Monday, September 29, 2008

Lyrics for a Special Occasion

It isn't much fun blogging about what a cruddy day it was. Besides, several people already beat me to it (Here's Seeking Alpha, The NY Times, the WSJ, and several links found by uber-smart Greg Mankiw). Most likely, more of the same tomorrow - crude down, stocks down, and the dollar (maybe) higher as the virulent contagion released from this version of the Manhattan Project continues to ripple out into the economies of Europe.)

I often find myself singing a song's lyrics in my head...unconsciously scrolling through the Ipod of my memory to select an appropriate lyric. A few days ago I was driving around in a friend's 1973 Mustang - getting ready to take it to the classic car show at the auto auction. The song I had in my mind then was "Maybelline" by Chuck Berry. Today, I had a different song in my head. It was "Song of the South" by Alabama.

Do you think this sums up our experience today? You turmoil, an appreciation for being able to afford the small things, and a unprecedentedly large government spending program???
Well somebody told us Wall Street fell
but we were so poor that we couldn't tell.
Cotton was short and the weeds were tall
but Mr. Roosevelt's a gonna save us all.

Well momma got sick and daddy got down.
The county got the farm and they moved to town.
Papa got a job with the TVA.
He bought a washing machine and then a Chevrolet.
Or alternatively...a few Eric Clapton lyrics for our investment banking brethren...
Once I lived the life of a millionaire,
Spent all my money, didn't have any cares
Took all my friends out for a mighty good time,
Bought bootleg liquor, champagne and wine.

Then I began to fall so low,
Lost all my good friends, had nowhere to go.
I get my hands on a dollar again,
Gonna hang on to it till that old eagle grins.
From "Nobody Knows You When You're Down and Out" - since I am sure that John Thain, Dick Fuld and Jimmy Caine have been humming a few bars of that one lately.

Thursday, September 25, 2008

Making a Market: Trigger and CMO's

I am a huge Willie Nelson fan.  His music has a classic sound that can't be duplicated or effectively described.  Just as impressive as the lyrics (Willie wrote Crazy for Patsy Cline, for example) are the instrument solos.  Like in this one, in "Angel Flying Too Close to the Ground."     
The acoustic guitar he plays has been the same for 39 years.  It is old, and worn, and imperfect, and awesome.  The large hole in the wooden body below the sound hole adds to its unique sound.  Willie named it Trigger, and it is as priceless a piece of Americana as there exists in modern pop culture.   Certainly, when Willie chooses to stop using it, it will be escorted with great care to the Smithsonian.  It will live there in perpetuity in the museum's humidity- and light-controlled glory.   If Michelangelo had used only one brush to paint the Sistine Chapel, that brush would be similarly revered.  

If Willie chose, instead, to auction it off to charity it would certainly fetch a handsome sum.  How much?  I have no idea - but folks are willing to pay lots of money for a one-of-a-kind piece of Americana (like a Honus Wagner baseball card).  But the auction would have to be held at Southeby's or Christies or some other top shelf auction house - and it would have to be marketed to folks that had interest in Trigger and the balance sheet to pay, right?  I mean, Willie pay an unannounced visit to the Kansas City Independent Auto Auction (, but he probably wouldn't find the type of qualified buyer that could be found somewhere in the worldwide network Southeby's and Christies have created.

I was thinking about the value of things today, and how values are contingent upon "interest" and "funds." There is a strong parallel between the story of Trigger and the toxic credit paper that are affecting the economy today.   During the early 2000's, most every global bank and large insurance company was writing CMO/CDO paper.  And they were trading that paper between one another, laying-off and taking-on risks as permitted by their own risk tolerance and needs.  The market was big in size (trillions of dollars), and the biggest banks had immense positions on both the buy and the sell side.  As some of the loans underlying these instruments began to go bad,  the banks incurred losses - some manageable, and some large.  

But this is where the story takes a stem the losses, these same banks (all nipped by initial derivative losses) simultaneously said "let's get these things off out books."  Suddenly, no one in the market had the "interest" nor the "funds" to take on additional credit derivative exposure, and the value for the paper plummeted. (When everyone is a seller and there are no buyers...price adjusts.)  This would be similar to Trigger being set out at a church rummage sale. Sure, lots of folks have the interest, but the most the guitar would bring would still be far less than it would bring in other - more appropriate - venues. 

There are two folks that have "interest" and "funds" these days.  The first is Warren Buffett, who pulled the trigger yesterday, spending $5 billion on a stake in Goldman.  The other is the US Government.  They are going to help the CDO/CMO market regain liquidity and traction by demonstrating that they have the "interest" and they have the "funds" to be a qualified buyer.  In theory, once Ben and Henry stabilize the bid-side of the market and the global banks control their internal hemorrhaging, the government can sell off the purchased securities into a liquid and functioning market at (at worst) an insignificant loss.  Maybe they will make enough profit that Ben will have the "funds" to purchase Trigger!  

Naah, I don't think he has the "interest." 

The risk that won't go away

This article on the dangers of derivatives is from Forbes from 2004, and was republished tonight on

Not a $700 billion expense, a $700 billion investment

From The Hedge Fund of America, available on Seeking Alpha (emphasis mine):

After listening to Congressional testimony and speaking with investors, it is clear people are confused about Treasury Secretary Hank Paulson's $700 billion dollar plan to rescue the financial system. There are many details and nuances to be worked out, and success is in no way guaranteed. Below is a simplified discussion of how the plan is structured, and what the plan is trying to accomplish.

Many are mistakenly under the impression the government is planning on raising $700 billion and making some type of expenditure that gets vaporized into an ailing institution, leaving the tax payer with a "bill" of $700 billion. This is a categorically false understanding of the plan, both in mechanics and financial reality.

The US Treasury is planning on raising $700 billion so it can invest in high yielding mortgage backed securities [MBS] currently owned by our nation's financial institutions. This does not constitute an expense; it is an exchange of cash for an asset. Mortgage related losses on securities have eroded capital so as to make it more difficult for many banks to make new loans, which is why this crisis is potentially devastating to the growth and health of the economy.

If executed properly, the plan could: allow financial institutions to get mortgages off their balance sheet, (while taking appropriate write downs), free up capital so institutions can once again lend, and actually make money for tax payers. Make money you ask? Yes. Here is how.

The Treasury is in the highly desirable position of being able to borrow billions of dollars for ten years at a measly 3.75% (the rate on treasury bonds). Under the plan, the $700 billion would be used to purchase mortgage backed securities with potential yields of 10-15% or even higher, depending on quality. Even if the government bought the most toxic debt and collected a couple of interest payments, they'd be in the money. Taxpayers would participate in gains as well as the losses. Every hedge fund in the world would love to have the government's low borrowing advantage and the benefit of time. What's more, there are plenty of distressed, high yielding opportunities out there.

One should not conceptualize this as moral hazard, socializing losses or rescuing the "bad apples" that created the problem. This is more akin to the US taxpayer committing capital to participate in a hedge fund with a large structural advantage. There are many risks involved in a government venture such as this, but conceptually it is simple: borrow at 3.75%, invest at 15%, and pocket the difference on $700 billion. Simultaneously this plan provides much needed liquidity to reignite frozen markets.

Wednesday, September 24, 2008

Not Just Another Bankruptcy

This is from the website "Chartoftheday"

Tuesday, September 23, 2008

The Top 5 Market Drivers for the Week of September 22nd

This is a new section, but I hope it catches on. I read somewhere that blog readers love lists. Here are the top things I think are driving the markets right now, as well as one thing that doesn't matter:

  • The Credit Crisis and Demand Destruction - We stand on the precipice. The economy is at a tipping point, and if the $700 billion dollar defibrillator that the Ben and Hank have proposed does not create a feeling of stability, certainty, and calm in the financial markets...we are in for a long next five years. Who needs history books when you can live through a great depression yourself???
  • The US Dollar - Everything related to the bailouts and stimulus packages are inflationary. That should push the value of crude and other commodities higher, as seen on Monday.
  • Global Economies and Global Currencies - Thank Goodness we aren't in this alone!!! Most every other major economy in the world is in the tank, too. Global economies growing more slowly take the burden off the demand side of the equation for raw commodities, and should help prices under control. And, as other country's central banks lower interest rates to juice their respective economies, the US Dollar looks less bad. Basically, it makes the dollar a little less worse. This should exacerbate weakness in the commodities markets.
  • Crude and Products Supplies - Hurricanes did shut in production and refining along the gulf coast - and we will need to watch stocks levels closely as those facilities come back on line.
And, under the heading of "This doesn't matter, even a little bit":
  • Geopolitical Instability - There is just too much else to worry about.

China, and the Answer to the $1.4 Trillion Question

This January, The Atlantic Monthly described the $1.4 trillion dollar question.

That is: How will China ever unwind its immense long position in US government debt? This purchasing spree helped keep interest rates low for a long time, as government paper always found a willing buyer in the Chinese government. That may be changing. Several news organizations state that information coming out of China is that the government is looking long and hard at whether to diversify its holdings after a financial tsunami here in the US.

My big concern is whether an orderly sale of even half of the position could doom the domestic economy into a 5-year period where interest rates are higher than expected, as fewer buyers are present to soak up the surplus of government paper that would hit the market.

Ben Bernake: Live and Uncensored

Helicopter Ben made an unscripted comment today at the congressional hearings. It is below in its entirety [emphasis is mine]. My thoughts and analysis follow...

"Let me come to the critical point: I believe that under the Treasury program, auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets. If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.

"First, banks will have a basis for valuing those assets and will not have to use fire sale prices. Their capital will not be unreasonably marked down. Second, liquidity should begin to come back to these markets. Third, removal of these assets from balance sheets and better information on value should reduce uncertainty and allow the banks to attract new private capital. Fourth, credit markets should start to unfreeze. New credit will become available to support our economy. And fifth, taxpayers should own assets at prices close to the hold-to-maturity values, which minimizes their risk.

"Now how to make this work. To make this work, we do need flexibility in design of mechanisms for buying assets and from whom to buy. We do not know exactly what the best design is. That will require consultation with experts and experience with alternative approaches.

"Second, understanding the concerns and the worries of the committee, we cannot impose punitive measures on the institutions that chose to sell assets. That would eliminate or strongly reduce the participation and cause the program to fail.

"Remember the beneficiaries of this program are not just those who sell the assets, but all market participants in the economy as a whole.

"But finally and very importantly, this is not to say the financial institution should not be reformed. It should be, it's critical. I agree with the Treasury secretary, the Federal Reserve will give full support to fundamental reform of the financial industry.

"But whatever reforms the Congress makes should apply to the whole industry, whether they participate in this program or not. So in summary, I believe that under the Treasury authority being requested, a program can be undertaken that will help establish reasonable hold-to-maturity prices for these assets.

"Doing that will restore confidence and liquidity to financial markets and help the economy recover without an unreasonable fiscal burden on taxpayers. So I urge you to act as soon as possible. Thank you."

Ben is a student of the Great Depression (here's a great NY Times Weekend Magazine article that I originally added to the Inergy market update back in February), and a man who has consistently made the same tough choice in the face of market adversity. That is - he has chosen liquidity and a larger, looser money supply (i.e. lower interest rates) to illiquidity and constricted money supplies. Each time he has lowered the Fed Funds rate, each time he has spent money on a bailout or shored up a lender...he has chosen liquidity. As maybe the foremost expert on central banking and its role in the Great Depression, he understands that economies can fall victim to their own negative inertia, imploding under the double-whammy of tight monetary policy and a broad economic malaise.

The problem with his consistent choice is that this liquidity impacts the currency values negatively. Inflation, Inflation, Inflation. We saw it in February when the first emergency rate cut was announced. We saw it again this Monday after the market had a chance to fully metabolize the "big give" that he and Hammerin' Hank were proposing. This should teach us something about Ben's belief system. Inflation, to Ben Bernake, is the lesser of two evils. In fact, in comparison to the metaphorical elephant of market liquidity, price inflation and currency devaluation is just a fly.

Remember this in your purchasing this year. Being long against the backdrop of Ben Bernake's belief system might be a prudent choice.

Monday, September 22, 2008

Tragic Comedy

I just was going through today's mail delivery and found some junk mail. It was a credit card application from Washington Mutual.


If they go under this week, would I have to pay them back? The mailer says I get "three bonus features," like online bill pay and money saving discounts.

If I were running WAMU, these are the bonus features I would be advertising:

1) Free office furniture with card enrollment (gently used by former WAMU employees)
2) Payback of outstanding balance optional if we go bust
3) Your choice of over 10,000 properties located in Southern California recently vacated and ready to go into foreclosure

Maybe I can get the IndyMac debit card to go with my WAMU credit card.

Links of Interest

One of my contemporaries sent me some links. They are good, and I thought I should pass them on:

What Billionaires Say About the Crisis

The Real Reason Behind the Global Financial Crisis

SAFE - Securing America's Future Energy

Oil Shockwave -A PBS Documentary

Hat tip to my buddy, and if anyone else wants to send recommended links, please do so - I look at them all.

My Trip to Mediocristan

Since I graduated from college, I have been actively involved in commodity markets. Well, mostly. You see, for the last 2 months I have been only a casual observer of commodity markets, blogging my thoughts as an outlet for the ideas and theories I create. You see, my old employer holds a non-compete agreement on me. That is cool, though. I signed the document without coercion, and knew (mostly) what I was getting myself into.

It has been fun, though, because now (to make myself useful) I am working in a completely different job in a completely different industry. I work at a wholesale auto auction. It is fascinating stuff and a great way to spend 10 or so months. The number of cars, the speed with which the sale is performed, the small details that need to be handled to be able to successfully choreograph the movement of the cars in and out of the sale lanes on auction is amazing. And it has given me the opportunity to take a trip to Mediocristan.

When I call the auto auction Mediocristan, I do not mean that it is "mediocre" or that it is "average" in any derogatory way. There is NOTHING average or mediocre about the auction I work for. However, in the last two months I have read a lot, and one of the books I read is called "The Black Swan: The Impact of the Highly Improbable." It is by Nasim Taleb, a former trader and risk manager/quant who now discusses in his writing the concept of uncertainty - especially as it relates to the financial markets. Taleb writes about two mythical places, Mediocristan and Extrimistan. In Mediocristan, it is impossible for any one measurement to materially skew the total average of the sample.

For example, Taleb discusses human height measurements. Most everyone is going to be between 4.5 feet tall and 7 feet tall, with the average being around 6 feet tall. Outliers (dwarfs and giants) are few and far between, and the chance inclusion of one inside the sample set will not affect the sample greatly. The auto auction is much the same, as the cars all bring a positive value, and because the cars that typically sell at a wholesale auto auction are standard Ford/Chevy/Mazda type cars, and likely cost no more than $45k brand new. So all the sale prices are going to be bounded on the low side by something north of zero, and on the high side with something lower than $30k. Even if there was some Ferrari-type outlier that skewed the sale price higher, its lack of frequency would not greatly alter the average of the large number of other cars.

Extremistan is different. Extremistan is a dangerous place, where analysis of past measurements inside a sample group of occurrences are worth nothing when trying to extrapolate to a future occurrence. The financial markets are Extremistan. That is, just because the market has never lost 1,000 points in a day (for example) does not mean that it cannot happen. Quite the contrary - with the current high volatility level present in the market, we just might get there by October!

Taleb mentions that current financial modeling attempts to put a Mediocristan "face" on an Extremistan "place". Economists and Quant guys are quick to pull together histograms and bell curves, but Taleb makes the point that "past performance is no indication of future results." The funniest example he gives of assigning misplaced trust to historical events is the life of a Thanksgiving turkey. For 300 days, the turkey might write in his journal "woke up, ate breakfast." Those data points are of little value or consolation on Thanksgiving morning - since the turkey's "script gets flipped" that day!

Last week on Thursday, I was witness to my first live auction. I watched with rapt fascination to the ballet going on before my eyes. It was controlled chaos. And, on occasion, I would drift past a TV set that had CNBC on it - reporting on the gyrations and hysteria of the broader markets that day. As the gravity of the current situation in the economy began to settle over me, I thought to myself that the auction attendees that day were inhabitants of Mediocristan, and that (in markets like these) they should feel lucky to be there.

I previously referred to the Taleb book: My Previous Post

Particularly Topical: Taleb's essay on the banking implosion

Taleb's Bloomberg Interview

Saturday, September 20, 2008

DEFCON 2 for the global financial system

The Significance of the current situation is impossible to underestimate.

Quotes from the attached article:

Although Mr. Schumer, Mr. Dodd and other participants declined to repeat precisely what they were told by Mr. Bernanke and Mr. Paulson, they said the two men described the financial system as effectively bound in a knot that was being pulled tighter and tighter by the day."

"You have the credit lines in America, which are the lifeblood of the economy, frozen." Mr. Schumer said. "That hasn't happened before. It's a brave new world. You are in uncharted territory, but the one thing you do know is you can't leave them frozen or the economy will just head south at a rapid rate."

Crisis Endgame

Here is an op-ed piece from the NY Times by the economist Paul Krugman.

He explains in plain terms what has happened to the US economy and what needs to happen next to keep us out of an ever-worsening credit environment. 

I am going to try my hand at an analogy that might fit our situation. The economy in this credit crisis is like an engine that has bad oil in it. Due to the pervasiveness of toxic derivative paper (everyone is holding it, and people don't know how much they have) inter- and intrabank lending is seizing. This is like a engine with oil that has lost its viscosity. Unless the economy can flush out the toxic paper (the bad oil), the economic system (the engine in my metaphor) will suffer permanent damage. 

The fed and the treasury have spent around one trillion dollars so far, engineering an oil change for the domestic economy.

A chart of the money spent on this oil change is here. Hey, next time, get to the discunt window before 8:00 am- I hear they have an early bird special that can save you some money. 

The question is...will this be enough for Hank and Ben - our favorite Qwik Lube employees - to make a difference?

Thursday, September 18, 2008

The Bush Presidency and Stock Market Returns

The blog "Infectious Greed" reports:

As of about 1:30PM EDT [9/18], we just blew through a Dow round-trip for the Bush Administration on the Dow. The Dow closed at 10,578 on January 22nd, 2001, and we are currently at 10,512, for a -0.6% decline overall, or -0.07% decline compounded annually.

Inflation Measurements - A defense of the "core inflation" metric

From the Wall Street Journal, this is the best explanation I have found to the Fed changing their methodology to measure consumer price inflation. Read the entire article here.

Shouldn't the Fed react more to the currently high inflation numbers by tightening policy, a view often advocated on this page, or at least not further lower the fed-funds rate if the economy looks like it might go into a tailspin? The answer is no.

It is certainly true that central banks should be worried about high headline inflation caused by high commodity prices. After all, households daily pay for energy and food items, and they are a big chunk of people's budgets. But central banks cannot control relative prices for food and energy. When a cold snap freezes the Florida orange crop or a tropical storm hits the gasoline refineries along the Gulf Coast, monetary policy cannot reverse the resulting spikes in prices for fresh orange juice or for gasoline at the pump that lead to high inflation in the short run. Particularly volatile items like food and energy, which are included in headline measures of inflation, are inherently noisy and often do not reflect changes in the underlying rate of inflation, the rate at which headline inflation is likely to settle and which monetary policy can affect.

This is why the Fed pays attention to measures of core inflation, which attempt to strip out or smooth volatile changes in particular prices to distinguish the inflation signal from the transitory noise. Relative to changes in headline inflation measures, changes in core measures are much less likely to be reversed, provide a clearer picture of the underlying inflation pressures, and so serve as a better guide to where headline inflation itself is heading. Of course, if a particular shock to noncore prices turns out to be more persistent, then the higher costs are likely to put some upward pressure on core prices.

I have been critical of a fed that ignores swiftly increasing energy and food prices in their analyzes in the past. This is a good explanation of their rationale.

Are We There Yet? - Peak Oil and $500/bbl

A good explanation of Hubbert's Curve and the Peak Oil Theory. Also, here is a good piece on the "Twilight in the Desert" author (note: not for those without strong stomachs - $500/bbl oil is his forecast).

Q and A on the meltdown

This is the best simple explanation of "what the hell happened" that I have found.

Wednesday, September 17, 2008

Warren Buffet Can Predict the Future...Why Can't I listen?

This is from Seeking Alpha, and was copied to my site in its entirety because i think it is very good reading.


Warren Buffet foresaw the current financial disaster more than five years ago. I pulled out his 2002 Chairman’s Letter, wherein he addresses derivatives and their potential to scuttle the entire financial system. Here are some key passages:

“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.”

“In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.””

“Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.”

“Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.”

“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

There’s much more, available on the Berkshire website. Warren and Charlie have made some additional comments at the 2007 annual meeting (courtesy of Whitney Tilson). Munger:

“As sure as God made little green apples this will lead to big trouble in due time. This will lead to a result we have been expecting for some time.”

On the math models used by Wall Street:

“They’re all crazy.” “Very smart people do very dumb things” and that just because people “have high IQs” does not prevent them from creating financial models that are “at least 50% twaddle.”

On Berkshire’s underwriting standards:

“We only write fire insurance on concrete bridges that are covered by water.”


“Not too many years ahead you will get disruption. Predicting when is something we can’t do…(It will reward) those with cash and guts.”


“Will Rogers said, ‘Learn not to pee on an electrified fence without actually doing it.”

Alas, heeding that last one would’ve saved Wall Street many times.

The financial system is built upon leverage. Its very existence depends on lack of correlation - the requirement that bad things don’t all happen at once: that depositors don’t make a run on the bank, insurance liabilities aren’t all claimed at once, derivative contracts don’t all go the same way at the same time, mortgages don’t all default at once. However, as Buffett says and I also heard Bill Ackman paraphrase, when the stuff hits the fan, everything correlates. That’s where we are now.

If you took on too much risk, levered up too much, didn’t prepare for the day when everything correlates… well then adios. See ya. Buh-bye.

Buffett and Munger were not so much prescient as good students of market history and innately conservative. They’d seen it all before in one form or another. I return to Galbraith from his book “A Short History of Financial Euphoria”:

“The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes it distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.”

Obviously Bear, Lehman, Freddie, Fannie, AIG, WaMu, Countrywide, on and on, went with the “lesser adequacy” model.

Monday, September 15, 2008

The Death Knell for A Business Model - Because of a Risk Model

As I write this, AIG has been downgraded by Fitch and S&P. So the abridged list of failed financial institutions reads: Bear Sterns, Fannie, Freddie, Lehman, Merrill, and (maybe) AIG - with WaMu ready to follow in IndyMac's footsteps within the week. Some analysts are now predicting that no investment bank will make it out of the crisis as an independent entity - that they will all be swallowed up or bankrupted before we reach more tranquil financial times.

These firms have been some of the pillars of Wall Street. They are sizable, too, Lehman is approximately 10 times the size of Enron when it collapsed 7 years ago. Likewise, from the Wall Street Journal: “[AIG] is such a big player in insuring risk for institutions around the world that its failure could undermine the global financial system.”

For me, the amazing part is not that any one of these firms has fallen on troubled times (certainly, it is possible for any one firm to have a significant negative occurrence - such as Barings Bank) but rather that they ALL have.  It is the industry's vulnerability to systemic risk that is so concerning.  There are two primary reasons why the industry has fallen systemically into this treacherous territory:

1) Over-reliance on a financial model that does not effectively capture the impact of the once-in-ten-years kind of event
2) A lack of appreciation for how much credit exposure would grow if a once in ten years event forced a change in credit ratings

Extreme things happen in financial markets. Without the true wisdom to understand that possible outcomes can vary drastically from possible modeled outcomes, business managers place large bets in particular asset classes or trades (such as mortgages) - in blackjack terms, they "double down".   A good blackjack player knows to double down on an 11 when the dealer has a 6.  Statistically, it is a solid bet.  However, as seen at every casino table, just because an opportunity is statistically solid does not mean that it can't lose. Since last summer, mortgages have been losing bets, and the debt leverage used to enhance returns has created a vulnerabilityof dramatic proportions.

These bad and leveraged bets make banks lose money.  And when companies lose money, the loss shows on their balance sheet. As the balance sheet is tapped to fund the losses associated with bad bets, the balance sheet becomes weaker. When balance sheets get weaker, the overall health of the firm suffers. And the rating agencies are forced to react. They adjust the credit rating of the firm to reflect the firm's newly compromised position. The downgrade reflects a company that has a less healthy financial outlook.

This is where item number two comes in to play. Over-the-counter derivatives are backed by the company that originates them. When a company receives a ratings downgrade, the downgrade may trigger the firm to have to make payments to their trading counterparties to stay in good standing. When a firm has lots of agreements with lots of counterparties, the ability to come up with large margin payments is a real challenge, since the firm is likely already in impaired shape.

Here is the scary part....all those trading instruments - the CDO's and CMO's and derivatives - all are either in the money or out of the money with a counterparty.  In other words, they have either made money or lost money for the counterparty.  If they are "in the money" the customer wants the troubled contract writer to perform, but if they are "out of the money" the customer views the writer's insolvency as a blessing, as the customer is able to re-cover that commitment elsewhere at an advantage to where it was originally struck.  For those companies that are "in the money" - well, you hope that the loss of the money that they had anticipated to make is not a business-threatening occurrence. If it is not, then it is just an unfortunate circumstance and a bad quarter. If it is, then the crisis of Wall Street becomes the crisis of Main Street.

Yes, due to a lack of appreciation for the risks of these trades, an entire segment of our economy is being sacked. Say goodbye to Investment Banking. And maybe we can say "good riddance" to the myopic risk modeling that helped get us to where the market is today.

Lehman Employees = Selfless Heroes???

Here is an email (originally published by the New York Times) from a Lehman executive regarding the meltdown.

—– Original Message —–
To: undisclosed-recipients 
Sent: Sun Sep 14 18:52:29 2008
Subject: Thank You Everyone, Contact information below

The 1985 NFL regular season was ending for the 49ers. Ronnie Lott and Cowboys running back Timmy Newsome collided in such a gladiator-esque hit that Ronnie’s left pinky literally lay scattered on the turf in bone fragments and parts. Ronnie would have none of it. Pain was not the issue. Winning was. After a brief sideline trip, Ronnie endured all pain, returned
to the battlefield and moved on to the playoffs. He taped up his fingers against the Giants in the first round where the 49ers season ended.

Then Ronnie faced a choice … risk missing some of the next season and potentially reinjuring a surgically reconstructed hand or just cut the end of his finger off and get ready for the battlefield. The choice was obvious for Ronnie. His gut knew no other way. The end of the finger would be gone forever, and he would lead the 49ers into the playoffs the next year whilst
returning to the Pro Bowl for the third time. Nothing more need be said about this iconic professional, and all that he represents to the world that knows him.

Everyone in the Lehman credit business knows the Ronnie Lott story. His story and character encompass what goes on here everyday.

It actually carries beyond this floor and throughout the entire firm.

There’s a new season that starts on Monday.

Take my finger.

The email is compelling and colorful. However, the writer fails to understand the nature of self-sacrifice. Patrick Henry - the brave and patriotic American revolutionary who was hung by the British and said "I regret I have but one life to give for my country" probably performed the most significant act of self-sacrifice the US has ever seen. He died so that others might live, and so that a country might be born. Lehman died due to a flaw in an economic model. Someone assumed that paper contracts and a financial risk model made 30 to 1 leverage a prudent business decision.  

In my humble opinion, the metaphorical self-aggrandizement in this letter demonstrates the hubris that permeates Wall Street. (And really, isn't that what got us into this mess?)

What was the Most Bullish Market Driver is Now Insignificant Noise

Yesterday, the Chinese Central Bank lowered interest rates, loosening money supply and effectively stimulating an economy that has been the consumptive engine behind the rally of the last five years. China chose to cut this rate because the economy is slowing - the Chinese stock market index is down 30% off the highs for the year.

Two months ago, China goosing the engine of economic growth with a rate cut would have been the most bullish occurrence I could have imagined, when thinking about crude oil's price direction. A cut would encourage consumption, and drive prices higher from $145.00. Instead, the rate cut has been ignored by the market, with crude down $6 today.

It seems that the contagion that started on Wall Street has rippled out throughout the markets of the free (and not-so-free) world...and is affecting even the Chinese in ways we could not have even imagined even 3 months ago.

Wednesday, September 10, 2008

Check out these fun websites

I am on the road tonight, and spending the night with a dear friend in Minneapolis who is on the high tech fringe. He also has a great sense of humor. He shared two websites that I feel behooved to pass along...

Precient and powerful market commentary is promised once I get back to KC and off my blackberry as my lone updating tool. Till then, I hope you enjoy these fun sites.

Thursday, September 4, 2008

Fair Value for Crude Oil?

I just found a fantastic op-ed article called  The Most Important Fact To Know About Oil Investing on the website Seeking Alpha.  I share it with my friends not because we are all invested in oil in our 401k, but rather because our professions necessitate us not only have a bias on crude and its constituent products, but to TRADE that bias by timing prebuys and by offering presales.   How unfair!!!  Especially on the Vomit Comet ride of 2008.  Let me draw out a few points for special emphasis:

"Only four months ago (May ’08), oil cleared $120 a barrel on its way to $145. Within a month, analysts were calling for $150, even $200 oil...Then Russia invaded Georgia, and oil took a nose dive falling more than 20 consecutive days from $145 down to $115 a barrel....So is oil going to go up or down?  The honest answer is that no one has a clue. We can talk all we want about worldwide supplies, Brazil’s latest discoveries, potential drilling in the US and other factors. But the reality is that an enormous slew of conflicting issues affect oil prices today..."

  1. Geopolitical Issues
  2. Speculation
  3. The Over-Leveraged Financial System

(The complete article goes into much more depth)

Personally, I agree with this analysis but would choose to go further. With crude oil, no one knows what price represents fair market value. In other commodities, things are just easier.  For example, if there is a shortage of corn, during the next planting cycle marginal acres of things like cotton (in North Carolina) and sugar beets (in North Dakota) move to corn.  High prices incentivize more production.  In that case, high price cures high price.  

But there isn't a place on earth that can produce an extra 300k barrels per day of oil within a period of time as short as a year (not since the days of Spindletop, anyway). That type of output costs billions of dollars and manifests itself in the form of a pipeline through Azerbaijan or a super-platform in the Deepwater Gulf of Mexico.  In each of these cases, today's high price creates incremental supply 10 years from now!  

Are we running out of crude?  I don’t know.  But I sincerely doubt it.  I am not a proponent of Hubbert's curve, and I do not think the hydrocarbon century is over.  But I DO know that recent large discoveries have come in challenging topographies (mountains and oceans) and inhospitable climates (the Arctic and the North Sea).  That can make people think that we are running out of crude - and THAT is all that matters.  

So if you are buying or selling a commodity that is finite in nature and the exact remaining quantity of that commodity also happens to be do you ascribe a fair market value to the barrel you are buying today?  Tomorrow?   It might be possible, but it is an estimation process fraught inaccuracy.  And when it feels like demand is growing uncontrollably or that supply is waning dangerously....well, price is off to the races. Price is the only rationalizing method that we have to rebalance these seemingly incongruous pieces of information.   

Previously in this blog, I have discussed how 15 foot corn isn't possible (but how - as we drive through the rearview mirror - it feels like it might be).   The market will trade from extreme to extreme again and again.  And the prevailing sentiment (however irrational) will carry the day. Dennis Gartman, the Canadian economist, says that "the market can stay irrational far longer than the individual investor can remain solvent."   Likewise, I have a Murphy's Laws for Commodity Traders on my desk that says "When the market is wrong, it doesn't pay to be right."   

Where's fair value for crude, you ask?  Today’s or minus $100 per barrel. 

Wednesday, September 3, 2008

Closing a Hedge Fund

This is an excerpt of Ospraie Hedge Fund's "blow up" letter. Ospraie recently purchased Con-Agra's trade shop for sereral billion dollars. This is what they had to send to investors this week:

"The losses were primarily caused by a substantial sell-off in a number of energy, mining, and resource equity holdings during a six-week period characterized by some of the sharpest declines in these sectors in the past ten to twenty years. As the Fund's performance deteriorated, we made the decision - despite continued confidence in the Fund's positions - to reduce and de-lever the portfolio significantly due to concern of incurring even greater potential losses..."
(Other excerpts from fund termination letters available here)
Only two thoughts here:  1) If a company is going to outperform the market for 19 out of 20 years...but then not return my capital in the 20th...I think I will pass on investing - since "return OF my capital is more important than return ON my capital."  2)  "Most models are wrong, some are useful." Risk modeling works until something crazy happens.  Sounds like they were overleveraged and putting too much faith in quantitative trading models.   They were caught by a Black Swan.  More on this book (by Nasim Taleb) in a later post. 

The Vomit Comet

For the last 35 years, NASA has had a famous plane that simulates weightlessness. It is nicknamed the Vomit Comet, for the impact it often has on its rider's constitution. I can only imagine what riding that plane must be like. But if there is a terrestrial proxy to the Vomit Comet, then I think this market is it. For example, since the beginning of 2008, the average daily volatility in crude oil has been more than $2.00. That is the most volatile period in the history of the market by far. 2007 comes in in second, at just over $1.00 of average daily volatility change. There have been years where the daily price change has represented a larger percentage of absolute price - the period of 1997-2000 was the most volatile from a percentage of the underlying commodity because prices were so cheap. But this is a misleading statistic, because most folks feel pain associated with absolute dollar losses and not percentage ones. For example, someone might buy one contract and see it go down $8 in one day. That is a $8,000 loss, and it is very painful to most folks. Well, it really doesn't matter whether the one day loss represents 1.5% of the underlying or 3% of the underlying, the investor still has to realize a loss of $8,000. The $8,000 loss makes him feel like his has taken a ride on that famous NASA plane.

Here is a list of the last ten years average daily price change:

1999 $0.34
2000 $0.65
2001 $0.52
2002 $0.44
2003 $0.58
2004 $0.76
2005 $0.90
2006 $0.93
2007 $1.12
2008 $2.08

Tuesday, September 2, 2008

Damage from Gustav

This is the second post about Gustav today (not ideal), but this is a very good graphic that I could not pass up. From The Oil Drum:

Rigs/Platforms: Blue: evacuated only; Yellow will require inspection before restart; Red: damage requiring repair
Refineries: Black: operational impact (partial shutdown) Green: Operational impact (full shutdown) Red: Damage likely

Internet Corn and Driving with the Rearview Mirror

A few years ago, when streaming internet video was just taking off, a tech savvy Iowa farmer put a web cam in his corn field, so that folks from all over the world could watch his corn grow. I am sure it was riveting entertainment. Maybe there was someone (somewhere) that watched with great rapture on those few hot July days where the corn grew 2.5 inches. Based on the data points associated with the growth rate of that corn on those days, an uneducated person or economist might have predicted that the corn would reach 15 feet tall by October.

In truth, most folks (even economists) know that corn won't reach 15 feet tall. It's a genetic thing. But this type of error - extrapolation of past observances into the future - happens all the time when trying to predict commodity market supply and demand. Watching previous months' supply rate or demand rate and forecasting based on these occurrences is commonplace...and it is a lot like driving a car by using the rearview mirrors. When the road is straight, it works great. But throw in an unseen curve, and the trip gets bumpy - quickly. I wish I could remember where I heard the quote: "All [economic] models are wrong. Some of them are useful."

It is the same thing for oil markets. Today, I want to focus in on the bully on the block, China. China has received a large amount of credit/blame for the recent bull market. Economists point to the 1.3 billion people that live there and note that the consumption in China has been going up about 10% per year. They also note that the Chinese use about 1/20th of the oil that US citizens use on a per capita basis. Based on those two data points, they predict an unmercifully compounding future consumption trend. And the market, driven by supply and demand, has reacted. In my opinion, the main driver of price from July 2007 to July 2008 was the worry that demand in emerging nations like China would outstrip the capacity for the oil industry to supply it. Indeed, even after a little "demand destruction" the market is still concerned that the recent demand growth rate is unsustainable.

What doesn't make much press is that China has problems of its own. Lots of problems. The communist government has built its economy upon making things. And those things must be bought by people. People in the US (by far the biggest consumer in the world) and other economies throughout the world. But now about half of the world's economies are teetering on the brink of recession.

The behemoth that is the Chinese economy is in trouble. The currency is weak, the stock market is flagging, and inflationary pressures are nipping at the central banks heels. So, I find myself asking the question: "Does something as complex as the economic growth of China deserve a straight line?" Alternatively, one could ask "Do the backwards looking economists really think that Iowa corn will hit 15 feet tall?"

Monday, September 1, 2008

Hurricanes and Hydrocarbon Industry Infrastructure

With Gustav having just made landfall as a category two hurricane around Cocodrie, (home of some excellent fishing), I thought it would be appropriate to spend some time on the the types of assets that are in the Gulf and in southern Louisiana that can be bothered by wind and waves - and where these assets are located. With crude down close to $8 on the board this morning, clearly none of these assets were damaged.

First, there are production platforms in the Gulf of Mexico. Some of these platforms are very expensive, complicated pieces of equipment - especially those that are located in deep waters. They are all named, and there are several that you may have heard of, like Thunderhorse, Atlantis, Mars, and LaKika. These platforms run upwards of $1.0 billion to build. Here is a great map from The NEW YORK TIMES:

Those pipelines are connected to a vast array of interconnected undersea gathering systems - often times much more expensive than the platform. Violent seas have the potential to cause underwater landslides, that can damage pipelines and gathering systems.

Additionally, off the coast of Louisiana is an offshore import terminal called the LOOP (Louisiana Offshore Oil Port). The LOOP is the only port in America that can handle the very largest crude ships ULCC's (Ultra Large Crude Carriers) and VLCC's (Very Large Crude Carriers). The Hurricane came very close to LOOP and Port Fourchon, the port that serves to support the offshore facility.

The final image is from The Oil Drum, and it is an old image of the terrestrial oil industry infrastructure that is in southern Louisiana. The path shown in red is the path of hurricane Katrina.