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 know...financial 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.

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 (www.kciaa.com), 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 turn...to 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 cnn.com.

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.

Not Just Another Bankruptcy

This is from the website "Chartoftheday"

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.

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.

REALLY???

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 day....it 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

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?

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.