Economic Dreams - Economic Nightmares

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 benefited 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 families 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 sums 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 price 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

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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 to one in which economic growth and personal freedom and better lifestyles are adopted across the globe. The most mature financial markets are here in the U.S., and we're the clearinghouse for the world, which can lead to long-term problems. But why turn a positive into a negative? The world is awash with growth. It is awash with liquidity, and our markets can clear liquidity better than any others.

Moderator: It is also awash in consumption, extravagance and debt.

Faber: America's current-account deficit has greased the whole world. Latin American markets are in the midst of a huge boom. The Argentine stock market is up 10 times from the lows. Latin American debt on a total-return basis has doubled in the past five years. In Asia we have bubbles in real estate. In the U.S. there's a debt bubble. Debt is now 330% of GDP. That will prevent the Fed from ever pursuing tight monetary policies, even if it becomes necessary.

Hickey: Asset bubbles are always fun while you are going through it. The tulip bubble was fun. The Mississippi bubble was fun. But they always end in tears and disaster.

Gabelli: I'll float a bubble. Abby, the Democrats won the midterm elections in a landslide. Marc, should we worry about a politically motivated constraint on global trade?

Faber: I'm less worried about that than this: The five brokerage firms in New York -- Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns and Goldman Sachs -- paid out $36 billion in 2006 bonuses. Compensation and bonuses together roughly are equal to Vietnam's GDP. I see a bipolar world in which there's the typical household in the U.S. or Western Europe, and then this huge wealth concentration. It will lead to a political backlash one day. Moderator: Starting in Connecticut.

Yeah, that's going to be the tricky part. One day they'll storm the castle and drive the asset shufflers out into the streets and then things might get ugly.

But it ain't going to happen this year.

Can Minsky Respond to Krugman's criticism of 'The Hangover Theory'?

Both Mark Thoma and Brad DeLong have recently been playing with Paul Krugman's dissing of the Austrians: The Hangover Theory. I have no such intent here. I have dabbled with Austrian thinking/writing enough to have a healthy respect for complexity, human psychology, market cycles, etc. I have learned economics from various schools of thought and especially, perhaps, from Robert Heilbroner, who was able to probe the minds of the "worldly philosophers". Looking across various schools of thought helped to round out my non-traditional views.

Instead of dissing the "Austrians" or any other school of thought, I just want to attempt to solve a puzzle left by Krugman. Here is a frame:

The Hangover Theory, 12/1998, Paul Krugman: …A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money?

Questions that Krugman ignores are: How exactly is the supply of money to be increased? How are those who are to lend to be induced to lend? How are those who are to borrow to be induced to dare to borrow? Remember that in the scene Krugman is exploring, 'bankers' (many) have just been burned because they were encouraging ever-more-speculative loans on the way up the credit-bubble mountain, some of which have now failed, leaving the bankers to shoulder some of the loss. What is to make the bankers think they are now encouraging prudent investments? Similarly what is to make businesses think that the environment is now safe to borrow into?

Krugman's puzzle: "The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present."

Maybe the Austrians cannot explain it, but Hyman Minsky, following Keynes ideas on market cycles and inherent problems, has managed such an explanation. At least I think so. In Minsky's explanation (expansion) of Keynes financial economics we move from the narrowness of Keynes historical perspective, looking "at a depressed economy, tending to chronic underinvestment and thus to high and long lasting unemployment"; to Minsky's later historical perspective, looking "at a vibrant economy with upward instability, naturally inclined to overinvestment and overindebtedness." (Elisabetti De Antoni, 2005, "The (too?) Optimistic 'financial Keynesianism' of Hyman Minsky" [PDF] p. 25). Dominating both scenes "are expectations and the degree of confidence placed in them" (De Antoni p. 9).

Central to Minsky's theory is "the relationship between debt commitments and profits." (De Antoni p. 5 ). This is where it gets interesting, psychologically and economically, in helping to address the questions, "Who is to lend what to whom?" "Why Would they dare?" What many writers are unwilling to entertain is the lag time necessary to induce either bankers to loan money or credible businesses to borrow money after bubbles burst.

A time lag is needed in order to allow the psychological cloud of pessimism to move far enough into the backdrop to once again begin the cycle of guarded optimism and trust that a better day is possible, then optimism, exuberance, irrational exuberance and boom, then bust, irrational pessimism, pessimism, guarded pessimism, and finally around again to guarded optimism and trust.

This story sounds a bit Austrian. The Minsky twist is that he advocates that central bankers (Minsky uses the term "big government") interrupt the cycle during "irrational" phases on both the upside and the downside in attempts to minimize the run-up and the run-down. Minsky also acknowledges that government action may do more harm than good if timing is not good, or if the form of government action is not appropriate.

This brings us to the "basic criticism made by Minsky against the Neoclassical Synthesis … that it neglected financial relationships, precisely those in which instability lurks" (De Antoni p. 2). The instability derives from time-lags in contracts between borrowers juxtaposed against changes in Fed policy or action, and expectations of such.

De Antoni lays out the story line of the boom/bust cycle:

The relationship between debt commitments and profits is central to Minsky's theory. … Given the limits of collective and individual rationality, in Minsky's world the recent experience is the main guide to the future. The ease with which payment commitments have been met in the recent past determines the confidence in the future fulfillment of debt commitments. This triggers an important deviation amplifying mechanism: "A history of success will tend to diminish the margins of safety that business and bankers require and will thus tend to be associated with increased investment; a history of failure will do the opposite." (Minsky, 1986 [Stabilizing an Unstable Economy] p.187). Expansion thus turns into a euphoric boom. Sooner or later, however, euphoria ends by clashing with reality: "As a previous financial crisis recedes in time, it is quite natural for central bankers, government officials, bankers, and even economists to believe that a new era has arrived. Cassandra-like warnings that nothing basic has changed, that there is a financial breaking point that will lead to deep depression, are naturally ignored in these circumstances" (Minsky, 1986, p. 213). Financing is often based upon the assumption that "the existing state of affairs will continue indefinitely" (Keynes 1936 [The General Theory of Interest, Employment, and Money] p. 152 ). On the contrary, "each state nurtures the forces that lead to its own destruction" (Minsky 1975 [John Maynard Keynes] p. 128). (De Antoni p. 5).

Did Minsky solve the puzzle? I think that he began the solution, and his followers are now continuing the inquiry/discovery, most recently through the work of Eric Tymoigne and others at The Levy Economics Institute, Bard College..". Am I wrong? At minimum I hope more economists will at least explore the work of Minsky and other Post Keynesians.

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See also:
Banking and Financial Crises, Gary A. Dymski, January 2005
Minsky's thesis: Keynesian or Marxian?, Steve Keen, 2001
Krugman and The Liquidity Trap: Why Inflation Won't Bring Recovery in Japan, Jan A. Kregel, March 2000
The Nonlinear Dynamics of Debt Deflation, Steve Keen, 1998

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{Note: I edited this slightly on 1/19, 1/23: Among other things, I put quotes around the word "irrational," i.e. :"'irrational' phases" of market cycles above. As Eric Tymoigne, correctly notes (In an email) " I would be careful to call all those behaviors "irrational" for two reasons. First I think they are rational given the uncertain world we leave in and the institutional framework of capitalism. Acting according to the rational expectation model is irrational. Second, even if large optimism are indeed a reality, they are not necessary, in Minsky's theory, to explain the weakening of the economy."}

Struggling to Make Sense of Ultra-Optimistic Financial News and Views

I started out a gloomy Saturday in Utah working my way through Wikipedia trying to better understand the arcane nature of things like structured finance, money supply, fractional reserve banking relative to full reserve banking, securitization, moral hazard and more. I realized, once again, why I'm usually confused about matters financial and geopolitical. Then I wandered over to Doug Noland's weekly update, building as he does from Hyman Minsky's Post Keynesian Financial Economics. I was once-again as well-rewarded for my efforts as a permabear can be.

Remember when Junk bonds used to be a bad idea? Remember when a steady stream of good economic/financial news was puzzling, particularly after years of it? Remember when people used to believe that investing involved risk — and increased returns were not something that you could insure against? Remember when central bankers believed in market cycles, and worried about the possibility that CB actions might amplify or otherwise negatively distort them? Doug Noland wants you to ponder the possibility that 2007 might be the year that you may have your memory refreshed, the year when a lot of economic nonsense is daylighted as such.