The Internet: Our Last Hope for a Free Press

Published on Friday, September 28, 2007 by CommonDreams.org



by Mark Klempner, a historian, author and social commentator.

LINK

I consider the Internet to be one of the world's great wonders. And also America's last hope for a free press.

When I was growing up in the 1970s, there were many people with a lot of things to say, but they generally had no platform. That's why we needed figures like Bob Dylan to be “the voice of a generation.”

The present generation has YouTube, whose motto-irresistible to young people-is “Broadcast Yourself.” So now, for example, a pert 18-year-old known as “AngryLittleGirl” can challenge her peers regarding their lack of critical thinking, especially when it comes to religion, by uploading a video op-ed. As of this moment, her piece has been viewed by more than two million people.

YouTube is but one manifestation of a rapidly expanding “social media” that performs the vital function of promoting honest discussion and analysis at a time when spin, trivia, and advertising dominate the mass market profit-driven mainstream media –or MSM as it is often called on the net. Social media also encompasses web-based interactive communication tools such as blogs, message boards, forums, pod casts, online communities, and wikis.

I have seen bloggers expose mistakes and biases in the MSM within hours or even minutes of an article's release. For instance, when New York Times science writer William Broad ran a piece deflating Al Gore's claims about global warming, numerous bloggers pounced on it for being sloppy and skewed. Among them were Robert Dietz and Julie Millican at Media Matters, who documented how Broad had misrepresented the backgrounds of most of the supposedly “rank-and-file” experts quoted.

I don't know what possessed Broad to so bend his reporting that he would lose credibility across a wide swath of readers (something he has in common with journalist Judith Miller, with whom he co-authored a book), but I do know that the MSM has become consolidated to the point that just a few transnational conglomerates and capital management companies control network TV, commercial radio, and most of our newspapers.

As for the repercussions of this ominous development, John Carroll, former editor of the Los Angeles Times, states them quite clearly: “Gone is the notion that a newspaper should lead, that it has an obligation to the community, that it is beholden to the public.” The current owners, he explains, care only about money, and “are sometimes genuinely perplexed to find people in their midst who do not feel beholden, first and foremost, to the shareholder.”

Bloggers are in an entirely different position: They tend to be mavericks who work for free, and operate far from the sources of power. Feeling no need to ingratiate themselves with the movers and shakers of industry and government, they simply tell it like it is from where they sit as concerned, informed citizens with diverse areas of expertise. Though they don't often have professional training as journalists, many of them exceed professional journalistic standards, because they answer to their consciences alone rather than to corporate honchos and fund managers. We need to hear from such people, and the fact that there are more blogs out there worth reading than anyone has time to read is a hopeful sign.

Of course, the blogosphere is also filled with nonsense, and worse –as might be expected in any open space that lacks gatekeepers. The all-too-human reality of the web is that the majority of its traffic is directed to sex sites. What's more, hate groups of all kinds find it a perfect forum to purvey their sick ideas. Even the benign Wikipedia can be used to disseminate false information with an effortlessness that has earned it the gratitude of propagandists everywhere.

How remarkable, then, that out of the cyberslime the lotus of a truly free press has been able to grow. Citizens seeking to avail themselves of the valuable commentary to be found on the web, as well as the fact checking services of legions of bloggers, can learn to easily bypass the detritus and go directly to those sites that offer valuable content.

Where, though, does one turn for in-depth investigative reporting? Though projects such as The Real News Network are attempting to create an alternative, the MSM is still pretty much the only show in town. Bloggers are generally not trained or equipped to do such reporting, and anyway, it´s a full time job that usually requires travel and a support staff, as well as knowledge and contacts developed over many years.

Newspapers carry out at least 80% of primary reporting. And yet the newspapers have repeatedly failed us, sometimes with tragic consequences, such as during the buildup to war in Iraq. In his documentary Buying the War, Bill Moyers (an exception to the rule that there are no outstanding journalists working in television) exposes how reporters at newspapers such as the Washington Post consistently deferred to the wishes of the Bush administration or were tricked, pressured or seduced into doing so. And behind Bush are the huge corporations that helped to put him into power, including those that own the MSM. What's a citizen to do?

Again I say: go to the Internet. Though it's worthwhile to read the print publications that pursue quality reporting-and some of the smaller ones really need our support-subscribing is not essential: nearly all of the important articles from these publications may be found on the web, and bloggers often link to them. And besides, there is also some fine web-based reporting, such as (to pick an example that is apropos to this discussion) the Salon piece that dissected and disposed of the myth, perpetuated by the MSM in tandem with then press secretary Ari Fleischer, that the exiting Clinton staff had removed the W's from their keyboards, and in other ways vandalized government property.

As our titanic democracy is sinking and the band of trivia and denial plays on, each Internet connection can function as an intellectual life preserver. The net has also proved invaluable as a way for concerned citizens to offer support to each other, and to act together for political and social change.

From Salon in 1995, to Common Dreams in 1997, AlterNet in 1998, truthout in 2001, The Raw Story in 2004, and The Huffington Post in 2005, the news coverage on the Internet has matured to the point where we don't really need to deal directly with the MSM anymore. As my wife says, “No MSG in my takeout; no MSM in my living room.” One household at a time, we'll escape the grasp of the Rupert Murdochs of this world, at least when they meddle with our freedom of the press.

Mark Klempner is a historian and social commentator. His book The Heart Has Reasons: Holocaust Rescuers and Their Stories of Courage was published last year by the Pilgrim Press. He would like to thank Paul Glover and Richard Silverstein for commenting on an early version of this piece.

Our Paradigm – History’s Greatest Credit Bubble -Tice

· Unconstrained Credit systems are inherently unstable.

· Markets are inherently susceptible to recurring bouts of instability and illiquidity.

· Wall Street financial innovation and expansion created what evolved into a precarious 20-year Credit cycle, replete with self-reinforcing liquidity abundance and speculative excess.

· “Wall Street Alchemy” – the transformation of risky loans into enticing securities/instruments - has played a momentous role in fostering myriad Bubbles.

· Unrelenting Credit and speculative excesses have masked a deeply maladjusted U.S. “services” Bubble Economy.

· The prolonged U.S. Credit Bubble and resulting interminable Current Account Deficits have cultivated myriad global Bubbles.

· Recessions are an integral aspect of Capitalistic development – and busts are proportional to the preceding booms.

· Today, speculative-based liquidity commands the financial markets and real economy, creating unparalleled fragility.

· Late-cycle “blow-off” excesses are the most perilous because of their deleterious affects upon the underlying structure of the financial system and economy.




Question: Can you provide a brief explanation of “Bubble Economies,” “Credit Bubbles” and some of your theory behind these concepts?

Bubble Economies are highly complex creatures. Clearly, they are dictated by financial excess - most notably a sustained inflation in the quantity of Credit. Substantial Bubble Economies develop over an extended period of time. The momentous variety are often nurtured by the interplay of extraordinary technological and financial innovation, and are almost always perceived at the time as so-called “miracle economies.” Both Credit and speculative excess play prominent roles, especially late in the cycle. Central bankers are likely to be caught confused and accommodating.

It is the nature of Credit that excess begets only greater excess. Major Bubbles are associated with exceptional yet generally unrecognized Credit system phenomenon (“Monetary Disorder”). It is imperative to appreciate that Bubble Economies are as seductive as they are dangerous. Credit excess causes different strains of inflation – rising consumer, commodity, and asset prices to note the most obvious. Asset inflation is the most dangerous, as there is no constituency to stand up and demand the Fed rein it in. Furthermore, the longer asset inflation and Bubbles run unchecked the greater their propensity to go to wild, destabilizing extremes – likely hamstringing policymakers in the process.

Bubble Economies become progressively distorted by inflations in incomes, corporate earnings, government receipts and spending, and Current Account Deficits. Inflationary spending, investment, and speculative financial flow distortions play prominent roles in progressive economic maladjustment. By the late stage of the Credit boom, inflation effects tend to be highly divergent and inequitable.

The greatest systemic danger arises when speculative-based liquidity comes to dominate financial flows and economic development, creating a highly Credit-dependent and unstable system. End of cycle market price distortions tend to create the greatest impairment to financial and economic systems. Bubbles are inevitably sustained only by ever-increasing Credit and speculative excess. Any bursting Bubble must be supplanted by a more pronounced one (or series of Bubbles). As we are witnessing these days, the great danger associated with central banks accommodating Credit and asset Bubbles is that a point of Acute Fragility will be reached – with policymaking gravitating toward prescriptions to sustain financial excess.

Question: You have discussed in the past a concept that you refer to as “The alchemy of Wall Street finance.” Can you describe it for us and relate it to our current environment?

There are two related concepts that are fundamental to our analytical framework – how we view Credit-induced booms and their inevitable busts. These are the “Alchemy of Wall Street Finance” and the “Moneyness of Credit.”


First, the “Alchemy of Wall Street Finance:” This is basically the process of transforming risky loans – loans that become increasingly risky throughout the life of the credit boom - into debt instruments that are appealing to the marketplace. This is very important, because as long as Credit instruments enjoy robust market demand they can be created in abundance – in an extreme case fueling a runaway Credit Bubble with dire consequences for the financial system and real economy.


Our second concept, “Moneyness of Credit,” also plays a central role in boom dynamics. If you think about contemporary “money”, it’s really not about the government printing press or Federal Reserve issuance. Instead, “money” is today largely the domain of private sector Credit and the Marketplace’s Perceptions of Safety and Liquidity. “Moneyness” always plays a prominent role in Credit booms, due to the unbounded capacity to inflate Credit instruments that are perceived as safe and liquid.


Think of it this way, a boom financed by junk bonds likely isn’t going to progress too far – market restraint will be imposed by limitations in demand for these risky Credits. On the other hand, a boom fueled by virtually endless quantities of highly-rated agency debt, ABS, MBS, commercial paper, repos and the like – instruments the market perceives as “money”-like no matter how many are issued – has the very real potential to get out of hand.


And this gets to the heart of the issue – the dangerous state of this Wall Street Alchemy. Over the life of the boom there has been a growing disconnect between the market’s perception of “moneyness” and the actual mounting risk associated with the underlying Credit instruments. Especially because of the heavy use of derivatives, sophisticated structures, and leveraging, along with Credit insurance and various guarantees throughout the intermediation process – the entire risk market became highly distorted and dysfunctional.


And we would argue that the market’s perception of “moneyness” has recently changed – and we believe this to be a momentous development. The market now has serious trust issues related to ratings, pricing, liquidity, leveraging, counter-party risk, Credit insurance, and sophisticated Wall Street structures in general. In short, Wall Street’s capacity to create contemporary “money” has been dramatically constrained.


Of late, the rapid growth of central bank and banking system balance sheets has taken up the slack. But this is only a temporary stop-gap. The unrecognized dilemma today is that to sustain our Bubble economy will require continuous huge quantities of Credit creation – and these loans are by nature high risk. Wall Street risk intermediation is impaired – the market today seeks risk avoidance and de-leveraging – and there is little alternative than the banking system turning to risky lender of last resort.

Question: So where are we today, and what are the ramifications for the current economy?

Putting it all together, a confluence of factors has created what we expect to be an ongoing highly unstable Credit backdrop. In the nomenclature of economist Hyman Minsky – we have today “Acute Financial Fragility” – as opposed to previous backdrops where the U.S. system, in particular, was positioned to weather periods of turmoil relatively well. Despite dogged global central bank interventions, we still fear the potential for the Credit market to seize up – with devastating economic consequences. And the combination of unusually frail financial and economic structures leaves us very fearful of a dollar crisis of confidence.

At the minimum, the bursting of the Mortgage Finance Bubble has instigated a serious tightening of mortgage Credit Availability, leading to escalating foreclosures, Credit losses, pressures on home prices, and ongoing marketplace illiquidity for MBS and mortgage-related debt instruments. A classic real estate bust will feed on itself, ensuring further havoc throughout mortgage finance and imperiling the over-borrowed consumer sector.

Question: There’s a lot of talk these days about the GSEs – their roles in market excess, previous financial crises, and the potential for GSE liquidity to come to the market’s rescue once again. What’s your view on these matters?

There is a key facet of GSE analysis that does not garner the attention it deserves – and it relates, importantly, to the stark contrast between the inherent stability of GSE obligations and the underlying instability of much of today’s debt market structures. Let me begin by sharing data I believe go far in illuminating recent acute financial fragility. Returning to the four-year period 1998 through ‘01, direct GSE borrowings expanded $1.2 TN versus a $788bn increase in outstanding asset-backed securities (ABS). Compare this to the three-years 2004 through ‘06, when GSE debt grew only $57bn while ABS ballooned almost $2.0 TN.

In developing his hypotheses of inherent financial instability, Hyman Minsky coined the terminology “Ponzi Finance.” It is crucial to appreciate that GSE-related debt (agency debt and MBS) behaves atypically during crisis: I refer to the GSEs as the “Anti-Ponzi Finance Units” – in that finance flows aggressively to this (quasi-government) asset class during periods of market tumult. The GSEs enjoyed basically unlimited capacity to expand liabilities during previous crises – 1994, 1998, 1999, 2000, 2001/02 – and their operations played a momentous role in repeatedly backstopping the Credit boom.

Today – the GSEs are constrained and their balance sheets will not play their typical prominent role in accommodating speculator deleveraging and system reliquefication. Furthermore, by far the greatest excesses over the past few years were in Wall Street “private-label” ABS/MBS – subprime and, more importantly, Alt-A, jumbo, interest-only and other mortgages that encouraged borrowers to reach for more home than they could afford.

So, from a GSE standpoint, these agencies played an instrumental role in fostering the Mortgage Finance Bubble. When, in 2004, the scandal-plagued GSEs faltered, Wall Street was keen to snatch control. Consequently, trillions of unstable non-GSE debt instruments now permeate the system. At the same time, the GSEs are today incapable of orchestrating their typical market liquidity operations. This helps explain the difference between previous relative stability during crises versus recent Acute Fragility – especially in Wall Street ABS, sophisticated leveraged strategies, and derivatives more generally.

And we don’t expect this dynamic to be easily reversed or even meaningfully mitigated. Central bank interventions will have minimal intermediate and long-term impact on the bursting Mortgage Finance Bubble. Liquidity today flows in abundance to gold, precious metals, crude oil, commodities and virtually any non-dollar asset market – where robust inflationary biases prevail – content to avoid Wall Street mortgage-related securities and exposures. The situation will only worsen as home price declines gather momentum and Credit losses escalate.

Question: So, it is your contention that the current crisis marks a major inflection point for the Credit system?

We strongly believe so. Going forward, markets will be decidedly more cautious when it comes to ratings and liquidity. “AAA” was perceived as “always liquid” – even in the midst of financial crisis. In reality, GSE-related debt and their ballooning balance sheets played a prominent role in fostering this fateful market misperception. Yet, over the past few years, the most egregious Credit excesses were in speculative leveraging of highly-rated non-GSE securitizations. This scheme is now over.

The bursting of the Mortgage Finance Bubble has ushered in a major tightening of mortgage Credit, which will lead to escalating foreclosures, Credit losses, home pricing pressures, and ongoing marketplace illiquidity for MBS and mortgage-related debt instruments. We see the so-called “subprime crisis” transforming over time to an expansive dislocation in “Alt-A”, jumbo and "exotic" mortgages.

There are now literally trillions - and growing - of suspect debt instruments and many multiples more in problematic derivative instruments. We suspect that the proliferation of sophisticated leveraged strategies created considerable demand for high-yielding mortgage products, and now these vehicles are trapped with losses and illiquidity. Worse yet, Credit insurance and guarantees in the tens of trillions have been written and, as the downside of the Credit cycle gains momentum, we expect this exposure to become a major systemic issue. In short, we see Credit “insurance” as a bull market phenomenon that will not stand the test of the impending Credit and economic downturns. In too many cases, Credit guarantees, “insurance,” and myriad other exposures have been “written” by thinly-capitalized speculators and financial operators. They will have little wherewithal in the event of a serious Credit event. This is a major evolving issue. We fear the entire Wall Street risk intermediation mechanism is at considerable risk.

Question: Can you wrap thing up with some summary comments?

To summarize, we believe the current fragile boom – one characterized by unprecedented imbalances and maladjustments – can only be sustained by ongoing massive Credit creation. In an increasingly risk-averse world, this poses a colossal risk intermediation challenge. Thus far, the confluence of a highly inflationary global backdrop, extraordinary central bank interventions, and a major expansion of U.S. banking system Credit has sufficed. We, however, view Fed and the U.S. banking system capabilities as constrained and aggressive actions feasible only over the short-term. Importantly, an impaired Wall Street risk intermediation mechanism – the main source of finance behind the past few years of “blow-off” excess - will be hard-pressed to meet challenges and new realities.

Likely, liquidity issues and faltering asset markets will instigate problematic de-leveraging upon highly over-leveraged Credit and economic systems. We expect significant unfolding tumult in the securitization, derivatives, and risk “insurance” marketplaces. We view ballooning Credit insurance and derivatives markets as a bull market phenomenon that won’t withstand the test of the downside of the Credit Cycle. We believe the stock market has of late benefited from a combination of complacency, misperceptions with respect to Fed capabilities, and its newfound status, by default, as favored risk asset class. We see US equities, in particular, highly susceptible to unfolding detrimental financial and economic forces. We expect the economy to soon succumb to recession. California and other inflated real estate Bubble markets are now poised to suffer severe price declines – residential as well as commercial. And we expect contemporary “Wall Street Finance” to face a crisis of confidence – to suffer on all fronts – liquidity, Credit losses and regulatory. Our faltering currency is, as well, a major issue.

mike morgan in florida

” . . .we're in deep doodoo."

Robert Toll, CEO of Toll Brothers



Quote of the Week – Bob hit it on the head when talking about the Fed cut this week. And it really doesn’t matter what the Fed does at this point, because we are waist deep in doodoo. The only way out is through the doodoo, and it is going to get deeper and stinkier.



Market Conditions – I’ve received many phone calls and emails asking whether I prepared an Outlook last week. I did not because I have been on the road looking at communities and speaking with brokers, analysts, builders, etc. throughout the country. I am still on the road, so this week’s Outlook will be short and sweet. Strike that. Make it short and bitter. Very bitter.

I have decided to cut back on writing weekly updates. I might write one a month, but I might step back and not write publicly anymore. My clients are keeping me busy on specific projects, so I have little time to spend a full day putting together a weekly update for public consumption. Folks, we have reached a point in this cycle that is a surprise even to me. I will provide you with a brief recap.

When I first spoke about negative sales more than a year ago I was the butt of many jokes. I have the last laugh, and I am going to make it a full belly laugh. Analysts like Kim, Oppenheim, Whelan and Zelman refused to leave their plush offices and homes. They went on builder sponsored tours instead of ground zero tours in the trenches. They saw what they wanted to see. Many analysts had to balance banking relationships, and we know what that has led to. Now it is very clear that most builders are experiencing negative sales in communities throughout the country. Negative sales are what you see when you have more cancellations than you have sales. But that is just one color of the nightmare I am going to paint . . . and have been painting for three years now.

The deterioration of the housing markets over the past six week has been devastating. I really don’t care what we hear on the conference calls this week, because I’m here to tell you from ground zero, it is much worse than anyone has discussed, and it is going to get far worse than any of the builders wants to admit.

Of the top five builders, maybe two will make it through this crash. But maybe just one. And here’s why.



Inventory – Nothing new here. These greedy pikers built more homes than the country needed . . . and they knew it. They were selling to anyone and everyone, even when they knew the buyers were not qualified and the buyers were lying on signed documents. The pikers sucked up bonuses in the hundreds of millions of dollars, all the while telling everyone that everything was fine. Now we have enough inventory for the builders to totally stop building for 12-18 months. That’s what it would take to absorb the current inventory. We all know that’s not going to happen.



Prices – If you believe anyone telling you prices are stabilizing, or even showing signs of stabilizing, you are either on drugs or you have the IQ of a green mango. Prices are now in total free fall, with buyers and competing builders in complete control. The latter is more of the driving force in prices than buyers are now. Here’s a perfect example. We visited a Lennar community where prices for townhomes were $215,000. But the sales person made it clear we should make an offer. In fact, he told us Lennar accepted an offer of $190,000 just a week ago. Lennar was willing to take a 10%+ haircut before we even saw the unit. But before you assume that is the negative to this story, read on. We left Lennar and drove to the front of the community where Prime Builders was developing a townhome section just outside the gated section where Lennar and Centex built.

Prices on Prime’s townhomes were in the $250,000 range . . . but Lennar’s townhomes were 2,200sf while Prime’s were in the 1,600sf range. So Lennar was willing to sell at $87 per square foot, while Prime is asking $156 per square foot. When I told the Prime sales agent that Lennar was selling at under $200,000, she winced and had a very interesting explanation to share with us. But the bottom line was clear. Builders are cutting each other’s throats at this point of the cycle . . . and they have no choice. Darwin would tell you this is how the world works. We are going to see extinction with a lot of blood and guts.

The townhome example I just shared is not unique. I’ve seen and heard the same thing in other markets. In fact, I don’t think any markets are immune from the builder-on-builder fight to the death. We’re seeing builders slash prices and then before a buyer can even digest the price slash, the builder is throwing in incentives, additional price cuts . . . and telling you these prices are not real, because you can make an offer!

Psssttt . . . Don’t tell the builders, but not only are they competing with each other and the flippers they loaded up, but the banks are now a very, very, very reluctant competitor in the residential real estate market. Since banks are not in the business of owning, maintaining, renting and managing single family homes, they dump them. And I mean dump. More on this for my clients.



Sales – Ara has been filling your heads with “traffic” numbers. Sure, we saw traffic, but when I “ground-zero” this traffic, I get the real story. I’d say two thirds of the traffic is a false reading. Many of the folks I spoke with are neighbors that want a feel for what is happening to the price of homes in their back yards. Another segment of the traffic is people who have sipped the Kool-Aid. They think prices have fallen far enough, and builders are making such great deals . . . that they can now afford a home. I have news for them, they can’t. Prices are still higher than five years ago and mortgage rates are not what they appear to be. Even with the 50bps cut, mortgages are tougher to get and with that comes higher rates for the folks that do qualify. Let’s face it, subprime deals and all of the creative financing we saw is gone. I’d say Ara’s Deal of the Century will soon be known as Fake-Out of the Century, unless Hovnanian cuts prices further or buys down mortgages further. Personally, I don’t buy the numbers Hovnanian released. I was in the field during his Deal of the Century, and I didn’t see what his numbers portray. I challenge Ara and some of the others to spend a day in the field with me mystery shopping their communities and the communities of their competitors.

Here’s another problem with sales. Builders are actually killing the sales they already have on the books. As builders cut prices and pile on the incentives, folks that purchased homes a year ago are canceling contracts . . . or the builders are forced to honor the current slashed prices and increased discounts. Did I say a year ago? While that is true, even sales made 2-3 months ago are no moot. If you signed a contract two months ago with a $5,000 deposit, and the builders have dropped prices $20,000, you do the math.
That means the sales we saw a year ago or even a few months ago with healthy margins, will actually be closed at low or no margins. From here on out, the majority of sales for all builders will be no and negative margins. Maybe I should color that a bit. Builders are telling you they are still at decent margins . . . exclusive of impairments. Think about that, but not too hard if you’re in the mango category. This one’s not that difficult. More on just how bad this problem is for clients, including land and spec issues that compound the sales problems.



Who Survives – I’m not sure anymore. I thought I knew based on what I see at ground zero and the numbers in the models, but now I am turning over rocks and finding slimy, stinky stuff that is going to feed the slide to the sewer. There will be three groups of survivors.

Smart Guys – These are the guys that have managed and continue to manage down inventory, and are shutting down operations like a frog shuts down during the dry season. The faster these guys can get out of sight into the soft mud, the healthier they will be when the rains return. From what I see now, there are only a handful of these frogs out there right now.

Bullies – These guys have the arrogant attitude that they can build their competitors out of business. They may have Einstein IQs but there super-egos smush out any clear thinking of what is best for the company. These blockheads announced plans to build and compete aggressively on pricing. They thought they could continue building and dropping prices to force the competition out of business. Some of these knuckleheads still believe this. But the bullies never left their comfy offices and the comfort of their boats, beach/mountain homes and vacations. They just didn’t get it. I’m not saying that sarcastically. These CEOs and other execs were (and are) so full of themselves, that they missed the heart of the problem, and instead of taking their foot off the gas pedal, they pushed it to the floor. They felt they could go through the wall with more speed. If they had bothered to take a ground zero look before heading for the wall, they would have seen two things. The wall is not two feet thick. It is twenty-two feet thick and it is reinforced with rebar.
There might be one or two bullies that survive. They will not make it through the wall. They will come out the side, in pain, with broken bones and a big hurtin’ to their vain pride.



Crippled Fools – This will be the largest group. There are builders out there with no cohesive plan for sales, marketing, customer service or how to navigate the mines. They've grown too big and swallowed up the good and the bad. They now have severe indigestion and they are so fat and sloppy, they can barely move. It will be hit or miss for these fools, since they have not taken the time to sit down and formulate a plan. There is a big difference between being “reactive” and “proactive.” The first two groups are being proactive, even if the brains of the bullies have the density and contents of a coconut. The crippled fools will come limping out of this two ways. If they lose a leg or two, they will come out with a partner or two who may have only lost and eye or an arm. The second group will come out, but will probably shrivel up and die.



Who and What to Buy – No one, yet. The big boys can’t buy any of the builders, since the Street has not priced in the reality of the twenty-two foot, reinforced wall. The big boys can’t buy the debt, because the debt is also overpriced. I’ve had several calls from deep pockets that want to step in with a checkbook. My advice is simple. Wait. Look, touch, smell, don’t taste, squeeze, poke . . . giggle and wait. More specifics on who survives and who to watch for clients.



Florida – I have been on the road in Florida since my return from New Jersey. Let me cut to the chase. Bad. Ugly. And getting worse. Much worse. I hope that is enough color, because if you don’t get it, you never will. If you are a Stephen Kim or Dan Oppenheim follower, and you think the bad is getting better, you need a good smack up the side of the head and a kick in the pants. And as Forrest would say, “And that’s all I have to say about that.”



WCI – You’ve got to see Bal Harbour to believe it. The CO promised for the end of August is nowhere in sight. The building is still under construction. Prices continue to drop. I’m here to tell you this one doesn’t close this year and the can-rate is going to be ugly. I also hear the attorneys grumbling, so for the bankers expecting cash this year, think again. In fact, you guys might need a couple mangos, a couple coconuts, some ice, and a bottle of vodka. Throw these in a blender and suck it up boys. If you’re on Oceanside too, you might want to go to the top of the building and open a window.



New Jersey – I visited the Mid-Atlantic this week to look at a few areas. Let’s start with the Jersey Shore and Asbury Park. I actually grew up on the Jersey Shore and attended Asbury Park High School. It’s the home of Bruce Springsteen and it was a jewel back in the 20’s. Just one hour from New York by train and with a mile of beautiful beaches, you’d think this area would have sprung back to life.

Unfortunately, ever since 1969, Asbury Park has been on a slow and steady decline. The shops closed and moved to the regional malls. The old hotels of the 20’s became less and less attractive to summer vacationers. And the state started dumping mental health patients in the rooming houses and old hotels. Johnny Cash and many others sunk money into projects to revitalize the beach district of Asbury Park. They all flopped. How can you expect buyers to return, when seedy hotels, boarded up buildings and worse, are just a block from the planned condos and hotels.

So a few years ago at the height of the housing bubble, a new group stepped in with big dreams and bigger promises. I drove past newly constructed town home projects that were totally empty. I drove past several mid-rise condos that are going up on Ocean Avenue, and right across the street it looks like a war zone with dilapidated buildings. The boardwalk has been repaired, but without the shops of the 60’s and 70’s, it is nothing more than a hang out for bums and kids with nowhere else to go. It’s sad. Very sad.

For my clients, the photos speak for themselves. For the good folks reading this piece, I have included a photo of what the buyers of the condos are looking at, if they close and move in. I doubt anyone will move into some of these towers. And just like other projects in Asbury Park, they will either eventually be torn down or filled with welfare and displaced mental health tenants. Unfortunately, that’s just the way it is in Asbury Park.

Whenever I return to the Jersey Shore, it’s great to see all of the great things happening. It’s sad, but never unexpected, to see failure after failure in Asbury Park.

At the other end of the State, we have Atlantic City. Several clients have asked me for information on what it looks like at ground zero and what’s ahead. It’s quite simple - Atlantic City has seen better days. AC saw better days in the 20’s just like Asbury Park. But AC got another shot in the arm with gambling. As many of you know, I was an executive with the Trump Organization in Atlantic City in the 90’s. Even then, if you walked one block away from the casinos, you were in another world. One of desperation, cheap hookers, street vendors (drugs) and run down buildings. Not much has changed, and any hope of Atlantic City turning things around has disappeared. Gambling in Pennsylvania has already hit Atlantic City hard, and PA is just getting it together. I don’t expect any new casinos in Atlantic City, nor do I see the potential of any new investments that will help the industry or the surrounding communities.



Blowing Smoke Article of the Week – The Wall Street Journal’s Mike Corkery does it again, as he touts the virtues of the return of Ivy Zelman. The title of his article is fitting, “Expert on Housing Has Her own Nest.” More on the nest in a moment. Corkery makes it sound as if Ivy led the way when it comes to the housing issues. Well . . . before you run out and plunk money down on Ivy, I can assure you she came to the party reluctantly and very late. She also had a rather sloppy track record for quite a few years prior to leaving Credit Suisse.

Analysts like Ivy and the giant financial institutions these analysts worked for, may have played a larger role in the housing issues than one might think. While analysts were touting the virtures of the builders and bankers were putting together CDOs, SIVs and other packages, there were very few voices talking about the clouds forming. Personally, I can't seem to balance how the analysts refuse to paint the true picture, while the banking side continues to fund the problem. And isn't it funny how Credit Suisse just put on a housing conference, providing the builders with a global forum to sing their song . . . without anyone to ask the hard questions.

As for the ground zero issues brewing over the last few years, Ivy tapped into me for quite a bit of information about the housing industry late in the game, but she never left the “nest” to come out and see ground zero. Ivy ran around on the guided tours offered by the builders, but that’s like asking a bank robber for a tour of the crime scene. With her team of cracker jack research analysts, she had massive amounts of data she could pump out. But having rear-view mirror data, and not being able to marry it to what is coming down the road is a major problem.

Ivy was socked away in her “nest” with her three pre-school children, while her research team was in New York and the builders were building in Florida, California, Arizona, Nevada, etc. And as Quirky Corkery points out, she will continue to work from her home in Cleveland, while her team remains in New York. The problem is . . . there’s not much going on with housing in Cleveland or New York, and using your kids as an excuse for not being able to get out in the field may have worked with Credit Suisse, but might not cut it in the real world.

Let’s forget about Ivy coming to the party late and failing to get out in the field at ground zero. Let’s look at the record. I asked Ivy why she didn’t come out and simply downgrade builders across the board. I asked why it seemed like she would downgrade one and upgrade another, and why she seemed to be almost neutral in her ratings. For those of you that know the game, her response will come as no surprise. Ivy told me she Credit Suisse required her to maintain an overall rating on the builders and she couldn’t simply downgrade them across the board. Maybe banking relationships are more important that coming out with what’s really happening and what the real long term fall out will be.

Analysts that sit in their offices (or at home with the kids) and think they can provide relevant information, are kidding themselves and their clients. Ivy comes across great on conference calls and she pumps out a lot of information. She’s a tough cookie, and I was always a bit shocked at her truck driver language on the phone, but her rear view analysis was not much different from the rest of the group. Coming across tough and pumping out volumes of data is not a replacement for field research and counter balancing what the builders tell you with what is happening – real-time in the real world.




Disclosure

Peak Oil is past -- from the oil drum

Executive Summary:
Broad revision (from 1980 to 2004) by the EIA this month but not significant in amplitude.
Monthly production peaks are unchanged:
All Liquids: the peak is still July 2006 at 85.54 mbpd ( 0.11 mbpd), the year to date average production in 2007 (6 months) is 84.28 mbpd ( 0.02 mbpd), down 0.07 mbpd from 2006 for the same period.
Crude Oil + NGL: the peak date remains May 2005 at 82.09 mbpd ( 0.01 mbpd), the year to date average production for 2007 (6 months) is 81.20 mbpd ( 0.04 mbpd), down 0.06 mbpd from 2006.
Crude Oil + Condensate: the peak date remains May 2005 at 74.30 mbpd ( 0.15 mbpd), the year to date average production for 2007 (6 months) is 73.23 mbpd ( 0.14 mbpd), down 0.25 mbpd from 2006.
NGPL: the peak date is still February 2007 at 8.03 mbpd ( 0.21 mbpd), the year to date average production for 2007 (6 months) is 7.97 mbpd ( 0.18 mbpd), up 0.19 mbpd from 2006.
Decline in crude oil + condensate continues: June 2007 estimate for crude oil + condensate is 72.82 mbpd compared to 73.11 mbpd one year ago and 73.92 mbpd two years ago.
Average forecast: the average forecast for crude oil + NGL based on 13 different projections (Figure above) is showing a kind of production plateau around 81 +/- 4 mbpd with a decline after 2010 +/- 1 year.

Don't blame Al - check the mirror

Which raises the question: just what the f*** was the public thinking when they bought half-million dollar houses on salaries under 60-K, taking out no-money-down, interest-optional balloon mortgages and other tricked-up contracts? The answer is: they walked into these arrangements with their eyes open because they thought they could get something for nothing. They thought the trend of steeply rising house prices would continue indefinitely and enable them to wiggle free of any hazard by flipping their houses to an endless supply of greater fools who would be there waiting to turn the very same trick. And the smoothies downstream in the mortgage and banking rackets were no less guided by avarice when they cooked up their formulas for bundling half-baked mortgages into tranches of tradeable securities. Easy Al may have failed to notice what was going on here, but then so did everybody else from The Wall Street Journal to the Securities and Exchange Commission.

This, of course, represents an insidious psychology. It could only happen in a culture that has come off the rails mentally, so to speak, as ours has in the sense that nobody has any sense of consequence, neither the leaders nor those who affect to follow the leaders. The leading religion in America is not evangelical Christianity, it is the worship of unearned riches, and its golden rule is the belief that is is possible to get something for nothing. Its holy shrines are Las Vegas and Wall Street. (And, by the way, has anybody heard the evangelical Christians complain about Las Vegas? They complain about a lot of things, but are themselves among the greatest believers in unearned riches -- given their preference for prayer over earnest effort in the service of solving life's problems.)

No, the American public, including the cheerleaders in the media, have only themselves to blame for the bitter harvest now underway in the asset and credit markets. And thus it would be a salutary thing for Baby Jeezus, or the forces of nature, or whatever powers guide the universe, to now kick the sh*t out of them, so to speak, financially, because that is exactly what the American public is full of, from top to bottom, from George W. Bush at his lonely desk on Pennsylvania Avenue to the pitiful, bankrupt householders of Orange County and Boca Raton.

http://jameshowardkunstler.typepad.com/clusterfuck_nation/

Friday arvo in the Titanic's Sydney suite

These superannuation managers employ investment and asset management professionals to ensure the funds are in the approved asset type consistent with the underlying mandate. They cannot be geared in any way. The returns above benchmark are the concern of the asset manager, whereas the returns of the overall superannuation is my friend's concern (ie switching from bonds to equities, credit to govt, short to long duration).

He has been arguing to reduce exposure to long end bonds and move to cash plus short end funds.

The asset managers said sure, except to get out of the existing fund he would have to cross a massive 80 point spread on some of the corporate bonds (apparently the fund marks the assets to "mid" - half way between the bid and the offer) and no one has actually crossed the spread on corporate bonds in the last 3 months. No one has bought or sold a corporate bond in Australia of any note in the last 3 months.

His candid discussion with the debt experts revealed that they think they are like the engineers in the Titanic whereas the guys in the equity markets are "like the 1st class passengers up on deck smokin' cigars". "One of us is wrong, and I don't think it's us" he said. He believes the Dow and S&P could reach 15 000 to 16 000 as part of the blow off top, that could be over within a few short weeks but that it was all valuation changes due to collapsing dollar prior to a massive collapse.

Leap 2020

As explained many times since the beginning of 2006 by LEAP/E2020's team of researchers, the main cause to the current systemic crisis is in the United States. This “end of the Western world as we've known it since 1945 ” anticipated by LEAP/E2020 in February 2006, is the collapse in all its dimensions (economic, monetary, financial, diplomatic, intellectual and strategic) of the central pillar of the 20th century world incarnated by the US. It is indeed in this country that is to be found the centre of the financial and banking crisis that has been affecting the whole planet since the middle of last summer. The pillar now lies on quick sands, and this of course implies that the global architecture is altogether subsiding, and then will collapse piece by piece.

In this 17th issue of GEAB, our team of researchers has therefore decided to focus on the analysis of the nature of the ongoing global systemic crisis (an analysis already well advanced for all GEAB subscribers) (1) and to publish an explanation in 1000 words only of the current crisis and its articulation with the systemic crisis altogether. We hope that this explanation, using a simple language, will help each and everyone to understand upcoming events. As indeed, and this is a key point, we now estimate that no ruling centre can stop the ongoing systemic crisis anymore, nor even limit the scope of its global impact (2).

Since 1945, and increasingly since the collapse of the Soviet bloc in 1989, the US economy became the single pillar of the entire international financial and banking system. After the August 15, 1971 severing of the US dollar convertibility to gold (3) (or to any other physical counterpart, thus available in limited quantities), the amount of US dollars in circulation worldwide increased dramatically. The emerging of new centres of industrial, technological and service production throughout the world, combined with weakening human resources training (and therefore productivity competitiveness) in the US, resulted in a dramatic increase of the US debt (public and private). Thanks to the creativity of financial operators, with the more of less naive complicity of the entire banking and financial chain (central banks, quoting agencies, financial media, politicians, economists, etc…), this debt progressively became the US main production.


US Household Debt Service Ratio - Source Contraryinvestor.com
With G.W. Bush and his ideological or business partners in Washington, the production of this type of « value » (debts) increased even more dramatically (4), under the active auspices of the Fed's president of that time, Alan Greenspan (5): public debt, real-estate debts, car debts, credit card debts (6),... in every field debt grew on as the good “produced” in greatest amount by the so-called dominant economy. Meanwhile the entire world kept on buying this new “made in USA” good, western elites in particular being completely fascinated by the incredible creativity of Wall Street and its backyard, the City of London.

For many years though, anyone owning two eyes to see (i.e. neither experts nor policy-makers whose eyes only read reports on reality and press releases) and crossing the United States could observe that, contrary to Europe or Asia, the country was in a process of generalised impoverishment: escheated infrastructures (7), free-falling education, growing poorly-trained immigration, increasing dependence on foreign energy, multiple technological retardation,… This statement inevitably raised a fundamental question: who would pay back, and how, this constantly growing colossal debt?


Debt Outstanding by Sector (1974-2006) – Sources: Federal Reserve / ITulip.com
However, until September 11th, until the catastrophic invasion of Iraq, until Katrina and the partial destruction of New-Orleans, and more recently until the Mississippi bridge collapse, everyone – in line with those « experts » - seemed willing to believe in the figures published by the system itself selling them its « debt » product, figures which of course guaranteed that all was well and the average debtor was solvent.

Then, little by little, with an acceleration starting a year ago, reality – this annoying parameter that often disturbs all equations carefully elaborated by experts and ideologists - invited itself to the financial and banking system. Bubble after bubble (Internet, housing, subprime), the attempts to increase the production of debt continued, with the hope that either the real economy would catch up with the level of the debt produced, or the rest of world would endlessly keep on buying US debts refinanced with new US debts (always more sophisticated, such as those famous CDOs, Collaterized Debt Obligations, invented to share risks while in fact they de facto infected the entire system).

However the bursting of the housing bubble triggered a fatal sequence, as the GEAB anticipated month after month since February 2006, progressively leading to mid-2007 and to banking and financial operators becoming aware that the ultimate debtor of this huge debt-producing plant (the US), i.e. the average US consumer, was either already insolvent or about to be (8), in a context of US recession (9).

From spring 2007 onward (tipping point of the global systemic crisis – see GEAB N°12 - February 20067), these large institutions began to try and evaluate their exposure, without taking the full measure of the crisis because, there again, habits, conformism, made them believe that there would be a « rebound in US economy », that « the fall in housing prices would not last », that « employment would stand firm”, that “corporate investment would respond”, etc… All of us read or heard these elements of wishful thinking presented as serious arguments by the big financial media and central banks themselves.

In the middle of summer 2007, large international banks had to admit it: a large proportion (though unquantifiable, the exact measure of the ongoing crisis being impossible to evaluate) of all those debts would never be paid back. It is very enlightening to observe the evolution of the market of « Commercial Papers », asset-backed (mostly financial ones), used in corporate financing and a key to understand the current banking and financial crisis. As shown on the chart below, it is a pure and simple collapse that started last August.


Asset-backed Commercial Paper Outstanding – through 08/22/2007
In consideration of their upcoming deadlines and unavoidable liabilities, large banks decided to start amassing real liquidities (and no longer pseudo-liquidities, such as most of those financial products sold to millions of savers in the past few years, ultimately US debt-backed) (10) rather than keep on financing operations likely to convey massive losses. In this field, they put an end to their mutual lending of funds, as, each of them being largely involved in US debt backed speculation, they now suspect one another to be more exposed and run the risk to go bankrupt.

And that's what it's all about! And that is the reason why the ECB is literally flooding European banks with liquidities. Jean-Claude Trichet probably remembers the collapse of Crédit Lyonnais (11). The subprime crisis is nothing but a trigger. Indeed the whole of the financial bubble based on US debt is bursting, because the US consumer is battered and the US economy is now in recessflation, as described by LEAP/E2020 in GEAB N°16 (June 2007). Behind those subprime mortgages, all US mortgages, car loans, credit cards… are now facing a dramatic increase in the default rate (the public debt follows the same trend as the US dollar and Treasuries keep on dropping).

In other words, the wisest people in the global banking and financial sphere (which excludes most of today's large international bank leaders) know that in the coming six months some entire sectors of activity and corresponding results will either vanish or experience record-losses.


- Foreign ownership of US debt - Source: US Department of the Treasury / Dollardaze
Given that the real economy is already infected not only in the US but all over the world, the collapse of the British, French and Spanish housing markets is next on this year's agenda, while Asia, China and Japan are about to face the simultaneous collapse of their exports to the US market and of the value of all their UD dollar-denominated assets (US currency, treasury bonds, corporate shares, etc…). The chart above is explicit about which countries will be hit hardest when the US debt bubble bursts, i.e. Japan, China, United Kingdom and countries exporting oil in US dollars.

Concerning future steps, LEAP/E2020 only has two interrogations: how many experts, central bankers, financial journalists, politicians fascinated by America will be able to understand this sequence of events that questions so deeply their vision of the world? And shall they understand soon enough, not wasting time expecting « jolts » and « rebounds » from an America that has not much left to do with mid-20th century' America.

A speed race between reality and theory is now open. All in all, a systemic crisis always boils down to such a race and the winner is always reality. Policy-makers, if they are lucid, can avoid a brutal and frontal collision with facts, thus sparing their populations from big damages. Throughout the planet, the months to come will enable to tell the wheat from the weeds in this matter.

LEAP/E2020 is convinced that the “US Very Great Depression” announced for 2007 is indeed next on History's agenda, and that it will have consequences incommensurable with the 1929 crisis, even though a number of indicators common to both crises started blinking a few months ago, and even though 1929 remains the last possible comparison in modern History (12).

---------
Notes:

(1) As regards the impact phase of the global systemic crisis, LEAP/E2020 now estimates that the third period of this phase as described in GEAB N°8 (10/15/2006) will in fact be a lot longer than anticipated by our teams at the time, and that it could spread until the beginning of 2009.

(2) The Fed's powerlessness in preventing a US recession, an accelerator of the ongoing crisis, will certainly not modify LEAP/E2020's opinion in this regard. Source: CNNMoney, 09/13/2007

(3) For more information: source Sherbrooke University, Canada.

(4) For an illustrated vision of this increase of US debts, it can be useful to visit this website: US National Debt Clock.

(5) Today Alan Greenspan would like to re-write history and claim that he has nothing to do with the financial rout currently sweeping away his country (source: New York Post, 09/14/2007); yet he was among the fervent promoters of one of the main triggers of today's crisis, i.e. adjustable rate mortgages (source Slate, 02/27/2004).

(6) The US consumer's rush on his credit card in an attempt to maintain his living standard, after he awoke from his dream of eternal mortgages, is about to entail new disappointments for large financial institutions in a few months time. Source: Sioux City Journal / AP, 14/09/2007

(7) For instance, the American Society of Civil Engineers estimated to USD 1,600 billion the investments required to put back into order US infrastructures (roads, harbours, airports, water supply and distribution, dams,…) over 5 years. Decades of collective incompetence have thus become a gigantic bill weighing on the future of each and every US citizen. Source: American Society of Civil Engineers.

(8) The US consumer's insolvency was described un GEAB N°9 (December 2006).

(9) The case of US car market, both collapsing and experiencing late payments on former sales, is eloquent. Source: The Colombus Dispatch, 09/02/2007

(10) Cf. on that matter, LEAP/E2020's advices in GEAB N°17 (September 2007)

(11) Cf. GEAB N°17

(12) Cf. GEAB N°17 on the comparison between 1929 crisis and 2007 crisis.

Chief strategist at CLSA predicts record gold run - Times Online

Chief strategist at CLSA predicts record gold run - Times Online: "t would be the biggest run on gold since the attempted French invasion of Britain of 1797 that sent prices through the roof. The precious metal, long a safe haven for investors, yesterday was predicted by a leading analyst to quadruple within three years as buyers seek shelter from prolonged turmoil in mainstream financial markets. According to Christopher Wood, chief strategist at the broker CLSA, market ructions and a collapse of the dollar could send gold prices to more than $3,400 an ounce within the next three years. Gold futures last night hit a 28-year high at $733 an ounce, but are more than $100 short of the record. Mr Wood said that the sub-prime conflagration would be the catalyst for a wider breakdown in markets. However, Wood predicted that investors would soon realise that the sub-prime crisis is simply the catalyst of a much wider breakdown, arguing that it has been the “Archduke Ferdinand assassination event” that sparks a bigger calamity. “This is not a sub-prime crisis. Sub-prime has merely exposed the bigger scam of structured finance; a scam that is about pretending that bad credit is good credit,” he said"

US rate cut decried as 'socialism for Wall St' - ABC News (Australian Broadcasting Corporation)

US rate cut decried as 'socialism for Wall St' - ABC News (Australian Broadcasting Corporation): "A timely correction or an encouragement to further irrational exuberance? Opinion is divided on the United States Federal Reserve's decision to slash official interest rates by 0.5 per cent. Stockmarkets around the globe rallied on the news - the cut was deeper than they had been expecting. The Fed justified it on the basis that the global credit crunch threatened to intensify the serious US housing downturn. But some doubt that the intervention will stop a recession. Others argue that it will make matters worse."

Satyajit Das is laughing.

Satyajit Das is laughing. It appears I have said something very funny, but I have no idea what it was. My only clue is that the laugh sounds somewhat pitying.

One of the world's leading experts on credit derivatives (financial instruments that transfer credit risk from one party to another), Das is the author of a 4,200-page reference work on the subject, among a half-dozen other tomes. As a developer and marketer of the exotic instruments himself over the past 30 years. He seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch -- and I expected him to defend and explain the practice.

I started by asking the Calcutta-born Australian whether the credit crisis was in what Americans would call the "third inning." This was pretty amusing, it seemed, judging from the laughter. So I tried again. "Second inning?" More laughter. "First?"

Still too optimistic. Das, who knows as much about global money flows as anyone in the world, stopped chuckling long enough to suggest that we're actually still in the middle of the national anthem before a game destined to go into extra innings. And it won't end well for the global economy.

An epic bear market

Das is pretty droll for a math whiz, but his message is dead serious. He thinks we're on the verge of a bear market of epic proportions.

The cause: Massive levels of debt underlying the world economy system are about to unwind in a profound and persistent way.

He's not sure if it will play out like the 13-year decline of 90% in Japan from 1990 to 2003 that followed the bursting of a credit bubble there, or like the 15-year flat spot in the U.S. market from 1960 to 1975. But either way, he foresees hard times as an optimistic era of too much liquidity, too much leverage and too much financial engineering slowly and inevitably deflates.

Like an ex-mobster turning state's witness, Das has turned his back on his old pals in the derivatives biz to warn anyone who will listen -- mostly banks and hedge funds that pay him consulting fees -- that the jig is up.

Rather than joining the crowd that blames the mess on American slobs who took on more mortgage debt than they could afford and have endangered the world by stiffing lenders, he points a finger at three parties: regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors; hedge and pension fund managers who gorged on high-yield debt instruments they didn't understand; and financial engineers who built towers of "securitized" debt with math models that were fundamentally flawed.

"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game," he says. "Those loans were invented so that hedge funds would have high-yield debt to buy."

The liquidity factory

Das' view sounds cynical, but it makes sense if you stop thinking about mortgages as a way for people to finance houses and think about them instead as a way for lenders to generate cash flow and create collateral during an era of a flat interest-rate curve. Although subprime U.S. loans seem like small change in the context of the multitrillion-dollar debt market, it turns out these high-yield instruments were an important part of the machine that Das calls the global "liquidity factory." Just like a small amount of gasoline can power an entire truck given the right combination of spark plugs, pistons and transmission, subprime loans became the fuel that underlays derivative securities many, many times their size.

Here's how it worked: In olden days, like 10 years ago, banks wrote and funded their own loans. In the new game, Das points out, banks "originate" loans, "warehouse" them on their balance sheet for a brief time, then "distribute" them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks don't need to tie up as much capital, so they can put more money out on loan.

The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door -- a task that was accelerated in recent years via fly-by-night brokers now accused of predatory lending practices.

Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the United States, these managers leveraged up their bets by buying the CDOs with borrowed funds.

So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.

In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.

Turning $1 into $20

The liquidity factory was self-perpetuating and seemingly unstoppable. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house.

These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper -- the short-term borrowings of banks and corporations -- which was purchased by supposedly low-risk money market funds.

According to Das' figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.

When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion -- or eight times total global gross domestic product of $60 trillion.

Without a central governmental authority keeping tabs on these cross-border flows and ensuring a standard of record-keeping and quality, investors increasingly didn't know what they were buying or what any given security was really worth.

A painful unwinding

Now here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention of what the models forecast, the CDOs those mortgages backed began to collapse. Because they were so hard to value, banks and funds started looking at all CDOs and other paper backed by mortgages with suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today's money markets.

Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been "orphaned," which means that they can't be sold off or used as collateral.

One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a vicious cycle. In this context, banks' objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.

Now it may seem hard to believe, but much of the past few years' advance in the stock market was underwritten by CDO-type instruments which go under the heading of "structured finance." I'm talking about private-equity takeovers, leveraged buyouts and corporate stock buybacks -- the works.

So to the extent that the structured finance market is coming undone, not only will those pillars of strength for equities be knocked away, but many recent deals that were predicated on the easy availability of money will likely also go bust, Das says.

That is why he considers the current market volatility much more profound than a simple "correction" in prices. He sees it as a gigantic liquidity bubble unwinding -- a process that can take a long, long time.

While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did Wednesday, the evidence is not at all clear.

The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.

Lower rates will not help that. "At best," Das says, "they help smooth the transition."

The fine print

Das notes that Japan in the 1990s lowered interest rates to zero and the country still suffered through a prolonged recession. His timetable for the start of the next serious phase of the unwinding is later this year or early 2008. . . . Das' most readable book for laypeople is "Traders, Guns & Money," an amusing exposé of high finance, published last year. Das occasionally writes a blog at his publisher's Web site. Also available are a boxed set of his reference books on derivatives and his book specifically on CDOs. . . .

Perhaps the oddest line on the subject by a world leader was uttered by Luiz Inacio Lula da Silva, the president of Brazil. Asked if he was worried about the effects of the credit crunch in his country, he dismissively called it "an eminently American crisis" caused by people trying to make a lot of "third-class money." . . . CDOs were first widely used back in the late 1980s by Drexel Burnham Lambert junk-bond king Michael Milken to sell off damaged and previously unsellable debt in a way that was more palatable to customers.

why the Titanic was actually a securitisation

10 reasons as to why the Titanic was actually a securitisation instrument:

1) The downside was not immediately apparent.

2) It went underwater rapidly despite assurances it was unsinkable.

3) Only a few wealthy people got out in time.

4) The structure appeared iron-clad.

5) Nobody really understood the risk.

6) The disaster happened overnight London time.

7) Nobody spent any time monitoring the risk.

8) People spent a lot trying to lift it out of the water.

9) People who actually made money were not in original deal.

10) Despite the disaster, people still went on other ships.

Remember Mises

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
Human Action - Ludwig Mises
human action

Safe Haven | HUI Upleg Cycles

Safe Haven | HUI Upleg Cycles: "By this designation, uplegs 2, 4, and 6 were massive uplegs while 3 and 5 were consolidation uplegs. And the recent provisional 7th upleg was also likely a consolidation upleg. If this proves to be the case, then we are now due for the next massive upleg. And if the upcoming upleg 8 is indeed massive, PM-stock investors and speculators have the opportunity to reap absolutely enormous gains in the next 6 to 12 months."

Financial Sense "Liquid Energy" by Elliott Gue 09/14/2007

Financial Sense "Liquid Energy" by Elliott Gue 09/14/2007: "In the most recent issue of The Energy Strategist, I took a detailed look at the Asian coal markets and how Australia is a key beneficiary of growing Asian coal trade. Much of the same is true for natural gas: Australia is fast becoming a major exporter of LNG to Asia. The nation is politically stable, and unlike many other resource rich countries, the government has been fair and transparent in its treatment of resource access and taxation. As a result, Australia has benefited from a massive increase in investment on the part of global energy firms. Source: EIA Australia’s natural gas production is set to increase at an annualized pace of 4.3 percent out to 2030. This is the fastest production growth projected for any country, anywhere in the world. The vast majority of that gas will be exported. In fact, Australia alone accounts for all the gas production growth forecast for the developed world out to 2030. I’ve studied the Australian market in recent years because the country's geographic proximity to Asia makes it an obvious beneficiary of rising Asian energy demand. The only problem is that Australian stocks have been tough for most US and Canada-based investors to access. But that's changing. Interactive Brokers recently gave account holders direct access to Australian stocks for a tiny commission.

Other brokers are considering following that move. And I've noticed that some of the US shares of Australian firms traded on the over-the-counter market have begun to pick up volume lately.

There are a number of ways to play the gas growth theme. One is to buy into the companies that supply compression equipment and provide engineering services necessary to build out LNG infrastructure--mainly gas liquefaction and regasification terminals. And I'm also looking more carefully at a number of Australian and US firms that will be big producers of LNG in coming years.

Cold turkey for financial addiction

Sep 13, 2007
AsiaTimes

By James Cumes

The time for financial detoxification seems to have come. Indeed, it seems to be long past due.

The addiction started with the junk-bond craze and the smart takeover merchants of the 1980s. Those junkies were on relatively soft drugs and they were fringe people - most of the serious investors and financial institutions saw them as market outlaws or barely legal cowboys. They were what I then called "adventurers, marauders and buccaneers". Some crossed the line and were convicted on serious criminal charges.

In 1988, in How to Become a Millionaire, I asked, "How true is it that 'what is happening in the financial markets today bears the same relationship to what happened in the "go-go years" of the 1960s as Caesar's Palace bears to the local bingo game'?" Were we, I asked, "turning the financial markets into a huge casino"?

In the years that followed, we all should have gotten the answer. Soft drugs gave way to hard. Addiction spread. The drugs diversified; so did the addicts. Into the 1990s and dramatically more so into the 21st century, many of those in the top-drawer financial world became addicted. Many became more, more became most, and most in the past few years became all: the biggest and most respectable financial institutions, financiers, creative investors and even regulators joined in with a sense of benevolent enthusiasm that defied any remaining scaremongers.

When everyone in the house is crazy, only the sane seem like fools. So it was when the financial addiction spread everywhere. Then everyone who was not taking his daily dose of heroin or cocaine became the fringe-dweller, the oddball, the brake on progress, the party-pooper at the greatest no-cash-down, how-to-spend-it shindig that our planet has ever known. Debt piled on debt everywhere: in households, corporations, public finances and international deficits, in magnitudes that had never been even glimpsed in the most creative imaginations before.

But the universality of drug-taking does not mean that deadly drugs will not harm and cannot kill.

The deadly nature of the addiction was obscured by the extraordinary variety, complexity and obfuscatory nature of much of the so-called structured finance: credit derivatives, commercial paper, hedge funds, CDOs, CDSs, SIVs, ABCP and the rest. They all looked not only creative but also splendidly professional and expertly managed. Mathematicians joined their creative genius to that of accountants and others to conjured up "models" that were guaranteed, reliable, blue-chip, fail-safe.

Even the most respected rating agencies spread their Alpha ratings around with such glorious abandon that anything else seemed to have gone out of style. Such was the chorus of acceptance that these instruments came to be regarded, above all, as secure as the banks or non-bank issuing or trading institutions confidently presented themselves as being.

So the final accolade was conferred on financial instruments that, in any world except one in which the entire population had gone crazy, would have been condemned as the deadly instruments of financial, moral and other ruin that they surely were - and are now proving themselves to be.

As one analyst writes: "Before this mess finally ends, there are going to be scores more hedge funds, pension plans, mortgage lenders, and possibly even banks carted out in a wagon wishing they never heard the terms 'swap', 'swaption', 'conduit', 'MBS', 'CDO', 'CDS', 'SIV', 'Mark to Market' and probably a dozen other terms as well."

Perhaps the credit derivatives, in all their manifestations, were the most addictive. They were as modern and creative as the latest technological marvel. From the initial concept in the late 1990s, they gave a dream ride to the mostly young, very smart people who were able to ride to financial glory on a tide that quickly swept along even the most staid, respectable and financially distinguished institutions in the United States and, in surprising measure, also around the world.

If some were spared addiction in the early years, they became fewer and fewer right up to July 2007. The regulators, including central banks, international agencies and others, did not regulate the ever thicker jungle of financial enterprises and their innovative financial products because, more and more, the addicts lay outside the banking system and therefore largely or wholly outside their jurisdiction.

The banks did not stay aloof from "structured finance" of virtually every kind, but they managed their participation in it, for the most part, in ways that avoided interference by the regulators - if, that is, the regulators might have been disposed to interfere. Increasingly, they accepted some form of "moral hazard", just as major banks at the very top of the financial heap did in their dealings with Enron in the course of its fraud and failure at the end of the 20th century and into the 21st.

So the addiction grew and spread without restraint - it became a sort of global financial frenzy sans frontieres - and the law-enforcement officers, having no powers of enforcement and/or no will to enforce, either cheered them on or snored at their desks.

Until now. Even yet, they are not wide awake, but they have now begun to stir.

When they do become fully alive to what has happened, they will be even more appalled at the terrifying financial situation that confronts them than many of us among the non-addicted are now. Their attempt to resolve that situation in any way that can be called acceptable will reveal both their culpable negligence in the past and, ultimately, their despair of finding any "cure", any "magic elixir" or any "soft landing" in the period ahead.

They will discover that they and the speculators, high rollers and just plain gamblers in global finance have been indulging an addiction for which there can be no painless detoxification. The addiction has persisted for too long and has become too deep and widespread.

To begin with, the addiction is too huge. The "value" of the creative financial paper circulating the globe is calculated, as close as one of our "experts" can reasonably count it, to be US$480 trillion. The Bank for International Settlements puts its count at $600 trillion. In fact, we do not know what the precise sum may be, but we do know that it is so mind-boggling that it seems to lie outside all reality.

What is certain is that somewhere in that massive sum are debts that have to be repaid and creditors who have to be satisfied; and we know that it is a domino game. If the creditors of the first debtor aren't satisfied, then they will become, in their turn, defaulting debtors for their own creditors; and so on down the line and around a global mulberry bush.

Global gross national product s calculated to be about $50 trillion a year. So the figure of $480 trillion is close to 10 times the entire global annual GNP, and $600 trillion is about 12 times. Alternatively, we can say that the "notional value" of the various pieces of financial paper circling the globe at the moment is probably somewhere between 40 and 60 years of the United States' GNP. It is several times the estimated market value of aggregate global wealth.

How much of this is double-counting? How much of it requires the liquidation of real assets to satisfy a structured-finance debt? We don't know, just as we don't know the answers to many of the magnitudes involved in what is undoubtedly the greatest, most complex and most intimidating financial problem that national economies or the global economy as a whole have ever faced. William Wordsworth wrote about "huge trunks, and each particular trunk a growth of intertwisted fibers serpentine up-coiling, and inveterately convolved". He could well have been writing about current financial instruments and the "system" they have contrived.

The unease, verging on panic, about subprime mortgages has given us a glimpse of what is ahead. But let us be very clear, it has been only a glimpse. Subprime securitized mortgages are only a relatively tiny part of the huge credit and debt structure involved in what we may group under the generic name of derivatives. They include credit derivatives, hedge funds, private-equity deals, mutual funds, pension funds and the whole gamut of financial instruments that have flooded not only US markets but markets around the world, especially in the past five to 10 years.

However, if the subprime crisis has given us only a glimpse, it has also given us a terrifying preview of what is yet to come. The first clear point is that the various pieces of financial paper do represent debts that have to be repaid or somehow liquidated. Creditors demand their money, and debtors must find the money to pay them, with the penalty for default heavy losses, with possible bankruptcy. The latter is especially likely in a world in which credit has become tight.

The second crucial point is that we don't know the "value" of the financial paper except in nominal or notional terms. On the books of the debtor it is "marked to his model"; and, most likely, on the books of the creditor, it is "marked to the model" of the creditor in the same way, or even more advantageously. However, the only thing that really matters in the end is how it is or will be "marked to market" at the moment of time when the market is called upon to pass judgment by giving it a cash value.

In this regard, we should note that financial assets worth trillions of dollars are from over-the-counter (OTC) transactions for which there is not and never has been any "market" to mark them to. They will not have an authentic market value until the moment comes for the deals to be liquidated in one way or another.

In a bull market, financial paper might be sold well above the "mark to model" price; but it is not at that point that the holder might be most likely to sell - or, most important, be forced to sell. It is when the market has become nervous, when confidence has been diminished and when the bears have begun to crowd the markets that the price will become most relevant and crucial.

Then, with the markets as we have seen them in the past two months, the price of the securitized paper is likely, as one analyst put it, to go "Pouf!" In other words, as we have seen with some of the paper of such a previously highly respected firm as Bear Stearns or a major bank such as BNP Paribas, the paper can become or be seen to be worthless, or very nearly so.

Does that result in real losses? For someone, it certainly does, however much the institution may say that it is in a position to bear those losses - of a few billion, tens of billions or, in some cases, hundreds of billions of dollars. Recently, the spotlight has been on subprime mortgages; but this is only because the collapse - the inability to pay outstanding debt - happened to appear there first.

We should have expected that. The mortgages, or a high percentage of them, were, it would seem deliberately - certainly with a high degree of studied negligence - designed to fail. They did fail; but the important thing is that, even in the wider housing-mortgage market, prime mortgages have been failing too - and they will continue to fail.

Household debt in the US and some other countries is more enormous and potentially more crippling that it has ever been before. In more and more instances, the mortgagee will be unable to service his debt - a real debt, whose failure, in aggregate, will have a real impact on the national and global financial situation and, eventually but fairly rapidly, on the productive economy.

So the infection will become an epidemic that will spread to the whole housing market; and markets other than housing have been deeply involved in the structured-finance caper. Credit derivatives of all kinds, a rapidly proliferating range of hedge funds, private-equity groups and the rest have shown no hesitation to exploit smart financial and above all, highly leveraged opportunities wherever they may have been offering.

Most of that enterprise has thrived - and can thrive only - in a booming market in which more money flows into the schemes than goes out; so there is a Ponzi element in much of current creative financial enterprise that makes its collapse as inevitable and potentially as destructive of value as the subprime mortgage debacle has been.

When the net inflow of funds into these schemes becomes a net outflow, the whole structure must inevitably begin to crumble. Hedge funds have been particularly - perhaps we can say, inherently - susceptible to collapse. Thousands have come into existence in recent years; and thousands of them have gone out of business. That has happened characteristically even when markets were booming. In recent years, those who exited the business were fewer than those who entered.

But now that the boom has turned more clearly in the direction of a bust, hedge funds heading for the exits have been increasing in numbers. If the exits are not crowded yet, it won't be long before they will be. Only those in the more traditional style of hedge funds - hedging genuinely for themselves and others who may be their clients - may survive.

One analyst has suggested that the current credit crunch has given us a chance "to see the hedge-fund emperors without their clothes". It has also been "an opportunity for investors to get some insight into an industry whose activities are often cloaked in secrecy and which has wandered far from its original purpose of hedging volatility" (Sharon Reier). That original purpose was to manage market risk by, for example, hedging long and short positions with modest leverage.

The contrast with the funds as between 6,000 and 10,000 of them have now evolved is stark. Even of the widely respected "quants" - the computerized quantitative or black-box models of the mathematical whizzes - Donald Pinto, an experienced hedge-fund manager himself, is quoted as saying, "The programs are quite sophisticated. They do work in stable markets, but they have a fundamental weakness. There is no room for judgment. When markets behave erratically - as they have recently - the inability to use common sense to make investment decisions, combined with a high level of leverage, is a recipe for disaster."

With the hedge-fund industry claimed currently to be the volatile repository of about $1.7 trillion, this can only give cause for acute alarm.

The fragility of the "system" can be seen further by analyzing each of the various elements contained in what is high-risk, speculative, "ownership" investment. That "investment" looks principally to profits through asset appreciation. The prices of assets are driven up because of a speculative fever and that fever, as in many asset-price booms of the past, is embedded in a conviction or expectation that it will feed on itself to drive prices to ever more feverish and ultimately unsustainable heights.

These booms persist only as long as funds are there to nourish them. If the flow of those funds diminishes or, more particularly, if their flow is reversed, the booms have historically and characteristically been prone to sharp collapse.

The present financial situation is more complex than any we have known before and has tended to draw in all markets - for stocks, real estate, currencies, gold, commodities and the rest - if only because what we may call the broad category of "derivatives" characteristically "derives" from those markets. Despite this spread and complexity, we may still postulate that the fundamentals of market behavior remain the same.

It is in that context that we might consider some elements in the present global financial situation. One such element is the carry trade. Its essence is that money is borrowed in a market where borrowing costs are low and invested in markets where returns are high. This has meant borrowing, for example, in Japan or Switzerland and investing in, for example, Australia or New Zealand - or, for that matter, Iceland or the United States.

The carry trade has apparent advantages. It is part of the financial regalia that enables the high-consumption economies to keep right on consuming; but that coddling of debt-based consumption also has its price, particularly by creating huge trade and payments deficits and by stimulating the export not of products of domestic industry but of the industry itself.

The US dollar, for example, loses value vis-a-vis "producer" currencies and commodities, its role as a reserve currency is undermined, and volatility - on which speculation thrives - replaces the stability derived from, for example, gold or the system based on the dollar, which in turn was related to gold, contemplated under Bretton Woods. Stability is replaced by an anarchy that encourages movement away from production and fixed-capital investment into asset-price speculation and "ownership" investment.

Another part of the price is that the tap might be turned off at any moment, and perhaps quite sharply, if the carry trade reverses - and, sooner or later, reverse is what it certainly will do. If the Japanese yen appreciates or threatens to appreciate sufficiently or if interest rates in Japan move up significantly, a robust carry trade will rapidly become a robust unloading exercise.

The outcome can then be that asset-price booms are sharply collapsed and, down the line a little, consumers too are required to adapt themselves to more Spartan living. The export-driven economies, which are based on high consumer-export markets, will also be hurt. So the markets will carry the impact of speculative volatility from one point to another.

As part of this, we might just take a quick look at the way in which the housing market in Australia has appeared to evolve. Recent years brought a frenetic boom to Australian residential property, especially in Sydney and, to a lesser but significant degree, in Perth. The boom then showed signs of slowing, again especially in Sydney.

That tendency to slow still applies to the Sydney market, although prices even there have recently seemed to be moving up again. However, what seems to be especially worthy of note at this point is that prices in the capitals of most of the other Australian states seem to be heading or to have already gone into frenetic mode. This is despite affordability for houses and apartments having declined dramatically for the average buyer. So it would seem that much, at least, of the persistent boom in housing is due to speculation rather than to demand from the consuming public.

That suggests that funds have been flowing into the housing market, presumably in a quest for capital gains through asset-price inflation. Where have these funds come from? Frankly, I do not know from any reliable data available to me; but a reasonable hypothesis may be that some of it is foreign money, possibly from the carry trade, seeking to find profitable outlets for the money borrowed cheaply in - most likely - Japan.

The housing that is being bought in Australia, except possibly some in Sydney, would seem to be different from the largely alpha-luxury property that, for example, is being bought in London by foreign money seeking speculative outlets for investable funds; but something the same kind of speculative stimuli may be producing much the same kind of ultimately unsustainable property boom in Australia.

In either the Australian or the London case, a collapse of the housing market - along probably with a collapse of other asset markets - is inevitable. It is a question only of when rather than if.

That "when" might now be rather close. It could get under way as early as the next couple of months. October and November have seemed to be dangerous for events of this kind in the past. The US stock-exchange crashes of 1929 and 1987 are examples. The current nervousness on Wall Street and stock markets around the world may quickly flow on to asset markets everywhere.

Central banks now recognize the dangers of a meltdown in credit markets and seem ready to do whatever they can to prevent it. They have already made available to banks at least half a trillion dollar-equivalent loans to give them extra liquidity. The US Federal Reserve has cut the discount rate. They have kept the more general interest rate, or "bank rate", on hold, and some might be about to reduce it.

But the feature that is perhaps of most significance and that carries the most startling risks is their willingness, already demonstrated by the Fed, to accept "securitized" paper, even relatively high-risk collateralized mortgage paper, as security for their loans to the banks. That process would seem to mean that that paper would become, in some measure, a substitute for Treasury bills or similar securities of other central banks that have been used in traditional open-market operations in the past.

Already the limited acceptance of this paper is a token of its extraordinary evolution toward respectability. The junk bonds or creations of what I once called the "adventurers, marauders and buccaneers" have now been endorsed by central banks as seeming to belong in the same ball-park of acceptability as gilts or Treasuries.

This may be, on the one hand, the only real way to deal effectively with the disruption to credit that this paper has caused and threatens further to cause on a vastly greater scale. Only in this way, perhaps, can the vast burden of intrinsically speculative debt be "neutralized". On the other hand, if the practice is indulged in any sufficient way for it to be effective in its "neutralizing" function, it will destroy the US dollar and perhaps other currencies and put the entire global financial system as we have known it at grave risk.

To make "liquidity" available to the banking system is not to be certain that the banking system will use it in a way to keep the credit markets adequately open to normal commercial business. At the same time, if the central bank proves willing to accept any amount of this securitized paper, then it would mean the injection of mountains of paper currency into the financial system, presumably starting with the United States but possibly or probably extending to other major financial markets and ultimately polluting the entire global system.

If the "notional value" of derivatives is something of the order of $600 trillion, we do not have to postulate that the central banks will absorb and "neutralize" all of this paper. Even if they were to absorb only 10% of the notional value, this would amount to about $60 trillion - more than the GNP of the entire world economy.

The figures are so staggering in themselves that the mind boggles; but perhaps the even more important thing is that we - and the central banks - cannot know the true extent of the problem that confronts them. Will they have to accept "only" 10% of this paper or will 1% turn out to be enough? If only 1%, what impact would acceptance of paper to that amount - $6 trillion - have in unfreezing the credit markets?

Would it also mean that central banks would have embarked on a course of hyperinflation that would make the US dollar and possibly several other major currencies worthless? There would then have to be an issue of new currencies as there was after the hyperinflation in Germany in the 1920s. There would also have to be a fundamental renegotiation of the ways in which the global financial system would operate.

All of that would take time. While it was going on, national economies and the global economy could be brought near to standstill. Economies might have to resort to some form of barter as the only way in which trade could continue securely to take place. Unemployment would become socially devastating. Many personal fortunes would disappear. There would be a whole reordering of societies and of relations among countries that might offer the most terrifying outcomes in terms of conflict of all kinds, including wars - civil, regional and worldwide.

Some analysts have been contending that the prospect of a depression - another great depression of global dimensions - has been feared for so long now that it will not be allowed to happen. That is too optimistic. Governments and central bankers will not want it to happen, but they have so far failed so miserably to prevent or deter us from stampeding to the brink that, whatever their motives may be, they seem now unlikely to be able to stop us from going over the edge.

Therefore, the best that we can hope for now may be that governments, central banks and others will apply such palliatives as they can without allowing their support of speculation to add further to destruction of the global economy and financial system, while at the same time embarking on national and international measures to restore primacy and vigor to fixed-capital investment, productivity and production in the real economy, national and global.

That raises the question of the impact and its extent that financial collapse will have on the real economy - the productive economy. The short answer is that it must inevitably be somewhere in a range from severe to devastating.

The immediate depressive effect of what we have already is likely to be sharp and severe. Employment in the United States appears already to have moved down sharply. This is largely in housing and construction, which contributed so much to growth in the recovery and boom years after 2001, and in associated industries such as durable goods, retailing and distribution, real-estate agencies and associated professional and legal services.

Consumer demand, which drew so much of its vitality from the housing boom, will be severely hit. Credit-card debt will have to be wound down. Auto credit is likely to diminish both in demand and supply, and the auto industry could suffer severely. So the impact of credit problems will flow through the US economy and must also impact on the trade that the United States will be able to conduct with the rest of the world.

The dollar is almost certain to decline in value, perhaps precipitously, especially in gold and key-commodity terms, and force a reduction in demand for imported goods. This will be in part beneficial for US exports; but domestic industries, especially in the more basic consumer sectors, are unlikely to be able to replace, at least in the short term, supplies from overseas. No longer the consumer without limit, the US will almost certainly infect other countries with its slowdown, recession or depression, and that in turn will reduce growth, investment, employment and output around the world.

Even the boom in commodities, though it might survive more robustly than other sectors, will certainly be affected and diminished, as demand collapses in other sectors. In other words, we are likely to see the characteristic snowball effect on trade and growth that we have experienced in similar - though almost certainly less devastating - circumstances in the past.

Some countries, such as China, which have more effective regulatory control of their economies as well as the inherent size and strength to "go it more nearly alone" may transit the worst of the coming crisis less painfully than some others.

To emerge from this crisis or complex of crises, we will need to resume attitudes of mind and policy that we had after 1945. After 20 years of world depression and world war, there was then a widespread passion for rebuilding national economies and the world economy on a sound basis of stability and growth, through multilateral cooperation for peaceful change.

Now we need to restore value to what produced real income and wealth for us in the past. We will need national institutions which can help us restore that value; and we will need to rebuild our international institutions. The United Nations and the host of associated or independent international institutions have proved to be useless or worse than useless, especially over the past three to four decades.

Their achievement has been to bring us to the brink of a tragedy - economic and financial in its outward aspects, but with deep political and strategic implications - which threatens to be the most cataclysmic to confront us during all the years since the advent of the Industrial Revolution.

So in a sense, the task that confronted us in 1945 is the task that confronts us again: to rebuild the world to a better pattern of economic and financial policies and practices, and to do so cooperatively and imaginatively, with the participation of all those of whatever backgrounds who share our objectives of positive and peaceful change. It is a huge task. It calls for cooperation among all countries and all regions, all races and all faiths if we are to see our way through it safely.

In tackling that task, we must start now. We have just seen an Asia-Pacific Economic Cooperation summit in Sydney that has been an exercise in futility, both in discussing vital issues in ways that could serve no purpose and ignoring issues whose neglect could bring us to the brink of self-destruction of much of human civilization. The APEC meeting reflected the impotence and irrelevance that a plethora of international gatherings and self-styled "summits" have displayed in recent decades. We must not persist in flagrant indulgence in this empty, exhibitionist futility.

The process of building new and effective international economic institutions was set out some years ago in my proposals for "Victory Over Want" (VOW). These proposals have been developed further in my proposals for a World Economic Authority and a World Development Authority put forward in my latest book, America's Suicidal Statecraft: The Self-destruction of a Superpower. There are other proposals being put forward, many of which are worthy of careful and urgent consideration.

However, with the best will in the world and with the utmost cooperation among the world's major powers, creating effective international agencies will take time. Until then, it seems inevitable that we cannot avoid some elements of a "cold-turkey" detoxification from the addiction to which our economic and financial policies have delivered us.

That "cold-turkey" detox threatens to be the most painful experience that the national economies and the world economy as a whole have suffered in the two or three centuries of the Industrial Revolution. It must be our objective, therefore, to keep this phase as short as we possibly can and to move to the phase of rebuilding through effective national and international measures and institutions as soon as may be practicable.

That is the imperative that we should now acknowledge and should seek to satisfy with all the energy, creativity and urgency we can contrive.

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Dr James Cumes is the author of America's Suicidal Statecraft, as well as other fiction and non-fiction works.


RE: My email to McCulley (shorter)... Thomas

NEW 9/12/2007 8:16:19 AM
Post Your Reply

Paul:

Your article on not bailing out Wall Street, but bailing out Main Street implicitly removes culpability from Main Street. The modern day consumer could use a little less--actually, a lot less--resiliency. As far as the eye can see there are lessons to be learned. Credit isn't tight. When I was a young punk with a full time job at Cornell, I was turned down for my first credit card. My college room mate and recently retired Senior VP at Goldman (Rick Sherlund) was turned down for his first credit card. My brother, while working at Arthur Young, was also on the rejection list. My house was 20% down and maximum 28% of gross salary. Now THAT's tight credit. Main Street needs to sober up (start saving, stop spending), and it won't happen as long as the tap keeps getting opened up. Consumers shouldn't get a put; they should get a kick in the butt. The system (especially central bankers who should know better) has become very purge-averse. Modern day purging is exemplified by lost pension plans and corporate restructuring; I think it should be liquidating companies (like a few airlines) that can't meet their obligations. Creative destruction and fault lines in California are metaphors of each other. Pay now or pay later.

But that's just one amateur's opinion. Sorry for the rant. I've read too many articles stuffed with pleas for help and promises to repent.

Hedge funds post shock losses

Some of the grandest names in the hedge fund world suffered last month having failed to anticipate the turmoil in the markets and failing to produce the absolute returns they promise investors.

The list of badly-hit hedge funds in August reads like a Who's Who of the best-known on Wall Street, according to investors.

They include Paul Tudor Jones, philanthropist and head of Greenwich, Connecticut-based Tudor Investment Corp; his friend and former colleague Louis Bacon of Moore Capital; Bruce Kovner, super-secretive head of Caxton Associates; and Matthew Tewksbury, who bought Wall Street trader Monroe Trout's hedge fund business and renamed it after himself.

The falls leave many of the biggest hedge funds in the world telling investors they have lost money for the year to date, while some of those that weathered the storm – such as Raymond Dalio's Bridgewater Pure Alpha fund – have returns this year only just better than cash.

The results are likely to rattle investors who are worried that the hedge industry had one of its worst months in August.

"There's a big concern about the redemptions in September in the hedge fund industry," said Arnauldt de Torquat, chief executive of Harmony Asset Management, a London fund of hedge funds that has not faced big redemptions itself.

The difficulties at Tudor are particularly painful for investors because Tudor – founder of the biggest hedge fund charity, the Robin Hood Foundation – profited handsomely from the 1987 market ructions, correctly betting that the market would fall.

Tudor BVI Global, the $6bn fund run by Mr Tudor Jones, tumbled 5.5 per cent in August to leave it down 1.5 per cent for the year, while Raptor, the $6bn Tudor fund run by head of US equities James Pallotta, was down 5.6 per cent in the month and down 9 per cent for the year so far, investors said.

Caxton's $11bn flagship fund was down 4.8 per cent in August, for a loss of 1.5 per cent this year, while Tewksbury's $3bn Investment fund fell 8 per cent, more than wiping out all this year's gains. Moore's $7bn Global fund fell 5.7 per cent in August, and its $4bn Fixed Income fund was down 4.3 per cent, although both remain up for the year.

Many other big-name managers struggled in August, with Atticus, a New York-based activist and financial specialist, down more than 10 per cent in both its flagship funds as holdings including Barclays and Deutsche Börse were hit hard in the month – although both funds remain up for the year.

Third Point, an aggressive activist run by Dan Loeb, was down 8.3 per cent, leaving it up 6.8 per cent for the year, while in the UK several funds from Lansdowne, GLG and Sloane Robinson had a weak month, investors said.

Jeffrey Gendell, who runs Tontine Associates from Greenwich, Connecticut, produced one of the worst results of all the big name managers with a 7.9 per cent drop in his $1bn Overseas fund – although it is still up 7.6 per cent this year. By contrast, his Financial Partners fund leapt 8.4 per cent in the month, one of the best performances – but remains down 37 per cent for the year, among the worst of all managers.

However, some well-respected managers have done very well. John Paulson of Paulson & Co produced another month of spectacular returns across his funds thanks to aggressive shorts of US subprime mortgages. Philip Falcone's Harbinger Capital distressed fund gained 3.7 per cent to take its total return for the year to more than 55 per cent.

Big name managers Dan Och of Och-Ziff, Izzy Englander of Millennium Partners and David Tepper of distressed debt specialists also came through the month with gains or slight falls, leaving them securely up for the year. The $6bn Bridgewater Pure Alpha fund was up 0.4 per cent for the month, for a gain of 3.6 per cent this year.

Copyright 2007 Financial Times

Credit Crunch – The New Diet Snack for Financial Markets

Charts


September 5, 2007
Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management and is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).



Living in the Kaliyuga …


Inflexion points in financial markets are difficult to identify. As Yogi Berra observed: “making predictions is difficult, especially about the future”.


In Indian mythology, we are in the Age of Kali - the last age. The world ends when Kali dances the dance of death. There are no such clear markers in markets. Recently, we came close - Jim Cramer, a CNBC pundit, launched a “we’re in Armageddon” tirade on air. Embattled Bear Stearns’ CFO Samuel Molinaro pleaded: “I’ve been out here for 22 years, and this is as bad as I’ve seen it in the fixed-income markets.” Kali had begun to shake her booty. The credit bubble was finally deflating.


In 2007, householders in “cabbage-ville USA” (an English fund manager’s term) failed to make repayments triggering a global credit crisis. Markets ruminated about “a re-pricing of risk”. The faux “business as usual” calm masked the fact that the problems threaten to be the single largest credit crisis since the Savings and Loans collapse in the USA in the 1980s.


The early 2000s were a period of “too much” and “too little” – too much liquidity, too much leverage, too much complex financial engineering, too little return for risk, too little understanding of the risks. Steven Rattner (from hedge fund Quadrangle Group) summed it up in the pages of the Wall Street Journal: “No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower.” Traditional money fueled by loose monetary policy, excessive capital flows and now turbo-charged by “financial engineering” lies at the heart of the current credit crisis.


Structured Credit - Supersize My Debt!

Candyfloss (cotton candy or fairy floss) - spun sugar - consists mostly of air. It is the quintessential experience of a visit to a fairground. New financial technology is “candy floss” money 1- money spun out and expanded into ever larger servings. Derivatives, securitisation and collateralised lending allow fundamental changes in credit markets and leverage.


Derivatives – highly leveraged commercial bets on movements in prices of interest rates, currencies, shares and commodities - can be used to manage or create risk. Investors increasingly use derivatives to increase risk to earn higher returns. As at the end of 2006, derivative outstandings were around $485 trillion. In comparison, total global Gross Domestic Product is around $ 60 trillion. Derivative trading created additional liquidity and leverage.


Derivatives on credit instruments are a relatively recent innovation. A credit default swap (“CDS”) is credit insurance on a specific company. The buyer of protection (usually a bank who has lent money to the company) pays the seller of protection (usually an investor) a fee. In return, the seller of protection covers the bank buying protection against losses should the company go bankrupt. CDOs are steroid-fueled mortgage loan securitisations. A portfolio of loans, bonds or mortgages is assembled. Interest and principal from the underlying portfolio is used to make payments on the CDO securities issued to investors.


In a CDS contract, unlike a loan or bond, the investor is not required to pay the full face value. CDS volumes are not limited to the outstanding amount of debt. General Motors has around US$130 billion of debt. CDS volumes on GM are around 6 to 10 times that. CDSs allowed the credit markets to “supersize” trading volumes.


In CDOs, the bank uses the dexterity of the Iron Chef to cut and dice the risk of the underlying loans. “Tranching” allows the creation of different CDO securities - equity, mezzanine and senior debt. Equity receives high returns and bears the most risk. If there are losses on the portfolio of loans then equity takes the first losses. The senior note holders take the least risk as they are first in line to get paid and last to lose. They get low returns but more than on comparable traditional securities. Mezzanine (code for subordinated debt) is somewhere in between. Tranching is used to alter credit ratings on portfolios of A/ BBB loans to manufacture AAA/ AA securities.


CDOs concentrate risk and increase the potential gain or loss for a given event. CDOs are based on “diversified” underlying portfolios; e.g. a $1,000 million portfolio made up of 100 loans of $10 million each. Assume that if any of the 100 firms goes bankrupt, you lose $6 million (60% of $10 million). If the equity tranche is $20 million (2%), then the investor takes the risk of the first 3 firms to go bankrupt out of the 100 firms in the portfolio ($20 million of losses divided by $ 6 million). The investor’s risk is not diversified; it is taking the risk on the 3 worst firms out of the 100 in the portfolio.




If the investor invested $20 million in the 100 loans ($200,000 per corporation calculated as $20 million divided by 100), then 3 defaults in the portfolio would result in a loss of only $0.36 million (loss of $120,000 per company (60% of $200,000) times 3). In a CDO, if there are the same 3 losses then the equity investor losses $20 million. The leverage to default is 56 times ($20 million versus $0.36 million). Frequently, the holder of the equity tranche borrows to fund its stake further increasing leverage. A regulated bank can leverage around 12 ½ times. CDOs concentrate credit risk – the term is “toxic waste”.


The structured credit market has supersized debt levels using techniques of staggering complexity, incomprehensible to all but a small group of practitioners. The market was so “like hot” that one professional confessed that even his headhunter had been recruited into a structured credit role at an investment bank.


Would you like debt with that?

Repurchase agreements or “repos” (secured lending against government securities) and margin loans (lending secured against stocks) are well established. Now, investors use repos to raise substantial amounts against any security or instrument, including distressed debt.


Investors routinely structure asset purchases as a total return swap (“TRS”). The investor receives the return on the asset (income and increases in price) in return for paying the cost of holding the asset (decreases in price and the funding cost of the dealer). The investor posts a modest initial margin or “haircut” and promises to post more cash if the value of the asset declines. The trader has bought the asset with money borrowed from the dealer with which it entered into the TRS. Favorable regulatory rules, optimistic views of liquidity (the collateral must be sold if the borrower fails to pay) and faith in the models used to set the margins drives aggressive use of collateral increasing available liquidity and leverage.


Banks have also institutionalized the collateral game in a plethora of off-balance sheet structures – arbitrage or conduit vehicles; structured investment vehicles (“SIVs”). The vehicles purchase high quality securities like AAA or AA rated CDOs and fund them with short-term borrowings (usually, commercial paper (“CP”) issued to money market funds). $1.2 trillion or 53% of the $2.2 trillion commercial paper in the US market is now asset backed, around 50% by mortgages. When investors now buy assets, the dealers automatically ask: “would you like debt with that?”


The New Liquidity Factory 2

Banks traditionally wrote and funded their loans. In the new money game, banks “originate” loans, “warehouse” them on their balance sheet for a short time and then “distribute” them to investors using CDOs. Banks require less capital, as they don’t hold the loan for its full term. The process encouraged declines in credit standards. The game relies on the ongoing liquidity of the market for securitised debt.


When the loans are sold, the bank effectively receives the difference between the interest on the loan and the return demanded by the investor “upfront”. As loans are sold off, more loans must be written. Ever larger volumes are necessary to maintain profitability forcing banks to rely on brokers. In the new money game, banks increased loan volumes, reduced capital available to absorb risk and lowered the credit quality of their loans all at the same time.


Insurance companies, pension funds, asset managers, banks, and private clients are buyers of credit risk. Hedge funds moved into the credit markets in search of higher returns based on leveraged structured credit instruments. The high returns came with additional risks – a lack of liquidity and complexity of the securities. Buyers from Switzerland to Slovakia, Boston to Beijing bought up credit risk. A feature of credit investing was that the complexity and risk of structures was inversely related to the understanding of the investor being sold it.


In the new liquidity factory, investors did the borrowing - hedge funds borrowed against investments; traders borrowed cheap money (especially yen at zero interest rates) to fund high yielding assets in the famous carry trade. Financial engineering disguised leverage so that an investor’s balance sheet today does not tell you the amount of leverage being employed.


The new liquidity factory is self-perpetuating. If you bought assets with borrowings then as the asset went up in price you borrowed more money against it. In an accelerating spiral, asset prices rise as debt fuels demand for the asset. Higher prices decrease the returns forcing the investors to borrow more to increase returns. Bankers became adept at stripping money out of existing assets that had appreciated in price, such as homes. In the USA, UK and Australia – the fast debt nations - home equity borrowing funded a frantic debt addiction.



By the early 2000s, the new liquidity factory had created a money pyramid that had no parallel in history. Diagram 1 sets out the money pile in modern markets. The tsunami of debt fueled price increases in financial assets - debt, equity, property, infrastructure. The current market volatility is not simply a correction in prices but this gigantic liquidity bubble unwinding.


Diagram 1

The New Liquidity Factory







Lying NINJA Mortgagors

A German banker recently accosted me: “vhat does a poor American defaulting in Looneyville, West Virginia have to do vith me?” There were also defaults in Gravity Iowa, Mars Pennsylvania, Paris Texas, Venus Texas, Earth Texas, and Saturn Texas.


Deregulation, abundant liquidity and rising house prices encouraged lenders to target less affluent borrowers with poor credit histories who have long been excluded from the American dream of home ownership. Sub-prime and Alt A housing loans included “innovations." 3




Loan to value ratio (“LVR”) – traditional mortgages provide 70-80% of appraised value. Sub-prime mortgages had more aggressive LVRs including “negative” equity loans (the lender is lending more than the value of the house). Undisclosed “piggyback” loans and silent second mortgages eliminated any deposit requirement.

· Interest payments – sub-prime mortgage repayments sometimes don’t cover interest on the loan. In a negative amortisation loan, the principal actually increases as interest is not covered. There were “teaser’ rates – 2/ 28 mortgages where there are artificially low rates (as low as 1%) for the first 2 years with the loan interest being reset at the end of the “honeymoon” period. Sub-prime mortgages were adjustable rate mortgages (“ARMs”) rather than the more typically fixed rate mortgages.

· Jumbo loans – these were large loans (above $417,000) needed to finance more expensive houses.

· Credit review and loan underwriting standards – the mortgage industry increasingly relied on credit scoring models. Statements of income and assets are not checked. Outsourcing mortgage origination to brokers and shifting of risk to investors led to a systematic decline in underwriting standards.

· Purpose of loan –a high portion of sub-prime was directed to monetisation of the equity in existing homes; between 2000 and 2005, total mortgage equity withdrawal increased from $289 billion to $900 billion.

Around 2003/ 2004, the housing market began to slow. Banks and brokers maintained volumes at the expense of even weaker standards. LVRs rose and documentation requirements collapsed. Demand for long term high-yielding assets from investors fueled the securitisation process that the sub-prime market relied upon. By 2007, the sub-prime market accounted for 20% of new mortgages and 10% of all mortgage debt.


Francois Rabelias, the French author, observed in the 16th Century: “debts and lies are generally mixed together.” NINJAs (“no income, no jobs or assets”) able to sign their name could buy a house without any money. In 2006, Casey Serin, a 24-year old web designer from Sacramento, bought seven houses in five months with US$2.2 million in debt. He lied about his income on “no document” loans. He had no deposit. In 2007, three of his houses were repossessed. The others face foreclosure. Serin’s website - www.Iamfacingforeclosure.com - has become the symbol of the excesses of the sub-prime mortgage market. 4


Hedge funds used leverage to “enhance” returns on sub-prime debt. Diagram 2 shows how a hedge fund uses $10 million to take the risk of the first $60 million of losses on a $850 million portfolio.5


Diagram 2
Investor Leverage






Source: Based on Merrit, Roger, Linnell, Ian, Grossman, Robert and Shiavetta, John (18 July 2005) Hedge Funds: An Emerging Force in Global Credit Markets; Fitch Ratings, Special Report, New York



A Gradual and Sudden Death


The “Goldilocks” economy led one commentator in 1997 to assume that the business cycle had been abolished.



“We are watching the beginning of a global economic boom on a scale never experienced before. We have entered a period of sustained growth that could double the world’s economy every dozen years and bring increasing prosperity for – quite literally – billions of people on the planet. We are riding the early waves of a 25-year run of a greatly expanding economy that will do much to solve seemingly intractable problems like poverty and to ease tensions throughout the world. And we’ll do it without blowing the lid of the environment.”6

Unfortunately, interest rates increased sharply in the US. Central banks tightened liquidity as inflation rose driven by higher oil prices, increasing costs in emerging countries and infrastructure constraints. US house prices stalled and then fell. Delinquencies in sub-prime mortgages reached 15% and in some types of loans approached 30%. Defaults rose. at an uncomfortable 45’ gradient.


In 2006, an asset based securities credit index had been introduced to provide some transparency to the opaque CDO and mortgage markets. The ABX.HE (Asset backed Securities Home Equity) entailed five separate indexes (AAA, AA, A, BBB, BBB-) referencing similarly rated tranches of 20 securitisation transactions. The BBB- 2006 index collapsed from around 100 to initially 60-70% of face value to its current level of around 30-40%. It was, according to Luiz Inácio Lula da Silva (“Lula”), President of Brazil, “an eminently American crisis” caused by people trying to make a lot of “third-class money”.


Like engine oil, credit lubricates and keeps the financial motor running. The oil was leaking out rapidly; the engine was seizing up. Sub-prime mortgage lenders closed as business dried up. Investments in the riskier tranches of the securitised mortgage pools were worthless. Investors in the “safe”, higher rated – AAA and AA tranches – had real problems In a typical securitisation, actual losses on the underlying mortgages pool would need to rise above 15-30% before they suffered losses. AAA tranches were quoted (if you could find a quote!) at between 80-90% of face value. AA and A were lower again.


The AAA rating of senior tranches is based on layers of subordinated securities to absorb initial losses. As expected losses mounted and the lower layers were eaten away, the AAA rating of the senior tranche fell leading to mark-to-market losses – i.e. what the security is worth if sold today.



If the investor ignored the current (mark-to-market) value then the investor was still unlikely to actually lose money. Lower ratings forced investors to sell as the securities did not comply with investment guidelines triggering losses. Hedge funds who borrowed against the securities faced margin calls as the values fell. The lenders tightened lending conditions reducing leverage and increasing the cost. “No man’s credit was now as good as his money”. 7


The sub-prime problem was initially a “specific problem” and “contained”. It was neither. It spread quickly and efficiently – the word “contagion” appeared. By August 2007, credit markets had just about ceased to function. A veteran commentator – Ian Kerr - compared the current credit crunch to death from radiation – CDOs, particularly those with sub-prime exposure, now stood for Chernobyl Death Obligations!


Bear in the Woods

Two investors see a bear in the woods. One investor starts to run. “You can’t outrun a bear,” the other investor shouts. “I can outrun you!” responds the running investor. Investors and financial institutions now wanted to get their money out before the cash vanished. Diagram 3 sets out how selling is exaggerated in a highly leveraged world.


Diagram 3







The United States absorbs around 85% of total global capital flows, or over $500 billion each year. Asia and Europe were the world’s largest net suppliers of capital, followed by Russia and the Middle East. Cross border debt flows funded the US government debt (up $400 billion) and a rapid expansion in US private debt (up $1.3 trillion). A key growth area was asset-backed securities (“ABS”), including mortgage-backed securities (“MBS”), reflecting the strong US housing market and high levels of home-equity lending.8 Global money funded the US debt binge and now global investors suffered losses.


Exposure started to show up in unlikely places via asset backed CP – money market funds. One institution disclosed that CDOs and subprime mortgages were classified as “cash and short term” on its balance sheet. Structured funding vehicles were unable to issue ABS backed CP. They drew on standby funding arrangements. Banks refused to fund arguing material changes in circumstances. Others had to forage down the back of the sofa for any loose change to add to their dwindling liquidity.


Reduced leverage and higher costs of funding affected hedge funds. Quantitative funds suffered large losses as forced selling and a liquidity driven market caused models to fail. Hedge fund investors, concerned about declines in returns and sharp falls in value, lodged redemption requests forcing selling. Goldman Sachs was forced to step in to offer liquidity support to one of its funds.


Overheated equity markets fell despite strong corporate earnings and a growing economy on concerns about less abundant and higher priced debt. Stock values exaggerated by the possibility of debt fuelled private equity bids fell sharply. Financial stocks fell as the losses, bailout costs and loss of future earnings was factored in. Investors regretted not taking Will Rogers advice: “don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”


Market credit spreads and margins rose sharply. There was a flight to quality – government securities and cash. Liquidity vaporized as fear about counterparty default meant that normal transactions between financial institutions became difficult. Risk lending dried up. AAA rated non sub-prime mortgage-backed securities could not be placed.


There is no difference between a run on a bank and shutdown of access to funding from the capital markets. US mortgage lenders faced old-fashioned runs. Central banks pumped money into the system. The Fed cut the discount rate. Four major US banks used the discount window: “to encourage its use by other financial institutions”. They did not need cash. It was a sign of strength. In the words of financial historian, Charles Geisst, it was : “like someone from the Upper East Side being seen in .. Wal-Mart”.


The problem was credit risk not liquidity. Lack of information and diffusion of risk meant that no one was certain who had exposure to what or to whom. EBC governor Jean-Claude Trichet pleaded for everybody “to keep their composure”. It was reminiscent of Emperor Hirohito’s response to the bombing of Hiroshima: “the War situation has developed not necessarily to Japan’s advantage.”


Waiting for the Shoe to Fall…


A pyroclastic flow is a part of volcanic eruptions consisting of lethal currents of Tephra (hot 1000 degrees Celsius gas, ash and rock) travelling at up to 700 km/hour. Pompeii was famously engulfed by pyroclastic flows in AD 79. The sub-prime losses had morphed into a fully-fledged “credit crunch”, the pyroclastic flow of financial markets.


Hedge funds faced substantial redemption requests especially from funds-of-funds in charge of allocating hot money in the coming months. Interest rates on large volumes of sub-prime mortgages were due to increase (by 3-4%) in 2008. The impact on delinquencies and losses were unknown.


The same model as sub-prime is used for leveraged funding in private equity, infrastructure and property financing. Banks underwrote the loans, warehoused them and then repackaged and distributed them to investors in the form of CDOs. Deterioration in credit standards was evident. “Covenant lite” loans where the borrower did not agree to normal financial restrictions had become fashionable. “Toggle” loans where borrowers could pay in cash interest using new debt (Pay-In-Kind or PIK securities) abounded.


The same model as sub-prime is used, worryingly, for funding highly leveraged private equity, infrastructure and property transactions. As of August 2007, $300 billion of leveraged finance loans made by banks is effectively “orphaned” - they can’t be sold off. One bank recently offered $1 billion to a client to walk away from an underwriting commitment where it stood to lose more if the transaction proceeded. Another bank, active until recently in making multi-billion dollar commitments to private equity transaction, told clients that “they were not in leveraged lending business any more”. It smacked of a day in the late 1980s when the then all powerful Japanese banks refused to participate in the leveraged financing of the United Airlines LBO ushering in the end of that era.


Keynes observed capital shifts “with the speed of the magic carpet … disorganizing all steady business”. The real economy effects are slower to emerge and more difficult to measure. Higher credit costs and tighter credit standards will affect all business. The US housing industry is badly affected with no immediate prospect of a quick recovery.


Private equity transactions in recent years were predicated on a combination of a growing economy, cheap debt and a buoyant stock market allowing the quick resale of the company. Weaker earnings and more expensive debt could lead to losses and distressed sales over time. Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions.


The fall in asset prices has “wealth” effects. US consumption, based on borrowing against the inflated values of financial assets, drives the export driven economies of Asia, Eastern Europe and Latin America. Lower commodity prices already point to slower global growth. While main street was trying the assess the fallout, Wall Street was already issuing “pink slips” by the thousands as banks and mortgage lenders shed staff.


The market anxiously waited for “the shoes to fall”, except it seemed the shoes were from Imelda Marcos’ collection.


Shell Games

Markets exaggerate the short-term impact and underestimate the long run impact of events. The new liquidity factories were based on the new age idea of “risk transfer”. The shell game requires three shells and a small, soft round ball, about the size of a pea. The pea is placed under one of the shells, then quickly the shells are shuffled around. Bets are taken from the audience on the location of the pea. It is a confidence trick used to perpetrate fraud. Through sleight of hand, the operator easily hides the pea, undetected by the victims. Risk transfer is the shell game of the credit markets; a short con, quick and easy to pull off.


Central banks believe that if banks sell off their risk then it is distributed widely reducing the chance of a crash. Banks frequently don’t sell off their real risks. For regulatory capital reasons, they sell off less risky loans. In a CDO, the bank typically takes all or a portion of the equity tranche. This is “hurt money” or the “skin in the game” to reassure other investors. Banks must hold the loans until they can be sold. If there is a market disruption and the bank is unable to sell then the risk remains with the bank.


The risk may also return to the bank via the back door. Where it acts as a prime broker –executing trades, settling transactions and financing hedge funds – the bank lends to investors using the CDO securities created as collateral. If the value of the securities falls and the hedge fund is unable to post additional margin to cover the loss then the bank is exposed to the risk of the securities. The bank assumes that it can sell the securities it is holding to pay itself back. There are few prime brokers - three dominate the business - concentrating the risk.


Banks provide “corporate credit cards” - standby lines of credit - to the conduit vehicles to cover funding shortfalls. If CP cannot be issued then the banks may be forced to lend against the assets that they have supposedly sold off. In the current crisis, some banks refused to lend arguing material changes in circumstances. Others foraged down the back of the sofa for any loose change to add to their dwindling liquidity to meet their commitments. Some bowed to the inevitable and took the assets back on to their balance sheets.


Credit risk moves from a place where it was regulated and observable to a place where it is less regulated and more difficult to identify. Around 60% of all credit risk is transferred to highly leveraged hedge funds that may be inadequately capitalised to bear the risk. Table 1 and Diagram 4 sets out the amount of leverage in modern credit markets – around one dollar of “real” capital supports between $20 and $30 of loans.


Table 1

Credit Strategy Leverage

Strategy
Leverage

Long/ Short Cash Credit
3-5 x

Long/ Short Emerging Market 1-2 x

Fixed Income Relative Value 10-20 x

Long Short Credit 5-15 x

CDS Leveraged Carry
20 x

MBS/ABS Arbitrage
5-10 x

Distressed Debt
1-2 x



Source: Based on Roger Merritt and Eileen Fahey (5 June 2007) Hedge Funds: The New Credit Paradigm ; Fitch Ratings




Diagram 4

Credit Market Leverage






Hedge fund trading strategies create risk concentrations as they hunt in packs taking bets on the same events. Hedge funds investors can withdraw funds at relatively short notice, typically, one to three months. The hedge fund’s borrowings (via repos and derivatives supported by collateral) are short term – one day. Short-term money finances long-term assets making them vulnerable to a credit crisis. As the credit problems spread and hedge funds faced margin calls, one humorist wryly suggested that they meet capital calls using nickels, pennies, and quarters.


Banks set up hedge funds and invest in them. When a hedge fund gets into trouble there is commercial and reputational pressure to support the fund bringing the risk back into the bank. Financial innovation may not decrease risk but increase risk significantly in complex ways.

Ph.D’s (Piled Higher and Deeper)

There are now more models in financial markets than on catwalks. Trading models tell you when and what to buy and sell. Pricing models value any conceivable security. Risk models tell you how much you may loss. Meta-models tell you which model to use.


Investors increasingly don’t know what they are buying and what the security is worth. Traders say that the cost of what they sold is lower then what they paid for it; the price they paid is always lower than what the security is worth. Traders are smart and everyone else is stupid. Complex securities frequently don’t trade at all so market prices are rarely available. Understanding and valuing structured securities requires a higher degree in a quantitative discipline, a super computer and a vivid imagination.


The current credit crisis is, in part, a case of model failure. In the US mortgage market, automated credit assessments where information such as stated income or assets are not verified led to poor lending. At the time of the purchase, HSBC had trumpeted Household’s mortgage financing skills. Mention was made of hundreds of Ph.D.’s skilled at cutting and dicing mortgage risk. In hindsight, HSBC would have been better served by old fashioned, common sense bankers who could eyeball clients and decide who was likely to pay you back.


Complex Monte Carlo models used to model and rate CDO securities performed badly. Trading models used by quantitative hedge funds malfunctioned as prices became driven by liquidity and market regimes shifted. Models used to set trading limits and set collateral levels significantly underestimated risk as volatility increased.


The risk of simplified, sometimes untested, models is not new. In 1987, portfolio insurance contributed to the crash. In 1998, LTCM’s trading and risk models failed. Robert Merton articulated the problems precisely. “At times we can lose sight of the ultimate purpose of the models when their mathematics become too interesting. The mathematics of models can be applied precisely, but the models are not at all precise in their application to the complex real world. Their accuracy as useful approximations to that world varies significantly across time and place. The models should be applied in practice only tentatively, with careful assessment of their limitations in each approximation.” The speech was less than a year before the collapse of LTCM.


Missing The Mark

Asset values, profits and losses, risk calculations and collateral requirements all require the current market price of securities. Even staid accountants have embraced mark-to-market (“MTM”) as the basis for financial reporting. MTM assumes a market and a price. In volatile markets, liquidity becomes concentrated in government bonds, large well know stocks and listed derivatives. For anything that is not liquid, MTM means mark-to-model entailing “model risk”. The only price available is from the bank that sold the security to the investor in the first place defying concepts of independence and objectivity.


As the 2007 credit crisis unfolded, there was no liquidity for structured securities. There was only one marketmaker - the person who sold it to you in the first place. In a dealing room during a crisis, the first rule is do not answer phone calls from clients. The second rule is say “wrong number” if you accidentally pick up the phone.


Inability to price or trade means that fund managers cannot establish current portfolio values or allow withdrawals of investor money. This forced funds to suspend withdrawals. Prime brokers could not establish the value of collateral. Where investors failed to make “top up” margin calls, the prime brokers could not sell the collateral securing their loans. They couldn’t get back their money and were at risk of further falls in the value of securities.


Banks shared one objective - prevent the complex and illiquid securities being sold at a discount and pushing down prices in the market. If these securities actually traded then the lower market price would have to be used to calculate the mark-to-market value increasing losses and margin calls on already cash strapped investors. Asset values, profit and loss calculations and risk computations were in the running for major awards in literary fiction.


Unknown Unknowns

One trader summed it up using Donald Rumsfeld’s immortal words: the known known was that there were losses in sub-prime mortgages and anything related; the known unknown was that everybody knew that they did not know the full extent of the problem; the unknown unknown was that there could be other problems that we didn’t know about yet.


Financial crises now are less the result of economic downturns, geopolitical events or natural disasters and more the result of the structure and activity in financial markets. 9 Risk is now driven by the increasingly tight coupling of markets and the resulting complexity and interdependence.

Modern financial markets assume free flow of information and relative transparency. There was little or no knowledge of the extent of sub-prime losses, who was exposed and what were the links.


Sometimes, investors themselves couldn’t work out whether they had sub-prime exposure or not. In the early stage of the crisis Baudoin Prot, the chief executive of France's biggest bank, BNP Paribas, sought to reassure markets: “With only three funds, for a total of € 2 billion, which for one-third of the assets have some sub-prime, US sub-prime exposure. For us this is not a significant problem at this stage.” Within the week, BNP Paribas had to freeze payments from the funds as they were unable to obtain market prices or trade the CDO securities. An analyst assured me that Asian banks’ exposure to sub-prime losses was minimal. Within days, Chinese, Korean and Japanese banks announced large exposures to sub-prime. The stock markets wiped 30-50 times the potential losses off the share prices of the banks. The issue was that the banks did not know what they owned and what they could lose.



Diffusion of risk across the globe to unregulated investors subject to variable financial disclosure rule is inconsistent with transparency. Investors like hedge funds have steadfastly fought for increasing transparency and disclosure, except when it relates to their own activities. One central banker observed that in the good old days, there would have been no problem as the risk would be where it always was - at the banks.

Truth in Labeling

CDO ratings have been crucial to selling securities to investors. 30% and 50% of the revenue of the major rating agencies – Moody’s Investor Services; Standard & Poor; Fitch Ratings – come from rating structured securities, including CDOs.


Ratings are opinions of the likelihood of default of a particular security based on mathematical models, history and snake oil. Investors, some ignorant about how a rating is determined, ascribed magical properties to the alphabet soup of letters assigned to a security. Investors and bankers made assumptions about the stability of the rating. Rating was linked to pricing and used to set the amount of banks would lend against a particular security. Protected by expansive exclusion clauses, the agencies did not discourage these uses, instead promoted the wide use of ratings.


CDO rating anomalies abound.10 The number of defaults in the “BBB” class of CDO securities is not materially different from that on “BB” CDO securities (see Table 2). BBB is classified as investment grade while BB is not. Many investors can only purchase investment grade securities but in a CDO it seems the risks are the same. CDO security ratings also seem to be less stable than comparable rated corporate bonds. Likely reasons include model failure, input problems and a certain naivete in the application of these models to new markets. Bill Gross, from PIMCO, colorfully observed that in rating CDOs the agencies had been seduced by “hookers in six-inch stilettos”.


There are uncomfortable similarities in the relationship between investment banks and rating agencies and that between auditors and the companies they audit. Investment banks pay the rating agencies to rate the CDO securities. Investment banks and rating agencies work closely in structuring the transactions. Rating agency staff cross over to the “dark side” to work for investment banks. CDO ratings pay more than rating conventional bonds. Politicians in the USA and the European Union have started to focus on the role of rating agencies.


Table 2

CDO Rating Comparisons


Rating
CDO Default Rate

(%)
Corporate Default Rate – 5 years (%)
Corporate Default Rate – 10 years (%)

AAA
0.00
0.085
0.208

AA
1.10
0.203
0.415

A
5.44
0.563
1.248

BBB
21.59
2.248
4.721

BB
24.25
11.845
21.038

B
55.56
29.734
46.931



Notes:

1. CDO Default Rates are from Jian Hu, Richard Cantor and Gus Harris (March 2005) Default and Loss Rates of US CDOs: 1993-2003; Moody’s Investor Services at Figure 10.

2. Corporate Default Rates are from David Hamilton, Praveen Varma, Sharon Ou and Richard Cantor (March 2006) Default and Recovery Rates of Corporate Bond Issuers 1920-2005; Moody’s Investor Services at Exhibit 35.



Who’s Watching the Watchers ….


John Kenneth Galbraith observed that: “in central banking as in diplomacy, style, conservative tailoring, and an easy association with the affluent count greatly and results far much less.” Central bankers fueled the liquidity factories through excessive monetary growth and low interest rates. They championed financial innovation and “new age” finance theories. The risks of a diffuse, globally interlinked, highly leveraged financial system were ignored.


Regulators have presided over substantive changes in financial institution balance sheets and risks. The balance sheet of large banks and investment banks hold illiquid assets, such as private-equity investments, bridge loans, hedge funds investments, distressed debt and exotic derivatives. Derivative transactions with and loans to hedge funds through their prime broking operations have increased. Assets and exposures in “arbitrage” conduit vehicles and hedge funds outside regulated bank balance sheets have increased.


Table 3 sets out a recent analysis of major banks’ exposures relative to capital. While banks have increased capital and reduced reliance on short-term funding, the increase in risk is equally significant.


Table 3

Hedge Fund Shares Of Prime Broker Counterparty Exposure




Total Credit Exposure

($ billions)
Ratio to Tier 1 Capital

(times)
Hedge Funds

($ billions)
Hedge Fund Total Exposure
Hedge Fund Exposure As Ratio to Tier 1 Capital

(times)

Loaned Securities
555
1.09
222
40%
0.44

Reverse Repos
1,864
3.65
466
25%
0.91

Derivatives PRV
885
1.74
292
335
0.57

Margin Loans
367
0.72
242
66%
0.48

Total
3,672
7.20
1,223


2.40



Notes:
1. Loaned securities refers to bank lends securities to hedge funds and others in order to short sell. The bank receives cash or other securities as collateral,
2. Reverse repurchase agreements refers to a form of secured lending where the bank buying securities from a hedge fund and others against a commitment to buy them back.
3. Derivatives positive replacement value (“PRV”) is the current value of the contract calculated as the cost to the bank of replacing the transactions where the bank is owed money. This is lower than and massively understates the notional value of derivative contracts (potential command over securities).
4. Margin loans refer to bank advances to hedge funds and other against collateral (usually cash and securities). This important activity is not separately disclosed by prime brokers. The figure is the total margin lending by members of the NYSE.
5. Tier 1 capital refers to shareholders funds but excluded most forms of subordinated debt and hybrid capital instrument.
6. Investment banks included in this analysis are (in alphabetical order): Bear Stearns; CitiGroup; Credit Suisse; Deutsche Bank; Goldman Sachs; JP Morgan; Lehman Brothers; Merill Lynch; Morgan Stanley; and UBS.

Source: Adrian Blundell-Wignall (2007) An Overview of Hedge Funds and Structured Products: Issues in Leverage and Risk; OECD



Banks also have increased trading risks, particularly in complex derivatives and structured investments. Constant Portion Portfolio Insurance (“CPPI”) products guarantee the return of capital to investors at a future date using a trading strategy similar to portfolio insurance. This requires continuously re-balancing of a portfolio of risky assets (usually shares and hedge fund investments) and cash. The trader is exposed to the risk of sharp changes in asset prices. It is unclear how these products and hedges will perform in volatile markets.


The Bank of International Settlements (“BIS”) in its 2007 annual report admitted that “our understanding of economic processes may be even less today than it was in the past”. Fundamental changes reshaping financial markets are needed. The temptation to seek a scapegoat (the brokers that sold sub-prime mortgages and rating agencies loom large) or a quick fix (lower interest rates) is ever present. The Fed has cut the discount rate. The Fed also clarified the rules – banks could pledge asset backed CP as collateral for funding at its discount window. Usually, only government securities are eligible. The Fed is effectively underwriting the credit risk and the liquidity of the financial system. It was arguably reverting to type bailing out banks and investors from poor decisions or irrational exuberance underwriting excessive risk taking.


John Maynard Keynes knew the problem well: “the difficulty lies not so much in developing new ideas as in escaping from old ones”. But as John Kenneth Galbraith observed: “faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.”


Credit Crunch


In Western societies, there is an increasing obesity problem, in part caused by poor diets that include fast food. A diet of cheap and excessive debt has created a bloated financial system.


Crash diets rarely work. The solution requires will power, a sensible but reduced food intake and exercise. In financial markets, the resolution requires regulatory will and an imposition of market disciplines on errant investors and banks. It also requires a sharp reduction in debt levels and addressing the problems of risk transfer, model risk and market transparency.


I am not hopeful that the required reassessment will occur. The current credit crunch will be the new wonder diet snack for financial markets. It will have some short term effects but leave the root cause untreated. As Charles Kindleberger noted in the opening sentence of his classic study (Maniacs, Panics and Crashs): “there is hardly a more conventional subject in economic literature than financial crises.”


© 2007 Satyajit Das. All rights reserved.

1. Gillian Tett of the Financial Times coined the phrase; see Gillian Tett “Should Atlas still shrug?” (15 January 2007) Financial Times

2. The phrase new liquidity factory was coined by Mohamed El-Erian.





3. See Joseph Mason and Joshua Rosener “How Resilient are Mortgage Backed Securities to Collateralised Debt Market Disruptions?” (13 February 2007)

4. See “Cracks in the façade” (22 March 2007) The Economist

5. See Merrit, Roger, Linnell, Ian, Grossman, Robert and Shiavetta, John (18 July 2005) Hedge Funds: An Emerging Force in Global Credit Markets; Fitch Ratings, Special Report, New York

6. See Peter Schwartz and Peter Leyden “The Long Boom: A History of the Future, 1880-1920” (July 1997) Wired
7. See E.W. Howe, Sinner Sermons

8. See McKinsey Global Institute (January 2007) Mapping The Global Capital Markets – Third Annual Report

9. See Woody Brock (2002) The Transformation of Risk: Main Street versus Wall Street

10. See Arturo Cifuentes and Georgios Katsaros “CDO Ratings: Chronicle of a Disaster Foretold” (4 June 2007) Total Securitisation 11-12.
charts and source here

"From failure to failure without loss of enthusiasm"

"Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited." (George Soros)

"The way of the Tao is reversal." (Lao Tzu)

"Chance favours the prepared mind.” (Louis Pasteur)

"It is neither necessary to hope to undertake, nor to succeed to persevere." (French proverb)

"You must have a willingness to do something when everyone else is petrified. You must learn the lesson of following logic over emotion." (Warren Buffett)

"Success consists of going from failure to failure without loss of enthusiasm." (Winston Churchill)

"May a fair road always be open to you." (CHS, April 2, 2006)

Prepare for the credit crisis to spread

By Wolfgang Munchau

Published: September 2 2007 18:57 | Last updated: September 2 2007 18:57

“Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”

A Short History of Financial Euphoria, John Kenneth Galbraith

The late John Kenneth Galbraith would have enjoyed this summer. He was no expert on modern credit markets but his analysis of historic bubbles fits our most recent boom and bust episode with uncanny precision.

All historic bubbles were accompanied by a sharp rise in leverage. A salient feature of modern bubbles is the emergence of innovative financial products. No matter whether we are talking about junk bonds or modern collateralised debt obligations (CDOs), as Galbraith has pointed out, such products boil down to variants of debt secured on a real asset.

By historic standards, our credit bubble is probably one of the largest ever, given the sheer size of the market itself and the degree of euphoria that was characteristic in the final stages of the boom. While the fallout was initially concentrated in the financial sector itself, it would be surprising if the ongoing problems did not trickle down into the real economy. The availability of credit affects house prices and numerous studies have demonstrated the interlinkages between US house prices and US economic growth.

So what should central banks do? I suspect that central banks are not going to be the main actors in any rescue operation, but rather governments. Central banks’ room for manoeuvre to cut interest rates is more constrained this time than during the most recent recession. But more important, this is not the kind of crisis that can easily be stopped by a few hasty rate cuts or bank bail-outs. If your subprime mortgage exceeds the value of your house by 10 per cent, and if the monthly payments exceed your income, no positive interest rate could bail you out. Your only hope is some serious debt relief.

The economists Dimitri Papadimitriou, Greg Hannsgen and Gennaro Zezza last week published a study* in which they demonstrated the danger to US economic growth posed by the present real estate crisis. Their policy recommendations go significantly beyond the usual bail-out calls. They argue that it is almost impossible for policymakers to stop the decline in real estate prices, but “if the Fed and Congress can work to stop any incipient recession, they will prevent job losses, which are one of the main contributors to foreclosures. An effective job-creation method could be some form of employer-of-last-resort programme that offers government jobs to all workers who ask for them”.

We should remember that the subprime market is not the only unstable subsection of the credit market. Once US consumption slows, we should prepare for a crisis in credit card and car finance CDOs. And once corporate bankruptcies start to rise again as the cycle turns down, both in the US and in Europe, we will probably hear about problems with collateralised loan obligations. The credit market is very deep and offers significant potential for contagion.

In this sense, the debate about whether this is a liquidity or a solvency crisis is beside the point. Banks may look at their CDO investments as a source of temporary illiquidity, but may sooner or later realise that they are sitting on a pile of junk. The fiscal and monetary authorities should therefore assume that they are confronted with a solvency crisis. Bailing out the odd bank, as the Germans did last month, is not going to be sufficient and perhaps not even necessary.

Instead, the monetary and fiscal authorities should stand ready to support the economy if and when needed. Lower interest rates will probably be part of any such deal, but a large part of the help will invariably come from fiscal policy. The US Federal Reserve will probably cut interest rates soon and the European Central Bank will almost certainly postpone the rate rise it unwisely preannounced only a few weeks ago. I am convinced the next interest rate movement both in the US and the eurozone will be downwards.

One of the problems the monetary authorities have to deal with is moral hazard. This is not a theoretical issue, as some suggest, but a far more immediate concern. Moral hazard is the result of asymmetric expectations, as markets expect the central bank to bail out the financial sector during a time of crisis. The problem of moral hazard is to some extent related to the monetary policy strategy of central banks, with their mechanistic focus on a single consumer price index. Such strategies often have no space for asset prices, but markets know fully well that central banks must invariably take account of asset prices during sharp downturns. One way out of this asymmetry is for central banks to include asset prices into their policy frameworks in some form or other.

This said, a bail-out of the financial system will probably become unavoidable, but it should be accompanied with structural policy changes. Tighter financial regulation is probable. The role of the ratings agencies is bound to change too. And central banks should reconsider their monetary policy frameworks. They are part of the problem.

Danger: Steep drop ahead - September 17, 2007

Danger: Steep drop ahead - September 17, 2007: "(Fortune Magazine) -- Credit crises have always been painful and unpredictable. The current one is particularly hair-raising because it's occurring amid the first truly global bubble in asset pricing. It is also accompanied by a plethora of new and ingenious financial instruments. These are designed overtly to spread risk around and to sell fee-bearing products that are in great demand. Inadvertently (to be generous), they have been constructed to hide risk and confuse buyers. How this credit crisis works out and what price we end up paying has to be largely unknowable, depending as it does on hundreds of interlocking and often novel factors and how they in turn affect animal spirits. In the end it is, of course, the management of animal spirits that makes and breaks credit crises. house_real_estate_for_sale.03.jpg Grantham: Home prices are well above the normal four times family income and will have to come down. More from FORTUNE 10 investments poised to soar The many faces of Ralph Lauren Selling P&G FORTUNE 500 Current Issue Subscribe to Fortune But even if this crisis is contained, we are facing some near certainties that should be understood. First, house prices may move on euphoria in the short term, but long term they depend on family income - the ability to pay mortgages and"

Peak Everything! Richard Heinberg

Richard refers to a citation from the National Academy of Sciences and cites an old blog of mine as his source, I'm pleased top have been able to help. I'm sure Richard won't mind if I reprint this.

Note: This issue is an edited version of the Introduction to Peak Everything: Waking Up to the Century of Declines.

During the past few years the phrase Peak Oil has entered the global lexicon. It refers to the moment in time when the world will achieve its maximum possible rate of oil extraction; from then on, for reasons having mostly to do with geology, the amount of petroleum available to society on a daily or yearly basis will begin to dwindle. Most informed analysts agree that this will happen during the next two or three decades; an increasing number believe that it is happening now - that conventional oil production peaked in 2005–2006 and that the flow to market of all hydrocarbon liquids taken together will start to diminish around 2010.1 The consequences, as they begin to accumulate, are likely to be severe: the world is overwhelmingly dependent on oil for transportation, agriculture, plastics, and chemicals; thus a lengthy process of adjustment will be required. According to one recent U.S. government-sponsored study, if the peak does occur soon replacements are unlikely to appear quickly enough and in sufficient quantity to avert what it calls "unprecedented" social, political, and economic impacts.2

This book is not an introduction to the subject of Peak Oil; several existing volumes serve that function (including my own The Party's Over: Oil, War and the Fate of Industrial Societies).3 Instead it addresses the social and historical context in which the event is occurring, and explores how we can reorganize our thinking and action in several critical areas in order to better navigate this perilous time.

Our socio-historical context takes some time and perspective to appreciate. Upon first encountering Peak Oil, most people tend to assume it is merely a single isolated problem to which there is a simple solution - whether of an eco-friendly nature (more renewable energy) or otherwise (more coal). But prolonged reflection and study tend to eat away at the viability of such "solutions"; meanwhile, as one contemplates how we humans have so quickly become so deeply dependent on the cheap, concentrated energy of oil and other fossil fuels, it is difficult to avoid the conclusion that we have caught ourselves on the horns of the Universal Ecological Dilemma, consisting of the interlinked elements of population pressure, resource depletion, and habitat destruction - and on a scale unprecedented in history.

Petroleum is not the only important resource quickly depleting. Readers already acquainted with the Peak Oil literature know that regional production peaks for natural gas have already occurred, and that, over the short term, the economic consequences of gas shortages are likely to be even worse for Europeans and North Americans than those for oil. And while coal is often referred to as being an abundant fossil fuel, with reserves capable of supplying the world at current rates of usage for two hundred years into the future, a recent study updating global reserves and production forecasts concludes that global coal production will peak and begin to decline in ten to twenty years.4 Because fossil fuels supply about 85 percent of the world's total energy, peaks in these fuels virtually ensure that the world's energy supply will begin to shrink within a few years regardless of any efforts that are made to develop other energy sources.

Nor does the matter end with natural gas and coal. Once one lifts one's eyes from the narrow path of daily survival activities and starts scanning the horizon, a frightening array of peaks comes into view. In the course of the present century we will see an end to growth and a commencement of decline in all of these parameters:

* Population
* Grain production (total and per capita)
* Uranium production
* Climate stability
* Fresh water availability per capita
* Arable land in agricultural production
* Wild fish harvests
* Yearly extraction of some metals and minerals (including copper, platinum, silver, gold, and zinc)

The point of this book is not systematically to go through these peak-and-decline scenarios one by one, offering evidence and pointing out the consequences - though that is a worthwhile exercise. Some of these peaks are more speculative than others: fish harvests are already in decline, so this one is hardly arguable; however, projecting extraction peaks and declines for some metals requires extrapolating current rising rates of usage many decades into the future.5 The problem of uranium supply beyond mid-century is well attested by studies, but has not received sufficient public attention.6

Nevertheless, the general picture is inescapable; it is one of mutually interacting instances of over-consumption and emerging scarcity.

Our starting point, then, is the realization that we are today living at the end of the period of greatest material abundance in human history - an abundance based on temporary sources of cheap energy that made all else possible. Now that the most important of those sources are entering their inevitable sunset phase, we are at the beginning of a period of overall societal contraction.

This realization is strengthened as we come to understand that it is no happenstance that so many peaks are occurring together. All are causally related by way of the historic reality that, for the past 200 years, cheap, abundant energy from fossil fuels has driven technological invention, increases in total and per-capita resource extraction and consumption (including food production), and population growth. We are enmeshed in a classic self-reinforcing feedback loop:

Fossil fuel extraction

--> more available energy

----> increased extraction of other resources, and production of food and other goods

------> population growth

--------> higher energy demand

----------> more fossil fuel extraction (and so on)

Self-reinforcing feedback loops sometimes occur in nature (population blooms are always evidence of some sort of reinforcing feedback loop), but they rarely continue for long. They usually lead to population crashes and die-offs. The simple fact is that growth in population and consumption cannot continue unabated on a finite planet.

If the increased availability of cheap energy has historically enabled unprecedented growth in rates of the extraction of other resources, then the coincidence of Peak Oil with the peaking and decline of many other resources is entirely predictable.

Moreover, as the availability of energy resources peaks, this will also affect various parameters of social welfare:

* Per-capita consumption levels
* Economic growth
* Easy, cheap, quick mobility
* Technological change and invention
* Political stability

All of these are clearly related to the availability of energy and other critical resources. Once we accept that energy, fresh water, and food will become less freely available over next few decades, it is hard to escape the conclusion that, while the 20th century saw the greatest and most rapid expansion of the scale, scope, and complexity of human societies in history, the 21st will see contraction and simplification. The only real question then is whether societies will contract and simplify intelligently or in an uncontrolled, chaotic fashion.

Good news? Bad news?

None of this is easy to contemplate. Nor can this information easily be discussed in polite company: the suggestion that we are at or near the peak of population and consumption levels for the entirety of human history and that it's all downhill from here is not likely to win votes, lead to a better job, or even make for pleasant dinner banter. Most people turn off and tune out when the conversation moves in this direction; advertisers and news organizations take note and act accordingly. The result: a general, societal pattern of denial.

Where might we find solace in all of this gloom? Well, it could be argued that some not-so-good things will also peak this century:

Economic inequality Environmental destruction Greenhouse gas emissions

Why economic inequality? The late, great social philosopher Ivan Illich argued in his 1974 book Energy and Equity that inequality increases along with the flow of energy through a society. "[O]nly a ceiling on energy use," he wrote, "can lead to social relations that are characterized by high levels of equity."7 Hunters and gatherers, who survived on minimal energy flows, also lived in societies nearly free from economic inequality. While some forager societies were better off than others because they lived in more abundant ecosystems, the members of any given group tended to share equally whatever was available. Theirs was a gift economy - as opposed to the barter, market, and money economies that we are more familiar with. With agriculture and full-time division of labor came higher energy flow rates as well as widening economic disparity between kings, their retainers, and the peasant class. In the 20th century, with per-capita energy flow rates soaring far above any in history, some humans also enjoyed unprecedented material abundance, such that they expected that poverty could be eliminated once and for all if only the political will could be summoned. Indeed, during the middle years of the century progress was seemingly being made along those lines. However, for the century in total, inequality actually increased. The Gini index, invented in 1912 as a measure of economic inequality within societies, has risen substantially within many nations (including the U.S., Britain, India, and China) in the past three decades, and in the world as a whole.8 In the decades just prior to the 20th century, the average income in the world's wealthiest country was about ten times more than that in the poorest; now it is over forty-five times more. According to one study released in December, 2006 ("The World Distribution of Household Wealth,") the richest one percent of people now controls 40 percent of the world's wealth, while the richest two percent control fully half.9 If this correlation between energy flow rates and inequality holds, it seems likely that, as available energy decreases during the 21st century, we are likely to see a reversion to lower levels of inequality. This is not to say that by century's end we will all be living in an egalitarian socialist paradise, merely that the levels of inequality we see today will have become unsupportable.

Similarly, it seems likely that levels of humanly generated environmental destruction will peak and begin to recede in decades to come. As available energy declines, our ability to alter the environment will do so as well. However, if we make no deliberate attempt to control our impact on the biosphere, the peak will be a very high one and we will do an immense amount of damage along the way. On the other hand, we could expend deliberate and intelligent effort to minimize environmental impacts, in which case the peak will be at a lower level. Especially in the former case, this peak is likely to lag behind the others discussed, because many environmental harms involve reinforcing feedback loops as well as delayed and cumulative impacts that will continue to reverberate for decades after human population and consumption levels start to diminish. As the primary example of this, greenhouse gas emissions will undoubtedly peak in this century - whether as a result of voluntary reductions in fossil fuel consumption, or depletion of the resource base, or societal collapse. However, the global climate may not stabilize until many decades thereafter, until various reinforcing feedback loops (such as the melting of the north polar icecap, which would expose dark water that would in turn absorb more heat, thus exacerbating the warming effect; and the melting of tundra and permafrost, releasing stored methane that would likewise greatly exacerbate warming) that have been set in motion play themselves out. Indeed, the climate may not return to a phase of relative equilibrium for centuries.

Well, if the goal of the last few paragraphs was to balance bad-news peaks with cheerier ones, that effort so far seems less than entirely successful. Surely we can do better. Are there some good things that are not at or near their historic peaks? I can think of a few:

* Community
* Personal autonomy
* Satisfaction from honest work well done
* Intergenerational solidarity
* Cooperation
* Free time
* Happiness
* Ingenuity
* Artistry
* Beauty of the built environment

Of course, some of these items are hard to quantify. But a few can indeed be measured, and efforts to do so often yield surprising results. Let's consider two that have been subjects of quantitative study.

Leisure time is perhaps the element on this list that lends itself most readily to measurement. The most leisurely societies were without doubt those of hunter-gatherers, who worked about 1000 hours per year, though these societies seldom if ever thought of dividing "work time" from "leisure time," since all activities were considered pleasurable in their way. For U.S. employees, hours worked peaked in the early industrial period, around 1850, at about 3500 hours per year.10 This was up from 1620 hours worked annually by the typical medieval peasant. However, the two situations are not directly comparable: a typical medieval workday stretched from dawn to dusk (sixteen hours in summer, eight in winter), but work was intermittent, with breaks for breakfast, midmorning refreshment, lunch, a customary afternoon nap, mid-afternoon refreshment, and dinner; moreover, there were dozens of holidays and festivals scattered throughout the year. Today the average U.S. worker spends about 2000 hours on the job, a figure somewhat higher than was the case a couple of decades ago (in 1985 it was closer to 1850 hours). Nevertheless, a long historical overview suggests that time-intensiveness of human labor seems to peak in the early phase of industrialization, and that a simplification of the modern economy could result in a reversion to older, pre-industrial norms.

In recent years the field of happiness research has flourished, with the publication of scores of studies and several books devoted to statistical analysis of what gives people a sense of overall satisfaction with their lives. International studies of self-reported levels of happiness show that, once basic survival needs are met, there is little correlation between happiness and per-capita rates of consumption of fossil fuels. According to surveys, people in Mexico, who use fossil fuels at one-fifth the rate of U.S. citizens, are just as happy.

The opportunities to continue to enjoy current (or elevated) levels of happiness and to reduce work hours may seem pale comforts in light of all the enormous social and economic challenges implicit in the peaks discussed earlier. However, it is worth remembering that the list above details things that matter very much to most people in terms of their real, lived experience. The sense of community and the experience of intergenerational solidarity are literally priceless, in that no amount of money can buy them; moreover, life without them is bleak indeed - especially during times of social stress. And there are many reasons to think that these two factors have declined significantly during the past few decades of rapid urbanization and economic growth.

In contrast with these indices of personal and social well-being, Gross Domestic Product (GDP) per capita is easily measured and shows a mostly upward trend for the world as a whole over the past two centuries. But it takes into account only a narrow set of data - the market value of all final goods and services produced within a country in a given period of time. Growth in GDP tells us that we should be feeling better about ourselves and our world - but it doesn't take into account a wide range of other factors, including damage to the environment, wars, crime and imprisonment rates, and trends in education. Many economists and non-governmental organizations have criticized governmental reliance on GDP for this reason, and have instead promoted the use of a Genuine Progress Indicator (GPI), which does take account of such factors. While a historical GDP chart for the U.S. shows general ongoing growth up to the present (GDP correlates closely with energy consumption), GPI calculations show a peak around 1980 followed by a slow decline.11 If we as a society are going to adjust agreeably to lower rates of energy flow - and less travel and transport - with minimal social disruption, we must begin paying more attention to the seeming intangibles of life and less to GDP and the apparent benefits of profligate energy use.

This is no mere palliative. Addressing the economic, social, and political problems ensuing from the various looming peaks will require enormous collective effort. If it to be successful, that effort must be coordinated, presumably by government, and enlisting people in that effort will require educating and motivating them in numbers and at a speed that has not been seen since World War II. Part of that motivation must come from a positive vision of a future worth striving toward. People will need to feel that there will be an eventual reward for what will amount to many years of hard sacrifice. The reality is that we are approaching a time of economic contraction and that consumptive appetites that have been stoked for decades by ubiquitous advertising messages promising "more, faster, and bigger" will now have to be reined in. People will not willingly accept the new message of "less, slower, and smaller," unless they have new goals toward which to aspire. They must feel that their efforts will lead to a better world, and tangible improvements in life for themselves and their families. The massive public education campaigns that will be required must be credible, and will therefore be vastly more successful if they give people a sense of investment and involvement in formulating those goals. There is a much-abused word that describes the necessary process - democracy.

As another way of mitigating our paralyzing horror at seeing our society's future as one of decline in so many respects, we should ask: decline to what? Are we facing a complete disintegration of everything we hold dear, or merely a reversion to lower levels of population, complexity, and consumption? The answer, of course, is unknowable at this stage. We could indeed be at the brink of a collapse worse than any in history. Just one reference in that regard will suffice: The Millennium Ecosystem Assessment, a four-year analysis of the world's ecosystems released in 2006, in which 1300 scientists participated, concluded of 24 ecosystems identified as essential to human life, 15 are "being pushed beyond their sustainable limits," toward a state of collapse that may be "abrupt and potentially irreversible."12 The signs are not good.

Nevertheless, a decline in population, complexity, and consumption could, at least in theory, result in a stable society with characteristics that many people would find quite desirable. A reversion to the normal pattern of human existence, based on village life, extended families, and local production for local consumption - especially if it were augmented by a few of the frills of the late industrial period, such as global communications - could provide future generations will the kind of existence that many modern urbanites dream of wistfully.

So the overall message of this book is not necessarily one of doom - but it is one of inevitable change and needed deliberate engagement with the process of change on a scale and speed beyond anything in previous human history. Crucially: We must focus on and use the intangibles that are not peaking (such as ingenuity and cooperation) to address the problems arising from our overuse of substances that are.

Our One Great Task: The Energy Transition

As we have seen, just a few core trends have driven many others in producing the global problems we see today, and those core trends (including population growth and increasing consumption rates) themselves constellate around our ever-burgeoning use of fossil fuels. Thus, a conclusion of startling plainness presents itself: Our central survival task for the decades ahead, as individuals and as a species, must be to make a transition away from the use of fossil fuels - and to do this as peacefully, equitably, and intelligently as possible.

At first thought, this must seem like an absurd over-simplification of the human situation. After all, the world is full of crises demanding our attention - from wars to pollution, malnutrition, land mines, human rights abuses, and soaring cancer rates. Doesn't a monomaniacal focus just on fossil fuels miss many important things?

In defense of the statement I would offer two points.

First, some problems are more critical than others. A patient may suffer simultaneously from a broken blood vessel in the brain and a broken leg. A doctor will not ignore the second problem, but since the first is immediately life-threatening, its treatment will take precedence. Globally, there are two problems whose potential consequences far outweigh most others: climate change and energy resource depletion. If we do nothing to dramatically curtail emissions of greenhouse gases soon, there is the substantial likelihood that we will set in motion the two self-reinforcing feedback loops mentioned previously - the melting of the north polar icecap, and the melting of tundra and permafrost releasing stored methane. These would, if set in motion, lead to an averaged global warming not just of a couple of degrees, but perhaps six or more degrees over the remainder of the century. And this in turn could make much of the world uninhabitable and make agriculture impracticable in many if not most places, and could result not only in the extinction of thousands or millions of other species but the deaths of hundreds of millions or billions of human beings.

The post-peak decline in availability of oil, natural gas, and coal - if our dependence on these fuels continues unabated - could trigger economic collapse, famine, and a general war over remaining resources. While it is certainly possible to imagine survivable transition strategies away from fossil fuels involving proactive efforts to develop alternative energy sources on a massive scale and to create policies mandating energy conservation, also on a massive scale, the world is currently as reliant on hydrocarbons as it is on water, sunlight, and soil. Without oil for transportation and agriculture; without gas for heating, chemicals, and fertilizers; and without coal for power generation, the global economy would sputter to a halt. While no one envisions these fuels disappearing instantly, we can avert the worst-case scenario of global economic meltdown - with all of the human tragedy that implies - only by proactively reducing our reliance on oil, gas, and coal ahead of depletion and scarcity. In other words, all that would be required in order for the worst-case scenario to materialize would be for world leaders to continue with existing policies.

These two problems are potentially lethal; they are first-priority ailments. If we solve them, we will then be able to devote our attention to other human dilemmas, many of which have been with us for millennia - war, disease, inequality, and so on. If we do not solve these two problems, then in a few decades our species may be in no position to make any progress whatever on other fronts; indeed, it will likely be engaged in a struggle for its very survival. We'll be literally and metaphorically burning the furniture for fuel and fighting over scraps.

My second reason for insisting that the transition from fossil fuels must take precedence over other concerns can likewise be framed in a medical metaphor: Often a constellation of seemingly disparate symptoms issues from a single cause. A patient may present with symptoms of hearing loss, stomach pain, headaches, and irritability. An incompetent doctor might treat each of these symptoms separately without trying to correlate them. But if their cause is lead poisoning (which can produce all of these signs and more), then mere symptomatic treatment would be useless.

Let us unpack the metaphor. Not only are the two great crises mentioned above closely related (both peak oil and climate change issue from our dependence on fossil fuels), but - as I have already noted - many if not most of our other modern crises constellate also around fossil fuels. Even long-standing and perennial problems like economic inequality have been exacerbated by high energy-flow rates.

Pollution is no different in this regard. We humans have polluted our environments in various ways for a very long time; activities like the mining of lead and tin have produced localized devastation for centuries. However, the problem of chemical pollution that is spread generally throughout the environment is a relatively new one and has grown much worse over the past decades. Many of the most dangerous pollutants happen to be fossil fuel derivatives (pesticides, plastics, and other hormone-mimicking chemicals) or by-productions from the burning of coal or petroleum (nitrogen oxides and other contributors to acid rain).

War might at first seem to be a problem completely independent of our modern thirst for fossil energy sources. However, as security analyst Michael Klare has underscored in his book Blood and Oil,13 many recent wars have turned on competition for control of petroleum; as oil grows scarcer in the post-peak environment, further wars and civil conflicts over the black gold are almost assured. Moreover, the use of fossil fuels in the prosecution of war has made state-authorized mayhem far more deadly. Most modern explosives are made from fossil fuels, and even the atomic bomb - which relies on nuclear fission or fusion rather than hydrocarbons for its horrific power - depends on fuel for its delivery systems.

One could go on. In summary: We have used the plentiful, cheap energy from fossil fuels quite predictably to expand our power over nature and one another. Doing so has produced a laundry list of environmental and social problems. We have tried to address these one by one, but our efforts will be much more effective if directed at their common root - that is, if we end our dependence on fossil fuels.

Again, my thesis: Many problems rightly deserve attention, but the problem of our dependence on fossil fuels is central to human survival, and so as long as that dependence continues to any significant extent we must make its reduction the centerpiece of all our collective efforts - whether they are efforts to feed ourselves, resolve conflicts, or maintain a functioning economy.

But this can be formulated in another, more encouraging, way: If we do focus all of our collective efforts on the central task of energy transition, we may find ourselves contributing to the solution of a wide range of problems that would be much harder to solve if we confronted each one in isolation. With a coordinated and voluntary reduction in fossil fuel consumption, we could see substantial progress in reducing many forms of environmental pollution. The decentralization of economic activity that we must pursue as transport fuels become more scarce could lead to more local jobs and more fulfilling occupations, and more robust local economies. A controlled contraction in global oil trade could lead to a reduction of international political tensions. A planned conversion of farming to non-fossil fuel methods could mean a decline in environmental devastation caused by agriculture and economic opportunities for millions of new farmers. Meanwhile, all of these efforts together could increase equity, community involvement, intergenerational solidarity, and the other intangible goods listed earlier.

Surely this is a future worth working toward.

The (Rude) Awakening

The subtitle of this book, "Waking Up to the Century of Declines," reflects my impression that even those of us who have been thinking about resource depletion for many years are still just beginning to awaken to its full implications. And if we are all in various stages of waking up to the problem, we are also waking up from the cultural trance of denial in which we are all embedded.14

This awakening is multi-dimensional. It is not just a matter of becoming intellectually and dispassionately convinced of the reality and seriousness of climate change, peak oil, or any other specific problem. Rather, it entails an emotional, cultural, and political catharsis. The biblical metaphor of scales falling from one's eyes is as apt as the pop-culture meme of taking the red pill and seeing the world beyond the Matrix: in either case, waking up implies coming to the realization that the very fabric of modern life is woven from illusion - thousands of illusions, in fact.

In order for that fabric to be held together, there is the requirement for one master illusion, which is the notion that somehow what we see around us today is normal. In a sense, of course, it is normal: the daily life experience of millions of people is normal by definition. The reality of cars, television, and fast food is calmly taken for granted; if life has been like this for decades, why shouldn't it continue, with incremental developmental changes, indefinitely? But how profoundly this "normal" life in a typical modern city differs from the lives of previous generations of humans! And the fact that it is built on the foundation of cheap fossil fuels means that future generations must and will live differently.

Again, the awakening I am describing is an ongoing visceral as well as intellectual reassessment of every facet of life - food, work, entertainment, travel, politics, economics, and more. The experience is so all-encompassing that it defies linear description. And yet we must make the attempt to describe and express it; we must turn our multi-dimensional experience into narrative, because that is how we humans process and share our experiences of the world.

The great transition of the 21st century will entail enormous adjustments on the part of every individual, family and community, and if those adjustments are to be made successfully, rational planning will be needed. Implications and strategies will have to be explored in nearly every area of human interest - agriculture, transportation, global war and peace, public health, resource management, and on and on. Books, research studies, television documentaries, an every other imaginable form of information transferal means will be required to convey needed information in each of these areas. Moreover, there is the need for more than explanatory materials; we will need citizen organizations that can turn policy into action, and artists to create cultural expressions that can help fire the collective imagination. Within this whirlwind of analysis, adjustment, creativity, and transformation, perhaps there is need and space for a book that simply tries to capture the overall spirit of the time into which we are headed, that ties the multifarious upwellings of cultural change to the science of global warming and peak oil in some hopefully surprising and entertaining ways, and that begins to address the psychological dimension of our global transition from industrial growth to contraction and sustainability.

Most of the peaks that are before us cannot be avoided, but there are many things we can do to navigate down and around them so as to enhance human sanity, security, and happiness. Let us do those things. Let us work to make a future world from whose vantage point, decades hence, we can look back on these premonitions as having been far too gloomy.

Notes

1. From the OPEC Bulletin, Nov.-Dec., 2006: "[A]ll in all, most would appear to agree that peak oil output is not very far away for all of us. It could take place sometime within the next decade or so, which in fact means that there is not much time left for a world economy to be driven largely by oil." Meanwhile, Claude Mandil, Executive Director of the International Energy Agency, speaking on the IEA World Energy Outlook 2006, had this to day: "WEO-2006 reveals that the energy future we are facing today, based on projections of current trends, is dirty, insecure and expensive." www.energybulletin.net/22042.html
2. Robert Hirsch et al., "Peaking of World Oil Production: Impacts, Mitigation and Risk Management" (2005), www.projectcensored.org/newsflash/the_hirsch_report.pdf
3. See also: Kenneth S. Deffeyes, Beyond Oil: The View from Hubbert's Peak (Hill and Wang, 2005), and Roger D. Blanchard, The Future of Global Oil Production: Facts, Figures, Trends and Projections, by Region (McFarland, 2005).
4. Energy Watch Group, "Coal: Resources and Future Production," www.energywatchgroup.org/files/Coalreport.pdf. See also Richard Heinberg, "Burning the Furniture," http://globalpublicmedia.com/richard_heinbergs_museletter_179_burning_the_furniture.
5. http://kontentkonsult.com/blog/2006/01/peak_metals.html
6. Energy Watch Group, "Uranium Resources and Nuclear Energy," Dec., 2006 www.energiekrise.de/news/docs/specials2006/REO-Uranium_5-12-2006.pdf
7. Ivan Illich, Energy and Equity (Calder & Boyars, 1974), p. 17.
8. See http://en.wikipedia.org/wiki/Gini_coefficient
9. www.wider.unu.edu/research/2006-2007/2006-2007-1/wider-wdhw-launch-5-12-2006/wider-wdhw-report-5-12-2006.pdf
10. Data for this paragraph are taken from from The Overworked American: The Unexpected Decline of Leisure, by Juliet B. Schor (Basic Books, 1993); see also www-swiss.ai.mit.edu/~rauch/worktime/hours_workweek.html
11. GPI www.socialfunds.com/news/article.cgi/117.html
12. See www.maweb.org/en/index.aspx, http://article.wn.com/view/2007/01/04/Global_warming_is_here_now_what/
13. Michael Klare, Blood and Oil: The Dangers and Consequences of America's Growing Dependency on Imported Petroleum (Metropolitan Books, 2004).
14. Thanks to my friend Chellis Glendinning, for her book titled Waking Up in the Nuclear Age (1987), which was an inspiration in more ways than one.

No good news really...

Two weeks away and little seems to have changed. Equities, commodities
and credit are slightly better and bond yields are little changed,
along with FX. The only change of note is short term interest rates as
the money market crisis that I wrote about three weeks ago persists.
Three month libor continues to rise. Yesterday it fixed 99 basis
points over the repo in GBP, almost 75bp over in euro and today
expectations are that 3 month dollars will fix at 5.69%, a level more
synonymous with Fed Funds at 5 1/2 percent.

So far other markets have treated these developments with a remarkable
degree of insouciance. Indeed they seemed to have completely ignored
the deteriorating situation. I can't help believing that this casual
approach is a mistake and largely due to the widespread ignorance of
many financial market participants about the functioning of money
markets, yet ultimately everything comes down to money and it's
availability. And that is the point about what is going on now.

There is a credit crunch going on. Believe it. It just has taken on a
different guise to previous forms. It's not a run on banks but on
non-banks, institutions that have become quasi-banking operations but
lack the capital and depth to ride the storm. The sheer size of the
positions of many of those entities (I can't bring myself to call them
businesses) is staggering. Tiny XYZ bank suddenly has a $20bn dollar
exposure along with numerous "conduit" vehicles and then there are the
SIV lites and the various hedge fund CP based mutants. In short things
are a mess and unless central banks start to properly recognise the
dangers, the situation could reach critical.

This may sound overly dramatic but the risk of a significant failure
is building and LTCM may come to be regarded as a walk in the park.

The problem is of course is that central banks don't seem to recognise
the dangers. Equities et al are not flashing red and the current
situation is unprecedented in recent financial history. Just look at
the chart of 3 month libor versus base rates over the past twenty
years. The spread has occasionally been as wide but this was back in
the late eighties when rates were moving dramatically higher and
interest rates moved in 1 percent steps. The reality is that central
banks don't know how to do to deal with the current situation within
the confines of their existing rule books. [[UK CREDIT CRUNCH.gif]

Fixed rate term repo is an obvious solution, but that doesn't itself
address the problem of financing all the rubbish out there. Ultimately
that will mean a continued liquidity unwind which will inevitably act
on risk asset valuations and economic activity. Rate cuts are
inevitable against this background and the Fed should move by a
minimum of 50 basis points on September 18th and another 50bp on
October 31st. The danger is of that even such aggressive action may
come to be seen as merely pushing on a string.

More later.

Good Luck,

PPG
Patrick Perret-Green
Director
European Derivatives & Bond Trading

more rules...our should i say good advice..

20 Timeless Money Rules
Sunday, September 02, 2007 | 06:26 AM
in Investing
In what has to be one of the most brazen examples of click whoring I have ever come across, is this list of “20 timeless money rules” from CNN/Money Magazine

I won’t lift their copyrighted material, but let me save you the 20 clicks: Here are a collection of quotes that addresses the same issues that CNN addresses:

1. Be humble
When you do not know a thing, to allow that you do not know it--this is knowledge.
--Confucius

2. Take calculated risks
He that is overcautious will accomplish little.
--Friedrich von Schiller

3. Have an emergency fund
For age and want, save while you may; no morning sun lasts a whole day.
--Benjamin Franklin

4. Mix it up
It is the part of a wise man to keep himself today for tomorrow and not to venture all his eggs in one basket.
--Miguel de Cervantes

5. It's the portfolio, stupid
Asset allocation...is the overwhelmingly dominant contributor to total return.
--Gary Brinson, Brian Singer and Gilbert Beebower

6. Average is the new best
The best way to own common stocks is through an index fund.
--Warren Buffett

7. Practice patience
It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!
--Edwin Lefevre

8. Don't time the market
The real key to making money in stocks is not to get scared out of them.
--Peter Lynch

9. Be a cheapskate
Performance comes and goes, but costs roll on forever.
--Jack Bogle

10. Don't follow the crowd
Fashion is made to become unfashionable.
--Coco Chanel

11. Buy low
If a business is worth a dollar and I can buy it for 40 cents, something good may happen to me.
--Warren Buffett

12. Invest abroad
The World is a book, and those who do not travel read only a page.
--St. Augustine

13. Keep perspective
There is nothing new in the world except the history you do not know.
--Harry Truman

14. Just do it
It takes as much energy to wish as it does to plan.
--Eleanor Roosevelt

15. Borrow responsibly
As life closes in on someone who has borrowed far too much money on the strength of far too little income, there are no fire escapes.
--John Kenneth Galbraith

16. Talk to your spouse
"In every house of marriage there's room for an interpreter."
--Stanley Kunitz

17. Exit gracefully
Only put off until tomorrow what you are willing to die having left undone.
--Pablo Picasso

18. Pay only your share
The avoidance of taxes is the only intellectual pursuit that carries any reward.
--John Maynard Keynes

19. Give wisely
The time is always right to do the right thing.
--Martin Luther King Jr.

20. Keep money in its place
A wise man should have money in his head, but not in his heart.
--Jonathan Swift

Never hurts to learn from people smarter and/or more experienced than yourself . . .

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) "

Volkssturm Meets the Wizard of Oz: Get Iron Crosses

Winter (Economic & Market) Watch » Volkssturm Meets the Wizard of Oz: Get Iron Crosses: "The rout in the financial and real estate related job arena is on. Stories are making the rounds that Pig Men of various stripes will move after Labor Day to slash head counts significantly. Financial Times writes it will be 10-15% of staff, and high paid Bully jobs. This follows on the heals of the collapse of a number of mortgage outfits in August. Housing finance support companies like LandAmerica aren’t wasting any more time either announcing 1,100 layoffs. So far the BLS (Ministry of Truth) reports that construction employment is only down 75,000 from September. I have reported all along that these are totally fictitious numbers, but now estimates of one million job losses in that sector are making the rounds. More signs that economic strains on Brazil Americans continues to mount."

Two very different analysts call the market top

Dr. Marc Faber and Jim Shepherd both have lively investment newsletters. But there the similarities end, their market analysis is from different ends of the spectrum. Yet both the top Asian based guru and this well respected independent US commentator now think the end is nigh for US equities.
Saturday, December 11 - 2004 at 14:24

It is quite a co-incidence that both these leading gurus have reached the same conclusion. I don't know if they have ever met, but it is unlikely.

Dr. Faber is based in Asia and rooted in global economic history, while Jim Shepherd is very much an American independent analyst whose commentaries often sound as though the rest of the world did not exist and history began in 1929.

Jim Shepherd is more specific in his latest newsletter. He compares the present US stock market charts to 1929-32 - the year of the Great Crash and subsequent 90% market wipe-out - and today.

His argument is that greater liquidity in modern times has distorted the exact timing - but that the 50% market recovery from the initial crash in 2000 has now been repeated, and that we are now in for the final grand sell-off.

The famous Shepherd 'model' is flashing a red indicator - and the time to exit is now while the market is still listening to the analyst pack whose self-interest leads them to support the market whatever their private concerns.

Likewise Dr. Faber is signaling a 'major top' in US equities. He is fairly comfortable with the idea of a year-end rally but is worried about February. This would follow the pattern set on President Nixon's re-election in 1972 - namely a brief rally followed by two of the worst years in US stock market history.

Dr. Faber is a celebrated contrarian, and the accuracy of his market calls over the past few years is almost uncanny.

He called the Nasdaq top in 2000, foresaw the rise of gold and even penned a book 'Tomorrow's Gold' which only really required an investor to note the title, and was virtually alone in seeing the Chinese takeover in 1997 as a negative for Hong Kong.

Thus far he has been fairly sanguine about the US equity market, and correctly saw that loose monetary policy and irrational optimism amongst investors would be enough to drive the market forward.

Now a combination of rising taxes and interest rates, and falling house prices combined with the twin US deficits have convinced him that US equities are very overvalued, and ripe for a major correction.

For a rational investor to conclude that both these commentators are wrong would appear a little fool hardy. Of course, there are powerful entrenched commentators that would always have investors invest. These are the guys who take a commission whether the punters win or loose.

You just have to ask yourself, 'Am I happy investing at a time when two of the major independent market gurus are in agreement that this is not the time to invest?'

But they don't agree on what to do. Dr. Faber thinks US bonds are also doomed and counsels the holding of cash in US dollars or buying gold. Jim Shepherd tells clients to invest a third of their assets in US Treasuries because a deflationary period is around the corner.

However, it will be interesting to see how the alternatives stack up in the months ahead. Will the US economic recovery continue and equities follow? Or will other factors over-power a manufactured, pre-election US economic boom?

The Writing is on the Wall

The Writing is on the Wall: "his week, Larry Kudlow and others strongly chastised Bernanke for his failure to read the writing on the wall and urged the Fed Chairman to quickly slash the Fed Funds rate. Methinks the pundits doth protest too much. For years, Kudlow, who practically coined the term “Goldilocks economy,” has dismissed with scorn suggestions that the American economy was anything less than ragingly healthy. If our economy is really so strong, why does he call so loudly for the artificial stimulus of a significant rate cut? In truth, the writing has always been clearly on the wall all along. A credit bubble has been steadily inflating for at least the last six years, which in its final frenzy produced some of the most absurd mortgage funding products the world has ever seen. To anyone not dependent on the hysteria, a no-doc, no money down, negative amortization, interest only, adjustable rate jumbo mortgage was a just as clear a sign of pending catastrophe as $200 for a share of Pets.com, or 5,000 Dutch guilders for a single tulip bulb."

Dow crash scenario --

http://buttonwood1792.blogspot.com/2007/08/citi-research-discusses-dow-crash.html

We get to see a variety of Wall Street research reports, and one that came through the email this week was a shocker. No, it didn't come from a perma-bear who's been looking for the market to crash since 1960.

The report is from CitiFX, or Citigroup Foreign Exchange, dated August 24, entitled "We hold with our freaky chart scenario on DJIA.....BUT"

But what? I wish I could just post the report with its great charts, but it is copyrighted, so I will quickly boil it down.

The rocket scientists who put this together at the CitiFX technicals team looked back at 1987, 1990 and 1998. In looking at '90 and '98 here's what they say:

"1990: The Djia peaks on 17th July 1990 and turns. This is the start of a correction that takes it down 21.8% over 63 trading days over shooting the 200 week moving average by 0.5%
1998: The Djia peaks on 17th July 1998 and turns. This is the start of a correction that takes it down 21.6% over 31 trading days
2007: The Djia peaks on 17th July 2007 and turns. This is the start of a correction at a time when the 200-week moving average was sitting 21.50% below the peak."

Fascinating that the 17th of July is duplicated. CitiFX goes on...

"With the 2 prior occasions averaging 21.7% down over 47 trading days the sweet spot (If this correction goes according to plan) would be to see the DJIA at just below 11,000 on or around 19 Sept 2007 and no later than 11 Oct 2007."

For the 1998 and 1990 scenario, the report concludes: "Our base case view has for some time been the 1990 focus as equities got hit in the crossfire of housing and Kuwait while the credit crunch of 1998 also caught equities in the crossfire. As a consequence we believed (and still do) that the Equity move is the sideshow again not the main event. "

This CitiFX report also examines 1987 where the market was center stage. They call '87, "our much less desired/favoured scenario". But they point to a variety of situations in '87 that are similar to today:


"The last 2 years have been very good years for the stock market in an extremely strong bull market that began 5 years ago.
This has been fuelled by leverage buyouts/merger mania
Massive amout of money raised by packaging low quality fixed income securities that have high interest rate due to high risk of loss
Large IPO issuance
Inflation concerns have become elevated
We have a new leader at the helm of the Federal reserve.
USD has been declining amid concerns about the trade and budget deficits
U.S. long end yields have started to push up sharply again to new high in the move having corrected back for a number of months"
All of the above were '87 characteristics. Talk about deja vu all over again.

Says the CitiFX report, "As we have noted this is not our base case scenario, but smarter people than us who we respect have articulated concerns about a 1987 dynamic."

The report concludes: "Bottom line we hold our view that these are trying times and that the worst is not over. We also hold our view that lower yields will be seen in the months ahead on the back of credit, housing, the economy and equities. We believe that as this develops the Fed WILL show leadership, will cut rates as necessary and will ultimately stabilise the situation.
If we are wrong in this assessment then as we have said previously, without the Bernanke PUT we may have to entertain the idea of the Bernanke crash."

Will this come to pass? I have no idea - but it's food for thought that within the canyons of Wall Street, at a firm like Citi, this stuff is circulating.