Understanding The Gobal Financial Crisis Upon Us

Bank losses on Fannie, Freddie stock apparently underestimatedAccording to a survey conducted by the American Bankers Association, nearly one-third of U.S. banks hold preferred stock issued by Fannie Mae and Freddie Mac. Nearly all $36 billion of such stock was cleaned out when the Federal Reserve took the mortgage giants over. "The negative impact on banks -- particularly Main Street community banks -- is far greater than regulators first thought," Edward Yingling, CEO of the ABA, wrote in a letter to the Treasury, the Federal Reserve and other banking regulators. Financial Times (23 Sep.)

SEC's Cox says "voluntary regulation doesn't work"Securities and Exchange Commission Chairman Christopher Cox said during a Senate Banking Committee hearing Tuesday that "voluntary regulation doesn't work." He said he is seriously concerned that no government agency has regulatory authority over investment banks. He wants the SEC to be granted authority to require disclosure statements as well as power over products such as credit-default swaps. InvestmentNews (23 Sep.)

Analysis: Privacy in market for credit-default swaps led to problems: No one truly knew the volume of trading in the market for credit-default swaps, possibly leading to overinsurance in the sector. That, in turn, fueled the financial crisis. "The pressure to hedge has led the most liquid contracts to overshoot, in effect pricing in absurd default risks and recovery rates," according to a Financial Times analysis. Financial Times (23 Sep.)

To fund those deficits, we're going to have to borrow an ASTRONOMICAL amount of money. The Treasury just held a record $34 billion sale of 2-year Treasury Notes. That was followed by a $24 billion sale of 5-year Notes, the biggest such sale in more than five years. Those numbers will only go higher with time.

White House, Congress agree on rescue proposal President George W. Bush's administration and congressional leaders came to terms on a $700 billion rescue plan for the financial system. The House and Senate will likely vote on the legislation this week. Many of the plan's mechanics were left to the Treasury, including how much the government would pay for toxic assets and which assets would be bought. The Treasury has 45 days under the bill to issue guidelines regarding those procedures. Read the draft proposal. ClipSyndicate/Bloomberg (29 Sep.) , The New York Times (28 Sep.) , Financial Times (29 Sep.)

In fact, Congress is raising the federal debt ceiling to a whopping $11.3 TRILLION to account for this additional borrowing.

The likely impact: All the additional supply will drive bond prices LOWER and interest rates HIGHER. Heck, 10-year Treasury Note yields have already surged from around 3.4% to almost 3.9%. That will blunt the impact of the bailout by driving financing costs higher on all loans whose rates are benchmarked to Treasuries. I’ll bet they will be lower interest rates soon to counter act this unwanted effect. (Bernanke lowered them on Oct 21st.)

Rescue plan defeated on Capitol Hill; Dow falls 777 points Despite pleas from President George W. Bush and leading lawmakers from both parties, the U.S. House of Representatives voted 228-205 against the $700 billion rescue plan. The development sent markets plunging -- the Dow dropped 777 points -- and left leading lawmakers scrambling. Only 65 Republicans, or about a third of those voting, supported the plan, while 140 Democrats, about 60%, said yes, although many voiced concerns. Both presidential nominees, Sens. John McCain and Barack Obama, supported the bill. ClipSyndicate/Bloomberg (29 Sep.) , International Herald Tribune (29 Sep.) , The Economist (29 Sep.) , The Wall Street Journal (subscription required) (30 Sep.) , Bloomberg (30 Sep.)

U.S. financial ills spread to Europe and beyondAbout a week ago, European leaders rejected calls from U.S. counterparts to join their economic-rescue effort. Now Europe is facing a financial crisis nearly as dire as the American situation. The turnaround of events shows just how quickly problems are spreading. "In this day and age, a bank run spreads around the world, not around the block," said Thomas Mayer, Deutsche Bank's chief European economist. "Once a bank run is under way, it doesn't matter anymore if you have good loans or bad loans. People lose confidence in you." International Herald Tribune (01 Oct.) , Reuters (01 Oct.)


Lack of confidence sends Libor to record levelWhile stock markets around the world suffer steep declines, the overnight dollar Libor surged to 6.88%, an indication that lenders are concerned that money they lend to other financial institutions may never been seen again. "The reason Libor is so elevated is a lack of confidence between counterparties in the financial sector," said Charlie Diebel of Nomura. The situation forced central banks to inject billions into the system. Telegraph (London) (01 Oct.)


Manufacturing contracts faster than expectedThe measure of American manufacturing activity marked its first significant decline of the economic downturn. The index of the Institute for Supply Management has been hovering for most of the year on what economists call "the boom-bust" line." "The headline ISM has plunged into recession territory," said Ian Shepherdson, chief U.S. economist at High Frequency Economics. The New York Times/The Associated Press (01 Oct.)

Credit-card debt may be next to slap finance sectorInnovest StrategicValue Advisors predicted that credit-card debt is the next wave to crash against the financial sector, saying banks will charge off $96 billion in delinquent accounts in 2009, twice the forecast for 2008. Gregory Larkin, senior banking analyst for Innovest, said all of that bad credit is going to surface rapidly, and he predicted that credit-card charge-offs will mimic those of mortgages. MarketWatch (30 Sep.)

SEC extends ban on short salesTo give Congress more time to pass the $700 billion economic-rescue plan, the Securities and Exchange Commission extended the temporary, emergency ban on short selling in nearly 1,000 stocks. The ban will continue until three business days after the rescue package is enacted, if it gets approved. But the ban will not last past Oct. 17. Reuters (01 Oct.) , Financial Times (02 Oct.)

FDIC seeks unlimited-borrowing authorityThe Federal Deposit Insurance Corp. asked Congress for temporary authority for unlimited borrowing. The request was in the U.S. Senate's bailout legislation. The 451-page bill would raise the limit on federal bank-deposit insurance from $100,000 per depositor to $250,000. Reuters (01 Oct.)

Commercial paper sees biggest weekly drop since 2001Data from the Federal Reserve show a stunning $95 billion drop in commercial-paper investment, the biggest weekly reduction in six years. The shrinkage in commercial-paper financing raises fears of serious cash-flow problems for corporate borrowers and banks. Freezing of the market is hitting even highly rated companies, including General Electric and AT&T. Financial Times (02 Oct.)

"Ghost of deflation" haunts marketsAs banks tighten credit, commodity prices plummet and asset values decline, the world may be turning from the dangers of inflation to the risk of falling into a vicious deflationary cycle. "The ghost of deflation could be dragged out of the closet again in coming months," said Joerg Kraemer, chief economist at Commerzbank in London. David Owen, chief European economist at Dresdner Kleinwort in London, agreed, saying, "We are certainly more worried about deflation than inflation." Bloomberg (06 Oct.)
U.S. plans bold moves to shore up financial system

The U.S. Treasury Department plans to invest as much as $250 billion in banks and guarantee newly issued bank debt for three years to battle the financial crisis, officials said. The Federal Deposit Insurance Corp. will guarantee all deposit accounts that do not earn interest. Capital injections will come from the $700 billion rescue package approved earlier this month. President George W. Bush is expected to announce the plan Tuesday. ClipSyndicate/Bloomberg (14 Oct.) , International Herald Tribune (14 Oct.) , Bloomberg (14 Oct.)

Economic slowdown clamps lid on runaway commodity pricesWorld prices for wheat and corn have dropped 40% since spring, oil is down 44%, and metals such as aluminum, copper and nickel have fallen by a third or more, as financial panic brings the commodity bull market to an end -- at least for the moment. This sudden about-face is the brightest news on the horizon for consumers because it puts money into their pockets at a time when they really need it. The New York Times (13 Oct.)

The world is on notice.

Several of the world's Central Banks launched a determined and coordinated attack against the widening global financial crisis by lowering short-term interest rates in unison last week.
The Federal Reserve Bank, the European Central Bank, the Bank of England, Canada, Sweden, Australia, and Switzerland all cut short-term interest rates by a half percentage point.
Across the Pacific Ocean, the People's Bank of China, Australia, South Korea, Hong Kong, Singapore, and Taiwan cut interest rates, too.

This is the first time that central banks have moved in unison since the September 11 terrorist attacks, and I think it is just the start of global government efforts to keep the global economy from further deterioration. Then, over this past weekend, we saw additional coordination from the U.S. and European Central Banks: The Fed, the European Central Bank, the Swiss National Bank, and the Bank of England all saying they would provide unlimited U.S. dollar funds to financial firms.


2 kinds of investors

Academics and economists deal in a world populated by rational investors. Unfortunately, we live in a world populated by behavioral investors. Rational investors look at the turbulence in today’s markets and calmly evaluate the potential risks and rewards of remaining invested. Rational investors do not confuse certainty with safety. They recognize that, although the principal value of funds invested in Treasuries and CDs may be certain, after factoring in taxes and inflation, the return they receive on their “safe” portfolio they realize that it may fall woefully short of what they need to maintain their standard of living in retirement.

This is not so for behavioral investors. They see the frightening headlines and are bombarded minute by minute on the radio, television, and internet with financial crazy making. The result is all too often a growing panic that leads them to seek the mythical “safety” of dumping stock and running to cash. Which one are you?

A bit of perspective

If the Central Banks were our kids, we'd be taking their credit cards away. They are spending us into the poor house!

Sure, Wall Street is at the rotten root of this crisis. Their toxic debt is poisoning the global economy and financial system. But there's plenty of blame to go around.

It makes you wonder just how big that $700-billion bailout package will need to be, now that they've expanded it from buying toxic debt to buying preferred shares in banks. All this new spending is in addition to the $1.8 trillion in total government bailout money since the financial crisis started.

Maybe we won't get those higher prices in gold right away, because investors are scared of deflation.

On the other hand, throwing trillions and trillions of dollars at the system is inherently inflationary.
Do you think Beijing thinks that the dollar's status as a reserve currency is soon going to be history. Just like the pound sterling lost its status as the world's reserve currency in the early 20th century.
Beijing's bank is overflowing with money. In fact, at nearly $2 trillion, China has the largest foreign reserves of any country in the history of the planet.

That's why they're going to back the yuan with gold ... loads of it. China has already started purchasing small amounts of gold.

Economists say U.S. housing market nowhere near bottomHome prices across most of the country are likely to continue falling through the end of 2009, economists said, and in some markets may keep falling even longer, depending on how bad the slowdown gets. In the hardest-hit states such as Arizona, California and Florida, the story is the same: More houses are going up for sale while escalating interest rates on mortgages, falling wages and rising unemployment are putting pressure on an already-diminished pool of possible buyers. The New York Times (15 Oct.)

IMF raises estimate of losses from crisis to $1.4 trillionIn its quarterly report on global capital markets, the International Monetary Fund increased its estimate of losses from the financial crisis to $1.4 trillion, up from $945 billion in April and $1.3 trillion last month. The IMF also estimated that major global banks will need approximately $675 billion in capital in coming years. "The combination of mounting losses, falling asset prices and a deepening economic downturn has caused serious doubts about the viability of a widening swath of the financial system," the IMF said in its assessment. International Herald Tribune/Reuters (07 Oct.)

Consumer borrowing sees first fall in more than decadeConsumer borrowing fell at an annual rate of 3.7% in August as households scaled back their use of credit drastically, according to the Federal Reserve. This is the first time that consumer borrowing fell in more than 10 years. Although economists expected a $5.25 billion increase in August from July, borrowing was instead down $7.88 billion, totaling $2.58 trillion. The New York Times/The Associated Press (07 Oct.)

The government is throwing everything ... and I do mean EVERYTHING ... at the credit and mortgage markets. But rates on 30-year fixed loans aren't going down. They're going up.

How can rates be going up when the economy is tanking and the government is throwing everything it can at the banking sector and credit markets?

Because bond investors are dumping the heck out of bonds — and when bond PRICES fall, bond YIELDS (interest rates) rise.

Why are investors selling bonds? Well, they just learned that the budget deficit soared to $454.8 billion in fiscal 2008, which ended September 30. That was more than double the $161.5 billion deficit in 2007 and the highest in the history of the country.

Politicians and policymakers would like you to think they can make things better, drive mortgage rates down, save the banking sector, and return us to the happy-go-lucky, reckless lending days of 2003-2007. But they can't. Well, they can and just today they lowered rates by another ¼ point… but the bond market is pushing back and saying loud and clear: "We can see the writing on the wall, there will be too much supply of future government bonds and too little demand, they are out of there."

Federal deficit takes back seat to stabilityConfronted with a hugely expensive economic crisis, Democratic and Republican lawmakers alike elected to pay the bill for a bailout by borrowing money rather than cutting spending or raising taxes. The problem lurking in the shadows is that while borrowing is relatively inexpensive in a weak economy with plummeting interest rates, the cost will become a much heavier burden when growth returns and interest rates climb. The New York Times (19 Oct.)

Job losses hurt every corner of U.S. economyLayoffs are spreading beyond the financial and home-building sectors to every corner of the economy, with the situation likely to worsen as the holiday season approaches. A survey of more than 100 chief financial officers and other senior executives found that 58% expect to reduce payrolls next year, while a majority plan to cut operating costs by at least 5%. A four-week moving average of new U.S. government jobless claims hit its highest point last week in seven years. Reuters (17 Oct.)

Bernanke backs another stimulus packageCongress would be wise to start thinking about another fiscal-stimulus package to pull the U.S. out of a long downturn, Federal Reserve Chairman Ben Bernanke said. Predicting an economy "likely to be weak for several quarters," Bernanke explicitly endorsed for the first time another stimulus package. For months, Democrats have been pushing for a second round of stimulus measures, targeted to domestic construction projects, expanded food stamps and broader federal spending to help states pay for growing health care costs for the poor. Reuters (21 Oct.)

And so it goes…

Moral Suasion and the Markets

Note: As most of you regular readers know, I have taken to the habit of posting clips of important news to your financial future at the beginning of my post. Because of the recent events there is quite a run-up from August 05, my last posting to this post. These clips are a fascinating story unfolding of to the lead up to the biggest market collapse since the Great Depression. See the financial storm brewing. After these news clips is my commentary. For those of you new to this blog, the current theme about the economy began in April of ’08. To get an in depth analysis of what is going wrong and why the rules are changing, begin in April.

Inflation outpaces rise in U.S. consumer spendingConsumer spending grew by 0.6% in June, but that gain was wiped out by inflation rising by 0.8%, the biggest monthly increase since September 2005. "That real consumer spending is down two-tenths in June is not a good thing in and of itself, but it also is a bad thing for what it means for third-quarter consumption," JPMorgan Chase economist Michael Feroli said. The New York Times (05 Aug.)

U.S. home prices could fall additional 33%, analyst saysU.S. home prices could fall by an additional one-third before mortgage lending resumes with gusto, a widely respected analyst said. "Home prices are going to fall much more than people expect," Oppenheimer analyst Meredith Whitney said. CNBC (04 Aug.)

What sounded alarmist a year ago is fairly accurate nowAs the Financial Times continues its look back over the credit crunch that began one year ago, it delves even further back into the recent history of investment banking, hedge funds and how the financial industry has changed. "This has been a very deep and unusual crisis that involves the unwinding of a decade of excess. The impact on the financial sector has been 7 on the Richter scale (a 'major' earthquake), as dramatic as anything for 25 years," said Bill Winters, co-head of the investment bank at JPMorgan Chase. Financial Times (04 Aug.)

IMF reduces forecast for growth in BritainThe International Monetary Fund dashed Alistair Darling's hopes for a quick recovery of the U.K. economy by lowering its forecast for growth and by warning of two more years of economic woes. Additionally, the fund said rising inflation gives the Bank of England little room to adjust monetary policy to bolster growth. The IMF also said the Treasury is on course to reach next year the national-debt limit of 40% of GDP, in a warning to the chancellor that he won't be able to borrow his way out of economic pain. The Times (London) (07 Aug.)

Credit crisis persists as banks take more hitsThe credit crisis continues to affect some of the biggest banks on Wall Street. UBS, Citigroup and Merrill Lynch have taken massive write-downs, and investors are still worried about more subprime costs. Although lower oil prices have lifted stocks, it apparently will take more than cheaper energy to boost consumer spending and business. CNBC/Reuters (12 Aug.)

U.S. health care expenses expected to jump 10.6%Health care costs in the U.S. are predicted to increase 10.6% next year. Employers have lowered many costs of health coverage with sizable investments in wellness programs that help prevent expensive critical care. FinancialWeek (12 Aug.)

Federal Reserve's concern about inflation continuesThe Federal Reserve said inflation is still a top concern, even as energy prices fell recently. Given the unimpressive growth rate, plus inflation, a recession is still possible for the U.S., although some officials see declining oil prices as keeping inflation under control. Reuters (12 Aug.)

The Cold, Hard Numbers on the Credit Crunch
RealtyTrac shocked Wall Street with the most explosive news imaginable:
U.S. home foreclosures skyrocketed an astonishing 55% in July ...
One in every 464 American homes went into foreclosure last month alone ...
A staggering 750,000 abandoned homes are now begging for buyers nationwide — a clear sign that prices will continue to plummet and that ever-increasing numbers of homeowners will walk away in the months ahead ...

Fed Loan Officer Survey Shows Widespread Tightening!
Every quarter, the Fed releases a report called the "Senior Loan Officer Opinion Survey on Bank Lending Practices." It quantifies how many banks are tightening standards, and on which types of loans. The third-quarter survey was conducted in July; 52 domestic banks and 21 foreign banks with operations here in the U.S. responded.

Some 74% of banks surveyed said they're tightening standards on prime mortgages, up from 62.3% in the second quarter of 2008. A net 84.4% said they were cracking down on nontraditional financing, up from 75.6%. And a net 85.7% said they were tightening on subprime loans, up from 77.7% a quarter earlier.

These numbers are off the charts. The previous record for the home mortgage category was 32.7% in 1991. So in plain English, you have more than twice as many banks tightening standards now than EVER before.

* The trend is spilling over into commercial real estate. This is no longer just a subprime mortgage crunch. In fact, it's not even a residential real estate crunch. The Fed's commercial real estate (CRE) figures prove it.

A net 80.7% of survey respondents said they were tightening standards on CRE loans. That was up from 78.6% a quarter earlier and the highest on record.

* Consumer credit is tougher to come by. The story is the same for credit cards, auto loans, boat loans, and other forms of consumer credit. Some 66.6% of lenders said they were tightening standards on credit card borrowers. That was up from 32.4% a quarter earlier and the highest since the Fed began collecting data in 1996. 67.4% are making it tougher to get other consumer loans, up from 44.4% and another record. Money and Markets by Mike Larson August 15, 2008

Economists: Taxpayers likely to bail out Fannie, FreddieThe consensus of 53 economists polled by the Wall Street Journal is that there is a nearly 60% chance that U.S. taxpayers will have to prop up Fannie Mae and Freddie Mac. The main mortgage-finance providers in the U.S. should be pushed to raise capital privately, said seven out of 10 economists surveyed. One in three said Freddie and Fannie should be nationalized and then sold off in smaller chunks when the housing market recovers, the newspaper reported. Bloomberg (15 Aug.)

Gas more expensive than cars for U.S. consumersIn May and June, U.S. dollars spent on gas surpassed money spent on cars and parts for the first time since 1982. The last time gasoline was such a large component of personal spending was in September 1982 during an energy crisis set off by the 1979 Islamic revolution in Iran, the second-largest oil producer of OPEC. Record prices at the pump have decreased U.S. gasoline demand, at a five-year low, and also affected consumer spending, including auto sales. Bloomberg (15 Aug.)

Concerns mount with U.S. inflation still on the riseMany were betting that slowing consumer demand coupled with declining energy prices would help smooth inflationary pressures, but last month saw U.S. consumer prices rise twice as fast as predicted, in the largest surge since 1991. This situation further emphasizes the predicament of the Federal Reserve as it tries to balance the risks of increasing cost of living with growing unemployment, the credit crunch, and a weakened consumer. Financial Times (14 Aug.)

Signs of economic slowdown pile up in Asia, EuropeGermany's economy is contracting, the Bank of England offered a dismal outlook and Japan seems to be near a recession. More bad economic news is expected in Europe this week. Although commodity prices are starting to come down, consumers are feeling the pressure from financial crises in the U.S. and elevated inflation. Experts said the U.S. economic slowdown is spreading through Europe and Asia. International Herald Tribune (14 Aug.)

Shrinkage of U.S. money supply causes further concernWith the U.S. money supply seeing its most acute contraction in modern history, there is a more heightened risk than ever of a severe economic slowdown. This comes on top of the current credit crisis and at a time when overall debt burden in the U.S. economy is at record levels. The acuteness of the drop, versus the absolute level, is what monetarists find most disturbing. Telegraph (London) (19 Aug.)

Former IMF economist predicts failure of large U.S. bankFormer International Monetary Fund chief economist Kenneth Rogoff expects to see a large U.S. bank fail in the next few months, estimating more trouble for the U.S. economy. "I think the financial crisis is at the halfway point, perhaps. I would even go further to say, 'The worst is to come,'" he said at a financial conference. Rogoff also said the Federal Reserve was wrong to slash interest rates as "dramatically" as it did. Reuters (19 Aug.)

Freddie Mac's bond sale underscores severity of crisisFreddie Mac paid a yield of 4.172%, 113 basis points over Treasuries, on a five-year debt issue to raise $3 billion. It is the highest risk premium that Freddie has paid, highlighting the severity of the U.S. housing crisis. Investors have demanded higher yields because of uncertainty in the market as well as questions about moves that the government might make regarding the government-sponsored enterprise. Financial Times (20 Aug.)

U.S. walks tightrope between inflation, recessionThe U.S. is battling inflation and a recession simultaneously as higher costs for food and energy affect nearly all products, increasing consumer prices. Some economists see the slowdown as an antidote for inflation; others see inflation as a continuing threat. Options for the average American are that either inflation will reduce their buying power or rising prices will spell the end of some jobs and businesses. The New York Times (19 Aug.)

SEC plans to broaden short-selling ruleThe Securities and Exchange Commission aims to propose a new short-selling rule in upcoming weeks, broadening an emergency order -- covering 19 financial stocks -- that ended last week. SEC Chairman Christopher Cox said the proposal "will focus on marketwide solutions" and possibly require more transparency in disclosing to the public significant short positions in stocks. Reuters (19 Aug.)

Cramer of CNBC suspects insider trading of Fannie, Freddie: CNBC's Jim Cramer called for a suspension in trading Fannie Mae and Freddie Mac stocks on the grounds that insider information was circulating. Cramer blamed the Securities and Exchange Commission and the New York Stock Exchange for not taking action when it seemed obvious that insider trading was happening. CNBC (20 Aug.)


Gold becomes solid as oil prices climb, dollar dropsThe combination of a falling dollar and higher oil prices has raised gold's appeal as the precious metal is expected to have its largest weekly gain in seven years. "In the short term, at least for another month or so, gold will stay in this consolidatory phase of rebounding on price drops and falling when gains get too much," said Lin Yuhui of China International Futures. "These movements will largely continue to be driven by movements in the U.S. dollar and crude oil." Bloomberg (22 Aug.)

Libor-OIS spread indicates credit crunch to continueThe spread between the three-month London interbank offered rate for dollars and the overnight indexed swap rate is at 77 basis points, up from 24 basis points in January. By mid-December the spread is expected to widen to 85 basis points. Alan Greenspan, former chairman of the Federal Reserve, said the spread should indicate when the markets have returned to normal. According to forward markets, that won't be for quite some time. "It's like an ongoing nightmare and no one is sure when we're going to wake up," said Stuart Thomson, a money manager at Resolution Investment Management. "Things are going to get worse before they get better." Bloomberg (25 Aug.)

Banks, firms pay more to raise money in bond markets Dismal economic conditions around the world, increasing default rates and concerns about the health of financial institutions are forcing yields to rise as bond investors demand higher spreads. According to Lehman Brothers, risk premiums for investment-grade companies and banks in the U.S. recently reached their highest level since the 1990s. Spreads in Europe and Asia for some investment-grade companies have hit 10-year highs as well. ClipSyndicate/Bloomberg (22 Aug.) , Financial Times (24 Aug.)

Central bankers acknowledge uncertainty of crisis: At the gathering of central bankers and other economic experts in Jackson Hole, Wyo., this weekend, the consensus was uncertainty as to how the credit crisis and other woes will ultimately affect the global economy. Policymakers from around the world seem conflicted as to whether resilience in the global economy will win out or if the worst is yet to come. Financial Times (24 Aug.)

Analysis: U.S. economic woes hinge on home buyersThe difference between a mild downturn of the U.S. economy and a severe recession depends on the ability and willingness of consumers to quickly return to the housing market, according to this Reuters analysis. In order for home prices to be in balance with incomes and rents, economists say they need to drop another 10%. However, prices could fall even further if Fannie Mae or Freddie Mac meltdown, or if private lenders tighten requirements. Depending on how far home prices fall, the U.S. could suffer a consumer-led recession. Reuters (25 Aug.)

Economists: Inflation tops credit crunch as greatest threatA survey of the members of the National Association of Business Economists showed inflation to be the chief concern, ahead of the mortgage and credit crises. Of the respondents, 15% see overall inflation as the greatest threat to the economy, and 16% find energy prices to be the greatest short-term threat. CNN (25 Aug.)

White House to keep pushing for stronger yuanThe Bush administration said it will continue pressing China to allow the yuan to appreciate more quickly. The yuan has strengthened 6.7% this year against the U.S. dollar and has appreciated 17% in the past two years. Bloomberg (26 Aug.)

Banks report second-lowest quarterly earnings since 1991Banks posted their second-lowest earnings performance since 1991 for the quarter from April to June, the FDIC reported. Earnings for the quarter tumbled 86.5%, from $36.8 billion a year ago to $5 billion this year. MarketWatch (26 Aug.)

British pound sliding toward $1.50 against dollarThe British pound could fall as low as $1.50 against the U.S. dollar in the next few years. The pound fell to $1.8386, the first time it slid to less than $1.84 since mid-2006. The decline came as the economic slowdown continues and foreign investors increasingly pull out of Britain's economy. Telegraph (London) (26 Aug.)

Canada doesn't meet forecast for quick growth in Q2Canada's economy apparently grew less quickly in the second quarter than the Bank of Canada predicted. In July, policymakers forecast that GDP would expand at an annual rate of 0.8% in the second quarter. The bank gave no new expectation for growth. The Globe and Mail (Toronto) (26 Aug.)

Retail stock ownership in U.S. falls to record lowRetail investment in U.S. stocks has hit a record low, showing that institutional investors will play a bigger role in domestic equity markets. At the end of 2006, the last year for which figures were available, individual investors owned 34% of all shares and 24% of stock in the top 1,000 companies, and institutions held 76% of the shares, up from 61% in 2000, according to a report. Financial Times (01 Sep.)

U.S. takes over Fannie, Freddie to stabilize mortgage market Source: CNBC The U.S. government placed Fannie Mae and Freddie Mac in a conservatorship Sunday and replaced their CEOs in a drastic move to stabilize lending in the mortgage market. Treasury Secretary Henry Paulson said the rescue is necessary because allowing either company to fail would trigger worldwide market turmoil. "This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement," Paulson said. CNBC (07 Sep.) , The New York Times (registration required) (07 Sep.) , Financial Times (08 Sep.) , Bloomberg (07 Sep.)

In July, consumers borrowed about half as much as forecastConsumers in the U.S. borrowed about $4.6 billion in July. The median estimate of 35 economists surveyed by Bloomberg News was an increase of $8.5 billion in consumer credit for the month. Consumers borrowed $11 billion in June. "A slowdown in the supply of credit is one of several factors that we think argues for a slowdown in consumer spending," said Zach Pandl, a Lehman Brothers economist. "There will be a period of weak consumer spending ahead." Bloomberg (08 Sep.)

Former Fed official calls Fannie, Freddie takeover a "stopgap": The government's seizure of Fannie Mae and Freddie Mac is an attempt to keep them running into next year, when the new president and Congress can determine their future. "Some of this is a stopgap to try to prevent the mortgage market from falling apart," said William Poole, former president of the Federal Reserve Bank of St. Louis. Poole also said it is "an unacceptable situation" to have a shareholder-owned company with taxpayers covering risks. Bloomberg

Interbank lending dries up over renewed fearsInternational money markets are once again under severe pressure as fears about the financial system were renewed with the bankruptcy of Lehman Brothers and other developments. "Sentiment is incredibly negative. It is getting much harder to raise money with the cost of funding getting more expensive," said Dominic White of fund manager Morley. "Banks are reluctant to lend out cash in this climate. It is difficult to predict whether the strains will increase or ease, but it is likely to remain difficult for some time for most institutions that want to raise cash with this much uncertainty." Financial Times (15 Sep.)

Analysis: Fed may cut interest rate after drama on Wall StreetFederal Reserve officials met Monday after the weekend's dramatic events in the financial industry and discussed an interest-rate cut, possibly in conjunction with other central banks. Before the latest turmoil on Wall Street, most officials speculated that the next move would be a rate increase. But after the weekend's events, there are concerns about a downward spiral, and a rate cut is more likely. Financial Times (15 Sep.)

Fed loosens emergency-lending standards in Lehman's wakeThe Federal Reserve dramatically loosened standards for emergency loans to investment banks to head off concerns in Monday's markets about fallout from Lehman Brothers' Chapter 11 filing. The central bank said it will not offer cash to potential buyers of Lehman. Meanwhile, 10 major banks worldwide agreed to contribute $7 billion each to an emergency fund that could be used if any of them faces problems similar to those facing Lehman. The New York Times (15 Sep.)

Central banks prepare to counter potential financial turmoilIn the wake of the U.S. banking crisis, the European Central Bank and the Bank of England announced that they are prepared to intervene in financial markets if necessary. "The ECB stands ready to contribute to orderly conditions in the euro money market," the ECB said. The Bank of England said it will carefully monitor the sterling money market. The ECB also announced that it will offer markets unlimited overnight liquidity. Financial Times (15 Sep.)

SEC to strengthen rule on short sellingThe Securities and Exchange Commission plans to move forward on creating permanent regulations for abusive short selling. The SEC will likely underscore the short-selling rule as well as shorten the time in which traders must buy back stock if they fail to deliver a security by the settlement date. The plans came about after Lehman Brothers was forced to file for bankruptcy and the U.S. government took over Fannie Mae and Freddie Mac. Reuters (15 Sep.)

Regulators propose rule changes to deal with crisisRegulators at four U.S. agencies proposed rule changes this week to stabilize financial markets and beef up the balance sheets of financial institutions. Regulators and the White House decided to ease accounting rules to help the banking industry cope with issues that some experts said stemmed from deregulation. The Securities and Exchange Commission issued guidelines for propping up money-market accounts and imposed new short-selling limits. The New York Times (free registration) (17 Sep.)

Voters, businesses appear to welcome more regulation: The Federal Reserve's rescue plan for AIG, coupled with a similar plan by the Treasury Department for Fannie Mae and Freddie Mac, could mark the end of 30 years of deregulation by the federal government. The government's involvement in financial markets follows similar shifts in food safety, airlines and trade and signals that increased regulation is now more acceptable to businesses and voters. BusinessWeek (18 Sep.)

CDS market to take hit from Lehman's bankruptcyMarkets are about to see just how accurate Warren Buffett's statement is about derivatives being "financial weapons of mass destruction," as fallout from Lehman Brothers' bankruptcy begins. The Economist explained how a bankruptcy of this size may affect the market for credit-default swaps, an arena that grew in recent years to a $62 trillion behemoth. The Economist (18 Sep.)

Emerging markets saddled with backlog of maturing debtDuring the next year, emerging-market economies will need to refinance about $111 billion of bonds, raising the likelihood of defaults and other problems. "Many corporates and banks in the emerging markets are highly levered without cash to fall back on. These will struggle should they need to raise money in the markets," said David Spegel, ING's global head of emerging markets strategy. "The bond and loan markets are much harder to access now, and it could get worse, which means there will be defaults." Financial Times (21 Sep.)

Moral Suasion and the Markets

Bigger than the dot-com bust? Yeps. Bigger than Black Monday in 1987? Yes. Bigger than the oil shock of the 1970s? Yes.

Well, this has been quite a year for your portfolio! If you have been following this blog since April, you understand what has happened and why. Simply, Government has created an empire of debt that has to be managed. Clearly, it has been mismanaged. People are responsible, and herein is the problem. “We” keep changing the rules to worship a GROWTH economy, rather than a SUSTAINABLE one. Good stewardship of the land, the sky and the seas is what “we” don’t do. “We” don’t hold ourselves accountable to the value of sustainability. We buy and sell our way into the value of a short-term growth economy at the expense of our children’s future, don’t “we”?

That’s the way this system works, like it always has, until it doesn’t. Don’t we continually change the rules to serve special interests where the rich get richer, and you know the rest? Don’t we invest for a gain in value, and don’t we look first at an investment’s financial return, and then the fundamentals to answer the question, is it sound? Do we ever ask if it serves our environment sustainability criteria first? If it does, then it follows that it would also stand to benefit the good of our communities, the infrastructure of our society, as well as individual shareholder value.
There is a disconnect between our ability to comprehend a financial economy in the context of an environmental one. This is not only GREEN but it is social responsible behavior to our future generations. The core problem is that it is our nature to “misplace” our values when it comes to the ethical choices we make in the name of the dollar first.

I am guilty of this. I want more… stuff. And it is easy for me to enjoy these tangible things, even if I know that they don’t serve the environment or my children’s future in a friendly and sustainable way. I want more return too. Oil is an obvious example of this trade off between the short-term positive return from the financial investment and the long-term negative return to the environment. Additionally, our short-term thinking colludes with our short-term greed and then there is at some level, a sell out to the value of sustainability. There is no surprise that the current market mess is in the financial sector and that it is in the Empire of Debt.

This current market crisis is precisely why those who espouse the virtues of a free market - need regulation, most especially, short-term speculators! Because short-term speculators in the market are allowed without regulation, to take enormous leveraged positions ($57.9 trillion), they threaten to undermine the very system that ironically supports them and gives them the freedom and power to do this. Today, with that power unchecked and with a government policy of deregulation all the way back to Regan economics we have this problem, 30 years in the making.

Guess what is the quick, politically expedient short-term solution? Why it is massive infusions of inflationary new capital, $1 trillion in more debt to still more future generations and while all this is preoccupying our attention, there is the negative consequences to our environment that we think we don’t have to be responsible to till we take care of our current problem. Am I right?
Philosophy and history lessons behind us, if you have your money in some financial institutions you may be thinking, how did this happen. Well, it relates to the collapse of the home mortgage market and derivatives. These are essentially bets on interest rates, foreign currencies, stocks or specific events like the bankruptcy of a particular company. The interest rate-related bets are by far the biggest. But the bets on bankruptcies — called credit default swaps — are the fastest growing and the most volatile.

These derivatives were originally designed to help hedge investments reduce risk — like insurance policies. But in practice, they've been increasingly used to leverage investments, increasing the risks of participants, again, all for short-term gain.
For a relevant explanation I defer to Mike Larson. In his most recent email he writes and explains this.

“It's been quite the eventful week on the bailout front. The Treasury and Federal Reserve drew the line at Lehman Brothers, allowing the fourth-largest broker in the U.S. to file for bankruptcy.
Then a couple days later, the Fed backtracked and arranged an $85 billion bailout of American International Group. The idea is to keep AIG afloat while it sells assets to raise money.
As I've been discussing for a long-time, crummy residential mortgages ... troubled commercial mortgages ... and all kinds of other souring loans are causing a huge chunk of the problems in the banking and brokerage industry. But in the case of AIG, something else is at work. It's an obscure kind of contract that, behind the scenes, is wreaking havoc throughout the financial industry.

And I want to talk about these "CDS" — or Credit Default Swaps — today.

How Credit Insurance Works
I'm sure you know how traditional insurance works. After all, you have some combination of homeowners insurance, life insurance, auto insurance, and maybe even a policy on an RV, a boat, or a motorcycle. You pay a monthly, semi-annual, or annual premium to an insurance company. And the company invests that money to generate returns. If a catastrophe strikes — you get in a car crash, your house burns down, or you die — the insurance company pays you or your heirs a lump sum of money.

It's a pretty straightforward business.

But in the past few years, many Wall Street firms, hedge funds, and companies like AIG plunged headlong into the Wild West World of CDS.

CDS operate like insurance on a bond or other security. Let's say you're a portfolio manager who owns $100 million in XYZ Corp. bonds. You read the paper, and you see that the industry XYZ is in is faltering, with sales declining and profits falling.

As a result, you might be concerned about the possibility that XYZ will default on the bonds you're holding. But for one reason or another, you don't want to sell your bonds and move on. So instead, you go into the market and buy CDS to protect you against the possibility of default.
You — the credit protection buyer — would pay periodic premiums (just like you and I do on life or car insurance) to a credit protection seller. If XYZ does NOT default, then the seller just collects his premiums and makes a decent return. If XYZ does default, then the seller either takes the bonds off your hands, paying you face value (regardless of where they're trading), or he pays you a cash settlement that makes you whole.

Either way, you as the buyer are protected from catastrophic loss — just like a homeowner is protected from catastrophe by his policy when his home burns down.

The Flaws in the System
Sounds good, right? But here are the problems...

First, CDS aren't highly regulated like the traditional insurance market is at the state level. In fact, the CDS market isn't really regulated at all. "Complacency is now unprecedented and regulators are asleep at the switch. The Securities and Exchange Commission says it has no direct supervision of trading in credit derivatives. The Commodity Futures Trading Commission also says it isn't responsible. The International Swaps and Derivatives Association (ISDA) says the industry can policy itself. We're not so sure."

Second, the CDS market exploded in size over the past several years. According to the British Bankers Association, the CDS market expanded from just $180 billion in 1996 to a stunning $20 trillion a decade later. That's a 111-fold expansion in this esoteric, opaque market. And by all accounts, it continued to grow LAST year as well — to a whopping $57.9 TRILLION, according to the Bank for International Settlements.

Third, the CDS market morphed into a vehicle for massive speculation on corporate credit rather than a way to hedge downside risk. Investors started buying CDS on companies with worsening credit — expecting those contracts to rise in value — and selling CDS on companies with improving credit — expecting to record a gain as those contracts declined in value.

Fourth, the quality of counterparties in the CDS market deteriorated substantially. What do I mean? When you bought your last homeowners or life insurance policy, you probably checked the credit rating of the company selling that policy. After all, what good is insurance if the company standing behind it can't make good on claims?

The problem is that more and more CDS were being bought and sold by hedge funds and other thinly capitalized companies during the boom days. This excerpt from a recent Minyanville column pretty much sums up the problem:

"A hedge fund trader once told me that they insured/sold 50 times their capital in CDS with the counterparty being a very large, well-known investment bank. "When I asked him if he was worried about that kind of leverage, he responded by saying that is the bank's problem because if he is wrong about writing all these insurance policies (in the form of CDS), they can only lose their investment capital in the fund." Comforting, eh?

The Fallout is Spreading
So how does AIG fit into all this?

Well, it sold protection on a mind-boggling $441 billion of fixed income securities. $441 billion! According to Bloomberg, almost $58 billion of those contracts referenced securities tied to subprime mortgages. That's what really brought AIG to its knees — the exposure to the CDS market.

Who else has massive exposure to credit derivatives?
According to a Fitch Ratings report from last year, the top five counterparties on CDS contracts (as of 2006) were:
Morgan Stanley,
Goldman Sachs,
JPMorgan Chase,
Deutsche Bank, and
ABN Amro.

It's impossible to know exactly how these institutions are positioned, how those rankings have changed since then, and so on. What we do know is that this garbage paper is spread throughout the system, that the underlying securities that CDS insure are plunging in value, and that the financial tally from this whole mess is rising month in and month out.

To understand why, put yourself in the shoes of a senior derivatives trader at a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital).

Let's say you're personally responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline. By itself, that would be a huge risk. But you're not worried because you have a similar bet with Bank B that interest rates will go up. It's like playing roulette, betting on both black and red at the same time. One bet cancels the other, and you figure you can't lose.

Here's what happens next...
Interest rates go up, reflecting a 2% decline in bond prices. You lose your bet with Bank A.
But, simultaneously, you win your bet with Bank B.

So, in normal circumstances, you'd just take the winnings from one to pay off the losses with the other — a non-event.

But here's where the whole scheme blows up and the drama begins: Bank B suffers large mortgage-related losses. It runs out of capital. It can't raise additional capital from investors. So it can't pay off its bet. Suddenly and unexpectedly ... You're on the hook for your losing bet. But you can't collect on your winning bet. You grab a calculator to estimate the damage. But you don't need one — 2% of $500 billion is $10 billion. Simple.

Bottom line: In what appeared to be an everyday, supposedly "normal" set of transactions ... in a market that has moved by a meager 2% ... you've just suffered a loss of ten billion dollars, wiping out all of your firm's capital.

Now, you can't pay off your bet with Bank A — or any other losing bet, for that matter.
Bank A, thrown into a similar predicament, defaults on its bets with Bank C, which, in turn, defaults on bets with Bank D. Bank D has bets with Morgan Stanley as well ... it defaults on every single one ... and it throws your firm even deeper into the hole.”

And so it goes, until it doesn’t! Enter the Fed bailout, yet again, this time we are in for a one trillion dollar bailout, increasing liquidity in the system for the short term. Again, this is short-term, inflationary and we haven’t even talked about commercial real estate foreclosures, energy prices or the environment, they are next. Keep you power dry and keep smiling… until next time.

The World We Invest In, Go Figure Volatility... And Black Swans

The news this past month:


Report shows consumer borrowing rose more than expected A report from the Federal Reserve shows that U.S. consumer borrowing increased by $7.78 billion in May. Analysts surveyed by Reuters had expected consumer debt to rise by $7 billion. April's figures were revised from an increase of $8.95 billion down to $7.76 billion. CNBC/Reuters (08 Jul.)

Fed hovers between a rock and a hard place Although the U.S. has thus far avoided recession, it is precariously poised to fall at any time. The situation puts the Federal Reserve and its chairman, Ben Bernanke, in a tough position as dismal economic data continue to mount. Even the resilience of the economy in the first half of this year may be more worrisome than previously thought. The Economist (subscription required) (17 Jul.)

Paulson: Months of work ahead to get through crisis Treasury Secretary Henry Paulson expects it to take months to work through the financial crisis. He made his comments as he sought to reassure the public that the banking system is sound. "Our regulators are on top of it. This is a very manageable situation," Paulson said. CNNMoney.com (20 Jul.)

Pimco head sees $1 trillion in U.S. mortgage losses The manager of the world's biggest bond fund said sliding U.S. home prices will wipe about $1 trillion off the balance sheets of the world's financial firms. About 25 million U.S. homes are at risk of negative equity, which could lead to falling home prices and more foreclosures, said Bill Gross of Pacific Investment Management Co. These factors could lead to less lending and a downward economic spiral. Bloomberg (24 Jul.)
Distressed sales more common on housing market: Four out of 10 homes sold in California and Nevada last quarter were foreclosures or some other distressed sale. BusinessWeek.com and Moody's Economy.com ranked 20 states where home sales were most influenced by forced sales. Michigan and Ohio, which did not have the overbuilding of Sun Belt states but continued to suffer big job losses, made the top 10. Affluent Connecticut was in third place. Massachusetts was No. 8. BusinessWeek (25 Jul.)

Mortgage rates up because of trouble at Fannie, Freddie Mortgage rates approached a five-year high as regulators and the White House strive to rescue Fannie Mae and Freddie Mac. Trouble at the mortgage giants could compound problems in the already-struggling housing market. HSH Associates said the average interest rate on a 30-year fixed-rate home loan increased from 6.44% on Friday to 6.71% on Tuesday. The New York Times (registration required) (23 Jul.)

Mortgage losses spur banks to reduce corporate loans Banks are significantly reducing forms of credit vital to American companies in the backlash from the subprime-mortgage crisis, and the slowdown threatens to further hamper the U.S. economy. Even healthy businesses are finding it difficult to borrow money as banks, burned by the fallout from looser lending standards, overcorrect and take a much closer look at repayment ability. The New York Times (28 Jul.)

Inflation presses reluctant retailers to raise prices As major manufacturers prepare to raise prices yet again, retailers that have avoided passing the increases to consumers may soon find themselves left with little choice. Retailers walk a fine line between keeping prices steady and reducing profits or raising prices and risking decreased sales. BusinessWeek/Associated Press (27 Jul.)

Analysis: Despite inflation, Fed likely to hold rates Inflation is at its highest level in 17 years, but the Federal Reserve is unlikely to change interest rates unless it makes a sudden, drastic leap. Oil and commodity prices, which are the underlying causes of the weak economy and high inflation, are directing the Fed's expected decision to keep rates at 2%. Reuters (29 Jul.)

Poll: Economy lost 75,000 jobs in July Economists expect a government report, scheduled for release Friday, to show that the U.S. economy lost jobs for a seventh straight month in July. A median estimate of 80 economists expects the report to show 75,000 lost jobs, which followed a decline of 62,000 in June. Bloomberg (01 Aug.)

Hedge funds suffer worst first half since tracking began Hedge funds have suffered an average year-to-date loss of 0.75%, their worst first-half performance since Hedge Fund Research started tracking returns in 1990. In 2002, the $1.9 trillion industry recorded its only losing year. Antonio Munoz of EIM Management USA in New York said investors have shifted assets to traders who have proven that they can succeed in turbulent markets. "We don't see investors pulling the plug across the board and putting their capital into cash," he said. Bloomberg (09 Jul.)


The World We Invest In, Go Figure Volatility… and Black Swans


It is always nice to check the news, the noise we live with, but what if we could suddenly soar to 10,000 feet and see the whole playing field below, see through the lens of some of this century’s greatest thinkers and then know, that you can’t know.


My grandmother told me that, on her deathbed, she said, “Danny, some things in life are a mystery, and that’s OK!”


Well, trying to make sense of the stock markets is a mystery too. Is that OK, I don't think so, so let’s get into it!


“Black Monday” on the 19th of October in 1987 provides a memorable starting point. On that single day, the Dow Jones Industrial Average dropped an astonishing 25%, nearly twice the drop of the largest previous daily decline of 13% back on the 24th of October 1929, known as “Black Thursday”. On that single day in 1987 the total stock market value lost $1 Trillion dollars, erased.


The point is not only can anything happen in the stock market, but anything does happen. What’s more, changes in the nature and structure of our equity market and a radical shift in its participants are making shocking and unexpected market aberrations ever more probable, ever more predictable.

For example, just recently:
SEC lengthens ban of short sales to mid-AugustThe Securities and Exchange Commission, which plans to implement broader rules to avert stock manipulation, announced that it is extending to Aug. 12 a ban on "naked" short sales of shares in 17 brokerages as well as troubled lenders Fannie Mae and Freddie Mac. The ban intends to protect companies of which collapse might lead to losses for the U.S. government. Bloomberg (30 Jul.)

Congress passes bill to rescue housing marketThe broad housing-rescue legislation passed by the House on Wednesday and the Senate on Saturday offers emergency funding to Fannie Mae and Freddie Mac along with establishing a $300 billion fund to help struggling homeowners. President George W. Bush, after dropping his opposition to the bill last week, is expected to sign the bill quickly. Reuters (26 Jul.)

Paulson unveils rescue plan for Fannie Mae, Freddie Mac After a weekend of discussions with Federal Reserve Chairman Ben Bernanke and New York Fed chief Tim Geithner, U.S. Treasury Secretary Henry Paulson announced a plan for the government to support Fannie Mae and Freddie Mac. The Fed will give the mortgage giants access to emergency funds similar to the access that banks have. Meanwhile, the government will ask Congress for permission to lend money to Fannie and Freddie. Most market participants did not expect such an aggressive plan, which reflects the authorities' fears about the consequences if one or both of the companies should fail. ClipSyndicate/Bloomberg (14 Jul.) , Financial Times (14 Jul.) , The Washington Post (14 Jul.)

Freddie, Fannie draw big bets on bonds Some of the world's biggest bond investors are snapping up debt sold by Fannie Mae and Freddie Mac as the best alternative in troubled times. Not only has the U.S. government agreed to back the beaten-down housing-finance companies but their yields compared with Treasuries also make the bonds a bargain. Bloomberg (28 Jul.)

And during 2007 we witnessed an unprecedented series of amazing market swings. In the 1950s and 60s, the daily changes were in the level of stock prices changing more than only 2%, only three or four times a year. In the second half of 2007 alone, we saw 15 such swings, 9 downward and 6 upward. Based on past experience, the probability of that happening was… zero.

The point is that the application of the laws of probability to our financial markets is badly misaligned. The truth is that an event, although never happening in the past, is not reason for such an event happening in the future.

Black Monday, then, is a rarity, an extreme event. Now, everyone knows that swans are white, right? So, a black swan would be an extremely rare event, like Black Monday.

And just because it has never happened doesn’t necessarily mean that it can’t happen, and conversely, just because an event is expected to happen, doesn’t mean it does. Unlike the 1929 antecedent, Black Monday did not prove to be an omen of dire days ahead, in fact, quite counter-intuitively, a harbinger of the greatest bull market in recorded history, ending when, in 2008?

None the less, despite the recent wild disturbances in both the stock and bond markets, market participants seem confident that future returns will resemble those of the past.

For example, Investors see huge GM losses as temporary The third-worst quarterly loss in General Motors' 100-year history left investors sobered but optimistic about the automaker's prospects. GM announced that its second quarter ended with a $15.5 billion loss, four times more than analysts expected, but that included $9.1 billion in one-time charges and expenses in North America. "That was about as ugly as you can get," said Mirko Mikelic of Fifth Third Asset Management. "But they did throw a lot of junk in there." ClipSyndicate/Bloomberg (04 Aug.) , Detroit Free Press (02 Aug.)

IMF backs U.S. measures, thinks upturn a year away The U.S. economy has been more resilient than expected but probably won't improve until the middle of 2009, as losses in home values depress consumption and worsen credit conditions, according to the International Monetary Fund. The dollar was near its equilibrium, though still overvalued by as much as 10%, the IMF said. Officials said they are in favor of new housing-support legislation. Reuters (30 Jul.)


And so the knowledge that black swans can and do occur, according to the work of Sir Karl Popper (1902 – 1994) holds important lessons for how we should think about risk. Writing about, Sir Karl Popper,in the New Yorker, journalist Adam Gopnik (2002) described Popper’s reasoning in this way:

No number of white swans could tell you that all swans were white, but a single black swan could tell you that they weren’t… Science, Popper proposed… didn’t proceed through observations confirmed by verification; it proceeded through wild, over-arching conjectures, which generalized way “beyond the data”.

Yet most of us, in our investment ideas and in our political ideas do exactly the reverse of this “scientific thought” that Popper pointed out, that is we continue to expect to see, in all probability, a white swan; that is, we remain confident that future returns will resemble the past. We search for facts to confirm our beliefs and hopes, not for facts that would negate them. For example, the news stories I started this article out with, which for most of us, negates what we want.

Thus, in the markets, few theories are advanced with the search for what is wrong with our ideas, because the language of finance uses terms like forecasts and probabilities. We are talking about probability, and probability is a slippery concept when applied to our financial markets. We use the word “risk” all too casually and the word “uncertainty” all too rarely.

The distinction was made first by Frank H. Knight, (1885 – 1972). In Knight’s view, the two things, risk and uncertainty are different. Risk is properly used as a measurable quantity to which probabilities and distributions are known (as with the roll of dice). Uncertainty is immeasurable, and therefore, not subject to probabilities.

According to Peter Bernstein, “Considering the consequences of being wrong is essential in decision-making under uncertainity”. In 2004, Glyn A. Holton pointed out in an article that uncertainty accounts for only one aspect of the idea of risk. The second aspect is exposure. People must have a stake in the outcome; it must matter to them.

Applying abstract theories of Popper and Knight to financial markets is what people do. That’s what Benoit Mandelbrot, the inventor of fractal geometry, did. Fractal geometry, simply defined, is about patterns that repeat themselves continually scaling up or down. This is observed in nature as well as geometry, where growth is not linear, but logarithmic.

Mandelbrot applied this concept to the daily price movements of the Dow. Since 1915, the standard deviation of the Dow has been 0.89 %, that is two-thirds of the fluctuations were within the 0.89 percentage points of the average daily change of 0.74%. None-the-less, the occasions when the standard deviation has been as high as 3 or 4 have been frequent; occasions when it has exceeded 10 have occurred infrequently, only once, and that was on that Black Monday back in 1989. The odds against such a happening are about 10 to the 50th power.

The fact is that the infrequent but extreme daily changes in the stock market can overwhelm the frequent, but usually humdrum fluctuations that take place each day within normal ranges. For example, since 1950, the S & P 500 Index has risen from a level of 17 to a recent level of 1,260. But, if we deduct the returns achieved on only the 40 market days in which the S & P 500 had its highest percentage gains, 40 out 14,588 days, then the level drops to 288. Contrarily, if we eliminate the 40 worst days, the S & P 500 will be sitting at 11,550.

That so much can happen on so few days and so unpredictably, suggests the perils of jumping into and out of the market and the value of simply staying the course. Put another way, investors are more volatile that investments. Economic reality governs the long-term returns earned by our businesses, and black swans in business are unlikely. But emotions and impressions, the tides of hope, greed and fear among the participants in the financial system govern the short-term returns generated in the markets. These emotional factors magnify or minimize the central core of economic reality, and in such an environment, a black swan may appear at any time.

More than 70 years ago, the great British economist John Maynard Keynes (1883 – 1946) recognized the critical distinction between the rational and the irrational in the stock market. And he remarked that in American markets, the influence of speculation is enormous. It is rare for an American to invest for “income” only, rather, he will probably purchase an investment in his hope for capital appreciation. This is another way of saying that the American is attaching his hopes to a favorable change in the conventional basis of valuation based on enterprise, to one based on speculation. This also was Keynes’s great concern.

Corporate earnings in the United States have grown with remarkable consistency at about the rate of the U.S. GDP. There have been no black swans in long-term U.S. investment returns. However, having said that, certainty about the future never exists, nor are probabilities always borne out, so applying reasonable expectations to both investment and speculation returns combined, has proved to be the sensible approach to projecting returns to the stock market over decades. In deed, despite the black swans of the stock market history, ownership of U.S. business of investors who have stayed the course has been a remarkably successful strategy.

Then along comes a U.S. economist Hyman Minsky (1919 – 1996) who observed the fundamental link between finance and economics with these words: “The financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.” He noted the symbiotic relationship between finance and industrial development which came to a head in the 1980s when institutional investors became the largest repositories of savings in the country and exerted there influence on financial markets and the conduct of business enterprises. Minsky’s key concept was that the financial economy, focused on speculation, should not be considered separate and distinct form the productive economy, focused on enterprise. This expectation and fear of Minsky, like that of Keynes, was that speculation would come to overwhelm enterprise. Recent history seems to confirm their fears, as rampant speculation in the markets has added a new elements of uncertainty into our economy.

This change in the structure of capitalism has been dramatic. A half-century ago, individuals owned 92 % of US stocks and institutions owned but 8%. Currently, individuals own 26% and institutions own 74%. Critically, in this new environment for money managers, where they are held accountable for the maximization of the value of investments made by their clients as measured in periods as short as years or even quarters. This means that institutional managers have turned increasingly to speculation (versus investment) just as Keynes had predicted and business executives became increasingly attuned to short-term profits and the stock market valuations of their companies.

This brings us up to our current situation, with the growing role of institutional investors to foster continued evolution of the financial system by providing a ready pool of buyers of securitized loans, structured finance products, and a myriad of other exotic innovations whose complex risks are shaking the financial markets of today.

Indeed, over the past two centuries the United States has moved from an agricultural economy to a manufacturing economy, to a service economy, and to what is predominantly a financial economy. The U.S. is becoming a country where no business actually makes anything. Where we merely trade pieces of paper, swap stocks and bonds back and forth with one another, and pay the financial croupiers a veritable fortune. Led by Wall Street’s investment bankers and brokers and mutual funds, followed by hedge funds, pension fund managers, financial advisers and all the other participants in the system. These costs have soared to staggering proportions. Aggregate annual costs incurred by market participants have risen from an estimated $2.5 billion as recently as 1988 to something like $528 billion in 2007, an increase of more than 20 times.

Even more staggering is the increase in financial transactions of all types, a global phenomenon whose implications are far from clear. Although the world’s GDP is about $60trillion, the aggregate nominal value of global financial derivatives is said to be $600 trillion, fully 10 times larger than all the goods and services produced in our entire world. Among the riskiest of these derivatives are credit-default swaps, which alone total $45 trillion, an amazing 9 fold increase in the last three years. These swaps are five times the size of the U.S. national debt and three times the U.S. GDP.

What do they look like? Consider the CDO, collateral debt obligations, which became more and more complex and more and more concealed. The US SEC registered rating agencies placed their imprimatur on hundreds of new issues of CDOs that were created entirely out of subprime mortgages that would likely been considered as rated B, C or even D in quality and then transformed 75% of them into series (traunces) of AAA, 15% into A and 5 percent were rated BBB. Only a remaining 5% carried a rating of B. One might as well call this magical conversion of low quality into high quality akin to turning lead into gold.

We all know, by early 2007, when mortgage defaults started to snowball, that the financial crisis in mortgages was upon us, and at great and growing cost to U.S. citizens and society. This crisis, although not yet a black swan, is a classic example of the impact of the financial economy on the real economy. Issuance of such bonds in the United States in the past five years totaled $2 trillion, of which the investment banks generated an estimated 80 billion. I conclude with Oscar Wilde, that the only thing that the banks could not resist was temptation.

And again, risks in our financial sector are not the only risks investors face. Some huge, seemingly unacknowledged risks also characterize U.S. society. Consider: the Social Security and Medicare payments committed to by our national government; the string of huge deficits in the U.S. federal budget; our enormous expeditions (soon to reach $1 trillion) on the wars in Iraq and Afghanistan; terrorism; the threat of global warming and the cost of dealing with it; unfettered global competition, our trade deficit, and the decline in the value of the US dollar.

Other risks are more subtle in nature: a political system dominated by money and by vested interests; a Congress and an administration seemingly focused entirely on the short term, the vast chasm between the wealthiest among us and those at the bottom of the economic ladder (the top 1% holds more than 33% of our total wealth), our self-centered, “bottom-line” society focused on money over achievement, charisma over character, and finally the paucity of leaders who are willing to lead, to defy the conventional financial wisdom of these times, and to stand up for what is right and noble and true.

Whatever the case, some surprising event out there, far beyond our expectations, will surely come to pass, an event that will carry an extreme impact, and one for which, once it happens, we’ll quickly concoct an explanation as to why it was so predictable after all. That event, if and when it comes, will just be one more black swan, something akin to “Disaster Capitalism” perhaps.

So, be watchful of the news and the noise of the news, and look into it not to support what you want to believe and hope for, but for what is actually happening. And to this end, I return you to the clips from recent news stories as I have come to collect and present in my blog lately.

Keep your powder dry and recognize that these times, they’re a’changing.

Credit crisis far from over, IMF warns Citing "fragile" global financial markets and softening European home prices, the International Monetary Fund warned that further reductions in U.S. credit growth are possible. The July update to the fund's Global Financial Stability Report reiterated the IMF's contention that losses this cycle could reach as much as $945 billion as the subprime-mortgage crisis continues to reverberate. Financial Times (28 Jul.)

Industry insiders expect more bank failures After the seizures of First National Bank of Nevada and First Heritage Bank of California, market professionals said more bank failures are expected before a recovery in the financial markets. "My real concern is that we're not finished," said Kathy Boyle, president of Chapin Hill Advisors. "Wall Street would like to think that the worst is over, but we've been saying that for a while." CNBC (28 Jul.)

And yet, More U.S. banks to issue covered bonds Three more U.S. banks said they would begin issuing covered bonds, a tool common in Europe that could free up mortgage financing. Citigroup, JPMorgan Chase and Wells Fargo said they would begin issuing the debt. The bonds are backed by mortgages but kept on a bank's books and backed by a layer of high-quality mortgages. Bank of America and Washington Mutual previously issued the bonds, but their appeal was limited because of regulatory uncertainty about where investors stand if a bank collapses. The Wall Street Journal (subscription required) (29 Jul.)

Investors worldwide bet big on plummet of stock pricesAround the globe, investors have wagered more than $1 trillion by speculating that the price of stocks will drop. In July, managers made at least $1.4 billion on bets against Fannie Mae and Freddie Mac, Bloomberg data show. Hedge funds and other financial firms have made large sums by short selling. "It's a huge amount of money," said Peter Hahn, a research fellow for Cass Business School. "Shorts have come a long way. They are getting into the mainstream, and long holders need to understand the shorts are not evil." Bloomberg (21 Jul.)

Analysis: Liquidity takes priority in Fannie, Freddie rescueThe U.S. government has made preventing a crisis in liquidity its top priority in rescuing troubled lenders Fannie Mae and Freddie Mac, and rightly so. But policymakers shouldn't overlook the longer-term problems of capital and structure that must be addressed if the two government-sponsored enterprises are to survive. Financial Times (15 Jul.)

Soros warns of more crises to come after Fannie, FreddieBillionaire investor George Soros said the latest financial crisis involving Fannie Mae and Freddie Mac will not be the last. Soros labeled the turmoil in the markets that has marred the last year as "the most serious financial crisis of our lifetime." He also said Federal Reserve Chairman Ben Bernanke might not be able to prevent the U.S. economy from deteriorating even further. "His options are limited -- he is boxed in," Soros said. Reuters (15 Jul.)

G-8 leaders indicate inflation is primary concernLeaders from the Group of Eight said the global economy is being threatened by rising oil and food prices. "We have strong concerns about the sharp rise in oil prices," they said in a statement before their annual summit. "The world economy is now facing uncertainty, and downside risks persist." The leaders proposed holding a discussion between consumers and energy producers with a focus on energy efficiency. "Production and refining capacities should be increased in the short term," the group said. Bloomberg (08 Jul.)

World Bank predicts 8%-plus inflation in Latin AmericaHigher food prices will push Latin America's inflation to an average of more than 8% this year, the World Bank's chief economist for the region said. The rapid rise in commodity costs will especially hurt importers in Central America and the Caribbean, while boosting major oil exporters such as Venezuela and Mexico. Bloomberg (30 Jul.)


Author’s note: This discussion paper is for the dental audience and is largely re-edited content taken from CFA Institute's private wealth resources which include edited portions of a speech delivered to the Risk Management Association on 11 October, 2007 by John C. Bogle. Its academic use and private study is permitted under the "fair dealing" guidelines which allow for its use here for the purposes of criticism and review.