Captain Credit-Crunch

Look up in the sky
It’s a CDO!!
It’s an SIV!!
No It’s a bear market.


After sitting down to a nice hefty bowl of Captain Credit-Crunch cereal I thought Id take the time to discuss something other than the complexities of this bear market in the making. Just like a good Captain I have come to realize it was the tactical plans laid by those in command which sowed the seeds of the current crisis.

The tactics employed by various financial institutions are at best voodoo accounting practices; dropping doll-like charts and graphs before the audience, poking them with needles in hopes of eliciting a positive reaction from the market.

More subversive has been the shuffling of assets into "tiers" with varying explanations of what said tiers actually represent, while delaying at all costs reporting of asset rotation through various levels of accounting hari-kari.

Last March Alan Schwartz, Bear Sterns CEO uttered these now famous lines on CNBC “Bear Stearns' balance sheet, liquidity, and capital remain strong... Our liquidity position has not changed at all, our balance sheet has not changed at all” Bear Sterns would effectively declare bankruptcy by the end of that week. Such carefully crafted statements about an institution’s “strong” or "solid" balance sheet and healthy "capitalization" are dubious at best.


Ive looked these terms up in the dictionary and have no idea what constitutes a "solid" balance sheet. In high school my friends used to talk about the girls who were a “solid” 8 out of 10, good house parties were "solid" jams, and my favorite record had 15 tracks on it but 10 of them were "solid" tunes.20 years later, 20 pounds heavier and many hairs lighter, in the most sickening of rerun’s we are told by men in fine woolen suits that their bank’s balance sheets are "solid"?
I don’t know whether to buy more shares or chest-thump them over a cigarette along the butt-wall after gym class?

Granted I did look up "well capitalized" in the dictionary and it made perfect sense from a fiscal point of view. Certainly I never referred to girls or my mother's cooking as "well capitalized". Yet within this sound definition, I wondered why banks kept uttering this phrase. Why was being well capitalized so fantastic? Who needs sound capitalization if all is well? And why have banks grown gun-shy about lending to other “well capitalized” institutions with “sound” balance sheets?

Its sheer madness that black swan events are even being discussed, if one just happened 6 months ago, what are the odds of another so in 2008 right? Sorry was my mic on?

I would gladly surrender the prospect of double digit returns YOY just to hear a CEO of a major financial institution give this speech after the credit crisis:

"We believed a new paradigm of wealth was being created in which we earned double digit returns on triple A rated bond-like creatures that only MIT trained mathematicians understood.For years we enjoyed the upside but seemingly none of the risk, as blue-chip financial institutions, the vanguard of wealth creation in America, our stock was rising in double digits annually while still holding "conservative blue-chip" status. It was the very definition of a financial WIN-WIN.

Surprisingly our clients enjoyed the returns and blindly trusted us to keep risk parameters in check. In a sense we began drinking our own Kool-Aid when we spoke of safe returns, of "risk-adjusted" parameters, and sound money management.When the risk hit the fan we fired our "risk" analysts because they failed to do their job. In their place we hired the finest PR and consultants (our client’s money could buy) who could begin the delicate process of applying lipstick to the pig we placed on the market's stage.

For some time they made the pig dance, stocks resumed their upward rise, and our PR people averted a disaster, convincing the masses the worst was over. We lost upwards of %30-50 of our share price but the financial media still said our company was a buy. I mean, you can’t buy that kind of support, bless their hearts.

The lower prices went the more ways people came up with ways to keep the pig dancing, our stock became "cheap", a bargain. It was as if the credit-crisis was this external event that was hurt our share price, yet we maintained our stance of mere victims in this crisis that spread like cancer across the financial landscape. It was going on out there but in here we were fine, just fine, and we would weather the storm because of all these words that drummed up images of fortress like risk-aversion.

It was 2nd most popular definition of a financial WIN-WIN.We rehired our old risk-analysts to find out the odds of 2 WIN-WIN's happening to big banks in the same 12 month time-frame. they said the odds were so improbable, their mathematical models required 4 dimensional fractal combinatorics to express the exponential.

We slid down in our high-backed leather chairs sipping the most delicate of ancient single-malts, the saltiest of caviar's while cloaking our thievery in the softest of silken suits

The fiscal ship may have been sinking but the passengers were certainly not rushing for the life rafts. If anything the people were content with the first-mate's explanation that the ship was on a "well-charted" path.

I guess its true what they say about us….Captains of Industry."

Today's post from my favourite financial blogger Mike "Mish" Shedlock is long as usual but required reading for anyone seeking a clearer understanding of the mountains of information being throwing out at the newswires.

J


Consumer Spending Mirage

Amidst the frequently heard drumbeat of bottom calls, this more realistic headline caught my eye: The Consumer Spending Mirage.

Stocks riding high on illusions of consumers continuing to spend may be in for a nasty surprise. Forecasting the stock market is a fool's game—but there are grounds to believe there's another drop in the market yet to come. The reason: a broad decline in consumer spending, which so far has been masked by a quirk in the government's statistics.

Combine that with a rapidly unraveling job market, high energy prices, and the continuing credit crunch, and you have the recipe for a drop in consumer stocks. A big decline there could take the rest of the market down with it. A closer look at the numbers shows that the consumer spending boom may already have come to an end, without investors noticing.

The problem is this: What the government calls "personal consumption" is actually a grab bag of items, some of which don't really fit the usual notion of consumer spending. For example, the nation's current annual personal consumption of $10 trillion includes about $1.8 trillion in outlays by Medicare, Medicaid, and private health insurance providers. This is real money, but consumers don't control or even see most of it, since it usually goes right to the health-care provider.

The government's count of personal consumption also includes "imputed" categories, that is, entries that don't involve any money changing hands. Two of the biggest examples: $1.1 trillion for "rent" that homeowners theoretically pay to themselves to live in their own homes, and $240 billion for "services furnished without payment by financial intermediaries"—in other words, the value of services like no-fee checking accounts.

In fact, once medical outlays and those two imputed categories are set aside, it turns out that the rest of personal spending has actually fallen since November, adjusted for inflation. The decline is pretty much across the board: inflation-adjusted purchases of food, clothing, furniture, and motor vehicles are all down.

Some economists think the combination of economic stimulus checks soon to arrive from the federal government and lower interest rates should keep consumer spending from falling off a cliff. "We think consumers will narrowly skirt a downturn despite the recession in the overall economy," write Richard Berner and David Greenlaw of Morgan Stanley (MS) in a just-released report.

But if the decline in consumer spending continues, it's going to be hard for the market not to follow. Like personal consumption expenditures, GDP also includes the government imputed value of "free" checking accounts and the value homeowners receive from renting their own house. Calculation of the latter is based on a survey of homeowners asking them what they would pay to rent their own house if they did not own it. This is as preposterous as counting the value of free sex one gets from one's lover as opposed to what one might have to pay visiting the local red light district. And pretending those "free" checking accounts have unrecorded value that consumers should be paying for is equally absurd. Banks sweep money out of checking accounts nightly, lend it out, and collect interest on it.

Hedonics are yet another mirage that never occurs. Computers are the best example of hedonics. Prices go down every year while processing power, disk space, and other features increase. Let's say you buy a computer for $500. The government tries to figure out what that computer would have cost last year. For the sake of argument let's say that number is $1,000. So the government records the sale at $1,000. Multiply this by every computer sold and you have a massive fictional number.

Hedonics also come into play with autos. For example, if the government decides there are new features or safety improvements on this year's models vs. last year's model, sales numbers are upwardly adjusted.Subtract out all of this nonsense and the US was likely in recession quite some time ago.

BusinessWeek has this correct: Consumer spending minus hedonics and imputations is lower than reported. One thing BusinessWeek did not mention is the massive increases in gasoline expenditures. The three month running total of gasoline purchases is 22% higher than a year ago. Wages are falling, unemployment is rising, and rising oil prices are cutting spending elsewhere.

Consumer spending, especially discretionary spending, has only one way to go and that is down. Psychology of Deflation Consumer Sentiment has soured. Most place the blame on falling home prices. However, such thinking is incorrect. Consumer sentiment did not sour because home prices fell. Home prices fell because sentiment soured. If that sounds wrong then think about it this way: "The pool of greater fools ran out". Once the pool of greater fools ran out, then and only then did home prices fall.

Interestingly, the pool of greater fools includes lenders. Countrywide Financial (CFC), Citigroup (C), Washington Mutual (WM), Wachovia (WB), and others were so arrogant that they thought they were immune from any crisis. They did not care if they sold homes to people who could not afford them. They thought rising prices would cushion them from losses. They thought wrong.

So who was the greater fool, the lender or the borrower? Walk-aways are going to show that lenders were as much the greater fools as borrowers. For more on this theme, please see

Walking Away: The Next Mortgage Crisis. Psychology has reversed for both consumers and lenders. Consumers no longer think they can sink $20,000 into a new kitchen and get any of it back. Instead of buying a new kitchen or an SUV, consumers are worried about the price of gasoline, eggs, cereal, milk, and produce as discussed in Energy Affecting Food Prices.

Lending standards have now tightened and banks are less willing to lend. Even those qualified to buy a home are having a difficult time in many instances.

In this case, cautious (even fearful) bankers are tightening credit. Why? Because it all started with cautious consumers refusing to play the greater fool's game with home prices. The attitude change by consumers caused an attitude change by banks. The attitude change by banks will cause a souring attitude in those who were still in denial and still willing to party. And so the cycle feeds on itself, and will continue to do so until it reaches an extreme in caution and fear.

Attitudes are like pendulums. Momentum carries both pendulums and attitudes to extremes. The pendulum of consumer recklessness has now reversed, having recently reached a secular peak. It will not stop at equilibrium on the way down. Instead, momentum will progress to a point of complete exhaustion marked by cautious saving instead of reckless spending.That process is now underway.

This secular reversal has a long, long way to go.

Mike "Mish" Shedlock

http://globaleconomicanalysis.blogspot.com

In-efficient market hypothesis?

This highly entertaining article courtesy of Johh Mauldin's weekly newsletter takes a no-nonsense look at the current debacle that is the credit crisis. I especially like the references to Efficient Market Hypothesis.

Enjoy,

J


Five Delectable Examples of "Stein's Law"

by H. "Woody" Brock

The most basic statement of Stein's Law says: "If something cannot go on forever, it will stop". More specifically, the late Herb Stein stressed that, when a trend cannot go on, it always stops--even when nothing is done about it. This yardstick of common sense is particularly apposite today, as we see in the following five examples of trends whose time has come and gone.

1. Mean Reversion in US Wealth Growth: A March 7 front page headline of the Financial Times proclaimed, "Fed Data Alarms Markets - Wealth of US Households Contracts". We have written about "mean reversion in national wealth growth" for the past five years, and explained why it would soon have to occur. In this regard, one of the most fundamental of all theorems in economics tells us that national wealth must (and empirically does) grow over the long run at the rate of GDP growth.

Well, wealth reversion has now arrived, and will be with us for far longer than most anyone expects. First, wealth has already contracted by $500 billion in 2007. Second, wealth contraction will continue to occur until mid-2009 when house prices reach their trough. And third, wealth growth will probably be sluggish up to and beyond 2020, running at about 3%. One reason why is that most baby boomers have their money in their houses--not in traditional defined benefit pension plans. Accordingly, the only way they will be able to retire in the style they expect is to sell their houses to one another. Next joke.

How remarkably this new 2.5% wealth growth regime of 2007-2020 will differ from the previous regime of 1981-2006! During that period, US net worth soared from $10 trillion to $57 trillion--an arithmetic average growth rate of 18% and a compound annual growth rate of 7.2%. For readers who doubt what we are arguing, note that the average growth of wealth across the two regimes being analyzed compounds at exactly 5.5%. This is precisely the long-run growth of nominal GDP. And all the Golden Rule Theorems in Growth Theory require that wealth growth and GDP growth converge to the same growth rate in the long-run.

This will fundamentally change both American politics and daily life. In particular, it will be the final nail in the coffin of hopes of early retirement for most baby-boomers. In short, "wealth reversion" is finally coming home to roost. What cannot go on does not go on.

2. Financial Services: The growth, profitability and excessive pay in this sector were always too good to be true, and now much of this excess may be over. Between (i) the deleveraging of bank balance sheets, (ii) the loss of confidence in exotic "financial products" by the investing public, and (iii) the need for banks to repay the Fed (or whomever) for existing and prospective bailouts, tepid growth and reduced profitability lie ahead for this sector during the next 5 years. For an analogy, look back on the growth and profitability of the telecom sector between the years 1991-2007, and in particular on the breakpoint of the late 1990s. What could not go on in telecom ceased to go on, and so shall it be in "finance".

3. The 2002-2009 US Housing Bubble and Burst: Many people suspected that the housing boom was indeed a bubble. There is no longer any doubt that it was, and for the following ex post reason: For house prices to have fallen as much as they have--and to do so with no interest rate shock--is proof positive that a pure bubble was in play. It was a speculative bubble fueled by excess credit creation and lax lending standards. What could not go on did not go on.

4. Excess Leverage: Commentaries about and explanations of today's credit market implosion continue to roll in from luminaries everywhere. Martin Feldstein of Harvard (allegedly the most important macroeconomist in the world) concludes that blame lies with the failure of Fed regulators to properly supervise the banks within their purview. Others blame the incompetence of those charged with "risk assessment" for dramatically underestimating risk. They claim that the solution to today's troubles lies in instituting much more effective risk management procedures.

Still others call for greater market transparency, truth in lending, and incentives to guarantee more of both. Finally, there are repeated complaints about the extent of greed on Wall Street. Yes, we have all become shockingly greedy!

Yet almost no one singles out the distinctive role of excess leverage not only as the principal culprit, but perhaps the only variable than can and should be regulated by government--as it once was. Indeed, in his lengthy and much discussed March 17 Op-Ed piece in the Financial Times, former Fed Chairman Alan Greenspan never once cited the role of leverage in wreaking today's havoc. This oversight is as irresponsible as it was unbelievable, but it epitomizes the deficient analyses of consensus pundits.

Chapters II-IV of our February 2008 PROFILE report explained how excessive leverage has exacerbated today's crisis, and why leverage is the principal "control variable" that must be managed in the future. More specifically,

• The Fed has no direct control over institutions that now make over 70% of all loans. As Chairman Bernanke has stressed in recent months, the Fed's powers are thus limited in dealing with the kind of crisis now at hand.
• The risks that allegedly should be "properly assessed" are largely endogenous in nature. The joint probability distribution characterizing such risk is often non-knowable. Think Heisenberg Uncertainty Principle! Because of this non-knowability, glib assertions that recent happenings are "four sigma events" are wholly invalid. For to state that an event is four-sigma implies knowledge of an underlying probability distribution that in fact does not exist and thus cannot be assessed!
• Human nature never changes, and hoping that people will become less greedy and optimally transparent is unrealistic.
• Leverage, however, is controllable. Moreover, since it exponentially amplifies endogenous risk, and in doing so creates "perfect storms" like that of today, the regulation of leverage can accomplish a very great deal, at least in circumstances when such measures are called for.

To sum up, those writing about today's morass seem as ignorant of the reality that excess leverage is largely responsible for what has happened as they are that much reduced leverage is the appropriate remedy for the future. Perhaps this oversight is no accident. After all, those who now run our major financial institutions increasingly owe their own fabled fortunes to the utilization of leverage subsidized by the public. Moreover, those financial economists who are handsomely paid to report today's developments happen almost exclusively to be employees of the very same institutions that have created, peddled and profited from toxic CDOs and SIVs.

In short, are we not forced to ask whether the foxes are finally guarding the chicken coop? If they are not, you would never know it. This author is frankly appalled by the failure of those who should know better to single out and stress the all-important role of excess leverage in creating today's crisis. Leverage will end up hurting millions of innocent bystanders far more than any other factor will have done. Hyman Minsky: Where are you when we need you most? And where for that matter are Wisdom and Common Sense?

This is a deep observation that constitutes a paradox within the very foundations of modern financial theory: The irrationally high levels of leverage justified by the Efficient Market Theory via its dramatic underestimation of risk becomes the source of Economic Inefficiency in the precise and revolutionary sense first proposed by Kenneth Arrow in 1953: a misallocation of risk itself. [Recall the reason why the EMT necessarily underestimates risk: It implies zero endogenous risk.]

Yet just as Stein's Law predicts, this trend too has had its day. Stay tuned for that large-scale deleveraging of Wall Street and indeed of the consumer that is just commencing.

5. Modern Financial Theory: Modern financial theory as applied ranks with string theory in physics as one of the greatest intellectual frauds of our time. Whereas the vacuous pretensions of string theory have finally been exposed (we now know that the theory never generated a single falsifiable prediction), those of "financial engineering" are just beginning to be exposed both in the press and in lawsuits alike.

What is remarkable to us is how this masquerade has continued for as long as it has both at a practical and at a theoretical level.

• At a practical level, it finally dawned on succored investors that you cannot transform a sow's ear into a golden purse. That is, in an era of 3.5% risk-free yields, investors should never have expected that securities yielding 6% could have been "AAA" in the first place. They have now learned that such a risk/return transformation is indeed impossible, notwithstanding claims to the contrary by modern alchemists of finance.
  
  Investors have also been discovering the vacuity of the longstanding claim that "the market correctly prices every security"--arguably the central tenet of the Efficient Market Theory. When the Chairman of the Federal Reserve Board stands up at lunch in New York and asks a packed audience, "Could someone please tell me what this stuff (mortgage-backed securities) is worth?"--then you know the game is over.
  
  The same holds true for the growing realization of the complete inadequacy of today's models of risk assessment. Indeed, this is one of the main points made by Alan Greenspan in his March 17 column. [Greenspan as always is allergic to good theory, so his analysis falls back upon "data analysis problems". But he is on the right track in admitting the sorry state of today's models.]

• At a theoretical level, are those professors of finance and CFA curriculum officials who have peddled efficient market dogma for decades aware of what is really happening? Do they understand that they are witnessing the collapse-in-disgrace of the fundamental theoretical conceit that has landed us in today's quagmire, namely: "Armed with portfolio theory, options pricing theory, Arbitrage Pricing Theory, reams of data, and banks of computers, we the Wizards of Wall Street can now optimally assess, price, slice, dice, and manage risk. Government happily is no longer needed to save us from ourselves in times of irrational exuberance."
  
  In Chapter II of our February 2008 report, we discussed what went wrong in the evolution of financial economics. In particular, we retraced the way in which Kenneth Arrow's original 1953 conception of the Economics of Uncertainty was bastardized by the Chicago School a quarter of a century later. Whereas Arrow's theory assumed that agents had diverse opinions about the future and were thus regularly wrong in their forecasts--wrong, not irrational--the Chicago School imposed the dogma of Rational Expectation: Agents all know and agree upon the true probability distribution of future news, and are thus never wrong. Moreover, they are assumed to know how to price all such news perfectly, with the result that markets are blithely assumed to price all assets correctly. Assumed, not demonstrated. Yes, assumed, not demonstrated.

• This was the origin of the theory of Economics Without Mistakes (our phrase) that lies at the heart of what has gone wrong in global markets. In particular, this was the origin of a family of theories predicting that financial market risk is very small, is fully assessable, is fully priceable, and thus is fully manageable. And this in turn was what intellectually justified today's extremely dangerous levels of leverage. [An agent of a given risk tolerance will be "excessively leveraged" if his models significantly underestimate the true risks at hand. In the real world, some 80% of total risk is endogenous, not exogenous. Yet in Efficient Market Theory models, there can be no endogenous risk at all.
• Having discussed all this in past commentaries, we conclude on a somewhat lighter vein with a proposal for improved pedagogy in financial theory in the future. In doing so, we express our own version of Stein's Law: Teachings that are absurd are eventually recognized to be absurd, and will cease to be taught to tomorrow's young