Economic Dreams - Economic Nightmares

Soros: Financial Crisis Stems from Super Bubble

Like me, George Soros is no believer in "equilibrium economics". Rather he believes that sometimes we will see an equilibrium, but that it will be short-lived. Like Hyman Minsky, Soros argues that stability will itself sow the seeds of the next instability. Soros says we are in a unique place with our current crisis, experiencing both inflation and a recession at the same time. Hear/read more from Soros on today's NPR Morning Edition, Financial Crisis Stems from Super Bubble:

… Soros blames what he calls a "super-bubble" that started about 25 years ago. That's when a less-is-more philosophy became popular with economic regulators. That allowed Wall Street to invest increasing amounts of money in credit.

"The idea was that regulators always make mistakes, state interference in the markets just messes things up," Soros says. "And that was a false idea .... Regulators are human and bound to make mistakes, but markets are also human and they are also bound to make mistakes. Instead of markets always being right, they're actually always groping at trying to find out what the facts are. But they never get it right." …

Soros says there's a "super-bubble" in the economy that's bigger than just the recent housing crises, and he blames exotic financial instruments for helping cause it.

"The markets have introduced financial instruments with fancy names — CDOs and CLOs and all these strange instruments that are traded in very large volumes. And they were all constructed on the belief deviations are random.

Soros also has a new book out. Here is a snip from the introducion:

A New Paradigm for Financial Markets, Introduction, George Soros: We are in the midst of the worst financial crisis since the 1930s. In some ways it resembles other crises that have occurred in the last twenty-five years, but there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process; the current crisis is the culmination of a super-boom that has lasted for more than twenty-five years.

To understand what is going on we need a new paradigm. The currently prevailing paradigm, namely that financial markets tend towards equilibrium, is both false and misleading; our current troubles can be largely attributed to the fact that the international financial system has been developed on the basis of that paradigm.

The new paradigm I am proposing is not confined to the financial markets. It deals with the relationship between thinking and reality, and it claims that misconceptions and misinterpretations play a major role in shaping the course of history. …

Let me explain briefly how the theory of reflexivity applies to the [current] crisis. Contrary to classical economic theory, which assumes perfect knowledge, neither market participants nor the monetary and fiscal authorities can base their decisions purely on knowledge. Their misjudgments and misconceptions affect market prices, and, more importantly, market prices affect the so-called fundamentals that they are supposed to reflect. Market prices do not deviate from a theoretical equilibrium in a random manner, as the current paradigm holds. Participants' and regulators' views never correspond to the actual state of affairs; that is to say, markets never reach the equilibrium postulated by economic theory. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner. There has been a bubble in the U.S. housing market, but the current crisis is not merely the bursting of the housing bubble. It is bigger than the periodic financial crises we have experienced in our lifetime. All those crises are part of what I call a super-bubble—a long-term reflexive process which has evolved over the last twenty-five years or so. It consists of a prevailing trend, credit expansion, and a prevailing misconception, market fundamentalism (aka laissez-faire in the nineteenth century), which holds that markets should be given free rein. The previous crises served as successful tests which reinforced the prevailing trend and the prevailing misconception. The current crisis constitutes the turning point when both the trend and the misconception have become unsustainable. …

NPR Does Subprime

If you want a very good lay person's edition of the Credit Bubble mess, listen to NPR's Global Pool of Money Got Too Hungry (audio, 13 min., All Things Considered, May 9): "Adam Davidson and This American Life's Alex Blumberg jointly report on how rising defaults on subprime mortgages in the U.S. have became a global financial crisis. This American Life host Ira Glass talks with Michele Noris".

NPR demystifies SEVs, CDOs, MBSs, "Liar Loans," and more. The narrative concludes: "… Nobody really questioned things. And why should they? Everybody was making money — right up to the day the bottom fell out."

An hour-long version — The Giant Pool of Money — airs this weekend on This American Life.

Grizzly Times, Yet Some Hope on Horizon

Grizzly Bears roam the financial landscape: Doug Noland and Michael Shedlock here (or here) are ever-bearish, but so is Barry Ritholtz (Forbes video link). The "D" word is uttered ever-more-frequently. Yet I find myself thinking that just beyond this likely deep recession we are at the leading edge of a reformation: re-forming financial institutions—private and government—and bringing US and other banking "kicking and screaming" into the 21st Century.

In this I share hopes with Brad DeLong, Paul McCulley, Robert Shiller, and George Soros (or better still watch Soros: via the Financial Times in extended post). No one who is awake believes we will escape our current moment without at minimum a deep, prolonged recession. But some observers, like those just mentioned are less cynical than are they who believe that we are predestined to once-again repeat the tragedies of the recent past and earlier times—in particular to continue to reward speculative excess.

As per reform, Thursday's Senate Oversight hearings on the Bear Stearns mess (C-Span video link)) is almost 5 hrs. long, but worth watching to better understand where Ben Bernanke (Fed), Timothy Geithner ( NY Fed), Christopher Cox (SEC), and Robert Steel (Treasury) stand regarding hoped-for reregulation. (I recommend first panel: 3 hr. 40 min.)

It is by no means certain that we will indeed reregulate our system to once-again disallow the worst excesses of extended bouts of irrational exuberance and the irrational pessimism that must follow. But wu might. We must! I've hoped for reforms too often in the past and been disappointed, but signs of hope are on the horizon at a time when moderates are beginning to take the reins of power in the US Congress away from borrow-and-spend neoCons on the far right and traditional tax-and-spend Democrats on the far left.

Let's not be eager to blame the Federal Reserve, the Treasury, and the SEC for this mess. NeoCons and "free market fundamentalism" are better targets for blame. And let's not forget that there was good reason for bringing the Federal Reserve system into being long ago—to curb the excesses of "boom and bust" cycles. The system worked reasonably well after the late 20s, early 30s debacle to disallow Hyman Minsky’s PONZI FINANCE moments. That is, it worked well until the so-called "Republican Revolution" dismantled regulatory functions of government here in the US.

I’m not naïve enough to believe that we could have weathered the storms brought about by recent financial and technological innovations without some pain, but the real tragedy I see is that "we the people" of the USA haven't yet figured out that we need good government to accompany good markets—and that neither can work effectively in isolation or without continued vigilance and oversight from citizens and the press (now fortified with internet commentary).

Government agencies and institutions must begin to wake up to realities that W. Edwards Deming, Peter Drucker, and many newer management writers have helped the best of our private-sector entities understand—that innovation and quality reform must be institutionalized into the fabric of agencies and institutions, to be ongoing and ever-vigilant of changes in external environment that must be incorporated into internal corporate and government cultures. Let's hope wider government reform begins with the Fed, the SEC, and the Treasury.

Doug Noland: 'Breakdown of Wall Street Alchemy'

In his latest Credit Bubble Bulletin, Doug Noland concludes that "GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. … Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks. "

Although Noland's assessments continue to be bleak, I find them to be more 'on the mark' week-on-week than any other source I go to. Maybe I'm just hearing what I confirms my preconceived biases. Or maybe not? More from Noland (emphasis added):

The Breakdown of Wall Street Alchemy, Doug Noland, Feb 15: This week provided further confirmation of ongoing momentous Credit market developments. … Like the asset-backed commercial paper market that was popular with structured investment vehicles until last summer, auction-rate securities, a form of rolling short-term funding for long-term municipal commitments, have become fashionable in recent years."

"Auction-rate securities" has joined the beleaguered ranks of "subprime," "asset-backed commercial paper," "SIVs," and the "monolines" — financial structures that flourished during the prolonged Credit Bubble but no longer pass market muster in today's Post-Bubble Risk Revulsion Backdrop. This week's "unwinding" of the "auction-rate" market and the blowing out of Credit spreads should be seen as an escalation of the ongoing unwind of "Contemporary finance" and its many avenues of Risk Intermediation.

On numerous fronts, the markets and economy confront a Highly Problematic Breakdown in "Wall Street Alchemy" — the disintegration of key processes that had for some time transformed ever-increasing quantities of risky loans into perceived safe and liquid debt instruments that enjoyed insatiable demand in the marketplace. In the case of the “auction-rate securities,” it was a clever restyling of long-term and generally illiquid municipal debt (as well as student loans and other borrowings) into perceived liquid securities that could be easily sold at regularly recurring auctions (every one to a few weeks). With scores of flush corporate treasury departments and wealthy clients (managing huge Credit Bubble-induced cash-flows) keen to earn extra (after-tax) yield on "cash equivalents," the Wall Street firms had been diligent in ensuring (making markets for clients, when necessary) a highly liquid and enticing marketplace. Now, with the onset of Risk Revulsion and Acute Financial Sector Balance Sheet Pressures, investors are running for cover and Wall Street firms are shunning the use of their own capital to support this and other markets. Market liquidity has evaporated, confidence has been shattered, and we are witnessing yet another "run" on a previously popular risk market/asset class. The music has stopped for another game of musical chairs.

This week saw heightened systemic stress stampede toward the epicenter of the U.S. Credit system. It certainly didn't help that insurance behemoth AIG Group reported an almost $5bn writedown of its Credit default swap portfolio or that international securities dealer behemoth UBS reported massive losses on its U.S. Credit positions. Confidence was further shaken by huge losses reported by mortgage insurers, as well the twists and turns of the "monoline" bust turned apparent bailout. In the markets, various indices of investment grade Credits widened sharply to record levels. The key "dollar swap" (interest-rate derivative hedging) market saw spreads widen sharply. Agency spreads also widened significantly. Benchmark Fannie Mae MBS spreads widened a remarkable 20 bps against 10-year Treasuries, while agency debt spreads widened a noteworthy 12.5 basis points to 69.5 bps (high since November). The Breakdown of Wall Street Alchemy is now pushing the Credit Market Dislocation uncomfortably close to the core of our monetary system.

I'll return to financial aspects of this crisis, but I definitely feel the economic ramifications of the unfolding Credit Crisis are receiving short shrift in the media. This week saw parts of the municipal debt market grind to a virtual halt and the corporate debt market take another significant blow. Investment grade debt issuance has now slowed markedly after beginning the year at near record pace. At this point, the junk, CDO, ABS, "private-label" MBS, muni, and even investment grade debt markets are all somewhere between impaired, dislocated and completely dysfunctional. There is no mystery behind the recent string of abysmal economic reports.

The preliminary reading on February University of Michigan Consumer Confidence dropped 8.8 points to the lowest level since the 1992 recession. The Economic Conditions index sank and the Economic Outlook index plunged, while one-year Inflation Expectations rose from 3.4% to 3.7%. The Economic Outlook has sunk a remarkable 22 points since July. Falling national home prices are clearly wearing on confidence. This week, Dataquick reported that home sales throughout much of California have collapsed to more than 20-year lows, while home price declines accelerate. This is a huge unfolding issue/debacle for the MBS, agency, mortgage insurance, CDO, and Credit derivatives markets, not to mention the U.S. banking system and real economy. Countrywide Financial reported delinquencies on its $1.5 TN mortgage servicing portfolio had jumped to 7.47%, up from the year ago 4.32%. The New York "Empire" Manufacturing index sank to the lowest levels since April 2003.

The economy is now faltering badly and there is every reason to expect the downturn to gather pace — negative real interest rates compliments of the Fed and stimulus package compliments of the federal government notwithstanding. While fourth quarter data is not yet available, one can look to the first nine months of 2007 to gain important perspective. Despite the dislocation in the subprime mortgage market, Non-Financial Debt Growth accelerated from Q2's 7.2% to Q3's 8.9% (from the Fed’s Z.1 report). And while Household Debt Growth had slowed to a 6.9% pace, Business Borrowings accelerated to a blistering 11.9% annualized rate in the third quarter. This was the strongest corporate debt growth since the tech/telecom boom in the late nineties. Importantly, total (financial and non-financial) Corporate Debt expanded at an 11.1% rate during the first three quarters of 2007, followed by 9.3% growth in State & Local government borrowings. And while residential mortgage debt was slowing meaningfully, Commercial Mortgage Debt was expanding at an almost 13% rate.

Total (financial and non-financial) Credit expanded a seasonally-adjusted and annualized record $5.0 TN during the third quarter — as nominal GDP expanded at a 6% pace. While many trumpeted the "resiliency" of the U.S. economy in the face of mortgage and housing woes — more adept analysis would have focused on the massive Credit creation that had come to be required to sustain the Bubble Economy. Importantly, the faltering subprime market initially instigated only greater excesses throughout commercial real estate, municipal finance, M&A finance, and corporate lending more generally. The Credit Bubble was sustained at the great cost of heightened instability and weakened structures — especially throughout leveraged lending, state & local finance, and investment-grade corporate borrowings. Keep in mind that through the third quarter CDO issuance was actually running ahead of 2006's record pace. Until the fourth quarter, record Credit growth continued to fuel the finance-driven economy. This is all now coming home to roost.

Today, with bursting bubbles in corporate and municipal finance joining the mortgage bust, the U.S. Bubble economy has quickly fallen desperately short of sufficient Credit and liquidity. And the greater the Credit market dislocation and broad-based tightness of Credit, the bleaker become economic prospects and the more intense the Revulsion to Wall Street's Credit instruments. The days of free-flowing cheap finance for home buyers, state and local governments, LBO firms, commercial real estate speculators, college students, risky auto buyers, and high-risk Credit card holders are over — and they will not be returning for some time to come.

When I have previously underestimated the "resiliency" of the U.S. Credit Bubble and economy, it was in each instance a failure to appreciate the capability of Wall Street finance to expand to ever greater degrees of Bubble excess. Today, with "contemporary finance" mired in a historic collapse, I am confident that the Credit system is today only in a position to surprise on the downside. It is this framework that shapes my view of a rapidly escalating Credit crisis feeding an arduous economic adjustment period.

And while it could undoubtedly prod a highly speculative stock market, there is no resolution to the "monoline" dilemma that would meaningfully influence the trajectory of the unfolding Credit and economic bust. As we've been saying for awhile now, confidence in Wall Street finance has been irreparably shattered. Trust has been broken in "AAA" ratings, "mark-to-model," CDO structures, myriad risk models, Credit insurance, counter-party risk, and various instruments and vehicles for intermediating risk in the markets. Moreover, old fashioned lending will not come close to sufficing the demands of a highly imbalanced Bubble economy, especially with bankers nervous and retrenching. Again, we're witnessing nothing less than the Breakdown of Wall Street Alchemy — one that took a turn for the worst this week.

In a disconcerting development, recent market developments seem to confirm that the leveraged speculating community and the GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. Along with the "monolines" and mortgage insurers, the "Credit default swap market" and GSE mortgage Risk Intermediation were at the epicenter of the most egregious Systemic Risk Distortions and Accumulations. They are now quickly moving to the forefront of Current Acute Fragilities. Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks.

Bill Gross: Mr. Bernanke - we have a problem

Bill Gross's Feb 1 Investment Outlook is worth a look. Echoing Paul Krugman, Gross suggests that we now need some deep Keynesian stimulus, not the 'Stimulus Lite' fare being bandied about by the Bush Administration and the Congress. Implicitly, but without any real plan to make it happen, Gross also suggests we need to return to earlier fundamentals of honesty and thrift, abandoning the 'quick fix' mentality that has at once encouraged speculation and outright financial fraud and buried the American middle classes under mountains of debt. Soundbite: "[T]he U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade." Here's more:

Bill Gross, Better Late than Never, Feb 1: … Paul Krugman, …, proposing revolutionary solutions for the Japanese recessionary malaise of the 1990s and writing a book in 1998 entitled The Return of Depression Economics … referred to the fact that the crucial task of future policy would be to bolster demand as was the case in the FDR-driven 1930s as opposed to encourage supply which has been the case since the Reagan revolution. Although Krugman doesn't comment, in my opinion, it's not that Reagan was wrong — he was in fact brilliantly correct and timely in his supply-side revolution.

Iverson aside: I can't go along with Gross here. I find the very idea that Reagan "was brilliantly correct" repulsive. I believe that Reagan helped to mislead the US, and helped jump-start a 30+ year-long "irrational exuberance" party that is now unwinding badly. Back to Gross:

That pendulum, however, appears to have swung too far in the direction of the private market. But Krugman (and yours truly) was a tad early in his forecast for reversal I think, because of the failure to recognize the potency and the inventiveness of modern finance.

Until recently, U.S. and therefore global demand has been driven by the ability to lower interest rates and extend credit to an increasing majority of Americans. Mortgages, auto finance, and credit cards were offered on increasingly liberal terms and continually lower yield and risk spreads because of Wall Street ingenuity and — importantly — the naïve endorsement of their black magic by rating services willing to sell AAAs for a fee. … Demand, as Krugman would likely retrospectively recognize, was bolstered and supported by innovative, securitized finance which in turn was nurtured by lax regulation and a belief that things could not go wrong — and if they did — that policy makers, both monetarily and fiscally oriented, would make things right. The repair, if needed, was labeled the "Keynesian compact" and it made for a deal with the American public: it would be OK to have free markets because policymakers know enough to prevent another Great Depression. Demand could always be stimulated with a combination of easy money/budget deficits. Prosperity in effect, was guaranteed.

Well "probably" guaranteed — but the historic growth rate of that prosperity may now be threatened. Because demand in the form of consumption has been artificially and fictitiously stimulated in recent years by financial engineering run amuck, there is a legitimate question as to whether its black hole imploding destructiveness can be totally countered with another dose of lower yields and deficit spending packages. The $150 billion "return to sender" deficit plan advanced by Bush and the Congress, for instance, amounts to just 1% of GDP and is labeled temporary. It will be of marginal benefit to long-term prosperity. To understand why, consider that the productivity of our economy ultimately depends on its ability to 1) innovate, and 2) save and invest, and that there is little of either in this stimulus package. Some have even suggested — and with my somewhat grudging concession — that this package will help the Chinese economy more than ours. Americans will use the rebates to buy Chinese imports offered at Wal-Mart and the $150 billion will then wind its way inevitably back to Asian coffers. The U.S. needs a Krugman "demand-based" fiscal package alright, but a $300-$500 billion permanent one, in addition to the proposed temporary package, because as mentioned in last month's Outlook [Pyramids Crumbling], as the system of modern day levered shadow finance slows to a crawl or even contracts at the edges, its ability to systemically fertilize economic growth must be called into question. But government writing checks for American consumers which then flow to foreign central banks is not the permanent solution; it only makes sense in the short-term as a life preserver. To provide a stable recovery path, government spending needs to fill the gap — not consumption. Public works programs, badly needed infrastructure repairs, as well as spending on research and development projects should form the heart of our path to recovery. Assistance for homeowners? That too — figure out a fiscal/regulatory way to stop the slide in housing prices and foreclosures but please — no traffic jams at the Wal-Mart checkout counter in 2009 and beyond.

Approaches to monetary policy must change as well. 1% short rates were so effective 5 years ago that they not only bolstered demand but created a housing bubble of Frankensteinian proportions. Those days, however were influenced by the creation and implementation of adjustable-rate mortgages (ARMs) that were priced at the short end of the yield curve. Millions of ARMs were issued at 2% and 3% teaser rates, many with terms of up to 5 years before their inexorable adjustment upwards. Surfeits of houses were bought at artificial prices because of these generous terms and billions in home equity loans were taken out — both driving demand and the economy forward. But adjustable-rate mortgages are a dying relic. Originators will no longer offer them except on onerous terms. No more teasers or pleasers of that ilk; there are regulators to deal with, and lawyers on the prowl with class action lawsuits in their briefcases.

And so the monetary attempt to halt housing's — and therefore the economy's — downward slide rests on the shoulders of the 30-year mortgage. If so, then Mr. Bernanke — we have a problem. First of all these 6-7% 30-year mortgages now require a significantly higher down payment than in prior years. 20% down? Say what? Where does a 30-year-old couple get that kind of money? Secondly, however, and just as important, what motivates a future homeowner to pay 6%+ interest for an asset that is going down in price? It was an easy decision to pay subprime yields of that and then some when housing prices were accelerating at double-digit annual percentages; the benefit was obvious. Now however, with prices in negative territory, the risk/reward is tilted towards the renter.

My point is that Chairman Bernanke must recognize the reduced benefits and obvious dangers of a déjà vu trek to 1% short rates. Those yields produced 5% 30-year mortgage rates to the homeowner for a 2-3 month period in 2003 and they could do so again, but bubble creating, inflation inducing damage to the U.S. dollar would be the likely result now. Best to stop far short of 1% and at the same time encourage reforms in FHA government assisted programs that would permit subsidized mortgage rates with minimal down payments.

An artificially low, 1% short-term interest rate was an elixir during the days of a burgeoning shadow banking system. It cannot be the solution now.

In combination, a well constructed, more than temporary fiscal/monetary stimulus plan is what is required to rejuvenate a U.S. economy reeling from a low punch delivered by a private market economy gone too far. Its "Rosemary's Baby" took the form of a shadow banking system based on leverage and the fateful conclusion that a finance-based economy alone can deliver prosperity. It cannot. As Keynes theorized and then Krugman affirmed, when private demand falters, it becomes the responsibility of government to fill the breach. Because it likely will not do so effectively until after a new Administration is elected in late 2008, the U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade. Better late than never.

Deconstructing 'Recession 2008?'

I spent an hour yesterday listening to three economists (Brad DeLong, Mike Mandel, and William Beach) discuss our current plight. I found their insights compelling. Areas of agreement, included:

• Don't look to the US Government for effective Fiscal Policy Help — particularly in an election year
• Don't look to the Fed to ease much pain since they are pretty much helpless in the face of a faltering US housing market (See Krugman too)
• Best we can do is to see both borrowers and lenders share the pain, with some pain (how much?) shared by the rest of us

The forum was hosted by Dave Iverson (a different, more erudite Dave Iverson) and aired on KQED, NPR, San Francisco. It's well worth an hour of your time, if only to get better acquainted with Brad DeLong's longer-than-a-post reflections (but skip the questions and answers). From Delong's Grasping Reality…

KQED | Forum: Recession 2008? [Jan. 11]

http://www.kqed.org/.stream/anon/radio/forum/2008/01/2008-01-11a-forum.mp3

Host: Dave Iverson

Guests:

• Brad DeLong, professor of economics at UC Berkeley
• Mike Mandel, chief economist for BusinessWeek
• William Beach, senior economist and director at the Center for Data Analysis at the Heritage Foundation

Thanksgiving Cheer: HERE'S ROUBINI!

With the stock markets increasingly jittery, and just in time for Thanksgiving, I can't resist leaving a little ray of sunshine BAG OF GLOOM at your doorstep: via FT Alphaville, Stand by for "generalized systemic financial meltdown", Helen Thomas, Nov 21 or straight to the source, HERE'S ROUBINI …

Nouriel Roubini, Nov 16: … I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks (with the latter at even more severe risk as the recent effective bailout of the formers’ losses by theirs sponsoring banks is not available to those not being backed by banks); ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe known-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate and related CMBS; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed's lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized. …

As differentiated a wee bit by Yves Smith:

Naked Capitalism, Nov 17: … I agree with Roubini that there is the very real possibility of a financial horrorshow, However, I differ with him on some of the particulars. We are not going to see bank runs. We didn't have them in the late 1980s where S&Ls were actually failing and Citi nearly went under. However, we are already seeing institutional money getting very costly for Citi, and their tsuris have only begun. And we are seeing more examples of Citi-type behavior, where banks have what effectively were contingent liabilities (think, for example, of the guarantees and/or cash injections to keep affiliated money market funds from breaking the buck). These funding or liability demands are coming at precisely the time when bank equity is under strain, due to the need to increase loss reserves and writedowns. Look, for example, at asset backed commercial paper. The Financial Times reported today that banks have shown substantial balance sheet growth of late. But it isn't net new lending; it's credit commitments or actual drawdown related to ABCP.

I expect Citi to be in serious trouble in 6 to 12 months, and that specter will increase risk premia for many banks, and could push others towards the edge. So I anticipate a lot of near-failures, some gunshot marriages, and possibly even real bank collapses, but the mechanism will not be a run by retail depositors.

But I expect to see more serious damage among the "large complex financial institutions" of which Citi is one. There are 16 behemoths that have been deemed by the Bank of England as especially important to global credit intermediation. One is already in the process of taking a body blow. If we see damage to any others, it will lead to a contraction in the credit markets, both directly (shrinkage of their balance sheets) and indirectly (shrinkage of everyone else's balance sheets due to new found conservatism and sharply higher borrowing costs). The securitization market, absent government agency paper, is not functioning very well right now. It will really start laboring if conditions on Wall Street continue to deteriorate.

And if securitization looks less attractive because investors are far more stringent (and maybe no longer believe ratings) and Wall Street looks to have lost a couple of cylinders, then the banks need to step into the breech. Ah, but will they? Banks for the most part are no longer in the habit of keeping a lot of their own loans on their balance sheet. …

Robert Kuttner's Parallels to 1920s, and some differences

Below find some of Robert Kuttner's very good, very harsh Oct 2 testimony to the US House of Representatives Committee on Financial Services. In addition to rehashing historical parallels between the era and the 20s euphoria and bubble bust, he talks to more-recent-era deregulation and letting the "free market" good times roll, and, of course, the bubbles that came as a byproduct. Here's a news story from Quote.com covering the hearing. And here are the other testimonies and a webcast of the hearing.

Kuttner's four parallels between this era and the one that led to the 1929 crash are:

• Creation of asset bubbles
• Securitization of credit
• Excessive use of leverage
• Failure of regulation to keep up with financial innovation
• The nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way

Kuttner's arguments are not unlike those made by some others over the last few years, that we've tried to chronicle here. It is nice to know, or to at least believe, that more people are listening now. To Kuttner:

Greenspan Still Doesn't Get It: Who does?

I was going to just lay out the guts of Doug Noland's latest, continued rant about the impending blow off of our giant "Credit Bubble". But then I wandered over to Jim Kunstler's place and found that his continued rant about our "Long Emergency" deals with Greenspan's reemergence as well. Kunstler's version is more fun, darkly, so we'll air it first (be sure to go to the source, 'cause I left out some of the funniest parts):

Shocked! Shocked! Jim Kunstler, Sept 17: Alan Greenspan's memoirs are being flogged across the airwaves, bandwidths and printing presses, and the cohort of those who comment on public affairs in these media are shocked by the Maestro's confessions -- first, that a housing bubble emerged out of his leadership in the banking sector, and second that the Iraq war is about oil. As usual, they're getting it all wrong -- about as wrong as Al himself got it. But that is the way of things in this age of cultural dissipation and gross cognitive dissonance.

Greenspan claims he had no idea that his cutting of interest rates to near zero would produce any irregularities in the US economy. Apparently he hadn't noticed that the Big Fund Boyz called him "Easy Al" for a reason. Or that when you introduce nearly free "money" (as in "available for lending") into a system of financial trade, the recognition of moral hazard tends to evaporate. As the nation's chief bank regulator, Greenspan also apparently failed to notice the upsurge in dodgy lending practices previously only seen among mafia loan sharks, drug dealers, or twelve-year-olds playing Monopoly.

But the really funny part of all this is that the media columnists are acting as though the American public got hoodwinked by Al. Which raises the question: just what the fuck was the public thinking when they bought half-million dollar houses on salaries under 60-K, taking out no-money-down, interest-optional balloon mortgages and other tricked-up contracts? The answer is: they walked into these arrangements with their eyes open because they thought they could get something for nothing. They thought the trend of steeply rising house prices would continue indefinitely and enable them to wiggle free of any hazard by flipping their houses to an endless supply of greater fools who would be there waiting to turn the very same trick. And the smoothies downstream in the mortgage and banking rackets were no less guided by avarice when they cooked up their formulas for bundling half-baked mortgages into tranches of tradeable securities. Easy Al may have failed to notice what was going on here, but then so did everybody else from The Wall Street Journal to the Securities and Exchange Commission.

This, of course, represents an insidious psychology. It could only happen in a culture that has come off the rails mentally, so to speak, as ours has in the sense that nobody has any sense of consequence, neither the leaders nor those who affect to follow the leaders. The leading religion in America is not evangelical Christianity, it is the worship of unearned riches, and its golden rule is the belief that is is possible to get something for nothing. Its holy shrines are Las Vegas and Wall Street. …

No, the American public, including the cheerleaders in the media, have only themselves to blame for the bitter harvest now underway in the asset and credit markets. And thus it would be salutary thing for Baby Jeezus, or the forces of nature, or whatever powers guide the universe, to now kick the shit out of them, so to speak, financially, because that is exactly what the American public is full of, from top to bottom….

Now, as to the shock of Al's revelation that the Iraq war is about oil -- the media and the public has got this all wrong, too. The logic here seems to be that because the Iraq war is about oil it is therefore unnecessary, optional, a mistake, an indulgence, something we should not dirty our hands in. In fact, the Iraq war is not about oil, per se, so much as it is about America's behavior here at home, about the choices we make for how we live on this continent. None of those who complain most loudly about our military presence in Iraq have advanced any proposals for reforming how we live here -- and hence for our enslavement to oil, much of the world's remaining supply of which happens to be in the neighborhood of Iraq. When these complainers start complaining about the ubiquitous acceptance of suburban sprawl and abject car-dependency -- and this includes the environmental boy scouts out there who want to get merit badges for buying hybrid cars -- then they will deserve to be taken seriously. Until then, the American people have got exactly the grinding war that they deserve. Let them whine about it all the way to the Nascar tracks, and let them console themselves with giant plastic bottles of Pepsi Cola and buckets of chicken raised on corn grown with oil byproducts.

On CBS's "60-Minutes" show last night, Greenspan, in his new role as a private sector economic consultant made predictions for the coming months in the US economy. He declared that the financial sector would get over the current credit squeeze as if it were a mild case of indigestion…. This gets back to the previous point about the Iraq war and oil in particular. Al doesn't get it. CBS's sycophant reporters don't get it. Nobody gets it. We are entering the zone of the long emergency in which the primary resource needed to run the industrial economies will become scarce, expensive, and profoundly destabilizing to markets and to normal life, such as it is known in this country. And the current problem in the markets is a reflection of the resource bankruptcy we are facing. Our problems are not about credit, they are about permanent insolvency. …

"Didn't Really Get It", Doug Noland, Sept. 14: I found it ironic that during the same week Alan Greenspan admitted he "Didn't Really Get It" when it came to the risks associated with subprime lending, Chairman Bernanke publicly reiterated and expanded his "global savings glut" thesis. …

Mr. Greenspan now admits that he didn’t really "Get It" until late 2005, while Dr. Bernanke's intellectual focus at the time was explaining how mounting U.S. Current Account Deficits were a phenomenon of global savings and investment dynamics. Both were more than intellectually content to sit back and marvel at U.S. economic "productivity" and the capacity of contemporary finance to Inflate Credit. Both also worked diligently to construct a framework rationalizing why the Fed needn't pierce Bubbles nor even go so far as administering a little "tough love". Both are curiously oblivious — at least publicly — to the notion of Pernicious Credit and Speculative Excess.

There is no reasonable excuse for our central bankers' failure to recognize and then move to check intensifying Mortgage Credit Bubble dynamics by 2004 — at the latest. It was (and remains) similarly inexcusable to disregard the U.S. Credit system's prominent role in financing rapidly escalating Current Account Deficits and resultant worsening global imbalances. …

The "global liquidity glut" has fomented myriad Bubbles — and the reality that seemingly all of the global ones remain very much in force empowers Chairman Bernanke to stick steadfastly to his "savings glut" theorizing. Yet "saving" doesn't fuel Bubbles — excessive borrowings do. …

Conventional thinking has it that the world economic backdrop, outside of U.S. subprime and housing woes, is vibrant and sound. This favorable backdrop, it is believed, explains global equities markets resiliency in the face of mounting U.S. and global Credit woes. [Alternatively,] the Global Credit Bubble and "Liquidity Glut" perspective takes a quite negative view of the current global backdrop. Bubbles proliferate.

Admittedly, most global Bubbles have been impervious to the Bursting U.S. Credit Bubble. China is a case in point. Yet there are important unappreciated dynamics to contemplate. First, domestic Credit Bubble Dynamics have become well entrenched around the world, especially with U.S. dollar impairment working to decisively limit the risk of currency runs in, say, China, Russia, Brazil, India, Asia and "developing" economies in general. The weak dollar and unrelenting U.S. liquidity outflows (C.A. Deficits and speculative flows) have nurtured quite atypical stability for a group of currencies that would otherwise suffer the acute vulnerability incident to overheated domestic Credit systems, asset markets, and economies.

[T]oday's backdrop would be altogether different had it not been for aggressive and concerted central bank intervention. Huge liquidity injections — and, as important, assurances from Chairman Bernanke to use "all of the tools at his disposal" — kept the U.S. and much of the global securities markets from seizing up. As it was, the extent of Acute Financial Fragility was perceived to require an immediate and bold marketplace onslaught that, ironically, worked to underpin most global Bubbles. Certainly, not much froth was allowed to come out of global equities. No froth has been removed from global inflationary pressures. Lower global yields are destabilizing and portend only greater Global Monetary Disorder.

It is the view of the Bernanke Fed (as it would have been of Greenspan) that a U.S. recession can and should be avoided. This is flawed and dangerous ideology. It is the market's view that the Fed will lower interest rates to whatever level necessary to sustain the U.S. expansion. This is wishful thinking. Recent history has spoiled both the Fed and the markets. Today, recession cannot be avoided, and the weak dollar and robust global inflationary backdrop will limit the Fed's flexibility.

As for our economy, there will be no escaping the harsh consequences associated with the bursting of a historic Mortgage Finance Bubble. Our Bubble Economy has been left severely imbalanced and acutely vulnerable, and it is simply impossible to avoid major disruptions associated with an abrupt curtailment of mortgage finance. California will be the poster child for this unfolding dynamic, although it will play out throughout the country. I'll reiterate my expectation that upper-end real estate — too frequently Bubbles financed by ARM, Alt-A, teaser rate, reset and interest-only mortgages — will prove greatly more problematic than subprime. Commercial real estate will be anything but immune. We have only begun to experience upheaval from the mortgage bust, dynamics that will follow a similar path to the burst technology Bubble — except the wreckage will be significantly more widespread and economic impact broad-based.

Unprecedented central bank interventions and, here at home, six-week Bank Credit growth to the tune of $220bn have sustained financial system liquidity. I question the sustainability of both. Especially with this week's apparent loosening of Credit conditions, there are great expectations for an impending revival in the securitization marketplace. The banks and Wall Street are praying. With an eye on California, I fear another ("jumbo") leg down in the ongoing mortgage crisis and an increasingly vulnerable economy. Another eye is planted on the hedge fund community, where I suspect we are only another market dislocation away from serious withdrawals and reinforcing liquidations.

One, if not the greatest, errors in central banking was committed back in 2002 — with Messrs. Greenspan and Bernanke at their respective strict and intellectual helms. They mistakenly reckoned THE bubble had popped. Together they set in motion an aggressive post-Bubble "mopping up" reflation, failing to appreciate that while the tech Bubble had burst THE Credit Bubble was poised for "blow-off" excess.

We are left today with an unbalanced Bubble Economy sustained only by ongoing and enormous Credit creation. Importantly, the Wall Street Risk Intermediation Machine is today gravely impaired, forcing the banking system to Balloon Bank Credit. This works effectively on a short-term basis, yet is an unfolding predicament. Credits to sustain a Bubble Economy are inherently highly risky (think CA mortgages or junk bonds) and it requires huge quantities of them. Bubble economies are replete with negative cash flow entities and others that become increasingly so as finance is curtailed and redirected. Today, the banking system is ill-prepared to play the role of lender of last resort for long. Moreover, the scope of required ongoing Credit inflation ensures dollar vulnerability.

An important aspect of my negative current view is the disconnect between unwavering marketplace confidence in the Fed's capacity to "reliquefy" and "reflate" and the reality of a limited arsenal and atypical lack of Federal Reserve control over unfolding developments. Importantly, Greenspan and Bernanke expended tremendous ammo in a historic reflation fight that, in the end, was a totally wasted cause. They misjudged and enfranchised the most profligate and wasteful Credit expansion in our history, while inciting a potent strain of inflation that now propagates largely outside of our control. They burned a major currency devaluation. A weaker dollar could have been a tool available to help soften today's much needed financial and economic rebalancing. Unfortunately, they used that policy card for a reflation that greatly exacerbated excesses and imbalances at home, while initiating global inflation dynamics much to the detriment of our citizens, economy and currency. We have today much greater financial fragilities, disastrous economic imbalances, and a feeble currency — whether the stock market chooses to discount it now or not.

Fear Makes a Comeback

An old adage says markets are driven and balanced over time by greed and fear. This seems particularly true when markets get into their manic phases. Martin Wolf reminds us that the tide has now shifted from greed to fear, and brings Hyman Minsky to the forefront of our thoughts:

Fear makes a welcome return
by Martin Wolf
Commentary
Financial Times

"At particular times a great deal of stupid people have a great deal of stupid money. . . At intervals. . . the money of these people — the blind capital, as we call it, of the country — is particularly large and craving; it seeks for someone to devour it, and there is a 'plethora'; it finds someone, and there is 'speculation'; it is devoured, and there is 'panic'." Walter
Bagehot.*

Panic follows mania as night follows day. … Ours has been a world of … confidence, cleverness and too much cheap credit. This is not new. It is as old as financial capitalism itself. The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with "displacement", some event that changes people's perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.

The fourth stage is over-trading, when markets depend on a fresh supply of "greater fools". The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry "bubble" are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.

In the latest cycle, displacement began with the huge cuts in interest rates in the early 2000s, which drove up prices in housing. The easy credit was stimulated by innovations that allowed those making the loans to regard their service as somebody else's problem. Then people started to buy dwellings to resell them, not live in them. Subprime lending was a symptom of euphoria. So, in a different way, was the rush of bankers into hedge funds and of the wealthy and big institutions into financing them. Then came profit-taking, falling prices and, last week, true revulsion.

This was what George Magnus of UBS bank calls a "Minsky moment". It was the moment when credit dried up even to sound borrowers. Panic had arrived.

The correct policy response is also well known. … The central bank must save not specific institutions, but the market itself. It must advance money freely, at a penal rate, on good security.

In providing money to the markets last week and this, the … central banks have been doing their jobs. Whether the terms on which they have done this were sufficiently penal is another matter.

Financial markets, and particularly the big players within them, need fear. Without it, they go crazy. Moreover, it is impossible for outsiders to regulate a global financial system riddled with conflicts of interest and dominated by huge derivatives markets, massive trading by highly leveraged hedge funds and reliance on abstruse mathematics and questionable statistical models. These markets must regulate themselves. The only thing likely to persuade them to do so is the certainty that the players will be allowed to go bust. …

The world has witnessed four great bubbles over the past two decades – in Japanese stocks in the late 1980s, in east Asia’s stocks and property in the mid-1990s, in the US (and European) stock markets in the late 1990s and, finally, in the housing markets of much of the advanced world in the 2000s. There has been too much imprudent finance worldwide, with central bankers and ministries of finance providing rescue at virtually every stage.

Unfortunately, there is every chance of repeating mistakes. A bail-out has already occurred in Germany. … More are likely. US legislators want Fannie Mae and Freddie Mac to bail out the mortgage markets.

The pressure on the Federal Reserve to cut interest rates will also grow. … The consequences [of this implosion] cannot be "ring-fenced", as those of LTCM were. Trust in counterparties and financial instruments has fled. The likelihood is a period of recognising losses, tightening credit conditions and deleveraging.

Such a period, desirable in itself, will lead to strong pressure for swift declines in interest rates, at least in the US, and so for another partial bail-out of a crisis-prone system. This pressure should be resisted as long as possible. …

*Cited in Manias, Panics and Crashes: a History of Financial Crises, fifth
edition. Charles P. Kindleberger and Robert Z. Aliber (Basingstoke: Palgrave
Macmillan, 2005)

[Note: This condensed version of Wolf largely borrowed from Mark Thoma, here.]

Andy Xie's perspective is similar. And Xie punctuates his own warning to the Fed, titled "It's time for central bankers to stop bailing out markets", Financial Times, Aug 14 [$] , with:

… If central banks try to bail out Wall Street, it would lead to high inflation for years. The inflationary effect of loose monetary policy of the past was offset by the deflationary effect of globalisation. Now China and other developing countries are experiencing high and rising inflation. Loose money will go straight into inflation. The vicious cycle of the wage-price spiral of the 1970s has not occurred as both labour and capital still believe in the inflation-fighting credibility of the central banks. If they loosen up again to bail out Wall Street, this credibility may be squandered. The ensuing wage-price spiral could ruin the global economy for years to come.

What is occurring is an opportunity for central banks to restore their credibility. Markets have been taking more risk than they should because they believe that central banks will come to their aid during times of crisis, like now. The penchant of Alan Greenspan, former US Federal Reserve chairman, to flood the market with liquidity during financial instability is the genesis of this "central bank put". As long as this expectation remains, financial bubbles will occur again and again. Now is the time to act. Let the crooks go bankrupt. Central banks should bury the Greenspan "put" for good.

So what's it going to be? Will Bernanke heed Xie's warning and attempt to restore faith in 'The Fed'? Or will he unleash the helicopters? Has he already?

I"m still willing to give Bernanke some rope. So far, I believe the Fed and other central bankers have done what they must in the wake of the recent crisis, although I wish they had done some things in advance, say mid-1990s.

If Bernanke moves to lower interest rates anytime soon, and if that indeed fuels fires of speculative frency once-again, then I'll join the ranks of the hounds, biting at the heels of the Fed. But not until/unless.

Housing as an 'Investment': Commentary

I've followed Bailey's comments on various finance blogs for several years. Bailey (who typically posts bailey@anon.com) always has something important to offer. Here is Bailey's comment on 'housing as an investment' from a recent Dave Altig, macroblog post titled In Praise of the Subprime Market:

… [In the wake of the Nasdaq Bubble crash, the Y2K scare, and the 9/11 mess] easy credit flowed to anyone who wanted it, not just those previously excluded from it. I know several people who refi'd, taking out every dime of equity to buy second homes because prices were rising and they were offered ridiculously low teaser rates by their friendly r.e. brokers who swore could be rolled over yearly. This was a money machine and it benefitted more than the poor few who Mr. Goolsbee would like us to be concerned for. …

Another obvious yet unquestioned point is that real U.S. home prices have increased only slightly (.4%) from 1890 - 2004 (Robert Shiller via James Grant). This calls me to question the viability of housing as investment. From 1975 - 1995 real prices increased .5%/yr for a total 10%, yet from '95-2004 they increased more than 40%. In CA home prices tripled from 1997 to 2005. First time buyers can't explain that meteoric rise.

For the new housing-as-investment paradigm to work home prices must continue to rise enough to provide the wealth needed to spur the spending to fund workers' increased income to pay for the mortgages to pay for the increasing price of houses …. Alan Greenspan acknowledged this when he recently chirped-in that all the lending failures we've recently seen would disappear if prices increased just 10%. What happens if we see just a 10% price retracement? Why shouldn't we expect this?

Way beyond these two concerns, my real peeve is how shortsighted this housing-is-investment "scheme" was from the start. CA contributes more than 13% of our GDP. Recent California home price increases probably created a trillion dollars in new wealth, an extraordinary number that's contributed enormously (in the short-term) to our "growing" national economy. But, it's transitory.

At current inflated price levels there are no more buyers on the sidelines to buy, and there are clear signs credit will finally be tougher to get than signing your name. As mortgage rates are repriced over the next three years to reflect repayment risk, way too many of those who've bought won't have the income needed to pay the mortgage. And that's a problem.

Fewer than 15% of ALL CA famililies can afford a median priced home here. Last year almost 40% of CA homes bought were purchased as second homes or investments. I interpret this to mean there are MANY extended in this folly. Young median income couples (whose salaries barely rose during the same period) are now priced out of the housing market in CA and other bubble states. This should be of national interest as these states comprise some 40% of national housing sales). So, what would Mr. Goolsbee like to see us do?

It seems obvious the engineers of our post-stock-bubble paradigm envisioned houses as mini-banks. Like depositors withdrawing large summs of money from banks, only a few homeowners should be expected to sell at any time. So, unless there is a rush to sell there should always be plenty of buyers. Wrong again.

Why didn't they consider the huge number of boomers who have no guaranteed pensions and next to no savings apart from their home equity. Isn't it reasonable to expect they'll line up as they start to see recent profits retrace, especially because of the huge $500,000. Gov't. tax exclusion? What else will they live on? And what will happen to prices when sellers get scared when they see there are so few buyers? And, what effect will the new lower home prices have on mtg. holders who bought since '04? And, what percent of the economy is dependent upon the consumer? And, how many consumers own homes?

For most of the period examined by Girardi, Rosen & Willen, housing prices grew at long-term trend growth rate, not at a skyrocking 40%+ rate much of our country has seen in the last seven years. More importantly, when they did the study we were in the midst of our meteoric prise rise. The new housing-as-investment paradigm had yet to be stress-tested. We're seeing the beginnings of this now with a lot more to come. (The bubble states have yet to enact the CSBS Nontraditional Mortgage Guidelines. And, in California we're still being besieged daily with r.e. lending infomercials offering 100%+ loans to those with "low or no credit".)

There's no question the game's changed, everyone knows this. There's no longer any doubt how this will play out, only the degree of severity. Personally, I'd like to know why so many people who know better signed on to such a short-sighted, poorly-conceived & worse-implemented sham. Dean Baker was screaming loudly way back in 2003. If wealth distribution was the objective, there were many better and more equitable ways. If political pay-off and greed were the motives, we should at the least pause to reflect on our frailties.

It's astonishing thing to me that no one's arguing how the dumbing down of America has affected our receptiveness to sophomoric arguments. Maybe we've moved to far from the depression for our own good. [Very lightly edited by Iverson]

China's Shenzhen Index: Shades of Nasdaq Bubble

(via Michael Panzner's Financial Armageddon)

Since December, China's Shenzhen Composite Index has soared more than 57% amid frenzied buying by investors blithely ignoring government attempts to rein in liquidity and clamp down on wild speculation.

Yet if you compare the graph of the Chinese market over the past year to that of the Nasdaq Composite Index prior to its March 2000 peak, it paints a decidedly less sanguine picture: that of lemmings poised to scurry madly over the edge of a cliff.

Panzner has more.

Subprime Mess as Minsky' Financial Instability

In his March commentary, PIMCO's Paul McCulley points to the unraveling of the subprime loans mess as a prime example of Minsky's Financial Instability Hypothesis at work. McCulley believes that the Fed will respond with rate cuts, noting: "Once the Fed begins easing, it will be a long journey down for short rates." Mike Shedlock is on this bandwagon too, but is less inclined to believe it will work. Shedlock says, "…[W]e have finally reached the point where these policies will no more work here than they did in Japan." James Hamilton expressed a similar concern that we aired earlier. Whatever else may unfold, the subprime mess is the latest scare point for nervous investors, and no doubt nervous central bankers.

[Global Central Bank Focus, Paul McCulley, 2/28/07] … it's the first-time buyer, stretching to buy, that is the life’s blood of vibrant property markets. And intrinsically, there is nothing wrong with a young family stretching to buy that first house; most all of us did, as did our parents (many with the aid of the GI Bill). Optimism about rising incomes and making lives better for our children is the cornerstone of the American Dream.

But the human condition is inherently given to the Mae West Doctrine that if a little of something is good, more is better, and way too much is just about right. Such is the case in capitalist finance, as brilliantly diagnosed by both John Maynard Keynes and his disciple, Hyman Minsky. I first introduced Minsky to these pages way back in January 2001, just as the corporate sector was sinking into recession, taking the aggregate economy with it, and the Fed was initiating a massive easing cycle.

Minsky, who passed away in 1996, was the father of the Financial Instability Hypothesis, providing a framework for distinguishing between stabilizing and destabilizing capitalist debt structures. He first articulated the Hypothesis in 1974, and summarized it beautifully in his own hand in 1992:

"Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on 'income account' on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to 'roll over' their liabilities — issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.

It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values."

Clearly, the explosion of exotic mortgages — sub-prime; interest only; pay-option, with negative amortization, et al — in recent years … have been textbook examples of Minsky's speculative and Ponzi units. …

… [A]s Minsky had forewarned, eventually this game must come to an end, as Ponzi borrowers are forced to "make positions by selling out of positions," frequently by stopping (or not even beginning!) monthly mortgage payments, the prelude to eventually default or dropping off the keys on the lenders' doorstep.

That is happening. And true to form, Ponzi lenders are now recognizing their sins of irrational exuberance, repenting and promising to sin no more, dramatically tightening underwriting standards, at least back to Minsky's Speculative Units — loans that may not be self-amortizing, but at least are underwritten on evidence that borrowers can pay the required interest, not just the teaser rate, but the fully-indexed rate on ARMs. From a microeconomic point of view, such a tightening of underwriting standards is a good thing, albeit belated. But from a macroeconomic point of view, it is a deflationary turn of events, as serial refinancers, riding the back of presumed perpetual home price appreciation, are trapped long and wrong.

And in this cycle, it's not just the first-time homebuyer … that is trapped, but also the speculative Ponzi long: borrowers who weren't covering a natural short — remember, you are born short a roof over your head, and must cover, either by renting or buying — but rather betting on a bigger fool to take them out ("make book", in Minsky's words). …

Which means that the bigger fish in the domestic and global economic sea are going to be living on leaner diets. It also means that any given level of central-bank enforced short-term policy rates will become ever more restrictive with the passage of time. That is nowhere more the case than in the United States, where mortgage originators' orgy of Ponzi finance stifled the Fed's ability to temper irrational exuberance in housing with hikes in the Fed funds rate.

More specifically, as long as lenders made loans available on virtually non-existent terms, the price didn’t really matter all that much to borrowers; after all, housing prices were going up so fast that a point or two either way on the mortgage rate didn’t really matter. The availability of credit trumped the price of credit. Such is always the case in manias.

It is also the case that once a speculative bubble bursts, reduced availability of credit will dominate the price of credit, even if markets and policy makers cut the price. The supply side of Ponzi credit is what matters, not the interest elasticity of demand.

Bottom Line
The ongoing meltdown in the sub-prime mortgage market would not matter, except for those directly involved, except that it marks the unraveling of Ponzi finance units…. As the bubble was forming, riding on first-time homebuyers with first-time access to credit on un-creditworthy terms, and first-time speculators riding the same with visions of bigger first-time fools to take them out, all looked well. But as Minsky warned, stability is ultimately destabilizing, as those who require perpetual asset price appreciation to make book are forced to sell to make book. Such is reality presently in the U.S. residential property market, which has flipped from a sellers' market on the wings of buyers with exotic mortgages to a buyers' market of only the creditworthy.

This state of affairs need not produce a U.S. recession. But it does unambiguously render any given stance of Fed policy more restrictive: a tightening of credit supply based on underwriting terms means that any given policy rate will elicit reduced effective demand for credit. And that’s the stuff of seriously easier monetary policy to come. Just as mortgage demand seemed inelastic to rising short rates when availability was riding relaxed terms, so too will demand seem inelastic to falling short rates when availability faces the headwind of restrictive terms.

It may be a while before the Fed accepts and recognizes this, waiting for these Minsky style debt-deflation dynamics to become evident in broader measures of the economy's health, notably job creation. But make no mistake: A Minsky Meltdown in the most important asset in most Americans' asset portfolio is not a minor matter. …

Once the Fed begins easing, it will be a long journey down for short rates.

---

[1st Helicopter Drop Now Being Organized, Michael Shedlock, 3/13/07]

Bloomberg is reporting Senate Weighs Aid to 2.2 Million Subprime Borrowers. … [Given the emerging subprime mess] some sort of reaction by the Fed or government was predicted well in advance by me and most likely a few other deflationists as well. I have no doubt the Fed will be cutting interest rates as well. But as I have pointed out before, such interference policies work until they don't. I think we have finally reached the point where these policies will no more work here than they did in Japan.

Three Reasons Bailouts Will Fail

---

1. Consumers are going to be unable to take on more debt in the face of falling home prices.
2. A recession will force a cutback in consumer spending.
3. Credit will tighten up such that banks will be unwilling to lend given falling asset prices and rising credit risk.

---

Number 3 above is happening already and it will spread further. A significant repricing of both assets and risk will be the result. Unfortunately this tsunami is about to hit the baby boomers just as they think they are ready to retire.

Financial Armageddon: New Book

Michael Panzner's Financial Armageddon: Protecting Your Future from Four Impending Catastrophes doesn't pull any punches. The book is a hard-hitting exposé of what may be our future, as events that have been wound up by more than a decade of irrational exuberance wind down in reverse. Against this frightening backdrop — made all the more frightening by this week's market jitters — Panzner concludes with book with some pointers to help average people navigate the treacherous waters of what may well be an inevitably dark near-term future. And to prepare them to better set a stage for brighter days on the other side of darkness for themselves and for their children.

Panzner's graphic depiction of future events is more detailed than I have seen before. In this it reminds me a lot of John Kenneth Galbraith's The Great Crash: 1929, which leaves Panzner in a great position to do a historical follow-up after the fact much like Galbraith did. For the rest of us, the book paints a picture to hold in front of us, and to test against as the future unfolds.

Clearly the future will not exactly follow the book. But that is not the point. Rather, Panzner wants us to better understand the complexities, the leverage-built-upon leverage, the gleefulness and gullibility of the actors, and more of what constitutes America's house-of-cards financial community that too many celebrate as America's highly-resilient economy.

On the run-up side we are led through the saga of America's decades-long party that has depleted the personal savings of many of our citizens. We are exposed to corporate shenanigans and government complicity in over-promising retirement and health care entitlements. We witness the mess that the government and "we the people" have made of our ever-more-bubbly housing sector, and how the Greenspan Fed misled average people into Adjustable Rate Mortgages in an era when interest rates could not fall, or at least would not fall further.

Among other misdeeds, Americans have forgotten that they need savings for security and they have used their houses (via refinancing) as giant ATM machines to buy new cars and other consumer goods. The party, as egged on by corporations and the government, seems never-ending. But, of course, the party must end. And it must end badly, in part due to too much greed, too much leverage, too little attention to prudent risk, and too much related "innovation" in the financial services sector that mislead many and their bankers, brokers, and commentators to believe that a new era had arrived, when all that was happening was a repeat of an age old penchant for mania, albeit with modern twists.

Add to this the never-ending consolidation in the financial services industry that helped keep stock prices pumped ever-higher and, when coupled with the perception that the true giants were now Too-Big-To-Fail, the stage was set for dominos to fall when one or more of the TBTFs actually begins to falter. Add in the recent Congressional and Administrative undoing of the many financial checks and balances put in place after the Great Crash and we see a stage set for disaster. Panzner elaborates:

There are too many links in the chain and too many points of vulnerability in the financial system, especially for commercial banks, which have been some of the most aggressive contributors to the recent credit bubble expansion. Ironically, a 2006 report that the FDIC was disbanding many bank closure teams because of a lack of failures may well have been one of the most ironic moments in the long and sorry saga of moral hazard and unintended consequences. Like dominos, when one begins to fall, the others won't soon be far behind.

If readers aren't shaken enough by the moral failures of the traditional banking community and supposed government overseers, Panzner devotes an entire chapter to derivatives, hedge funds, leverage, and risk concentration — and the seeming calm-before-the-storm that collectively they have wrought on the markets. His devotion is that of an "insider," with more than 25 years experience in stock, bonds, and security markets working with some of the biggest players including HSBC, Soros Fund, ABN Amro, Dresdner Bank, and JPMorgan Chase. Here is how Panzner sums up the problem:

… [D]espite recent efforts to address at least some of the concerns, past and present structural deficiencies have laid the groundwork for a chaotic and possibly nightmarish scenario. Thos who believed they were covered might be left scrambling to hedge their sudden and unexpected exposure, desperate to make up the shortfall under conditions of duress.

But the systemic risks do not only stem from a particular instrument or market. They exist also because of the concentration of exposure at certain large commercial banking groups, including JPMorgan Chase, Bank of America, Citibank, Wachovia, and HSBC. According to data collected by the U.S. Comptroller of the Currency, as of the fourth quarter of 2005, these five institutions accounted fo 96 percent of the more than $100 trillion of derivatives contracts outstanding among 836 U.S. Banks. Remember too, the exposure of Fannie Mae and Freddie Mac, who have $1.5 trillion of derivatives between them to hedge against risks in their massive portfolios.

Panzner follows with thorough looks into possible depression and hyperinflation, investigating the economic, financial, social and geopolitical aspects of these possible nightmares.

In the last part of the book, Panzner help us better understand necessary planning for these depressing contingencies. His philosophy parallels mine: Better that we heed an old maxim: "Assume the worst, hope for the best, and be prepared for whatever happens." Panzner gives us insights (and hope) in terms of investments, relationships, and lifestyles.

Having just finished both Peter Bernstein's Against the Gods and Charles Kindleberger and Robert Aliber's Manias, Panics, and Crashes I didn't expect to be impressed with Financial Armageddon. But I was impressed! Don't take my word for the worth of Panzner's book. Wander over to his blog and take a look at the advance praise from the back cover. Then explore the rest of his website, including Panzner as Featured Guest on Jim Puplava's Financial Sense Newshour, 3/3/2007.

CAPM (Capital Asset Pricing Model) or CRAP?

In his latest "Outside the Box" newsletter, John Mauldin thanks Kathryn Welling, partner of Welling@Weeden for this week's installment: 'Capital Ideas' or CRAP? — an interview by Welling with Peter Bernstein and James Montier. In the interview, Bernstein takes on criticism of the CAPM [Capital Asset Pricing Model], particularly from Montier (See Montier's earlier article). In the process all three provide good insights and information.

Kathryn (Kate) Welling introduces the interview this way:

A cordial but pointed letter hit my inbox not long after w@w's Dec. 1, '06 interview with Dresdner Kleinwort's James Montier appeared. None other than Peter L. Bernstein was taking exception to potshots James and I had aimed at the Capital Asset Pricing Model during our chat. Not the least of which was James' suggestion that CAPM should be renamed "CRAP," for "completely redundant asset pricing." And his charge that "an awful lot of the pseudo-scientific revolution in finance is...based on some very fraudulent assumptions."

Peter, the author of the financial classic, Capital Ideas, and a forthcoming sequel, called Capital Ideas Evolving, which is due to hit bookstores this Spring, quite naturally sprang to the defense of the financial theories that are, in considerable measure, his intellectual charges. "Your readers should understand," wrote Peter, where CAPM "fails and where it works." How could I refuse to give him the floor? I quickly read the partial manuscript Peter kindly sent to me, and arranged a conference call with James.

Skipping toward the end of the interview, we gain a glimpse of a convergence of opinion among the three relative to hedge funds, herding behavior, and risk concentration:

[Kathryn Welling]: Hedge fund managers are theoretically unconstrained but in reality they're just as much a part of the herd as everyone else.

James [Montier]: Yes.

Peter [Bernstein]: Yes. Clearly, this was not the vision when it began and I have not had the chance to go back to [David Swensen, Yale] and ask him how he feels about the little monster that he's created. He was a pioneer when he said that the only way to have a successful institutional portfolio is to make uninstitutional decisions. But those uninstitutional decisions have now become institutionalized, yes.

[Kate:] One of the scourges of modern life is that the crowd very quickly catches up with innovators. In fact, I'm wondering if the ubiquity of the computer isn't more responsible than "capital ideas" for the changes we've been talking about in finance, Peter.

Peter: I think they go together. The computer is—I can't find the word. The magnitude of its influence is pretty obvious. The computer has provided the means for implementing some of these "capital ideas" in ways that you couldn't have imagined with a slide rule. The real thing about computers is the speed at which they work and the volume of information that they can process. …

[Kate:] But haven't computers allowed a lot of models to be implemented, in size, without…necessarily…a whole lot of thought? (Something that we humans tend to be all-too-happy to do without.)

Peter: They screwed up pretty good before the computer too— Yes, but everything happened much more slowly. And had many fewer zeros attached. … After all, 1929 and 1962 and 1974 were all events that took place before the computer. The computer just adds different ways of doing it.

[Kate:] But those train wrecks happened in relatively slow motion. Even crises like Penn Central and Drysdale Government Securities that I recall from early in my career unfolded at a pace I'm sure my kids would consider antediluvian.

Peter: Well, there's an even bigger difference. In every one of those financial crises, some big financial institution went bust, or New York City nearly went bust. There were major bankruptcy problems in every one of them. I'm not sure that I'm secure about this as a prediction, but just consider that the crash in 2001 was a big shock. The market decline started from a very high level. God knows, there had been a lot of crazy speculation—and yet no financial institutions blew up. The only companies that blew were things like Enron, where they were doing crappy accounting, and those failures didn't matter. They were independent events. That's pretty amazing. I don't know whether it's going to be that way the next time. But when you think about the magnitude, the suddenness, of that crash and the number of people who were involved in the market in some way, and that no institution blew—well that took me by surprise. I was waiting for it any minute. It's very interesting.

[Kate:] That surprised me, too. But I'm still not certain that some sort of systemic crisis or washout hasn't merely been postponed.

Peter: I'm not nearly as secure about the next one, whenever it comes, because the derivatives business has gotten so much more complex and involved and financial institutions—I'm talking about the banks, who used to be in the business of collecting deposits and lending money—are now deep into derivatives and the whole mortgage business is a derivatives business. How that will hold up when the heat gets into the boiler next time, I'm not nearly as confident. To say nothing of the world's currencies and what goes on there. …

[Kate:] So at the same time that you're celebrating the whole financial construct built on "capital ideas," you're standing back and saying, "But don't trust it."

Peter: I don't see any contradiction there. I mean, the markets can go crazy. Nobody can deny that. But what I'm saying is that the way we think about investments and the way we lead up to our decisions and the kinds of judgments that we make are the not the same as they were before all these ideas came to the fore. What I call "capital ideas" have opened insights and opportunities to people that they probably would not have seen before. God knows, the options pricing model, which was the last of these ideas to be developed and grew out of all of the others, has changed the world. In many ways, it has done so for the better because it has opened so many different kinds of opportunities for risk management. But it also has, like everything in life, the seeds of its own destruction within it. Somebody has referred to the option-pricing model as a bombshell and that really describes it.

James: The problem with bombshells is that they tend to explode.

Peter: But I don't see how that dilutes my theme. The theme is not that everything is going to be benign and wonderful because of Harry Markowitz and his followers, but that the ideas they promulgated have changed the way that people invest in a very profound way. "Capital ideas" have, in many ways, exposed opportunities and means of dealing with risk that people didn't think about before. They've made risk a central part of the investment equation. For sophisticated investors, risk is the beginning and the end of every investment decision.

[Kate:] But there's the rub, Peter. If we're using a definition of risk that elegantly fits mathematical models but doesn't begin to capture true investment risk, what does that say about the investment processes and all of the convoluted financial structures built on top of it? … Doesn't it come down to this: The super investors you're writing about are people who've been able to take your "capital ideas" and profitably turn them on their heads, in one way or another, before anyone else?

Peter: Yes, yes.

[Kate:] While the great unwashed, all the portfolio managers who dutifully apply the calculations they learned in school, produce at best mediocre returns?

Peter: Yes.

James: That's something that we're all agreed on.

[Kate:] It's not a particularly grand insight…

Peter: But there's a bigger insight than the one you just expressed. Portfolio theory says that the market is the dominant influence on returns. So those people may screw up and may not beat the market, or maybe they get lucky and beat it, but ultimately the market is going to determine how they come out. The market is the dominant influence. It's a simple idea but a very, very important one. …

Yet for all the talk about ever-more-free markets, and the reluctance to regulate them, we still have central bankers trying to smooth things over, while institutions deemed by many as "too-big-to-fail (to be be allowed to fail) continue to seek ever-more-heroic gains. There is something akin to Moral Hazard at work here I believe.

And, as Doug Noland reports, we see would-be regulators ducking for nearest cover again this week:

Speculator Watch:
February 23 – New York Times (Stephen Labaton): "The Bush administration said Thursday that there was no need for greater government oversight of the rapidly growing hedge fund industry and other private investment groups to protect the nation’s financial system. Instead, the administration, in an agreement it reached with the independent regulatory agencies, announced that investors, hedge fund companies and their lenders could adequately take care of themselves by adhering to a set of nonbinding principles. The principles, many already being followed by the sharpest investors and best-run companies, say that investors should not take risks they cannot tolerate and should carefully evaluate the strategies and management skills of hedge funds. They also call for funds to make clear and meaningful disclosures to investors. The decision came after months of study by a presidential working group of top officials and regulators. They looked at both the hedge fund industry…and the management of private equity firms… The group's conclusions reflected both the strong antiregulatory ideology of the administration and the formidable influence of Wall Street and the increasingly wealthy hedge fund industry among both Democrats and Republicans in Washington. Three of the administration's most senior economic policy makers… Henry M. Paulson Jr., his top deputy, Robert K. Steel, and White House chief of staff Joshua Bolten… are alumni of Goldman Sachs…"

Will Sub-Prime Loan Defaults Create Another Amaranth?

Will Sub-Prime Loan Defaults Create Another Amaranth?, 2/14/2007: When HSBC Holdings (NYSE:HBC) announced an earnings restatement last week, setting aside 20 percent more for loss provisions on sub-prime mortgage loans, the equity market for HBC and other sub-prime lenders such as New Century Financial Corp (NYSE:NEW) sold off sharply. But the prospect of rising loan defaults on bank balance sheets, in relative terms, is the good news.

Rising loan defaults are a normal feature of any credit cycle. What makes the past few years different is the degree to which derivatives and aggressive loan securitizations have spread the risk around, beyond the financial institutions which historically have specialized in creating and managing such illiquid risks. According to the FDIC, in 2005 almost 68 percent of home mortgage originations were securitized. …

Over the rest of 2007, we fully expect to see most of the major money centers announce higher loan losses and provisions for retail mortgage portfolios, and some banks may even be forced to restate previous periods. But the real threat to all of the major US banks involved in significant asset securitization lies in the probability that many of the collateralized loan structures employed to shift risk off bank balance sheets will unwind.

As Jody Shenn of Bloomberg wrote this week: "Subprime loan buyers typically can force lenders to buy back the mortgages they sell if borrowers miss their first few payments, any type of fraud is discovered, or the loans otherwise fail to meet the guidelines laid out in a sales contract." This is true even if the loans were packaged into a collateralized debt structure or CDO, anointed with a credit derivative enhancement from a hedge fund, and blessed with an explicit credit opinion from a rating agency, before being sold to yet another hedge fund.

Jamie Dimon, chief executive of JPMorgan Chase (NYSE:JPM), disclosed last week that JPM held only $5bn of higher-risk sub-prime loans, just two per cent of its total retail portfolio. He then bragged that the bank had sold much of its mortgage exposure — but to whom? Fact is that JPM, the largest derivative dealer on earth, likely sold much of its loan exposure to its hedge fund clients, highly leveraged entities that have significant clearing and credit exposure to JPM.

As the wheels start to come off of the mortgage collateral wagon in 2007, a number of money center banks and broker dealers, particularly the ones with large prime brokerage operations, may be forced to repurchase CDOs from hedge funds, mutual funds, banks and other clients who discover to their dismay that there is no bid for this paper, credit agency rating or no. This situation will be particularly poignant for JPM, which seemingly was the proximate cause of the Amaranth hedge fund failure and even profited from the fund's demise, as we wrote in a previous issue of The IRA. …

(via Institutional Risk Analyst):

See also, Hedge Fund Problems Start With the Fed, 2/5/2007

The Asset Shufflers meet the Pessimists (Realists?)

Earlier this week Tim Iacano commented on last weekend's Barrons ($) roundtable discussion, headlining a group he referred to as "a large group of asset shufflers who plan to make as much hay as they can while the sun still shines, and a smaller coterie of realists who fear that something will eventually go terribly wrong."

Included in the latter category is Cassandra-like Mark Faber, who I look to for insight more than a little. Here's a snip:

The Asset Shufflers, Tim Iacono: A consumption based economy driven by rising asset prices where most of the asset owners do not yet know how much "wealth" they've lost in the last year due to falling home prices. What could possibly go wrong?

Moderator: You've been quiet, Marc. What's wrong?

Marc Faber: I agree with Art [Samberg] that we are in the midst of the greatest synchronized economic expansion in the world. In the first 150 years of capitalism, the colonial system prevailed. It was never the objective of the industrialized countries to boost growth rates in the colonies. They were used for exploitation. Once the colonial system broke down, roughly three billion people fell under communism and socialism. After 1980 commodity prices collapsed and Latin America went into a depression. Then the Soviet Union collapsed. While Latin America began to recover in the 1990s, Japan, at that time the second-largest economy in the world, had stopped growing. The Asian crisis hit in '97, the Russian crisis in '98. So there was no synchronized growth.

The recovery began in November 2001 in the U.S. Strong consumption growth in the U.S. boosted industrial production, notably in China. Incremental industrial growth, combined with strong personal-income gains and capital spending, then led China to import resources, in particular oil. That led to rising commodities prices, which greased the economies of the Middle East and the former Soviet Union. Demand from China for copper and iron ore greased Latin America and Australia, and those countries grew rapidly. They demanded more imported goods, capital goods and luxury goods from Europe and Japan, and bingo! You suddenly had the whole world expanding rapidly. However...

Moderator: We knew that was coming.

Faber: Global imbalances have increased. The emerging world has grown much more rapidly than the United States. In the U.S., ultra-expansionary monetary policy got under way ahead of Y2K in 1999. It continued after 2001, when the Fed slashed interest rates to 1% from 6.5%. Though the Fed has raised rates since 2004, to 5.25%, we still have expansionary monetary policies worldwide. If you define economic growth by consumption, the U.S. has grown rapidly and will probably continue to grow. If you print money you give people the opportunity to spend. But along with the spending came a growing trade and current-account deficit, which was offset by surpluses in Asia. Every region of the world has a current-account surplus with the U.S. For the first time in capitalism, the poor countries, notably China, are financing consumption in the U.S. This will not last forever.

In 2006 -- hurrah, hurrah -- the Dow Jones Industrial Average was up 16% and the S&P 500 14%. But in euro terms the S&P was up less than 5%. In gold terms it was down. Against most commodities, the Dow was down. The U.S. also has a split economy. The typical household is not doing well. But one economy is doing exceedingly well: the asset shufflers in this room. [Nervous laughter] This economy is in the greatest bubble ever. There's a bubble in the art market; art prices were up 27% last year. There's a bubble in equities, especially in emerging markets, and in real estate in Anglo-Saxon countries. The big threat is not that liquidity will vanish because of Federal Reserve action. The Fed will print money, I guarantee you. But when asset markets go up, they create liquidity by allowing people to borrow more money against appreciating assets. When asset values go down, liquidity contracts immediately because people repay loans. The moment the asset bubble begins to deflate, liquidity will contract.

Some would call Dr. Faber a wet blanket, others would call him a realist. …

Samberg: Where is the bubble? I'm confused. Marc appropriately gave us a history lesson about how the world has changed