ensuing hedge fund blowups, busted buyouts, and credit market gridlock have another bold idea: buying up and running troubled corporate pension plans. And despite the subprime fiasco, some regulators may soon embrace Wall Street's latest scheme...

[T]he world's biggest big investment banks, insurers, hedge funds, and private equity shops have been quietly laying the groundwork for such deals over the past year. They would be a big prize for Wall Street. The $2.3 trillion pension honey pot has $500 billion in "frozen plans" that are closed to new employees and whose benefits are capped... By managing those troubled plans, Wall Street also gains entrée to an appealing set of customers to whom it can sell a broad array of fee-generating products...

The concept of off-loading pension funds sounds great. For businesses it's a chance to rid themselves of struggling plans, which can weigh down a balance sheet. It's especially good timing now. New accounting rules take effect in the next year or so that will require companies to mark their pension assets to prevailing market prices each quarter—a change that could devastate some companies' profits...

Critics, including some on Capitol Hill, worry that financial firms don't have workers' best interest at heart, which would put some 44 million current and future retirees at risk... The biggest fear is that Wall Street could use retirement portfolios as a dumping ground for its most toxic and troublesome investments. It's not unlike what regulators allege UBS officials did with its stockpile of risky auction-rate securities by trying to off-load them to wealthy clients.

If Wall Street gambles with those pension assets and loses, U.S. taxpayers would probably foot the bill. When a company with a pension goes belly up today, the PBGC, under federal law, has to take on the fund's obligations and dole out money to its beneficiaries. It's a costly burden: The PBGC currently runs a $14.1 billion deficit.

Former PBGC director Bradley Belt argues that pension buyouts could actually strengthen the agency. If financially strapped companies could dump the plans rather than ponying up money for them, they might stay out of bankruptcy. That would mean the PBGC wouldn't have to step in and pick up the pieces of the pension... [According to Belt,] "This is really in the public interest if it's done correctly."

The federal agencies that oversee the nation's pension system are expected to weigh in on the issue—potentially paving the way for big firms that have been pursuing it, such as Aon, Cerberus Capital Management, Citigroup, JPMorganChase, Morgan Stanley, and Prudential... Regulators are almost certain to put the kibosh on buyouts by free-standing, independent firms that aren't tied to the books of any big firm. The worry is that such a weakly capitalized company wouldn't have the balance sheet heft to deal with the pensions if their assets soured. After all, even big Wall Street firms have been crippled by the $400 billion in subprime related losses.

In theory, this is a win-win proposal. So why, in practice, does it leave me cold? Since these are defined benefit plans, the plan owners take the loss if they mismanage pension money, so retirees should be indifferent to the transfer unless they believe that a potential sponsor will go belly up. Similarly, taxpayers are only on the hook when plan sponsors go bankrupt. If transfers are restricted to firms with strong balance sheets, the likelihood of sponsors collapsing might diminish, leaving both taxpayers and retirees better off. Financial firms could benefit from economies of scale in managing the plans, invest in expertise, and profit by increasing efficiency while totally delivering on plan promises.

I'm nervous not because this is a bad idea in theory, but because I no longer have confidence in the firms that would run these plans. Large financial firms have proven too adept at circumventing prudential regulations until a crisis erupts, and then compelling rule-changes that offload the cost of errors to third parties, which would be taxpayers and retirees in this case. In theory, taxpayers shouldn't be on the hook for whatever happened at Bear (and every other bank the Fed is lending to), but look where we are.

Supporters of these transfers are right that not permitting the proposal to go forward has real costs. Potentially salvageable, productive firms may buckle under the weight of legacy pension guarantees that expert financials could successfully bear, harming both the private economy and the public purse.

There are costs to not having a financial system worthy of confidence.

Antidote du Jour 8/8/08

The Value of Capital vs. The Value of Management

There is an interesting tug-o-war between the value of capital and the value of management evident in hedge funds, but even more strikingly highlighted perhaps in reinsurance. This is worthy of examination if only for the fact that they sit at opposite ends of the proverbial rope, producing (at present) an unimaginably large gulf between the two.

Anchoring one side, we have have the traditional reinsurance company. Once jokingly the last refuge for those ex-college football players that failed in the sleepy primary insurance market, these companies have come a long way from their disparaging caricature and Lloyds scandals - a time coinciding with capacity shortages from Hurricane Andrew that spawned a new class of dedicated entity with less-conflicted, more professional managements. They now sport reasonably disciplined underwriting and specialty lines that give them some diversification, with some even moving up the food chain to compete in the primary market. In this realm, the market for new-venture creation is reasonably efficient with an able management team able to raise capital from a variety of experienced private equity and dedicated insurance investors and garner between 5 & 10% of equity on long-term incentive plans in exchange for pedigreed stewardship of capital in a start-up. Capital thus maintains 90% to 95% of the upside (less operating costs), symmetrically bearing the same downside. As with most externally-funded enterprises, it is Capital that reaps most (90 - 95%) of the the reward in the growth [if any] of the enterprise. This "split" is seen as reasonably sufficient to align Management's and Capital's interests, without creating undue agent-principal dilemmas, or grandiose empire-building endeavors.

Anchoring the other side, we have a hedge-fund model applied to a dedicated reinsurance risk-taker, such as that which London-based MAN recently purchased a portion. Here, Capital (i.e. the Investor) pays "one-and-something" plus a deeded 20% performance fee on the (net) upside, though bears the full burden of the downside-risk, albeit without performance fees. Perhaps there is also a high-water mark, for which one would need to review the PPM in detail, the presence of which increases the attractiveness over the course of the profit and loss of a full cycle. Capital placed at risk here has ALL the downside of the underwritten "risk", but none of the upside of the business growth. Here management receives a full 20% of immediate economic spoils and 100% of the business-growth options that arise from the successful stewarding of Capital ostensibly through wise portfolio management, prudent risk-management, and avoiding adverse risk, and undoubtedly a barge-full-'o-luck.

The obvious question arises as to precisely "why" the Capital funding a purposeful reinsurance company formation is able to obtain seemingly so much more of the upside (at the expense of management) with seemingly the same downside, than Capital investing in a reinsurance hedge fund. If it were a matter of a small difference, it would be a dull topic of conversation, and you might be watching "House" re-runs instead of reading this. But being that the order of magnitude of difference is so large, it demands an answer.

The first question should be: are we comparing "like with like"? Th answer is essentially is yes. Both are providing risk-capital to effectively underwrite reinsurance risk. Both are more or less dependent upon external events for realization of profit. Both use essentially the same standard industry modeling techniques (eg RMS). And both profit more (less) in hard (soft) markets respectively. There may exist subtle differences in risk selection, leverage, and portfolio management, but these are less important determinants in the scheme of things. Florida windstorm or California quake are essentially homogenuous risks.

So what is different that might possibly be used as an excuse to justify keeping all the business upside or yielding ALL of it in its entirety it to one's agent? Liquidity, for one, differs - at least on the surface. The commitment of insurance VC is not an annual event, whereas Capital in a reinsurance hedge fund can be withdrawn within stipulated guidelines, typically less onerous than VC lock-ups. Of course if you buy a share of a listed reinsurance company in the secondary market, there are no restrictions. In fact, the reinsurance hedge-fund might be "less liquid", by comparison. To be fair, buying risk through the trading of shares entails high market impact for sizable risk, but this too is reasonably manageable if spread across a portfolio.

Leverage and prudence may also differ. Katrina fatally blew-apart more than one catastrophe reinsurer - not because it was SOOO bad, but because management over-leveraged and under-diversified. In bridge and traders parlance it's called "shooting the moon". Most diversified, well run companies took hits and stomached the loss but it IS easier for the corporate entity to "reach" via leverage than the reinsurance investment manager who - without a proper balance sheet - well might face jail for a similar transgression. That is, of course, if he could a find a counterparty dullard enough to accept an under-capitalised promise for which there is no recourse...

Investment returns - premiums, excess capital, etc. provide another temptation for management not available to the reinsurance hedge fund. This could be good or bad, depending upon whether your investment pecadillo happens to be called "SCA" and Amaranth or its called "Paulson Global Opportunity Fund". On this front, many-a-reinsurance company has failed miserably in its pursuit of higher returns(hedge funds), non-core empire building (SCA), or social status hob-nobbing (Hollywood movie investment). Others however have soundly and soberly managed to earn higher returns than those available to just underwriting risk and placing it some collateralized trust structure. It is understandable for investors to desire to disentangle the two. However, IF one, for whatever reason, has investment alpha, the coorporate structure allows this to be better exploited resulting in higher returns overall to investors. However, the jury thus remains out on this front as to whose advantage this favours.

Cost structures are different. That is a major selling point of the hedge fund, vs. the largesse of corporate boards, Sarbox compliance, prima-dona underwriters, staff pensions costs, etc. But many costs are inherent in acquiring business to develop a more diversified risk book, and building an enterprise with depth, longevity, and redundancy that makes counterparty's feel safe, and allows more complex structures and risks to be assumed (presumably with better spreads) rather than merely marginally providing liquidity to a limited number of homogenous markets. Wining and dining, freebies, conferences, etc.fees, commissions, kickbacks all entice business, and senior people with relationships and expertise require meaningful compensation all which hits the bottom line. Moreover, these costs exist even in a disaster year where losses pile up due to the disaster or catastrophe-du-jour. One could argue that the Corporate's expense ratio is not dissimilar to "2&20" which might make one agnostic as to which structure one invests with. In reality, these "costs" are part-capex, and should build greater long-term value. Yet, even IF the former were true, and one was indifferent, there is still the little chestnut about whether the business "optionality" should accrue to Management or Capital.

Transparency. Paradoxically, the HF structure provides MORE transparency than the corporate entity. Industry insiders say that a "clean reinsurer" is an oxymoron. There are only "less bad ones". Whether its the investment portfolio, or the current risk position, legacy risks, or malfeasance, one is never quite certain what's under hood. That said, there is no shortage of younger (both public and private cos. who are - relatively speaking - "clean", and there is nothing to prevent motivated capital from essentially setting up themselves (as Citadel, DE SHaw, and others have done), and cutting a deal with a capable management team.

While none of these reasons themselves are compelling, is there not something that explains it? For here where are today, with fine (not that I am qualified to pass this judgment) listed reinsurance companies trading at 5x forecast (and historical) earnings and up to 25% discounts to tangible book, solid management teams and well-operating infrastructures, existing relationships and books of business, and YET, MAN decides to buy into the other model, i.e. the hedge fund model, despite the seeming availability of BOTH the underwriting upside AND future enterprise appreciation upside, and do it at a reasonable discount too.

One possible answer might be - as queer and comical as it sounds - is that they simply have different investor bases. The corporates have smart, long-term, money who presumably value long-term growth and are willing to stomach illiquidity, volatility and discounts to book over the intermediate-term. The hedge fund model has investors that values one thing: "one-percent-per-month" in addition to the technicality that they often CAN ONLY INVEST IN HEDGE FUNDS, irrespective of how sub-optimal it may in comparison to investing in the same risk through a listed corporate. Yet another example of a local optimization problem. For the reinsurance HF investors are NOT irrational - just constrained, and a tad self-interested (yet another principal-agent dilemma). One can measureably sympathize with the investor who rolled the dice and bought a portfolio of listed reinsurers in 2007, which navigated the storm season and earthquake risk well, made ~18% returns on their equity except for the odd-ball who had monoline(s) exposure, YET their shareholders stomached negative mark-to-market returns (including dividends) despite the increases in book vals. But that was then, and this is now. When listed co's are trading at large prems to book, I can understand the aversion of opportunistic investors who just want the underwriting risk. But when they are cheap, very cheap, wisdom almost certainly favours the listed corporate, hands-down.

While the original question was "why would Capital not extract full potential rents from its existence, size and investment horizon?" perhaps I should lay that aside, and invert it into the more germane question which is: "IF the gulf is so wide, why would one start or join a reinsurer when they could start a reinsurance hedge fund??!?!"

Xposted by "Cassandra" from Cassandra Does Tokyo

Examination of public debate.....

This post is by Jim Fitch of Some Assembly Required.

Examination of public debate in the US
reveals little but childishness.

The New Sub-Prime: FirstFed, 4th largest LA based bank, reports that 40% of its mortgages are at least 30 day delinquent, after ARM mortgages reset. These are mainly 'payment option mortgages' and the debtors are opting not to pay. Don't worry, Bernanke and Paulson will soon explain that the problem is confined to the middle class market and won't affect the real economy.

Fiscal Innovation: Morgan Stanley is pioneering a new form of home-equity lines of credit, which involves determining the amount of equity a homeowner has accumulated and not letting them borrow against it.

Joker Jack of Diamonds Turns out Saddam's Intelligence Chief, Tahir Jalil Habbush, was working for the US all along. Before the war he told the US there were no WMD. The US paid him $5 million and put him in the 'Knows Too Much' protection program.

Down And Out: Market analysts breathlessly reported that the Fed didn't raise interest rates. Unemployment is climbing past 5.5%, mortgage rates are climbing towards 7% and folks were worried about an increase in Fed Funds rates? Hello? Anybody home?

Speechless: The Treasury Department hired Morgan Stanley to advise it on Fannie and Freddie's capitalization and ways to support their financial operations. Really. You can't make this stuff up.

Batting Order: Twenty-nine states have entered the budget shortfall contest. Currently leading the pack are: CA with a 21% budget shortfall, followed by AZ at 18%, NV 13%, RI 12%, FL 11% and NY 9% It is expected that there will eventually be 50 entrants in the contest, many having constitutional prohibitions against unballanced budgets.

Belt & Suspenders: The Fed is not worried about inflation; the rest of us better be.

More Math: If a train leaves Detroit with $10 million in GM debt, how much will the total cost be for a five year credit-default swap? (a) $7.2 million - $4.7 up front and half a million a year for five years - or (b) Less than $5 million - because the CDS will pay off before the half-million annual fee kicks in.

Some Assembly Required reflects my somewhat cynical view of the world on a daily basis. Think of it as having coffee with a curmudgeon. Come visit.

Too much risk?

One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on "too much risk" in recent years. I think it is equally accurate to suggest that the financial system took on too little risk.

Consider the risks that were not taken during the recent credit and "investment" boom. While hundreds of billions of dollars were poured into new suburbs, very little capital was devoted to the alternative energy sector that is suddenly all the rage. Despite a "global savings glut" and record-breaking levels of "investment" in the United States between 2005 and 2007, capital was withdrawn from a variety of industries deemed "uncompetitive" in large part due to obviously unsustainable capital flows. Very few brave capitalists took the risk of mothballing rather than dismantling factories and maintaining critical human capital through the temporary downspike. Under the two to five year time horizon of our most far-sighted managers, whatever is temporarily unprofitable must be permanently destroyed. To gamble on recovery is far too great a risk.

I don't pretend to know where all that capital, that incredible swell of human energy and physical resources, ought to have gone. But it doesn't take an Einstein to know that it probably should not have gone into building Foxboro Court. Sure, hindsight is 20/20. But lack of foresight really wasn't the problem here. In 2005, how many macroeconomists or big-picture thinkers were arguing that the US economy lacked suburban housing stock of sufficient size and luxury? We gave the building boom the benefit of the doubt because it was a "market outcome". But the shape of that outcome was more matter of institutional idiosyncrasies than textbook theories of optimal choice. It resulted as much from people shirking risk as it did from people taking big bets.

The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up "super-senior AAA" tranches of CDOs were looking for safe assets, not risky assets. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper. Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed 'em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was "safe", so who cared what it was funding?

Finance is not a closed system, a zoology of exotic contracts and rocket scientist equations. The job of a financial system is to make real-world decisions, "What should we do?" A good investment is a simple answer to that question, with clear consequences for getting it right or wrong. Mom and Pop can have FDIC insured bank accounts, and imagine that there is such thing as a "risk-free return". But that's a lie, a sugarcoated subsidy. Foregone consumption does not automatically convert itself into future abundance. People have to make smart decisions about what to do with today's capital. If they don't, no amount of regulation or insurance will prevent all those savings accounts from going worthless. When huge institutions treat the financial system like a bank, depositing trillions in generic "safe" instruments and expecting wealth to somehow appear, they are delegating the economic substance of aggregate investment to middlemen in it for the fees, and politicians in it for whatever politicians are in it for. And we are surprised when that doesn't work out?

Of course we should regulate and manage the risks that were the proximate cause of the credit crisis. Anything too big to fail should be no more leveraged than a teddy bear, and fragile, poorly designed markets should be fixed. But that won't be enough. We've trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I've nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.

Investors' childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.

Crossposted from Interfluidity.

Leverage (not what you think)

I'm talking platform leverage – the sort of leverage you can get in a proxy battle by putting a page like this in front of millions of people, many of whom may in fact own your stock, the week before the meeting, for free:

Or, the leverage in media you can get by interjecting a few weeks before a major global sporting event a "feature" that redirects searches related to that event to content within your own pages (from TechCrunch):

In preparation for the start of the summer Olympics on August 8, Yahoo has added Olympic-themed Shortcuts to its search results. Yahoo Shortcuts serve up contextually relevant content from various Yahoo properties inline within the search results. Now, whenever somebody searches for Olympic results, news, or athletes, different Shortcut widgets will pop up.

Something like this:

or this:

Not that Google won't do the same.

MSNBC has already done a deal to display Olympic video online in a format that is only supported on the Windows Media Centre.

In this insidious arms race the browser (or browsing enabled OS) is the ultimate high ground. Search captures about 50% of internet users each day, but everyone uses a browser. Sneaking in the door as a general purpose tool or service, pretty soon they can begin dictating what you may or may not do or see. Why shouldn't Firefox (or Microsoft, or Apple) release a plug-in or widget this week which will dynamically update the medal counts and serve athlete profiles (and why not video) from some OTHER source which pays them money to do so. Then you won't even need to use a search engine...

I still remember the sense of outrage when Yahoo first began selling the top positions in search results to the highest bidder... it made it that much easier to jump ship when an alternative came along.

(Oh, yes. This post brought to you by Paul Davis at Technology Investment Dot Info.)

Antidote du Jour 8/7/08

Links of the Day 8/6/08

• Now we've hit crisis proportions!
  Hobbit Crisis: The Shire in Foreclosure


• Citi may be the first to cut a deal with the states over auction-rate securities. Could others follow? And how much will the ultimate settlement be?
  Citi Talks With Regulators May Bring Billions in Buybacks


• In case your dog died, your wife left you, and your truck broke down, Prof. Roubini is here to tell you it's okay. The rest of the world is going to be doing much, much worse than you:
  Two CNBC Interviews: $2 Trillion of Credit Losses, a Severe Banking and Financial Crisis, a Severe US Recession and a Broader G7 Recession

Futures vs CDSs: the case for regulated markets

In less than a month, NYMEX crude oil futures have dropped about 15% in value. Other commodities ranging from precious metals to agriculture have had significant drops as well. Even for the traditionally volatile commodity markets, this is somewhat unusual and has led many people to scratch their heads to figure out what's happening. Is this simply a pause before the inexorable rise continues? Were there speculators that blew up and are rapidly unwinding their positions? Was there indeed a commodity bubble that has now been pricked? Or are market forces acting the way they're supposed to, with demand declining as the world's economies slow down?

Despite the confusion of what exactly is going on in the commodity markets, one point bears mention: no one is worried about what the true value of the September NYMEX CL contract is, or whether the counterparty to their future will be able to deliver as contracted. You can find out the price to the penny, and if you buy and hold a contract, you will get your 1000 barrels of light, sweet crude in Cushing, OK come hell or highwater. In other words, despite an impressive and unexpected 15% drop in a month, the normal market functions of price discovery, liquidity, counterparty guarantees, etc, exist and continue to work fine.

Contrast this with OTC derivatives such as CDO/CDS/MBS securities where the biggest problem has been the lack of a functioning market at all. Much of the turmoil in these markets is not because there are no investors interested in these securities per se as that in the absence of fundamental market infrastructure such as accurate prices, counterparty guarantees, and standardized, easily understood contracts, not even vulture investors want to touch this stuff, even if there might be money to be made.

So why have futures markets survived such volatility while OTC markets have essentially been destroyed? IMHO, it's not for these reasons:

1. Market size. The notional value of the CDS market has been estimated in the tens of trillions. Far in excess of the notional value of commodity markets. Yet CDSs collapsed while futures haven't.
2. Liquidity. OTC securities had large dealers and bankers who were contractually obligated to make a market in the securities they created.
3. Leverage. Both OTC securities such as CDOs/MBS/CDSs and futures are highly leveraged.

Thus, I'd argue that there is no reason intrinsic to the nature of either OTC securities or futures that would naturally make one instrument more susceptible to market breakdown than the other.

I would assert that the difference lies soley with the differing regulation of these markets. The regulation and oversight of futures has created a market for highly levered securities that is able to continue to function despite large, rapid, unexpected, and unexplained changes in price (such as we have been seeing this past month). In contrast, OTC security markets collapsed (by which I mean the market itself, not the price) by last year when price declines were less than 15% (remember when it was shocking that some AAA tranches may sell for <95% of par?).

So far, the collapse in oil prices has not required emergent Fed intervention to maintain the stability of the strategically important oil market. In contrast, the collapse of OTC security markets has necessitated the creation of several emergent lending facilities, the bailout of BSC, and now possibly the GSEs. And markets still remain frozen after nearly a trillion dollars of government liquidity and direct intervention.

Stephen Cecchetti made a similar observation last year in the Financial Times:

In September 2006 Amaranth Advisors, a US-based hedge fund specialising in trading energy futures, lost roughly $6bn (£3bn) of the $9bn it was managing and was liquidated. With the exception of its shareholders, most people watched with detached amusement. Eight years earlier, reaction to the impending collapse of Long-Term Capital Management was very different: people were horrified and the financial community sprang into action. One big difference is that Amaranth was engaged in trading natural gas futures contracts on an organised exchange, while LTCM’s exposures were concentrated in thousands of interest-rate swaps.
. . .
The difference between futures and swaps is that futures are standardised and exchange-traded through a clearing house. This distinction explains why Amaranth’s failure provoked a yawn, while LTCM’s triggered a crisis. It suggests that regulators, finance ministries and central bankers should be pushing as many securities on to clearing house-based exchanges as possible. This should be the standard structure in financial markets.

While Amaranth and LTCM were individual firms, I believe Mr. Cecchetti's observations are generalizable to the behavior of their respective markets as well. Standardized contracts, exchanges, and clearinghouses are three of the primary institutions through which the government regulates and supervises futures trading. They have been successful in maintaining functional markets despite tremendous leverage and volatility. Perhaps it's time to bring them to the rest of the derivatives world...

Things could have turned out otherwise.

This post is by Jim Fitch of Some Assembly Required.

Things could have turned out otherwise.

Pot / Kettle: Headline: Bush: China Must End Detentions, Ensure Freedoms.

Optimism: Why all the cheering for oil at under $120 a barrel? The price is falling not because some new supply has been found, but because the economies of the world are expected to crash and thus destroy some of the demand oil-based energy.

Either / Or: Stopping catastrophic climate change depends almost completely on stopping carbon dioxide emissions from coal before they trigger melting of the Arctic permafrost. The more coal we burn, the less chance our children have of a future. The industrial revolution is about to eat its children.

Quoted: "If the hard truth is that the federal government can't do much to lower gas prices, the really hard truth is that it shouldn't try." Elizabeth Kolbert.

All The Tea In China: At the 95% confidence level, the Arctic holds about 3 billion barrels of oil. Another 12 billion barrels have a 50-50 chance of actually existing. The USGS reports a "mean" estimate of about 30 billion barrels - less than a one year supply for the world and a rather deceptive presentation of the facts. If this is our last, best hope, there is no hope.

Win - Win: Climate changeniks say coal-fired power plants are the bane of our existence. Energy experts and investors say that coal-fired power plants are the only viable solution to our energy problems. Both groups are right.

Public Debate: Proper tire inflation can improve gas mileage 3%, regular tuneups can add another 4%. The current Administration estimates that offshore drilling may meet 1% of our demand, 20 years from now. One one hand, reason. On the other, magic. We'll vote for magic.

Scale: Osama Bin Laden knocked down a couple of buildings and killed some 3,000 US citizens. We launched two wars, destroyed the Constitution and created Homemade Security. Global warming will kill hundreds of thousands, destroy cities and farmland and forests and oceans and Bin Laden is still at large.

Some Assembly Required reflects my somewhat cynical view of the world on a daily basis. Think of it as having coffee with a curmudgeon. Come visit.

Inflation conundrum

Krugman doesn't think inflation expectations will lead to wage growth:

... inflation is well under control: wages aren’t taking off, the labor market is weak, and once oil and food price spikes end we’ll be, if anything, in a deflationary environment... I don’t think there’s any fundamental inflation problem, just a one-time hit on food and energy.

and posts the following chart on correlations to show that it really is different this time:

Menzie Chin on EconBrowser has a very interesting chart which may explain why it doesn't feel as if inflation is contained, and asks "Is the GDP deflator plausible?"

Four quarter inflation rate for GDP deflator (blue) and gross domestic purchases (red), calculated as 4 quarter log difference. NBER-defined recession dates shaded gray. Source: BEA GDP release of 31 July 2008, and author's calclulations. Figure 1 highlights how the inflation rate for what we buy has accelerated over rates for what we make.

The way I read this is that the purchase deflator is consistently running ahead of the production deflator, except for a brief period in the 2001/2 slump, and since mid-07 they have completely diverged. The other term for a price change which deflates what you export/sell and inflates what you import/buy is a terms of trade shock. I suspect that the US middle class is experiencing just that on a personal level.

UPDATE:

James Hamilton at EconBrowser further explains the difference between “inflation” - which only describes what is produced locally - and let’s call it “purchasing power” - which includes the imported things I also buy - in a way that even I can understand it, ie. with coconuts and oil.

In 2007, Islandia produced 500 coconuts, which residents sold to themselves for $1 each, and imported 1 barrel of oil, which cost $100... Nominal GDP in Islandia for 2007 was $500. If you wanted to describe that in real terms, you'd call it 500 coconuts. You don't count the oil in either nominal or real GDP because Islandia didn't produce any oil... 

Here are the numbers for 2008. We grew 510 coconuts, sold them for $1.01 each, and still imported 1 barrel of oil, paying $125 for it. So nominal GDP was $515.10 (a 3% increase) and real GDP was 510 coconuts (a 2% increase). The change in the implicit GDP deflator would be the change in the ratio of nominal GDP to real GDP, namely, +1%... 

But wait a minute, Islandia's pundits decry. How can your crummy accounting claim that inflation was only 1%? Last year we bought 500 coconuts and 1 barrel of oil for $600, but this year if we tried to buy the same thing it would cost us $630. The inflation rate, they tell you, is obviously 5%, not 1%.

Now I understand. But since I buy at least some imports every year my purchasing power is not even meant to be described by the "inflation" number. So TIPS aren’t really going to do me any good are they. What I need is a "purchasing power" protected bond. Likewise, if I want to know if my wealth is growing in "real" terms it does me no good to compare it to inflation - a production basket which only includes part of what I need to buy.

I am genuinely surprised after all this time to discover that inflation was never intended to do this.

China Desk

Brad Setser thinks that China is again holding the RMB down to maintain export volume in the face of softening global demand. From the comments (my emphasis):

China prefers subsidizing US consumption of Chinese goods to subsidizing Chinese consumption of Chinese goods... if China’s foreign asset accumulation continues at $800b a year, it will add $3.2 trillion to its foreign portfolio over the next four years — more than it added in the preceding twenty...

Bloomberg also points out that by dodging the debt bubble bullet China's banks have drifted to the top of the market cap tables as well as providing some of the only investment gains for their competitors:

Chinese banks hold three of top six spots among the world's largest financial companies based on market value... The Chinese banks owe their rankings in part to having avoided almost all of the $480 billion in writedowns and credit- market losses that have sent bank stocks tumbling worldwide... Only two years ago, the world's biggest banks were led by Citigroup Inc. and Bank of America Corp. of the U.S. and UBS AG in Europe... ICBC's unaudited figures... show first-half profit rose more than 50 percent... Beijing-based China Citic Bank Co. said earnings jumped more than 150 percent in the same period. China Construction Bank followed, saying net income may have advanced more than 50 percent... Chinese funds and companies spent $19.3 billion buying stakes in Blackstone Group LP, Morgan Stanley, Barclays Plc, Fortis and Johannesburg-based Standard Bank Group Ltd. since May 2007 that are now worth $7 billion less on paper... China Investment Corp.'s $5 billion purchase of a 9 percent stake in New York-based Morgan Stanley, the second-biggest U.S. securities firm... has declined 18 percent... The $200 billion sovereign wealth fund also invested $3 billion in shares of New York-based Blackstone, manager of the world's largest buyout fund, only to see their value decline 41 percent... By contrast, foreign banks' investments in Chinese financial firms have fared much better, showing $50 billion of paper profits... HSBC is sitting on a $16 billion gain... Bank of America, which bought 9 percent of China Construction Bank for $3 billion in 2005, has a $14 billion paper profit...

And, for those many investors bullish on both oil and the RMB, has the FT got a deal for you:

Shareholders in Petrochina have approved a plan for China’s largest corporate bond sale by a listed company... up to Rmb60bn ($8.77bn) through one or more tranches of bonds with maturities of up to 15 years... In the first half of this year, 21 listed Chinese companies issued a combined Rmb74.5bn of domestic bonds. While tiny compared with more developed economies, this amount was 6.35 times larger than the corresponding period last year...

The moment of truth for the un-coupling thesis is at hand; as pretty much everyone agrees (which is a sign for extreme caution) that there will be a post-olympic slump in China. In order to beat the rush, the IHT has already come out with their announcement: "China's post-Olympics economic slowdown has started before the Games have even begun."

New orders at Chinese factories plunged last month. Exports are barely growing, after adjusting for inflation and currency fluctuations. The real estate market is weakening, with apartment prices sinking in southeastern China... Any slowing of growth, which has been spurred in part by China's herculean investment program to showcase the Olympic Games that open this week, could prove a shock to Chinese workers who have been receiving double-digit pay increases each year... any significant slowing below its recent pace of 11 percent or more a year would also make it much harder to find jobs for the millions of people moving from rural areas to cities each year in search of work. Economists have been forecasting growth of 9 percent to 10 percent over the coming year, and these estimates are being ratcheted downward.

I'm pretty sure this is just MSM type spin and speculation - no sources, no hard data. Rodger Baker at Stratfor is also concerned at the difficulty business VIP's are having getting visas for the Olympics, and reads into this a wider post-Olympic crisis lurking:

China’s rapid and contradictory economic and security policies, rising social tensions, and seemingly counterproductive visa regulations appear to be signs of a government in crisis. They are the reactionary policies of a central leadership trying to preserve its authority, stabilize social stability and postpone an economic crisis. At the same time, we see signs that the local governments, and even organs of the central government, are putting up steady resistance to the announcements coming from Beijing... It may be that the contradictory policies Beijing is tossing around these days will simply fade away after September and things will get back to “normal.” But already, Chinese officials are downplaying the previously hyped political and economic benefits of the Olympic games. They are now warning that economic conditions may not be so strong in the future, and at least internally discussing the distinct possibility that at least certain regions of China are facing the same economic crises faced by their mentors Japan, South Korea and the Asian tigers.

A few more specific items which may argue against the post-olympic slump thesis:

China's tax revenues rose 30.5% in the first six months of the year. The country collected about $472 billion on a surge that reflected corporate profits in 2007. Almost half of the tax revenue came from value-added, consumption and turnover taxes, which rose 22.4 percent, 18.5 percent and 25.7 percent, respectively. Import tariffs showed the fastest growth, rising 34.9 percent to 395.6 billion yuan, followed by stamp tax on securities trading, which rose 34.2 percent to 83.7 billion yuan.

China's booming Internet population has surpassed the United States to become the world's biggest, with 253 million people online... a 56 percent increase from a year ago... The United States had an estimated 223.1 million Internet users... Total revenues for China's Internet companies soared to 40.5 billion yuan ($5.9 billion) in 2007, up 48.6 percent from the previous year... revenues should keep growing at an annual rate of at least 30 percent in coming years, reaching 137.5 billion yuan by 2010... By contrast, U.S. online advertising revenues alone in 2007 were $21.2 billion (145.2 billion yuan)... China's online population should keep growing by 18 percent annually, reaching 490 million by 2012...

A survey of 3,591 US companies with annual revenues of $25 million or above ranked China as the most favourable location for offshore investment... India was second with 45.1 percent, followed by Mexico with 30.1 percent, the United Kingdom with 25.4 percent and Canada with 22 percent.

An update: Setser doesn't see signs of a slow-down yet, and has a good chart showing that the month to month variation isn't large enough or serially trending.

(Posted by Paul from Technology Investment Dot Info)

An oil standard

Ok. Oil. Exxon Mobil reported a second-quarter profit of nearly $12 billion -- a number that works out (as many did) to about $39 for every man, woman and child in America; $90,000 a minute etc.

Mark Thoma has a think about the future price of gasoline for us. The punch line:

If past global expansions are a guide, global demand will recede only gradually. This is a direct implication of the model underlying this analysis. This suggests that US gasoline prices will remain high for the time being. Barring a major economic collapse in emerging Asia, prices will stabilise only as the world economy learns to economise on the use of oil and gasoline and as the supply of crude oil expands. Both corrective forces will take time to gain momentum.

As an investor however I believe that there is a definite skew in the probability distribution. Who ever heard of an extra 5 million barrels per day unexpectedly hitting the market? Yet, there is a distinct possibility of that much being unexpectedly withdrawn. Better to own the upper tail than the lower.

Brad Setser revisits the Gulf-inflation story -- single digit interest rates, double digit inflation.

I'd like to see more game theory applied to the oil price analysis. If they did peg their currencies to price, the Gulf could be the world's ultimate monetary authority. They can open the spigots whenever world growth flags below a targeted rate, and pull back when things are running a little hot... I'd rather own a currency based on oil than one based on gold.

Alternatively, they could pull back whenever there is talk of carbon caps, open up when it looks like alternative energy is getting too much interest and investment...

If I were advising them, here's my spin: Gulf states announce that they are voluntarily limiting the production and export of petroleum in order to contain global warming; and coincidentally conserving global oil resources for future generations... Home run.

Antidote du Jour 8/6/08

Techonomics

When people ask what I do for a living I tell them I do wealth preservation. If they ask how I do that, I say I do three things:

1. read the direction of inevitable changes in the world,
2. discover and value investment possibilities in the context of those changes, and
3. allocate risk capital among those possibilities.

Part of what I therefore do from day to day is to cover the intersection of technology, economics and finance; and I publish most of the general interest content to my blog as a sort of public filing cabinet that I can search for myself as well as refer people to. While Yves' blog is not concerned with technology per se, and much of what I post is industry specific, I thought I'd cross post a brief selection of recent technology news items which I think do have wider economic implications...

I'm becoming increasingly aware of the tightening feedback loop between companies, press and blogs. One recent example was the Lehmans R3 shenanigans, which was (for me) first mooted on Naked Capitalism but is now the background for reporting from the FT, Bloomberg and Reuters. With Merrills it was less than a week between the official window-dressing (w/placement), the debunking online, and the press taking it mainstream. Apparently, blogs are the new "exchange", and the SEC is about to make that official.

For several years, Sun CEO, Jonathan Schwartz has lobbied the SEC to allow disclosure of financial information through corporate blogs. In a landmark announcement, it seems that Mr. Schwartz may indeed get his wish, and with it, a historical decision that could break the age-old shackles that bound businesses to traditional media and distribution channels in order to satisfy full disclosure...

SEC special counsel Kim McManus outlined new guidance the SEC is about to give companies on when they can use their Websites, including blogs, to disclose material information... UNDER certain circumstances, companies can rely on their websites and blogs to meet the public disclosure requirements under Regulation FD (Fair Disclosure), according to new guidance unanimously approved by the US Securities and Exchange Commission today.

An essay in the New York Times called "OPEC 2.0" points out that communications is just as vital and expensive as gasoline; and just as monopolized although, as in the early days of oil, by domestic monopolies.

AMERICANS today spend almost as much on bandwidth — the capacity to move information — as we do on energy. A family of four likely spends several hundred dollars a month on cellphones, cable television and Internet connections, which is about what we spend on gas and heating oil... That’s why, as with energy, we need to develop alternative sources of bandwidth...

The U.S. Court of Appeals in New York has cleared the way for Cablevision to offer so called “network DVRs,” in which consumers would be able to record video programming for future viewing “in the cloud,” rather than relying on hard-drive in their set-top boxes... So, in effect, your cable provider can record and store video content on your behalf without violating any copyright. I believe that all video content except news and sports will move to a store and foreward model... and bit-torrent has already worked out the platform.

DVRs have been one of the largest single drivers of capital spending in recent years, accounting for as much as 10% of capital spending for the major [cable companies.] Further, cable gains a huge differentiator versus their satellite competitors. Under the ruling, cable operators will not only be able to offer DVR functionality to all digital subscribers - whether they have a DVR or not - but also to every TV outlet in the house that has a digital set top box... DVR penetration is now about 25% of TV households; he says in short order effective penetration of DVR penetraton could jump to north of 60% - and with an even larger increase in DVR outlets per home... Broadcast TV companies are especially exposed to enabling ad skipping on time-shifted programs, since they are 100% ad supported... Also losing here: the satellite companies, who have no way to offer network DVR capability, which requires point-to-point connectivity.

I was listening to a William Gibson (Neuromancer...) podcast from IT Conversations yesterday while I stacked firewood. He said something like: "In the future, anyone of any public profile whatsoever is going to be subject to forensic data mining tools to an extent that we can only glimpse today. Every piece of data generated by anyone is going to be available and related to all other data." Anyway, in the spirit of that famous quip that the future is already here, it's simply not evenly distributed, I post the following from Slashdot:

Sometime in 2005-2006, White House Liaison Jan Williams attended a seminar on LexisNexis searches, and wrote one herself:

[First name of a candidate]! and pre/2 [last name of a candidate] w/7 bush or gore or republican! or democrat! or charg! or accus! or criticiz! or blam! or defend! or iran contra or clinton or spotted owl or florida recount or sex! or controvers! or racis! or fraud! or investigat! or bankrupt! or layoff! or downsiz! or PNTR or NAFTA or outsourc! or indict! or enron or kerry or iraq or wmd! or arrest! or intox! or fired or sex! or racis! or intox! or slur! or arrest! or fired or controvers! or abortion! or gay! or homosexual! or gun! or firearm!

Needless to say, when asked about it, Williams first said she didn't remember ever seeing it, then said she'd used an edited version just once. LexisNexis records show she used it, as shown, 25 times.

Just a few things that are changing the landscape (from Paul Davis at Technology Investment Dot Info).

Ever wonder....

This a post by Jim Fitch of
Some Assembly Required.

Ever wonder where the adults have gone?

Coal Mine: Citigroup reports a $176 million 2Q08 loss on credit-card secutization. A pittance, but perhaps the canary for a business that previously generated over $3 billion in revenues.

Company's Here: For the first time since the 70's, inflation is rapidly rising around the world. Morgan Stanley reports double-digit inflation in over 50 countries. Seems globalism's downside spreads faster than its upside ever did.

Tough Times: The wealthy have taken to telling their personal shoppers to look for bargains.

Tourist of Duty: Italy is deploying the Carabinieri, a paramilitary police force, in cities to help cut down on "the thieves, the rapists, the criminals." Action is pending on the overpriced meals in Venice.

Catch The Wave: The crest of the next wave of mortgage defaults will either be (a) a larger number of foreclosures or (b) a smaller number of more expensive foreclosures.

Export Land Model: OPEC internal oil consumption is increasing at 8% a year and in ten years will match Saudi Arabian production. Since they cannot sell what they use at home, world net exports will fall 20% from their 2005 peak. That oil fell on world markets today tells us about the time horizon of world markets.

Pillow Talk: Jet Blue is charging customers $7 to use a pillow and blanket, $4 each if sharing the blanket... US Airways, charging $2 for water and but $1 for coffee is "vigorously moving towards more a la carte options.” And truth in pricing.

Some Assembly Required reflects my somewhat cynical view of the world on a daily basis. Think of it as having coffee with a curmudgeon. Come visit.

Ruminations on Moral Hazard

I hate to start with apologies, but I’m clearly a little late to this guest-blogging gig. I knew that would be the case—Thursday morning 10 minutes or so after the market opened I headed north from Hartford, Ct, on my way to Grand Lake Stream, Maine, about two hours northeast of Bangor, to a gathering of economists, money managers, and assorted hangers-on, for a weekend of talking markets and economics while fishing, eating, drinking wine—pretty much every second except for those precious few that were spent asleep. I thought I’d find time to dash off a note or two, but the weather, which miraculously didn’t drown us while we were out on the water casting for small mouth bass, perch, and pickerel, inundated us the rest of the time, to such effect that internet service was extremely spotty, and the vigilance required to catch the moments of service distracted too much from the food, wine, and conversation to be a viable alternative.

The curve balls, though, started appearing Sunday morning on the drive south, and provide I suppose an object lesson for investors, in what they say about both the ability to predict the future—often, in my experience, vastly over-estimated—and as important, the ability to price or value it accurately, once having predicted it. Mordecai Kurz of Stanford’s theory of endogenous risk writ large, if you will. While driving south to the Bangor airport, huddled in terror on the floor of my car while Barry Ritholtz of The Big Picture fame demonstrated everything he hadn’t learned at some driving school, hurtling down fog-enshrouded hills and careening around curves, moose jumping out in my imagination around every terrifying corner, I regained cell phone service, and called my wife, from whom I learned that her step-sister had died the night before. Now this was hardly unpredictable, or a surprise, but somehow I didn’t think through the ramifications when offering to help Yves out during her absence. So now I’ve got siblings coming in from around the country, all of us shattered by the untimely and heartbreaking death of a great woman in her prime, to deal with over the course of the week.

The future which I didn’t predict at all involves my internet service, which has slowed to something like early dial-up, for reasons which only my Cox repairman can divine, and he ain’t showing up until tomorrow, when with luck an easy solution will appear.

So the future’s not predictable, and even when we can predict it, pricing it presents a whole additional host of difficulties. One thing that’s been on my mind a great deal over the last 12 months or so, say from that first 50 basis point rate cut that the Fed laid on us in August last year, or in the weeks prior to that as I tried to suss out what the Fed might do at that meeting, and how the markets might respond, which plays straight into the prediction game, is the subject of moral hazard. Of course, the subject’s been much in the air, and increasingly so, as we’ve lurched from one emergency to the next, most recently several weeks ago with the weekend rescue of Fannie Mae and Freddie Mac.

I was very critical of the earlier Bear Stearns, or JP Morgan, if you prefer, rescue in mid-March. It wasn’t, and still isn’t, completely clear to me that the world would have come to an end if Bear had declared bankruptcy; I can’t even say with assurance that Bear was bankrupt when it was forced into the embrace of JPM, with the taxpayer potentially picking up the tab for the liaison.

However, I can’t say the same about Fannie and Freddie; their demise would seem to have catastrophic implications for the larger financial world and the real economy, and couldn’t be allowed. And the fact that they were on the brink seems pretty clear to me as well. As Jim Bianco, among others, has pointed out, Fannie and Freddie, as part of their penance for their accounting malfeasances earlier in this decade, are required to show fair value balance sheets as part of their financial statements. Accompanying these balance sheets, they put out multiple pages explaining why the investor should pay no attention to them, that they don’t paint a true picture of Fannie and Freddie’s financial health. I’d venture to say that the two institutions would prefer investors not look at those balance sheets for another reason—they show both to be insolvent, or so close as to make the thought of investing in them the diciest of propositions.
And yet the two sport a combined market cap of more than $15 billion, hardly bankruptcy territory, and the world’s largest fixed income investor, Pimco, has made a very public and very large bet on their debt securities.

Of course, one other reason that Fannie and Freddie couldn’t be allowed to go the way of all flesh is the foreign holders of their debt. Mike Panzner of Financial Armageddon has a post up now on the subject (http://www.financialarmageddon.com/2008/08/economic-blackm.html), and certainly the rumor is that Treasury Secretary Paulson was fielding a series of concerned phone calls from foreign central bankers and finance ministers who strongly suggested that Fannie and Freddie’s debt securities better be money good. (On that subject, an astute and experienced market participant over the weekend in Maine remarked that if Secretary Paulson answered such a question in the affirmative, or at all, for that matter, it was a violation of Fair Disclosure regs; as a possessor of material inside information, he could not pass that information only to some holders of Fannie and Freddie’s securities before announcing it to the public at large.)

It should be axiomatic under circumstances such as these that equity holders get wiped out. Bear shareholders received $10 more per share than they deserved. Yet, for the moment at least, there’s that $15 billion of market cap, which exists only because the government put the taxpayer at risk to defend the agencies’ obligations. Given that the taxpayer is at risk for Fannie and Freddie’s potential failure, shouldn’t he also own any potential upside in the firms’ share prices? Private profit, socialized loss, indeed.

And what of the debtholders? In an ordinary bankruptcy, they’d be scrambling for position to win the scraps. Instead, in this instance, we have the unseemly appearance of Bill Gross and Paul McCulley using their bully, er, bullish, pulpits on cnbc to pound the table for agency debt. This is a moral hazard bet, pure and simple. And there are lots of them out there at the moment. Roughly two Fridays ago—and that chronology may be slightly off—I was an amused bystander to an impromptu email debate among several friends about buying Wamu debt, on the theory that it would shoot from the (I believe) 40 cents on the dollar at which it was trading to par at the moment it was forced into the arms of JPM, or BAC, or one of the other remaining few “good” banks, over the weekend.

Don’t misunderstand me; I find nothing wrong with an investor making the calculation that the government will follow the morally hazardous path in any given circumstance, and betting upon that perception. It’s an entirely legitimate exercise; alpha grows in mysterious ways. But surely it takes moral hazard to a whole new level, and if I were presiding over this trainwreck, I’d worry about the fact that bigtime and very successful investors were pricing the future based solely on the perception that the government so feared the ramifications of the failure of a large financial institution that it would not let that happen, unintended consequences be damned. It surely is no way to run a bond market.

PS My lawyers suggested that I make mention of the fact that I’m the general partner of a hedge fund, and that it’s not inconceivable (lawyerly phrase that, huh?) that I might have positions in securities that I talk about here. As it happens, I’ve got no positions in any securities issued by Fannie or Freddie, or Wamu, JPM, BAC, or Bear. That could change at any minute, of course, but if you trade on anything you read here, you’re on your own.

PPS I note, although I haven’t read the article yet, that the New York Times has a prominently displayed article on Richard Syron and Freddie Mac on its website. http://www.nytimes.com/2008/08/05/business/05freddie.html?_r=1&hp&oref=slogin

Given the SEC’s Christopher Cox’ interest in shutting down people who trade in false rumors in order to push stock prices around (JPM’s Jamie Dimon wants them all sent to Gitmo.), I’ll note in case he missed it that on the Friday of the Fannie-Freddie meltdown, preceding the weekend rescue, in the late afternoon, as the market as a whole seemed on the verge of tumbling off a precipice, Mr. Syron announced that the Fed had opened its discount window to Freddie Mac. Although it later did just that, Syron’s statement was untrue; the Fed had not yet opened the discount window to them. The market took off like the proverbial scalded dog. Presumably the Fed received news of Syron’s false statement, but couldn’t scramble quickly enough to get out a correction until a good 20 or 30 minutes after the market closed. Messrs Cox and Dimon, the ball’s in your court.

Bernanke facing revolt over inflation?

According to the Times, U.S. inflation hit a 27 year high in June:

Inflation jumped by 0.8 per cent in the month of June, the most since February 1981, when prices rose by 1.0 per cent, according to the Commerce Department.

Bloomberg reports today that while the Fed will likely keep interest rates unchanged for now, Bernanke is facing a dissenting block of 3 governors who are arguing for more action against inflation.

The fastest inflation in 17 years adds to the risk that three members of the Federal Open Market Committee will dissent for the first time since 1992. Gary Stern, president of the Fed's Minneapolis bank, and the Philadelphia Fed's Charles Plosser joined Dallas's Richard Fisher since the last meeting in June in calling for an increase in rates to limit price increases.

The trio wield more clout than usual because two seats assigned to Fed governors on the 12-member panel are currently vacant.

According to the article, this may result in Bernanke talking tougher about inflation in his official statements.

Personally, I'm a little skeptical that this means much. Talk is cheap. Even Fed-speak. Bernanke has talked tough about inflation ever since he assumed the chairmanship. Yet he has allowed inflation to rise to the current stunning levels. Inflation, even core inflation that excludes food and energy (i.e. the things that have been rising the most in recent years), has consistently exceeded Bernanke's stated targets, but his actions have been few. While admittedly he is in a tough position right now, his actions in the past year have demonstrated that when push comes to shove, he is willing to sacrifice inflation to pursue other goals, all the while paying lip service to being an inflation hawk.

Furthermore, while 3 governors openly dissenting may have been rare during Greenspan's term, Bernanke is apparently genuinely interested in fostering open discussion among the governors. From Bloomberg:

Bernanke may be willing to accommodate dissent. Bernanke has praised the Bank of England, whose chief, Mervyn King, has been outvoted twice on rates, as a ``leading exponent of increased transparency.''

Bernanke has also opened up FOMC meetings to allow officials to speak out of turn during debates. That means the sessions may resemble the frank exchange of conflicting views common to Bernanke's discussions during 23 years as an economics professor, said Edward McKelvey, a senior U.S. economist at Goldman Sachs Group Inc.

In 20 FOMC interest-rate decisions as chairman, Bernanke has recorded nine with one dissenting vote and two with a pair of `nays.' His predecessor, Alan Greenspan, had 17 decisions with one or two dissents in his last 10 years as Fed chief.

Thus, having 3 governors dissenting may not be indicative of all that much more dissent than usual. For any professional Fed-watchers out there: does this really mean there is true dissension in the ranks that might actually force action on inflation that is rapidly approaching the '70s era we all have nightmares about? Or is this another good P.R. move to appease the inflation hawks with empty words while pursuing other goals?

Antidote du Jour 8/5/08

Year of Lending Dangerously

The FT's Gillian Tett writes up a blow-by-blow of the credit crisis; and the spread chart is a good reminder of how different things still are:

On August 9 2007, the European Central Bank sent shock waves around world financial capitals when it injected €95bn ($150bn, £75bn) worth of funds into the money markets to prevent borrowing costs from spiralling sharply. The US Federal Reserve soon followed suit. But while the central banks had billed these moves as “pre-emptive” actions to quell incipient market tensions, they did not bring the panic to an end... A year later, there is still no sign of an end to these problems. Instead, the sense of pressure on western banks has risen so high that by some measures this is now the worst financial crisis seen in the west for 70 years.

There were a few people on the record as anticipating problems, and no easy way out - Hiroshi Nakaso, a senior official at the Bank of Japan; Jean-Claude Trichet, governor of the ECB; Timothy Geithner, president of the New York Federal Reserve - but it's easy to data mine in retrospect. These are the drivers of the train, or at least in the engine cabin, and they just watched it crash.

Yet most investors, bankers and even regulators did not change their behaviour to any significant degree, owing to a widespread adherence to three big assumptions – or articles of faith – that have steathily underpinned 21st century finance in recent years.

The first of these was a belief that modern capital markets had become so much more advanced than their predecessors that banks would always be able to trade debt securities. This encouraged banks to keep lowering lending standards, since they assumed they could sell the risk on...

Second, many investors assumed that the credit rating agencies offered an easy and cost-effective compass with which to navigate this ever more complex world. Thus many continued to purchase complex securities throughout the first half of 2007 – even though most investors barely understood these products.

But third, and perhaps most crucially, there was a widespread assumption that the process of “slicing and dicing” debt had made the financial system more stable. Policymakers thought that because the pain of any potential credit defaults was spread among millions of investors, rather than concentrated in particular banks, it would be much easier for the system to absorb shocks than in the past...

Because the risk was systemic, there was no risk? A big mistake.

As a result, when high rates of subprime default emerged in late 2006, there was initially a widespread assumption that the system would absorb the pain relatively smoothly. After all, the system had easily weathered shocks earlier in the decade, such as the attacks of September 11 2001 or the collapse of the Amaranth hedge fund in 2006. Moreover, the US government initially estimated that subprime losses would be just $50bn-$100bn – a tiny fraction of the total capital of western banks or assets held by global investment funds... And as the surprise spread, the three pillars of faith that had supported the credit boom started to crumble... First, it became clear to investors that it was dangerous to use the ratings agencies as a guide for complex debt securities... [The end of that franchise.] Then, as bewildered investors lost faith in ratings, many stopped buying complex instruments altogether... As a result, western banks found themselves running out of capital in a way that no regulator or banker had ever foreseen... [Whocouldaknown?] Banks started hoarding cash and stopped lending to each other as financiers lost faith in their ability to judge the health of other institutions – or even their own... Then a vicious deleveraging spiral got under way... The IIF calculates that in the year to June, banks made $476bn in credit writedowns, as debt prices plunged in the panic (although tangible credit losses are hitherto just $50bn). However, they have also raised $354bn in capital...

It all seems so familiar somehow... but I cannot remember how the story ends. (Paul at Technology Investment Dot Info)

Oil below $120: Has the commodities bubble been pricked?

NYMEX Crude oil futures dipped below $120 today for the first time since May.

Furthermore, Bloomberg reports that "Plunging prices for cocoa, natural gas and sugar are sending the Reuters/Jefferies CRB Index of 19 commodities to it biggest one-day decline since March."

Bloomberg cites the slowing U.S. economy, rising inventories, and prospects for improved production of various commodities for the broad-based declines.

Of course, commodity trading is highly volatile, and this may just be a slight retrenchment before the march higher resumes, as commodity bulls argue. OTOH, could the commodity bubble be deflating? There must be financial players in the commodity market getting squeezed by their >$20 loss in current crude oil contracts. If the margin calls start coming, we may see further sell-offs...

Quelle Surprise! Greenspan warns about the dangers of regulation

(Apologies to Yves, but I believe she would have tagged it similarly)

Despite the mounting evidence that the worst financial crisis since the Great Depression was at least exacerbated by the lack of appropriate regulation and oversight in numerous markets ranging from the home mortgage lending to the securitization process to OTC derivatives markets to brokers and banks, Alan Greenspan, in a new commentary in the Financial Times warns against the dangers of too much regulation.

A commentary entitled "Repel the calls to contain competitive markets" contains such choice nuggets of advice to the world's financial regulators as these:

The economic edifice – market capitalism – that has fostered this expansion is now being pilloried for the pause and partial retrenchment. The cause of our economic despair, however, is human nature’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship. Regulation, the alleged effective solution to today’s crisis, has never been able to eliminate history’s crises.

This discounts the tremendous amount of regulation and oversight that is required for "market capitalism", embodied in such institutions as the stock market and private corporations, to function and thrive. Stock markets are one of the most highly regulated and supervised markets in existence.

Furthermore, Mr. Greenspan conveniently ignores that the Great Depression was solved through the government's fiscal and monetary policies (and of course the greatest government fiscal stimulus: war), rather than market forces. He also ignores that much of the regulatory apparatus in place is specifically designed to combat human nature's so-called propensity to sway from fear to euphoria and back (including the circuit-breakers instituted in the markets under his watch after the 1987 crash).

Mr. Greenspan then goes on to assert that:

A financial crisis is heralded, in fact defined, by sharp discontinuities of asset prices. The crisis must thus be unanticipated. The fact that risk was heavily underpriced for much of this decade was broadly recognised in the financial community, but the timing of the sharp price correction was nonetheless a surprise.

While it may have been a surprise to Mr. Greenspan and other market boosters, the coming collapse in housing prices, and their long-term unsustainability at current levels was widely discussed. While it was not the majority opinion, it was nevertheless widely held by many respected economists. Mr. Greenspan can admit he was wrong, but here goes further to assert that no one can be right and this is clearly not true.

Despite Mr. Greenspan's heavy blinders, it is heartening to see that he has finally accepted certain truths:

The credit crunch of the past year has not followed the path of recent economically debilitating episodes characterised by a temporary freezing up of liquidity – 1982, 1989, 1997-8 come to mind. This crisis is different – a once or twice a century event deeply rooted in fears of insolvency of major financial institutions.

In other words, even Mr. Greenspan is finally forced to admit that this is not a liquidity crisis but an insolvency crisis, something that others such as Mr. Roubini have been arguing for at least the past year.

The insolvency crisis will come to an end only as home prices in the US begin to stabilise and clarify the level of equity in homes, the ultimate collateral support for much of the financial world’s mortgage-backed securities.

Does this mean that Mr. Greenspan finally admits that while public and private interventions can ameliorate the declines and slow down the crisis, its ultimate resolution will only come when house prices return to sustainable levels?

So perhaps the cup is half full. Mr. Greenspan is still clearly wedded to his "free market" dogma despite the obvious truth that "free markets" can only exist and thrive within a framework of regulation and supervision. But even he is being forced to admit that the current crisis is fundamentally one of solvency which will only be solved when housing prices decline to sustainable levels.

Maybe after another year of unrelenting bad news and market failures, and another $500 billion in government intervention, Mr. Greenspan will finally be forced to admit the error of his past ways. One can only hope.

If Your Stock Goes Down, It MUST Be Short-Sellers

IF one is the chief a monoline, bank or other financial holding company with large, dubious, asset-backed exposures, it is understandable that during the denial phase of coming to terms with one's fate, that one would like to blame someone else, anyone else, but in particular, blame the nefarious Short Sellers. We'll ignore the asymmetry of absent blame (or even mere introspection) on the way up.

But today's short-seller whinging award comes from the most unlikely of sources in the most unlikely of sectors: Australia's richest man, none other than John "Twiggy" Forrest, chairman and founder of emerging iron-ore behemoth, Fortescue Metals Pty. (ticker FMG AU Equity for Bloombergers).

According to today's Sydney Morning Herald,

Iron ore miner Fortescue Metals Group Ltd, headed by Mr Forrest, has being targeted by hedge funds resulting in a more than one third fall in the company's value over the past six weeks.

The activity has also cut Mr Forrest's paper fortune in Fortescue since hedge funds began targeting the stock when it was trading at a high of $13.15 a share on June 25.

"Those people who make a living out of short selling stocks ... are bordering on criminality," Mr Forrest told delegates on Monday at the Diggers and Dealers conference in Kalgoorlie, Western Australia.

No matter that FMG (seen in chart above) vaulted more than 115% from A$6 to A$13 in the current YTD, punctuated by an unusually firm End-of-Quarter-2 close, nor that it had increased more than 900% since Jan 1, 2007.

The SMH continued:

"Those stock market players who have no interest in the company, who spread or propagate rumours that they haven't been bothered to check ... and then sell into the back of those rumours, I don't think they're doing anyone any good," Mr Forrest said.

"And of course, when we hear that we've got cracks in the bottom of our ore cars, or even a ship has sunk at the berth.

"We know those things are being put out to scare the mums and dads into selling their shares and of course the people who've shorted their shares then go and buy those shares off."

Mr Forrest also attacked investment banks who defended the practice.

"The investment banks who defend short selling are defending real personal interest," he said.

Mr Forrest, of course, is not in any way defending his personal real interest with his accusations. After all his mark-to-market wealth of Fortescue shares alone only declined a mere A$4 billion to A$8 billion. And while Mr Forrest's faux-concern for little Bruces & Sheilas across oz is heart-warming, by way of full disclosure, most of FMG stock is locked up between himself, Steinberg's Leucadia, Falcone's Harbinger, whom together control @63%. Perhaps, one of the other big-three is hedging out the enormous gains of the prior 18 months, particularly as bottom falls out from under US economic activity in general, and the commodity complex in particular.

In any case, I am not defending short sellers. Nor making any statement about whether FMG's share price is too high or too low. But I remain intrigued by the ease and rapidity that longs unsheath their asymmetrical insinuations that anything which goes down - even something that has appreciated as outrageously as Fortescue - even something with some serious logistical issues which remain to resolved - must have a nefarious connection...and is not the result of ordinary profit-taking, trend-followers reversing positions, or principled value investors using it to hedge the market risk of other, now-less-exuberantly valued miners, in currencies less susceptible to carry-unwind risk.

I wonder if Mr Forrest is backing up his giant Terex Titan to buy more down here from The Short Sellers, particularly if such a fall is as unwarranted as he suggests? Last official filings, however, showed him selling a cool A$40million of stock during the prior quarter...

(xposted by "Cassandra" from Cassandra Does Tokyo

Some Futures need throwing away...

This a posting by Jim Fitch of
Some Assembly Required.

Some futures need throwing away.
William Gibson, Spook Country

Buy The Numbers: GM sold 2.29 million vehicles in the most recent quarter, loosing $6,756 a vehicle.

A Word From Our Sponsor: In the yelling match discussion over drilling in the Arctic and in the magical kingdom of 'off-shore', keep in mind that the oil being fought over may not exist. Estimates are based on USGS surveys that base 'undiscovered oil' on geologic suggestion. But the USGS previously thought there were immense supplies in the off-shore Baltimore Canyon, too, but $3 billion in dry holes convinced the majors that the were none. Carry on.

Passing In Review: James Quinn at Seeking Alpha ends a long and thorough and highly recommended review of the banking/financial situation with this: "When you see a bank CEO or a top government official tell you that everything is alright, run for the hills. They are lying. They didn’t see this coming and they have no idea how it will end." Amen.

Millennium: Peace and Brotherhood are not about to break out in Iraq. The Kurds want to control Kirkuk and the northern oil fields, and the Arabs aren't dumb enough to let them. In Anbar Province and the rest of western Iraq, the Awakening movement is wresting power from the Sunni Iraqi Islamic Party. The Islamic Supreme Council of Iraq (Iran's horse in this race) has - with US blessing - made gains under Maliki that Muqtada al-Sadr's Mahdi Army will reverse as soon as the US Army heads home. And any oil deal Bush has forced on Our Gang will be reversed as soon as Iraq actually becomes run by Iraqis. They all want the US to leave, and leave the spoils behind for them to divvy up among the survivors.

You Didn't Hear It Here: Some view Meredith Whitney's prediction that US house prices will fall 33% from 2007 highs as conservative; 50%, 60% and even 80% estimates have surfaced. S&P predicts a further 17% fall in the next 8 months...

The Bigger They Come: The Royal Bank of Scotland is expected to report the biggest loss in UK banking history, taking a hit of almost £6 billion from the credit crisis.

Some Assembly Required reflects my somewhat cynical view of the world on a daily basis. Think of it as having coffee with a curmudgeon. Come visit.

Pity the US consumer?

I like this cartoon (h/t Kedrosky) for perspective on the past year, though I would perhaps swap a few of the roles around. To me, it's the regulators that lacked the courage to prick this bubble, and the investors that lacked a brain. I never expected the lenders to have a heart.

The Wizard of Oz was originally written around the turn of the century (last one) as a populist allegory railing against the banks and railroads and Yip Harburg, the lyricist for the 1939 movie, specifically stuck to that intention. I believe the tin man was the factory worker, the straw man the farmer, the cowardly lion was William Jennings Bryan, the fake wizard was Wall Street (as today) and the witches the monopoly trusts. The munchkins were the "little people". Dorothy was you and me.

Plus ca change...

GDP for Q407 was revised to a negative 0.25%, Q108 to 0.9%, but Q208 was reported at 1.9%. The big story in the data was net exports. Dean Baker (via DeLong):

Exports grew at a 9.2 percent annual rate. More importantly, imports fell at a 6.6 percent annual rate. Together, the change in net exports added 2.42 percentage points to GDP growth for the quarter...

Jobs are weak.

Nonfarm payrolls fell for the seventh straight month in July, while the nation's unemployment jumped to 5.7%, a four-year high, according to the Labor Department. Underemployment, a more comprehensive measure of the extent of labor market weakness, rose to 10.3%, its highest level since 2003 and two points above its July 2007 level. Since December, 463,000 jobs have been lost, the strongest signal yet that the economy is in a recession.

Tourism is not responding as strongly as one would hope to the weak dollar.

The world's long-haul international travelers have jumped by 35 million since 2000, yet America has been largely overlooked by those new travelers, despite favorable exchange rates resulting from a weak dollar and attractions like Disney World and the Grand Canyon. In fact, the annual number of foreign visitors to the US is about 2 million lower than in 2000, leading travel-industry experts to figure that from 2000 to 2007, the US economy took a hit of about $150 billion... Foreign visitors to Orlando, Fla., dropped by one-third from 2000 to 2006; by nearly 40 percent over the same period to Anaheim, Calif. (read Disneyland); and by 22 percent to Las Vegas, a frequent entry point for foreigners to the Southwest... in all 50 states, travel and tourism figure somewhere among the top four industries by economic impact.

New York may go broke (again).

Costs are rising and revenues are falling fast. In June 2007 the 16 banks that pay the most taxes on their profits remitted $173m to the state treasury. Last month this dropped to $5m, a 97% decrease. This is a frightening fall given how much the state's coffers rely on Wall Street taxes: 20% of all state revenues come from financial companies... Wall Street lost 4,300 jobs during the month of June alone... In less than 90 days, the projected deficit over the next three years has jumped 22% to $26.2 billion.

Peter Bernstein has added his voice to the chorus, waxing apocalyptic.

In 2007, as if some kind of secret signal went out among them, housing prices accelerated their decline while the prices of oil and food rocketed higher... the most unusual feature of our current problems: the primary impact of all of them has been on consumers, not on businesses... Today, a halt in the decline of home prices seems the necessary condition to transform the system from despair to hope and to turn the financial sector, now embattled and disorganized, back into the functioning organism the economy needs so badly... To sit back and let nature take its course is to risk the end of a civil society.

Too many developed economies got addicted to asset inflation - the increasing valuations were the only source of yield to service the debt incurred in their purchase - a Ponzi scheme in the Minsky sense. Now that bubble has burst. Houses are a non-productive asset, a consumption good. Values have to fall to where they can be serviced from current incomes - whether via a mortgage payment or rent - or incomes have got to rise via wage inflation. I still don't see any other way out. The first decimates (many) banks, the second decimates the dollar.

(Paul Davis at Technology Investment Dot Info.

Antidote du Jour 8/4/08

Eye candy, and some more substantial fare

Paul Davis here, with my first go at guest posting for Yves so you'll have to excuse me if I'm rusty on the formatting. Another week gone by; a pile of charts for you to consider (a click will mostly give you a larger size).

Krugman made the point with this chart that the Fed is pushing on a string here. The "bond market vigilantes" (remember that term) aren't nearly as sanguine about the credit or inflation risk as Ben seems to be.

This one is also quite interesting. You can clearly see Mae/Mac taking up the mortgage baton when the S&L's took a fall, and then the ABS market stepping into the breach when the agencies ran out of ammo. I believe Mae/Mac has moved back up to 80% of the mortgage market. Is mortgage broking going to be declared a strategic industry?

I like to see this type of GDP readout when I read the headline number. The various components have such disparate character it reminds me of the wheels on a slot machine. Depending where they end up any given quarter you can have GDP from -1 to +3... Taking them in turn: consumption had a bit of a bounce from the tax checks but I would expect less next quarter; non-residential is looking very anemic and steadily so, a bad sign; residential is falling less rapidly over time, could probably plot the bottom; inventories are all over the place from quarter to quarter, but it looks like they were just flushed out which could be good as they refill, or an indicator that businesses are genuinely pulling back on production, or it could just be too expensive to finance them; both exports (more) and imports (less) were positive for growth, probably the most encouraging data on the chart. Government is exogenous... no insight from me.

This chart pair shows the marked difference between the current residential-led slump and the 2001 capex drought.

The bigger picture shows that this is still not desperate territory in GDP growth terms, although my "ruler on the screen" technique reveals we are tracking below the trend since 2001.

Good news? The US deficit relative to GDP is also not the worst its ever been. The absolute numbers sound much worse.

But this chart from Ned Davis really scares me.

Unemployment is going up, but still not historically dramatic though DeLong and others argue that a wider indicator (U6) is now more useful.

With all the legal crossfire, perhaps we can expect something of a litigation-led recovery:

I know, oil prices are so last week, but I've been tracking this chart and the rollover in US miles driven is impressive. What also amazes me is that in 25 years the distance driven by Americans doubled. Why? The country didn't change size. Everybody just did more driving. It's hard for me to believe that that lead to an increase in quality of life (is driving per se a consumption good?) but that is just me. I would love to see this figure for Japan, Europe, China...

More behaviour modification in action. The invisible hand upside the head. Ouch!

Looking at this chart, it's hard to fault the hot money flooding China.

On the other hand, you can now get 100,000,000,000 dollars issued with the full faith and credit of the Reserve Bank of Zimbabwe on eBay for about US$80 last time I checked. Of course, it won't buy a loaf of bread in-country. A new export market?

I think I'll leave it there for today. Cheers from down-under. (cross-posted from TechnologyInvestmentDotInfo)

2007 was the year of subprime...

This a submission by Jim Fitch of
Some Assembly Required.

2007 was the year of subprime.
2008 seems to be the year of everything else

One Size: Pundits worry that Freddie, Fanny, GM, Citibank, and such are teetering on the edge, but are relieved that they are too big to fail and that Uncle Sam will (somehow) save the day. Why isn't the concern that they, and the US, are simply too big to save?

Essay Question: In 500 words or less, describe Obama's proposed $1,000 tax rebate based on a windfall energy profits tax without using the words 'pandering' and 'ridiculous'. Usual prize.

Waiting Room: By 2011 the VA be able to accurately track every veteran who died for lack of care while the VA spent $11 billion improving its record keeping.

Dear Diary: Economist Paul Krugman says "I don’t think there’s any fundamental inflation problem, just a one-time hit on food and energy." Just for the record, the hit was by a 32 ton cement mixer falling from a great height.

Indecent Proposal: Interesting that oil at $140 or, more accurately, gasoline at $4, can change core beliefs. In California and Florida, a majority of voters now support drilling off the coast.

Peak Travel: Even with higher fares, airlines are charging for suitcases, coffee, water. And going broke. Air travel is perhaps the poster child for what the End of Oil will mean. Not the end of travel; the rich and politically prominent will still travel, but the rest of us will slowly lapse into a 15th century parochialism, seldom traveling more than 25 miles from home.

Third Degree: Researchers say that examination of 30 billion 'instant messages' sent during July 2006 showed that we are all Kevin Bacon. Results of NSA's examination of the same 30 billion messages have not been released.

Some Assembly Required reflects my somewhat cynical view of the world on a daily basis. Think of it as having coffee with a curmudgeon. Come visit.

WSJ.Com: Was Cramer Right?

If anyone needs any any evidence that the Wall Street Journal is a mere prenteder in comparison to Pearson's Financial Times, they need look no farther than Dancing The Freakout - Was Jim Cramer Right?. Of course one piece doesn't make a newspaper, but attributing early call of The Arrival of The Big One to Mr Cramer - a mere housetop weatherwane - albeit a Tourette's-affected one - is absurd, though perhaps not an unexpected one for The Journal.

The primary difference begins with both media organizations obviously need to serve their respective audiences. The quality of the output initially reflects this. But why should the FT feel compelled to constantly scratch under the skin of capitalism (and prevailing politics) whilst the WSJ cheerleads, rarely ruffles feathers, and maintains the narrowest (and most dogmatic) of political lines - the former evidenced again in this piece by asking the most fatuous of questions, rather entertaining pre-emptive thoughts about how "the market" might be wrong?

I believe that it is a function of "class", eschewed as the term may be in America, and most American analyses. For in Britain, the City readers of the FT knew their class inherently. Mobility was poor, and along with one's class, one's political interests were implicitly understood. And so a far more factual, unintermediated approach evolved, with opinion segregated and flagged. The readers of the Wall St. Journal being aspirational, were far amorphous and without solid class affiliations and attendant interests, far more politically malleable. And so the Journal editors took it upon themselves to shape and mold the opinion of numerous fence-sitters into the dubious but doctrinaire fold of the inviolable primacy of the free market, with all its political baggage. In perfect markets, this may be tolerable, but in a modernity where business interests have captured the flag, investment in rent-seeking is often more attractive than capital investment, oligopoly's are rife, the potential for the mouthpiece of the market to morph into something not dissimilar from Radio Pyangyang is a clear and present danger.

It is precisely the FTs confidence that gives it the freedom to critical analyse anything and everything pursue systemic faults objectively. For despite their role as protaganist for capitalism, there are no sacred cows that threaten their, and their reader's position. It is understood implicitly that ironing out the kinks in the market and the system, however inimical to one special interest or another enhances the their positions. It is this same confidence that allows it to comfortably inject collegiate humour, satire and parody - as seen in Lex, or FT Alphaville - something completely absent from the strident, over-earnest, near-paranoid dogmatism one witnesses in the Journal.

So one year on, asking whether Cramer is "Da' Man" for his syphilitic rant really misses the point, which should be: Where was he (and this refers to all Cramers and their mindless ilk) during the prior four years? Why wasn't he ranting about the sheer stupidity of Americans withdrawing equity from their homes en masse at increasingly inflated prices? Why, pray tell was he not doing angry cartwheels in regards to the PBoCs absurd accumulation of USD reserves to prevent a classical BW correction of the USD relative to the RMB? Why was he not flagging the Bush tax cuts and lack of US energy policy as massively shortsighted endeavors with imminent and meaningful negative consequences for the entire nation (and perhaps the financial system of the entire world)?? Where was the outcry when AGs fed sat at nearZIRP, woefully behind the curve? And one can go on, but I've already beaten it to death.

There is a reason I eschew The Journal except when I am stranded without my own material and find a copy laying about upon the airline seat next me, which is rarely if ever...

Antidote du Jour 8/3/08