Kontent News

My take on the commodity supercycle zeitgeist...and the rise of the precious metals, uranium and alternate energy. Get ready for peak everything, the repricing of the planet and "black swans" all over the place..

Sunday, July 29, 2007

Be wary of buy and Hold

Those receiving conventional buy-and-hold advice from their brokers and advisors should be leery. We referenced Barton Biggs', former Chief Global Strategist with Morgan Stanley, book Hedgehogging in our April 2006 issue, Losers: Why We Invest with Them.

"Secular cycles, both in markets and sectors of the market, make a big investment management firm a very conflicting enterprise to manage if you are a businessperson, because the rational things to do to maximize short-term profitability are exactly the wrong things from both an investment and a long-term profitability point of view. For example, during 2000, even as the bubble was bursting, Morgan Stanley Investment Management, which has a business-dominated management, acted like businessmen: they heavily promoted the underwriting of technology and aggressive growth stock funds because those were the funds the salespeople could sell and that the public would buy. Management was not evil; they were doing what they thought was right. Large amounts of public money were being raised and very quickly lost. Short-term sales profits were collected at the expense of, not only the public, but the firm's long-term credibility and profitability."

Those who are looking for warnings from our "trusted" government officials should consider their track record. On July 12th of this year, U.S. Treasury Secretary Paulson declared, "This is far and away the strongest business economy that I have seen in my lifetime." Several days prior, on July 2nd, he stated, "In terms of housing, most of us believe that we are at or near the bottom."

If the truth is not already obvious to us, history can be instructive. With the help of Dr. Mark Thornton, of the Ludwig Von Mises Institute, one needn't look far to find examples of misleading statements at major market and economic turning points. Paul Warburg, an early advocate of the Federal Reserve, was on the Federal Reserve Board when he made this statement in January of 1930.

"Happily, we have now turned our backs upon the events of this unfortunate event."

Even more incredulously, on November 22nd of 1929, William Green, President of the American Federation of Labor, stated:

"All the factors which make for a quick and speedy industrial and economic recovery are present and evident. The Federal Reserve System is operating, serving as a barrier against financial demoralization. Within a few months industrial conditions will become normal, confidence and stabilization in industry and finance will be restored."

As a final word of warning, we leave you with the words of Dr. Carroll Quigley, a noted historian, former professor of history at Georgetown University, and consultant to the U.S. Defense Department, the Smithsonian Institute, and NASA. His tome, Tragedy and Hope: A History of the World in Our Time was used as a resource in our December 2006 issue: Mind Games.

"All past history shows that espionage has been generally successful and intelligence has been generally a failure. By this I mean that no country had much success in keeping secrets, in the twentieth as in all earlier centuries,but neither has any other country had much success in evaluating or in interpreting the secrets it obtained. The so-called 'surprises' of history have emerged not because other countries did not have the information, but because they refused to believe it. The date of Hitler's attack on the West in May 1940 had been given to the Netherlands by the German Counterintelligence Office as soon as it was decided; the Western countries refused to believe it. The same was true of every one of Hitler's surprises. Stalin was given the date of the German attack on the Soviet Union by a number of informants, including the United States Department of State, but he refused to believe. Both the Germans and Russians had the date of D-Day, but ignored it. The United States had available all the Japanese coded messages, knew that war was about to begin, and that a Japanese fleet with at least four large carriers was loose (and lost) in the Pacific, yet Pearl Harbor was a total surprise."

While the evidence of trouble has just begun to surface in U.S. equity prices, the love affair with credit, as demonstrated by record profits in the banking and brokerage industries, has only made investors, especially large institutional investors, more attached to this bullish run than ever. But, with the continuing contraction in the housing sector, and its impact on borrowing, the early warning signals are blowing.

The following is an excerpt from the email we sent our subscribers last Thursday, July 19th, regarding our latest issue of The Investor's Mind:

"We are releasing this month's Investor's Mind early because a variety of technical indicators are pointing to an end to the bull market run that began in the fall of 2002. I thought it important to release this piece on three high-level financial meetings that have taken place over the last few months, which I believe make it clear that those at the top of the money game have known for some time that the end of this period will bring massive shifts to the global capital markets."

Doug Wakefield

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Banks burnt by credit meltdown

Credit derivatives markets saw a strong bout of further heavy selling on Thursday in both Europe and the US, with the widely watched indices of riskier credits bearing the brunt of the pain.

Behind the headline numbers, banks and other financials have been among the worst affected as investors worry about their exposure to a range of problem areas from mortgage markets to the leveraged loans that fund private equity buy-out deals.

The iTraxx Crossover index, the key barometer of appetite for credit risk in Europe, saw the cost of protecting €10m ($13.7m) of mostly junk rated corporate debt jump above €400,000 per year on the five-year contract for the first time in almost two years.

The index at 400 basis points is more than twice the level at the start of June. Its US cousin also traded at record levels, hitting 326bp.

The perceived credit risk of owning the debt of US banks, which has soared in recent weeks, jumped to new highs yesterday as investors reacted to revelations that Wall Street had been left saddled with billions of dollars of unsold corporate debt.

Analysis by the Financial Times shows that investment banks in the US and Europe could have already been forced to retain more than $40bn worth of high-yield debt that they intended to sell in recent weeks.

Investor appetite for high-risk, high-yield debt has significantly diminished – illustrated this week by the failure to place about $20bn worth of loans for just two companies, Chrysler and Alliance Boots.

US banks especially had already seen both their stock prices and credit default swaps – which provide a kind of insurance against non-payment of debt – under heavy pressure owing to their exposure to US subprime mortgage crisis and to the hedge funds that were invested in related products.

“A lot of people are spooked that the [credit] lines extended to hedge funds have created massive counterparty risk,” said Christian Stracke, a senior analyst at CreditSights. “We can’t really have a great sense for what counterparty exposure is – and these players are beginning to drop off like flies under the weight of subprime.”

However, he added that the market was nervous more because of uncertainty than because banks were obviously in dire straits.

JPMorgan and Goldman Sachs postponed on Wednesday the sale of $12bn of debt financing for Cerberus’s purchase of Chrysler. The US carmaker has agreed to hold $2bn, leaving the banks with a hefty $10bn on their books.

The two banks’ CDS hit their highest levels since 2003 yesterday. JPMorgan’s CDS was at 75bp, an increase of 25bp on the day, according to data from broker Phoenix Partners Group.

The bank is Wall Street’s biggest underwriter of leveraged loans, according to Bloomberg data, and its cost of protection in CDS markets has tripled in the past five weeks.

Meanwhile, Goldman’s CDS jumped as much as 18bp to 85bp.

However, one of the worst hit is Bear Stearns, the largest US underwriter of mortgage-backed bonds, which saw its CDS rise to 105bp from 83.50bp on Wednesday. This is five times the level seen at the beginning of this year, and the highest of any bank on the Street.

Most of these banks have also seen their stock prices stumble. Bear is down 23 per cent this year after falling another 3.7 per cent to $124.49 on Thursday. JPMorgan is down 8.5 per cent and Lehman 16 per cent.

The S&P investment bank index tumbled 3.7 per cent on Thursday and is down 9.1 per cent in 2007.

Another barometer of bank stress and a leading indicator for credit market weakness is the interest rate swaps market, which is now at the widest levels over US Treasury yields since February 2002.

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11 reasons to freak out

"Total world stock market capitalization was about $37 trillion in 1990; it grew to about $51.225 trillion in March 2007. According to Morgan Stanley, the total world nominal value of derivatives stood at around $5.7 trillion in 1990; it grew to $415 trillion at the end of 2006.

Doing the math, it means the $ value of derivatives are about 8 times larger than stocks now, whereas in 1990 stocks were 6.5 times larger than derivatives. Hmmm!
1) There are too many derivatives in the world
2) The parceling out of those derivatives into smaller bundles for all to play the game doesn't seem to be reducing risks as “experts” expected.
3) They have never faced a serious test in this cycle
4) They have become increasingly complicated to price
5) Ratings agencies (S&P and Moody's) preferred fees to due diligence
6) Private equity is more interlinked to derivatives than most realize
7) Stress testing a derivatives portfolio can be tricky if you don't know whether or not the
counterparty (maybe one of the 3,000 hedge funds) will be in business
8) One wonders why stock prices aren't a lot higher given that massive amount of leverage
i.e. liquidity manufactured across the globe
9) Tied to point #7: It sets the stage for a massive global deflation, though everyone seems
to think inflation is the problem. (If we accept that inflation is too much money chasing
too few goods, then why isn't it higher with so much money generated since 1990?
Maybe the massive deflationary pump of billions of new labor market entrants and
overcapacity is stronger than experts realize.) A debt default is deflationary. And it
leads to forced savings, which adds deflationary pressures in a world driven by “drunken
sailor spending.”
10) There could be much, much further to go “on the downside” as funds rush for the rapidly
narrowing exits.
11) We want to pull the cover over our heads and go back to bed when we contemplate the
potential for a real market cleansing. We use the words “real market cleansing” because
we think the relative stimulus from central banks through rate cutting, in a world where
$415 trillion in credit craters, ain't going to have much impact.
So, if your friend turns to you today, or anytime in the near future, and says this: “You know
something, there are going to be some real bargains in the market soon!”—we suggest its time
to find a new friend."
From http://www.blackswantrading.com

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Friday, July 27, 2007

Gold will soon sparkle again

Telegraph Blogs : Business : Ambrose Evans-Pritchard : July 2007: "A lot of readers have asked why I duck the issue of gold when talking about the dollar crisis and the M3 monetary blow-off.

So here we go:

I started buying gold mining shares in September 2001, missing the bottom by four months. I still hold some shares (mostly duds, since I am the village idiot when it comes to picking stocks). Gold’s 15 to 20 year upward cycle is alive and well.

For those who don’t follow bullion, gold hit $252 an ounce in the Spring of 2001 in a final capitulation sell-off when Gordon Brown began his Treasury sales. It rose to a peak of $730 in May 2006.

Gold has languished since, in part because of sales by the Spanish and Belgian central banks. I remain very wary in the short to medium-term.

What unnerves me is the way gold has tended to move in sympathy with global stock markets. Whenever risk appetite rises, it rises. When investors shun risk, it falls. In other words, it has become correlated with all the speculative trades - notably the yen and franc carry trades - responding to abundant global liquidity. This liquidity is now being drained as the BoJ, ECB, SNB, BoE, Riksbank, and Chinese Central Bank, etc, turn off the tap. So be careful.

While the pattern appears to have changed over the last couple of weeks, this is not long enough to establish a “paradigm change”, excuse the ghastly term. My concern is that gold will fall hard along with everything else (except the yen and the Swissie) in any market crash/correction.

At some point it will decouple, as it did during the 1987 crash when it fell hard, found a ledge, and then recovered hard, while the DOW kept falling. But, I would rather hold Swissies or Yen until gold finds that ledge in a downturn, resuming its old role as a safe store of value. This may happen quite quickly in a crisis. (Of course, I may also be left behind right now in an accelerating rally, but that is a risk I accept)

Ultimately, gold will surge, once it becomes clear that the euro lacks the staying power to serve as an alternative to the dollar. To restate a point I have made many times, the euro-zone is an ill-assorted mix of 13 unconverged national economies – with national treasuries, debt structures, taxes, pensions, and labour laws - that are not ready to share a currency, and are drifting further apart by the day.

(Lest anybody forgets, the motive behind monetary union was PURELY political. The economists at the European Commission warned that the project could not survive over time if it included a Latin Bloc of countries with an unreformed culture of high inflation, rising wage costs, and an export base exposed to Asian competition [unlike Germany’s, which is complimentary] – unless it were backed by a full superstate. They were ignored. Indeed, any future crisis was to be welcomed as the “beneficial crisis”, a chance to force through full political integration that would otherwise have not been possible, as Romano Prodi so candidly admitted when he was Commission chief).

At some point it will become clear to everybody that: the Club Med group cannot compete at an exchange rate of $1.40, $1.45, $1.50, or whatever it reaches; their credit booms are tipping over; they will soon need stimulus more than the US.

Goldman Sachs, by the way, is already 'shorting' Italian and French bonds, while going 'long' on German bunds to play the divergence (the opposite of the euro-zone 'convergence play' that made the banks rich in the 1990s).

We may have a situation where sharp dollar falls caused by impending rate cuts by the Fed sets off a systemic crisis for Euroland. If so, politics will quickly take over from economics and begin to dictate events in Europe. The ECB will have to stop raising rates (whatever Berlin wants), and the euro will become a structurally weak currency tilted to the need of the weakest players. If it doesn’t, the EU itself will blow up. So the ECB will have to change tack to support the union. And the European Court will interpret the treaties in such a way as to force the ECB to do so.

Gold will fly once investors can see that neither of the two reserve currency pillars (euro and dollar) is on a sound foundation, and once the pair are engaged in a beggar-thy-neighbour devaluation contest to stave off a slump (if necessary with the use of Ben Bernanke’s helicopters, meaning mass purchase of Treasuries, mortgage bonds, stocks, or assets of any kind to support the markets). This would amount to a partial breakdown of the monetary system. Gold will not stop at $800. It might well go beyond $2,000.

We are not there yet. Timing is not my forté, but 2008 looks ripe. Watch the Spanish housing market. Watch the French trade data. Watch Chinese inflation. And, of course, watch the US jobs market – the bogus prop to the alleged US recovery

Thursday, July 26, 2007

Absolute Capital Hedge Fund Suspends Withdrawals

By Laura Cochrane and Stuart Kelly

July 26 (Bloomberg) -- Absolute Capital Group Ltd., an Australian hedge fund that invests in collateralized debt obligations, suspended withdrawals from two of its funds after forecasting losses amid a rout in U.S. subprime mortgages.

The firm froze its Yield Strategies Fund and Yield Strategies Fund NZD, which together have about A$200 million ($177 million) under management, Chief Investment Officer Bill Entwistle said in an interview today. The Sydney-based company is 50 percent owned by ABN Amro Holding NV's Australian unit

Absolute Capital, which says it doesn't invest in the riskiest portion of CDOs, is suffering from the widening impact of delinquencies on U.S. home loans to people with poor credit. Basis Capital Fund Management Ltd., another Australian hedge fund battered in the North American market, has hired Blackstone Group LP to negotiate with bankers to help it limit losses.

``Because of the contagion from subprime, all of the credit sectors are re-pricing,'' Sydney-based Entwistle said. ``There are lots of sellers and no buyers, the market has to settle down before we can get some clarity.''

The Yield Strategies Fund returned 6.4 percent the past year while the Yield Strategies Fund NZD, which started in May, gained 0.2 percent to June 30.

Australia's hedge fund industry has been rocked by losses at Basis Capital, which has said the value of its Yield Alpha Fund may plunge more than 50 percent if its assets are sold at distressed prices. Sydney-based Mariner Bridge Investments Ltd. on July 20 wrote down the value of its U.S. residential mortgage-backed securities.

Biggest Investors

The nation's 20 million people are the world's biggest investors per capita and Australia has the fourth-largest managed funds industry. Unlike in the U.S., where only qualified investors can place money in hedge funds, Australia allows individuals to invest in the vehicles.

Australian hedge fund managers directly controlled A$41 billion in assets as of July last year, the most in Asia, according to AsiaHedge. Assets almost tripled in the two years to June 2006 as money from compulsory pension savings, tax breaks, a new state-owned investment fund and takeovers boosted fund inflows, according to government data.

Absolute Capital said it won't process any requests for withdrawals until Oct. 25, estimating it may take three months for enough buyers to return to the CDO market.

Repackaged Debt

CDOs pool assets ranging from investment-grade debt to high-yield loans, and repackage them into bonds. Different portions of a single CDO have their own rating, ranging from as high as AAA to nothing at all.

Entwistle said 50 percent of Absolute Capital's two funds is invested in the so-called ``mezzanine'' portions of CDOs, which are typically assigned the second-highest non-investment grade rating of BB by ratings companies.

Basis Capital's investments included the unrated portions of CDOs, the first in line for losses when borrowers fall behind on mortgage payments.

``There's probably more pain to come,'' said Michael Birch, who helps manage $133 million at Wallace Funds Management, a Sydney-based hedge fund. ``We need more clarity as to the scale of the writedowns at Basis and Absolute. It might take six months for the full impact to come out.''

The sting from U.S. subprime mortgage delinquencies that hit a decade-high this year is being felt across businesses, regions and asset classes.

Buyers Vanish

Almost 40 companies have reworked or abandoned debt offerings in the past three weeks as after struggling to find buyers. Federal Reserve Chairman Ben S. Bernanke said July 19 there will be ``significant financial losses'' from risky mortgages, pointing to estimates as high as $100 billion.

Bear Stearns Cos., the fifth-largest U.S. securities firm, on July 18 told investors in its two failed hedge funds they'll get little if any money back after ``unprecedented declines'' in the value of subprime mortgage securities.

Investors earlier this month were demanding an extra 10.5 percentage points in yield over benchmark rates to own some of the lower investment-grade rated parts of CDOs, up from about 3.1 percentage points in July 2006, according to data compiled by Morgan Stanley.

Sales of CDOs surged to $503 billion last year, compared with 2003. Investor appetite for the securities is now waning. Analysts at New York-based JPMorgan Chase & Co. said CDO sales in the U.S. this month reached just $9.1 billion at July 20, compared with $42 billion for all of June.

Ratings Criticized

Ratings companies have been criticized by investors for not acting quickly enough to the subprime mortgage crisis. Leah Rhodes, a Melbourne-based director of structured finance at Standard & Poor's, today said losses from U.S. subprime loans ``did exceed our expectation.''

A spokeswoman for the Australian Securities and Investments Commission, the corporate regulator, didn't immediately return telephone calls seeking comment on Absolute Capital.

Kim Ivey, chairman of the Australian Alternative Investment Management Association, which represents 80 of the nation's hedge fund managers, said there will be more hedge funds hurt by the subprime market.

``I expect that it will be contained to just a handful,'' he said. ``More of a concern is what will happen once the fallout moves from the subprime sector to more senior debt, when many more managers have exposure.''

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Monday, July 23, 2007

Trouble in Hedgefundistan

Two columns of black smoke can be seen rising over Wall Street and disappearing into the ice-blue New York sky.


Not quite. The plumes of smoke are all that's left of two major hedge funds which blew up just weeks ago leaving nothing behind but a few smoldering embers and a mound of black soot.

The compiled assets of the Bear Sterns High-Grade Structured Credit Strategies Fund—nearly $20 billion—have vanished into the miasma of cyber-space where they will soon be joined by $1.4 trillion of other, equally worthless, Collateralized Debt Obligations (CDO).

If you look carefully, you can almost see the mangled and bloodied bodies of the CDOs, the CSDs, the RMBS and the other shaky debt-instruments being pulled from the wreckage and tossed unceremoniously on the bonfire.

Is this how it all ends? The first whiff of trouble in the housing market and then—in a flash--all the funds in “Hedgistan” begin teetering towards earth?

“No Value”-“No Bids”

According to Bloomberg News, Bear Sterns announced last week that there's “little value left” in one of its funds and “no value left” in the other.

Nothing, nada, zippo.

The news was like a bucket of cold water dumped on the stock market leaving slack-jawed traders shuddering in trepidation.

What does it all mean?

Does that mean that the entire hedge fund empire—which is built on a foundation of dodgy loans and quicksand---may be headed for the crapper?

No one really knows. But a pall has settled-in over downtown Manhattan where gloomy-looking men in pinstriped suits are waiting for the other shoe to drop.

Y'see, the hedge fund industry is based on the bizarre notion that one does not have to produce anything of value to make boatloads of money. You don't even need assets any more---just a risky loan that can be transformed into an investment grade security through the magic of “securitization” a sprinkling of Wall Street snake oil.

Abrah Kadabra---presto-chango!

It's like taking shards of bottle-glass and selling it as the Hope Diamond. Who's gonna notice?

The only catch is that--now that these toxic CDOs are going to auction--there are no bids. That's a bad thing.

“No bids” means that $1.4 trillion of shaky investments have no discernable market-value. The CDOs were graded “mark to model” which translates into “mark to fantasy”. It means that the investment bankers and hedge fund managers got together over Martinis one night and pulled a number out of a hat.

Now no one wants to buy them. They're worthless.

The skydiving hedge funds just pulled the CDO rip-chord and nothing came out but confetti.


And that's just half the story. There's trillions of dollars in derivatives riding on these shaky CDOs. That's enough to bring down the whole market in a heap once interest rates rise or liquidity dries up. Now it's just a matter of “when” now, not “if”.

This illustrates an important point, though. It shows what it takes to be a good hedge fund manager:

Take a shabby sub-prime mortgage; chop it into “investment”, “mezzanine” and “equity” tranches. Bundle it with other equally suspect mortgage backed securities (MBS). Decide (arbitrarily) what the CDOs are worth Tell your banker. Leverage at a ratio of 10 o 1. Take 2% “off the top” plus salary for your efforts. Buy a summer home in the Hampton's and a Lexus for the wife. Wait for the crash. Then repeat.

Congratulations; you are now a successful hedge fund manager!

Oh yeah; and don't forget to prepare a few soothing words for the investors who just lost their entire life savings and will now be spending their evenings squatting beneath a nearby freeway off-ramp.

“We're so very sorry, Mrs. Jones. Can we get you some cardboard-bedding to keep off the rain?”

The problems that are appearing in the stock and bond markets all started at the Federal Reserve when Fed-Chief Alan Greenspan opened the sluice-gates in 2003 and lowered interest rates to 1%. (Way below the rate of inflation) Since then, trillions of dollars have flooded into the markets creating multiple equity bubbles in real estate, stocks and credit.

Serial bubble-maker Greenspan is to finance-capitalism what Wrigley is to chewing gum. The greatest flim-flam man of all time.

The Fed has tried to conceal the massive increase to the money supply, but the evidence is everywhere. (Many analysts now calculate that inflation is running at roughly 13%) Food and energy have skyrocketed. Housing prices have soared. Everything has gone up except the cheapo imports which the Fed uses to manipulate the inflation stats.

The gigantic housing bubble is mostly Greenspan's doing. After printing-up mountains of cash and creating artificial demand through low interest rates; he promoted his product-line with the typical huckster sales-pitch. “Maestro” advised us that the extension of credit to all-God's creatures, worthy or not, is a good thing.

Here's a clip of Alan praising subprime lending in a speech on April 8, 2005:

"With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. . . . As we reflect on the evolution of consumer credit in the United States, we must conclude that innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. . . . This fact underscores the importance of our roles as policymakers, researchers, bankers and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers."

Yes, of course, with all these “advances in technology” and new-fangled “credit-scoring models” why would we need to verify a loan-applicant's income or require that he scrape together a measly $5,000 for a $450,000 mortgage?

That's all so 20th Century!

Now that foreclosures are mushrooming at an unprecedented pace, the Fed is trying to distance itself from the problem by blaming the banks for their shoddy underwriting practices. But the guilt lies with the Central Bank. Its all part of their whacko plan to crush the dollar and create a police state.

It may sound trite, but “inflation is theft”. Unfortunately, inflation is also part of the ruling class' strategy to rob the poor, fuel the stock market with cheap credit, and move jobs overseas. It is the autocrat's method of “social engineering”---shifting wealth from one class to another by simply printing more money and pumping it through the system via low interest rates. Remember, bankers know that people will ALWAYS borrow money if lending standards are relaxed and the money is cheap enough. At 1%, the Fed was basically losing money on every transaction, but persisted with their plan anyway.

Anyone who cares to go back and trace interest rates moves for the last 7 years will see that the Fed is really a political organization that decides monetary policy entirely on the basis an elite agenda that supports endless war, outsourcing of American jobs, and domestic repression.

Are you surprised?

Now, a bad situation is about to get a whole lot worse. Consumer credit rose last month by a whopping 12.9%---credit card debt by 9.8%! Since housing prices have flattened out, homeowners can no longer borrow on their dwindling equity (Mortgage Equity Withdrawal; MEWs) which is forcing the maxed-out American consumer to use plastic even though rates are averaging from 18% to 27% monthly.

Automobile repos have also hit historic highs. But the real damage is showing up in the subprime market where the percentage of defaults continues to rise unabated.

In itself, a correction in real estate is not enough to bring down the whole economy. Unfortunately, the contagion from the subprime meltdown has spread to the stock market, the insurance industry, banking and pensions. Not even Secretary of the Treasury, Henry Paulson or Fed-master Ben Bernanke are claiming that the subprime problems are “contained” anymore. Just this week, the scholarly looking Bernanke said to Senators on the Hill that the housing market has “deteriorated significantly”.

It's about time. If anyone still has any doubts about the magnitude of fiasco, I recommend they look over these eye-popping charts which tell the whole story. The housing blowdown will spread the carnage from “sea to shining sea”. http://www.itulip.com/forums/showthread.php?p=12232#post12232

The faltering housing market has drawn attention to an even more colossal credit bubble that is limping towards earth as loan requirements tighten and liquidity dries up.

The prevailing fear on Wall Street is that we may be seeing the beginning of a global credit crunch.

The danger is not just the subprime loans or even the mortgage companies that made the loans, but the overall risk to the secondary market where these loans have been sold as CDOs to the tune of $1.8 trillion.

In this new deregulated environment, the banks don't have to rely on savings anymore to make the loans. They simply originate the loans, take their commission, and sell the debt as CDOs. They're even allowed to sell the risk of default through credit default swaps (CDS) which are a form of insurance that minimizes the banks exposure. These weird innovations have spawned riskier and riskier loans and increased the likelihood of damage to the broader market.

The Toxic Cycle of Debt?

Economics correspondent, Stephen Long, explains it like this:

“The problem that arises from the subprime mortgage collapse is that it creates a toxic cycle of debt. Banks originate loans or bundle up loans that mortgage companies have made and sell the risk on to the hedge funds. Then the hedge funds say, ‘Hey, we've got this product that has an investment grade rating so we'll borrow against it from the banks.' (oftentimes leveraged at a ratio of 10 to 1) Now the hedge funds are trying to buy the original loans to stop them from going into default.”(The hedge funds are forced to slow the rate of foreclosures so they won't go bankrupt.)

So, what happens when these shaky bonds (CDOs) are “down-graded”?

Will the hedge funds fall like dominos just like the subprime mortgage-lenders? Will we see liquidity evaporate in the broader market triggering a plunge in the stocks and a massive sell-off in the bond market?

CDOs were conjured up with the idea that vast amounts of money could be made on very meager assets through a complex expansion of leverage. They were promoted as “limiting risk” by spreading it to a greater number of investors and providing extra protection through derivatives. Mortgage Backed Securities were sliced and diced into “more risky” and “less risky” tranches depending on investor appetite. Only now—to everyone's surprise---“collateralized debt obligations with stellar Triple-A ratings have been getting hit by the subprime market's woes.” (Wall Street Journal, “Bernanke revises subprime outlook”) On top of that, the ABX derivative index “has started showing pronounced weakness at the top of its ratings structure.” (ibid WSJ, 7-19-07)

Get it? In other words, even the VERY BEST of these multi-trillion dollar investments are beginning to falter. The contagion is spreading through the entire market. The CDOs are worthless. No one wants them. In fact, the whole new regime of exotic debt-instruments which emerged from 2000-on, is barely hanging on by a thread. One minor downturn in the stock market and the hedge funds will go freefalling through open space.

A speech by Robert Rodriguez of First Pacific Advisors (CFA) gives us a good idea of the enormity of the money involved. In his “Absence of Fear” address in Chicago on June 28, 2007 he states:

“Since 2000 hedge funds have more than doubled in number, while their assets have tripled. They too are using elevated levels of leverage, as are PE (Private Equity) firms and investors in highly leveraged fixed income securities. These funds are heavy users of derivatives. The Global derivatives market grew nearly 40% in 2006--the fastest pace in the last nine years--to $415 trillion, per the Bank of International Settlements. The amount of contracts based on bonds more than doubled to $29 trillion. The actual money at risk through credit derivatives increased 93% to $470 billion, while that amount for the entire derivatives market was $9.7 trillion. The International Monetary Fund, in its April 2006 Global Financial Stability Report, estimated that credit-oriented hedge fund assets grew to more than $300 billion in 2005, a six-fold increase in five years. When levered at 5-6x, this represents $1.5 to $1.8 trillion deployed into the credit markets. Fitch, in their June 5, 2007 special report, “Hedge Funds: The Credit Market's New Paradigm,” says that despite the upward trend in maximum allowable leverage, “notably, no prime broker reported raising margin requirements in response to historically tight credit spreads and growing concerns about the general level of risk-complacency in the credit markets.”

If Rodriguez's “eye-popping” numbers are accurate and the market slumps a mere 5%, “the value of a hedge fund's assets could lead to a forced sale of as much as 25% of its assets”. If the market falls just 10%, the fund would get a 50% haircut!

Yikes! That just shows how over-exposed the industry really is.

As the requirements on mortgages gets tougher and the subprime market continues to languish; bankers will naturally become more hesitant to loan zillions of dollars to hedge funds and private equity firms. When credit gets tighter, the hedge funds will begin to nosedive which will send the stock market in a long-term swoon. That's what happens when a market is this over-leveraged. It's unavoidable.

The markets are now perfectly poised for a full-system breakdown. FDIC Chairman Sheila Bair expects a CDO time bomb. She summed it up like this:

"Its going to get worse before it gets better. How much worse, I don't know."

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Saturday, July 14, 2007

Presentation to CFA association, New York

A recent example of the flawed nature of this market came to my attention when my associate, Julian Mann, showed me a very garden variety LIBOR sub-prime floating rate security. A major pricing service valued this bond at par, while on March 19, 2007, one of the major rating agencies rated this bond A3. To affirm the accuracy of this bond's pricing, we went to two brokerage firms that traffic in this type of security and requested what their bid might be, if we owned this security. One responded with a $7 bid. In other words, a 7% of par bid, a difference of 93% to the pricing service. The other firm declined to bid, but they did indicate that, if they were to, their bid would have probably been around this level. Julian has found several other similar examples, so this one does not represent the proverbial “needle in the haystack.”

We believe that many of these models are flawed and give a spurious representation of accuracy. Given the deterioration in underwriting standards, models predicated on prior experience have little value when compared to the data of the last two or three years. In essence, one is assuming a normal distribution curve of data for modeling purposes, while in reality you have data that comes from a highly skewed distribution. We are beginning to see the negative effects of flawed modeling by the growing number of downgrades in the sub-prime sector. This trend is also starting to develop in the Alt-A sector as well. We believe these trends will continue to unfold over the next two or three years and should lead to a retrenchment in the securitization/origination industry. If our assessment is reasonably correct, mortgage credit availability will likely contract and, therefore, exacerbate the housing contraction and its effects upon the general economy. We disagree with the opinion expressed by our esteemed Federal Reserve Chairman Bernanke, when he said in his speech of May 17, 2007 at Chicago's 43rd annual conference on Bank Structures and Competition, “We believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the sub-prime market to the rest of the economy or to the financial system.” We will see if this optimistic assessment proves to be the correct one.

We are of the opinion that the distancing of the borrower from the lender has contributed to the development of lax underwriting standards. Each participant, in the securitization/origination process, takes their ounce of payment, but no one truly worries about the underlying credit quality since the loan will be sold. Furthermore, most participants are compensated on volume and not quality of loan originated. In our opinion, “a rolling loan gathers no loss.” Possibly, with so many sub-prime originators failing because of loan put-backs to them, some degree of underwriting discipline will return to the market; however, with so many types of loan originators operating outside of the regulatory system with minimal capital, it is far better to originate a loan, capture the fee, and then get out of Dodge, should the business go bad. One can always return another day.

Finally, the securitization market and the multiplicity of products that have been created have never been truly tested in a major credit contraction like that of 1990-94. This is because most of today's securitization products did not exist back then. Another risk is how have they been used in various types of leveraged investment strategies? Have the creators of these products structured their operations to be able to handle a contracting market? It remains to be seen how this all works together. One may gain some insight to the potential risk by reviewing the collapse of the manufactured-housing securitization market. After seven years, it is still a fraction of its former size with all the former major originators gone.

Another example of risk knowing no boundaries, on June 1, the Government of Pakistan issued a $750 million 6.875% of 6/1/2017 dollar denominated bond priced at par and rated B1/B+ at barely 200 basis points above the ten-year Treasury bond yield. The following week in the Los Angeles Times, the headline read, “Musharraf's grip falters in Pakistan.” The second headline, “Dismay over U.S. support of general.” I guess the market believes the extra 200 basis points of yield spread is sufficient compensation for risk. I think not.

This weakening in credit quality trend also applies to the corporate bond market. High-yield bond spreads are at record lows, with the CCC component of the Merrill Lynch high-yield index at 18%, more than double the proportion ten years ago. 7 High-yield spreads have declined from nearly 1100 basis points over the Treasury yield in 2002, to barely 240 basis points recently. We believe this narrowing of credit spread is being driven by the near-record low default rates. For this trend to continue, a near “perfect” credit environment must continue. We see virtually no margin of safety for this sector. This narrow credit spread environment is the key driver that is propelling Private Equity and their bids for companies. As Dan Fuss, manager of the top-performing $10.7 billion Loomis Sayles Bond Fund, recently said, “I haven't felt this nervous about a market ever.” 8

The Private Equity (PE) industry is flourishing. PE has seen its capital raising rise more than ten-fold between 1990 and 2000, only to witness a temporary pullback in 2002, and then more than double between 2000 and 2006. PE is no different than any other hot investment trend, in that its peak capital raising and capital deployment occurred in 2000, the stock market peak, only to see this process collapse in 2002, the stock market trough. Capital deployment fell from $270 billion in 2000 to $49 billion in 2002, per the Leuthold Group. I call this process “buy higher” and then “don't buy lower.” Now we've seen PE fundraising rise to new all-time highs and along with that, acquisitions as well. Leuthold estimates that in 2006 $469 billion in cash acquisitions were announced and/or completed. While this was occurring, valuations have skyrocketed, according to JP Morgan's data. 9 Between 2001 and 2006, the average EV/EBITDA multiple paid rose 41%, from 6.1x to 8.6x. Leverage increased 54%, with the Average Total Debt/EBITDA multiple rising from 4.6x to 7.1x.

We are of the opinion that PE is pushing the boundaries of prudence and that this trend is elevating valuations in the equity market. It would not surprise us that there will be many other Chrysler situations in three to five years. By that I mean, Daimler-Benz A.G. paid approximately $36 billion for the Chrysler Corporation in 1998, only to sell 80.1% of its ownership for $7.4 billion in 2006. Given that this is other people's money, why worry.

Since 2000 hedge funds have more than doubled in number, while their assets have tripled. They too are using elevated levels of leverage, as are PE firms and investors in highly leveraged fixed income securities. These funds are heavy users of derivatives. The Global derivatives market grew nearly 40% in 2006--the fastest pace in the last nine years--to $415 trillion, per the Bank of International Settlements. The amount of contracts based on bonds more than doubled to $29 trillion. The actual money at risk through credit derivatives increased 93% to $470 billion, while that amount for the entire derivatives market was $9.7 trillion. 10The International Monetary Fund, in its April 2006 Global Financial Stability Report, estimated that credit-oriented hedge fund assets grew to more than $300 billion in 2005, a six-fold increase in five years. When levered at 5-6x, this represents $1.5 to $1.8 trillion deployed into the credit markets. Fitch, in their June 5, 2007 special report, “Hedge Funds: The Credit Market's New Paradigm,” says that despite the upward trend in maximum allowable leverage, “notably, no prime broker reported raising margin requirements in response to historically tight credit spreads and growing concerns about the general level of risk-complacency in the credit markets.” The report provides a forced unwind example where an initial 5% price decline in the value of a hedge fund's assets could lead to a forced sale of as much as 25% of its assets, assuming leverage of 4.0x (20% margin). They conclude that liquidity risk is among the more important issues facing credit investors. In an era of constrained returns and narrow yield spreads, increased leverage is the solution since volatility is low; therefore, a higher level of leverage may be utilized. We question this logic.

Enhanced risk taking is widespread here as well. Equity mutual funds are now at or near their all-time record low cash percentage holding of 3.6%. According to the Leuthold Group's data, investors are directing their cash flows to among the riskiest areas of the equity universe—foreign focus equity funds. $80 billion has flowed into these funds through May compared to $11.8 billion for large-cap domestic equity funds and a net outflow of $4.2 billion for small-cap equity funds. This is the second year in a row that the foreign sector has overwhelmed the flows into domestic equity funds. We are of the opinion that investors are chasing the enhanced returns in the foreign sector but do not realize the extent of the risks they may be taking. We see little value in the domestic equity market since we view valuations as being elevated because, in our opinion, consensus profit expectations are assuming unsustainably high operating margins. There appears to be minimal valuation differentiation across most market cap sectors. For example, my value screen just hit a new low in terms of the number of qualifiers. Prior to the recent equity market decline, only 33 companies, with market caps between $150 million and $3 billion, were identified out of nearly 10,000 in the Compustat universe. The previous low was 46 this past February, and before that, it was 47 for both January 2004 and March 1998. When the market cap upper limit was expanded to $150 billion, only ten additional companies qualified. In times past, I would generally get 250 to 400 companies in just the smaller market cap range alone.

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Wall Street Chasing Performance through Chemistry

“It’s like they’re chasing a dream. Even when they make tremendous profits, they’re still worried,” he said.

Alden Cass, a clinical psychologist who counsels Wall Streeters with drug addictions, said drug abuse and high anxiety are undercurrents to the current boom.

“When things are really good, they feel invulnerable,” Cass said. “That can lead to adultery, substance abuse, problems with the law.”

When it comes to profits, things are really good.

Six of the largest U.S. investment banks — Goldman Sachs, Lehman Brothers, Citigroup, JPMorgan & Chase Co., Morgan Stanley and Bear Stearns — combined for $17.6 billion in first-quarter profit this year. That’s after shelling out $28.8 billion for pay and benefits, financial statements show.

Those profit and pay figures are more than double those seen in the first quarter of 2000, the last days before the dot-com bubble burst. New York’s comptroller estimates Wall Street’s 2006 bonuses will generate $1.6 billion in state tax revenue.

Cocaine and hillbilly heroin
“To my knowledge, we have not seen an uptick in drug use,” Morgan Stanley spokeswoman Jean Marie McFadden said.

The other five firms declined comment or did not return telephone calls.

But Cass said opiate abuse among his clients is rising and they openly talk about being hooked on prescription drugs like OxyContin, known as hillbilly heroin.

“That’s what has changed from previous booms on Wall Street,” he said.

Cass and Stratyner said their clients sometimes conceal their habits by taking prescription drugs they get for back surgery or sports-related injuries. The Internet has also expanded the black market for drugs.

Wall Street professionals in their 20s use Ritalin and Adderall, prescription drugs used to treat attention-deficit disorder and hyperactivity, to enhance their performance as they grind out 100-hour weeks, Cass said.

Big bonuses and the need to blow off steam have helped invigorate demand for cocaine in Manhattan, according to two junior bankers who did not want to be named.

Juan Rodriguez, convicted of selling drugs to investment bankers and other professionals, said his clients never complained about the price of cocaine, even as it escalated.

“My customers were all business individuals,” Rodriguez said, citing Morgan Stanley bankers as among his clients.

Morgan Stanley said the company has a strong policy against substance abuse and uses random drug testing.

Passing the test
One hiring manager at a major New York bank said new staff must take a urine test, which is typical for the industry. But he said new hires can choose when to schedule the test during a 45-day period before their start date.

“Our drug test is not so much a test of whether you actually take drugs as it is an intelligence test to see if you can figure out how long it takes to get traces of the drug out of your system,” said the manager, who asked not to be named.

The hiring manager said his employer also had a policy of random drug tests for employees but that in several years he had never encountered anyone subjected to such a test.

Drugs are not the only reason for executive meltdowns.

Overwhelming pressure and anxiety to meet profit goals undid star trader David Becker as he rose the Citigroup ladder.

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Nine months after becoming global commodities chief, Becker found himself on the fast track to prison. The largest U.S. bank discovered in 2004 that Becker and others conspired to overstate profits by $20 million.

Becker, 41, pleaded guilty and is serving a 15-month sentence in federal prison. He declined to comment.

Before he committed his crime, he sought psychiatric help to deal with the pressure of balancing family and career, court papers show.

A metaphor for his life was a painting he owned depicting a man being pulled by all four limbs, Becker’s psychiatrist, Dr. Barbara Deutsch, wrote to the judge in the case.

“He felt enormous pressure to make the group’s budget at all costs,” Deutsch wrote. “He felt identified with this tortured man.”

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Friday, July 13, 2007

Australian hedge fund warns about withdrawals

The resets are just starting and detailed information about Basis Capital's positions would be interesting to look at. Basis report that they avoided 2006 vintage loans but it's likely that 2005 isn't far behind. Anyway this report in from the Financial Times.

FT.com / Capital markets - Australian hedge fund warns about withdrawals: "An Australian hedge fund manager with $1bn in structured credits and junk-rated loans warned investors yesterday it could restrict withdrawals to ensure its survival as it reported losses of 14 per cent in one fund in June.

Basis Capital, based in Sydney, said in a letter to investors it had been hit by “indiscriminate” repricing of “otherwise fundamentally sound collateral” amid the crisis in US home loans to less creditworthy investors. It said it had deliberately avoided the worst-hit 2006 subprime loans.

The warning that redemptions can be restricted comes as a series of hedge funds in the US and UK have run into trouble from the collapse in price of illiquid, or hard-to-trade, securities linked to subprime loans.

Restrictions on redemptions are closely monitored by hedge fund investors as an indication of trouble."

Swinging the Market - Calvin Bear

NEW 7/12/2007 4:08:50 PM
Two politically independent factors affect what happens in the share market – one is the real market price of money, and the other is the range of competitive options available for the equity dollar, in other words, comparative risk values.

Three politically dependent factors affect what happens in the market – whether or not the investment bankers who have supported their political candidates feel they have control of these politicians, whether they are individually extracting an evenhanded distribution of favours and money between their ranks from their political ‘slaves,' whether they have sufficient control over the minds and actions of the voting public.

There is only a very small handful of investment banks that exert that much control over the White House. But they control by far the largest dollar push in the equities markets virtually worldwide.

Whereas the judiciary is not politically independent in the USA, it is very very much independent in Israel – and consequently, there is a dynamic that is not much referred to even among those Jewish Banking Conspiracy ‘nutjobs' which often produces disturbances and wide differences of opinion among the operators in the bullfight ring who normally ‘should' be going along a consistent and collusive pathway; except that they don't regularly. This condition innately part of the Israel Lobby, allows for sudden dark volatility in almost every function of policy coming out of the White House, and equivalently it is the root cause of unheralded volatility within the share market collusive banking cartels who operate at the top of capital flow decisions in New York.

Although it is true that there has been for a long time a total lack of discipline surrounding the extending of money from the US Treasury to a small handful of investment banks and their associated interests – this cannot completely overcome the forces of money worldwide that really are the drivers of the interest rate; notwithstanding that it is also due to the trade currency status of the US Dollar and its link to the policy decisions of Japanese banks and the Japan Government, that the Treasury can get away with its bizarre belief in the printing press over the minting press.

Although I find it extremely odd for me to be making references to Lyndon Larouche, nevertheless he is an exact example of a brand name thinker whose printed body of recent work draws from so much excellent historical background, yet still manages to say that dead people are behind the active decisions of today's money and capital managers: it is perfectly true that there was a London City merchant base of corruption and greed that developed into a collusive trans-Atlantic elite two or three hundred years – but these people suffered just as much decimation through all the major wars since Napoleon and there is no evidence they still exist today.

In the same way, it is perfectly possible that Henry Kissinger was part of a globally powerful elite that includes Rumsfeld and Cheney – an elite that directed the current wars in the Middle East – it is not at all certain these people fully control all the complexities of US political reality and there is far more evidence that Congress is swinging brutally strongly AWAY from this clique and its interests.

The investment banks that are not aligned with the Kissinger ideologues currently running the White House, could already be operating on a long term plan to undo the present Republican ruling faction, and these banks will far prefer to create a BIG BUBBLE that can be pinned on the current Bush administrations negligence. Consequently you are more likely to see the share market withdrawals closer to the elections and not quite yet, so that the ‘problems' are fresh in the minds of voters and hot in the media AT THE TIME OF VOTING, and not sooner.

Kissinger is an old man, and Cheney is past his best aggressive years. Olmert is a political dead man walking. These people are dancing their swan songs, not their Bolero Fire Dances!

I mean career fund managers out of the establishment business schools can jump on all the bandwagons they want to but the fact will remain that they have no real access to private equity or hedge fund knowledge no matter how many new IPOs they set up.
ALL debt is supposed to have collateral supporting its downside risks – why should the phrase ‘collateralised debt obligation' suddenly imply an intrinsically self-immolating investment structure?

There is private equity that can NEVER be looked into by the SEC no matter it tries to do – there are secrets of financing and funding that simply are not in the public arena of knowledge. And there are hedge operations that can build or destroy any currency and these have nothing whatsoever to do with the types of leverage and derivative positions and the CREDIT DEFAULT SWAPS (which are totally different to CDOs in essence).

The sub-prime lenders are called sub-prime because everyone always knew they could not meet their repayment schedules – why is it surprising to the professional investor that these will default? It might be surprising that the packaged funds that sell such sub-prime bundles to pension funds collapse with such regularity – but not to me. The fact is, the pension fund contributers are not collapsing; THEY are still making payments to someone, anyone, and probably just the next risky fund that replaced the collapsed one!

The only time there will be a market crisis is when the pension holders start making large scale capital calls… But this might conceivably be actuarily defeated as a ‘problem' if a lot of pensioners simply die. Which they inevitably will at some point.

No. The equity market will not fall just because idiot hedge fund managers or CDOs fail the investor. The equity market will only start to become a slide downwards when the quiet private equity investment bankers sell their equity positions in large scale in order to take up a position in a more competitive investing position. And this will require interest rates closer to 7 per cent than to 5.

Calvin J. Bear

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Thursday, July 12, 2007

Does neo-classical Economics make sense?

July 11, 2007
In Economics Departments, a Growing Will to Debate Fundamental Assumptions
NY Times

For many economists, questioning free-market orthodoxy is akin to expressing a belief in intelligent design at a Darwin convention: Those who doubt the naturally beneficial workings of the market are considered either deluded or crazy.

But in recent months, economists have engaged in an impassioned debate over the way their specialty is taught in universities around the country, and practiced in Washington, questioning the profession's most cherished ideas about not interfering in the economy.

“There is much too much ideology,” said Alan S. Blinder, a professor at Princeton and a former vice chairman of the Federal Reserve Board. Economics, he added, is “often a triumph of theory over fact.” Mr. Blinder helped kindle the discussion by publicly warning in speeches and articles this year that as many as 30 million to 40 million Americans could lose their jobs to lower-paid workers abroad. Just by raising doubts about the unmitigated benefits of free trade, he made headlines and had colleagues rubbing their eyes in astonishment.

“What I've learned is anyone who says anything even obliquely that sounds hostile to free trade is treated as an apostate,” Mr. Blinder said.

And free trade is not the only sacred subject, Mr. Blinder and other like-minded economists say. Most efforts to intervene in the markets — like setting a minimum wage, instituting industrial policy or regulating prices — are viewed askance by mainstream economists, as are analyses that do not rely on mathematical modeling.

That attitude, the critics argue, has seriously harmed the discipline, suppressing original, creative thinking and distorting policy debates. “You lose your ticket as a certified economist if you don't say any kind of price regulation is bad and free trade is good,” said David Card, an economist at the University of California, Berkeley, who has done groundbreaking research on the effect of the minimum wage.

Most economists are still devoted to what is known as the neoclassical model. Philip J. Reny, chairman of the economics department at the University of Chicago — the temple of free-market economics — said the theory and methods were “taught to avoid personal biases and conclusions that aren't found in the data.” Like any science, he said, the field changes course slowly: “It requires evidence, and if evidence is there, it will accumulate and positions will move.” He added, “I personally have a lot of faith in the discipline.”

But as issues like income inequality, free trade and protectionism have become part of the presidential candidates' stump speeches, more thinkers have joined the debate. In addition to Mr. Blinder, other eminent economists like Lawrence H. Summers and the Nobel Prize-winner George A. Akerlof have pointed out what they see as the failings of laissez-faire economics.

“Economists can't pretend that the consensus for free markets and free trade that existed 30 years ago is still here,” said Robert B. Reich, a public policy professor at Berkeley who served in President Bill Clinton's cabinet.

Part of the reason is the growing income inequality and dislocation that global markets and a revolution in communications have helped create. Economists who question the free-market theories “want to speak to the reality of our time,” Mr. Reich said.

Meanwhile, critics have also pointed out the limits of standard cost-benefit accounting to measure items like the cost of inequality or damage to the ecosystem.

The degree to which economists wander from the mainstream varies widely.

Dani Rodrik, an economist at the Kennedy School of Government at Harvard, for instance, said, “I fall into the methods of the mainstream, but not the faith,” which he defines as the belief that more markets and free trade are always good and government regulation is always bad. Thinkers like these may come up with controversial ideas but are hardly marginalized. Other economists, however, go much further, and try to chip away at the field's underlying theoretical foundations. So while Mr. Blinder, Mr. Card and Mr. Rodrik might be considered mere heretics, this second group has earned the label “heterodox.”

Although the meaning of the term is slippery, Frederic S. Lee, an economist at the University of Missouri-Kansas City who edits the Heterodox Economics Newsletter, says it refers to those who reject the neoclassical model, which Milton Friedman helped create, and which Ronald Reagan championed when he took over the White House.

Mr. Reny and others point out that the increasing popularity in the mainstream of behavioral economics, which looks at people's complex psychological reactions to events, has offered a fuller picture of how consumers operate in the marketplace. Still, Mr. Lee criticizes neoclassical economics for maintaining that the market, if left alone, would ultimately find a happy balance. He also takes the discipline to task for relying on abstract theories and mathematical modeling instead of observation and sociological analysis.

In Mr. Lee's view, for example, oil companies — not the natural workings of the market — determine gas prices, and the federal deficit is a meaningless term because the federal government prints money in the first place.

According to his estimates, 5 to 10 percent of America's 15,000 economists are heterodox, which includes an array of professors on the right and the left (post-Keynesians, Marxists, feminists and social economists).

Heterodox economists complain that they are almost completely shut out by their more influential neoclassical colleagues who dominate most American university departments and prestigious peer-reviewed journals that are essential to gaining tenure. There are a few university departments where these iconoclasts are welcome, like Amherst in Massachusetts, the New School in New York and Professor Lee's home, the University of Missouri-Kansas City, but these are exceptions.

The experience of Mr. Card's graduate students suggests how the process can work. Mr. Card is by no means on the fringe, but he said his research on the minimum wage in New Jersey “caused a huge amount of trouble.” He and Alan B. Krueger, an economist at Princeton, found that contrary to what free-market theory predicts, employment actually rose after an increase in the minimum wage.

When Mr. Card's graduate students went on job interviews, he said other economists would ask questions like “What's wrong with your adviser? Has he started drinking?”

This is why Mr. Blinder said he advises graduate students “not to do what I do” when it comes to challenging the standard model.

Criticizing the approach that currently dominates the field, Mr. Blinder said economists must look more closely at the real world instead of modeling it in the lab. “Economics is insufficiently scientific,” he said. “Mathematics may be useful, but mathematics is not scientific. It doesn't generate refutable hypotheses.” In a recent issue of The Nation, Christopher Hayes spurred an energetic debate on the Web by suggesting that some precepts of heterodoxy were being incorporated into the mainstream — even if many heterodox economists were not.

Max B. Sawicky at the Economic Policy Institute in Washington, a nonprofit research organization that is a bulwark of heterodoxy, wrote in a discussion on tpmcafe.com that, “The duty of orthodoxy is clear: deny departmental positions and resources to inferior research programs and purify the top journals of incorrect thinking, all understood as maintaining high standards.”

This is the point where Mr. Rodrik, who has written extensively on the downside of globalization, departs from both Mr. Sawicky and Mr. Blinder. Although he acknowledged that inflexible rules about how one makes an argument and what counts as evidence can create blind spots, but insisted that once those rules were accepted, there was tremendous openness inside the academy.

The problem is outside, where economists are expected to “regurgitate ideas” about the glories of the free market. Most mainstream economists think that voicing any skepticism or doubt provides “ammunition to the barbarians,” he said, and allows narrow-minded people to “hijack any argument to suit their purpose.”

Mr. Rodrik said he used to worry about this until he realized that “on any issue, there are barbarians on both sides,” so there was no point in shading an argument to “suit one set of barbarians over the other.”

“And I've slept a lot better since.”

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The trader as Hero -- A must read

Courage is more exhilarating than fear, and in the long run it is easier. We do not have to become heroes overnight … just one step at a time, meeting each new thing that comes up, seeing it not as dreadful as it appears and discovering we have the strength to stare it down — Eleanor Roosevelt

Seasons come and go, markets change and evolve, but human behavior, which is hardwired into the brain, has not really changed much over many generations. Each of us looks and acts differently, but these are outward manifestations which are subject to societal pressures and ever-changing cycles of fashion and trends. Inwardly, we are all classic, fragile and captivating human beings. We have wants, needs, hopes, dreams, fears, joys and tears. Even now, when we have come so far in time and space of evolution, we are still enchantingly and ever-fascinatingly human. It is simply wonderful!

Every one of you who is reading this wants to learn how to make money from the markets. Over the years, I have provided a number of guidelines and principles to put you on the path to trading mastery. While simple, they are certainly not easy. Take personal responsibility for your trades, cut your losses quickly, stay healthy in mind and body, always practice good risk management , plan your trade and trade your plan, master your emotions, strengthen your neuropsychological capital, learn patience, stay with what is working, and take profits on a regular and radical basis. That sounds all well and good, but the majority struggle daily to figure out how to do it. Most continue to search for this or that method or this or that indicator or newsletter which will give them the answer they seek.

I cannot emphasize too strongly that there is one immutable fact which underlies all successful trading: The answer is within you. It is not out “’there” somewhere. It is about your brain (your true trading system) and how, not what, you think. Traders, with few exceptions, are made, not born. Anyone, given the passion, determination and willingness to work hard, lose, fall down and keep getting up, can learn to trade successfully. I assure you, if I can do it, you can do it. Now I will tell you secret that only a few know: I have two Ph.D. degrees, one in Brain Anatomy, and one in Futures Market Losses. I had to get the latter in order to get a true grip on who I was as a person, and turn myself around completely onto a path of success and consistent profitability. It’s a long story, but it took five years and was the most gut-wrenching and painful period I can recall. Would I change one single minute of the excruciating process? Absolutely not! Not one second of it, because all of those seconds brought me to where I am today.

How important it is for us to recognize and celebrate our heroes and she-roes!... Maya Angelou

The point is this… If I can do it, you can do it.

How? You must totally believe that you are called to trading, that it is the one thing about which you are completely passionate and that you are willing to forego many things in order to succeed. If you can take these steps, you will make it. It’s not easy. If it were, everyone would be doing it. But it can be done, and it is within the reach of every one of you who is reading this. You can do it, but you must be willing to sacrifice everything you are for everything you can and will become. You must be willing to change key elements about yourself, particularly the way you think and act in real time when bombarded with conflicting information in an environment where you have total freedom of choice and where the only thing you can control is yourself. Moreover, you must learn to make decisions involving varying degrees of risk in an atmosphere of real time and total unpredictability. You must learn to change the way you think and what you have been taught about right and wrong and good and bad. You must entrain the qualities of being counterintuitive and peripatetic. You must become a chameleon, and a great actor, an acrobat on the largest and most intimidating stage in the world. Most of all, you must be absolutely determined and passionate about it.

And then what? What do you have left in your life once you have made it? What happens when you finally do "get" it, and trading becomes relatively effortless and you are consistently making more than you are losing? What is up with the trader who is wildly successful, has all the” stuff” he or she needs, and yet keeps trading? Why is that? Is it greed, and the need to keep making more and more money in the face of abundance? Yes, in part it is. But there is much more and on an intensely deeper level.

Why do we trade? Why do successful and wealthy traders keep trading, some of them into their 80's or until death? Passion. Challenge. Continual striving to be better and better with each passing day. Mastery. Freedom. And what do most of these great traders have in common, besides the ability to amass (and keep) large amounts of money?

The answer may surprise you as much as it delights me. They have in common: an attitude of gratitude, humility, manifestation of kindness to themselves and others and an intense understanding of their personal neuropsychology and the mass neuropsychology of the markets. They have learned from the greatest and most brutally honest psychotherapist in the world: the financial markets. They have suffered, been beaten down, brutally battered, lost money, but kept the therapy going because they knew that somewhere inside of them was the person they wanted to be. After intense personal pain and internal searching, they found out who they really are and embraced it without fear. They went to the darkest recesses of their souls and emerged as their own hero. Now, they bring flowers to themselves instead of waiting for someone to send them flowers.

Their wants have been met, so they work on their needs. For them, trading becomes an activity which nourishes and uplifts the spirit. They approach the markets with humility and passion, yet can be fierce ambushing wolverines while in the trading moment. They can be sharks, waiting to feed on the poor little fishes. Yet, they are chameleons. For the master, trading is a game to be played to the ultimate scope of his or her ability. He/she never forgets the ones that got away, the Ph.D. in losses, the missed opportunities, the times when he/she was the little fish. A master remembers these bitter, gut-wrenching times and has them etched in the hippocampal memory so as to never forget.

Masters have rich and full lives outside of trading, especially those who took the time to keep family and friends in some degree of intactness. They cherish relationships and put people before money. People first, money second and "stuff" third. They value and reward those who have supported and loved them. They cherish and love themselves. They are kind to themselves and others and recognize that kindness is the greatest gift we give to each other. Even the most successful traders and investors with the highest degree of longevity approach the markets with humility. They are non-confrontational and go flexibly with the flow. They are in sheer joy with the moment. It is the perfect moment, and they are always in it. They are in gratitude for the privilege of partaking of the gifts which they receive from the market. For them, trading is a spiritual activity!

My greatest hope for each of you is that you never forget this. In the end, it is always about gratitude, humility, kindness and love. Love what you do, and those who nurture and sustain you. Focus on yourself, who you are, and what you want and need and then practice and keep practicing. Do what you truly love, and the money will always follow. In the process, you will begin to see that you are evolving and growing your capital: financial capital, mental capital, emotional capital, and — as the topic of this essay — spiritual capital.

Thank you for the opportunity to share with you my experience, strength and hope. I wish each of you everything and more that you wish for yourself.

When you feel like all is gone, look inside you and be strong. And you'll finally see the truth, that a hero lies in you… from” Hero”, Mariah Carey

© 2007 Janice Dorn, MD, PhD


Wednesday, July 11, 2007

The Crack up boom!

Safe Haven | TedBits: "he Crack Up Boom series is exploring the unfolding 'Indirect Exchange' (as detailed by Ludvig Von Mises), that dollar holders will be using to exit their holdings now and eventually is will be followed by all holders of fiat currency holdings no matter which country is perpetrating the 'crime' of confiscation of wealth through the printing and credit creation process that all such monetary schemes evolve into. The 'Crack Up Boom' will drive an inflationary global expansion to inconceivable heights over the coming years. Asset prices will skyrocket as people do what they always do when threatened they will modify their behavior and do the things necessary for 'SELF PRESERVATION' of their families, countries, economies and their wealth. Let's take a look at Von Mises's description of the CRACK UP BOOM once again:

This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict the"

Bloomberg.com: Worldwide

Bloomberg.com: Worldwide: "A total of 11 percent of the loan collateral for all subprime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 percent.

Investors depend on guesswork by Wall Street traders for valuing their bonds because there is no centralized trading system or exchange for subprime mortgage securities. Credit rating companies supported high prices because they failed to downgrade the debt as delinquencies accelerated.

Headed Lower

While there's no consensus on prices, traders agree that the bonds are headed lower. Some of the securities have already declined by more than 50 cents on the dollar in the past few months, according to data compiled by Merrill Lynch & Co.

One subprime mortgage bond, Structured Asset Investment Loan trust 2006-3 M7, is valued at about 91 cents on the dollar to yield 9.5 percent, according to the securities unit of Charlotte, North Carolina-based Wachovia Corp. Merrill Lynch in New York puts the price of the same security at 67 cents to yield 18 percent."

Monday, July 09, 2007

The Crashing U.S. Economy Held Hostage

The Crashing U.S. Economy Held Hostage: "Remember when the U.S. was the world’s greatest industrial democracy? Barely thirty years ago the output of our producing economy and the skills of our workforce led the world.

What happened? It’s hard to believe that in the space of a generation our character and capabilities just collapsed as, for example, did our steel and automobile industries and our family farming. What then are the causes of the decline?

Here’s how I would put it today: our economy is on an artificial life-support system, a barely-breathing hostage in a lunatic asylum. That asylum is the U.S. and world financial systems which are on the verge of collapse.

The inmates are the world’s central bankers, along with most of the financial magnates big and small. The fact is that the economy of much of the world is in a decisive downward slide which the financiers cannot stop because the systems they operate are the primary cause. As often happens, the inmates rule the asylum.

The problems aren’t confined to the U.S. Unemployment worldwide is increasing, debt is rampant, infrastructures are crumbling, and commodity prices are rising.

Saturday, July 07, 2007

$ONE:AFBIX - SharpCharts 2 from StockCharts.com

$ONE:AFBIX - SharpCharts 2 from StockCharts.com: "I took the inverse of the AFBIX (which is a short ETF following credit spreads) and logged that with the $SPX in the background. Notice the nice corrolation up to April. After April, there is divergence meaning one has become detached from the other. Does it mean that credit spreads no longer matter? I don't think so. I think the market is trying to decide what's acceptable.

I've been in the financial market for a long time....this is erilly like the 1986/1987 timeframe."

charles hugh smith-Weblog and wEssays

charles hugh smith-Weblog and wEssays: "Investors in the worse-hit of two stricken Bear Stearns hedge funds are offering to sell their holdings for as little as 11 cents on the dollar but still finding no buyers, according to unfilled trades on Hedgebay, a secondary market for funds.

Vulture funds and others have been quick to bid for holdings in the two funds, but the best bid for Bear Stearns High-Grade Structured Credit Strategies Enhanced Leveraged Fund, the more geared of the two, is just 5 cents on the dollar.

Private sales of stakes are the only way investors can exit the two Bear funds, after the bank suspended redemptions in May amid a wave of withdrawals.

'There are buyers but they can't agree on price,' said Jared Herman, co-founder of Bahamas-based Hedgebay.

The less-geared Bear Stearns High-Grade Structured Credit Strategies Fund, which the bank has rescued with a $1.6bn loan, is being offered at about 70 cents on the dollar. The fund is only attracting bidders at about 30 cents, according to people who use the system.

Market participants estimate the CDOs the Bear funds held would sell for at least 10 per cent less than the values calculated by lenders. 'Where things transact is still many points below where dealers have been marking them,' said one manager of CDOs and hedge funds. 'That is the big ugly se" Market participants estimate the CDOs the Bear funds held would sell for at least 10 per cent less than the values calculated by lenders. "Where things transact is still many points below where dealers have been marking them," said one manager of CDOs and hedge funds. "That is the big ugly secret of this market."

Does any of this strike you as just a tiny wee bit worse than the mainstream U.S. press suggests? A nickel on the dollar means a 95% loss; 30 cents on the dollar for the "high quality" tranches means 70% loss. How much money do you reckon will be lost as the hedge funds, banks and pension funds reporting huge losses turn into dozens, then hundreds or even thousands?

Comments on Liquidity boom and looming crisis - iTulip.com Forums

Comments on Liquidity boom and looming crisis - iTulip.com Forums: "Comments on 'Liquidity Boom and Looming Crisis'

by John Craig - Centre for Policy and Development Systems, Queensland (CPDS)

Editor's Note: John Craig qualified initially as a civil engineer and has had over 30 years involvement in strategic policy R&D, the majority of it working in government agencies in Queensland. This has particularly involved a systems approach to both organizational and economic development. His commentary on Henry Liu's analysis of the potential for a global liquidity crisis is mainly based on study of the different ways Western and East Asian societies have developed, and the implications that this has for their economic, financial and monetary systems.

John has generously provided his thought provoking commentary, from the perspective of an economic policy professional based in Australia, for iTulip readers.

In May 2007 Henry C K Liu produced an interesting and challenging analysis of the possibility that a 'liquidity trap' (which can arise if few want to borrow even at very low interest rates) could prevent the US Fed from again protecting the 'real' economy from an imminent financial crisis - so that the prevailing global financial market boom and sustained pattern of economic growth could be seriously disrupted (Liquidity boom and looming crisis, Asia Times Online, 9 May")
In brief Henry Liu's article seems to argue that:

* US economic growth is slowing;
* there is a 10 year cycle of financial crises (ie the US market crash of 1987 and the 1997 Asian financial crisis), which have similar causes (ie dubious leveraged international short term funding of long term investments);
* another financial crisis could be looming associated with the spreading effect of weaknesses in US sub-prime mortgage markets which adversely affects demand, while at the same time Fed responses are constrained by both inflation risks and a potential liquidity trap (ie an inability to increase liquidity if few want to borrow);
* the wealth effect which is now disappearing has been driven by international capital flows (linked to US current account deficits) over which US authorities have little control;
* the difficulties are compounded by: the mal-distribution of wealth and growing unemployment (which constrain consumer demand) and financial market techniques such as securitization (which increase systemic risks);
* China faces difficulties associated with current account imbalances and $US hegemony, but has little scope to pick up the slack as US demand declines - and can only try to isolate itself from the coming financial crisis;
* in 1980, before dollar hegemony allowed the US to finance current account deficits from a capital account surplus, the Fed had to raise interest rates to nearly 20% to curb the stagflation resulting from the US trade deficit. The Plaza Accord tried to force a revaluation of the Yen to cut that deficit - and this forced Japan into a deflationary depression from which it it has not really recovered;
* the subsequent liquidity boom (under which growth has been driven largely by increasing asset values) has its origin in Fed policies, $US denominated structured finance and $US hegemony;
* the liquidity boom requires many things to be just right and could easily be disrupted, resulting in a prolonged bear market. Thus a global financial crisis is inevitable.

This article presents the present writer's summary of Henry Liu's paper interspersed with comments which suggest that, while the potential risk is real, it originates as much in East Asian economic strategies and financial/monetary systems as anything else, and that the prospects that others can be isolated from the consequences are much less than Henry Liu's paper suggests.

In brief, CPDS' comments suggest that:

* the most obvious common feature of both the 1987 and 1997 financial crises was that they were triggered by large-scale withdrawal of Japanese capital;
* the liquidity boom (whose bursting could dislocate global growth) is partly a consequence of the need for trade surpluses by major economies in East Asia to protect financial institutions that have poor balance sheets due to a lack of commitment to the profitable use of capital;
* Japan's need to stimulate its economy (long at risk because of weak consumer demand and business investment) is another key factor in the liquidity boom - and arose because of its failure to properly reform its financial system after the 1980s property bubble burst;
* some of Henry Liu's interpretations of past events, and of financial market imperfections, seem to need refinement;
* the key question is how to unwind trades imbalances, capital transfers and easy money policies that have been associated with the emergence of a liquidity bubble. This seems to require international collaboration in reform of global and national trading, financial and monetary regimes.

CPDS Comments
on a Summary of Liquidity boom and looming crisis
(Henry C K Liu, Asia Times Online, 9 May 2007)

Economic growth in the US slowed to 1.3% in the first quarter of 2007, the worst performance in four years of an overextended debt bubble. Yet the The DJIA is now 82% higher than its low in 2002, during which US GDP grew only 38%.

There is a 10-year cycle of financial crises. This included the 30% US market crash of 1987 which was set off by the 1985 Plaza Accord (to push down the Japanese yen so as to cut the US trade deficit with Japan) and the Asian financial crisis of 1997.

COMMENT: Presumably this includes an inadvertent mis-statement. The Plaza Accord was surely intended to increase (not reduce) the value of yen (and other currencies) relative to the $US.

While there seemed to be many causes of the 1987 US market crash including a bubble linked to rapid growth associated with high rates of public spending and a very large budget deficit, the trigger for the crash seemed to be Japan's sudden large withdrawal of capital from the US (by sale of about $US 400bn in assets) - which resulted in rapid rises in interest rates. Such a withdrawal of capital would be expected to reduce the value of $US relative to the yen - though whether this was done in the Plaza Accord context or as a result of Japan's domestic financial predicament (noting that Japan's 1980s' real-estate bubble subsequently burst) or for other reasons is unknown.

The 1987 market crash was unexpectedly prevented from affecting the real economy because the US Fed boosted liquidity to support distressed financial institutions in ways that would traditionally have been impossible (ie before the gold standard was abandoned, this action would have led to a current account crisis).

The Asian financial crisis of 1997 was associated with unproductive use of capital under 'crony capitalism' arrangements - and appeared to be triggered (as in 1987) when Japan suddenly withdrew large amounts of capital from elsewhere in Asia (Hartcher P. ‘Look East, Dr Mahathir, for the source of Asia’s decline’, Australian Financial Review, 25-26/10/97).

A wave of deflation spread over all of Asia from which Japan has yet to fully recover. Now in 2007, a debt-driven financial crisis threatens to end the liquidity boom associated with the flow of trade deficits into capital-account surpluses which US dollar hegemony has permitted.

COMMENT: The liquidity boom is also due to the circular flow of (mainly) Asian trade surpluses and capital deficits (which are the mirror image of the US trade deficit/capital surplus). It is also due to creation of cheap credit (a) by Japan to stimulate its domestic economy otherwise long at risk of deflation due to low consumer demand and stagnant business investment and (b) by the US and others to maintain global growth to compensate for the (mainly) Asian demand deficit - an initiative that had been made possible with limited inflation risk by cheap imports.

Asset bubbles have appeared in Asia (driven by trade surpluses and easy credit) just as they have elsewhere (driven by easy credit).

The financial crisis that could be looming is partly a feature of East Asian economies in which return on capital has not been taken seriously - and financial institutions are often burdened with bad debts. The consequence of any US inability to drive global demand will be an end of East Asian current account surpluses, and thus an urgent need for (say) Japan's and China's banks to have the sound credit rating needed to borrow internationally.

While details differ, these financial crises have similar causes - leveraged short-term borrowing of low-interest currencies financing high-return long-term investments in high-interest currencies through "carry trade" and currency arbitrage, with projected future cash flow supporting share prices.

COMMENT: As noted above, the situations were not all that similar and there were other factors involved.

Eventually the rise in asset prices beyond market fundamentals ended. On one occasion a steady fall in the value of the US dollar, the main reserve currency, caused a sudden market meltdown that spread across national borders through selling in strong markets to try to save hopeless positions in distressed markets.

COMMENT: A fall in the value of the $US was not involved in both 1987 and 1997.

The strength, not the weakness, of the $US was its only impact on the 1997 Asian financial crisis. Countries such as Indonesia tried to maintain a fixed exchange rate with $US without the large current account surpluses that Japan and China (for example) used to prevent the weak balance sheets of their financial institutions from being exposed.

As noted above, the most obvious common feature in triggering these events seemed to be a sudden large withdrawal of Japanese capital.

Such a point is now again imminent - given weak US GDP growth associated with a housing slump caused by a meltdown in the subprime mortgage sector. This has not bottomed, and its full global impact has not yet been felt.

COMMENT: Fair point.

Deprived of expanding wealth by falling home prices, US consumer spending was up only 0.3% in April 2007. The US Federal Reserve and Treasury have denied that a recession is likely - though former Fed chief Alan Greenspan has put the odds at one in three. Inflation pressure continues to complicate Fed policy deliberations.

While the Fed views inflation as the main danger, it hopes that inflation will fall as monetary policy remains tight. The Fed's stated goal is to cool the economy to limit inflation without provoking a recession. Yet in an age of derivatives, the Fed's interest-rate policy does not dictate the supply of liquidity. Virtual money created by structured finance has reduced central banks to the status of players not controllers of financial markets. A liquidity boom that allows rising equity markets while the economy slows can turn toward stagflation, with slow growth and high inflation.

COMMENT: Fair point about Reserve Banks' limited influence.

However 'stagflation' (in the 1970s) was associated with increasing wages and consumer prices while the economy stalled - rather than with asset price inflation. It is not clear that asset inflation driven by a liquidity boom must lead to wage and consumer price inflation.

The wealth effect from rising equity prices has been caused by a debt bubble fed by liquidity created beyond the Fed's control, by the US trade deficit denominated in dollars returning as capital-account surpluses.

COMMENT: The liquidity boom - which is global rather than confined to US - has been driven by others' trade surpluses as much as by US trade deficits (as these are simply mirror images of the same thing).

Also, the wealth effect has not been broadly distributed, resulting in a boom in the luxury consumer market while the general consumer market stalls.

COMMENT: Fair point - though it is noted that restraint on wage earnings has been due significantly to international competition from economies who workers' increasing skills and education have perversely not yet properly increased their wages.

While the DJIA rose 5.9% in Q1 2007 with inflation at 2.2 %, wages and benefits grew by only 0.8%.

COMMENT: Presumably the DJIA (etc) reflects corporate earnings which derive increasingly from global, not simply US, operations.

By acting as the dominant HQ for global businesses, the US may be best positioned for flow-on of corporate profits to the rest of the workforce.

There was concern in the 1980s that the benefits of US high tech industries would not be widely shared - then in the 1990s the emergence of the 'new' (knowledge/network) economy allowed those benefits to be shared. Perhaps something like this effect will occur with respect to globalization of operations.

Labor's share of the US GDP growth of 1.3% was -2.6% (after a 3.4% inflation) while capital's share was +2.5%. If labor's share of GDP growth remains negative, companies won't be able to sell their products and will be forced to lay off workers, thus further slowing growth.

COMMENT: This further demonstrates why stronger demand in Europe and Asia, and the reforms of trading, financial and monetary systems needed to make this possible, are vital to maintaining global growth.

US job creation has slowed, and unemployment has risen. The slowdown in job creation reflects recent economic weakness but is likely to be viewed perversely by the Fed as a sign that wage inflation pressures are easing.

COMMENT: Presumably a recession is possible, but 4.5% unemployment is by no means high by international and historical standards.

Before the age of securitization, risk was evenly spread and all mortgages shared the cost of default. Securitization through collateralized debt obligations (CDO) permits the unbundling of risk into tranches of increasing risk and return levels, while squeezing additional value out of the mortgage pool by increasing risk / return efficiency.

COMMENT: Arguably value was genuinely 'created' by this means. The unbundling of risk leaves the debt instrument holder initially in the same position - i.e., with an overall risk and return package the same as before. It is just that the components are separately worth more to others.

This extra value, when siphoned off repeatedly from the overall mortgage pool, requires an ever larger supply of risky subprime mortgages, thus increasing the systemic risk further.

COMMENT: Why are sub-prime mortgages needed to make this arrangement work? Surely any set of mortgages can be used.

Subprime borrowers are no longer just low-income borrowers. The extra risk-premium value taken out of the mortgage sector increases liquidity to feed the debt market further, further reducing credit standard of subprime lending. When prime-credit customers have borrowed to their limits, growth can only come from lowering credit standards.

COMMENT: This seems a bit simplistic. The 'value taken out' through this function is no different to the value-added in any other business dealing. The goal of any marketing strategy is to identify where others value goods or services a great deal more than they cost to produce.

And 'value-added' through securitization does not go only to increasing liquidity. It may for example be used to pay wages or taxes, and thus ultimately increase demand and improve real returns on capital.

This is the structural unsustainability of CDO securitization.

COMMENT: For reasons suggested above, perhaps this suggestion is in need of more development.

China's foreign-reserves data showed as much as $US73 billion in unexplained new reserves. If these funds were swaps, this would have only minor economic implications, but if they were $US inflows this could further stimulate an overheated economy.

Dollar inflows would require further monetary tightening by the PBoC to reduce the risks of an equity bubble fuelled by expanded money supply. China has been raising required bank reserves, reducing funds available for lending trying to cool an investment boom that could spark a financial crisis. The effort has had only limited success. China's international balance-of-payments problem is boosting excessive liquidity in its economy.

COMMENT: Fair point. The solution presumably is more balanced trade (which in turn requires more determined efforts to strengthen financial systems in trade-surplus countries).

Chinese global trade surplus increased 74% to $177.5 bn in 2006 - though, ignoring $73 billion of capital inflow and $60 billion in returns on foreign capital, the net trade surplus was only about $40 billion (less than Japan's $168 bn and Germany's $146 bn surpluses).

COMMENT: Why take away capital inflow and returns on capital? China's trade surplus was still $177bn.

And the trade surplus of China plus that of countries to which component production for products finished in China is sub-contacted was presumably much greater.

The US trade deficit with China widened to $233 billion in 2006, out of a global total of $857 billion. If the US trade deficit with China falls, China will reduce its own trade deficit with other trading partners, with little effect on the US global trade deficit.

COMMENT: Fair point. The problem is unbalanced trade generally, not exclusively that with China.

The question is how trade surpluses in countries such as China, Japan and Germany can be reduced, and how US deficits can be reduced.. This might require changes to global and national trade, financial and monetary systems, as all seem to be involved in this imbalance.

Dollar hegemony is hurting the Chinese economy. As the $US-denominated trade surplus mounts, the PBoC must tighten domestic monetary measures to neutralize the increased yuan money supply which results from buying up the surplus dollars in the Chinese economy with yuan.

COMMENT: Fair point.

However presumably the $US has hegemony for a reason - partly as a result of history, and partly because US financial markets take more seriously than many others the business of producing a return on invested capital,

The solution to this is (perhaps) more attention to the profitable use of capital elsewhere.

The new yuan money doesn't finance interior development but is attracted by speculative real estate and equities, pushing prices up beyond fundamentals.

COMMENT: Fair point. However the asset bubbles are as much due to demand deficits / trade surpluses in East Asia, as they are to trade deficits that lead to capital account surpluses in US.

Led by China and Japan, all the exporting economies are fuelling a global liquidity boom focused on the importing economies (led by the US).

COMMENT: Fair point.

China has kept the global cost of manufacturing too low by not paying adequately for pollution control and worker wages and benefits. Domestic political pressure is forcing the government to normalize production costs, and boost global inflation.

COMMENT: Fair point.

Financial globalization has not banished inflation, nor ended the business cycle - though the cycle now lasts longer than 7 years. To avoid a market collapse, anti-inflation measures need to be implemented slowly - making a crash inevitable as a system that requires ever rising asset values can't survive years of slow growth.

Bonds will be the first asset class to fall in this anti-inflation cycle, and others will follow. Deflation can't be cured by printing more dollars, as this would merely convert price deflation into monetary devaluation. Globalization and hedging have merely postponed, not eliminated, inflation.

The bursting of the tech bubble, the September 11 shock, and outsourcing caused disinflation in 2002 which neutralized debt-driven dollar inflation. Then, facing dollar deflation, the Fed cut its Funds Rate to 1% in July 2003 while the Bank of Japan maintained a zero interest rate. This led to a massive liquidity boom that increased the US trade deficit.

COMMENT: It is unrealistic to suggest that the Fed's actions were solely based on US domestic considerations.

Its actions were also presumably motivated by a desire to maintain global growth in the face of the deflationary demand deficit implicit in the export driven economic strategies of major East Asian economies - on the not unrealistic assumptions that (a) those economies would simply have to continue financing the resulting US current account deficit or themselves face economic disaster and (b) cheap imports would keep inflation in check.

In 1980, before the emergence of dollar hegemony, which allowed the US to finance it trade deficit with a capital-account surplus, the Fed had to raise its Funds Rate to 19.75% to curb stagflation caused by its trade deficit. In 1985, the Plaza Accord aimed to revalue the Japanese yen against the dollar to curb the US trade deficit with Japan. This pushed Japan's economy into a deflationary depression from which it has not yet fully recovered.

COMMENT: Why suggest that stagflation in the 1970s was due to a trade deficit? It seemed to be due to inflationary shocks associated with (a) rapid increases in oil prices, that were transmitted without restraint into a wage-price spiral, and (b) serious difficulties in maintaining productivity (due to Japanese and Asian tiger competition in capital intensive manufacturing) which could not be overcome without huge structural adjustment (that took market liberalization and many years to achieve).

Why suggest that the $US was not the dominant global currency before 1980? If it was not, what was its competition, and why did that competition subsequently lose ground?

Japan's deflationary depression was not due to the Plaza Accord. Japan had a massive property bubble in the 1980s, funded by the government dominated banking system, and the bubble burst. Japan then endured many years of deflation and slow growth because, rather than writing off losses and reforming its financial institutions as was common elsewhere, those problems were covered up - presumably because the bureaucratic elite, who govern Japan behind a democratic facade, would otherwise have lost control of Japan's financial system.

The source of the global liquidity boom (which has boosted demand by inflating asset values) is the increased supply of US dollars, both as a result of Fed monetary policy and of $US-denominated structured finance under dollar hegemony.

COMMENT: As indicated above, the liquidity boom also has its genesis in: recycling of trade surpluses back into investment in $US assets - which is heavily associated with a defensive approach to weakness in the balance sheets of East Asian banks; and cheap credit generated in Japan which is cycled through the carry trade into US financial markets.

Moreover, the hegemony of the $US reflects the weakness of financial systems in countries that might otherwise challenge its role.

Liquidity is affected by the monetary environment created by central-banks. It can be increased by lower interest rates or easing money-supply relative to nominal economic activity. However availability of money alone does not create liquidity. There must also be a market in which assets can be traded without regulatory restrictions or causing big shifts in price levels. The demand for assets relative to their supply also affects liquidity.

COMMENT: Fair points. However, a key factor in increasing the demand for assets (and thus increasing liquidity) has been the large capital inflow associated with recycling of trade surpluses and the Yen carry trade.

Hedge funds contribute significantly to the increase of liquidity by enlarging investor appetite for risk-taking.

COMMENT: Hedge funds only increase liquidity because they are seen to be using capital profitably. These arrangements may, however, increase systemic risk.

The liquidity boom requires all these factors to continue - as even slight changes could end it. A sudden fall in the $US could trigger market sell-offs, as it did after the Plaza / Louvre Accords of 1985 and 1987, first to push down and later push up the $US, which contributed to the 1987 crash.

COMMENT: Good point regarding potential instability.

However there seems to be a need to further justify claims about the effect of a fall and rise in $US in the 1980s.

In 2007, the market won't cause the $US to fall rapidly in value unless there is something to take its place - eg the currency of a country whose financial markets take profitability in the use of financial assets more seriously than the US does. A serious $US crisis could also be triggered by politically motivated action by large holders of $US assets - a step that would be most damaging to the interests of economies that rely on exports to US.

Other causes of the 1987 crash were proposals for changes to tax legislation that would have disadvantaged investors.

COMMENT: As noted above, there were many other factors that contributed to that situation.

There are many ways in which the current liquidity boom could turn into a liquidity bust (eg hedge fund regulation, rapid revaluation of yuan, imbalance between assets and credit).

COMMENT: Fair point. The Bank of International Settlements has argued that global financial imbalances - which are central to the emergence of the liquidity boom - represents the world's key economic problem.

Dislocation in the real economy could also potentially end the liquidity boom rather than the other way around (eg consider the effect of a pandemic (a more dangerous successor to SARS and Bird Flu) or disruption of global oil supplies as a result of political instability in the Middle East).

Financial globalization and the dominance of derivative plays by hedge funds and private-equity firms could turn a minor disruption into a crisis. The main uncertainty in the coming adjustment is the effect (perhaps beneficial or destabilizing) that these new players could have on international markets as liquidity recedes. Alternatively, the global growth boom and bull market may simply run out of steam.

The liquidity boom has allowed growth through asset inflation without much expansion of the real economy. Unlike real physical assets, virtual financial mirages can evaporate without warning.

COMMENT: It is unwise to assume that 'real physical assets' are more solid than financial assets. The symbolic economy is vital to coordination of actions within the 'real' economy. If the symbolic economy were to fail, those with 'real' assets would often be left with piles of rusting junk for which they had no use.

The emphasis that many in East Asia place on a strong 'real' economy with disregard for the symbolic economy is a major cause of (a) their need for current account surpluses to protect their weak financial institutions (b) global trade imbalances and (c) the emergence of the liquidity boom and asset bubbles that have the potential to be economically disastrous.

Massive fund flows from less experienced investors into hot-concept funds have caused a financial mania that must unwind.

Inflationary pressure in OECD economies makes a bear market inevitable and an orderly unwinding unlikely. Central banks can't ease because of a liquidity trap - that arises when banks can't find creditworthy borrowers at any interest rate or, when interest rates are near zero, people don't expect positive investment returns and so hoard cash.

COMMENT: While a liquidity trap is possible, why will this necessarily happen now? Certainly the fact that some asset values have been high and are likely to devalue suggest the possibility than few will want to borrow, but could not new asset classes be identified (e.g., in alternative energy) that make borrowing profitable and so re-generate liquidity?*

As the decade-long US consumption boom collapses, an ongoing bear market will arise. Asia's growth has been driven by low-wage exports, so it will not be ready fill in as the growth engine in time to prevent a crash. China is just starting to change its development model to boost worker incomes and consumption. Its only option is to insulate itself by resisting US pressure to open its financial markets. Its purchasing power is too low to save the global economy from a deflationary depression.

COMMENT: It isn't only China that needs to do more to boost domestic demand to prevent a global crisis. Japan (and various other countries whose positions are not constrained by low income levels) also need to make a major contribution.

It seems most unlikely that China would be able to protect itself from a global economic meltdown - because of its export dependence. Moreover, the political 'legitimacy' of ruling elites seems to depend heavily on continued economic growth - so any disruption could lead to political instability as well.

A global financial crisis is inevitable and this could trigger a global economic hard landing. Global financial markets look like a pyramid game (noting complex derivative products catering to short-term trading strategies and that, in the absence of good returns in the US, investors allocate funds to emerging-market and commodity specialists - whose investment in small and illiquid stocks has been all that has supported the latter's rise in value). Rising leverage has also artificially boosted liquidity in hot markets.

Before financial globalization, if short-term $US interest rates were higher than longer-term rates, US Treasury bonds could not be boosted by carry trades. Now however this is routine. More profitable still has been borrowing in Japanese yen to invest in Brazilian or Turkish bonds, using various derivatives to hedge currency or credit risk.

Financial markets experienced minor shocks recently when the BOJ soaked up a lot of liquidity and hinted at the need to commence a rate-hike program. A liquidity boom will continue as long as a central bank with large foreign reserves, such as the BOJ, price short-term credit at low levels and lends to all comers.

COMMENT: Fair point. The BoJ deserves close attention in this respect - especially given that withdrawal of Japanese capital seemed to play a role in triggering both the 1987 and 1997 financial crises.

The People's Bank of China also contributes to the global liquidity boom.

COMMENT: Fair point.

The US current-account deficit is the key driver of the liquidity boom. Those who call for a cut in the US trade deficit are calling for a US recession.

COMMENT: As noted above the US current account deficit does not exist in isolation - but is a reflection of economic strategies and financial institutions elsewhere - especially in Asia.

Given sounder balance sheets in (say) Japanese and Chinese financial institutions, there would be no reason that the US capital account surplus / current account deficit could not be reduced without a recession - because stronger demand in Asia would then compensate for a reduction in US demand.

When the meltdown in the subprime mortgage market spreads to other parts of the credit markets, the Fed will be forced to try a monetary ease. But a liquidity trap will complicate matters - as long-term rates may fall faster than the Fed Funds Rate. When demand for bank reserves falls because of a slump in loan demand, then the Fed will have to destroy bank reserves to prevent the Fed Funds Rate falling to zero.

A liquidity trap can be a serious problem because the world is still plagued with excess liquidity potential. A global liquidity trap with $50 trillion of currently idle assets will implode like a doomsday machine.


In summary, it seems to be being predicted that:

* Many factors could trigger a liquidity "bust" which brings an end to to the asset boom and strong demand associated with rapidly expanding liquidity;
* Inflationary pressures will lead to a bear market which reserve banks won't be able to stop by monetary easing, because few will want to borrow creating a 'liquidity trap';
* US demand will collapse - and Asia's export-oriented economies will be structurally incapable of filling the gap;
* A global financial crisis is inevitable;
* Derivate products and globalization (which encourage funds to flow to illiquid emerging markets, and create 'hot' money via carry trades) increase the potential damage in a financial crisis;.
* Japan has moved towards higher interest rates to soak up liquidity;
* Any reduction in the US trade deficit will result in recession;
* Poor credit quality in subprime mortgages will spread, forcing the US Fed to ease monetary policy - but this will not be effective in stopping a liquidity bust.

All these things could happen, but are not guaranteed.

This paper has presented it's author's perspective on a diverse range of current economic parameters - and these comments have attempted to present another point of view on them.

The paper predicts a plausible, but not inevitable, financial crisis that would have severe economic consequences (i.e., a collapse in demand and a recession/depression) with attendant global social pain and political instability.

Clearly it behoves political and financial authorities to collaborate more effectively in developing global and national trade, financial and monetary regimes in which these risks are reduced.

* This point will resonate with iTulip Select readers. John did not get his thoughts on our theories on a future Alt Energy and Infrastructure bubbles from reading iTulip nor did we get these ideas from John. His belief that a deflationary bust does not necessarily follow a global asset bubble is also consistent with ideas we have developed independently over the years. Given John's background, experience, and location, we find the areas of agreement most intriguing.

Thursday, July 05, 2007

Amid Financial Excess, a Revival of Austrian Economics

Does the U.S. risk repeating the mistakes that led to the Great Depression? The Bank for International Settlements’ annual report, released Sunday, suggests that it does, and offers a remedy steeped in the doctrine of Austrian economics.

In the 1930s adherents of the “Austrian school,” named for its Austrian-born proponents Ludwig von Mises, Joseph Schumpeter and Friedrich Hayek, argued the Great Depression represented the unavoidable remediation of misallocated credit and overinvestment in the 1920s. The Austrian school largely failed to become orthodoxy as first Keynesian demand management appeared to end the Depression and later monetarism blamed the Depression on inadequate attention to the money supply.

Austrian economics, however, has enjoyed a minor revival in the last decade, most prominently at the Basel, Switzerland-based BIS, which has few formal banking duties but is an important talking shop (it is sometimes called the “central bankers’ central bank.”) The BIS’s leading “Austrian” is a Canadian, William White, the head of the bank’s monetary and economic department and sometimes-rumored successor to retiring Bank of Canada governor David Dodge. In a 2006 paper Mr. White wrote that under Austrian theory, “credit creation need not lead to overt inflation. Rather…. the financial system … create[s] credit which encourages investments that, in the end, fail to prove profitable.” This leads to an “an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it [because] the capital goods produced in the upswing are not fungible, but they are durable. Mistakes then take a long time to work off.” He argued that in recent decades, “financial liberalisation has increased the likelihood of boom-bust cycles of the Austrian sort.”

Although the concluding chapter of the BIS’s latest annual report, released Sunday, never mentions the Austrian school, it is suffused with its influence. “Virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s, respectively,” it begins. “In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived.”

It notes that “the prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003.” While fundamental economic improvements are at the root, “the market reaction to good news might have become irrationally exuberant. There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking… [S]uch endogenous market processes … can, indeed must, eventually go into reverse if the fundamentals have been overpriced.”

Apart from financial imbalances, the report argues the world economy also displays dangerous misallocations of capital. In its “recent rates of credit expansion, asset price increases and massive investments in heavy industry, the Chinese economy also seems to be demonstrating very similar, disquieting symptoms” to Japan in the 1980s. “In the United States, it is the recent massive investment in housing that has been unwelcome from an external adjustment perspective. Housing is the ultimate non-tradable, non-fungible and long-lived good.” In other words, the U.S. could be stuck with a lot of houses that are hard to sell to each other and impossible to sell to foreigners, and won’t need replacement for a long time.

What does the BIS say central bankers should do? Essentially, relax their single-minded focus on price stability, and tighten monetary policy when “a number of indicators — not just asset prices but also credit growth and spending patterns — are simultaneously behaving in a manner that indicates increasing exposures.” In other words, when easy credit is fueling excesses, raise interest rates to end the party, even if inflation is quiescent.

In practical terms, few central banks are ready yet to heed the Austrian prescription. Federal Reserve Chairman Ben Bernanke spent a lot of his life arguing just those sorts of prescriptions helped bring about, and deepen, the Great Depression. (See, for example, his 2002 speech, “Asset-Price ‘Bubbles’ and Monetary Policy.” Under him, the Fed remains focused on inflation. The European Central Bank has recently reasserted the importance of money and credit growth in its deliberations, but its policy for practical purposes also remains focused on inflation. The Bank of Japan comes closest to sharing the BIS view and has routinely cited the risk overinvestment as a reason to raise rates, but it has recently stopped tightening as inflation remains near zero.

As Mr. White has acknowledged, the Fed can rightly argue its practice of leaving bubbles alone and cutting rates to mitigate their bursting appears to have worked well. The post-stock bubble rate cuts may have in turn created a housing bubble whose consequences haven’t fully played out. But the strength of economic growth since 2002 appears to have placed the burden of proof on advocates of an alternative policy.

This isn’t to say Fed officials are unsympathetic to some of the BIS’s diagnoses. Some, in particular New York Fed president Tim Geithner, regularly warn that risk-taking is at an extreme and a reversal could trigger a self-reinforcing spiral of price declines and asset sales. Yet, having thought it over, they’ve concluded anything the Fed does with interest rates to address this risk would likely make matters worse. –Greg Ip

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Investor Jim Rogers says sell Wall Street banks | Bonds News | Reuters.com

Investor Jim Rogers says sell Wall Street banks | Bonds News | Reuters.com: "SINGAPORE, July 5 (Reuters) - Fund manager and investment author Jim Rogers said he was selling stock in Wall Street banks because of a likely housing market slump and suggested buying sugar as a way into commodities.

Rogers, who co-founded the Qantum hedge fund with billionaire investor George Soros in 1970, is a long-time commodity bull and believes that fast growth in Asia, especially China, makes the region more attractive to investors than the United States or Europe.

'Financial companies, stock brokers, investment banks -- I am short. I am short financial services companies, mainly in America. I am short (U.S. home funding firm) Fannie Mae (FNM.N: Quote, Profile , Research),' he told reporters after a speech to investors, adding that America's financial sector offered 'the best' short selling opportunities available."

nvestors have been increasingly nervous about U.S. financial stocks as the market for risky, or subprime, mortgages faces a possible crisis due to rising defaults and repossessions.

"The problems with the housing market have a long way to go in the United States. Probably more so than in any other country. But the excesses in the world economy are on Wall Street: investment bankers. Those guys are making vast fortunes, that's not the way the world works."

Rogers traveled around 116 countries in 2000-2002 in a yellow Mercedes coupe. He also traveled through China in the 1990s, looking for investment ideas and collecting material for his popular books, which include titles such as "Hot commodities: How anyone can invest profitably in the world's best market" and "Investment Biker: Around the World with Jim Rogers".

"China is the next great country in the world -- whether we like it or not. And a lot of people in the West do not like it that China is the next great country in the world," he said, citing the country's high savings rate and hard-working people. Continued...

Has the global bubble Popped

Is this the 'Big One'? Is the Bear Stearns blow-up the moment when America’s subprime debacle spills over into the global credit markets and pops the greatest bubble of all time?

Or have China, India, and Russia changed the game? Has their inclusion in the traded world economy - the “great doubling” of the global consumer base, in the words of Professor Richard Freeman – stretched the economic cycle by an extra couple of years?

Well, the coal-face analysts I talk to at Morgan Stanley, Goldman Sachs, Deutsche Bank, Barclays Capital, et al, all think there is enough liquidity to keep the global boom going well into 2008 - with Europe, Japan, and the emerging BRICs doing the heavy lifting as America takes a breather.

Most expect a nasty squall now, or soon, one that will knock another 7-8pc off stock markets, perhaps pushing America’s S&P500 down a hundred points to its 200-day moving average - currently at around 1432.

Every bull market needs mini-purges on the way. Technically, Wall Street and the Euro-bourses look wicked, with double tops and momentum indicators tipping into the graveyard (RSI, ROC, Stochastics, and MACD).

So no, the 'pros' are not yet calling the big one. But then they never do, until it happens. Such is the curse of consensus, and slavery to linear economic models. Crashes are famously non-linear.

We have clues. Alchemy’s boss Jon Moulton told the House of Commons this week that the private equity boom was “somewhere near its top.” Anthony Bolton, Britain’s Warren Buffet, told a forum in Monaco that the vast CDO and CLO debt boom was based on false models and could “collapse”.

We learn that investors in the Bear Stearns Enhanced Leveraged Fund are getting offers of just 5 cent on the dollar for their stakes. A wipe-out, in other words.

The Bear Stearns rot goes much deeper of course. When Merrill Lynch forced a fire-sale of assets, it revealed that even A-grade tranches of these CDO mortgage debt securities were worth just 85pc of face value, and the B-grades nearer zilch.

The creditors orchestrated a quick cover up, but the CDO cat is already out of bag. We now know that some $2 trillion of subprime and 'Alt A' mortgage debt is falsely priced on the books of banks and funds worldwide. Worse is surely to come. Bank of America warns that $500bn of adjustable mortgage debt in the US will be reset upwards in the second half of this year by an average 2 percentage points, and a further $700bn next year.

For now, bears are all watching the yield on that 10-year US Treasury bond – the benchmark price of world money, the Christmas Tree upon which all the other baubles hang: property booms, the emerging market bubbles, leveraged buy-outs, hedge funds and private equity, those $410 trillion in derivatives contracts (seven times global GDP) and that $2.5 trillion of debt packaged as “structured finance”.

The yield surged 65 basis points from early May to mid June to nearly 5.25pc on inflation scares, the fastest rise since 1994. Interestingly, the 94 bond shock did not in itself cause a US recession. But then the US was a very different country. There was no housing bubble, for starters.

However, it did set off the chain of events that led to Mexico’s Tequila crisis and the China bust a year later. Notice the time delay. My guess is that the latest credit crunch will set off a slow-fuse crisis in Eastern Europe, now the epicentre of speculative excess. Watch Hungary and Latvia, both current account disaster cases.

For now, the 10-year yield has since slipped back to 5.04pc. Don’t be fooled. Part of that is a fear reaction as spreads widened between quality and junk. There most certainly is a credit crunch at the low end – or a “gale force wind” in the words of SocGen’s debt guru, Suki Mann.

Just $3bn of the $20bn junk bonds planned for issue last week were actually sold. A long list of leverage buy-outs and dodgy floats have been pulled, or cancelled. Alliance Boots will have to pay 35 basis points more for the £9bn of debt required for its own jumbo buy-out by KKR.

(Strange, is it not, that victims of these bandit raids should have to pay for their own funeral pyres. Why is KKR not be raising its own debt, on its own books, or have we all lost sight of the greater morality here?.. But I digress.)

Roughly $300bn of leveraged buy-outs waiting in the pipeline will face a frosty reception, and perhaps a volley of rotten eggs. Without the takeover spree to juice the stock markets, the indexes will falter and then fall back.

Never take my rotten advice on the markets, but it might be good time to cash in a few stock gains, and rotate a little wealth into banal interest-bearing accounts. The cycle is already one year beyond its normal life. The balance of risk and reward it turning ever less friendly. Ambrose Evans-Pritchard in The Telegraph

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What a difference two months makes or who's the idiot now

The investors: How to get rich trading "idiot" loans
Investors have made a fortune trading bonds backed by mortgages.
By Stephen Gandel, Money Magazine senior writer
May 2 2007: 1:21 PM EDT

(Money Magazine) -- The housing boom was good to John Devaney. Really good. He owns a Rolls-Royce, a Gulfstream Jet, a 12,000-square-foot mansion in Key Biscayne and a 143-foot yacht, as well as a few Renoirs and a valuable 1823 reproduction of the Declaration of Independence. Devaney's not a developer, and he's certainly not a flipper. The 36-year-old CEO of United Capital Markets is a bond trader. And one of his specialties is buying and selling bonds that are backed by the mortgage payments of ordinary homeowners.

Option ARMs? Devaney loves 'em. "The consumer has to be an idiot to take on those loans," he says. "But it has been one of our best-performing investments." Devaney's not out to get people into bad loans - or into good ones. He just makes bets on how many people will repay and when...Devaney, who told a crowd of investors that the riskiest mortgage bonds looked "awful" before the crash, says he thinks he'll be buying. "I don't believe the carnage and fallout will be as bad as people think," he says.


Hedge funds call 'time out'
The top trader at United Capital Asset Management took the extraordinary step of suspending redemptions on four hedge funds.

Wed, Jul. 04, 2007

Flashy Key Biscayne trader John Devaney has temporarily stopped allowing customers to withdraw money from his four Horizon hedge funds, which invest in subprime mortgage securities, in a bid to avoid a fire sale at depressed prices.

His firm, United Capital Asset Management, which has assets of about $570 million, took the extraordinary step of suspending redemptions after many Horizon investors in recent days ran for the exits as volatility in the structured debt market spiraled.

The funds are Horizon Fund L.P., Horizon ABS Fund L.P., Horizon ABS Fund Ltd., and Horizon ABS Master Fund Ltd., which have assets of roughly $510 million and are run by Devaney.
The trader started his brokerage firm, United Capital Markets, in the Florida room of his Key Biscayne home in 1999 and it grew rapidly, adding the asset management arm in 2005.
The firm's move likely signals widening woes for hedge funds, which are largely unregulated entities that invest money for wealthy clients.

Among those seeking to cash out of the Horizon funds is an investor holding almost a quarter of the total assets managed, said United Capital, which invests in bonds backed by consumer and commercial obligations such as home equity and car loans and aircraft and equipment leases.
''Over the past 10 days we have received an unusually high number of redemption requests, including a request from our largest investor that accounts for nearly one-quarter of our assets under management,'' the Key Biscayne firm said in a statement.

Horizon disclosed that it incurred losses -- both from securities trading and from the plunge in prices -- which resulted in a loss for June and year to date, but it didn't say how much.
A spokesman for United Capital said the temporary halt on fund withdrawals is aimed at protecting investors from losses. ''We didn't want to be in a situation of being forced sellers in a market that's very unfavorable,'' the spokesman said. ''We thought if we dumped, that would be a disservice to everyone in the portfolio.''

United Capital's move comes as the market for the sophisticated structured debt it wheels and deals is being buffeted by a rising wave of uncertainty and investor jitters. Among other things, Wall Street firm Bear Stearns has been mired in the recent meltdown of two of its hedge funds whose bets on risky subprime mortgages went bad, prompting a costly bailout. The subprime mortgage market is suffering from rising delinquencies and foreclosures as housing sales have weakened and interest rates have climbed. Such mortgages are typically packaged into securities and sliced and diced into a variety of sophisticated investments, which have plunged in price recently, triggering wider fallout in the markets.

Devaney, 37, the son of a local attorney and a special-education tutor, has established himself as a brash and energetic trader who has drawn national recognition and is comfortable with a high level of risk... Devaney boasts a Gulfstream jet, a collection of yachts, and a Rolls Royce. As of last year, he had 27 properties ranging from Vero Beach to the Bahamas. Last year, he and his wife bought a $16.25 million home in Aspen, Colo., and he has assembled an art and antique collection that includes Renoirs, Picassos and Chagalls. He also has one of the few original copies of the Constitution.

In a statement, United Capital and Horizon emphasized they aren't liquidating and intend to continue operations. The firm said as a defensive move it reduced its risk exposure during June by selling off investments and paring back on its bets... "We have spoken to our lenders and they are supporting our efforts,'' United Capital said. ''We will stay committed to our investors and counterparties into the future and look forward to processing these redemptions.''


Wednesday, July 04, 2007

Blow-up costs Milan bank ¬610m

Blow-up costs Milan bank ¬610m | Markets | Business | Money | Telegraph: "A derivative blow-up at the Italian bank Italease has sent tremors through Milan's banking fraternity and exposed the hidden dangers of exotic credit instruments.

The bank has paid off €610m (£419m) in recent days to counter-parties in what amounts to a massive margin call after interest rate rises in Europe caused hedging and derivative losses by clients to mushroom out of control. The share price has tumbled 9pc so far this week, and is down 64pc since the troubles first began to emerge in April.

'These derivatives were very complex and suddenly turned against us,' said Pierantonio Arrighi, the bank's spokesman.

'They started moving in a non-linear way, so the losses were rising exponentially. We were afraid that in the worst case some of our clients would not be able to pay the contracts, so we stepped in to protect them, which means we took over the risk,' he said."

MIAMI VISE GRIP | By RODDY BOYD | Business News | Financial | Business and Money

MIAMI VISE GRIP | By RODDY BOYD | Business News | Financial | Business and Money: "July 4, 2007 -- A series of disastrous bets on a key subprime asset-backed index and subprime mortgage bonds has put a high-profile Miami hedge fund in dire straits.

United Capital Asset Management's Horizon ABS fund family yesterday said that so many investors have tried to withdraw their capital over the past 10 days that it has been forced to suspend heeding those requests. The fund - up 39.52 percent last year - is down 5 percent over the past two months.

UCAM, based in Key Biscayne, Fla., manages about $620 million; about $266 million in client capital has been temporarily frozen.

Horizon suffered mightily when fund founder and portfolio manager John Devaney purchased 'hundreds of millions of dollars' worth of a highly watched asset-backed subprime bond index called the ABX, betting that the index would rise in value, according to traders familiar with the matter.

After the initial buying pushed the index a few points higher, the index has essentially collapsed in price. The trades appeared to have been executed at prices in the high $60s; the index is now trading in the low $50s.


Global Guerrillas: THE IED MARKETPLACE IN IRAQ: "To get a sense of the decentralized, commercial process of the Iraq's open source bazaar, let's take a look at the IED industry in Iraq. Here's a ground breaking article from the current Defense News based on American intelligence:
Number of IED events a day: 40 (exploded or disarmed) Number of US soldiers killed by IEDs in 2005: 209+

Greg Grant for the Defense News lists his sources:
The following revealing picture of how these cells operate and why they remain so hard to penetrate comes from extensive interviews with military intelligence officers with the U.S. Army's 3rd Infantry Division in Iraq, briefing documents, and interviews and presentations at an Army sponsored counter IED conference June 13-17 at the Army's National Training Center at Fort Irwin, Ca. Much of what U.S. officials know about IED cells was gathered through the interrogation of captured Iraqi insurgents."

Building Homes in Florida --- a nightmare

Building in Cape Coral a Homebuilders Perspective


Where do I begin with this mess?
We are homebuilders in the cape, and cannot believe what is going on out there. The general public and Florida lawmakers need to be aware of this situation.
If you drive around the cape and see alot of unfinished homes, have you ever wondered how that transpired? Well, let me tell you!
Situation #1 Customer comes into the builders office and wants to sign up for a home. Customer signs on the dotted line, gets there loan.....sometimes the bank is on the NOC/sometimes not! The price of the home is divided into 5 draws. Builder gets a deposit draw does work, then gets another draw.
Builders are having subs do work, getting draws, and then not paying subs.
Subs file liens, title co does not do title updates, builder gets other subs to finish trimouts etc. Builder gets another draw. Now the builder is 75% done with the home. Builder has profited (example 350k home w/out lot price in there)
$280k builder maybe paid for some earlier subs work, say concrete and site work 40k
builder now has $240k in his pocket. Bank isn't aware, homeowner has gotten
a few nto, but builder says its standard proceedure, that bill was paid etc.
Now bank has a title update! Bank says no more draws....there are liens out there. Customer wonders why there is not activity on there home, now that
there interest payments are getting larger based upon amount borrowed.Bank does not relay no draws to builder to homeowner. Homeowner has never built before and isn't sure of building time frame.
Builder then decides to exit. The property has 140k of liens to subs,
some subs didn't file nto/per builder request? and the property is 70k away from being completed. Now a new builder tries to complete it.
plus the liens have to be contested , paid, or neg. The new builder goes out to bid.
New builder checks property and the soffit panels are missing for scrap metal
$500, The a/c copper lines have been cut $500, a couple cabinets are gone
$300 and the pocket sliders have been ripped out taken into a bedroom and the glass broken out and the frames and used for scrap metal. with a rock, (that the vandals just left on the floor, with the broken glass) a bathrom door is missing $50.
Why aren't the police checking for "new metal slider frames: at scrap yards?
There are areas with 200 properties that are going through this right now!
The builder comes in with a price of say 85k to finish.
Bank has 70k draw money left, new builders bill is 85k to handle the mess, and warranty work that has been done by numerous subs he didn't know, and
several subs doing electrical, in some cases three companies completing one house's wiring.
So at the end of the day, the homeowner has a lot he bought for 100k,
had a builder build a 350k home on it. So instead of the homeowner having a 450k dream home, this is what he has........

a lot for 100k
a home 75% complete
a home with 140k liens on title
a new builder who will finish for 85k
draw money left in loan 70k
amount buyer must come up with to finish home 15k
liens contested, some stay,some go away
to leave a balance of 90k

Now builder has helped client get everything on track, homeowner borrowing against his personal credit lines to pay liens and come up with the shortfall
of what is needed to complete construction.
Now bank says"the borrower has gone over the aloted time for construction,
now we have to protect ourselves, and at our discretion, we will need a new appraisal and will requalify borrower for the loan. If the home does not appraise for the loan amount, we will need to put that borrower in default".
That came from a bank that has written loads of loans in cape coral.
The market has taken a nose dive, the homeowners lot has gone down say half of its value,.....mr banker, I can tell you now, that it will not appraise for what it did a year ago!
So what does this homeowner do?
He has a home that he double paid for on some subs work.
Essentially he has a home that has cost him 100k lot
350k const 90k liens 15k to finish over draws left=$555k home and lot
that will appraise in todays market at about $370k
So he is upside down $185k, instead of the 80k in todays market.

So the cape has hundreds of these homes scattered around from other builders doing the same thing, leaving the homeowners in a bad situation.
Where is the previous builder? Well he is still building! By the way, he built
a mini mansion for himself and didn't pay subs on that either......but his home got a CO, where as the (9) homeowners we are working with didn't get their CO, just problems. Plus he has the cash from the draws.
This needs to stop!!!!
This is the atmosphere in the cape-
Hundreds of half finished houses, hundreds of empty new houses just sitting vacant, 19k homes for sale oin lee county. Eight hundred forclosures last month.
When I drive around the cape north of veterans, and see all this, like the lady I saw struggling to put out the last of her belongings , she couldn't take with her.....(she was probably losing her home) it gives you an earie feeling that
I have never experienced in my life before.
Ps, another builder who did this has started a new company in the cape, and a bank just loaned him over a million to build his personal home!
After checking more closely on this one, he changed his first name on his license to the state, but forgot, and put the first name he used on his old license on the NOC of
his new mansion being built.
This builder left his homebuyers in forclosure, didn't finish homes, we could not even help them!
They only had home loans for the under 200k range.
What is this ............people are getting two loans and one closing to avoid the pmi insurance. That insurance is so if the homeowner defauts there is something for the bank to fall back on to resell the property.
Ps, even the million dollar loan has this. Who is allowing this behavior.
I like cape coral, but all of this is wearing on us, and it leaves us wondering
what is coming down the road. What happens when the lenders go under?
Helping these people move forward is somewhat rewarding, with alot of
problems at every turn most loans take 2-3 months each to get on track. My emaillog is the thickness of a phonebook!
It is very frustrating when the lender gives you the title co name, and they are out of business, and then you go through three more to finally get the
one who is still in business, and they are handling the work from 3 out of business locations so it takes weeks to get anywhere.
We called a homeowner last week to give them a heads up about ther home
with liens and that they might want to look into it. We told them they are so far under we cannot help them, they stated that it is under control.
Some builders advertise a cheap price and rob peter to pay paul.
As long as new deals are signed they can go on for a very long time, until
no new deals are signed, then someone is left holding the ball.
We can have a sign telling homeowners that we can build there home for
100k, but after the builder starts nearing the end of the job and the house costs
150k to build, as long as the builder signs new deals and subs are floated
payment it won't catch up until new deals are not signed.
Each deal I have worked, the identical home has ranged in price(construction price only) same areas of town, same options,and time frames 20-30k.
What does this tell you? Someone was building for cash flow only.
Maybe with a home builder in high places, this will all change.
P.S. These homeowner are too distraught with what has happened to them they never file anything against the builders.
Some I have worked with are on their 2nd or 3rd builder on one house!!!

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Tuesday, July 03, 2007

China Challenges U.S., Europe in African Push: Frederick Kempe

By Frederick Kempe

July 3 (Bloomberg) -- One cannot escape the relentless Chinese economic invasion of Africa even here in the South African bush, where business and political leaders gathered at the Tswalu Kalihari Reserve to track lions, zebras and global trends.

With a ring of crackling fire holding insects at bay inside our boma, a converted nocturnal cattle enclosure, a South African energy executive describes how Chinese competitors undercut his bid for a power project in Namibia by using engineers of similar skill at half the price. Yet Chinese influence can be beneficial as well: He has formed a joint venture with a Chinese partner that is getting close to completing deals of far greater magnitude.

Many in the West view the Chinese in Africa as a strategic threat, but African business leaders I met in South Africa and Nigeria last week see an historic opportunity without equal since the end of the Cold War.

In contrast to the U.S. and Europe, the Chinese are determined investors, willing to take more risks, offer more subsidized loans, pose fewer human rights and democratization conditions, pay more bribes and operate in more remote places. They are also willing to undercut local labor markets and manufacturers by shipping in tens of thousands of their own workers and low-cost goods.

``They are changing the African development model in ways the West has not yet grasped,'' says Greg Mills of South Africa's Brenthurst Foundation, who assembled the group at Tswalu with the Atlantic Council of the U.S.

Next Act

That's only part of the story.

Africa also has become the best place to get a sneak preview of globalization's next act. It is one that will be less American and more Asian, one where rising players challenge established rules and institutions.

The decline in the West's economic and political influence is already clear in Sudan, where only the Chinese have sufficient leverage to change the behavior of a regime the U.S. has charged with complicity in genocide. Beijing has refused to join sanctions and has only belatedly applied political pressure due to its foreign policy of non-intervention and its overriding priority of holding onto 60-percent plus of Sudan's oil reserves.

The Chinese at the same time are challenging the so-called Washington consensus that economic success requires democratic capitalism with a light state hand presiding over privatizing economies. China's expanding aid programs carry a different sort of conditionality: Namely that their partners end diplomatic recognition of Taiwan and enter long-term economic arrangements that commit their resources and spending almost exclusively to China.

Strings Attached

A case in point was last week's start of the first $1 billion phase of the state-owned China Development Bank's much- ballyhooed $5 billion China-Africa Development Fund.

This economic assistance is available to Africans only if invested in Chinese enterprises and their projects. Beijing will require 70 percent of contracts go to approved Chinese companies and the rest to Africa partners, most of whom will be Chinese joint-venture partners. Europe, the U.S. and Japan have had different forms of such conditionality in the past, but they abandoned these approaches because they have been shown to reduce aid's effectiveness by 25 percent or more.

Senior U.S. officials are at pains to deny scaremongers' insistence that Africa has become a strategic battleground. They are right that China isn't the ideological enemy it was in Africa during the Maoist period.

Yet Africa is a front-line of another sort: Chinese competitors working hand-in-glove with the state are already supplanting Western business and reducing Western political leverage. That could in turn slow or even reverse what has been an encouraging democratic evolution.

Held Captive

It's hard to fault Africans for embracing China after 50 years of development help from the West that has left them with just 2 percent of world trade, down from 7.5 percent in 1948. With notable exceptions, Africa remains the captive of poor governance, corruption and fragile economies that fuel war, rebellion and poverty.

China is succeeding on the continent not because its model makes more sense to African business leaders, most of whom still prefer further democratic evolution, but because it is focused and strategic, having defined Africa as a vital interest in a way the U.S. and Europe have not. President Hu Jintao has visited 17 Africa countries in the past 12 months, more than any head of state.

The smart money is betting that China hits its trade target of $100 billion by 2010, a 10-fold increase in a decade and almost double last year's $56 billion. Some 800 Chinese companies have become the continent's most-aggressive investors, with an estimated $6 billion in foreign direct investment through 900 projects.

Aid Package

Africa provides China with some 25 percent of its oil compared with 8 percent for the U.S. Beijing has secured future oil deliveries from Angola, Africa's second-largest producer after Nigeria, in what has become the typical manner -- with a $2 billion package of loans and aid that includes funds for Chinese companies to build schools, railways, hospitals, roads, lay a fiber-optic network and train Angolan telecom workers.

Yet Africans themselves are coming to understand the downsides of China's interests -- an influx of Chinese labor and goods that are undermining their own markets and propping up odious regimes that continue to give Africa a bad name.

In the end, Africa's best approach would be to embrace China's economic carrots but reject its undemocratic and opaque economic model. If they don't do that, the only possible outcome is merely a Chinese twist to Africa's long cycle of bad governance, unpaid debts, rampant corruption and failed hopes.

(Frederick Kempe, president of the Atlantic Council, is a Bloomberg News columnist. The opinions expressed are his own.)

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July 2, 2007 -- Shell-shocked mortgage bond traders who just closed the books on a surpassingly ugly June are eyeing the calendar warily, waiting for the next two weeks to bring the first word of just how much damage hedge funds sustained as a result of the subprime mortgage mess.

With a series of bad bets on subprime bonds and arcane structured securities triggering the near-collapse of two Bear Stearns hedge funds, wide swaths of the $6 trillion mortgage-backed bond market have sold off sharply. In turn, it is believed that many investors - especially hedge funds, which can borrow over a dozen times their capital base - have seen their already lackluster performance shellacked.

If the performance of subprime investors is as bad as expected, institutional hedge fund investors and the investment banks that loan funds money and clear their trades will be faced with investors' concerns over capital withdrawal, matched by the banks' need for better collateral and reduced exposure.

With a fear of lawsuits for breach of duty and a lack of faith in the quality of the loans backing the subprime mortgages, there could be little incentive to ride out the storm.

In 1994 and again in 1998, this cycle of fund redemptions and reduced leverage resulted in something akin to a panic in the mortgage market, triggering the closing of hedge funds and brutal losses for Wall Street firms.

Already there are some unsettling indications that the global retreat from risk is spreading and Cheyne Capital's Queen Walk fund, both were hit with significant losses as a result of exposure to the mortgage bond market. Late last week, two British mortgage funds, Cambridge Place's $900 million Caliber Global Investment fund and Cheyne Capital's Queen's Walk fund, announced plans to close.

The trading on Friday gave little indication that things will get any better in the near-term. The widely watched ABX index, a key gauge of the health of the asset-backed and subprime mortgage markets, began what one market player called "a collapse." One index, called the ABX 06-2 Single-A, saw its value drop four points Friday; as recently as two weeks ago, a move of one or two points was considered unusual.

Another looming crisis is the potential for widespread downgrades by rating agencies of arcane, illiquid securities called collateralized debt obligations - essentially bonds created from pieces of other bonds. With about $200 billion worth of CDOs backed by the bonds and loans of mortgage issuers - many of which have suffered bankruptcy or near-collapse - the market has avoided disaster only because of a loophole in valuation.

However, if the rating agencies begin downgrading CDOs, these securities could be re-valued, potentially sending their market prices down as much as 50 percent.

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Global systemic crisis / Summer 2007 : Fed loses control on US interest rates and crisis reaches China and EU

GEAB N°16 is available! Global systemic crisis / Summer 2007 : Fed loses control on US interest rates and crisis reaches China and EU: "This second quarter's fundamental event about to shove most players' anticipations over the coming months, is certainly the final and simultaneous failure of the two key-strategies defined by US leaders, i.e.:

. in the economic, financial and monetary fields, the Fed' policy initiated a year ago when M3 publishing was abandoned and aimed at substituting a financial and stock bubble to the bursting housing bubble in order to maintain US growth (and capital attractiveness) has now patently failed, thus entailing a historical loss of the Fed's control on US interest rates (for the first time since 1918, except in times of war or social/economic depression)

. in the military, strategic and diplomatic fields, the stability plan for Iraq is a complete failure taking place in the framework of Washington's growing political paralysis (which LEAP/E2020 plans to describe in GEAB N°17 - on subscription).

Spring 2007 indeed appears as the tipping point of the global systemic crisis: the US economy went into recession, US interest rates were restored, the bond market is in crisis, the subprime crisis begins to hit large US financial institutions such as Bear Stearns (1), Goldman Sac"

When hedge funds implode

By Axel Merk

The US trade deficit with the rest of the world leapfrogged in recent days. Aside from goods and services, the United States is now importing "consensus-based crisis management" from Japan.

Out of fear that a cleanup of bad loans would trigger widespread defaults, Japanese banks got themselves deeper and deeper into trouble by hushing up the problems. We are talking about the crisis at Bear Sterns' subprime hedge fund. The crisis shows that major adjustments on how the market prices risks are overdue; this may have negative implications for stocks, bonds, and commodities, as well as the US dollar.

Bear Sterns is a leading provider of services to hedge funds; it is also one of the largest originators of subprime-backed collateralized debt obligations. CDOs are what their name implies: a security backed by collateral. CDOs are created when mortgages with various risk profiles are grouped into different tranches or segments. Among others, Bear Sterns would create a CDO in a bundle according to a client's specifications. Indeed, Bear Sterns would work with a rating agency, such as Moody's, to obtain the desired rating (a practice likely to face more scrutiny as some allege that Moody's no longer acts as an independent rating agency, but as a syndicator in the offering).

The explosive demand in this sector has attracted ever more creative structures. Investors should have grown concerned when dealmakers started suggesting that one can create a higher-grade security by grouping together a couple of lower-grade securities; it is rare that 1 + 1 = 3. As these instruments have grown more complex, the clients buying these instruments often do not have a full understanding of what they buy.

How do you make a best-seller better? You introduce leverage. Not only can leverage be introduced in the credit derivatives that define some of these securities, but brokers eager to attract hedge-fund business may also accept CDOs as collateral to lend money. The hedge fund now attracting so much attention is Bear Sterns' High Grade Structured Credit Strategies Enhanced Leverage Fund, launched only 10 months ago. It shall be noted that Bear Sterns did not put much of its own money into the fund, but supplied many of the CDOs. A total of US$600 million in invested capital was boosted with borrowings of about $6 billion.

The collateral provided by the fund had the highest ratings by Moody's. However, a high rating does not ensure that the CDOs are liquid, ie, that they can be sold off on short notice. This became painfully clear as bets of the fund were creating heavy losses and some lenders asked for more collateral for the loans extended. In the industry this is called a margin call. Bear Sterns told other lenders, including Merrill Lynch, JPMorgan and Citigroup, that the fund was unable to provide more collateral. On a side note, it is rather grotesque that Merrill, JPMorgan and Citigroup are among the larger investors in a fund managed by Bear Sterns. The company put little of its own money into the fund.

In the brokerage industry, when a margin call is not met (when the borrower cannot provide sufficient collateral), the broker may seize the collateral and liquidate open positions. While a forced sale of the collateral may be painful for the borrower, it protects the system as a whole. Such forced sales happen all the time in the futures market, where positions are "marked to market" every day to evaluate the profitability and risk of open positions.

But the CDO market is not a regulated futures market; there is no daily market price that would allow one to assess the value of the collateral. The primary methods used to value CDOs are called "mark to market" and "mark to model". In the more conservative "mark to market" approach, independent parties are asked to value the securities; as the name implies, the "mark to model" approach is more aggressive and uses a computed, theoretical value.

But because these instruments are sold in privately negotiated transactions, rather than a regulated and liquid market, neither valuation method is suitable in case of a forced liquidation. In the case of Bear Sterns' fund, Merrill Lynch sent bid sheets to numerous parties, soliciting prices for their holdings; as everyone knew that Merrill wanted to get rid of the securities at any price to cut its losses, it is fair to assume that the prices offered were significantly below the value assumed for the collateral.

As Merrill went public with its plan to auction off the collateral, others tried to rescue the fund. There was talk that Citigroup would inject $500 million and Bear Sterns might inject $1 billion. And the Blackstone Group was very interested in supplying much-needed capital. Blackstone's offer required the brokers to abstain from further margin calls for 12 months. Such restrictions may be common in the private-equity world that Blackstone is active in, but was not acceptable to Merrill.

As the rescue plan fell through, Merrill stated that it would go ahead with its auction yet again. In the meantime, JPMorgan was front-running Merrill by trying to unload collateral it held for the Bear Sterns fund. When all was said and done, it wasn't clear how much which broker was able to sell, but the sales were halted once again, and the parties seem to have agreed on an "orderly unwinding" of the positions.

This had the hallmark of the biggest financial crisis since the bailout of Long Term Capital Management. In 1998, the US Federal Reserve coordinated a bailout that led to the orderly unwinding of a fund that threatened the stability of the financial system. But this time is different: the instruments involved are so complex that journalists have had difficulty relaying the issues to the public, but the multiple calling and canceling of auctions by Merrill highlight the behind-the-scenes maneuvering to avoid fallout to the rest of the industry and beyond.

The risk to the financial system was not merely that some large brokerage firms may have been forced to write down a couple of hundred million dollars - they may still have to do that. But had the fire sale gone through, market values would have been available to the securities sold. This in turn would have forced other lenders to revalue the collateral they hold, and as the collateral is worth less, the brokers will lend less money. That would have triggered further margin calls, further forced liquidations.

When hedge funds implode, they tend to sell off more liquid assets first. At the end of the sale, the prices of the liquid assets are depressed, yet the fund may still be left holding illiquid securities. To illustrate this, take the example (this is not the Bear Sterns fund) of a hedge fund that may make bets on CDOs and, say, the price of oil. As such a fund needs to raise cash, it would close out the more liquid oil positions, causing a spike (or drop - depending on which way the unwinding works) in the price of oil. The resulting volatility in the markets would be most painful for leveraged investors in the oil market, although the crisis originated in the CDO market.

Too many leveraged investors have become complacent because of the low volatility enjoyed in recent years. Aside from the short-term volatility, the high leverage employed by many hedge funds would need to be reduced permanently. As speculators pare down their leverage, they sell off assets to raise cash.

The well-intended attempts to unwind the Bear Sterns fund in an orderly fashion are highly problematic. The fund's problems have clearly shown that the credit extended to the industry is too large. The bankers involved commit similar mistakes to those of bankers in Japan in the 1980s and 1990s, where clearly bad loans were kept afloat with artificial means; those involved had the best intentions, but caused more than a decade of pain to Japanese banks, corporations and consumers.

It may well be that the value obtained in a fire sale is less than that obtained in an orderly liquidation. But the lesson to take home from this is that CDOs must not be used as collateral for 10:1 leverage. In our assessment, the unreasonable leverages employed by many hedge funds have contributed to a global liquidity glut that has driven up all asset classes, from stocks to bonds to commodities and other hard assets. As lenders have ignored risk, volatility reached abnormally low levels in 2006. Markets need risk to price assets properly; it is urgently necessary that volatility come back into the markets, so that lenders make more reasonable decisions.

The Bear Sterns debacle highlights that the industry has gone too far, and that it is high time that credit be reined in. So far, the first good that has come out of all this is that the planned initial public offering (IPO) of Everquest Financial seems to have been aborted: Bear Sterns was the underwriter in Everquest, a firm that specializes in buying CDOs from hedge funds.

Another hope is that traditionally more conservative investors, such as pension funds, will reduce their exposure to overly leveraged hedge funds. If such investors are told that they should not "rock the boat" with a rushed decision, they may be well served to take their losses now rather than potentially even greater losses later.

Federal Reserve chairman Ben Bernanke is particularly proud that regulators have extensive experience on how to manage crises. The danger of superior crisis management is that you take the "danger" out of investing. Without risk, speculators have no restraint; in recent years, we have called this the "Greenspan put", named after the reputation of former Fed chairman Alan Greenspan to allow bubbles to be created, and then bail out those who suffer from the bursting of the bubble. The Fed is shooting itself in the foot with such an attitude, as the Fed loses control of the money supply in a world where risk is underpriced.

When European Central Bank president Jean-Claude Trichet was recently asked whether the latest interest-rate hike in the euro-zone meant credit was now tight, he mused that higher interest rates mean little when sources of credit are abundant. His comments came before the recent selloff in bond prices. But as bond prices sold off in recent weeks, lower grade bonds fell not significantly more than government bonds. A healthy market requires a greater risk premium for junk bonds. The collapse of an overly speculative fund must be allowed, so that investors have an incentive to demand higher yields for riskier investments.

In summary, we expect volatility to pick up in all markets. As volatility picks up, speculators may sell assets to raise cash. Given the gains experienced in just about every asset class, there may be few places to hide. As bond prices may be under further pressure, the cost of borrowing goes up; this in turn may have implications for American consumers whose spending habits are interest-rate-sensitive because of their high levels of debt. This is where the circle to the trade deficit is closing.

The US dollar is dependent on inflows from abroad, as Americans import more than they export. If higher borrowing costs cause consumers to spend less, foreigners may redeploy more of their investments to other, more robust areas in the world. While Treasuries tend to be the first safe haven in times of increased volatility, the dollar no longer is the safe haven it used to be. In our view, a diversified approach to something as mundane as cash is something investors may want to evaluate. Gold is one such diversification; a basket of hard currencies is another.

Axel Merk is the portfolio manager of the Merk Hard Currency Fund.

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Monday, July 02, 2007

Does It All Add Up?


By Saskia Scholtes and Gillian Tett
Financial Times, London
Thursday, June 28, 2007


As head of the financial stability unit at the Banque de France, Imene Rahmouni-Rousseau travelled to America this month to look at the current turmoil in the US subprime mortgage world.

Although initially that had seemed an all-American saga, Rahmouni suspected that French and other European investors also held assets linked to subprime securities. So on behalf of her central bank she wanted to assess the risks.

What she discovered surprised her. There was little confidence about how to value the holdings. "Pricing data are difficult to obtain," she says.

It is a discovery being shared by numerous other policymakers and investors around the world as the fallout widens from a subprime lending boom, in which US banks provided vast amounts in home loans to financially stretched borrowers who put little money down and gave no proof of income. Among the casualties have been two hedge funds run by Bear Stearns, the Wall Street investment bank.

Until recently, when late payments and defaults on these mortgages spiked higher, the problem drew little attention. This was because, through the magic of so-called structured finance, risky assets such as subprime mortgages could be packaged into attractive investment products.

These elaborately constructed securities, called collateralised debt obligations (CDOs), are designed to yield juicy returns while also carrying high credit ratings. They have proved popular with hedge funds as well as with longer-term investors such as pension funds and insurance companies, many of which have bought billions of dollars of such securities in recent years, thus providing the liquidity that was then channelled into mortgage loans.

But heavy losses incurred at the two Bear Stearns hedge funds as a result of such financial haute couture have prompted fears that the CDO emperor may turn out to have no clothes. Such a revelation could threaten the value of investor portfolios around the globe -- not just in the mortgage sector but in the way many sorts of company fund themselves.

This is because unlike stocks listed on an exchange or US Treasury bonds, CDOs are rarely traded. Indeed, a distinct irony of the 21st-century financial world is that, while many bankers hail them as the epitome of modern capitalism, many of these newfangled instruments have never been priced through market trading.

Instead, products such as CDOs, which are designed to be held until they mature, have often been valued in investor portfolios or on the books of investment banks according to complex mathematical models and other non-market techniques. In addition, fund managers and bankers often have broad discretion as to what kind of model they use -- and thus what value is attached to their assets.

So when Wall Street creditors last week threatened fire sales of CDOs seized from the stricken Bear Stearns funds, thus creating a market price for them for the first time, they also threatened to create a wider shock for the system. Fire sales rarely realise anything close to the previously expected value of assets. But if these deals went ahead, they would provide a legitimate trading level that would challenge current portfolio valuations.

In the event, Bear Stearns' creditors sold only a fraction of the assets put up for auction. Market participants suggest that this was in part because bids fell far below expectations, with traders increasingly reluctant to take on CDOs tainted with subprime exposure. But the crisis at Bear's funds has left investors, brokers, and regulators asking an uncomfortable question: Can the pricing models that have provided the foundations for this new financial edifice really be trusted? Or will valuations turn out to be over-optimistic and result in further investor losses?

"Investors are slightly more cautious, becoming more picky and asking more questions," says Michael Ridley, co-head of high-grade debt capital markets at JPMorgan. "They want us to lift the lid off the box a bit more."

To an extent, the valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. It has often been the case that when new instruments emerge in the banking world, the market is initially quite illiquid, meaning that the level of trading is low. But the murky nature of new products has rarely had broad systemic implications, because they have typically occupied a small niche.

What makes the CDO sector unusual is that it has exploded at such a breakneck pace with bankers packaging bonds, loans, and other debts into ever more complex structures. Last year alone, about $1,000 billion (£500 billion, E745 billion) in cash and derivatives CDOs was issued in Europe and the US, according to data from the Bank for International Settlements. More than one-third was composed of asset-backed securities, often including low-grade mortgages.

As this explosion has occurred, some corners of this universe have already become relatively widely traded and transparent. Every day in the London and New York markets, for example, billions of dollars worth of deals are struck involving indices of derivatives on well-known corporate bonds -- making it easy to obtain prices.

However, many other such products are created by bankers directly with their clients and then simply left to sit on the books of an investor. Since such instruments typically last three to five years -- and the CDO boom is so recent -- many have not come to the end of their life. Nor have they been traded. Christopher Whalen of Institutional Risk Analytics, a consultancy, says: "The lack of a publicly quoted market for CDOs and like assets is exacerbating the liquidity problems for these assets beyond the underlying economics, for example, in subprime real estate."

To compensate, investment institutions and banks use a variety of techniques to assign a value to these instruments in their accounts. In some areas, third-party data groups exist that can offer price estimates. However, the pace of innovation is so intense that it is hard for these providers to keep up with all corners of the market. So in many cases, investors are turning to alternative techniques to create prices. One tactic used by hedge funds entails asking several brokers for price quotes and taking an average. Results vary -- not least because dealer banks may hold positions in these instruments themselves.

"It is very easy for hedge funds to shop around to find valuations that suit them best and then book their assets at that," says one banker who advises hedge funds. "Going back to the bank that sold you a CDO and asking for a price is rarely likely to produce an accurate picture."

Another approach is to estimate valuations based on the ratings the instruments receive from credit rating agencies. Yet this does not offer a fail-safe valuation method either. The rating agencies have been downgrading bonds backed by subprime mortgages in recent weeks but critics say they have been slow to act and face difficulties in analysing the market.

Christian Stracke, analyst at CreditSights, a research company, says: "With so little truly relevant historical data on the behaviour of subprime mortgages, and with such massive structural changes having occurred in the mortgage landscape in recent years, any time-series analysis approach is little more than a not-so-educated guess."

Moreover, while ratings attempt guidance on the chance of default, they offer no indication of how market prices could behave -- as the rating agencies stress. As the BIS noted in its annual report this week, ratings reflect expected credit losses rather than the "unusually high probability" of events that "could have large effects on market values."

That means that on the rare occasions that instruments are traded, a large gap can suddenly emerge between the market price and its book value. This week Queen's Walk Fund, a London hedge fund, admitted it had been forced to write down the value of its US subprime securities by almost 50 per cent in just a few months. That was because, when it was forced to sell them, the price achieved was far lower than the value created with the models the fund had previously used -- which had been supplemented with brokers' quotes.

But unless circumstances arise that force a market trade, valuations often remain at the investment managers' discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex.

Moreover, incentives do not always encourage fair valuations: for example, hedge fund managers are typically paid a percentage of the profits they book, giving them a vested interest in reporting a high asset valuation. At best, this means that the valuations of CDOs, for example, may often lag behind any swings in broader asset classes; at worst, this ambiguity may enable hedge fund managers or investment bankers to keep posting profits -- even when markets fall.

But Amitabh Arora, head of interest rate strategies at Lehman Brothers, points to a further potential impact from the Bear Stearns upheaval. "The bigger risk now is that it calls into question CDOs as a financing vehicle in the corporate credit market. I think in the next six to 12 months we will see a significant reassessment of CDOs as a financial vehicle not just in the subprime world but the corporate world too."

Adil Abdulali, a risk manager at Protege Partners, a fund of funds, recently studied the performance of hedge funds and discovered clear statistical indications that they tend to stage-manage their earnings when they trade illiquid instruments. "Conservatively, 30 per cent of funds trading illiquid securities smooth their returns," says Mr. Abdulali.

Some bankers and policymakers argue that this is simply a teething problem that will fade as structured finance becomes more mature. History suggests that most opaque, illiquid markets eventually become more transparent when they grow large enough -- and behind the scenes, the Bear Stearns hedge fund problems are prompting bankers and investment managers to re-examine their valuation techniques. "We are getting a lot of calls from worried people," says one third-party data provider.

However, history also shows that large-scale structural dislocations -- such as a serious mispricing of assets -- are rarely corrected in an orderly manner. Thus the big risk now is that if thousands of banks and investment groups suddenly have to slash the value of the securities they hold, the wave of accounting losses might at best leave investors wary of purchasing all manner of complex financial instruments. At worst, it could trigger more distressed sales and a broader repricing of financial assets, not just in the subprime sector but in other illiquid markets too.

"If every CDO was forced to mark to market their subprime holdings, it would be. ... Well, I can't think of a strong enough word to describe what it would be," confesses a US policymaker.

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Sunday, July 01, 2007

Stockmarket Cycles Current Observations

Stockmarket Cycles Current Observations: "There is a chance, of course, that the 25 year cycle will cause a severe decline into the first quarter of 2007. It is our contention, however, that the more probable course of action will be to see the current rally which has carried many of the market averages to new all-time highs continue into the first quarter of 2007. Should that occur, then we face the possibility of adding two more very long term potential bottom-to-bottom-to-top patterns that would be due to resolve in 2007, probably in the first quarter of that year. That would mean that between the fourth quarter of 2006 and the first quarter of 2007 there would be potential resolutions of bottom-to-bottom-to-top patterns of two years, four years, eight years, 12 years, 16 years, 25 years, 32 years, and 75 years. A culmination of that many patterns within such a relatively short time zone would mean that we could be facing one of the most important six month time periods in market history. We will look forward to facing those resolutions along with our subscribers."