Kontent News

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

Wednesday, October 31, 2007

History's warning about the price of money

By Manuel Hinds and Benn Steil

Published: October 30 2007 02:00 | Last updated: October 30 2007 02:00

The Federal Reserve's dramatic 0.5 per cent interest rate cut on Sep-tember 18 was greeted with euphoria in the stock market, which soared 5 per cent in the two weeks that followed. This fact itself was hailed as vindication for a Fed that felt Jim Cramer's pain, and gave the world the cheaper dollars the market guru shrieked for in CNBC's (and YouTube's) most memorable "Mad Money" segment ever.

To those who worry about inflation, the Fed could point to crunching credit as a danger to growth, and ipso facto a force for disinflation. Waiting for the numbers to prove it would just be reckless dithering.

We have sympathy for Ben Bernanke, Fed chairman, and company. The job of a price fixer is never easy. What should money cost? For most of human history this was easy: once you fixed a conversion factor with gold, you just sat back and let the forces of supply and demand do their stuff. But since the collapse of the Bretton Woods currency regime (the last vestige of thousands of years of commodity money), discretion has been the watchword. Nine smart folks at the Fed board have taken over the job of deciding what the price of money should be. If the hagiography and hatred showered on Mr Bernanke's predecessor, Alan Greenspan, is any indication, that price should be wisely wiggled down to make jobs, up to prick bubbles and now, apparently, back down to offset losses on millions of bad credit decisions.

So, are our cheaper dollars now at the right price? In the coming months, all eyes will be on the consumer price index for the answer.

Unfortunately, there are circumstances in which excessive monetary creation can destabilise the economy while the rate of CPI inflation remains low. These tend to be present when the danger of monetary destabilisation is at its highest because people have lost faith in the ability of money to keep its value through time.

As one of the great monetary economists of the last century, Jacques Rueff, pointed out in the late 1960s, people react to the "growing insolvency" of a reserve currency, such as the dollar, by acquiring "gold, land, houses, corporate shares, paintings and other works of art having an intrinsic value because of their scarcity". Sounds familiar? Indeed, this is the story of our present decade, one in which alternatives to the dollar as a store of value have soared even while the CPI has remained subdued.

This phenomenon is well-known in developing countries, where asset booms combined with low CPI inflation have preceded monetary and financial crises. In Mexico, for example, share prices rose 12-fold between January 1989 and November 1994, while inflation fell from 35 per cent to 7 per cent. Inflation then soared as the Tequila crisis exploded.

Prices of shares and real estate more than doubled from 1993 to 1996 in Indonesia and South Korea while CPI inflation rates were declining. In May 1997, just weeks before the currencies collapsed, inflation was only 4.5 per cent in Indonesia and 3.8 per cent in South Korea.

The same symptoms have been visible in many other monetary crises in developing countries. They seem to be visible today in the US. Following the 2001 dotcom crash, resources flowed into real estate, foreign exchange and commodities, while CPI inflation remained modest. In 2007 the housing bubble finally burst, causing credit to crunch as the market struggled to out the owners of dud mortgages and -mortgage-linked contracts. The Fed reacted with cheaper dollars, which did precisely nothing in that regard. Credit risk fears remain unabated. But the market duly dumped dollars for harder assets, pushing the euro, shares, oil and gold to record dollar prices.

Gold, having been global money for the better part of 2,500 years, and therefore the commodity most sensitive to expectations of macroeconomic in-stability, provides the best measure of the extent of the rush towards -inflation-proof hard assets.

Between August 2001 and August 2007, the dollar price of gold soared 144 per cent, while the CPI rose only 17 per cent. The last time such a substantial and sustained appreciation of gold was observed was in the 1970s, on the heels of America's loose money policy and balance of payments deterioration in the 1960s and Rueff's warnings regarding "the precarious dominance of the dollar". There were two episodes, from 1971 to 1975 and from 1977 to 1980. In both, the increase in the price of gold and other commodities presaged substantial increases in CPI inflation as well as significant falls in the international value of the dollar.

The dollar sustained its role as the international standard of value because of good fortune on two fronts. First, the Fed under Paul Volcker hammered out inflationary expectations with a painful but necessary period of high interest rates. Second, there was no viable alternative.

It may not be so lucky this time. Today, not only does the euro wait in the wings as understudy, but gold banks have risen in tandem with the dollar's decline and offer the world a viable private alternative that has permanent intrinsic value.

As the Fed debates whether the world is truly crying out for even cheaper dollars, it would be wise to heed the lessons of monetary history.

Manuel Hinds is a former Salvadoran finance minister and author of Playing Monopoly with the Devil. Benn Steil is director of international economics at the Council on Foreign Relations and co-author of Financial Statecraft

Tuesday, October 30, 2007

The Secrets of Intangible Wealth -- Education, dudes!

By Ronald Bailey
September 29, 2007

A Mexican migrant to the U.S. is five times more productive than one who stays home. Why is that?

The answer is not the obvious one: This country has more machinery or tools or natural resources. Instead, according to some remarkable but largely ignored research — by the World Bank, of all places — it is because the average American has access to over $418,000 in intangible wealth, while the stay-at-home Mexican’s intangible wealth is just $34,000.

But what is intangible wealth, and how on earth is it measured? And what does it mean for the world’s people — poor and rich? That’s where the story gets even more interesting.

Two years ago the World Bank’s environmental economics department set out to assess the relative contributions of various kinds of capital to economic development. Its study, “Where is the Wealth of Nations?: Measuring Capital for the 21st Century,” began by defining natural capital as the sum of nonrenewable resources (including oil, natural gas, coal and mineral resources), cropland, pasture land, forested areas and protected areas. Produced, or built, capital is what many of us think of when we think of capital: the sum of machinery, equipment, and structures (including infrastructure) and urban land.

But once the value of all these are added up, the economists found something big was still missing: the vast majority of world’s wealth! If one simply adds up the current value of a country’s natural resources and produced, or built, capital, there’s no way that can account for that country’s level of income.

The rest is the result of “intangible” factors — such as the trust among people in a society, an efficient judicial system, clear property rights and effective government. All this intangible capital also boosts the productivity of labor and results in higher total wealth. In fact, the World Bank finds, “Human capital and the value of institutions (as measured by rule of law) constitute the largest share of wealth in virtually all countries.”

Once one takes into account all of the world’s natural resources and produced capital, 80% of the wealth of rich countries and 60% of the wealth of poor countries is of this intangible type. The bottom line: “Rich countries are largely rich because of the skills of their populations and the quality of the institutions supporting economic activity.”

What the World Bank economists have brilliantly done is quantify the intangible value of education and social institutions. According to their regression analyses, for example, the rule of law explains 57% of countries’ intangible capital. Education accounts for 36%.

The rule-of-law index was devised using several hundred individual variables measuring perceptions of governance, drawn from 25 separate data sources constructed by 18 different organizations. The latter include civil society groups (Freedom House), political and business risk-rating agencies (Economist Intelligence Unit) and think tanks (International Budget Project Open Budget Index).

Switzerland scores 99.5 out of 100 on the rule-of-law index and the U.S. hits 91.8. By contrast, Nigeria’s score is a pitiful 5.8; Burundi’s 4.3; and Ethiopia’s 16.4. The members of the Organization for Economic Cooperation and Development — 30 wealthy developed countries — have an average score of 90, while sub-Saharan Africa’s is a dismal 28.

The natural wealth in rich countries like the U.S. is a tiny proportion of their overall wealth — typically 1% to 3% — yet they derive more value from what they have. Cropland, pastures and forests are more valuable in rich countries because they can be combined with other capital like machinery and strong property rights to produce more value. Machinery, buildings, roads and so forth account for 17% of the rich countries’ total wealth.

Overall, the average per capita wealth in the rich Organization for Economic Cooperation Development (OECD) countries is $440,000, consisting of $10,000 in natural capital, $76,000 in produced capital, and a whopping $354,000 in intangible capital. (Switzerland has the highest per capita wealth, at $648,000. The U.S. is fourth at $513,000.)

By comparison, the World Bank study finds that total wealth for the low income countries averages $7,216 per person. That consists of $2,075 in natural capital, $1,150 in produced capital and $3,991 in intangible capital. The countries with the lowest per capita wealth are Ethiopia ($1,965), Nigeria ($2,748), and Burundi ($2,859).

In fact, some countries are so badly run, that they actually have negative intangible capital. Through rampant corruption and failing school systems, Nigeria and the Democratic Republic of the Congo are destroying their intangible capital and ensuring that their people will be poorer in the future.

In the U.S., according to the World Bank study, natural capital is $15,000 per person, produced capital is $80,000 and intangible capital is $418,000. And thus, considering common measure used to compare countries, its annual purchasing power parity GDP per capita is $43,800. By contrast, oil-rich Mexico’s total natural capital per person is $8,500 ($6,000 due to oil), produced capital is $19,000 and intangible capita is $34,500 — a total of $62,000 per person. Yet its GDP per capita is $10,700. When a Mexican, or for that matter, a South Asian or African, walks across our border, they gain immediate access to intangible capital worth $418,000 per person. Who wouldn’t walk across the border in such circumstances?

The World Bank study bolsters the deep insights of the late development economist Peter Bauer. In his brilliant 1972 book “Dissent on Development,” Bauer wrote: “If all conditions for development other than capital are present, capital will soon be generated locally or will be available . . . from abroad. . . . If, however, the conditions for development are not present, then aid . . . will be necessarily unproductive and therefore ineffective. Thus, if the mainsprings of development are present, material progress will occur even without foreign aid. If they are absent, it will not occur even with aid.”

The World Bank’s pathbreaking “Where is the Wealth of Nations?” convincingly demonstrates that the “mainsprings of development” are the rule of law and a good school system. The big question that its researchers don’t answer is: How can the people of the developing world rid themselves of the kleptocrats who loot their countries and keep them poor?

Monday, October 29, 2007

The Catastrophist View

Peter Schiff is laughing at me. I've just asked him to entertain the following notion: that we dodged a bullet during August's financial-market turmoil and, with the stock market bouncing right back from every dip, things might be okay. So why worry?

He stops laughing. “Why worry?” he asks. “Because we dodged a bullet but are about to step on a hand grenade.”

Sitting in a corner office of a nondescript building just off I-95 in Darien, Connecticut, Schiff, the president of brokerage Euro Pacific Capital, will spend the next hour spelling out a singularly pessimistic view of the American economy. And he will do so while exhibiting a curious juxtaposition unique to the bearish prognosticator: He speaks of disaster with a smile on his face. No, he's not happy about our impending doom. But he is happy that people are finally taking him seriously.

THREAT NO. 1
The Bottom Continues to Fall Out of the Housing Market

Manhattan's gravity-defying real estate aside, it's quite clear the nation is experiencing a genuine housing crisis. In August, pending home sales dropped 6.5 percent, and they currently sit at their lowest level since 2001. The National Association of Realtors conducted a recent survey that showed more than 10 percent of sales contracts fell through at the last moment in August, primarily owing to disappearing loan commitments from banks. The crisis will only deepen, when more borrowers see their adjustable-rate mortgages adjusted upward. There was a foreclosure filing for one of every 510 households in the country in August, the highest figure ever issued, and by one estimate, more than 1.7 million foreclosures will occur in the country by the end of 2008. That's not just subprime borrowers: According to the Federal Housing Finance Board, while nearly 35 percent of conventional mortgages in 2004 used ARMs, some 70.7 percent of jumbo loans—those above $333,700 (the jumbo threshold in 2004; it's now higher)—did too.

Hedge-fund veteran Rick Bookstaber, the author of A Demon of Our Own Design, spells out a potentially disastrous scenario that could unfold regardless of what the Fed does: Continued foreclosures result in a further drop in housing prices, which results in further foreclosures, which result in a further drop in housing prices. Even for those of us not selling, reduced home values result in a reduced sense of security, which results in reduced consumption, which results in a slowing economy, which … you get the point.

THREAT NO. 2
The Derivatives-Related Meltdown, Part II

Each time one of these write-downs has been announced, the market has had a curiously positive response, taking the news as a sign that the worst was over and the banks were cleaning up their books. But because these derivatives are linked to other debt, there's no reason to be certain that trouble won't bleed into other markets. Among other things, the liquidity crisis froze the market in structured investment vehicles (SIVs), a nifty bit of financial engineering that banks use to profit from the spread between short-term debt and long-term debt. No one yet knows how nasty these losses could turn out to be because SIVs are stashed, Enron style, off the books.

THREAT NO. 3
Consumers Run Out of Steam (and Take the Economy Down With Them)

The willingness of consumers to keep spending and piling on debt in the midst of a slowing real-estate market is hailed on Wall Street as an act of patriotism, which Schiff considers perverse. Imagine, he suggests, that you ran into a good friend and asked him how he was doing. His reply: “I took out a third mortgage, maxed out my credit cards, and emptied out my kids' college savings account so I could buy a bigger TV and a new car, and we're going to Greece on vacation over the holidays. Things are great!” Schiff lets the idea sink in and then finishes the thought: “And we're celebrating the fact that we're doing this as a nation?”

THREAT NO. 4
That the Rest of the World Decides They Don't Need Us and the Dollar Tumbles Hard

The dollar is falling, possibly collapsing, depending on whom you talk to. The greenback has sunk close to its lowest point in the post-1973 floating-exchange-rate era, so low that it's been overtaken by the Canadian dollar—affectionately known as the loonie—for the first time since 1976. How low will it go? When Alan Greenspan was asked by Lesley Stahl of 60 Minutes last month what currency he'd like to be paid in, his response was telling: “[The] key question … is, ‘In what currency do you wish to hold your assets?' And what I've done is I diversify.” Translation: He isn't betting on the dollar. And neither is the majority of Wall Street.

THREAT NO. 5
That We Don't See It Happening Because It's a Slow-Motion Train Wreck

4 phases of the US bust

A friend of mine who is a senior professional in one of the largest financial institutions in the world has sent me
privately – and confidentially - the following email messages. Like me, he predicted a year ago that this would be
the worst housing recession in US history and described a bust process that would go through 4 phases. Here is the way he is putting it:

It appears that we are now entering phase 2 on the timeline for the housing bust:

Phase 1: rising mortgage defaults, homes prices start falling, sale volumes falls, housing starts and permitsdecline.

Phase 2: home-builders' bankruptcies, housing starts and permits crash, substantial layoffs in construction and real estate-related fields (mortgage brokers, mortgage lenders, etc.).

Phase 3: substantial price declines in major metro areas, large rise in defaults of prime but low-equity mortgages.

Phase 4: large-scale government intervention to help households going bankrupt. This is a political phenomenon, so the timing and nature of this cannot be reliably forecast.

Evidence of financial distress and default among homebuilders in phase 2:

Public builders in trouble:

Levitt Corp (LEV): "Levitt home-building unit gets loan default notices"

Tousa (TOA): "A creditor group that owns more than $1 billion in senior notes and subordinated debt has hired law firm Akin Gump Strauss Hauer Feld to assess its rights in the event of a bankruptcy filing"

Plus many smaller, private builders in trouble or bankrupt:

"As countless builders and subcontractors go out of business or find themselves unable to pay their bills, Glover and his fellow repossession agents are snapping up the vehicles at the behest of lien holders such as Ford Motor."

Neumann Homes: "Crippled by the downturn in the housing market, Neumann Homes, one of Chicago's largest home-building companies, said Monday that it plans to file for bankruptcy."

Enterprise Construction (FL) files for bankruptcy

I fully agree with him with one caveat: we are not just at the beginning of phase 2 but most likely already at phase 3 as most of the aspects of phase 2 have already occurred by now and some elements of 3 are already on their way (home prices are falling sharply in some major metro areas, we are seeing the rise in defaults in near prime and prime mortgages and some near prime and prime lenders are in trouble). And we are getting close to phase 4 as over a dozen proposals to rescue 2 million plus households on the way to default and foreclosure are now being debated in
Washington.

Next, this senior colleague sent me the following additional message - after my latest blog revisiting my predictions – on the macro impact of the worst housing bust in US history:

Follow-up to your blognote today... I think you deserve credit for your bold forecast, violating the rule of never predict both an event and a date.

Even more interesting is that the current view has not substantially changed from that of a year ago. The evidence is now overwhelming and consensus admits what they denied last year: that we will experience at least a severe
housing downturn -- in price action unlike anything since the 1930's, probably also in rates of foreclosure.

But consensus opinion remains unshaken that there will be only minor macro effects. This seems extraordinary to me. A 70 year record decline in what is perhaps the largest private asset class, the collateral for the majority of
household debt, whose leverage is at an all-time record high. A downturn - perhaps crash - in the construction and real estate industries (18% of 2005 total metropolitan area GDP).

Perhaps the most astonishing aspect of this event is the refusal to recognize the possible dimensions, the impact,of what is coming.

Indeed, the soft landing consensus is increasingly delusional in believing that the biggest housing recession in US history will not have severe macro effect. Most of the consensus now recognizes that, after the spurt in growth in Q3 (probably a little above 3%) the economy is now rapidly decelerating and Q4 will be weak: for example one of the most bullish houses – JP Morgan – is now forecasting a Q4 growth of only 1%, fully in the growth recession territory (Bloomberg consensus for Q4 is an optimistic 1.8%). But this consensus next goes to assume and predict that Q4 will be the bottom of the US growth slowdown and that economic growth will recovery in soft landing territory (2.5%).

What is the basis for this alleged 2008 growth recovery? Mostly wishful thinking as the economic and financial shocks leading to falling demand (a worsening housing bust; anemic capex spending; slowdown in commercial real estate demand; sharp private consumption slowdown) and weak supply (weakening ISM; slowing down employment; glut of supply of new and existing homes, auto/motorvehicles, consumer durables; a capacity overhang; an excess inventory buildup) will fully persist into 2008. Indeed, as David Rosenberg, the chief US economist for Merrill Lynch put it in his most recent report:

"We think a miracle is needed to avoid recession. With domestic demand growth struggling to stay above a 1% run-rate, if we manage to avoid a recession with another huge down-leg in homebuilding activity and home prices, we
think it will be a miracle."

A miracle to avoid a recession! Indeed it seems that many of the soft landing optimists are now in wishful thinking mode, if not hoping for a miracle. As Ed Leamer showed in his Jackson Hole paper, six of the last eight housing recessions have ended up in a economy-wide recession; and this housing recession will end up being more severe than
all of the former eight ones. The only two exceptions of a housing recession not leading to economy-wide ones were those during the Korean War and the Vietnam war when a massive fiscal stimulus rescued the economy. What we spent –
or waste – on Iraq is not sufficient to get that fiscal stimulus; we would need another equivalent of $200 billion fiscal stimulus to do the job. A war with Iran is such an option: but a war in Iran would lead to an overnight doubling of oil prices to $200 per barrel plus and would lead to a certain U.S. and global recession.

Home prices will have to fall by 20% to bring back home affordability to semi- normal levels; or mortgage rates would have to fall by 200bps to get the same result. Chances of the latter happening are zippo as long rates went up
after the Fed eased on September 18th. So the adjustment will occur via a painful and deflationary 20% fall in home prices that will trigger an economy wide recession as any mainstream macro-econometric model shocked with a 20% fall
in home prices shows.

No wonder that Mishkin – in his Jackson Hole paper – went through a benchmark scenario where home prices fall by 20%; do you think that Bernanke had not read Mishkin's paper before the Jackson Hole meeting? And the implication of
the Mishkin paper was that the Fed needed to start with a 200bps Fed Funds cut to try to attempt to counter this home price shock alone; even that would not be enough as long rates and mortgage rates are likely to fall less than otherwise hoped by the Fed.

So no surprise that Marty Feldstein urged at Jackson Hole the Fed to cut rates right away – to start with – by 100bps. But, at best, the FOMC will give us another 25bps as a Halloween Treat on Wednesday, not the 200bps implied by the Mishkin analysis. So, what the Fed does is – again – too little too late. The consensus among the independent academic luminaries at Jackson Hole (Feldstein, Leamer, Shiller, and even implicitly, Mishkin) was that this was the worst housing bust ever and that the macro effects would be severe with a high risk of a recession. So why is the
Wall Street consensus and the Fed not getting it?

What does the macro econometric model used by the Fed imply if you shock it with the worst US housing recession, 20%fall in home prices, collapsing HEW, a severe liquidity and credit crunch, a rise in investors' risk aversion and
uncertainty, and oil at $90? Would someone at the Fed let us know? And - based on that model - which cut in the Fed Funds rate it will take to avoid a recession? Hopefully someone at the Fed may have that answer and provide it to
the public.

Wednesday, October 24, 2007

The Blow up artist - Niederhoffer

Can Victor Niederhoffer survive another market crisis?
by John Cassidy

Niederhoffer’s approach is eclectic. His funds, a friend says, appeal “to people like him: self-made people who have a maverick streak.”


“Practical Speculation” On a wall opposite Victor Niederhoffer’s desk is a large painting of the Essex, a Nantucket whaling ship that sank in the South Pacific in 1820, after being attacked by a giant sperm whale, and that later served as the inspiration for “Moby-Dick.” The Essex’s captain, George Pollard, Jr., survived, and persuaded his financial backers to give him another ship, but he sailed it for little more than a year before it foundered on a coral reef. Pollard was ruined, and he ended his days as a night watchman. The painting, which Niederhoffer, a sixty-three-year-old hedge-fund manager, acquired after losing all his clients’ money—and a good deal of his own—in the Thai stock market crash of 1997, serves as an admonition against the incaution to which he, a notorious risktaker, is prone, and as a reminder of the precariousness of his success.

Niederhoffer has been a professional investor for nearly three decades, during which he has made and lost several fortunes—typically by relying on methods that other traders consider reckless or unorthodox or both. In the nineteen-seventies, he wrote one of the first software programs to identify profitable trades. In the early eighties, he went into business with George Soros, then arguably the world’s most successful investor. A few years later, when prominent money managers were based almost exclusively in Manhattan, Niederhoffer moved his home and his trading room to Connecticut, to a twenty-thousand-square-foot neo-Tudor mansion crammed with books, manuscripts, silver jewelry, art work, and a collection of seashells. The walls of his vast living room, which has a ceiling about thirty feet high, are covered with more than two dozen paintings, many depicting industrial landscapes or Western shoot-’em-ups, and the floor is occupied by, among other objects, a large painted pony, a black-spotted wooden hound carrying three quail on its back, a seated pig, and two miniature black bears. Niederhoffer’s home is also frequently occupied by various of his children. (He has six daughters and an infant son, from two marriages and an extramarital relationship.)

After the 1997 Asian financial crisis, Niederhoffer was forced out of business for several years. Then, in his late fifties, he made a dramatic recovery. He founded three new hedge funds and launched a Web site, DailySpeculations.com, where he posts his idiosyncratic insights into the stock market—“What can we learn from shelled species about the markets?” he wrote in May—as well as opinions about sports, politics, and culture (“ ‘The Fantasticks,’ currently running as a revival on Broadway, is the perfect musical”). He has mentored dozens of successful traders, many of whom regard him as a guru. “Before I joined Victor, I used to trade for a Wall Street firm,” James Lackey, a self-employed Florida investor who placed trades for Niederhoffer from 2002 to 2006, told me. “But I quickly realized that I didn’t know very much. What he taught me was how to approach the market as a whole, and how to analyze it scientifically. He was just amazing at seeing what was happening and showing us how to make money.”

Niederhoffer, a former national squash champion who is considered one of the most talented Americans to have played the game, relishes the acclaim, but he knows that in his field circumstances can change quickly. By the end of August, his funds were in trouble, and on Wall Street rumors circulated that he would soon be out of business again. Niederhoffer had been worried all summer, but he tried to project a wry, self-deprecating humor. “If an event like 1997 occurred again, my dependents would be up the creek, and I would be a night watchman somewhere, just like Captain Pollard,” he said to me when I visited him at his home one morning in June. “In America, they give you a second chance but not a third.”

Tall and trim (he still looks like an athlete), with closely cropped white hair, olive skin, and a long, expressive face, Niederhoffer speaks softly, with a strong Brooklyn accent. He was wearing a yellow shirt, pink trousers, and white socks, but no shoes—he maintains a “no shoes” rule in the office, to reduce noise—and was sitting behind his desk, which is dominated by two Bloomberg screens, in a large room over the garage which he shares with his partner, Steve Wisdom, and several members of his company, Manchester Trading. (The trading operation fits into two rooms; the other one is over the kitchen.) In one hand, he was holding a telephone receiver, and his light-blue eyes were fixed on the computer screens. “The market’s way down today,” he said by way of greeting. Turning back to the telephone and addressing his broker at the Chicago Mercantile Exchange, he asked, “Can you repeat those quotes, please?” After a few seconds, he said, “I’ll sell two hundred red March at five hundred and ten. I’ll sell two hundred blue March at eleven ten.”

The Chicago Merc is a futures market, where people trade contracts that give them the right to purchase a particular commodity at a specified date in the future. Originally, the items traded on the exchange were physical commodities, such as eggs, butter, and pigs, and its main customers were farmers and food companies. In recent decades, futures trading has become more abstract; professional speculators now use the exchange to place bets on the prices of financial securities, such as stocks, bonds, and currencies—a development that Niederhoffer, a former math prodigy who has a Ph.D. in economics, has exploited. He likes to be at his desk well before the Chicago market opens, especially on days when he has big positions riding overnight. He is mainly a short-term operator—he bets on how prices will move in the subsequent few minutes, hours, or days—and most of his knowledge of current events comes from Bloomberg. (He doesn’t read newspapers or watch television.) When he arrives at his office, he turns on his computer and reads about developments in the Asian and European markets, which often foreshadow the day’s action in the United States.

At the end of the previous week, the yield on ten-year Treasury bonds had surged to almost five per cent, prompting Niederhoffer to turn uncharacteristically bearish on stocks. Once the bond yield reached five per cent, he had reasoned, some investors would move their money from stocks to bonds, which would depress stock prices. Accordingly, he had sold short more than a billion dollars’ worth of stock futures. (Selling short, a common tactic among speculators, involves selling something you don’t own with the intention of buying it back later, at a cheaper price. If the price of the security falls while you are “short,” you make a profit; if the price rises, you lose money.)

Even by Niederhoffer’s generous standards, going short a billion dollars of stock futures was a large bet, but it worked out well. Not long after the markets reopened on Monday, the bond yield climbed to five per cent, and stocks and stock futures tumbled. On Wednesday, the morning of my visit, shortly after the opening bell sounded on Wall Street, Niederhoffer repurchased the futures he had sold, making more than five million dollars.

He didn’t look pleased, though. During the morning, stocks had continued to fall, and he knew that if he had waited he could have made an even bigger profit. He says that in twenty-eight years as a professional investor he hasn’t had a single truly satisfactory trading day. At eleven o’clock, the Dow Jones Industrial Average had slipped about a hundred points and the S. & P. 500 Index was down about thirteen points. Niederhoffer stared morosely at his Bloomberg screens. “The score doesn’t look good,” he muttered. The screens were tracking the movements of various stock-market indices in Europe and Latin America, but I noticed that they weren’t displaying any American prices. Niederhoffer used to invest heavily overseas, but since his 1997 misadventure in Thai stocks he has confined his trading to the United States. He explained that when the U.S. market was falling he preferred to track the DAX, a German stock index that generally moves in synch with the American market. “You can see how much you are losing, but it doesn’t hurt as much as watching the S. & P.,” he said.

Before long, Niederhoffer cheered up a bit. “There have been three big down opens in a row, which is unusual,” he said. “The market doesn’t like to do the same things repeatedly.” He turned to Alex Castaldo, a thin, bespectacled fifty-three-year-old Italian who has a degree in electrical engineering from M.I.T. and a Ph.D. in finance from CUNY, and asked him to compile some data. “Doc,” he said to Castaldo, “what does the market do when it opens down a lot three days in a row?” A few minutes later, Castaldo handed Niederhoffer a computer printout, which showed that since the start of 2003 there had been just ten occasions on which, for three consecutive days, the S. & P. 500 had fallen sharply in the first hour and a half of trading. On eight of those occasions, stocks had bounced back, with the average market rise by the end of the following trading day amounting to three tenths of one per cent. For a trader like Niederhoffer, who uses leverage—borrowed money—to scale up his bets, the ability to predict even relatively small changes in the market can pay off handsomely.

The software that Niederhoffer uses to identify stock-price patterns is a version of the code that he wrote thirty years ago. Many hedge funds and Wall Street banks now rely on such programs to spot potentially lucrative market fluctuations and place orders automatically—a practice known as “black box” investing—but Niederhoffer is scornful of this method. Although markets sometimes move in predictable ways, he says, the patterns change constantly, and reliance on mathematical algorithms can be disastrous. At Manchester Trading, Niederhoffer or Wisdom reviews each trade before it is placed.

In this instance, Niederhoffer expected the market to rebound, but he decided to hold off on buying. Morgan Stanley had just issued a notice advising its clients to reduce their stock holdings. “Plus, the Fed has been making bearish noises,” Niederhoffer said. A few minutes earlier, the Dow had dropped below thirteen thousand five hundred. Castaldo went over to Niederhoffer’s Bloomberg and called up some U.S. stock charts. Niederhoffer, looking at the falling lines, announced, “It’s gone down two per cent—that’s enough.” Then he turned to Owen Wilson, a young Englishman who has worked for him for a couple of years. Holding a phone to his ear, Wilson shouted out quotes from the Chicago Merc. “Buy a hundred and fifty at eighteen seventy-five,” Niederhoffer said. Wilson placed the trades and called out more numbers. Again, Niederhoffer told him to buy. Within a few minutes, Wilson had purchased tens of millions of dollars’ worth of stock futures.

Niederhoffer received his first lessons in finance as a child growing up in Brighton Beach. He learned to bet on stoopball, paddleball, and checkers, which he played with other local kids, and with adults who went by nicknames such as Bitter Irving, Bookie, and Nervous Phil. His father, Artie, a New York City cop who spent twenty years on the force before becoming a professor of sociology at John Jay College of Criminal Justice, tried unsuccessfully to dissuade him from gambling. “Everything was a money game,” Niederhoffer told me. “My father hated it, but I loved to win a nickel or a dime.” With the encouragement of his uncle Howie, who was in high school, he also placed wagers on professional sports. In October, 1951, on Yom Kippur, Howie and Victor, who was eight, sneaked out of synagogue and bet eight hundred dollars on the Brooklyn Dodgers, who were playing the New York Giants in a pennant-decider. When Bobby Thomson hit his famous home run, defeating the Dodgers, Howie and Victor were devastated. (The knowledge that only two of the lost dollars were Niederhoffer’s did little to console him.)

Niederhoffer says that as far back as the Middle Ages his ancestors were money changers. At the end of the nineteenth century, his paternal great-grandparents moved from Austria to the Lower East Side, where several of their seven sons sold fruit from a horse and cart. Niederhoffer’s grandfather Martie, who had a good head for figures, became an accountant. In the boom years of the nineteen-twenties, Martie borrowed money and invested it in real estate and stocks, assembling a portfolio that made him nearly a millionaire. The stock-market crash of October, 1929, destroyed most of his wealth; two years later, the market dived again, wiping out what he had left.

Martie, who spoke Yiddish and pidgin Spanish, got a job as a translator in a Brooklyn courthouse. But he retained an interest in the stock market, and in 1954 he financed Victor’s first equity investment: a hundred shares of the Benguet Mining Company, which was trading at fifty cents. For several years, the stock hardly moved. Then, in just a few months, it doubled in value. On Martie’s advice, Victor sold his shares, and made a profit of fifty dollars. During the next thirty-six months, the stock’s value increased to thirty dollars a share. “I have repeated the mistake of grabbing at small profits and selling at a targeted round number over and over in my speculative career,” he wrote in “The Education of a Speculator,” a memoir that he published in 1997. “I believe many others make this same error.”

At the age of six, Niederhoffer says, he was such an accomplished paddle-tennis player that he had to spot his opponents fifteen points a game. At thirteen, he defeated a seventeen-year-old to win the New York City junior singles tennis championship. (In school, his competitiveness elicited mixed reactions. At the end of his last year at P.S. 225, his sixth-grade teacher wrote, “Although a little trying at times, you were the spark the class needed this year. You have a keen mind; learn to curb your inclinations to demonstrate superiority.”) At Abraham Lincoln High School on Ocean Parkway, Niederhoffer was the president of his class, the captain of the tennis team, the star of the math team, a pianist in the orchestra, a clarinettist in the band, the sports editor of the newspaper, and a frequent contributor to Vanguard, the school magazine. In an article that appeared in the June, 1958, issue, Niederhoffer warned that automation “will require a complete reorientation” in the attitudes of trade unions. Five months later, displaying a view of government intervention that he would later renounce, he argued that “federal aid to education is imperative if equality of educational opportunity in our democracy is to have real meaning.”

Niederhoffer’s father, whom he idolized, encouraged his athletic and intellectual pursuits, and his mother, Elaine, who was descended from a long line of rabbis, pressed him and his younger brother and sister—now, respectively, a commodity-fund adviser and a psychiatric social worker—to succeed. “My mother was never content,” Niederhoffer told me. “She pushed us to be No. 1.” In January, 1960, at his mother’s urging, he applied to Harvard. In a letter of recommendation, his academic adviser and tennis coach, Milton Hecht, wrote, “Victor ranks among the first in intellectual achievement and promise in comparison with the thousands of students I have taught in the last thirty years.” Harvard awarded him a partial scholarship, as did Columbia and the University of Pennsylvania. Niederhoffer chose Harvard, where he majored in economics.

Niederhoffer spent less time in the classroom than he did on the squash court. Until he moved to Cambridge, he had never played squash—or squash racquets, as it was then called—but the physical demands of the game appealed to him. He borrowed every book on squash at the Widener Library, and took some with him to the practice court, where he opened them on the floor and repeatedly copied the moves they described. In 1962, as an eighteen-year-old sophomore, Niederhoffer won the junior championship of the National Intercollegiate Squash Racquets Association. A year later, he won the Harry Cowles tournament, a prestigious competition for amateurs. “He has good size, quickness, and a skillful touch,” his Harvard coach, Jack Barnaby, told the News and Views of Harvard Sports, a campus publication, in January, 1963. “But a lot of players have those attributes. What he has beyond that is one of the most competitive characters I’ve ever seen. He makes you feel like you are watching a person of Ty Cobb’s cut in action again.”

In the 1963-64 season, Niederhoffer, now a senior, was captain of the Harvard squash team, which went undefeated. He also won the individual national collegiate title, and his aggressive playing style attracted the attention of a reporter at Sports Illustrated, who wrote, “Niederhoffer thinks he is unbeatable and clamors loudly for justice when his shots go awry. Consequently, on those rare occasions when he loses a tournament, squash lovers are delighted.” The reporter quoted Niederhoffer’s freshman coach, Corey Wynn, who recalled his former student’s penchant for “handballing it”—physically blocking his opponents from reaching the ball, a tactic that was frowned upon in New England. Niederhoffer’s mother read the article and consulted a Fifth Avenue law firm, Cohn & Glickstein, about suing Sports Illustrated for libel. (On the firm’s advice, she decided not to file a suit.)

In February, 1966, Niederhoffer won the U.S. national amateur championship, the culmination of a series of important victories. Sports Illustrated and Time sent reporters to these events, and Niederhoffer wasn’t pleased with the coverage. First, he wrote to Time, denying its claim that during the national championship he had offered odds of two-to-one against himself. An editor replied, defending the magazine’s reporting as having been based on “reliable sources.” Unsatisfied, Niederhoffer wrote another letter, to a senior executive at Time-Life, the parent company of both Time and Sports Illustrated, complaining that the articles had “created the impression that I was a poor boy from Brooklyn who had adjusted badly to the rigors of a social sport.”

An aura of class and ethnic prejudice pervaded press accounts of Niederhoffer’s achievements; he was widely viewed as an ill-mannered upstart from the wrong side of the East River. The Times Magazine noted that he was “built wrong for a squash player: not lithe and wiry, or even tall and gracefully powerful. He is shaped rather like a block—fairly broad in the shoulders, no waist, thick shapeless legs—and his color is sallow, the deep oyster sallow of a New York street creature.” In Chicago, where Niederhoffer moved in 1964, to attend graduate school, he couldn’t find a squash club that would admit him. He was so offended that for several years he gave up the game.

After he returned to the court, in 1972, he won the national amateur championship four years running, an unprecedented feat. In January, 1975, in Mexico City, he won the North American Open, a major professional tournament, defeating the legendary Pakistani player Sharif Khan in four games. Afterward, Niederhoffer wasn’t very gracious. “Khan had a fatal plan—a lack of real toughness,” he told Sports Illustrated. “He’s been winning so long he doesn’t know anymore what it is to play a battle to the death.”

Shortly after noon, a housekeeper’s voice announced over an intercom, “Victor’s lunch is ready. Does he want it?” “No,” Niederhoffer replied. “I can’t eat lunch with the market like this.” He looked at his screens. “Europe got killed,” he said to nobody in particular. He was still irked by Morgan Stanley’s bearish notice to clients. “If the big brokerage houses are going to make money from commissions, they have to get people selling as well as buying,” he said dismissively. Unlike most Wall Street firms, Manchester Trading doesn’t have a television in its trading room, partly because Niederhoffer doesn’t want to be distracted but also because he can’t abide doom-mongering market commentators, like Alan Abelson, a columnist for Barron’s, the financial weekly, and Robert Prechter, Jr., the publisher of the Elliot Wave Theorist. “These people have been bearish since Dow 700,” Niederhoffer said angrily. “When the market is going up, they can’t get a hearing. But when the market falls they get invited back on. They say it’s like 1997, or 1987, or 2002. How about 1907? That was a bad year. Interest rates went up; the market went down by nearly fifty per cent.”

Just after one o’clock, the market hit a new low for the day, with the Dow down about a hundred and twenty-five points, and the S. & P. 500 down about fourteen points. It is a strange feature of financial markets that time occasionally seems to speed up. On quiet days, when prices aren’t moving much, traders monitor their positions, read the papers, and chat with each other, and it can seem as though an eternity passes before the closing bell sounds. But when the market becomes volatile every move brings with it a fresh opportunity for profit or loss, and each minute can fly by. The mathematician Benoît Mandelbrot, who pioneered the application of chaos theory to financial markets, refers to this phenomenon as the “multifractal nature of trading time.”

Niederhoffer turned to Castaldo. “This day is far from over,” he said. “Doc, what happens when the market is down twelve points at one o’clock and it has been down significantly the previous two days?” A few minutes later, Castaldo handed him another computer printout. “Most of the time, these computer analyses don’t work, but it gives you an anchor,” Niederhoffer said as he scanned the sheet. “My checkers teacher said even a bad system is better than no system at all.” The data showed that the last time trading seemed to follow the current pattern was between November, 2000, and September, 2002, when there had been eight such three-day periods. In most of these instances, the market had rebounded strongly during the subsequent seventy-two hours. Niederhoffer looked at Owen Wilson. “I’ll buy another fifty at eleven-fifty,” he said.

Niederhoffer’s investment philosophy is based on a belief that over the long term the market goes up, but over the short term it constantly reverses itself. In his books—his second, “Practical Speculation,” was published in 2003—he compares the behavior of investors to that of herds of rampaging elephants that retrace their steps over and over. He refers to this pattern as a “LoBagola,” after Bata LoBagola, the author of “LoBagola: An African Savage’s Own Story,” a book published in 1930 describing the customs and wildlife of West Africa. After the book appeared, LoBagola was revealed to be an African-American vaudeville entertainer from Baltimore, the son of a former slave. In a 2004 post on DailySpeculations.com, Niederhoffer wrote, “Regrettably LoBagola was an American con man. . . . Nevertheless, I claim that despite his imposture, the moves back and forth in big markets often follow a LoBagola, and even though, nay especially because, LoBagola was an impostor his name should be given to major moves which would seem to follow a symmetry up and down.”

Niederhoffer doesn’t claim to be able to say what the Dow or the S. & P. 500 will do next week or next month, but he believes that over shorter periods—hours or days—there are sometimes predictable patterns that can be exploited. In “The Education of a Speculator,” he devotes an entire chapter to this notion, comparing the market’s movements to some of his favorite pieces of classical music, and juxtaposing pages of sheet music with stock charts. “When the markets are moving in my favor in a nice, gentle way—never below my initial price—I often think of the ‘Trout Quintet,’ ” he writes. “Another frequent work I hear in the market is Haydn’s Symphony No. 94. . . . Right after lunch, or before a holiday, the markets have a tendency to meander up and down in a five-point range above and below the opening. The pattern is similar to the twinkling C-major fifths of Haydn’s symphony.”

In the early eighties, when he was making a presentation to potential clients, Niederhoffer sometimes took along Robert Schrade, a friend who was a classical pianist. After Niederhoffer talked about his methods, Schrade would demonstrate the rhythms of the market on the piano. This double act didn’t always impress investors. “CalPERS”—the California Public Employees’ Retirement System—“is not going to be interested in investing with Victor, nor is the Harvard endowment,” Paul DeRosa, a partner at the hedge fund Mt. Lucas who has known Niederhoffer since the late seventies, said to me. “Your basic, buttoned-down endowment, advised by professional consultants, wouldn’t touch him with a ten-foot pole. His is a fund that is going to appeal to people like him: self-made people who have a maverick streak.”

A few months ago, after visiting a Redwood forest in Northern California, Niederhoffer became fascinated by the ecology of trees. He bought several books on the subject and posted an article on his Web site applying what he had learned about trees to the stock market:




Lesson Two: The forest thrives and benefits after many seemingly disastrous events. Fires clear the underbrush. Dead trees still standing provide cover for much flora and fauna. Trees contain so much water that there is still much biomass left when they die, and they contain the nutrients and moisture that other plants or fungi need for survival. This situation is called a biological legacy by the scientists, but is just known as a gift by the laymen.

The number of, the amount of time in between, and the extent of watershed declines that the market has witnessed in the last year, as well as the resilience of the market to these declines, is a good measure of the health of a system. It is often good for future growth, to see decimated parts of the market landscape, such as the U.S. real-estate sector, which has currently taken it on the chin, or the Saudi Arabian market, which is down 75%.



After he wrote the article, Niederhoffer gave the books he had read to one of his employees, Charles Pennington, a former professor of physics, and asked him to develop precise numerical analogies between the life cycles of forests and those of corporations, in the hope that the exercise might suggest some profitable investments. Niederhoffer’s employees are used to such requests. “Things sometimes work that you wouldn’t believe, and things don’t work that you would expect to work,” Steve Wisdom said to me after we had left Niederhoffer at his desk and gone downstairs to eat lunch in his formal dining room. (The dining room is next to the library, where Niederhoffer keeps his collection of rare books and manuscripts, including a first edition of Adam Smith’s “Wealth of Nations” and a copy of David Ricardo’s “Principles of Political Economy and Taxation” which has margin notes by Thomas Malthus.)

Wisdom, a clean-cut man of forty-six, met Niederhoffer twenty-five years ago, in New York City, when Wisdom was a philosophy major at Harvard and the chairman of the university’s Libertarian Club. “We hit it off, and that was that,” Wisdom recalled. After graduating, in 1983, Wisdom worked for Niederhoffer for fourteen years, until Niederhoffer’s business collapsed, in 1997. He returned in 2003, largely, he told me, because of Niederhoffer’s willingness to try new ideas. “Everyone has computers; everyone has Ukrainian math Ph.D.s,” Wisdom said. “There are people chopping at the data every which way. Making money is not easy, and it requires a lot of creativity. Victor always says, ‘Suppose I didn’t know anything. Suppose I’d never traded this instrument before. What would I think?’ ”

Manchester Trading’s three hedge funds are relatively small by current standards. At the end of June, the funds’ collective value was about three hundred and fifty million dollars, of which about half belonged to Niederhoffer and Wisdom. In 2003 and 2004, the funds increased in value by more than forty per cent each year, and in 2005 the value of the largest fund, Matador, rose fifty-six per cent—a performance that earned Niederhoffer an industry award. Last year, his funds were flat. But in the first six months of 2007 they were up again, by between thirty and forty per cent.

Niederhoffer acknowledges that his aggressive investing style and his reliance on borrowed money increase the volatility of his returns and the likelihood that he will suffer a calamity. In May, 2006, Matador lost about thirty per cent of its value, and in February of this year it suffered another big fall. Many hedge funds claim that they can generate high returns with little risk. Niederhoffer tells friends who want to invest money with him that it is too risky. (Most of his clients are multimillionaires and financial institutions.) “The idea that you can make a lot of wealth in a steady, unspectacular fashion, with no great gyrations, is a canard,” he said to me. “If you are going to try and make forty or fifty per cent a year, tremendous variations are inevitable.”

At three o’clock, when Wisdom and I went back upstairs, Niederhoffer was outside playing tennis with one of his traders, Duncan Coker. Soon, however, he returned, sitting down at his desk in a T-shirt, tennis shorts, and sneakers, ignoring the no-shoes rule. “The market’s supposed to go up from three until the close,” he said. “Let’s see if it does.” While Wisdom and I were having lunch, the Dow had stabilized and Niederhoffer had sold some of the stock futures he had purchased earlier in the day. “The worst mistake in this business is to be in over your head,” he said. “I was long about seventy-five million dollars. In addition to that, I had my regular option position. So I took the opportunity to reduce my exposure.”

In addition to speculating on short-term market movements, Niederhoffer frequently sells financial contracts, called “put options,” which, in the event of a steep fall in the market, would oblige him to pay out large sums of money. The buyers of these options are usually other investors seeking to hedge their positions, and in a sense Niederhoffer acts like an insurance company: in return for a premium—the price of the option—he agrees to bear the risk of a market crash. Often, this is a good business; but whenever the market enters a volatile period he is in peril. (“He is his own worst enemy,” Nassim Taleb, the author and derivatives trader, says of Niederhoffer. “One of the most brilliant men I have ever met, and he wastes his time selling options—something nobody can have any skill in—and it leaves him vulnerable to blowing up.”)

As 4 P.M.—the close of trading—approached, the Dow was again down, by about a hundred and twenty points. Niederhoffer didn’t seem particularly discouraged, though. He thought that he discerned a LoBagola pattern. “It’s going to be very bullish for tomorrow,” he said. “It will be the first one-hundred-point drop in sixteen hundred points. I’m going to buy some more futures.”

Niederhoffer’s theories about market behavior date to his college years. In 1964, when he was a senior at Harvard, he wrote a thesis on stock-market patterns. At the time, the so-called “efficient market hypothesis,” which states that stock prices move randomly and therefore can’t be predicted, was coming into vogue. Niederhoffer, citing data on trading volumes and subsequent price movements, claimed to have found evidence that contradicted the random model. His argument didn’t fully convince his adviser, the economist Robert Dorfman, but it helped earn him admission to the University of Chicago Graduate School of Business, where he enrolled in September, 1964.

At Chicago, Niederhoffer wrote several research papers arguing that it was possible to detect predictable movements in the stock market. He uncovered evidence, for example, that the market tended to do worse on Mondays than on Fridays. Several members of the faculty had helped to develop the efficient market hypothesis, and Niederhoffer’s relationships with his professors were often contentious. At one seminar, he later recalled, “I criticized all those who had concluded that markets were random, including most of the professors in the room, as being too heavy-handed in their testing methods to uncover the structure of price variations. Further, I cautioned them that their failure to disprove a hypothesis that no structure existed was methodologically inadequate to support a conclusion that prices were random. When I put it in the vernacular, ‘You can’t prove a negative,’ pandemonium broke loose.”

Niederhoffer was an early proponent of what is now called behavioral economics, and his unorthodox theories made him something of an academic celebrity. In 1969, he was hired at Berkeley as an assistant professor, and several hundred students signed up for his course on finance. Three years later, enrollment had dropped precipitately. “I wasn’t too good at it, frankly,” he told me. “I was not a very good teacher, and I had my own ideas about things. I was earning nine thousand dollars a year. I was playing squash, doing research, dabbling in business. It was all too much.”

Niederhoffer had also married—Gail Herman, a graduate of Bryn Mawr whom he met at the wedding of a Harvard friend, the economist Richard Zeckhauser. In the early seventies, Gail and Niederhoffer, who had decided to leave academe, moved to New York, where he started an investment-banking firm that sought out small, family-owned companies and helped sell them to bigger, public companies. The venture proved so successful that before long Niederhoffer and a partner, Dan Grossman, started buying and operating businesses themselves. Among the firms they acquired were American Almond, a Brooklyn company that provided almond paste to bakeries, and Tech Com Inc., a Florida defense contractor that built navigation equipment for planes and ships. “I would run the companies. Victor would visit them every two years or so, and cause havoc,” Grossman, a lawyer by training, recalled recently. “He’d say something like ‘What this company needs is sales. No more research, no more secretarial duties—I want you all out there selling things.’ Then he’d leave, and I’d say, ‘Don’t take any notice of what he said. That’s just Victor being Victor.’ ”

By the late seventies, Niederhoffer and Gail had two daughters: Galt, who was named after Francis Galton, the Victorian polymath who helped to develop regression analysis and coined the term “eugenics”; and Katie. In 1981, Niederhoffer and Gail separated, and he began dating his assistant, Susan Cole, whom he married in 1991. They have four daughters: Rand, Victoria, Artemis, and Kira. The mother of Niederhoffer’s son, Aubrey, who is one and a half, is Laurel Kenner, a former editor at Bloomberg whom he met in 1999. “My personal life is more complicated than Rupert Murdoch’s,” Niederhoffer joked to me. (Murdoch has six children from three marriages.)

Niederhoffer began investing seriously in the stock market when Galt and Katie were young. In 1979, using money he had saved, he started trading more or less full time and opened an office in midtown. “I got lucky,” he told me. “In eighteen months, I ran fifty thousand dollars up to twenty million dollars. I had an idea that there was going to be inflation, so I kept selling Treasury bonds and buying gold and silver. For a long time, it worked very well. Then one day I was playing racquetball in Staten Island with a guy who subsequently became the U.S. champion. After the first game, I called the office to see where the market was. The price of gold had fallen from eight hundred and fifty dollars to six hundred dollars in an hour. My net worth had gone down to ten million dollars.

“That was where my Brighton Beach training came in,” Niederhoffer went on. “I’d seen a lot of gamblers die broke. My father used to say I’d end up on the Bowery, like the other gamblers. I’d say, ‘Dad, I’ve got a system.’ He’d say, ‘Baloney. Those guys on the Bowery had more statistics and systems than you’ve got.’ I took what he said seriously. I told my assistant, who later became my second wife, ‘If I ever lose more than half my stake, close out all my positions. Don’t let me trade anymore.’ I went back to my match. During the second game, she sold everything. By then, my ten million dollars had dwindled to five million, but at least I got out with that much.”

Wall Street in the late seventies was much less technologically sophisticated than it is today. “If you could solve two equations in two unknowns, you were a high-tech person,” Paul DeRosa recalled. “Someone with Victor’s quantitative skills was a rare bird. In the early years, that gave him a big advantage.” In 1981, George Soros, who was by then a wealthy investor but who was having a bad year, heard about Niederhoffer’s reputed ability to predict short-term market movements and arranged to meet him at his office. Soros left the meeting impressed, and gave Niederhoffer some money to manage. The men shared an intellectual fascination with markets, and they became close, talking on the phone nearly every day, and playing tennis or chess several times a week. “My father had just passed away,” Niederhoffer recalled. “George was struggling. He needed a ledge to give him some purchase. I provided that.”

By the mid-eighties, Niederhoffer was managing many of Soros’s investments in bonds and commodities, which were worth hundreds of millions of dollars. On Tuesday, October 20, 1987, a day after the Dow dropped five hundred and eight points, Niederhoffer and Soros played tennis, as usual. Both men had lost a lot of money in the crash, and Niederhoffer had trouble concentrating; Soros, however, was calm. Don’t worry, he told Niederhoffer, the market will reopen tomorrow, and there will be plenty of opportunities to make back our losses.

Over the next several years, Niederhoffer’s funds yielded an annual average return of about thirty per cent, which put them near the top of the industry. In 1994, Business Week named him the best commodities-fund manager in the country. A year later, he started two new hedge funds: Niederhoffer Investments and Niederhoffer International Markets. For a while, he hardly slept. During the day, he traded stocks and currencies in Europe and the United States, and at night he bought and sold Japanese yen. He also invested in emerging markets, making successful plays in Turkish bonds and Mexican stocks.

Toward the end of 1996, another profitable year for him, Niederhoffer decided that he wanted to invest in Southeast Asia, which was widely seen as a growing market. He dispatched an old friend, Steven (Bo) Keeley, to the region. Keeley, a veterinarian who spent six months of the year living in the California desert without a telephone or electric power, had trekked in dozens of countries. On one trip, while paddling down the Amazon, he had contracted malaria, briefly gone blind, and been comatose for a week. Keeley believed that assessing a developing country’s economic prospects involved not only meeting with the C.E.O.s of leading companies but studying the lengths of discarded cigarettes—the theory being that the wealthier people are, the longer their butts—and the state of the brothels. After a couple of months in Asia, he reported to Niederhoffer that the brothels in Bangkok had recently become much cleaner and safer, and that Thailand was an excellent place to invest. During the previous decade, the Thai economy had grown at an annual rate of almost ten per cent; its interest rates were among the lowest of any country in the region; and its stocks were cheap because they had fallen sharply earlier in the year. In the spring of 1997, Niederhoffer invested several hundred million dollars in Thailand. Instead of buying stocks in some of the country’s biggest companies, he entered into complicated deals with Wall Street firms to buy futures contracts that were tied to the value of Thai stocks. The margin requirements for futures purchases are much lower than those for stock purchases, so he was able to put up a relatively modest amount of cash, while using borrowed money to accumulate substantial holdings.

His timing was atrocious. In May and June, a wave of selling swept through the Asian financial markets, and Thailand was especially hard hit. Many overseas investors tried to repatriate their money, and the Thai government started to run out of foreign-exchange reserves. On July 2nd, it was forced to abandon what amounted to a fixed exchange rate between the baht and the dollar, which had been in place for more than a decade. The Thai currency collapsed, and so did the stock market. The value of many of Niederhoffer’s Thai holdings dropped by more than ninety per cent. His lenders demanded that he put up more collateral. In order to meet their demands, he was forced to sell many of his profitable investments, which left his funds severely depleted. “We were like someone who is immune-deficient,” Steve Wisdom recalled. “We had lost so much money that we had no resistance left to other maladies.”

Apart from his Thai holdings, Niederhoffer’s most substantial investments were in the American futures markets. At first, the U.S. market weathered the Asian crisis pretty well, but in the fall of 1997 it became more volatile. On October 27, 1997, the Dow fell by more than five hundred points, and, for the first time in recent history, the market closed early. Amid widespread panic, Niederhoffer fielded calls from lenders. Some, including Refco, a large commodities broker, demanded that he give them more money to support his options positions. Niederhoffer was unable to come up with the cash, and the next morning Refco liquidated his portfolio.

“It was a very poor decision on my part to invest in Thailand,” Niederhoffer told me. “I had no scientific basis for investing there. In the U.S. market, there is evidence that it is a good time to invest after a big fall. In Thailand, there was no such statistical evidence. It was purely a qualitative idea. I’d seen Soros do that a lot of times and make a lot of money, but it didn’t work for me. Previously, I had had two or three qualitative ideas that made money—Turkish bonds, Mexican stocks—and it lured me into a false sense of security.”

We were sitting on a bench outside a building in the East Fifties, where Laurel Kenner lives and Niederhoffer stays when he visits. He was drinking a bottle of organic lemonade. I asked him whether hubris had contributed to his downfall. “Yeah, I’d say,” he replied. “In those days, we always wanted to be No. 1 in the ratings. There was a Canadian firm, Friedberg—they were having a good year, and we wanted to keep up with them. It was always nip and tuck between us and them.” Niederhoffer was silent for a moment. Then he spoke quickly: “You asked for reasons—I could name another ten. We had no stops. We picked the wrong country to invest in. We were too illiquid. We had too big a percentage of the market, and we didn’t have the ability to get out of our positions. We were too financially vulnerable to the brokers. I didn’t take account of the fact that I could be squeezed and that customers could withdraw their money. But mainly I didn’t have a proper foundation for my investment there. I had no knowledge of the country. I’d never even visited the country. All I had done was finance a trip by Bo Keeley to the brothels there.’’

After his funds folded, Niederhoffer fell into a deep depression. His eldest daughter, Galt, a film producer and novelist who is thirty-one and lives in Manhattan, recalls coaxing him to Long Island for a walk on a beach, where he knelt on the sand like a zombie. “It wasn’t just depression,” she said. “It was self-hatred and hopelessness. He felt like he had let people down. It was so shameful. This was a guy who grew up in a modest house, the son of a cop. Imagine what it would be like to create all of those things for your family and then to lose them.”

Niederhoffer had managed to retain some of his assets. He mortgaged his house in Connecticut and sold a collection of trophy and presentation silver and some of his rare books, which enabled him to pay off his creditors. He used this period of enforced inactivity to reconsider his approach to investing and to retool his pattern-recognition software. After about six months, using several hundred thousand dollars of his own money, he started trading again. “I had no brokerage account—no broker would do business with me under ordinary terms,” he said. “No customers would open a new account with me.” In 1999 and 2000 he did well, and in 2002 he started Matador, an offshore hedge fund. Its biggest investor was Octane, a hedge fund based in Switzerland, whose chief investment officer, Mustafa Zaidi, is an old friend of Niederhoffer’s.

At the beginning, Matador had less than ten million dollars to invest. In its second year, the fund had a return of forty-one per cent, and Niederhoffer’s renewed success helped him attract more money, including some from former clients who had lost their investments in 1997. (For these investors, he waived the hefty fees that hedge funds normally charge.) Eventually, he had enough cash to open two more funds. In February, 2003, Niederhoffer published “Practical Speculation,” a manual for serious investors, which he co-wrote with Laurel Kenner, whom he had been dating for several years. That year, he separated from his wife, Susan, and in 2004 he and Kenner launched DailySpeculations.com, which they dedicated to “the scientific method, free markets, deflating ballyhoo, creating value, and laughter.”

The Web site has since evolved into an informal social-networking site for speculators and aspiring speculators. “I met a lot of my friends through the site,” James Lackey, the trader who once worked with Niederhoffer and who posts regularly on the site, said. “Victor is like the hub where the wheels of speculation turn. He’s the center of so many of our relationships—we call him the Chairman. He’s the guy who keeps everyone in line.”

In April, 2006, Niederhoffer attended a dinner at the St. Regis Hotel, where MARHedge, a company that published a newsletter for the hedge-fund industry, presented him with an award as the top manager in the commodity-fund category. “What I’m proudest of is that we’ve made several hundred million dollars after fees,” Niederhoffer said to me in July.” “We’ve returned a lot more money to our investors than they have invested.”

As Niederhoffer and his funds prospered, it appeared to many of his old friends and colleagues that he had finally become a master speculator. “It is impossible to go through what Victor went through without it altering what you do,” Paul DeRosa told me in July. “It made him more conscious of risk, more attuned to it. It was an expensive education, but the important thing is that it wasn’t wasted.” Irving Redel, a former gold and silver trader and chairman of the New York Commodities Exchange, who was a mentor to Niederhoffer in his Wall Street days, said, “To be a great trader you need discipline. You have to have certain strategies that you follow, but you also have to have the flexibility to know when it is going wrong. And you have to know to never go beyond what you can afford to lose.” I asked Redel whether Niederhoffer has these qualities. He replied, “He does now.”

On the first Thursday of every month, Niederhoffer hosts a meeting of libertarians at the General Society of Mechanics and Tradesmen, on West Forty-fourth Street. One Thursday evening in early June, about seventy people were gathered in the society’s library, listening to an elderly woman in a white hat, who stood at a lectern talking enthusiastically about Christopher Hitchens’s book “God Is Not Great.” A middle-aged man with a beard spoke next, urging the others to accompany him on a walking tour he hosted called Ayn Rand’s New York, in which he visited local buildings where Rand had lived and held objectivist salons, as well as sites—the Waldorf-Astoria, Grand Central Terminal—that served as inspirations for places in her novel “Atlas Shrugged.”

The meetings are open to the public, and Niederhoffer, who was sitting on a table at the back of the room, swinging his legs, encourages each person to speak. He calls these sessions the New York City Junto, after the discussion group that Benjamin Franklin founded in Philadelphia in 1727, which held meetings for thirty years and eventually became the American Philosophical Society. Niederhoffer’s Junto is more casual, but he takes libertarianism seriously, considering it to be a natural complement to speculating. As a statement on his Web site puts it, “Victor Niederhoffer believes the purpose of life is the pursuit of happiness and achievement, and that the voluntary transactions that flow naturally out of an enterprise system are the key to material and personal freedom, and peace.” In an op-ed article that he published in the Wall Street Journal in 1989, he argued that speculators serve several important economic functions. When a good becomes scarce, he said, speculators bid up prices, which encourages firms to produce more and consumers to buy less, and helps to restore balance to the market. “I am proud to be a speculator,” Niederhoffer wrote. “I am proud that my humble attempts to predict Tuesday’s prices on Monday are an indispensable component of our society. By buying low and selling high, I create harmony and freedom.”

The guest speaker at the meeting was Thomas DiLorenzo, an economics professor at Loyola College, in Maryland, and the author of fourteen books, including “How Capitalism Saved America: The Untold History of Our Country from the Pilgrims to the Present.” DiLorenzo’s subject was the filmmaker and liberal gadfly Michael Moore. Not having seen Moore’s latest movie, “Sicko,” DiLorenzo was at something of a disadvantage, but he expressed outrage at Moore’s failure, in his previous films, to recognize the importance of competition, the virtues of sweatshops, and the depredations of socialism. At one point, Niederhoffer interrupted him and asked, “What are the general principles?” DiLorenzo replied, “Markets work and government-run monopolies don’t.”

At least one member of the audience, a gray-haired man, seemed to think that this was going a bit too far. He cited the Federal Home Loan Banks, an agency that makes mortgages more readily available, and the National Park Service. Don’t you agree that the government does some things well? the man asked. “No,” DiLorenzo replied. “The government has screwed up the national parks. I think capitalism would do a much better job with land.”

Shortly after ten o’clock, Niederhoffer ended the meeting. I was eager to speak to him about the stock market, which had fallen by almost two hundred points that day. “I can’t talk about it,” he said when I approached him. “It’s too painful. I might be able to review it in a few days.” He walked across the room to greet Kenner and Aubrey. He put his son on his shoulders and disappeared onto Forty-fourth Street.

On May 3, 2006, the day that Aubrey was born, Niederhoffer’s wife, Susan, filed for divorce. As his spouse and the legal owner of many of his assets, which he had transferred to her in 1997, she had claim to much of his fortune. For months, the couple’s lawyers argued. Then, in February, Niederhoffer persuaded Susan to drop the divorce proceedings. In return, he agreed to leave Kenner at the end of 2007 and return to her. Then he informed Kenner of the plan.

For now, Niederhoffer shuttles between the women. From Sunday to Tuesday, he and Susan share the house in Connecticut. (Three of their four daughters have left home; the youngest, Kira, attends boarding school.) He spends the rest of the week in Manhattan, with Kenner and Aubrey. “He’s emotionally involved with both of those women right now,” Galt said to me. “He never really leaves women. Wives become extended-family members, like in-laws, or honorary members of the harem. They tolerate it because he’s a flawed genius and a man. They take the good with the bad. It’s all I’ve ever known. All I’ve ever known is we are weird.”

I was having lunch with Galt at a French restaurant near her apartment in Chelsea. Although Aubrey’s birth had been a shock to the family, she went on, her father sees his other children regularly, and he is on good terms with his first wife, Gail—Galt’s mother—who divides her time between New York and Texas. “We’ve become kind of like this very functional dysfunctional family,” Galt said. “To most people, it is completely abnormal, and yet we’ve come to have this somewhat wholesome, happy dynamic. All of the girls are close. My mother and Susan have grown very close.” Recently, Galt added, she, Gail, Susan, and all her sisters except Artemis, who was away, got together to celebrate the third birthday of her daughter, Magnolia. Laurel was not at the party. “Laurel is another story,” Galt said. “Susan and Laurel are not close. There’s nothing happy about that.”

Last year, Galt published a novel, “A Taxonomy of Barnacles,” which she described to me as “an effort to exorcise my demons about living in a family that was different from everybody else’s.” The novel features an eccentric and domineering businessman who has six daughters and desperately wants a male heir. Eventually, he acquires one in surprising circumstances. Shortly after the book came out, Niederhoffer took Galt to lunch at the Four Seasons and told her that her book had been prescient. “Oh, my God, you have a love child!” Galt blurted out. “No,” Niederhoffer said. “I have a son.” A few months later, Aubrey was born.

Kenner, who is fifty-three, told me that she is unhappy about Niederhoffer’s arrangement with her. “Obviously, there is a lot of anger there,” she said. “But it is not just me. There is a baby involved.” I expressed surprise that her relationship with Niederhoffer remained cordial. “We had eight great years,” she replied. “He gave me so much. I am immeasurably better off on so many levels through meeting Victor. He was the best lover I ever had—not just in sexual terms. We wrote a book together. He is a great, romantic, gentle person.”

Niederhoffer declined to discuss his relationship with Susan. As for Kenner, he said, “We’ve had a very fine collaboration and had much pleasure and happiness together, and we have a wonderful son. We’re parents, and we still have mutual respect and admiration for each other.” He went on, “We didn’t have in mind the ultimate outcome, but we created a fantastic legacy—the baby, the books, and the articles.”

On Tuesday, July 17th, the Dow rose above fourteen thousand for the first time. The economy was growing, the long-term interest rate had dropped back to five per cent, and the volatile trading days of early summer seemed largely to have been forgotten. After the market closed, however, Bear Stearns announced that two of its hedge funds, which had investments in securities tied to subprime mortgages, had lost almost all their value. Problems in the subprime market spilled into money markets that banks and other financial institutions rely on to finance their daily activities; several more hedge funds went under; and commentators began to speak of a looming “credit crunch.” Stock markets around the world experienced wild fluctuations.

On Tuesday, July 24th, the Dow fell two hundred and twenty-six points. Two days later, it dropped three hundred and eleven points. Commentators on CNBC were making ominous pronouncements. I sent Niederhoffer an e-mail, saying that I hoped he had been well positioned for the market’s correction. He replied in three words: “I was not.” On Friday, July 27th, the Dow fell another two hundred points, closing four per cent down for the week. The markets were still volatile a week later, when Niederhoffer came into Manhattan for his monthly libertarian meeting. After it ended, we went across the street to a restaurant, where he ordered a cappuccino. He looked pale and haggard, and years older. For several minutes, we sat in silence. Then, in a low voice, he said, “Things have changed totally since we last spoke. The situation is fundamentally different. It is critical.” Kenner and Aubrey joined us, but Niederhoffer hardly seemed to notice them. “We are fighting for survival night and day,” he said when I pressed him for details. “I was caught wrong-footed in the market turbulence. I’m not as smart as I thought I was.”

The previous week, the Chicago Mercantile Exchange, in response to the turmoil in the market, had raised its margin requirements on futures traders, a move that was potentially devastating for Niederhoffer, who had hundreds of millions of dollars in options. He had more money in reserve than he had had in 1997, but he was worried. “It’s a matter of redeploying resources,” he said. “Also, in trying to be courageous in response to the crisis, I put up a lot of my own capital. You remember the story of the Essex and Captain Pollard? We are like a tiny fishing boat off the coast of Alaska that has been caught in the biggest waves in a hundred years.”

Talking about his predicament seemed to improve Niederhoffer’s mood a little. He ate some sorbet and played with Aubrey. Then he said, “Now I have to go home and work.” Kenner got up to leave, straightening her dress and inadvertently exposing a thigh. “Do that again,” Niederhoffer commanded. “Do what?” Kenner asked. “Lift it up,” he said. “It can keep a man afloat.” They both laughed.

During the next two weeks, I tried repeatedly to talk to Niederhoffer. Part of the reason for his reticence was that he feared a leak. Hedge funds depend on access to borrowed money. If lenders learn that a fund is in trouble, they might decide to stop giving it money—which can have disastrous consequences for the fund. On July 30th, Sowood Capital Management, a Boston-based fund, announced that the assets under its management had lost more than fifty per cent of their value in a few weeks, and the fund closed shortly afterward. By mid-August, two funds operated by Goldman Sachs had lost about a third of the value they’d had at the beginning of the year. Goldman decided to invest two billion dollars of its own money in one of the funds, Global Equity Opportunities, and it persuaded several wealthy investors to put up another billion dollars on favorable terms.

The spectacle of one of Wall Street’s most profitable firms being forced to shore up one of its flagship funds suggested some of the pressures that Niederhoffer was confronting. In today’s interconnected financial markets, there is no such thing as an isolated incident. When a dramatic event occurs in one sector, the effects are felt in others. The Goldman funds were computer-driven funds, and their software programs had failed to predict the size and speed of movements in the stock market. Prices had got “way out of whack,” David Viniar, Goldman’s chief financial officer, complained. “We were seeing things that were twenty-five standard-deviation moves several days in a row.”

Like Niederhoffer’s funds, the Goldman funds were heavily leveraged. For every hundred dollars of capital that the Global Equity Opportunities fund owned, it had borrowed about six hundred dollars. When a fund is leveraged six to one, a five-per-cent fall in the value of its portfolio becomes a thirty-per-cent loss in capital. “Leverage is a double-edged sword,” Richard Bernstein, an analyst at Merrill Lynch, wrote in a note to clients a few days before Goldman announced its efforts to prop up the Global Opportunities fund. “It enhances returns on the upside, but also makes underperformance more rapid and severe.”

Of course, Niederhoffer was aware of these dangers. But, between the middle of 2003 and the start of this year, the financial markets had been mostly calm. Stock prices had gone up, and, atypically, they had done so in a fairly straight line, with only two significant reversals, in May, 2006, and in February, 2007. From Niederhoffer’s perspective, the decline in market volatility was a welcome development, because it made his options trading much less risky. With prices steady or rising, he was less likely to be caught on the wrong end of a big market move. As the quiet times continued, many investors were lulled into believing that a less volatile era had begun. Alan Greenspan, who was the chairman of the Fed until February, 2006, helped to feed this illusion by talking about how financial innovations, such as the development of asset-backed securities, had spread risks more widely, making the market less vulnerable to shocks.

The crisis in the subprime-mortgage market changed all this. In the stock market, volatility was more pronounced than it had been for years. Even on days when the Dow closed just a few points down, prices lurched around. On Friday, August 10th, the Dow fell more than two hundred points before recovering at the close. On Thursday, August 16th, it fell almost three hundred and fifty points before closing down just fourteen points. A measure of market turbulence which many traders watch closely is the Chicago Board Options Exchange Volatility Index, known as the VIX. Between January, 2003, and January, 2007, the VIX fell from more than thirty to about ten. By the end of July, it had surged above twenty, and on August 16th, the day before the Fed cut the discount rate, it hit thirty-seven.

The surge in volatility prompted the Chicago Merc to raise its margin requirements for options on S. & P. 500 Index futures twice, first from two per cent to three per cent, and then from three per cent to four per cent. Niederhoffer was asked to double the amount of capital supporting his positions, and he found it difficult to raise the necessary cash. Some of his investments had lost a lot of their value, and the value of others was difficult to determine. There were so many moving parts in his portfolio that he wasn’t sure where he stood. When a trader can’t meet his margin requirements, he is at the mercy of his creditors. As Niederhoffer’s financial situation deteriorated, ADM Investor Services, a Chicago-based brokerage firm that caters to futures traders, ordered him to liquidate some of his options positions. Working late into the night, Niederhoffer berated himself for leaving himself so exposed. Referring to the margin calls, he said to one acquaintance, “I shouldn’t have been in the position where it could have had such an impact.” Despite the lessons of 1997, and the precautions he had taken, he was again in over his head.

Every August, Niederhoffer throws a big party in New York City, to which he invites dozens of regular contributors to his Web site as well as some of his friends. This year, there were about seventy-five guests. Most were New Yorkers, but some had come from as far away as England. For three days, Niederhoffer entertained them at his expense. On Friday, he organized a trip to the New York Botanical Garden and to a Mets game. On Saturday, he hosted a beach outing at Coney Island and a dinner at Delmonico’s, near Wall Street. On Sunday, he provided a picnic brunch in Central Park’s Conservatory Garden.

As the crisis in the market spread, Niederhoffer had briefly considered cancelling the party, but he decided that to do so would have alerted people to his troubles. At three o’clock on Saturday afternoon, I saw him in the crowd on the boardwalk at Coney Island, across from the Cyclone roller coaster. As usual, he wasn’t difficult to spot: he was wearing yellow trousers and a yellow T-shirt that said “Chief Speculator” on the back. On the beach, his staff had set up a blue canopy, and about a dozen people had gathered underneath it, taking shelter from the sun.

Niederhoffer had Aubrey on his shoulders, and he seemed to be in a better mood than when I had last seen him. He makes frequent visits to Coney Island and Brighton Beach; the house he lived in as a boy was about half a mile east of where we were standing. “We are going on the Wonder Wheel,” Niederhoffer said, gesturing over his shoulder at the slowly turning Ferris wheel, which dates to 1920. While he was gone, I spoke with two of his guests, a young Liberian M.B.A. student who said that he had recently posted an article on DailySpeculations.com about gambling on thoroughbred racing, and an older Frenchman who traded stocks at a Wall Street firm. The atmosphere was friendly and relaxed. None of the guests mentioned Niederhoffer’s financial predicament.

At 6 P.M., the party reconvened at Delmonico’s, which Niederhoffer had reserved for the evening. After cocktails in the dark-panelled bar, his guests entered the ornate dining room, where a Broadway tap dancer and a family of Hawaiian singers performed. I was seated next to Laurel Kenner and Aubrey, but didn’t see much of Niederhoffer, who was wearing a lilac jacket and spent most of the evening table-hopping. After dessert was served, he stood up to speak.

“This is a historic gathering,” he said, swaying slowly back and forth. “We are here in the middle of one of the greatest turmoils in Wall Street history. I am sure that many of you are keen to know how we are doing. Well, I can tell you that it has been very difficult. The battle has been joined, and it is still to be determined who the victor is. I always say that when you are in the middle of one of these situations it is better to say nothing. If you say you are doing badly, it gives ammunition to your enemies. If you say you are doing well, you are tempting fate. . . . We will see what happens and who wins the final point.”

Later in August, after the Federal Reserve cut the discount rate—the rate at which it lends to banks—the markets calmed down; but Niederhoffer’s woes continued. In September, he was forced to close two of his funds, including his flagship, Matador, which had declined in value by more than seventy-five per cent. After cashing out many of his investments, Niederhoffer repaid his lenders and returned what money was leftover to his clients. He laid off several employees and consulted with his lawyers. Meanwhile, rumors circulated on the Internet that, for the second time in a decade, his funds had “blown up.”

Had he been able to wait a little longer before liquidating his trades, his funds might have recouped most of the losses. After the Federal Reserve cut interest rates again, on September 18th, the stock market rallied further and volatility decreased. Still, Niederhoffer sounded philosophical. “The market was not as liquid as I anticipated,” he said. “The movements in volatility were greater than I had anticipated. We were prepared for many different contingencies, but this kind of one we were not prepared for.” Niederhoffer was still trading for his own account, and for some remaining clients. “My basic ideas about the creative power of the market, buying in panics, buying on weakness—I don’t think what has happened has anything to do with that stuff,” he said. “I am going to keep going, for better or worse.” ♦

Saturday, October 20, 2007

Iran pricing crude in euro's upsets Paulson --- G7

We reaffirmed our commitment to vigorously counter money laundering, terrorist and proliferation financing in order to promote economic development and safeguard the integrity of the global financial system. We discussed ways to deal with Iran's pursuit of a nuclear capability and ballistic missiles, the regime's vast financial support to lethal terrorist groups, and the deceptive financial tactics employed by Iran to evade sanctions and mask illicit transactions. We welcomed the recent statement by the Financial Action Task Force highlighting the significant threat Iran's illicit conduct poses to the international financial system.

War with Iran in works

The Secret History of the Impending War with Iran That the White House Doesn't Want You to Know
Two former high-ranking policy experts from the Bush Administration say the U.S. has been gearing up for a war with Iran for years, despite claiming otherwise. It'll be Iraq all over again.



In the years after 9/11, Flynt Leverett and Hillary Mann worked at the highest levels of the Bush administration as Middle East policy experts for the National Security Council. Mann conducted secret negotiations with Iran. Leverett traveled with Colin Powell and advised Condoleezza Rice. They each played crucial roles in formulating policy for the region leading up to the war in Iraq. But when they left the White House, they left with a growing sense of alarm -- not only was the Bush administration headed straight for war with Iran, it had been set on this course for years. That was what people didn't realize. It was just like Iraq, when the White House was so eager for war it couldn't wait for the UN inspectors to leave. The steps have been many and steady and all in the same direction. And now things are getting much worse. We are getting closer and closer to the tripline, they say.

"The hard-liners are upping the pressure on the State Department," says Leverett. "They're basically saying, 'You've been trying to engage Iran for more than a year now and what do you have to show for it? They keep building more centrifuges, they're sending this IED stuff over into Iraq that's killing American soldiers, the human-rights internal political situation has gotten more repressive -- what the hell do you have to show for this engagement strategy?' "

But the engagement strategy was never serious and was designed to fail, they say. Over the last year, Rice has begun saying she would talk to "anybody, anywhere, anytime," but not to the Iranians unless they stopped enriching uranium first. That's not a serious approach to diplomacy, Mann says. Diplomacy is about talking to your enemies. That's how wars are averted. You work up to the big things. And when U.S. ambassador to Iraq Ryan Crocker had his much-publicized meeting with his Iranian counterpart in Baghdad this spring, he didn't even have permission from the White House to schedule a second meeting.

The most ominous new development is the Bush administration's push to name the Iranian Revolutionary Guards a terrorist organization.

"The U.S. has designated any number of states over the years as state sponsors of terrorism," says Leverett. "But here for the first time the U.S. is saying that part of a government is itself a terrorist organization."

This is what Leverett and Mann fear will happen: The diplomatic effort in the United Nations will fail when it becomes clear that Russia's and China's geopolitical ambitions will not accommodate the inconvenience of energy sanctions against Iran. Without any meaningful incentive from the U.S. to be friendly, Iran will keep meddling in Iraq and installing nuclear centrifuges. This will trigger a response from the hard-liners in the White House, who feel that it is their moral duty to deal with Iran before the Democrats take over American foreign policy. "If you get all those elements coming together, say in the first half of '08," says Leverett, "what is this president going to do? I think there is a serious risk he would decide to order an attack on the Iranian nuclear installations and probably a wider target zone."

This would result in a dramatic increase in attacks on U.S. forces in Iraq, attacks by proxy forces like Hezbollah, and an unknown reaction from the wobbly states of Afghanistan and Pakistan, where millions admire Iran's resistance to the Great Satan. "As disastrous as Iraq has been," says Mann, "an attack on Iran could engulf America in a war with the entire Muslim world."

Mann and Leverett believe that none of this had to be.

Flynt Lawrence Leverett grew up in Fort Worth and went to Texas Christian University. He spent the first nine years of his government career as a CIA analyst specializing in the Middle East. He voted for George Bush in 2000. On the day the assassins of Al Qaeda flew two hijacked airplanes into the World Trade Center, Colin Powell summoned him to help plan the response. Five months later, Leverett landed a plum post on the National Security Council. When Condoleezza Rice discussed the Middle East with President Bush and Donald Rumsfeld, Leverett was the man standing behind her taking notes and whispering in her ear.

Today, he sits on the back deck of a house tucked into the curve of a leafy suburban street in McLean, Virginia, a forty-nine-year-old white American man wearing khakis and a white dress shirt and wire-rimmed glasses. Mann sits next to him, also wearing khakis. She's thirty-nine but looks much younger, with straight brown hair and a tomboy's open face. The polish on her toenails is pink. If you saw her around McLean, you wouldn't hesitate:

Soccer mom. Classic soccer mom.

But with degrees from Brandeis and Harvard Law and stints at Tel Aviv University and the powerful Israeli lobby known as AIPAC, she has even better right-wing credentials than her husband.

As they talk, eating grapes out of a bowl, lawn mowers hum and birds chirp. The floor is littered with toy trucks and rubber animals left behind by the youngest of their four children. But the tranquillity is misleading. When Mann and Leverett went public with the inside story behind the impending disaster with Iran, the White House dismissed them. Then it imposed prior restraint on them, an extraordinary episode of government censorship. Finally, it threatened them.

Now they are afraid of the White House, and watching what they say. But still, they feel they have to speak out.

Like so many things these days, this story began on the morning of September 11, 2001. On Forty-fifth Street in Manhattan, Mann had just been evacuated from the offices of the U.S. mission to the United Nations and was walking home to her apartment on Thirty-eighth Street -- walking south, toward the giant plume of smoke. When her cell phone rang, she picked it up immediately because her sister worked at the World Trade Center and she was frantic for word. But it wasn't her sister, it was a senior Iranian diplomat. To protect him from reprisals from the Iranian government, she doesn't want to name him, but she describes him as a cultured man in his fifties with salt-and-pepper hair. Since early spring, they had been meeting secretly in a small conference room at the UN.

"Are you all right?" he asked.

Yes, she said, she was fine.

The attack was a terrible tragedy, he said, doubtless the work of Al Qaeda.

"I hope that we can still work together," he said.


That same day, in Washington, on the seventh floor of the State Department building, a security guard opened the door of Leverett's office and told him they were evacuating the building. Leverett was Powell's specialist on terrorist states like Syria and Libya, so he knew the world was about to go through a dramatic change. As he joined the people milling on the sidewalk, his mind was already racing.

Then he got a call summoning him back to Foggy Bottom. At the entrance to a specially fortified office, he showed his badge to the guards and passed into a windowless conference room. There were about a dozen people there, Powell's top foreign-policy planners. Powell told them that their first job was to make plans to capture or kill Osama bin Laden. The second job was to rally allies. That meant detailed strategies for approaching other nations -- in some cases, Powell could make the approach, in others the president would have to make the call. Then Powell left them to work through the night.

At 5:30 a.m. on September 12, they walked the list to the office of the deputy secretary of state, Richard Armitage. Powell took it straight to the White House.

Mann and Leverett didn't know each other then, but they were already traveling down parallel tracks. Months before September 11, Mann had been negotiating with the Iranian diplomat at the UN. After the attacks, the meetings continued, sometimes alone and sometimes with their Russian counterpart sitting in. Soon they traded the conference room for the Delegates' Lounge, an airy two-story bar with ashtrays for all the foreigners who were used to smoking indoors. One day, up on the second floor where the windows overlooked the East River, the diplomat told her that Iran was ready to cooperate unconditionally, a phrase that had seismic diplomatic implications. Unconditional talks are what the U.S. had been demanding as a precondition to any official diplomatic contact between the U.S. and Iran. And it would be the first chance since the Islamic revolution for any kind of rapprochement. "It was revolutionary," Mann says. "It could have changed the world."

A few weeks later, after signing on to Condoleezza Rice's staff as the new Iran expert in the National Security Council, Mann flew to Europe with Ryan Crocker -- then a deputy assistant secretary of state -- to hold talks with a team of Iranian diplomats. Meeting in a light-filled conference room at the old UN building in Geneva, they hammered out plans for Iranian help in the war against the Taliban. The Iranians agreed to provide assistance if any American was shot down near their territory, agreed to let the U.S. send food in through their border, and even agreed to restrain some "really bad Afghanis," like a rabidly anti-American warlord named Gulbuddin Hekmatyar, quietly putting him under house arrest in Tehran. These were significant concessions. At the same time, special envoy James Dobbins was having very public and warm discussions in Bonn with the Iranian deputy foreign minister as they worked together to set up a new government for Afghanistan. And the Iranians seemed eager to help in more tactical ways as well. They had intimate knowledge of Taliban strategic capabilities and they wanted to share it with the Americans.

One day during the U.S. bombing campaign, Mann and her Iranian counterparts were sitting around the wooden conference table speculating about the future Afghani constitution. Suddenly the Iranian who knew so much about intelligence matters started pounding on the table. "Enough of that!" he shouted, unfurling a map of Afghanistan. Here was a place the Americans needed to bomb. And here, and here, he angrily jabbed his finger at the map.

Leverett spent those days in his office at the State Department building, watching the revolution in the Middle East and coming up with plans on how to capture the lightning. Suddenly countries like Syria and Libya and Sudan and Iran were coming forward with offers of help, which raised a vital question -- should they stay on the same enemies list as North Korea and Iraq, or could there be a new slot for "friendly" sponsors of terror?

As a CIA analyst, Leverett had come to the view that Middle Eastern terrorism was more tactical than religious. Syria wanted the Golan Heights back and didn't have the military strength to put up a serious fight against Israel, so it relied on "asymmetrical methods." Accepting this idea meant that nations like Syria weren't locked in a fanatic mind-set, that they could evolve to use new methods, so Leverett told Powell to seize the moment and draw up a "road map" to peace for the problem countries of the Middle East -- expel your terrorist groups and stop trying to develop weapons of mass destruction, and we will take you off the sponsors-of-terrorism list and start a new era of cooperation.

That December, just after the triumph over Afghanistan, Powell took the idea to the White House. The occasion was the regular "deputies meeting" at the Situation Room. Gathered around the table were the deputy secretary of state, the deputy secretary of defense, the deputy director of the CIA, a representative from Vice-President Cheney's office, and also the deputy national security advisor, Stephen Hadley.

Hadley hated the idea. So did the representatives from Rumsfeld and Cheney. They thought that it was a reward for bad behavior, that the sponsors of terrorism should stop just because it's the right thing to do.

After the meeting, Hadley wrote up a brief memo that came to be known as Hadley's Rules:

If a state like Syria or Iran offers specific assistance, we will take it without offering anything in return. We will accept it without strings or promises. We won't try to build on it.

Leverett thought that was simply nutty. To strike postures of moral purity, they were throwing away a chance for real progress. But just a few days later, Condoleezza Rice called him into her office, warming him up with talk of how classical music shaped their childhoods. As he told her about the year he spent studying classical piano at the Liszt Academy in Budapest, Leverett felt a real connection. Then she said she was looking for someone to take the job of senior director of Mideast affairs at the National Security Council, someone who would take a real leadership role on the Palestinian issue. Big changes were coming in 2002.

He repeated his firm belief that the White House had to draw up a road map with real solutions to the division of Jerusalem and the problem of refugees, something with final borders. That was the only remedy to the crisis in the Middle East.

Just after the New Year, Rice called and offered him the job.


The bowl of grapes is empty and the plate of cheese moves to the center of the table. Leverett's teenage son comes in with questions about a teacher. Periodically, Mann interrupts herself. "This is off the record," she says. "This is going to have to be on background."

She's not allowed to talk about confidential documents or intelligence matters, but the topic of her negotiations with the Iranians is especially touchy.

"As far as they're concerned, the whole idea that there were talks is something I shouldn't even be talking about," she says.

All ranks and ranking are out. "They don't want there to be anything about the level of the talks or who was involved."

"They won't even let us say something like 'senior' or 'important,' 'high-ranking,' or 'high-level,' " Leverett says.

But the important thing is that the Iranians agreed to talk unconditionally, Mann says. "They specifically told me time and again that they were doing this because they understood the impact of this attack on the U.S., and they thought that if they helped us unconditionally, that would be the way to change the dynamic for the first time in twenty-five years."

She believed them.

But while Leverett was still moving into the Old Executive Office Building next to the White House, Mann was wrapped up in the crisis over a ship called the Karin A that left Iran loaded with fifty tons of weapons. According to the Israeli navy, which intercepted the Karin A in the Red Sea, it was headed for the PLO. In staff meetings at the White House, Mann argued for caution. The Iranian government probably didn't even know about the arms shipments. It was issuing official denials in the most passionate way, even sending its deputy foreign minister onto Fox News to say "categorically" that "all segments of the Iranian government" had nothing to do with the arms shipment, which meant the "total government, not simply President Khatami's administration."

Bush waited. Three weeks later, it was time for his 2002 State of the Union address. Mann spent the morning in a meeting with Condoleezza Rice and the new president of Afghanistan, Hamid Karzai, who kept asking Rice for an expanded international peacekeeping force. Rice kept saying that the Afghans would have to solve their own problems. Then they went off to join the president's motorcade and Mann headed back to her office to watch the speech on TV.

That was the speech in which Bush linked Iran to Iraq and North Korea with a memorable phrase:

"States like these, and their terrorist allies, constitute an axis of evil, arming to threaten the peace of the world."

The Iranians had been engaging in high-level diplomacy with the American government for more than a year, so the phrase was shocking and profound.

After that, the Iranian diplomats skipped the monthly meeting in Geneva. But they came again in March. And so did Mann. "They said they had put their necks out to talk to us and they were taking big risks with their careers and their families and their lives," Mann says.

The secret negotiations with Iran continued, every month for another year.

Leverett plunged right into a dramatic new peace proposal floated by Crown Prince Abdullah of Saudi Arabia. Calling for "full normalization" in exchange for "full withdrawal" from the occupied territories, Abdullah promised to rally all the Arab nations to a final settlement with Israel. In his brand-new third-floor office at the Old Executive Office Building, a tiny room with a very high ceiling, Leverett began hammering out the details with Abdullah's foreign-policy advisor, Adel Al-Jubeir. When Ariel Sharon said that a return to the '67 borders was unacceptable, Al-Jubeir said the Saudis didn't want to be in the "real estate business" -- if the Palestinians agreed to border modifications, the Saudis could hardly refuse them. Al-Jubeir believed he had something that might actually work.

But the White House wasn't interested. Sharon already rejected it, Rice told Leverett.

At the Arab League meeting, Abdullah got every Arab state to sign his proposal in a unanimous vote.

The White House still wasn't interested.

Then violence in the Palestinian territories began to increase, climaxing in an Israeli siege of Arafat's compound. In April, Leverett accompanied Colin Powell on a tour that took them from Morocco to Egypt and Jordan and Lebanon and finally Israel. Twice they crossed the Israeli-army lines to visit Arafat under siege. Powell seemed to think he had authorization from the White House to explore what everyone was calling "political horizons," the safely vague shorthand for a peaceful future, so on the final day Leverett holed up in a suite at the David Citadel Hotel in Jerusalem with a group of senior American officials -- the U. . ambassador to Israel, the U. S. consul general to Jerusalem, assistant secretary of state for Near Eastern affairs Bill Burns -- trying to hammer out Powell's last speech.

Then the phone rang. It was Stephen Hadley on the phone from the White House. "Tell Powell he is not authorized to talk about a political horizon," he said. "Those are formal instructions."

"This is a bad idea," Leverett remembers saying. "It's bad policy and it's also humiliating for Powell, who has been talking to heads of state about this very issue for the last ten days."

"It doesn't matter," Hadley said. "There's too much resistance from Rumsfeld and the VP. Those are the instructions."

So Leverett went back into the suite and asked Powell to step aside.

Powell was furious, Leverett remembers. "What is it they're afraid of?" he demanded. "Who the hell are they afraid of?"

"I don't know sir," Leverett said.

In the spring, Crown Prince Abdullah flew to Texas to meet Bush at his ranch. The way Leverett remembers the story, Abdullah sat down and told Bush he was going to ask a direct question and wanted a direct answer. Are you going to do anything about the Palestinian issue? If you tell me no, if it's too difficult, if you're not going to give it that kind of priority, just tell me. I will understand and I will never say anything critical of you or your leadership in public, but I'm going to need to make my own judgments and my own decisions about Saudi interests.

Bush tried to stall, saying he understood his concerns and would see what he could do.

Abdullah stood up. "That's it. This meeting is over."

No Arab leader had ever spoken to Bush like that before, Leverett says. But Saudi Arabia was a key ally in the war on terror, vital to the continued U.S. oil supply, so Bush and Rice and Powell excused themselves into another room for a quick huddle.

When he came back, Bush gave Abdullah his word that he would deal seriously with the Palestinian issue.

"Okay," Abdullah said. "The president of the United States has given me his word."

So the meeting continued, ending with a famous series of photographs of Bush and Abdullah riding around the ranch in Bush's pickup.

In a meeting at the White House a few days later, Leverett saw Powell shaking his head over Abdullah's threat. He called it "the near-death experience."

Bush rolled his eyes. "We sure don't want to go through anything like that again."

Then the king of Jordan came to Washington to see Bush. There had to be a road map for peace in Palestine, the king said. Despite the previous experience with Abdullah in Crawford, Bush seemed taken by surprise, Leverett remembers, but he listened and said that the idea of a road map seemed pretty reasonable.


So suddenly they were working on a road map. For moderate Arab states, the hope of a two-state solution would offer some political cover before Washington embarked on any invasion of Iraq. In a meeting with the king of Jordan, Leverett made a personal promise that it would be out by the end of 2002.

But nothing happened. In Cheney's and Rumsfeld's offices, opposition came from men like John Hannah, Doug Feith, and Scooter Libby. In Rice's office, there was Elliott Abrams. Again they said that negotiation was just a reward for bad behavior. First the Palestinians had to reject terrorism and practice democracy.

Finally, it was a bitter-cold day just after Thanksgiving and Leverett was on a family trip to the Washington Zoo, standing in front of the giraffe enclosure. The White House patched through a call from the foreign minister of Jordan, Marwan Muasher, who said that Rice had just told him the road map was off. "Do you have any idea how this has pulled the rug out from under us, from under me?" Muasher said. "I'm the one that has to go into Arab League meetings and get beat up and say, 'No, there's going to be a plan out by the end of the year.' How can we ever trust you again?"

On Monday, Leverett went straight to Rice's office for an explanation. She told him that Ariel Sharon had called early elections in Israel and asked Bush to shelve any Palestinian plan. This time Leverett couldn't hide his exasperation. "You told the whole world you were going to put this out before Christmas," he said. "Because one Israeli politician told you it's going to make things politically difficult for him, you don't put it out? Do you realize how hard that makes things for all our Arab partners?"

Rice sat impassively behind her broad desk. "If we put the road map out," she said, "it will interfere with Israeli elections."

"You are interfering with Israeli elections, just in another way."

"Flynt, the decision has already been made," Rice said.

There was also an awkward scene with the secretary of defense. They were in the Situation Room and Leverett was sitting behind Rice taking notes when suddenly Rumsfeld addressed him directly. "Why are you laughing? Did I say something funny?"

The room went silent, and Rumsfeld asked it again.

"Why are you laughing? Did I say something funny?"

"I'm sorry Mr. Secretary, I don't think I know what you're talking about."

"It looks to me like you were laughing," Rumsfeld said.

"No sir. I'm sorry if I gave that impression. I was just listening to the meeting and taking notes. Didn't mean to disturb you."

The meeting continued, message received.

By that time, Leverett and Mann had met and fallen in love. They got married in February 2003, went to Florida on their honeymoon, and got back just in time for the Shock and Awe bombing campaign. Leverett quit his NSC job in disgust. Mann rotated back to the State Department.

Then came the moment that would lead to an extraordinary battle with the Bush administration. It was an average morning in April, about four weeks into the war. Mann picked up her daily folder and sat down at her desk, glancing at a fax cover page. The fax was from the Swiss ambassador to Iran, which wasn't unusual -- since the U.S. had no formal relationship with Iran, the Swiss ambassador represented American interests there and often faxed over updates on what he was doing. This time he'd met with Sa-deq Kharrazi, a well-connected Iranian who was the nephew of the foreign minister and son-in-law to the supreme leader. Amazingly, Kharrazi had presented the ambassador with a detailed proposal for peace in the Middle East, approved at the highest levels in Tehran.

A two-page summary was attached. Scanning it, Mann was startled by one dramatic concession after another -- "decisive action" against all terrorists in Iran, an end of support for Hamas and the Islamic Jihad, a promise to cease its nuclear program, and also an agreement to recognize Israel.

This was huge. Mann sat down and drafted a quick memo to her boss, Richard Haass. It was important to send a swift and positive response.

Then she heard that the White House had already made up its mind -- it was going to ignore the offer. Its only response was to lodge a formal complaint with the Swiss government about their ambassador's meddling.

A few days after that, a terrorist attack in Saudi Arabia killed thirty-four people, including eight Americans, and an intelligence report said the bombers had been in phone contact with Al Qaeda members in Iran. Although it was unknown whether Tehran had anything to do with the bombing or if the terrorists were hiding out in the lawless areas near the border, Rumsfeld set the tone for the administration's response at his next press conference. "There's no question but that there have been and are today senior Al Qaeda leaders in Iran, and they are busy."

Colin Powell saw Mann's memo. A couple weeks later he approached her at a State Department reception and said, "It was a very good memo. I couldn't sell it at the White House."

In response to questions from Esquire, Colin Powell called Leverett "very able" and confirms much of what he says. Leverett's account of the clash between Bush and Crown Prince Abdullah was accurate, he said. "It was a very serious moment and no one wanted to see if the Saudis were bluffing." The same goes for the story about his speech in Israel in 2002. "I had major problems with the White House on what I wanted to say."

On the subject of the peace offer, though, Powell was defensive. "I talked to all of my key assistants since Flynt started talking about an Iranian grand bargain, but none of us recall seeing this initiative as a grand bargain."

On the general subject of negotiations with Iran, he responded with pointed politesse. "We talked to the Iranians quietly up until 2003. The president chose not to continue that channel."

That is putting it mildly. In May of 2003, when the U.S. was still in the triumphant "mission accomplished" phase of the Iraq war, word started filtering out of the White House about an aggressive new Iran policy that would include efforts to destabilize the Iranian government and even to promote a popular uprising. In his first public statement on Iran policy since leaving the NSC, Leverett told The Washington Post he thought the White House was making a dangerous mistake. "What it means is we will end up with an Iran that has nuclear weapons and no dialogue with the United States."

In the years that followed, he spoke out in dozens of newspaper editorials and a book, all making variations on the same argument -- America's approach to rogue nations was all sticks and no carrots, all economic sanctions and threats of war without any dialogue. "To bring about real change," he argued, "we must also offer concrete benefits." Of course states like Iran and Syria messed around in Iraq, he said. Iran was supporting the Iraqi opposition when the U.S. was still supporting Saddam Hussein. It was insane to expect them to stop when the goal of a Shiite Iraq was finally in reach. The only way to solve the underlying issues was to offer Iran a "grand bargain" that would recognize the legitimacy of Iran's government and its right to a role in the region.

But that was an unthinkable thought. The White House ignored him. Democrats ignored him. The Brookings Institution declined to renew his contract.

Then he started talking about the peace offer. By then it was 2006 and the war wasn't going well and suddenly people started to respond: You mean Iran isn't evil? They helped fight the Taliban? They wanted to make peace? He summed it all up in a long paper for a Washington think tank that happened to be scheduled for publication last November, a vulnerable time for the White House, just after the Democrats swept the midterm elections and the Iraq Study Group released its report calling for negotiations with Syria and Iran. When he submitted the paper to the CIA for a routine review, they told him the CIA had no problem with it but someone from the NSC called to complain. "You shouldn't have cleared this without letting the White House take a look at it," the official said.


Leverett told them he wasn't going to let White House operatives judge his criticisms of White House operatives and distilled his argument into an op-ed piece for The New York Times. This time he shared a byline with his wife, who had experienced the peace offer up close. They submitted their first draft to the CIA and the State Department on a Sunday in early December, expecting to hear back the next day.

The next morning, Leverett gave a blistering talk on Bush's Iran policy to the influential conservatives at the Cato Institute. The speech was carried live on C-SPAN. Later that day, he flew to New York and made the same arguments at a private dinner with the UN ambassadors of Russia and Britain. He was starting to have an impact.

By Tuesday, he still hadn't heard from the CIA review board.

They called on Wednesday and told him that there was nothing classified in the piece as far as the agency was concerned, but someone in the West Wing wasn't happy with it and would be redacting large sections.

"You're the clearing agency," Leverett said. "You're the people named in my agreement."

They said their hands were tied.

After consulting a lawyer, Leverett and Mann and a researcher worked through the night to assemble a list of public sources where the blacked-out material had already been published. They also took out one line that might have been based on a classified document.

But the White House wouldn't budge. It was a First Amendment showdown.

On Thursday, Leverett and Mann decided to publish the piece with large sections of type blacked out, 168 words in all. Since the piece had been rendered pretty much incomprehensible, they included a list of public sources. "To make sense of our op-ed article, readers will have to look up the citations themselves."

As they tell their story, Mann rushes off to pick up one of their sons from a play date and Leverett takes over, telling what happened over the following months:

Bush sent a second carrier group to the Persian Gulf.

U.S. troops started to arrest Iranians living in Baghdad, accusing them of working with insurgents.

Bush accused Iran of "providing material support" for attacks on U.S. forces, a formulation that suggested a legal justification for a preemptive attack.

Senator Jim Webb of Virginia pushed through an amendment requiring Bush to get congressional authorization for an attack.

Colin Powell broke his long silence with a pointed warning. "You can't negotiate when you tell the other side, 'Give us what a negotiation would produce before the negotiations start.' "

Even Henry Kissinger started giving interviews on the need to "exhaust every possibility to come to an understanding with Iran."

From inside the White House, Leverett was hearing a scary scenario: The Russians were scheduled to ship fuel rods to the Iranian nuclear reactor in Bushehr, which meant the reactor would become operational by this November, at which point it would be impossible to bomb -- the fallout alone would turn the city into an urban Chernobyl. The White House was seriously considering a preemptive attack when the Russians cooled things down by saying Iran hadn't paid its bills, so they would hold back the Bushehr fuel rods for a while.

That put things into a summer lull. But by August, tensions were rising again. U.S. troops in Baghdad arrested an official delegation of Iranian energy experts, leading them out of a hotel in blindfolds and handcuffs. Then Iran said that it had paid its bills and that the Russians were ready to deliver the Bushehr shipment. In Time magazine, former CIA officer and author Robert Baer quoted a highly placed White House official:

"IEDs are a casus belli for this administration. There will be an attack on Iran."

Mann steps back out on the deck and starts collecting the scattered toys to prepare the house for a dinner party, the typical modern American mother multitasking her way through a busy day. "The reason I have to be so careful now is that I'm legally on notice and they will prosecute things that I say or do," she says, picking up a plastic truck.

"Because of that one article?"

"Yeah."

Outside, it's getting warmer. There's a heavy haze and floating bugs and for a moment it feels a bit ominous, a gathering silence, one of those moments when giant pods start to sprout in local basements.

"We're tired," Mann says. "Nobody listens."

It seems inconceivable to her that once again a war could be coming, and once again no one is listening. Another pair of lawn mowers joins the chorus and the spell breaks. A cab pulls in the driveway. The caterer comes to prepare for the dinner guests.


Find this article at: http://www.esquire.com/features/iranbriefing1107

Friday, October 19, 2007

PEAK EVERYTHING -- MINERALS FOR SURE

Abstract: We examined the world production of 57 minerals reported in the database of the United States Geological Survey (USGS). Of these, we found 11 cases where production has clearly peaked and is now declining. Several more may be peaking or be close to peaking. Fitting the production curve with a logistic function we see that, in most cases, the ultimate amount extrapolated from the fitting corresponds well to the amount obtained summing the cumulative production so far and the reserves estimated by the USGS. These results are a clear indication that the Hubbert model is valid for the worldwide production of minerals and not just for regional cases. It strongly supports the concept that “Peak oil” is just one of several cases of worldwide peaking and decline of a depletable resource. Many more mineral resources may peak worldwide and start their decline in the near future.
“Peaking” is commonly observed for oil production in many regions of the world (e.g. Laherrere 2005). According to Hubbert (Hubbert 1956) the production curve of crude oil and of other minerals is “bell shaped” and approximately symmetric; that is the peak occurs when approximately half of the extractable resources have been extracted. From the regional data, it is a logic step to extrapolate to worldwide production and arrive to the conclusion that a global peak (“peak oil”) will be reached. In most cases, the analyses based on the Hubbert model say that peak oil could occur within a few years from now. Since crude oil is the single major source of primary energy in the world, it is widely believed that the consequences of peaking could be important, or even disastrous.
However, there is a problem with the idea that we are close to a worldwide oil peaking: no major energy resource (oil, gas, and coal) has peaked globally so far. So, how can we know that the global case is comparable to the regional cases we know? One way to answer this question is to look at the economic and geologic mechanisms that produce peaking. The Hubbert model has been analyzed in several studies (Naill, 1972, Reynolds 1999, Bardi 2005, Holland 2007). In all these models, peaking and decline is the result of the gradual increase of the cost of production of the resource; in turn due to depletion. These costs can be seen in monetary terms, but can be measured in energy units as well. In the case of oil, this increasing cost is related to factors such as the lower success rate with oil prospecting, the necessity of exploiting smaller fields, and the higher costs of processing lower quality oil. These costs will gradually reduce profits and, therefore, reduce the willingness of operators to invest in further extraction. That will slow down the growth and, eventually, cause the peak and the successive decline. This analysis is independent on the kind of resource considered and on the global/regional conditions of extraction.

However, this interpretation is far from being accepted by everybody. Some say that many regional cases of peaking are not due to progressive depletion but to political or market factors or both (see, for instance, Engdhal, 2007 for a recent restatement of this idea). Hubbert’s model is also criticized because it doesn’t take into account prices. In the global case, it is said, increasing market prices will keep profits coming and, therefore, operators will continue investing on increasing the extraction rate; if not forever at least well beyond the midpoint. This interpretation goes back to the 1930s, (Zimmermann 1933) with the so called “functional model” of minerals extraction that had a considerable success in the later economic literature (e.g. Nordhaus 1992, Simon 1995, Adelman 2004). Recent model studies that take prices into account (Holland 2006) indicate that peaking should occur anyway, but the idea that increasing prices will invalidate the Hubbert model lingers around. Some studies, indeed, assume that oil production will never peak worldwide but, rather, reach a longlasting plateu (CERA 2006).

Theories come and go, but one thing is certain: even the most elegant theory needs to be supported by facts. If we can find historical examples of global resources that have peaked and declined following a bell shaped curve, that will strongly support the idea the Hubbert theory holds for global production. Up to last year, there was only one example of such a case reported in the literature: that of whaling in 19th century (Bardi 2006). Whales are not a mineral resource, but the whale stock behaved as a non renewable resource as whales were “extracted” (hunted) at a rate much faster than their reproductive rate. Recently, Dery and Anderson (2007) have shown that the global production of at least one mineral resource, phosphate rock, has peaked in the 1980s.

Just two cases may not be enough to prove the general validity of the Hubbert model but, here, we can report that there are many more cases of global peaking for minerals production. After an exhaustive examination of the USGS database of the world mineral production (Kelly 2006) we found at least 11 cases of minerals that show a global “bell shaped” curve with a clear peak. Peaking was evident by visual examination and it was confirmed by fitting the data using a bell shaped function. We used both gaussian and logistic derivative functions, finding very similar results. Both kinds of curves can be used to fit the Hubbert curve as shown by Bardi (2005) and by Staniford (2006). In addition, we found several more cases of minerals that may have recently peaked or be near peaking, although that is not completely certain yet.

more here

Thursday, October 18, 2007

The end of the beginning

In this month's issue of the GlobalEurope Anticipation Bulletin (N°18, October 16, 2007), these sequences are described in nature and timing. This timeline has also been gathered in a synthetic chart.

This public announcement provides the full description of the first sequence in addition to the complete list of sequences.

Sequence 1 - US debts infect the financial planet: A century after the « Russian loans”, meet the “American debts”!

Sequence 2 - Stock market collapse, in Asia and the US mainly: between - 60% and -30% in two years according to the regions

Sequence 3 - Bursting of global housing bubbles: UK, Spain, France and emerging countries

Sequence 4 - Monetary storm: Volatility at the highest / USD at the lowest

Sequence 5 - Global economy in stagflation: Recessflation in the US, soft growth in Europe, recession

Sequence 6 - « Very Great Depression » in the US, social unrest and the militaries' growing influence on public affairs

Sequence 7 - Major acceleration in world's strategic rebuilding, attacks on Iran, Israel on the brink, Mid-eastern chaos, energy crisis


Sequence 1 – US debts infect the financial planet: A century after the « Russian loans », meet the « American debts » (2nd quarter 2007 – 3rd quarter 2008)
As LEAP/E2020 described in GEAB N°17, the financial aspect of the current crisis originates from the fact that, in the last two decades, the US economy specialized in the production of debts mostly (household, corporate and public ones), knowing that an increasing share of this collective debt was sold to foreign investors who are beginning to realise that they might never see some part of their loans back (thanks to which the “American Way of Life” financed itself in the past few years). The most prudent, or rather the most sagacious, are even beginning to wonder if they will be paid back at all. The comparison with the “Russian loans” is not a mere trait of humour , it is in fact quite reasonable ; indeed, if today they did not have the possibility to print their own money in order to honour their payments, the US would simply be defaulting given that their collective debt exceeds 400 percent of their GDP.
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GEAB N°18 is available! Seven sequences of the impact phase of the global systemic crisis (2007-2009)
Public announcement GEAB N°18 (October 16, 2007)




Since the existence of a global crisis has been generally acknowledged, the course of events of the impact phase of the global systemic crisis has become more accurately anticipable. The psychological factors involved as well as the possible types of actions and reactions, cast a lot of light on the upcoming processes.

Today, LEAP/E2020 researchers have come to the conclusion that the impact phase of the ongoing systemic crisis would be longer than they anticipated a year ago (cf. GEAB N°8). Indeed, the magnitude of the first banking financial shock felt last August indicated to our team of researchers that the impact will develop under the form of seven sequences or seven major shocks affecting sometimes specifically the world's main regions.

The phase of impact will spread over at least two years starting from April 2007 « tipping-point » (cf. GEAB N°12) until the end of 2009. Then will begin a so-called “settling” phase (cf. GEAB N°5) corresponding to the emergence of new sustainable global order equilibriums.

Until June 2007, previous issues of GEAB anticipated and described the system's sinking down and warned against upcoming collapses. From now on, our team will focus on anticipating the development of the seven sequences of the collapse.

In this month's issue of the GlobalEurope Anticipation Bulletin (N°18, October 16, 2007), these sequences are desbribed in nature and timing. This timeline has also been gathered in a synthetic chart.

This public announcement provides the full description of the first sequence in addition to the complete list of sequences.

Sequence 1 - US debts infect the financial planet: A century after the « Russian loans”, meet the “American debts”!

Sequence 2 - Stock market collapse, in Asia and the US mainly: between - 60% and -30% in two years according to the regions

Sequence 3 - Bursting of global housing bubbles: UK, Spain, France and emerging countries

Sequence 4 - Monetary storm: Volatility at the highest / USD at the lowest

Sequence 5 - Global economy in stagflation: Recessflation in the US, soft growth in Europe, recession

Sequence 6 - « Very Great Depression » in the US, social unrest and the militaries' growing influence on public affairs

Sequence 7 - Major acceleration in world's strategic rebuilding, attacks on Iran, Israel on the brink, Mid-eastern chaos, energy crisis


Sequence 1 – US debts infect the financial planet: A century after the « Russian loans », meet the « American debts » (2nd quarter 2007 – 3rd quarter 2008)
As LEAP/E2020 described in GEAB N°17, the financial aspect of the current crisis originates from the fact that, in the last two decades, the US economy specialized in the production of debts mostly (household, corporate and public ones), knowing that an increasing share of this collective debt was sold to foreign investors who are beginning to realise that they might never see some part of their loans back (thanks to which the “American Way of Life” financed itself in the past few years). The most prudent, or rather the most sagacious, are even beginning to wonder if they will be paid back at all. The comparison with the “Russian loans” is not a mere trait of humour , it is in fact quite reasonable ; indeed, if today they did not have the possibility to print their own money in order to honour their payments, the US would simply be defaulting given that their collective debt exceeds 400 percent of their GDP.



Component of US total debt (private and public) - 1957/2006 – Sources: Grandfather Economic Report/ US Federal Reserve
For the time being, due to the fact that they are still in a central position in terms of currency and as pillar of the world's financial system (1), they make the most of the constant weakening of their currency to reimburse the rest of the world into « phony money » (a trend anticipated in February 2006 in GEAB N°2). They have also tried to conceal the insolvency of their economic players by having Wall Street's large banks (and their greedy international partners) reselling « virtual » financial assets, based on abstruse mathematical formulas, the famous CDOs (cf. GEAB N°17). A similar method of valorisation was used in the Ancient times when the future was read by examining chicken entrails. CDOs work along the same principles (except that today investors' portfolios, instead of chickens, are being eviscerated): these fictitious assets are all over the banks' (big and small) balance sheets: hedge-funds portfolios, corporate cash flows, individual investments... And no one has the faintest idea of what they are worth (2) - which, in the world of finances, would tend to mean that they are not worth anything.

Losses announced by the large international banks these days puzzle our team: a small twenty billion USD only in total. Since mid-August 2007, a number of interventions of historical magnitude by the biggest central banks injecting hundreds of billions of Euros in the global financial system in order to « reboot » (with no significant results up to this day) (3) the “liquidity pump” would only entail a small twenty billions USD of negative fallout in their profit growth? According to LEAP/E2020, it can only be the sign of an extreme manipulation of share-holders, savers and investors (4).

Well, here is a clear indication that those who believed that the financial crisis was behind us were mistaken (unless they were simply speculating on the stock markets) (5) : large US banks recently made the decision to create a « pool » of 75 billions USD in order to face the risk of collapse of the CDOs value, and therefore of the stock market, in case the liquidity crisis extends further. According to LEAP/E2020, the money currently vanishing in the air as the awareness grows that those CDOS are not worth much, probably amounts to hundreds, instead of dozens, of billion USD.

Thanks to this 75 billions “shooting power”, US Treasury Secretary and former Goldman Sachs chairman Hank Paulson, orchestrated US banks' direct contribution against the looming confidence crisis. According to our team, he is probably one of the very few political executives in the US to be aware somehow of the scope of the unfolding crisis and to try something against it (6) (instead of being merely reactive such as Fed chairman Ben Bernanke). He is probably hoping to prevent this liquidity crisis to turn into an immense confidence crisis affecting all US financial and monetary values. He also probably realised that central banks interventions would not be enough to contain the problem.

Indeed, after two months of massive financial infusions, after an aggressive rate drop by the Fed (-0,5%) and after a stop in ECB rate growth, the situation is not back to normal. Large financial institutions, namely US ones, are merely gaining time in the hope that the situation will improve (that's for the most optimistic or naive of them) or more probably to organise the disappearing of their losses from their balance sheets by transferring them to other operators and by arranging that the entire profession participates in this sleight of hand. US banks are of course on the frontline on this case because it is their market which is vanishing. The newly created “pool” indicates that the next financial shock is coming soon, and that it will be even more violent that last August (our team anticipates it between November 2007 and February 2008).

According to LEAP/E2020, one more year is needed to evaluate accurately the extent of the losses generated by the subprime crisis and its amplification via CDOs. Meanwhile, confidence in the US financial system (and in Western financial systems altogether) will continue to fall (7). The breathing space provided by the Fed's rate drops is drained, unless by taking the risk of an utter collapse of the USD (8); a possibility which US economic partners (Europeans mainly and Chinese just behind) conceive and try to prevent.

In the previous issues, we described the predictable consequences of this financial crisis for the partners of the United States and owners of US financial assets. However we should bear in mind that this crisis has a major impact on the US themselves, as 30 percent of the US debt is owned by American individual investors. We shall come back on this in the sequence on America's “Very Great Depression”.

US changes gold reporting to include "swaps"

Is the U.S. government sneaking gold out of Fort Knox? This may be exactly the case, as evidenced by a very curious change in U. S. Treasury reporting on gold supplies.

Up until April 27th of this year, the U. S. Treasury reported on a weekly basis its international reserve position on this form:

http://www.treas.gov/press/releases/2007581342179779.htm

On this form, the gold supply (valued at the old fixed price of $42.22 per ounce) is reported as $11,041 million.

The following week, the Treasury changed the form and, as first spotted by Bill Rummel and reported in the Free Market Gold and Money Report, the new form has a change to its reporting of the gold supply. No longer is the gold supply listed as simply 'gold stock', it is now reported as "gold stock including gold deposits and, if appropriate, gold swapped” (our emphasis).

See the new report here: http://www.treas.gov/press/releases/20075141738291821.htm.

Very interesting. This is a strong indication the Treasury may be sneaking gold out the back door.

A 'gold swap' is really pushing gold out the back door. It is not sold, it is, ahem, loaned for the value of the gold. Generally, it is loaned to bullion banks who then do the selling on the open market. If this is going on, the current climb in the price of gold is even more remarkable, given that it is occurring when, literally, Fort Knox gold may be in play and being sold.

The new report from the Treasury is sufficiently vague, which makes it difficult to know exactly what is going on as far as specifics of gold swaps, it is just enough cover your butt info so that if anyone ever does an audit at Fort Knox and the gold at Fort Knox doesn't equal what the Treasury is reporting, the Treasury's reply can be "Oh yeah, that's part of the gold we loaned out," and then point to the "gold swap" clause on the new form and say, "Oh yeah, this is where we report the gold swaps."

Sounds like a good time for Congress to demand an audit of just how much gold actually is in Fort Knox.

this is good technical analysis of DOW

Minyanville - NEWS & VIEWS-Article: "Diamonds may not be a bull's best friend. A look at the daily chart of the DJIA for the year reveals that the index has completed a potential bearish megaphone or broadening top pattern."

Wednesday, October 17, 2007

Expect the US sharemarket to follow

The Blow-Up

In Wall Street's summer of scary numbers, all eyes were on the mathematically trained financial engineers known as "quants."
By Bryant Urstadt
On Wednesday, August 8, not long after the markets closed, 200 of the smartest people on Wall Street gathered in a conference room at Four World Financial Center, the 34-story headquarters of ­Merrill Lynch. August is usually a slow month, but the rows of chairs were full, and highly paid financial engineers were standing by the windows at the back, which looked out over black Town Cars below and the Hudson River beyond. They didn't look like Masters of the Universe; they looked like members of a chess club. They were "quants," and they had a lot to talk about, for their work was at the heart of one of the most worrisome summer markets in decades.

The conference was sponsored by the International Association of Financial Engineers (IAFE), and its title asked, "Is Subprime the Canary in the Mine?" "Subprime" borrowers are home buyers whose poor credit history means they don't qualify for market interest rates. Loans to subprime borrowers, which have become more common in recent years, typi­cally have variable interest rates; as those rates rose, many borrowers were failing to meet their mortgage payments. Their defaults, in turn, had triggered unexpected problems in the market for financial instruments known as derivatives.

A derivative is a tradable product whose value is based on, or "derived" from, an underlying security. The classic example of a derivative is the option to buy a stock at some time in the future. In comparison, more recent derivatives are extraordinarily complex, and they had been invented by quants like the ones at the Merrill Lynch headquarters.

Things had started to go wrong in June, when the weakness in the subprime market had led to the collapse of two huge funds at the investment bank Bear Stearns, costing investors some $1.6 billion. When the quants gathered in August, the most pessimistic among them imagined that the collapse of the subprime market could lead to a shortage of credit as banks dealt with defaults. That would chill the economy, causing worldwide job losses, still more defaults, decreased spending, and withdrawals from the stock market, culminating in a global recession, or worse.

The panel was moderated by Leslie Rahl, an MIT graduate and the founder of Capital Market Risk Advisors. Her job is to advise companies on risk and help them understand the products quants invent. But understanding was in short supply in August. Some of the quants' financial products had collapsed in price, with unexpected consequences in another financial sector: the trading of equities.

The stock market had plunged in July and had been behaving erratically since. In the weeks after the conference, an organizing narrative of sorts would develop. But at the time, the economic view was dizzying. The market would drop precipitously over the course of a day, then rebound nearly to its previous level in the last 45 minutes of trading. Stranger still, stocks with strong financial reports and a good outlook were falling; these were the blue chips, which normally rose in uncertain times. Stocks with weak financials and a gray future were rising. These were normally the dogs that got dumped.

No one quite knew why, yet, but the market's odd behavior would turn out to be closely linked to the work of the quants. In addition to creating arcane financial products, quants have been pushing the frontiers of computer-driven trading systems, and not enough of those systems were working the way they were supposed to--or, to put it more precisely, the way they were supposed to work turned out to be counterproductive in volatile times like these.

Quants like the ones at the August conference were knee deep in the troubles threatening the global financial system. It all raised two very good questions: Who exactly are the quants? And what do they really do?

"Quant" is an elastic word that has meant different things at different times. Historically, the term referred to back-room technicians who used quantitative analysis to support the bankers who sold financial instruments. It came into wider use in the 1980s, when academics--pure mathe­maticians and physicists, mostly--began to appear in the financial world in larger numbers. Classic geeks, the newcomers were at first treated as déclassé immigrants by the financial establishment. Emanuel Derman was a theoretical physicist at Columbia University before he joined Goldman Sachs in 1985, and he remembers in his fine memoir My Life as a Quant when "it was bad taste for two consenting adults to talk math or Unix or C in the company of traders, salespeople, and bankers." But success lent the quants credibility. What was at first a disdainful term was cheerfully embraced by those whom it was originally meant to insult. It finally came to encompass a larger group of people, including, most broadly, anyone involved in mathematical or computational finance. In this article, the word "quant" refers to any practitioner of quantitative finance, a wide-ranging discipline that includes, among other things, the pricing of financial instruments, the evaluation of risk, and the search for exploitable patterns in market data.

A quant sees the financial world through a mathematical lens. This does not necessarily describe the average Wall Street salesperson or trader, whose success is often based as much on intuition and, maybe more important, connections and personal charisma as on any understanding of a topic like stochastic calculus. To give some idea of how far the quant mind is from that of the typical financier, stochastic calculus--a branch of mathematics dealing with randomness--is sometimes derided by quants as "folk math." The quant, unlike his slicker counterpart, seeks to understand and profit from the markets on a purely numerical basis. Or as Herbert Blank, a quant who devises algorithms for evaluating the financial health of companies, says, "If you think you can find out what you need to know by going to see the management of a company, then I have nothing to say to you."

If quants in one guise or another have been around for a while, they have also made trouble before. The hedge fund Long-Term Capital Management, which collapsed in August 1998, boasted some of the founders of the field among its directors and officers. Nonetheless, in recent years, quants' numbers and influence have grown. Over-the-counter derivatives, such as the ones at the heart of the subprime crisis, have become more popular, fueling a boom in lending by making loans easier to trade. The value of over-the-counter derivatives, one shorthand measure of activity in the market, went from $298 trillion in December 2005 to $415 trillion a year later, according to statistics kept by the Bank for International Settle­ments. By some measures, the money invested in two of the most common types of quant funds has grown 60 percent in the last two years (including both expanding assets and new investments), and the funds have generated some of the highest returns in the financial industry.

They're also among the industry's most mysterious organizations. Firms that keep their methods secret are known as "black boxes," and the quant-driven hedge funds are as black as any. It is not unusual for billions of dollars to be invested in such firms with little revealed except the results. Previous results, though, can be a powerful incentive for giving money to someone who won't tell you what he's going to do with it. A case in point is James Simons's Renaissance Technologies, which has earned an average of more than 30 percent a year since its founding in 1988. Like other quant funds, it is ferociously secretive. Still, so many investors have trusted Simons that the two funds under his management now total more than $30 billion. In 2006 alone, he earned $1.7 billion running the fund.

The press often refers to Simons as the world's leading quant. A world-class mathematician with a PhD from the University of California, Berkeley, he spent years in academia, making significant contributions to mathematics. He worked primarily in geometry and in a subfield called differential geometry, where his most prominent contribution was the Chern-Simons theory, a topological description of quantum field behavior that has been useful to string theorists. Many of his employees have backgrounds in physics, astronomy, and mathematics.

The quants of Renaissance Technolo­gies are unusual in that many might have enjoyed significant careers in academia. But quants of a less exalted sort are becoming ubiquitous at financial institutions. There are quants at investment banks, developing new loan structures. There are quants at hedge funds, crunching years of market data to develop trading algorithms that computers execute in milliseconds. And there are more and more quants at pension funds, trying to understand and value the tools created by the banking quants, and trying to evaluate the methods of the investing quants.

"We used to send our graduates mainly to the big banks," says Andrew Lo, the director of MIT's Laboratory for Financial Engineering, where many quants are trained. "Now they're going everywhere, to pension funds, insurance companies, and companies that aren't finance companies at all." MIT's lab was founded in 1992, one of a host of academic programs in the discipline that have sprung up on campuses around the United States and abroad; a new institute at the University of Oxford is one of the most recent additions. "Financial markets and investment processes are becoming more quant across the board," says Lo.

To understand who they were and what they were doing, I spoke with current and former quants, on and off the record. Many would speak happily and at length. Others spoke guardedly or anonymously--especially those using proprietary analysis and algorithms to conduct trades. I read memoirs of quants--a recently expanding genre--and dipped into an introductory textbook for quants, Paul ­Wilmott Introduces Quantitative Finance, a 722-page condensation of the author's 1,500-page, three-volume anvil of a book, Paul Wilmott on Quantitative Finance. And I went to a quant drinking party, which convened in the basement of a pub next to Grand Central Station. The name of that event proves, as much as anything, that the quants have geek in their veins: it was the August meeting of the New York chapter of the Quantitative Work Alliance for Applied Finance, Education, and Wisdom, or QWAFAFEW.

Though derivatives were simpler once, they were never very simple. The breakthrough in the valuation of derivatives in general, and options in particular, was the model and formula know as Black-Scholes, first proposed by Fischer Black and Myron Scholes in the 1970s and formalized by Robert Merton in 1973. (Merton, like so many of the best quants, came not out of Wall Street but out of aca­demia, earning a PhD in economics from MIT in 1970.)

In quantitative finance, the formal expression of Black-Scholes by Robert Merton is so important that everything that followed has been called a "footnote." The Black-­Scholes model assumes that a stock's price changes partly for predictable reasons and partly because of random events; the random element is called the stock's "volatility." The idea can be represented mathematically by a simple equation:




St is the value of the stock, and dSt is the change in stock price. The symbol µStdt represents the stock's predictable change and its volatility. (View the results of Black-Scholes model using this interactive calculator.) That final, kabbalistic combination of letters, dWt, is the mathematical expression for randomness, known as either Brownian motion or the ­Wiener process. (Chemically, Brownian motion is the random movement of particles in solution, identified by the botanist Robert Brown in 1828 and mathematically described by the great MIT mathematician Norbert Wiener. Black-Scholes shares some qualities with heat and diffusion equations, which describe everyday events like the flow of heat and the dispersion of populations. That some physical processes seem relevant to finance has inspired all kinds of far-out work, such as efforts to bend general relativity to a theory of finance.) Black-Scholes prices an option according to the amount of randomness in a stock's price; the greater the randomness, the higher the stock could climb, and thus the more expensive the option.

Quants have since refined Black-Scholes, and with the increasing power of computers, they have developed other, more processing-intensive methods of valuing derivatives. In Monte Carlo simulations, for instance, powerful computers model the performance of a stock millions of times and then average the results. Where Black-Scholes, as a mathematical shortcut, assigns a constant value to a stock's volatility, Monte Carlo simulations vary the volatility itself. In theory, this provides a better approximation of price fluctuations in the real world. And quants have devised yet more arcane methods of derivatives pricing. Some particularly complicated models track other economic factors--like the stock market as a whole, or even larger macroeconomic factors--in addition to a stock's price.

Running such computationally intensive simulations has become a lot easier in the last decade. Gregg Berman, a former experimental astrophysicist who left the academy for the world of finance in 1993, is one of what he calls "a ­plethora of PhDs" at RiskMetrics, a firm that provides models, tools, and data to the majority of important banks, brokerages, and hedge funds. (Among other things, the company tries to predict how a derivative will behave in a variety of market conditions--how it might respond, for instance, to weakening exchange rates or increased interest rates.) When Berman started in the business, he says, "full-blown simulations [of the Monte Carlo type] were rare." Now that computers can be so easily linked, however, ­Berman might put as many as 1,000 processors to work at once to run "simulations within simulations," which might measure risk on a product like a mortgage-backed security.

The net result of this improved ability to assign values to increasingly complex derivatives was an explosion in their variety. That meant there was a derivative to suit every investor's appetite for risk. In consequence, investors were increasingly willing to put more money into derivatives.

Recently, one of the most popular of these new instruments has been collateralized debt obligations, or CDOs. Crucially for our story, CDOs are also the product most closely associated with the summer's subprime mess. The CDO has been called a "derivative of a derivative," and to further confuse things, there are CDOs of CDOs, and even CDOs of CDOs of CDOs. A CDO combines both high- and low-risk securities that might derive their cash flow from mortgages, car loans, or more esoteric sources like movie revenues or airplane leases. Investors in a CDO can buy the rights to different levels of income and associated risk, called "tranches." Generally, the most risky tranche of a CDO pays the most income. Created by quants and priced by quants, CDOs have become a popular way for hedge funds, pension funds, insurance companies, and other investors to buy pieces of high-risk but high-profit sectors like subprime loans. According to the Securities Industry and Financial Markets Association, annual issues of CDOs worldwide nearly doubled between 2005 and 2006, going from $249.3 billion to $488.6 billion.

The quants who devise such derivatives work more or less in public view. They're obscured mainly by the complexity of their work. But our knowledge of the quants who design trading strategies is additionally occluded by the secrecy of the big fund operators like Renaissance Technolo­gies. I did manage to speak with some current traders, who gave me a general idea of their approach, and with some ex-traders, who were slightly more specific.

One common method that quants use to identify market opportunities is pairs trading. Pairs trading involves trying to find securities that rise in tandem, or that tend to go in opposite directions. If that relationship falters--if, say, the values of two stocks that travel together suddenly diverge--it's likely to indicate that one stock is undervalued or overvalued. Which stock is which is irrelevant: a trader who simultaneously bets that one will go up and the other one down will probably make money. It's a strategy that lends itself to the use of computers, which can sort through huge numbers of price correlations over many years of stored data--although the final decision to speculate on the relative pricing of paired stocks generally rests with a fund's managers.

Quants have also been pursuing a strategy known as "capi­tal structure arbitrage," which seeks to exploit inefficient pricing of a company's bonds versus its stocks. Again, computers do the searching, looking for instances where, for one reason or another, the securities are slightly misaligned.

In a similar technique, Max Kogler, a principal at the newly launched MM Capital in New York, uses computers to look for inconsistencies in value between the option on an index fund and the options on the stocks that compose that index. Kogler has a master's from the University of Cambridge in pure mathematics with a focus on statistics. He says his algorithms look for "baskets of options that are not doing what they're supposed to be doing." When his computers find such a basket, he and his partners discuss whether or not to buy.

Kogler runs his algorithms on "one Linux box." "Part of the allure of our algorithm," he said in an e-mail, "is that it cuts down computational requirements dramatically. Nonetheless, you'll want to have a speedy machine with pretty decent clock speed and a couple of parallel CPUs."

In what's called nondiscretionary trading, computers both find the inefficiencies and execute the trades. The Aite Group, a financial-services research firm, estimates that roughly 38 percent of all equities may be traded automatically, a number it expects to increase to 53 percent in three years.

Computers also underlie another developing frontier, high-frequency trading, which is a fantastically exaggerated form of day trading. The computer looks for patterns and inefficiencies over minutes or seconds rather than hours or days. An algorithm, for instance, might look for patterns in trading while the Japanese are at lunch, or in the moments before an important announcement. There is a massive amount of such data to crunch. Olsen Financial Technolo­gies, a Zürich-based firm that offers data for sale, says it collects as many as a million price updates per day.

One trader I spoke with at a $10 billion hedge fund based in New York said that his computer executed 1,000 to 1,500 trades daily (although he noted that they were not what he called "intra-day" trades). His inch-thick employment contract precluded my using his name, but he did talk a little bit about his approach. "Our system has a touch of genetic theory and a touch of physics," he said. By genetic theory, he meant that his computer generates algorithms randomly, in the same way that genes randomly mutate. He then tests the algorithms against historical data to see if they work. He loves the challenge of cracking the behavior of something as complex as a market; as he put it, "It's like I'm trying to compute the universe." Like most quants, the trader professed disdain for the "sixth sense" of the traditional trader, as well as for old-fashioned analysts who spent time interviewing executives and evaluating a company's "story."

High-frequency trading is likely to become more common as the New York Stock Exchange gets closer and closer to a fully automated system. Already, 1,500 trades a day is conservative; the computers of some high-frequency traders execute hundreds of thousands of trades every day.

Linked with high-frequency trading is the developing science of event processing, in which the computer reads, interprets, and acts upon the news. A trade in response to an FDA announcement, for example, could be made in milliseconds. Capitalizing on this trend, Reuters recently introduced a service called Reuters NewsScope Archive, which tags Reuters-issued articles with digital IDs so that an article can be downloaded, analyzed for useful information, and acted upon almost instantly.

All this works great, until it doesn't. "Everything falls apart when you're dealing with an outlier event," says the trader at the $10 billion fund, using a statistician's term for those events that exist at the farthest reaches of proba­bility. "It's easy to misjudge your results when you're successful. Those one-in-a-hundred events can easily happen twice a year."

The events of August were outliers, and they were of the quants' own making. (Some dispute that verdict: see "On Quants.") To begin with, quants were indirectly responsible for the boom in housing loans offered to shaky candidates.

Derivatives allow banks to trade their mortgages like bubble-gum cards, and the separation of the holder of a loan from the writer of a loan tended to create an overgenerous breed of loan officer. The banks, in turn, were attracted by the enormous market for derivatives like CDOs. That market was fueled by hedge funds' appetite for products that were a little riskier and would thus produce a higher return. And the quants who specialized in risk assessment abetted the decision to buy CDOs, because they assumed that the credit market would enjoy nine or so years of relatively benign volatility.

It was a perfectly rational assumption; it just happened to be wrong. Matthew Rothman, a senior analyst in quantitative strategies at Lehman Brothers, called the summer a time of "significant abnormal performance"; according to his calculations, it was the strangest in 45 years. James Simons's Renaissance Technologies fund slid 8.7 percent in the first week of August, and in a letter to his investors, he called it a "most unusual period." As Andrew Lo put it, "Unfortunately, life has gotten very interesting." The Wall Street Journal called it an "August ambush."

The damage quickly spread beyond the market for low-quality debt instruments. It was almost as if the financial world had become a market for nothing so much as standard deviations, the mathematical term for the spread of values straying from a mean. In fact, the summer might be described as a time when too many investors had purchased standard deviations that were too high for their means.

Among the lessons that August taught is that there may be a finite number of viable investing strategies--a suspicion borne out by the oddly synchronous decline of many quant funds this summer, including Simons's Renaissance Technologies. August's bizarre market behavior, according to Rothman and others, was probably the product of some large hedge funds' seeking cash to meet their debt obligations, as the value of their CDOs declined, by selling those securities that were easiest to shed, chiefly stocks. (And which funds? In another example of the secrecy of fund managers, no one really seems to know, or wants to say.)

According to most of those to whom I spoke, something like the following occurred this summer. Quants had, in the ordinary nature of their jobs, "shorted" many stocks. Shorting is an arrangement whereby an investor borrows a stock from a broker, guaranteeing the loan with collateral assets placed in what is called a margin account. The investor straightaway sells the borrowed stock; if the stock then declines in value, the investor buys it back and pockets the difference in price when he returns the stock to the broker. But if the stock unexpectedly increases in value, even for a little while, the investor must either place additional collateral in the margin account to cover the difference or buy back the shorted stock and return it to the broker.

CDOs had functioned as the collateral on the quants' short positions. When the subprime crunch squeezed the financial markets, the value of those CDOs declined, forcing quants to increase the collateral in margin accounts, buy back the shorted stocks, or both. But in either case, in order to supplement their shrinking collateral, quant funds were forced to sell strong blue-chip stocks, whose prices consequently fell. At the same time, as quants bought back shorted stocks, the prices of those stocks increased, demanding the posting of yet more collateral to margin accounts at the very time that the value of CDOs was suffering. That the quants were, apparently, long on the same strong stocks and short on the same weak stocks was a result of a number of strategies, pairs trading among them.

Another related explanation for the August downturn was that the quants' models simply ceased to reflect ­reality as market conditions abruptly changed. After all, a trading algorithm is only as good as its model. Unfortunately for quants, the life span of an algorithm is getting shorter. Before he was at RiskMetrics, Gregg Berman created commodity­-trading systems at the Mint Investment Management Group. In the mid-1990s, he says, a good algorithm might trade successfully for three or four years. But the half-life of an algorithm's viability, he says, has been coming down, as more quants join the markets, as computers get faster and able to crunch more data, and as more data becomes available. Berman thinks two or three months might be the limit now, and he expects it to drop.

For Richard Bookstaber, a quant who has managed hedge funds and risk for companies like ­Salomon Brothers and Morgan Stanley, the August downturn proved that concerns he'd long harbored were well founded. ­Bookstaber was on the panel sponsored by the IAFE; in fact, he is everywhere these days. His book A Demon of Our Own Design, which appeared in April, was eight years in the making, and it made some very prescient predictions.

Bookstaber is a quiet, thoughtful man, with sharp brown eyes and an attentive look. He studied with Merton in the 1970s at MIT, where he got his doctorate in economics. Today, he is very worried about the tools and the methods of the quants. In particular, he frets about complexity and what he calls "tight coupling," an engineer's term for systems in which small errors can compound quickly, as they do in nuclear plants. The quants' tools, he feels, have became so complicated that they have escaped their creators. "We have gotten to the point where even professionals may not understand the instruments," he says. This, to Bookstaber, was perfectly demonstrated this summer, when the subprime troubles touched off a reactionary wave of selling in equities that would nominally seem unrelated, or, as Wall Street puts it, "uncorrelated."

"Nobody knew that what happened in the subprime market could affect what was going on in the quant equity funds," he says. "There's too much complexity, too much derivative innovation. These are the brightest people in the business. If it could happen to them, it could happen to anyone. No one could have predicted the linkage."

Linkage is one of Bookstaber's favorite topics. He believes that quants' instruments have "linked markets together that wouldn't normally be linked," and that such linkages are dangerous because they are unforeseen.

Berman and others I spoke to agreed with many of ­Bookstaber's concerns. "The products are getting an order of magnitude more complex," says Berman. "Things change slightly, and get correlated where they weren't correlated before." Or, as he put it a little less gnomically, "You can't make it without understanding it, but you can buy it."

Beneath all this beats the great hope of the quants: namely, that the financial world can be understood through math. They have tried to discover the underlying structures of financial markets, much as academics have unlocked the mysteries of the physical world. The more quants learn, however, the farther away a unified theory of finance seems. Human behavior, as manifested in the financial markets, simply resists quantification, at least for now.

Emanuel Derman remembers dreaming of such a unified financial theory in the early 1990s, a little after he had made the leap from the university to the Street. But those dreams, he says, are dead. Quantitative finance "superficially resembles physics," he says, "but the efficacy is very different. In physics, you can do things to 10 significant figures and get the right answer. In finance, you're lucky if you can tell up from down."

So up was down and down was up this summer, and Bookstaber and others hope it is a warning that will be heeded, rather than the beginning of a major systemic crisis.

And was subprime the canary in the mine? It was a question the panelists and the audience who showed up at Four World Financial Center last August are only beginning to answer. Leslie Rahl, for instance, cautiously told me in a follow-up e-mail that it is "looking more and more like the answer is yes." Many signs have suggested so, from job losses to a continuing credit drought to a weakening dollar, but that history has not yet been written.

As a prelude to the panel discussion, Rahl asked the audience to predict whether credit spreads would shrink or widen in the coming months. She was talking about the difference between the price of a treasury bond and the price of a riskier corporate bond, a standard Wall Street gauge for the health of the economy. A widening credit spread is generally seen as a sign of uncertainty, and a narrow spread as a sign of optimism.

"How many think spreads will widen?" she asked.

The hands of about half the smartest people on Wall Street shot up.

"And how many think they'll narrow?"

The other half--equally smart--raised their hands.

"Well," she said. "That's what makes a market."

If they didn't know, nobody could.

Bryant Urstadt is a freelance writer based in New York. His work has appeared in Harper's and Rolling Stone.

Copyright Technology Review 2007.

Bryant Urstadt is a freelance writer based in New York. His work has appeared in Harper's and Rolling Stone.

Copyright Technology Review 2007.

I share this premise

if you go back two K cycles ago there are a lot of resonances to the present situation. At the time we had out of control fiat inflation in Europe (Russia expanded the money supply by x10 and France x4 between 1900-1915, the British and French were borrowing like crazy while the Americans were saving during the same period. The commodity cycle was on the rise globally during the same period while the Europoean stock market went into a 20 year bear 1900-1920 while the US market rose, the British even had their own concept of free trade while everyone else was putting up barriers.

Here is the hypothesis, modern market commentary relies exclusively on US data and virtually ignores all other economies, we ignore most other stock markets and economic data are refer almost obsessively to US data. How many times have you heard folks refer to the London bear market of 1900-20?

Kondratiev found his cycles in pricing data from Europe and only later confirmed it with American data at a later stage, much of Schumpeters analysis also relied on European data, this was only natural then as most economic activity happened outside the US.

To replicate the 1900 K wave growth period all we need is a bear stock market in the US, a bull in Asia and a commodity bull, the US looks much like France and England at the start of the 20th century , rising debt and poor savings , while Asia looks like the US , rising savings and lower debt.

Peak oil is a western problem in that the Asians are more robust people and use less, where as in the US the people have become fragile and less robust. I don't mean to say that Peak Oil wont impact everywhere , it will but it wont have the human impact it will have on the US lifestyle and pysche.

Wednesday, October 10, 2007

Hunter Hall'ss strategy notes

Hunter Hall Global Value Limited's pre-tax NTA increased 0.2% over the month, after adjusting for the final 3.0 cent fully franked dividend. The benchmark MSCI Index in Australian dollars declined by 3.7%. The rise was despite the strength of the Australian dollar, up 7% against the US dollar, British pound and Japanese yen, over the month which reduced the value of the Company's foreign holdings.
Equity markets appear to have shrugged off the sub-prime induced credit crisis to rally for the time being although the ability of banks and companies to borrow money remains constrained. Despite the US Federal Reserve's half a percentage point interest rate cut we expect many more mortgagee foreclosures over the next year, and the weak US housing sector looks set to dent US economic growth. In light of these concerns we are raising cash to preserve capital and be better prepared for bargain hunting.
We have trimmed our Korean positions, but also took profits from Singaporean global logistics company Noble Group (+30%) and Singapore Petroleum (+15%). We put more of the Company's assets into prospective iron ore miner Atlas Iron (+34%), which had an especially strong month as iron ore contract negotiations continue between
major miners, BHP, Rio Tinto, CVRD and Chinese steelmakers.
Australian cancer treatment provider Sirtex (+10%) released its 2007 full year results showing sales rising to $33m from $23m in 2006. The underlying business is steadily improving with sales growing in Europe (up 142%), the US
and Asia and new distribution arrangements providing an entry into previously untapped markets. Profits were negatively affected by non-recurring items such as legal fees and foreign exchange losses.
At month-end unaudited net assets were $499 million pre-tax and $472 million post-tax, ex the 3.0 cent per share final fully franked dividend. The asset breakdown was 5% net liquids, 22% Australian and New Zealand equities,
19% European equities, 46% Asian equities and 8% U.S equities. Hedging was in place for 42% of the Company's foreign currency exposure.

The Price of perpetual prosperity

We are at a pivotal intersection in the timeline of our economic history as we again further separate our money supply from economic reality. Another credit bubble has been overseen and now patched on-the-fly by the Deus Ex Machina of our time, the Federal Reserve. It may look clever to save the world from a dilemma you helped create, but at what price? Cutting interest rates reduces the denominator of a fraction that then presumes a higher intrinsic value of the numerator, equities. Money is cheapened and more credit is pushed into the bubble so that it doesn't look like a bubble. As absurd as it might look in black and white, it sold and illusion has become reality. Al sold it with virtually no derivatives available and it's even easier for Ben, with an estimated 500 trillion in global derivatives now trading.


Bailing out another round of creative financing seems to be the new role of a redefined Federal Reserve, one dedicated to sustaining the myth of perpetual prosperity. That prosperity depends upon domestic consumption which seems headed toward indenturing our children to support. Inflating the currency to re-inflate the housing bubble further disconnects the money supply from bona fide GDP growth. Such leaps define fiat money and broach the trust everyone deftly bestows upon the Fed. Creating bubbles to substantiate prior bubbles increases the probability of the deferred pop creating a deflationary accident.

The carnage of this folly isn't hard to see; a once fiat-resistant dollar steadily losing ground against more fiscally responsible countries, most of the world. Imagine the foresight involved in voluntarily diminishing dollar denominated assets worldwide just keep our debt laden consumers buoyed. Are we in reality so much in debt, our currency so valueless, that we need a fire sale on our assets just to raise money for our shaky banking system? Do we need the hard currencies of other countries as they once needed ours?

I sincerely ask for one of the PhDs, who extol the virtues of a declining dollar, to explain how a first world economy does anything other than admit fiscal irresponsibility by inflating its currency. Our banking system is no different than any other (non- collateralized) banking system on the scrap heap of history that inflated its money out of existence. I'm sure that all those bankers felt it prudent to pretend things would somehow get righted in the future rather than realistically confronting their difficult present. Am I alone in seeing that it's not the rest of the world on the way up, as much as it's us on the way down?

http://seekingalpha.com/article/49194-the-price-of-perpetual-prosperity

A huge rant from marketticker

"Although financial markets were expected to stabilize over time, participants judged that credit markets were likely to restrain economic growth in the period ahead. Given existing commitments to customers and the increased resistance of investors to purchasing some securitized products, banks might need to take a large volume of assets onto their balance sheets over coming weeks, including leveraged loans, asset-backed commercial paper, and some types of mortgages. Banks' concerns about the implications of rapid growth in their balance sheets for their capital ratios and for their liquidity, as well as the recent deterioration in various term funding markets, might well lead banks to tighten the availability of credit to households and firms."
Now you have the truth.

Why weren't those liabilities on the bank's balance sheets up front?

THE FED HAS BEEN COMPLICIT IN ABROGATION OF THE REGULATORY BANKING FRAMEWORK AND HAS KNOWINGLY LOOKED THE OTHER WAY WHILE BANKS CREATED SIVS AND CONDUITS FOR THE EXPLICIT PURPOSE OF EVADING REGULATORY CAPITAL REQUIREMENTS.

THIS HAS NOW BEEN ADMITTED TO IN THE ABOVE QUOTE OF THE FOMC MINUTES!

THIS SHIT MUST STOP AS IT MAKES AN ABSOLUTE FUCKING BALD-ASS MOCKERY OF BANKING SYSTEM REGULATION!

THERE IS NO REGULATION WHATSOEVER WHEN IT COMES TO CONTROL OF THE MONEY/CREDIT SUPPLY NOR DO RESERVE REQUIREMENTS AND REGULATORY CAPITAL MEAN A THING ANY MORE!

ITS ALL BULLSHIT AND THE ENTIRE BANKING SYSTEM IS LITERALLY HANGING BY A FUCKING THREAD!

WHEN ARE YOU PEOPLE GOING TO FUCKING WAKE UP AND START SCREAMING AT YOUR CONGRESSFOLK?

WILL IT BE BEFORE OR AFTER WE HAVE THOUSANDS OF BANK FAILURES AND THE FDIC GOES BANKRUPT, LEAVING YOUR SO-CALLED $100,000 BANK ACCOUNT "INSURANCE" WORTHLESS?

ARE YOU GOING TO GO GET YOUR MONEY OUT OF THE BANK TOMORROW? YOU BETTER BECAUSE YOU JUST READ THAT THE FED KNOWS THAT THE BANKS ARE GAMING THE SYSTEM AND HAS REFUSED TO STOP IT!

Ok, next fraud:

Inflation "expectations" are "well-anchored."

Notice that Poole is NOT saying "inflation" remains well-anchored. That is because its not.

There's deflation if you want to buy a computer, but how many computers can you eat?

I don't know about you but I have to eat FOOD, not computer chips.

EVERYTHING that the Middle Class must buy and spends half or more of their money on is inflating at rates of 10, 20 or even more percent A YEAR.

Bernanke, Poole and the rest of the FOMC are now in the Public Disinformation business instead of the monetary policy business and Congress refuses to act in accordance with their Constitutional MANDATE to do something about this shit.

I don't know why I do this any more guys and dolls.

Nobody will get off their ass. Oh sure, there are a few. But most? No. Media? Forget it. People? No.

I'll keep at the database updates until I can get a formal petition out, but unless I see some serious efforts by others that's it for me. I'm going to go spend my time trading rather than writing, because this doesn't make money and trading does.

Oh, and I'm going to do a lot more fishing and diving too.

This has been fun kids but the fact of the matter is that I hear lots of "thanks man, that says a lot" but nobody's doing what needs to be done.

Specifically, getting 10 of your friends to get 10 of theirs to get off their fucking ass and start bombarding the press and your politicians. Has this shown up on the "national stage"? Nope. Nor will it, until the Middle Class is destroyed because so long as you can drink a beer and fuck your wife or girlfriend - not to mention still use your credit card - its all ok right?

I'm tired of tilting at windmills. I know what's coming and I'm well-positioned for it.

Bottom line - nobody cares.

There are 30,000 people a month - unique people - who read this blog.

I have repeatedly asked that every one of you call and write your Congresscritters, and get 10 of your friends to do so as well, spending however long it takes explaining it to them.

How many of you have done what needs to be done? I guarantee you that if we had 30,000 people hammering on their Representatives and Senators - say much less 300,000 - that by now someone would have come out in public and demanded an investigation on this FRAUD upon the public. And DON'T mention "Ron Paul", because if you do in the thread on the forum related to this - its good for an INSTANT BAN. That man is no better than Hillary, who I'm going to vote for - at least she tells you she's going to buttfuck you straight up front.

Obviously, too few of YOU who get from this update daily have done a thing. Lifted the phone. Used your computer to send a fax. In other words, 99% of you just take and take and take and refuse to get off your asses and act, even today in the world of "free" long distance phone calls to Washington DC on almost every cellphone plan.

Well its time to put up or shut up.

Let's see if there are 30,000 AMERICANS out there who give a fuck whether we have a middle class in this nation a couple of years down the road or not.

My money is on "NOT" and my willingness to continue to spend the time on this blog on a DAILY BASIS is now up to you.

I'm going to find out firsthand whether or not the majority of you who read this blog are of net benefit to this nation or net cost.

If the answer is not "net benefit", I'll post when I feel like it - but it won't be daily and sure as hell won't be twice a day with updates, video or not.

The way I see it, being that I can daytrade for $1,000 or more daily, writing this blog costs me in excess of $30,000 a month.

Its well worth it if our nation benefits.

But if not - then I'll spend my time trading, fishing and diving.

Your move guys and dolls.

I'll be watching and whether you see daily, every few days or perhaps once a week updates depend on you.

PS: Alcoa missed, International Paper warned, Chevron warned, Toyota warned on domestic (Japanese) sales after already warning on US Sales. The bad news is starting..... and no, the market won't like it. Be careful if you intend to play what looks like a parbolic blow-off - we could fail here literally at any time and that failure is likely to come completely without warning in the form of a huge gap downward.

here is the rant

Tuesday, October 09, 2007

Global warming driving number crunching

by Christopher Lazou
HiPerCom Consultants, Ltd.
"Our civilisation is destroying itself because it is determined to disregard all limits in all areas."
-Dominique Bourg, philosopher of sustainable development

Global warming and its dire consequences have at long last permeated the special interest barriers and are at the centre of political debate. A recent EU Research magazine produced a special feature with the title: "Climate Change: We can't wait any longer," stating: "The 4th IPCC report was issued and adopted this spring amidst a blaze of publicity and debate. It summarises two decades of important multidisciplinary research and formally concludes that the symptoms of global warming due to human activity are all too real, and will inevitably progress faster than was previously thought. We must act."

The "business as usual" model will inevitably increase global warming and consequently destruction, faster than previously predicted. The European Union (a high polluter) has taken onboard the IPCC conclusions and the findings of Nicholas Stern, an economist and author of a forceful report commissioned by the UK government on the cost of global warming. The EU already agreed to drastically reduce green house gas emissions by 20 percent between now and 2020.

The recent Asian Pacific Economic Community (APEC), which includes the USA, China, India, Australia -- the biggest polluters -- are however dragging their feet. This is likely to reduce the pressure on EU countries to deliver their targets. In the meantime, the devastation of property, infrastructure and threat to life continue unabated. Heat waves, forest fires, drought, flooding and hurricanes are becoming everyday news items.

It was in this climate that from Sept. 9-13 about eighty meteorologists and HPC experts from large-scale computing centres from eleven countries attended the bi-annual Computing in Atmospheric Sciences (CAS) workshop on the use of HPC in meteorology, held at the idyllic Imperial Palace Hotel, Annecy, France. The workshop was organised by the National Centre for Atmospheric Research (NCAR), USA. This excellent small and friendly workshop provided a tour de force in meteorological and computing techniques by active practitioners, some of them IPCC contributors, striving to maximise the latest HPC technology to refine and improve their climate prediction models.

Refinement of models is an urgent requirement for the development of realistic mitigation strategies to address the potential catastrophic consequences of global warming. These talks were augmented by speakers from broader scientific centres of excellence, like CERN, NERSC and ORNL, and from funding bodies such as the NSF, in the USA.

Most presenters came from sites in the USA with large Cray XT3/4, IBM Power5/6 and Blue Gene/L systems, while the European and Australian contingent included a strong representation from sites with large-scale parallel vector NEC SX-8 systems. The main HPC vendors described their upcoming products, their vision for petaflops computing and the technology advances needed for exaflops systems. What became abundantly clear during this workshop is that the "business as usual model" -- be it in human activities as a whole or in developing computing technologies -- is not a realistic option and radical new approaches are needed. This article highlights a few of the many climate and technology issues raised by presentations given at this workshop.

There were 38 presentations in three and a half days, some describing grid's enabling potential for international collaboration, such as CERN and also within the community of climate system modelling. The talks were crammed with technical information on how to use parallel supercomputers for computation using mathematical models that describe climate/weather patterns over time. These were interspersed with weather maps and video pictures from simulations and compared with satellite pictures of actual weather events.

Why are meteorologists doing all this Earth System Modelling and what is the urgency? As stated above, dramatic flooding and other extreme events related to climate change are happening and frequently reported in the press and on television. For example, it has just been reported that satellite images show that the North West passage connecting the Atlantic and the Pacific oceans is free of ice, making it navigable for the first time since records were kept. Also, seventeen central African countries are currently flooded, with millions of peoples' homes and crops devastated. "It is common knowledge that it is the countries of the south that stand to be hardest hit by global warming when at present it is the countries of the north that are the biggest polluters," Nicholas Stern was reported as saying.

Climate simulations show that green house gases attributed to human activities are causing an increase in the Earth's average temperature. Consequently, fires from intensely hot summers and flooding from heavy rainfall are becoming more common. These images of devastation and the economic aftermath are injecting a political dimension into the proceedings.

A number of talks dealt with prediction and mitigation strategies, to deal with devastating events such as flooding and hurricanes. The costs of these events are enormous. Hurricane Mitch caused the deaths of over 9,000 people in Nicaragua mostly from flooding and landslip.

Greg Holland from NCAR gave a stimulating keynote talk titled: "Anthropogenic Influences on Intense Hurricanes," which focused not only on observed hurricanes, but also on the scientific evidence for causal attribution.

He explained that apart from direct impacts, indirect impacts arise from forecast uncertainty, design and preparations and imperfect knowledge of cyclone parameters. Coastal impacts from tropical cyclones include harbour damage, house and crop destruction, forest damage from wind, waves, flooding and landslips. Excluding the loss of life, the direct damage from hurricane Katrina was about $80 billion dollars and an additional $40 billion as indirect costs to the USA. About 95 percent of the oil and gas production in the Gulf was disrupted and about 150 oil rigs were lost. Tornadoes and flooding reached as far away as Quebec and people were displaced from most coastal states. Government recovery costs were $10-15 billion. The Consumer Price Index (CPI) impact was around 1.4 percent to 2.3 percent. The total CPI cost was estimated to be: $16 to 26 billion. The cost per household ranged from $140 to $230. Reduction in economic growth rate was about 1 percent, but this was compensated by a subsequent overshoot in the economy. In the USA, 50 percent of the population live within 50 miles from the coast and the cost for evacuating one mile of coast is about $1 million per day. Note that recovery from a storm impact takes years.

Greg went on to convey the IPCC position on hurricanes: "It is likely that increases have occurred in some regions since 1970; it is more likely than not a human contribution to the observed trend; it is likely that there will be future increasing trends in tropical cyclone intensity and heavy precipitation associated with ongoing increases of tropical SSTs [sea surface temperatures]." He demonstrated with detailed graphs that the bulk of the warming since 1970 is due to anthropogenic effects. He reviewed Atlantic SST and atmospheric modes of variation and demonstrated that these are not accounted for by natural variability. His conclusion was unequivocal: "Anthropogenic climate change is substantially influencing the characteristics of North Atlantic tropical cyclones through complex ocean-atmosphere connections and may be influencing other regions."

The above view was reinforced by Dr. Warren Washington in his talk titled: "Computer Modeling of the 21st Century and Beyond." From the 1970s, Warren sat on a committee that advised six U.S. presidents on climate issues. He is also heavily involved at NCAR in the Community Climate System Model (CCSM), which has produced one of the largest data sets for the IPCC fourth assessment. Echoing Greg's sentiments, he said, "As a result of this and other assessments, most of the climate research science community now believes that humankind is changing the Earth's system and that global warming is taking place." He also told me that every question raised by sceptics was thoroughly reviewed and rigorously refuted. "Natural events do not explain global warming. The smoking gun is human emissions, and once included, the warming can be reproduced from year to year," he stated.

According to Paul Crutzen, another IPCC participant: "The only criticism that could be made of the IPCC report is of it being too cautious."

For HPC vendors the good news is that there is a lot of new work to be done requiring oodles of computing power. The computing requirements are for data assimilation, modelling internal oscillations, prediction of external forces and hurricane/climate feedback. A system delivering 200 teraflops of sustained performance would be appreciated and utilised today.

In fact, most sites pursuing climate change research are well endowed with computer resources. Three years ago they were lucky to muster 0.5 teraflops of sustained performance. Current procurements in progress have minimum requirements of around 10 terflops of sustained performance in phase one followed by at least twice that by 2009. The climate applications, of course, can use an order of magnitude more power now without waiting for the end of the decade. The tantalising fact is at least one system capable of delivering 200 teraflops of sustained performance with less than 9,000 processors will be available from Japan early next year, but it is unlikely to be sold in the USA.

In the next few years, the CCSM will be further expanded to include reactive troposphere chemistry, detailed aerosol physics and microphysics, comprehensive biogeochemistry, and ecosystem dynamics, and the effects of urbanization and land use change. These new capabilities will considerably expand the scope of earth system science that can be studied with CCSM and other climate models of similar complexity. Higher resolution is especially important near mountains, river flow, and coastlines. Full hydrological coupling including ice sheet is important for sea level changes. It will include better vegetation and land surface treatments with ecological interactions as well as carbon and other biogeochemical cycles.

For example, Dave Randal has a five-year NSF grant to study clouds using high-resolution models. Clouds are central to earth sciences, climate change, weather prediction, the water cycle, global chemical cycles and the biosphere. Dave stated: "We are being held back in all of these areas by an inability to simulate the global distribution of clouds and their effects on the Earth system." The need for high resolution catapults this application into the realm of petaflops computing.

The computer requirements for the next generation of comprehensive climate models can only be satisfied by major advances in computer hardware, software, and storage. The classic climate model problems with supercomputer systems are: The computers (with the exception of vector systems) are not balanced between processor speed, memory bandwidth and communication bandwidth between processors, including global computational needs. They are more difficult to program and optimize; it is hard to get I/O out of computers efficiently and computer facilities need to expand archival data capability into the petabyte range. There is a weak relationship between peak performance and performance on actual working climate model programs.

Thus with sustained teraflops computing performance now on stream, meteorologists are moving from climate to Earth System Modelling (ESM). This is because feedback loops between climate, ecology and socio-economics are significant. Climate modelling is not possible without proper representation of these systems. Earth System Modelling is: multi-scale (time and space), multi-process, multi-topical (physics, chemistry, biology, geology, economy, etc.). which is both compute- and data-intensive. Some people claim it requires several orders of magnitude more computing power to tackle the problem. Petaflops and exaflops are therefore eagerly awaited.

Stefan Heinzel, director of Garching computing centre of the Max Plank Society (RZG), Germany, gave a keynote titled: "Toward Petascale Computing in Europe – A Challenge for the Applications and the Hardware Vendors." He listed the current petaflops projects and their likely hardware architectures. The Riken project in Japan, the Cray Cascade and the IBM PERCS in the USA were all mentioned. Doing the math, he indicated that one petaflop of sustained performance would need hundreds of thousands of cores. Even for vector machines, it could be around 50 thousand cores. The question is how does one deal with O(50000) parallelism using local memory and MPI? What about the CPU memory gap, which keeps widening as CPUs grow much faster per year than the 7 percent increase of memory speed?

Transistors on an ASIC are still doubling every 18 months at constant cost, but in the last two years, neither AMD nor Intel announced significantly faster cores. Performance improvements are now coming from an increase in cores on a processor. Presently four cores are standard; soon this will be eight. Intel already announced an 80-core processor technology. IBM doubled the performance from the Power5 to Power6 reaching 4-5 GHz, but using 2 cores. The Power6+ could increase the frequency incrementally, but doubling the frequency of the Power7 is going to be difficult. After the year 2015 one envisages about 512 cores or more (nanocore).

Sequential applications are of O(1). There is no substantial performance increase delivered by faster cores. It is the same on the desktop and on HPC systems. The snag is that memory speed increases only seven percent per year, with no improvement of latency of the cache architecture or memory bandwidth. Current HPC applications can use O(K) MPI tasks, mapped to threads. "Classical" scaling can achieve not higher than O(3,000); while the Blue Gene/L can achieve O(30,000). Higher scalability in the range of O(M) requires new technologies in the processor and in the nodes. An SMP programming model between hundreds of cores requires hardware support for lock mechanisms, transactional memory for atomic updates, new micro architecture for latency hiding and pre-fetch hints, i.e., with "assist threads." The memory bandwidth wall is the limiting factor for scalability of the multicore architecture.

The file and I/O system needs to support hundreds of thousands of clients. To solve the scalability problem, a low latency communication is required. One expects a huge number of files in a single file system -- trillions of files with terabyte-per-second transfer rates. For robustness different techniques are also needed, since RAID6 is not an adequate I/O connection mechanism.

For petaflop systems, the operating system (OS) and middleware need to have awareness of massive parallelism. OS failures have to be reduced. OS jitter impacts can have dramatic performance degradations for applications. Lightweight operating systems or special reduced standard kernels should be considered. There is necessity for interrupt synchronization and dynamic management of various page sizes. Applications should adapt their page sizes dynamically, which should result in a reduction of boot time and time to load an application. Hierarchical concepts should be implemented to solve scalability issues; hierarchical daemon structures are required for supporting hundreds of thousands of clients and for queuing and monitoring systems.

And, of course, one hits the processor power wall. Smaller cores help, providing more operations per watt. A lower frequency also helps to increase the number of cores, i.e., more operations per watt. This implies higher scalability, but the ratio of sustained performance is an open question. Memory and huge caches use significant power too, as does the interconnect. The challenge is to optimize the power consumption of each component.

In summary, the use of multicore, and later nanocore, architectures implies a challenge for petascale applications. There is a need to hide the memory wall. Cache architecture and memory have to improve latencies and bandwidth. New synchronization mechanisms have to be realized with SMP parallelism becoming more important. Helper threads will support pre-fetch techniques, but the applications have to improve latency tolerance. The interconnect limit implies new programming techniques are needed. Increased power consumption is the most critical problem due to budget limitations. The necessity of reinventing parallel computing is an enormous challenge caused by the massive increase of cores in future architectures.

The Cray XT series and IBM Power and Blue Gene systems, as well as other vendors in the USA and vendors such as NEC and Fujitsu from Japan, are developing petaflops systems, but how effectively these systems can be utilised is an open question and fraught with a myriad of challenges.

During the last CAS workshop in 2005, a strong emphasis was placed on data management and the challenges it entails. This time, the emphasis was more on power used by supercomputers (carbon footprint) and the facility footprint (space) requirements.

In my view, global warming is the most pressing challenge of the 21st century, and we all need to reduce our carbon footprint and become carbon neutral. Our political leaders should be judged whether they are "fit for purpose" and then held accountable for the mitigation policies they enact. When Mr Alan Greenspan, the former federal reserves (U.S. central bank) chairman, says in his newly published autobiography that "the Iraq war is largely about oil," he should have added that it is also an irresponsible way of avoiding making the economic decisions needed to start mitigating "an inconvenient truth," global warming.

The workshop presentations are available on the NCAR Web site: http://www.cisl.ucar.edu/dir/CAS2K7/.

Harry on gold

On the other hand, Schultz' slowness doesn't seem to have hurt his performance over the past several years.

And Shultz's focus on gold is right on the news. He writes: "With an election coming, the Fed went for bandaging a slipping economy which affects votes and sacrificing the dollar, which is harder for the public to measure. Big rate cuts, like this 50 points, are always an act of desperation. Such cuts have usually been followed by recessions. More cuts will follow. It set the future in cement for the U.S. dollar. Cement overshoes. Currency debasement never produces wealth. Fed knows this, but took a political decision. Nothing new about that. Much higher inflation now guaranteed ... My tentative targets (by end of 2008): 14% (inflation), $1,600 (gold) and $45 (silver)."

Elsewhere, Schultz writes: "Gold is starting into the most exciting part of its long-term bull market, the so-called second (and monetary) phase. Herein we normally see the biggest percentage gains, matched by biggest corrections as we saw in the '70s gold rush: in 1974, gold corrected 25% in 4 months (most gold shares fell 50-70%); in 1975-76 gold fell 50% (most shares fell 70-90%) and took 2 1/2 years to get back to old high before then rocketing to new highs. But that makes for great trading opportunities. This is the phase where the BIG money is made, by those who go with the tides. In and out, in and out ..."

http://cryptome.org/burma01/burma-kill-01.htm

AVE 1000 LIVES, BY FORWARDING THIS TO FRIENDS.

There is a genocide going on in Burma(Myanmar). Please help it stop by forwarding to your friends. Thank you!
http://picasaweb.google.com/burmamyanmargenocide

Today, tyrant military government of Burma (Myanmar) has shot down and wounded over 100 unarmed protesters.
9 dead bodies, including a Japanese journalist, were collected and confirmed by the Burmese soliers.
Many wounded fled away and believed to die in a few hours on their way home. Number of death toll is not confirmed.
The murdered Japanese journalist is called Mr Kenji Nagai, APF Tsushin Media.

http://en.wikipedia.org/wiki/2007_Burmese_anti-government_protests

People of Burma were simply asking for peace. Due to torture, people were so scared to protest first.
But the buddhist monks initiated this revolution, without self interest.
However, when a Buddhist monk was tied to pole and tortured in public,
most Buddhist monks around the country and 200,000 protesters joined in.

The protest were very peaceful. They were simply reading Buddhist prayers called Metta Sutta
(http://en.wikipedia.org/wiki/Metta_Sutta), while walking around town. That was all.
The tyrant Than Shwe (http://en.wikipedia.org/wiki/Than_Shwe) ordered the military to attack,
and shoot into the crowd, causing a genocide like in 1988 again.

Please ask the United Nations to send UN forces to Burma:
http://www.un.org/terrorism/contact-us.asp/

Please ask the US President to send US forces to Burma:
comments[at]whitehouse.gov

Monday, October 08, 2007

BME predict 9000 a tonne copper

In a presentation at Mining Journal's 20:20 Copper Day in London, Chris Welch of copper specialist analytical service, Bloomsbury Mineral Economics (BME), made a strong case for copper reaching $9,000 a tonne - $4.08 a pound - by 2009. Given that BME has a great track record on copper price predictions such a prediction should not be taken lightly!

The premise behind the prediction is that the supply gap is continually underestimated by many analysts and factors which should be built into their pricing models are often excluded. Notably Welch feels that mine production is invariably over-estimated, and the figures also do not take into account the amount of copper or concentrate which is, at any given time, tied up in working stocks, and material in transit and being processed.

This effectively means that even if, for example, metal production moves into a small surplus, as is possible in 2008, the amount that is actually available to the market is somewhat less than this and helps maintains the copper price at current levels.

The stock low point is likely to occur late this year, but copper availability is still likely to be in commercial deficit through 2008 and 2009 and may achieve balance in 2010. This is the basis for the BME price prediction of $9,000 copper by the end of 2009.

This scenario - or at least the general overestimation of copper mine production by analysts - was also commented on by another speaker, Justin Longley of International Copper Resources. He showed a most interesting chart of analysts' predictions against real output which showed a huge divergence, based on figures from Xstrata.

The point perhaps that both speakers were making is that individual corporate presentations of copper mine supply are frequently heavily overestimated but many analysts may take these as reality without applying a big enough discount for projects which are cancelled, fall behind schedule or for major supply disruptions for technical, political and labour reasons. Real growth in copper consumption remains very strong, older mines are becoming depleted and grades are declining sharply.

Another interesting point which arose in Longley's presentation was the rate of copper usage per capita in the Asian sector in particular. It was pointed out that growth in Taiwan and South Korea has been very high in relation to the developed nations where the curve was lower because of the existing copper based infrastructure. But in the real growth economies like China and India, this growth pattern has hardly started yet, and should this rise to Korean or Taiwanese levels then the effect on the$ supply/demand pattern could enormous with price development which could make $9,000 copper itself a huge underestimate!

Satyajit answers questions

What are some other techniques employed by quant traders besides market-neutral pairs trading?
Darko Bodnaruk, Ljubljana, Slovenia

Satyajit Das: Pairs trading is a big area though I would never call it market neutral as you are taking correlation risk. There are different classes of models:

a) short term, high frequency data model - these look at liquid traded markets and are look at short term price fluctuations and try to detect anomalies in price action and do quick in and out trades to take advantage of order driven dislocations e.g. those caused by algorithmic execution.

b) statistical arbitrage type models - these use a fundamental price relationship or pattern to trade things like volatility skews, volatility term structure, swap or credit spreads or merger arbitrage.

My favourite these days is ”double agent” models. You try to find out who is using which model to price or trade and then try to take advantage of what their model is going to do and try to exploit this. Am not sure it is sensible or even works.

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I am a private investor who runs a mechanical long short fund but with longer hold periods, eg 3 or more months. In the recent turmoil my shorts (picked using several factors including RS) performed uncharacteristically poorly. Maybe I was short the same stocks as the quants who were forced to close their positions. My question is: how do the quants pick the stocks to go short on (so I can avoid the same stocks!)
Anonymous

Satyajit Das: RS indicators are very unreliable in the type of market that prevails today as they don’t handle choppy trading condition very well. It is impossible to say why your model underperformed. I don’t typically find it easy to do ex post attribution of model performance as you need to have a fairly complete information set which you will rarely have. It is useful to the words of Isaac Newton, one of the founding figures of modern science, when he faced his own moment of certainty. He lost £20,000 (a very large sum today) in the stock market as a result of the South Sea share bubble. Chastened, Newton said: ”I can calculate the motion of heavenly bodies but not the madness of people.”

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The algorithmic trading with the application of randomized algorithms used for the control of uncertain systems creates an innovative IT platform, which will change the way of smart trading to be performed at stock exchanges globally. Do you see the factors of time and space as the most critical elements in the global spatio-temporal redistribution of wealth through the novel approaches to the valuation of asset classes, use of computer modelling in decision making process, liberalization of trade, presence of an open access for wide categories of traders in the exchange process during the algorithmic trading in the credit derivatives, equity derivatives, commodities and currencies markets worldwide?
Viktor O. Ledenyov, Ukraine

Satyajit Das:Maybe. But I think you should take Paul Valery, the French poet, advice: ”The future is like everything else, it is not what it was”.

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Having read Traders, Guns and Money, it’s hard to imagine why banks continue to make use of models, especially when they’ve proven to be imperfect time and time again. Or is it more a case of everyone else is doing it so I should do it too?
Jasdev Sekhon

Satyajit Das: I am always amazed at how little things change in financial markets at all. We all seem to have exceedingly short and imperfect memory. Martin Baker’s advice in ”A Fool and His Money” about the nature of financial activity says it best: ”Take a speculative cocktail shaker. Add four parts public ignorance and 33 parts greed. Toss in a little perceived genius. If you don’t have any freshly ground perceived genius to hand, a little dried genius status will do. Season generously with mystique. Add apparent publicity shyness to taste. Serve in opaque tumbler of awes, ill informed media coverage”.

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It seems to me that widespread condemnation of quantitative methods is an over-reaction. As for the modellers, they may have forgotten the principles of simplicity and robustness in constructing quantitative models. And, of course, the investment edge comes from being a little bit more original and creative than other modellers. Most of the recent problems faced by quant strategies are the result of the replication of well-known methods in a crowded field, assuming benign circumstances. Do you think lessons have been learnt?
Iran Pouyandeh, Bermuda

Satyajit Das: I think people tend to be wildly and irrationally optimistic at some stages and wildly and irrationally negative just a little later. I think the point you make about crowding is very relevant. There is too much money chasing too few opportunities. Louis Bacon (of Moore Capital) when returning capital to investors commented: ”Size matters. It is the bane of the successful money manager”. Clever people can make money if there are a few clever people and lots of opportunities. This is the problem of ”scalability” – what works on a small scale cannot work on a larger scale. In 2004, Hilary Till argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. There are other constraints. Some hedge fund strategies need liquid markets and a complete set of instruments. There are few such markets.


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How will career opportunities in the quant investing business develop in the next 5 years? What are the required qualifications?
Rudolph Fosilio, Zurich

Satyajit Das: I think we will continue to worship at the shrine of quantitative finance for a while yet. The best qualification I think is success which admittedly is a little difficult to establish in advance. If this fails a degree in maths or a quantitative discipline can’t hurt.

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I think the problem is skewed payoffs for quant strategies. They seem to work well for several dozen months, and they get levered up as the historical performance is viewed as confirmation of their success. Then idiosyncratic risk rears its head (like the current credit squeeze) and they do horribly during that time period. This would also explain why hot traders at prop desks can easily start their own quant funds, but people warning of black swan events like Nassem Taleb aren’t able to raise hedge fund money. What are your thoughts?
Shawn McFarlane, St. Paul, Minnesota, USA

Satyajit Das: I would tend to agree with your point on leverage. A model which has reasonable predictive power may not function well when you leverage it significantly as the need to liquidate on drawdown may well not allow the strategy to operate. Similarly when you leverage it naturally means that you are changing the sizing of the position which means you start to hit trading liquidity constraints - what may be a great strategy for $100 m may not be a great one for a $1,000 million traded.

You also make the point about incentive structures. That is a major but different issue more generally in financial markets - moral hazards and asymmetric returns. Assume a $100 million fund where the manager’s fees are 1% and 20% of performance. Assume also the manager has a $5 million (5%) interest in the fund. If the hedge fund losses $20 million (20%) then, the manager losses $1 million (20% of $ 5 million). The loss is offset by the management fee received (1% of $100 million equalling $1 million). If the hedge fund makes $20 million (20%), then the manager earns $ 4 million (20% of $20 million) plus the management fee ($1 million) - a 100% return. In the words of Mark Twain: ”I am opposed to millionaires, but it would be dangerous to offer me the position.”

As to why black swan funds are more common, I am not sure. Maybe the timing was wrong. In recent time, you would have done well to follow Galbraith’s advise: ”a rising market and a long position is a sure sign of investment genius”. Maybe the tide will turn after recent events.

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Given the failure of quant strategies to work in the subprime generated turmoil would you reckon the use of more Artifical Intelligence and neural network based approach where past historic training of the systems would be in a better position to help detect and avert failures of purely computer based strategies or would you suggest a shift away from computer based algorithmic trading altogether?
Sandeep Manhas, London


Satyajit Das:I am not sure that more complicated modeling is necessarily the way forward. I think we need to understand that the data we work with is poor. Also we have limited understanding of cause and effect in financial markets e.g. our understanding of asset price processes or price evolution is limited. 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. Complexity and inter-connections within the financial markets have increased. Risk is now driven by the increasingly tight coupling of markets and the resulting complexity and interdependence. I am not we will be able to model them successfully. This doesn’t mean that models are not useful but need to be used with great care and understanding of their limitations as well as their predictive powers.

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How do we explain the fact that the models being used had 25-standard deviation events, several days in a row?
Antony Paul Kozhipatt

Satyajit Das:I don’t think a 25 standard deviation event means anything. The assumption is that the distribution is normal or a known form. Also the assumption is that the volatility calculated using the immediate past is relevant as a benchmark in the analysis. Both assumptions are risky. Writing in 1995, Robert Merton foreshadowed the events that were to unfold 3 years later at LTCM: ”any virtue can become a vice if taken to extreme”.


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How do you square your criticism of quant with your involvement in derivatives? At the end of this, who can ignore Buffett: what else is there other than value investing?
ORC Cox, Tokyo

Satyajit Das:I am not uncritical of derivatives or quant trading. Like all tools both are useful if utlised sensibly and with an understanding of the intrinsic limitations of the models. I see quant models as just one tool amongst others just as I see derivatives as potentially useful ways to transfer or create risk. Most forms of analysis are some form of data mining exercise. I think Warren Buffet once observed that ”If past history was all there was to the game, the richest people would be librarians”.

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It seems that ’quant’ strategies can encompass a large range of trading styles, from the extremely short-time period statistical arbitrage through intra-day positioning and also including much longer-term quant-model driven macro strategies. Which of these types of strategy has been affected most by the recent market volatility?
Adam Wall, New York

Satyajit Das: You are quite correct. ’Quant’ strategies cover a wide area of widely disparate activities. For example, is price earning ratios a quant strategy? I think short period high frequency data based strategies are vulnerable to poor performance when market are under stress. This is because the market becomes liquidity driven and choppy. I think quick fill, mean reverting types of price relationship over a very short time horizon are difficult to implement in this environment. Long term macro strategies are not going to be affected to the same degree. The more interesting question for longer term strategies which are frequently based on cause-effect value relationships is does the volatility signal a major regime shift. If it does then clearly you have problems.

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What other options are as good as quants for making investment decisions?
Praveen Tyagi, London

Satyajit Das: In the end all trading is about using information in various ways to predict likely future price movements . Quant models are one of them. They are just heuristic aids to decision making. Anything that helps make the correct decision helps as does anything that helps your understanding of what is happening. I think we need to be clear that any decision-making tool is a reduced form model which approximates reality. Most traders in reality trade ”outside the model”. They use the model predictions and adjust for other things. A major issue is that all our models assume rational markets and behaviours. As John Maynard Keynes observed that ”the market can remain irrational longer than you can remain solvent”. So all option are good or bad - just depends on whether they make money.

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Do you observe the capital convergence or divergence trends in credit markets in conditions of increasing volatility and decreasing liquidity of capital flows globally? How can you explain these dependencies using economics theory, and correlate the theoretical propositions with the practical outcomes at stock exchanges worldwide? Viktor O. Ledenyov, Ukraine

Satyajit Das: A very interesting question. In the short run, you see liquidity driven > convergence but it is liquidity driven. If I am a hedge fund and want to de-leverage or am forced to de-leverage by margins calls then I am forced to sell firstly what is liquid and secondly what might have profits (to avoid realising losses). This makes certain assets highly correlated at least in the short run. As time goes by, I think market adjust and you get de-coupling. For instance, in the current credit crisis, in the medium term, we might get significant changes in capital flows. A McKinsey & Co study showed that the United States absorbed 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. 75% of cross-border capital flows were loans and debt securities. Conservative Asian and European investors prefer debt. Older investors in developed countries wanted income to finance retirement spending. Cross border debt flows funded the US financed 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 which was being securitized. This is causing a lot of the current problems in terms of the global spreading of credit issues. In time, foreign investors may decide that such cross border investing entails ”unknown unknowns” and seek other investments. For example, local capital markets may be encouraged to develop more quickly. Thsi would cause divergence.

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What effect or consideration is given for the credit rating of companies given that some of these appear to be over rated?
Joseph Kelly, Park Row


Satyajit Das: Ratings are an expression of opinion of the likelihood of default of a particular security based on mathematical models, history and snake oil. Investors, woefully 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. They also chose to link rating to pricing and set the amount of borrowing supported by a particular security. Protected by expansive exclusion clauses, the agencies did not discourage these uses of ratings, instead promoting their use as widely as possible.

I also think the nature of structured ratings is more complex than normal corporate ratings. They are based on the subordination (i.e. the amount of securities available to absorb the initial losses). Unfortunately, this may make them vulnerable to rapid downgrading when losses rise rapidly.

CDO ratings in particular show some anomalies. The number of defaults in the BBB class of CDO securities is not materially different from that on BB CDO securities. BBB is classified as investment grade while BB is not. Many investors 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. The 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”.

I have worries about different issues. 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 also pay more than rating conventional bonds. The knives are already out as politicians in the USA and the European Union have started to focus on the role of rating agencies.

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In your highly entertaining, yet educational book ’Traders, Guns & Money’ you mentioned that LTCM endured such heavy losses because banks had copied LTCMs strategy. Could we argue the same is the case with the quantitative funds today, such that - by and large - they employ the same strategies, hence resulting in an aggregate effect in the market? If so, do we need to pull the plug of the quantitative funds during times of distress?
Ali Dicleli, Istanbul


Satyajit Das: I think a fundamental problem in markets is convergence. Everybody has the substantially the same education (Chicago free market logic), similar information or dis-information (whichever you prefer), similar price data and increasingly similar models (though quants would protest on this point as they still like have a tendency to ’model envy’ - my model is better than your model!). This means we tend to all put on similar trades exaggerating the effect on the market. This also strain liquidity. In a breakdown as liquidity evaporates, as we have seen recently, then people cannot exit and enter positions as quickly as they or the models need to leading to problems. In distress, I think the models actually become pro-cyclical and exaggerate the problems.

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Fiscally irresponsible to tax for war

Every so often a quote comes out of the Bush administration that leaves you asking: Am I crazy or are they? I had one of those moments last week when Dana Perino, the White House press secretary, was asked about a proposal by some congressional Democrats to levy a surtax to pay for the Iraq war, and she responded, "We've always known that Democrats seem to revert to type, and they are willing to raise taxes on just about anything."

Yes, those silly Democrats. They'll raise taxes for ANYTHING, even - get this - to pay for a war!

And if we did raise taxes to pay for our war to bring a measure of democracy to the Arab world, "does anyone seriously believe that the Democrats are going to end these new taxes that they're asking the American people to pay at a time when it's not necessary to pay them?" added Perino. "I just think it's completely fiscally irresponsible."

Friends, we are through the looking glass. It is now "fiscally irresponsible" to want to pay for a war with a tax.

THESE DEMOCRATS JUST DON'T UNDERSTAND: THE TOOTH FAIRY PAYS FOR WARS. Of course she does - the tooth fairy leaves the money at the end of every month under Treasury Secretary Hank Paulson's pillow. And what a big pillow it is! My God, what will the Democrats come up with next? Taxes to rebuild bridges or schools or high-speed rail or our lagging broadband networks? No, no, the tooth fairy covers all that.

Today in Opinion

Questioning the India deal

On torture and American values

Terror and personal demons

She borrows the money from China and leaves it under Paulson's pillow.

Of course, we can pay for the Iraq war without a tax increase. The question is, can we pay for it and be making the investments in infrastructure, science and education needed to propel our country into the 21st century? Visit Singapore, Japan, Korea, China or parts of Europe today and you'll discover that the infrastructure in our country is not keeping pace with our peers'.

We can pay for anything today if we want to stop investing in tomorrow. The president has already slashed the National Institutes of Health research funding the past two years. His 2008 budget wants us to cut money for vocational training, infrastructure and many student aid programs.

Does the Bush team really believe that if we had a $1-a-gallon gasoline tax - which could reduce our dependence on Middle East oil dictators AND reduce payroll taxes for low-income workers, pay down the deficit and fund the development of renewable energy - we would be worse off as a country?

Excuse me, Ms. Perino, but I wish Republicans would revert to type.

I thought they were, well, conservatives - the kind of people who saved for rainy days, who invested in tomorrow for their kids, folks who didn't believe in free lunches or free wars.

No wonder The Wall Street Journal had a story Tuesday headlined, "GOP Is Losing Grip on Core Business Vote." It noted that traditional fiscal conservatives were defecting from the Republican Party, "angered by the growth of government spending during the six years that Republicans controlled both the White House and Congress."

And no wonder Alan Greenspan told The Journal: "The Republican Party, which ruled the House, the Senate and the presidency, I no longer recognize."

Of course, the chairman of the House Appropriations Committee, the Democrat David Obey, in proposing an Iraq war tax to help balance the budget was expressing his displeasure with the war. But he was also making a very important point when he said, "If this war is important enough to fight, then it ought to be important enough to pay for."

The struggle against radical Islam is the fight of our generation. We all need to pitch in - not charge it on our children's Visa cards.

Previous American generations connected with our troops by making sacrifices at home. We have never passed on the entire cost of a war to the next generation, said Robert Hormats, vice chairman of Goldman Sachs International, who has written a history - "The Price of Liberty" - about how America has paid for its wars since 1776.

"In every major war we have fought in the 19th and 20th centuries," said Hormats, "Americans have been asked to pay higher taxes - and nonessential programs have been cut - to support the military effort. Yet during this Iraq war, taxes have been lowered and domestic spending has climbed. In contrast to World War I, World War II, the Korean War and Vietnam, for most Americans this conflict has entailed no economic sacrifice. The only people really sacrificing for this war are the troops and their families."

In his celebrated Farewell Address, Hormats noted, George Washington warned against "ungenerously throwing upon posterity the burdens we ourselves ought to bear."

Friday, October 05, 2007

on financial risk in America

Mr. Chairman and members of the Committee:

Thank you for this opportunity. My name is Robert Kuttner. I am an economics and financial journalist, author of several books about the economy, co-editor of The American Prospect, and former investigator for the Senate Banking Committee. I have a book appearing in a few weeks that addresses the systemic risks of financial innovation coupled with deregulation and the moral hazard of periodic bailouts.

In researching the book, I devoted a lot of effort to reviewing the abuses of the 1920s, the effort in the 1930s to create a financial system that would prevent repetition of those abuses, and the steady dismantling of the safeguards over the last three decades in the name of free markets and financial innovation.

Your predecessors on the Senate Banking Committee, in the celebrated Pecora Hearings of 1933 and 1934, laid the groundwork for the modern edifice of financial regulation. I suspect that they would be appalled at the parallels between the systemic risks of the 1920s and many of the modern practices that have been permitted to seep back in to our financial markets.

Although the particulars are different, my reading of financial history suggests that the abuses and risks are all too similar and enduring. When you strip them down to their essence, they are variations on a few hardy perennials -- excessive leveraging, misrepresentation, insider conflicts of interest, non-transparency, and the triumph of engineered euphoria over evidence.

The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy. This was the essence of the abuse of public utilities stock pyramids in the 1920s, where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers. This only became exposed when the bubble burst. As Warren Buffett famously put it, you never know who is swimming naked until the tide goes out.

There is good evidence -- and I will add to the record a paper on this subject by the Federal Reserve staff economists Dean Maki and Michael Palumbo -- that even much of the boom of the late 1990s was built substantially on asset bubbles. ["Disentangling the Wealth Effect: a Cohort Analysis of Household Savings in the 1990s"]

A second parallel is what today we would call securitization of credit. Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank -- e.g. Morgan or Chase -- as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be commercial banks -- part of the monetary system, closely supervised and subject to reserve requirements, given deposit insurance, and access to the Fed's discount window; or investment banks that were not government guaranteed, but that were soon subjected to an extensive disclosure regime under the SEC.

Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s -- lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way. And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn't paper at all, and the whole process is supercharged by computers and automated formulas. An independent source of instability is that while these credit derivatives are said to increase liquidity and serve as shock absorbers, in fact their bets are often in the same direction -- assuming perpetually rising asset prices -- so in a credit crisis they can act as net de-stabilizers.

A third parallel is the excessive use of leverage. In the 1920s, not only were there pervasive stock-watering schemes, but there was no limit on margin. If you thought the market was just going up forever, you could borrow most of the cost of your investment, via loans conveniently provided by your stockbroker. It worked well on the upside. When it didn't work so well on the downside, Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money. The equity is fairly small. As in the 1920s, the game continues only as long as asset prices continue to inflate; and all the leverage contributes to the asset inflation, conveniently creating higher priced collateral against which to borrow even more money.

The fourth parallel is the corruption of the gatekeepers. In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. 1990s, it was accountants, auditors and stock analysts, who were supposedly agents of investors, but who turned out to be confederates of corporate executives. You can give this an antiseptic academic term and call it a failure of agency, but a better phrase is conflicts of interest. In this decade, it remains to be seen whether the bond rating agencies were corrupted by conflicts of interest, or merely incompetent. The core structural conflict is that the rating agencies are paid by the firms that issue the bonds. Who gets the business -- the rating agencies with tough standards or generous ones? Are ratings for sale? And what, really, is the technical basis for their ratings? All of this is opaque, and unregulated, and only now being investigated by Congress and the SEC.

Yet another parallel is the failure of regulation to keep up with financial innovation that is either far too risky to justify the benefit to the real economy, or just plain corrupt, or both. In the 1920s, many of these securities were utterly opaque. Ferdinand Pecora, in his 1939 memoirs describing the pyramid schemes of public utility holding companies, the most notorious of which was controlled by the Insull family, opined that the pyramid structure was not even fully understood by Mr. Insull. The same could be said of many of today's derivatives on which technical traders make their fortunes.

By contrast, in the traditional banking system a bank examiner could look at a bank's loan portfolio, see that loans were backed by collateral and verify that they were performing. If they were not, the bank was made to increase its reserves. Today's examiner is not able to value a lot of the paper held by banks, and must rely on the banks' own models, which clearly failed to predict what happened in the case of sub-prime. The largest banking conglomerates are subjected to consolidated regulation, but the jurisdiction is fragmented, and at best the regulatory agencies can only make educated guesses about whether balance sheets are strong enough to withstand pressures when novel and exotic instruments create market conditions that cannot be anticipated by models.

A last parallel is ideological -- the nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way.

We all know the history. The regulatory reforms of the New Deal saved capitalism from its own self-cannibalizing instincts, and a reliable, transparent and regulated financial economy went on to anchor an unprecedented boom in the real economy. Financial markets were restored to their appropriate role as servants of the real economy, rather than masters. Financial regulation was pro-efficiency. I want to repeat that, because it is so utterly unfashionable, but it is well documented by economic history. Financial regulation was pro-efficiency. America's squeaky clean, transparent, reliable financial markets were the envy of the world. They undergirded the entrepreneurship and dynamism in the rest of the economy.

Beginning in the late 1970s, the beneficial effect of financial regulations has either been deliberately weakened by public policy, or has been overwhelmed by innovations not anticipated by the New Deal regulatory schema. New-Deal-era has become a term of abuse. Who needs New Deal protections in an Internet age?

Of course, there are some important differences between the economy of the 1920s, and the one that began in the deregulatory era that dates to the late 1970s. The economy did not crash in 1987 with the stock market, or in 2000-01. Among the reasons are the existence of federal breakwaters such as deposit insurance, and the stabilizing influence of public spending, now nearly one dollar in three counting federal, state, and local public outlay, which limits collapses of private demand.

But I will focus on just one difference -- the most important one. In the 1920s and early 1930s, the Federal Reserve had neither the tools, nor the experience, nor the self-confidence to act decisively in a credit crisis. But today, whenever the speculative excesses lead to a crash, the Fed races to the rescue. No, it doesn't bail our every single speculator (though it did a pretty good job in the two Mexican rescues) but it bails out the speculative system, so that the next round of excess can proceed. And somehow, this is scored as trusting free markets, overlooking the plain fact that the Fed is part of the U.S. government.

When big banks lost many tens of billions on third world loans in the 1980s, the Fed and the Treasury collaborated on workouts, and desisted from requiring that the loans be marked to market, lest several money center banks be declared insolvent. When Citibank was under water in 1990, the president of the Federal Reserve Bank of New York personally undertook a secret mission to Riyadh to persuade a Saudi prince to pump in billions in capital and to agree to be a passive investor.

In 1998, the Fed convened a meeting of the big banks and all but ordered a bailout of Long Term Capital Management, an uninsured and unregulated hedge fund whose collapse was nonetheless putting the broad capital markets at risk. And even though Chairman Greenspan had expressed worry two years (and several thousand points) earlier that "irrational exuberance" was creating a stock market bubble, big losses in currency speculation in East Asia and Russia led Greenspan to keep cutting rates, despite his foreboding that cheaper money would just pump up markets and invite still more speculation.

And finally in the dot-com crash of 2000-01, the speculative abuses and insider conflicts of interest that fueled the stock bubble were very reminiscent of 1929. But a general depression was not triggered by the market collapse, because the Fed again came to the rescue with very cheap money.

So when things are booming, the financial engineers can advise government not to spoil the party. But when things go bust, they can count on the Fed to rescue them with emergency infusions of cash and cheaper interest rates.

I just read Chairman Greenspan's fascinating memoir, which confirms this rescue role. His memoir also confirms Mr. Greenspan's strong support for free markets and his deep antipathy to regulation. But I don't see how you can have it both ways. If you are a complete believer in the proposition that free markets are self-regulating and self- correcting, then you logically should let markets live with the consequences. On the other hand, if you are going to rescue markets from their excesses, on the very reasonable ground that a crash threatens the entire system, then you have an obligation to act pre-emptively, prophylactically, to head off highly risky speculative behavior. Otherwise, the Fed just invites moral hazards and more rounds of wildly irresponsible actions.

While the Fed and the European Central Bank were flooding markets with liquidity to prevent a deeper crash in August and September, the Bank of England decided on a sterner course. It would not reward speculators. The result was an old fashioned run on a large bank, and the Bank of England changed its tune.

So the point is not that the Fed should let the whole economy collapse in order to teach speculators a lesson. The point is that the Fed needs to remember its other role -- as regulator.

One of the odd things about the press commentary about what the Fed should do is that it has been entirely along one dimension: a Hobson's choice: -- either loosen money and invite more risky behavior, or refuse to enable asset bubbles and risk a more serious credit crunch -- as if these were the only options and monetary policy were the only policy lever. But the other lever, one that has fallen into disrepair and disrepute, is preventive regulation.

Mr. Chairman, you have had a series of hearings on the sub-prime collapse, which has now been revealed as a textbook case of regulatory failure. About half of these loans were originated by non-federally regulated mortgage companies. However even those sub-prime loans should have had their underwriting standards policed by the Federal Reserve or its designee under the authority of the 1994 Home Equity and Ownership Protection Act. And by the same token, the SEC should have more closely monitored the so called counterparties -- the investment and commercial banks -- that were supplying the credit. However, the Fed and the SEC essentially concluded that since the paper was being sold off to investors who presumably were cognizant of the risks, they did not need to pay attention to the deplorable underwriting standards.

In the 1994 legislation, Congress not only gave the Fed the authority, but directed the Fed to clamp down on dangerous and predatory lending practices, including on otherwise unregulated entities such as sub-prime mortgage originators. However, for 13 years the Fed stonewalled and declined to use the authority that Congress gave it to police sub-prime lending. Even as recently as last spring, when you could not pick up a newspaper's financial pages without reading about the worsening sub-prime disaster, the Fed did not act -- until this Committee made an issue of it.

Financial markets have responded to the 50 basis-point rate-cut, by bidding up stock prices, as if this crisis were over. Indeed, the financial pages have reported that as the softness in housing markets is expected to worsen, traders on Wall Street have inferred that the Fed will need to cut rates again, which has to be good for stock prices.

Mr. Chairman, we are living on borrowed time. And the vulnerability goes far beyond the spillover effects of the sub-prime debacle.

We need to step back and consider the purpose of regulation. Financial regulation is too often understood as merely protecting consumers and investors. The New Deal model is actually a relatively indirect one, since it relies more on mandated disclosures, and less on prohibited practices. The enormous loopholes in financial regulation -- the hedge fund loophole, the private equity loophole, are justified on the premise that consenting adults of substantial means do not need the help of the nanny state, thank you very much. But of course investor protection is only one purpose of regulation. The other purpose is to protect the system from moral hazard and catastrophic risk of financial collapse. It is this latter function that has been seriously compromised.

HOEPA was understood mainly as consumer protection legislation, but it was also systemic risk legislation.

Sarbanes-Oxley has been attacked in some quarters as harmful to the efficiency of financial markets. One good thing about the sub-prime calamity is that we haven't heard a lot of that argument lately. Yet there is still a general bias in the administration and the financial community against regulation.

Mr. Chairman, I commend you and this committee for looking beyond the immediate problem of the sub-prime collapse. I would urge every member of the committee to spend some time reading the Pecora hearings, and you will be startled by the sense of déjà vu.

I'd like to close with an observation and a recommendation.

My perception as a financial journalist is that regulation is so out of fashion these days that it narrows the legislative imagination, since politics necessarily is the art of the possible and your immediate task is to find remedies that actually stand a chance of enactment. There is a vicious circle -- a self-fulfilling prophecy -- in which remedies that currently are legislatively unthinkable are not given serious thought. Mr. Chairman, you are performing an immense public service by broadening the scope of inquiry beyond the immediate crisis and immediate legislation.

Three decades ago, a group of economists inspired by the work of the late Milton Friedman created a shadow Federal Open Market Committee, to develop and recommend contrarian policies in the spirit of Professor Friedman's recommendation that monetary policy essentially be put on automatic pilot. The committee had great intellectual and political influence, and its very existence helped people think through dissenting ideas. In the same way, the national security agencies often create Team B exercises to challenge the dominant thinking on a defense issue.

In the coming months, I hope the committee hears from a wide circle of experts -- academics, former state and federal regulators, financial historians, people who spent time on Wall Street -- who are willing to look beyond today's intellectual premises and legislative limitations, and have ideas about what needs to be re-regulated. Here are some of the questions that require further exploration:

First, which kinds innovations of financial engineering actually enhance economic efficiency, and which ones mainly enrich middlemen, strip assets, appropriate wealth, and increase systemic risk? It no longer works to assert that all innovations, by definition, are good for markets or markets wouldn't invent them. We just tested that proposition in the sub-prime crisis, and it failed. But which forms of credit derivatives, for example, truly make markets more liquid and better able to withstand shocks, and which add to the system's vulnerability. We can't just settle that question by the all purpose assumption that market forces invariably enhance efficiency. We have to get down to cases.

The story of the economic growth in the 1990s and in this decade is mainly a story of technology, increased productivity growth, macro-economic stimulation, and occasionally of asset bubbles. There is little evidence that the growth rates of the past decade and a half -- better than the 1970s and ‘80s, worse than the 40's, 50's and ‘60s -- required or benefited from new techniques of financial engineering.

I once did some calculations on what benefits securitization of mortgage credit had actually had. By the time you net out the fee income taken out by all of the middlemen -- the mortgage broker, the mortgage banker, the investment banker, the bond-rating agency -- it's not clear that the borrower benefits at all. What does increase, however, are the fees and the systemic risks. More research on this question would be useful. What would be the result of the secondary mortgage market were far more tightly subjected to standards? It is telling that the mortgages that best survived the meltdown were those that met the underwriting criteria of the GSE's.

Second, what techniques and strategies of regulation are appropriate to damp down the systemic risks produced by the financial innovation? As I observed, when you strip it all down, at the heart of the recent financial crises are three basic abuses: lack of transparency; excessive leverage; and conflicts of interest. Those in turn suggest remedies: greater disclosure either to regulators or to the public. Requirement of increased reserves in direct proportion to how opaque and difficult to value are the assets held by banks. Some restoration of the walls against conflicts of interest once provided by Glass Steagall. Tax policies to discourage dangerously high leverage ratios, in whatever form.

Maybe we should just close the loophole in the 1940 Act and require of hedge funds and private equity firms the same kinds of disclosures required of others who sell shares to the public, which in effect is what hedge funds and private equity increasingly do. The industry will say that this kind of disclosure impinges on trade secrets. To the extent that this concern is valid, the disclosure of positions and strategies can be to the SEC. This is what is required of large hedge funds by the Financial Services Authority in the UK, not a nation noted for hostility to hedge funds. Indeed, Warren Buffet's Berkshire Hathaway, which might have chosen to operate as private equity, makes the same disclosures as any other publicly listed firm. It doesn't seem to hurt Buffett at all.

To the extent that some private equity firms and strategies strip assets, while others add capital and improve management, maybe we need a windfall profits tax on short term extraction of assets and on excess transaction fees. If private equity has a constructive role to play -- and I think it can -- we need public policies to reward good practices and discourage bad ones. Industry codes, of the sort being organized by the administration and the industry itself, are far too weak.

Why not have tighter regulation both of derivatives that are publicly traded and those that are currently regulated -- rather weakly -- by the CFTC: more disclosure, limits on leverage and on positions. And why not make OTC and special purpose derivatives that are not ordinarily traded (and that are black holes in terms of asset valuation), also subject to the CFTC?

A third big question to be addressed is the relationship of financial engineering to problems of corporate governance. Ever since the classic insight of A.A. Berle and Gardiner Means in 1933, it has been conventional to point out that corporate management is not adequately responsible to shareholders, and by extension to society, because of the separation of ownership from effective control. The problem, if anything, is more serious today than when Berle and Means wrote in 1933, because of the increased access of insiders to financial engineering. We have seen the fruits of that access in management buyouts, at the expense of both other shareholders, workers, and other stakeholders. This is pure conflict of interest.

Since the first leveraged buyout boom, advocates of hostile takeovers have proposed a radically libertarian solution to the Berle-Means problem. Let a market for corporate control hold managers accountable by buying, selling, and recombining entire companies via LBOs that tax deductible money collateralized by the target's own assets. It is astonishing that this is even legal, let alone rewarded by tax preferences, even more so when managers with a fiduciary responsibility to shareholders are on both sides of the bargain.

The first boom in hostile takeovers crashed and burned. The second boom ended with the stock market collapse of 2000-01. The latest one is rife with conflicts of interest, it depends heavily on the perception that stock prices are going to continue to rise at multiples that far outstrip the rate of economic growth, and on the borrowed money to finance these deals that puts banks increasingly at risk.

So we need a careful examination of better ways of holding managers accountable -- through more power for shareholders and other stakeholders such as employees, proxy rules not tilted to incumbent management, and rules that reward mutual funds for serving as the agents of shareholders, and not just of the profit maximization of the fund sponsor. John Bogle, a pioneer in the modern mutual fund industry, has written eloquently on this.

Interestingly, the intellectual fathers of the leveraged buyout movement as a supposed source of better corporate governance, have lately been having serious second thoughts.

Michael Jensen, one of the original theorists of efficient market theory and the so called market for corporate control and an advocate of compensation incentives for corporate CEOs has now written a book calling for greater control of CEOs and less cronyism on corporate boards. That cronyism, however, is in part a reflection of Jensen's earlier conception of the ideal corporation.

I don't have all the answers on regulatory remedies, but people smarter than I need to systematically ask these questions, even if they are beyond the pale legislatively for now. And there are scholars of financial markets, former state and federal regulators, economic historians, and even people who did time on Wall Street, who all have the same concerns that I do as well as more technical expertise, and who I am sure would be happy to find company and to serve.

One last parallel: I am chilled, as I'm sure you are, every time I hear a high public official or a Wall Street eminence utter the reassuring words, "The economic fundamentals are sound." Those same words were used by President Hoover and the captains of finance, in the deepening chill of the winter of 1929-1930. They didn't restore confidence, or revive the asset bubbles.

The fact is that the economic fundamentals are sound -- if you look at the real economy of factories and farms, and internet entrepreneurs, and retailing innovation and scientific research laboratories. It is the financial economy that is dangerously unsound. And as every student of economic history knows, depressions, ever since the South Sea bubble, originate in excesses in the financial economy, and go on to ruin the real economy.

It remains to be seen whether we have dodged the bullet for now. If markets do calm down, and lower interest bail out excesses once again, then we have bought precious time. The worst thing of all would be to conclude that markets self corrected once again, and let the bubble economy continue to fester. Congress has a window in which restore prudential regulation, and we should use that window before the next crisis turns out to be a mortal one.
Mr. Chairman and members of the Committee:

Thank you for this opportunity. My name is Robert Kuttner. I am an economics and financial journalist, author of several books about the economy, co-editor of The American Prospect, and former investigator for the Senate Banking Committee. I have a book appearing in a few weeks that addresses the systemic risks of financial innovation coupled with deregulation and the moral hazard of periodic bailouts.

In researching the book, I devoted a lot of effort to reviewing the abuses of the 1920s, the effort in the 1930s to create a financial system that would prevent repetition of those abuses, and the steady dismantling of the safeguards over the last three decades in the name of free markets and financial innovation.

Your predecessors on the Senate Banking Committee, in the celebrated Pecora Hearings of 1933 and 1934, laid the groundwork for the modern edifice of financial regulation. I suspect that they would be appalled at the parallels between the systemic risks of the 1920s and many of the modern practices that have been permitted to seep back in to our financial markets.

Although the particulars are different, my reading of financial history suggests that the abuses and risks are all too similar and enduring. When you strip them down to their essence, they are variations on a few hardy perennials -- excessive leveraging, misrepresentation, insider conflicts of interest, non-transparency, and the triumph of engineered euphoria over evidence.

The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy. This was the essence of the abuse of public utilities stock pyramids in the 1920s, where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers. This only became exposed when the bubble burst. As Warren Buffett famously put it, you never know who is swimming naked until the tide goes out.

There is good evidence -- and I will add to the record a paper on this subject by the Federal Reserve staff economists Dean Maki and Michael Palumbo -- that even much of the boom of the late 1990s was built substantially on asset bubbles. ["Disentangling the Wealth Effect: a Cohort Analysis of Household Savings in the 1990s"]

A second parallel is what today we would call securitization of credit. Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank -- e.g. Morgan or Chase -- as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be commercial banks -- part of the monetary system, closely supervised and subject to reserve requirements, given deposit insurance, and access to the Fed's discount window; or investment banks that were not government guaranteed, but that were soon subjected to an extensive disclosure regime under the SEC.

Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s -- lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way. And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn't paper at all, and the whole process is supercharged by computers and automated formulas. An independent source of instability is that while these credit derivatives are said to increase liquidity and serve as shock absorbers, in fact their bets are often in the same direction -- assuming perpetually rising asset prices -- so in a credit crisis they can act as net de-stabilizers.

A third parallel is the excessive use of leverage. In the 1920s, not only were there pervasive stock-watering schemes, but there was no limit on margin. If you thought the market was just going up forever, you could borrow most of the cost of your investment, via loans conveniently provided by your stockbroker. It worked well on the upside. When it didn't work so well on the downside, Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money. The equity is fairly small. As in the 1920s, the game continues only as long as asset prices continue to inflate; and all the leverage contributes to the asset inflation, conveniently creating higher priced collateral against which to borrow even more money.

The fourth parallel is the corruption of the gatekeepers. In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. 1990s, it was accountants, auditors and stock analysts, who were supposedly agents of investors, but who turned out to be confederates of corporate executives. You can give this an antiseptic academic term and call it a failure of agency, but a better phrase is conflicts of interest. In this decade, it remains to be seen whether the bond rating agencies were corrupted by conflicts of interest, or merely incompetent. The core structural conflict is that the rating agencies are paid by the firms that issue the bonds. Who gets the business -- the rating agencies with tough standards or generous ones? Are ratings for sale? And what, really, is the technical basis for their ratings? All of this is opaque, and unregulated, and only now being investigated by Congress and the SEC.

Yet another parallel is the failure of regulation to keep up with financial innovation that is either far too risky to justify the benefit to the real economy, or just plain corrupt, or both. In the 1920s, many of these securities were utterly opaque. Ferdinand Pecora, in his 1939 memoirs describing the pyramid schemes of public utility holding companies, the most notorious of which was controlled by the Insull family, opined that the pyramid structure was not even fully understood by Mr. Insull. The same could be said of many of today's derivatives on which technical traders make their fortunes.

By contrast, in the traditional banking system a bank examiner could look at a bank's loan portfolio, see that loans were backed by collateral and verify that they were performing. If they were not, the bank was made to increase its reserves. Today's examiner is not able to value a lot of the paper held by banks, and must rely on the banks' own models, which clearly failed to predict what happened in the case of sub-prime. The largest banking conglomerates are subjected to consolidated regulation, but the jurisdiction is fragmented, and at best the regulatory agencies can only make educated guesses about whether balance sheets are strong enough to withstand pressures when novel and exotic instruments create market conditions that cannot be anticipated by models.

A last parallel is ideological -- the nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way.

We all know the history. The regulatory reforms of the New Deal saved capitalism from its own self-cannibalizing instincts, and a reliable, transparent and regulated financial economy went on to anchor an unprecedented boom in the real economy. Financial markets were restored to their appropriate role as servants of the real economy, rather than masters. Financial regulation was pro-efficiency. I want to repeat that, because it is so utterly unfashionable, but it is well documented by economic history. Financial regulation was pro-efficiency. America's squeaky clean, transparent, reliable financial markets were the envy of the world. They undergirded the entrepreneurship and dynamism in the rest of the economy.

Beginning in the late 1970s, the beneficial effect of financial regulations has either been deliberately weakened by public policy, or has been overwhelmed by innovations not anticipated by the New Deal regulatory schema. New-Deal-era has become a term of abuse. Who needs New Deal protections in an Internet age?

Of course, there are some important differences between the economy of the 1920s, and the one that began in the deregulatory era that dates to the late 1970s. The economy did not crash in 1987 with the stock market, or in 2000-01. Among the reasons are the existence of federal breakwaters such as deposit insurance, and the stabilizing influence of public spending, now nearly one dollar in three counting federal, state, and local public outlay, which limits collapses of private demand.

But I will focus on just one difference -- the most important one. In the 1920s and early 1930s, the Federal Reserve had neither the tools, nor the experience, nor the self-confidence to act decisively in a credit crisis. But today, whenever the speculative excesses lead to a crash, the Fed races to the rescue. No, it doesn't bail our every single speculator (though it did a pretty good job in the two Mexican rescues) but it bails out the speculative system, so that the next round of excess can proceed. And somehow, this is scored as trusting free markets, overlooking the plain fact that the Fed is part of the U.S. government.

When big banks lost many tens of billions on third world loans in the 1980s, the Fed and the Treasury collaborated on workouts, and desisted from requiring that the loans be marked to market, lest several money center banks be declared insolvent. When Citibank was under water in 1990, the president of the Federal Reserve Bank of New York personally undertook a secret mission to Riyadh to persuade a Saudi prince to pump in billions in capital and to agree to be a passive investor.

In 1998, the Fed convened a meeting of the big banks and all but ordered a bailout of Long Term Capital Management, an uninsured and unregulated hedge fund whose collapse was nonetheless putting the broad capital markets at risk. And even though Chairman Greenspan had expressed worry two years (and several thousand points) earlier that "irrational exuberance" was creating a stock market bubble, big losses in currency speculation in East Asia and Russia led Greenspan to keep cutting rates, despite his foreboding that cheaper money would just pump up markets and invite still more speculation.

And finally in the dot-com crash of 2000-01, the speculative abuses and insider conflicts of interest that fueled the stock bubble were very reminiscent of 1929. But a general depression was not triggered by the market collapse, because the Fed again came to the rescue with very cheap money.

So when things are booming, the financial engineers can advise government not to spoil the party. But when things go bust, they can count on the Fed to rescue them with emergency infusions of cash and cheaper interest rates.

I just read Chairman Greenspan's fascinating memoir, which confirms this rescue role. His memoir also confirms Mr. Greenspan's strong support for free markets and his deep antipathy to regulation. But I don't see how you can have it both ways. If you are a complete believer in the proposition that free markets are self-regulating and self- correcting, then you logically should let markets live with the consequences. On the other hand, if you are going to rescue markets from their excesses, on the very reasonable ground that a crash threatens the entire system, then you have an obligation to act pre-emptively, prophylactically, to head off highly risky speculative behavior. Otherwise, the Fed just invites moral hazards and more rounds of wildly irresponsible actions.

While the Fed and the European Central Bank were flooding markets with liquidity to prevent a deeper crash in August and September, the Bank of England decided on a sterner course. It would not reward speculators. The result was an old fashioned run on a large bank, and the Bank of England changed its tune.

So the point is not that the Fed should let the whole economy collapse in order to teach speculators a lesson. The point is that the Fed needs to remember its other role -- as regulator.

One of the odd things about the press commentary about what the Fed should do is that it has been entirely along one dimension: a Hobson's choice: -- either loosen money and invite more risky behavior, or refuse to enable asset bubbles and risk a more serious credit crunch -- as if these were the only options and monetary policy were the only policy lever. But the other lever, one that has fallen into disrepair and disrepute, is preventive regulation.

Mr. Chairman, you have had a series of hearings on the sub-prime collapse, which has now been revealed as a textbook case of regulatory failure. About half of these loans were originated by non-federally regulated mortgage companies. However even those sub-prime loans should have had their underwriting standards policed by the Federal Reserve or its designee under the authority of the 1994 Home Equity and Ownership Protection Act. And by the same token, the SEC should have more closely monitored the so called counterparties -- the investment and commercial banks -- that were supplying the credit. However, the Fed and the SEC essentially concluded that since the paper was being sold off to investors who presumably were cognizant of the risks, they did not need to pay attention to the deplorable underwriting standards.

In the 1994 legislation, Congress not only gave the Fed the authority, but directed the Fed to clamp down on dangerous and predatory lending practices, including on otherwise unregulated entities such as sub-prime mortgage originators. However, for 13 years the Fed stonewalled and declined to use the authority that Congress gave it to police sub-prime lending. Even as recently as last spring, when you could not pick up a newspaper's financial pages without reading about the worsening sub-prime disaster, the Fed did not act -- until this Committee made an issue of it.

Financial markets have responded to the 50 basis-point rate-cut, by bidding up stock prices, as if this crisis were over. Indeed, the financial pages have reported that as the softness in housing markets is expected to worsen, traders on Wall Street have inferred that the Fed will need to cut rates again, which has to be good for stock prices.

Mr. Chairman, we are living on borrowed time. And the vulnerability goes far beyond the spillover effects of the sub-prime debacle.

We need to step back and consider the purpose of regulation. Financial regulation is too often understood as merely protecting consumers and investors. The New Deal model is actually a relatively indirect one, since it relies more on mandated disclosures, and less on prohibited practices. The enormous loopholes in financial regulation -- the hedge fund loophole, the private equity loophole, are justified on the premise that consenting adults of substantial means do not need the help of the nanny state, thank you very much. But of course investor protection is only one purpose of regulation. The other purpose is to protect the system from moral hazard and catastrophic risk of financial collapse. It is this latter function that has been seriously compromised.

HOEPA was understood mainly as consumer protection legislation, but it was also systemic risk legislation.

Sarbanes-Oxley has been attacked in some quarters as harmful to the efficiency of financial markets. One good thing about the sub-prime calamity is that we haven't heard a lot of that argument lately. Yet there is still a general bias in the administration and the financial community against regulation.

Mr. Chairman, I commend you and this committee for looking beyond the immediate problem of the sub-prime collapse. I would urge every member of the committee to spend some time reading the Pecora hearings, and you will be startled by the sense of déjà vu.

I'd like to close with an observation and a recommendation.

My perception as a financial journalist is that regulation is so out of fashion these days that it narrows the legislative imagination, since politics necessarily is the art of the possible and your immediate task is to find remedies that actually stand a chance of enactment. There is a vicious circle -- a self-fulfilling prophecy -- in which remedies that currently are legislatively unthinkable are not given serious thought. Mr. Chairman, you are performing an immense public service by broadening the scope of inquiry beyond the immediate crisis and immediate legislation.

Three decades ago, a group of economists inspired by the work of the late Milton Friedman created a shadow Federal Open Market Committee, to develop and recommend contrarian policies in the spirit of Professor Friedman's recommendation that monetary policy essentially be put on automatic pilot. The committee had great intellectual and political influence, and its very existence helped people think through dissenting ideas. In the same way, the national security agencies often create Team B exercises to challenge the dominant thinking on a defense issue.

In the coming months, I hope the committee hears from a wide circle of experts -- academics, former state and federal regulators, financial historians, people who spent time on Wall Street -- who are willing to look beyond today's intellectual premises and legislative limitations, and have ideas about what needs to be re-regulated. Here are some of the questions that require further exploration:

First, which kinds innovations of financial engineering actually enhance economic efficiency, and which ones mainly enrich middlemen, strip assets, appropriate wealth, and increase systemic risk? It no longer works to assert that all innovations, by definition, are good for markets or markets wouldn't invent them. We just tested that proposition in the sub-prime crisis, and it failed. But which forms of credit derivatives, for example, truly make markets more liquid and better able to withstand shocks, and which add to the system's vulnerability. We can't just settle that question by the all purpose assumption that market forces invariably enhance efficiency. We have to get down to cases.

The story of the economic growth in the 1990s and in this decade is mainly a story of technology, increased productivity growth, macro-economic stimulation, and occasionally of asset bubbles. There is little evidence that the growth rates of the past decade and a half -- better than the 1970s and ‘80s, worse than the 40's, 50's and ‘60s -- required or benefited from new techniques of financial engineering.

I once did some calculations on what benefits securitization of mortgage credit had actually had. By the time you net out the fee income taken out by all of the middlemen -- the mortgage broker, the mortgage banker, the investment banker, the bond-rating agency -- it's not clear that the borrower benefits at all. What does increase, however, are the fees and the systemic risks. More research on this question would be useful. What would be the result of the secondary mortgage market were far more tightly subjected to standards? It is telling that the mortgages that best survived the meltdown were those that met the underwriting criteria of the GSE's.

Second, what techniques and strategies of regulation are appropriate to damp down the systemic risks produced by the financial innovation? As I observed, when you strip it all down, at the heart of the recent financial crises are three basic abuses: lack of transparency; excessive leverage; and conflicts of interest. Those in turn suggest remedies: greater disclosure either to regulators or to the public. Requirement of increased reserves in direct proportion to how opaque and difficult to value are the assets held by banks. Some restoration of the walls against conflicts of interest once provided by Glass Steagall. Tax policies to discourage dangerously high leverage ratios, in whatever form.

Maybe we should just close the loophole in the 1940 Act and require of hedge funds and private equity firms the same kinds of disclosures required of others who sell shares to the public, which in effect is what hedge funds and private equity increasingly do. The industry will say that this kind of disclosure impinges on trade secrets. To the extent that this concern is valid, the disclosure of positions and strategies can be to the SEC. This is what is required of large hedge funds by the Financial Services Authority in the UK, not a nation noted for hostility to hedge funds. Indeed, Warren Buffet's Berkshire Hathaway, which might have chosen to operate as private equity, makes the same disclosures as any other publicly listed firm. It doesn't seem to hurt Buffett at all.

To the extent that some private equity firms and strategies strip assets, while others add capital and improve management, maybe we need a windfall profits tax on short term extraction of assets and on excess transaction fees. If private equity has a constructive role to play -- and I think it can -- we need public policies to reward good practices and discourage bad ones. Industry codes, of the sort being organized by the administration and the industry itself, are far too weak.

Why not have tighter regulation both of derivatives that are publicly traded and those that are currently regulated -- rather weakly -- by the CFTC: more disclosure, limits on leverage and on positions. And why not make OTC and special purpose derivatives that are not ordinarily traded (and that are black holes in terms of asset valuation), also subject to the CFTC?

A third big question to be addressed is the relationship of financial engineering to problems of corporate governance. Ever since the classic insight of A.A. Berle and Gardiner Means in 1933, it has been conventional to point out that corporate management is not adequately responsible to shareholders, and by extension to society, because of the separation of ownership from effective control. The problem, if anything, is more serious today than when Berle and Means wrote in 1933, because of the increased access of insiders to financial engineering. We have seen the fruits of that access in management buyouts, at the expense of both other shareholders, workers, and other stakeholders. This is pure conflict of interest.

Since the first leveraged buyout boom, advocates of hostile takeovers have proposed a radically libertarian solution to the Berle-Means problem. Let a market for corporate control hold managers accountable by buying, selling, and recombining entire companies via LBOs that tax deductible money collateralized by the target's own assets. It is astonishing that this is even legal, let alone rewarded by tax preferences, even more so when managers with a fiduciary responsibility to shareholders are on both sides of the bargain.

The first boom in hostile takeovers crashed and burned. The second boom ended with the stock market collapse of 2000-01. The latest one is rife with conflicts of interest, it depends heavily on the perception that stock prices are going to continue to rise at multiples that far outstrip the rate of economic growth, and on the borrowed money to finance these deals that puts banks increasingly at risk.

So we need a careful examination of better ways of holding managers accountable -- through more power for shareholders and other stakeholders such as employees, proxy rules not tilted to incumbent management, and rules that reward mutual funds for serving as the agents of shareholders, and not just of the profit maximization of the fund sponsor. John Bogle, a pioneer in the modern mutual fund industry, has written eloquently on this.

Interestingly, the intellectual fathers of the leveraged buyout movement as a supposed source of better corporate governance, have lately been having serious second thoughts.

Michael Jensen, one of the original theorists of efficient market theory and the so called market for corporate control and an advocate of compensation incentives for corporate CEOs has now written a book calling for greater control of CEOs and less cronyism on corporate boards. That cronyism, however, is in part a reflection of Jensen's earlier conception of the ideal corporation.

I don't have all the answers on regulatory remedies, but people smarter than I need to systematically ask these questions, even if they are beyond the pale legislatively for now. And there are scholars of financial markets, former state and federal regulators, economic historians, and even people who did time on Wall Street, who all have the same concerns that I do as well as more technical expertise, and who I am sure would be happy to find company and to serve.

One last parallel: I am chilled, as I'm sure you are, every time I hear a high public official or a Wall Street eminence utter the reassuring words, "The economic fundamentals are sound." Those same words were used by President Hoover and the captains of finance, in the deepening chill of the winter of 1929-1930. They didn't restore confidence, or revive the asset bubbles.

The fact is that the economic fundamentals are sound -- if you look at the real economy of factories and farms, and internet entrepreneurs, and retailing innovation and scientific research laboratories. It is the financial economy that is dangerously unsound. And as every student of economic history knows, depressions, ever since the South Sea bubble, originate in excesses in the financial economy, and go on to ruin the real economy.

It remains to be seen whether we have dodged the bullet for now. If markets do calm down, and lower interest bail out excesses once again, then we have bought precious time. The worst thing of all would be to conclude that markets self corrected once again, and let the bubble economy continue to fester. Congress has a window in which restore prudential regulation, and we should use that window before the next crisis turns out to be a mortal one.