Monday, March 30, 2009

Is the party over?

The markets are down about 3.5% today following a modest decline on Friday. I think it is important to keep this move in perspective. On the one hand we are still up 16% from the lows we reached on March 9th which is a respectable move. Another way to look at it is that where we are today is where we were a few hours after Tim Geithner announced the government’s plan to remove “legacy” assets from bank balance sheets.

Even during the course of the main rally there was a lot of disagreement as to how real it was. Some thought it signalled a bottoming or others that it was a sucker rally that would soon reverse itself and retest the lows.

Personally I think it is too early to answer this question. Todays move was big but not outrageous in the context of what has been going on. It’s important to remember that what got the big rally going was a few comments from Vikram Pandit about how things were looking up at Citibank followed by similar comments from the CEOs of other banks. Since then we have also gotten some economic data which was bad but no worse than people had expected. We also got the Geithner plan fully fleshed out. The markets ran ahead on this but we never got close to the level that we got to in the euphoria in the run up to the inauguration.

Generally my view is the following. The markets are counting on bad economic data and maybe even bad earning data for the first quarter so the data would have to be really shockingly bad for the markets to trade down on data and earnings. Additionally the markets tend to look toward the future and while there is uncertainty about the effectiveness of the various government programs the markets know they will take time to work. I don’t think we’ll move too much on economic data until the second or third quarter when we start to get hard numbers about whether the stimulus package and banking support programs are having an effect.

Having said that the markets are willing to give the economy time to recover I think there are certain things that will move the markets because it is not possible for them to anticipate them. Those things are US government actions and international events.

Today was an example of US government action. The Treasury Secretary said over the weekend that some banks would need massive assistance, and the markets took that as a bad sign even though he said the aid would be forthcoming. The government also took some aggressive moves against the auto-industry removing the CEO of GM and basically setting strict deadlines for the resolution of the auto-industry problems. This aggressive stance spooked the markets a little but was probably necessary in order to get the various stakeholders, to concentrate on a solution.

The other thing that can’t be ruled out are problems internationally. There are very serious problems in Europe both on its periphery and within the Eurozone itself. A major default by a Eurozone country or a serious political problem in the Ukraine that draws in Russia would be very bad for markets which are generally already nervous. Add to this the very interesting dialog between the US and China about what the form of the international monetary system should look take and you have a combustible mix for the G20 meeting this week.

So I can’t really say whether the market will hold this rally or not, I can tell you that the high intraday volatility is here to stay.

Wednesday, March 25, 2009

PRC to USA: “If you devalue the dollar and with it our savings, we’ll stop saving into dollars! Instead we will... um... er.... we’ll save into ahhh

The battle of wits and words going on now between the United States and China over the nature of the international currency system is the most important thing going on in the world right now. It is bigger than the TARP, bigger than the Geithner Plan, bigger than the stimulus package, bigger than the 2009 Federal budget. The reason for this is that the money for each of those things is going to have to come from somewhere and the debate between the US and China on this subject will decide from where the money will come and at what price.

Last night the Chinese Central Bank published a white paper outlining a potential future monetary system which would rely not on the currency of any individual country but on a “super sovereign” currency. Their candidate for this is the SDR, a synthetic currency created by the IMF in the 1960s which is itself a basket of the US Dollar, the Euro, the Yen, and the Pound Sterling. This is a direct response to the decision by the federal reserve last week to purchase $300 billion of US treasuries which was itself at least partially a response to the Chinese Premier’s comments raising concerns about the safety of US government bonds.

This is a huge deal. Not because the Chinese will be able to replace the US dollar at the international reserve currency with the SDR. They won’t. It is important because what it says about the mentality of the people running China.

The world has to look uncomfortable to the Chinese leadership now. The legitimacy of the Chinese government has come to be connected closely with the rapid economic growth in China. That economic growth has largely been driven by a massive export boom which sees China import raw materials (priced in dollars,) turn them into manufactured goods using low wage low skill labor and then sell them abroad largely to American consumers.

To protect themselves from having their labor cost advantage degraded by an appreciating currency they have fixed the Chinese currency, the Reminbi, to the dollar. This gives them an advantage over Japan. If the Japanese yen appreciates against the dollar the cost of things made in Japan goes up in the US so Americans buy less. The Chinese don’t want to take that risk so they pegged the Reminbi to the dollar. They maintain that peg by keeping large amounts of dollars handy to defend the peg. Thus when they earn dollars by selling goods in the US they don’t sell the dollars, they save them. The best instrument for saving dollars is the US government bond market because of its size. This is how China came to own so much US government debt.

The problem is now that American consumers are deep in debt and so have cut back on consumption in order to work off some of that debt. This means they are buying fewer imports. This is having a massive effect on the Chinese economy and it is slowing very quickly. From the Chinese perspective two things need to happen: 1.) the US economy has to recover so that they can export their way out of their recession, and 2.) the value of their US treasuries has to hold up in case they need to sell them to make up for lost export revenues during the recession.

Sadly for them they have no control of either one of those things. The Chinese probably think, along with a lot of US taxpayers, that the US government efforts to stimulate the economy and repair the financial system are not producing the desired results. The Chinese government has made some comments regarding that. Additionally, in order to finance all this the US government is going to have to sell a HUGE amount of US government debt. This at the same time that the Chinese think –they- may have to sell some of their holdings. What happens when two people have to sell over a trillion dollars of the same thing at the same time? The price goes down. All of this is very bad news for China which is why they wish they could save into an imaginary currency other than dollars but still maintain their dollar peg.

Just because the Chinese are trapped in their US treasures and are stuck with the decisions of the Federal Reserve doesn’t mean that the joke is only on them. It's on us too.

If the Chinese stop buying or start selling US government bonds the US government is going to have to make some difficult choices as well. If the price of US government bonds goes down it implies that the interest rates on those bonds will go up. If interest rates on government bonds go up so do rates on everything more risky than the government, your mortgage for example.

Then the government will have to decide whether to live with higher interest rates and potentially choke off the recovery they are borrowing the money to start in the first place, or to print enough money to fund the government and risk massive inflation and all the social dislocation that goes along with it. We might find ourselves wishing for an imaginary currency ourselves at that point.

Tuesday, March 24, 2009

Why the Government is taking the long road of PPIP instead of the nationalization shortcut

Krugman’s Attack

I have to respect Paul Krugman. He is attacking the Obama administration which is politically more aligned with his worldview with the same ferocity and insight as he did the Bush administration which for him was probably like shooting fish in a barrel, and fish he did not particularly like.

Yesterday morning he published a scathing critique of the new Geithner plan in his regular column in the New York Times. It is a well written and well thought out, if gloomy, piece. It seems to me that he thinks the plan is simply another subsidy for Wall Street, and it is that. He also says that it won’t work on account of the valuations involved and he laments the fact that the government is not nationalizing the banks and getting on with things.

This is a cogent argument and while I think he should spend more time explaining why he thinks it won’t work than he does explaining why it is unjust, I think he is missing something with his alternative. There has to be some reason why the government is not taking what Krugman thinks is the shortest path to a full recovery, that is nationalization of the troubled banks. What might that be.

The Shortest Distance Between Two Points: Nationalization?

So what precisely is Krugman recommending? He is recommending that the government guarantee some, but not necessarily all, bank debts. Take over the bank and temporarily takes control of insolvent institutions and cleans up their balance sheets. This is largely what was done at the end of the S&L crisis in the early 90s and indeed it did work then. The government liquidated a lot of banks, paid off their depositors through the FSLIC and then worked off the assets through the Resolution Trust Corp. Investors in the failed S&Ls were wiped out and some of those that could be salvaged were then resold to the public. Krugman is recommending this be done for the largest US banks that are insolvent and it is very likely that this would include Citibank, Bank of America, Wells Fargo and perhaps even JP Morgan.

So why not?

The trouble with this plan is the phrase in Mr. Krugman’s article referring to how some but not all debts of the banking system would be guaranteed. This is an important point. There are basically three groups of creditors to the banking system: the depositors, the bondholders, and trading counterparties. In a nationalization where the government seized an insolvent institution the depositors would be made whole by the FDIC. This would leave the bondholders and the trading counterparties. Presumably Mr. Krugman would want to wipe out the bondholders as they were people who were not using banking services like the depositors but were people who knowingly took a risk lending the bank money they should be wiped out too. This is where we run into trouble.

The trouble is this, you cannot wipe out the bondholders without wiping out the trading counterparties because they are at the same point in the capital structure, that is they have the same rights to any proceeds, if any of the firm. So you can’t say to the bondholders, sorry you get nothing but then make all the counterparties whole.

Who are these trading counterparties anyway and why should I care?

In talking about the plan Geithner made the point that “we are not Sweden” our financial system is “complicated.” What he means by this is that the problem with seizing a bank, making the depositors whole and wiping out the equity and bondholders is that you would wipe out the trading counterparties at the same time. As it turns out, these trading counterparties are the rest of the financial system both the solvent and the insolvent parts of it. Thus by liquidating a few insolvent firms and wiping out their investors who had made bad decisions the government may wind up pushing other firms into insolvency themselves. And why is this? It is because of the nature of the market structure for Credit Default Swaps.

What are Credit Default Swaps?

Credit Default Swaps (CDSs) are ingenious financial products that enable lenders to insure themselves against the default by someone who to whom they have lent money. If I have a loan to IBM but I am worried about IBM defaulting to me I can trade a CDS with another bank. A CDS is a a security that is traded between two firms and its cash flows look a lot like those of the bonds themselves. Let’s say I sell protection to someone. We choose a reference company, in this case IBM, and a term, the length of time I will provide the protection and a notional amount, the amount of principal I am insuring. The way a CDS is structured I would pay them their funding cost, say LIBOR, and they would pay me some premium which corresponded to how likely the chance of default was. The greater the chance of default the greater the premium I will receive and that premium will look a lot like the rate that the reference company would have to pay if they were to issue new loans. If the reference company defaults I have to pay the notional amount less anything that can be recovered from the reference company. As you can see it looks a lot like a loan.

In fact it looks so much like a loan an investor could actually take on the risk profile of a bank without actually setting up a bank just by selling CDSs to banks. Banks raise money from depositors and then lend it out and earn the spread. During the life of the loan they pay interest to their depositors (LIBOR) and take in interest from the company they lent to (the premium.) In the end if the company pays the loan back all is well and you give the depositors their money back and stop paying LIBOR and if they don’t you lose the money and have to pay them the depositors back out of equity or in the case of the CDS you pay the protection buyer. So you can see how useful these things are and in fact many firms essentially became banks by selling these products. This is sometimes called the “shadow banking system.” AIG was simply the largest and not most notorious part of it but hedge funds were also involved as are the banks themselves.

CDS are very useful because they allow non-banks to take on bank risk and allow banks to manage their risks. The market for them has grown into a multi-trillion dollar affair that trades around the clock in all markets all over the world though primarily centred in London, New York and Hong Kong.

If these things are so useful why are they at the center of so much trouble?

As with so many things both God and the devil are in the details. The main problem is in the market structure itself. By this I mean that nuances of the product interact with the way they are traded to preserve the usefulness of the individual instruments while putting the market at large at risk. The problem is the combination of the fact that they are traded OTC and that they look like loans with a stream of cash flows with a potential payout at the end.

The fact that they are OTC means that they are traded against individual firms. The opposite of OTC derivatives are exchange traded derivatives like futures and options traded on the Options and futures exchanges in the US. On exchanges the person who is the other side of your trade is the clearing house of the exchange. The clearinghouse checks the creditworthiness of all the counterparties and takes a fee for clearing the trades and in the event that any given market participant folds the clearinghouse uses its fees (which act like insurance) to make the other side whole. This effectively eliminates the risk of counterparty default. In an OTC market you take the risk that the person you are trading against defaults and doesn’t pay you if the reference company actually does default.

Another problem with OTC trading is that the contracts are not fungible. If buy a future from the Chicago Mercantile Exchange clearing corporation and then sell it back I have no net position, that is I have no risk. With a CDS this is only the case if I trade EXACLTLY the same terms with the original counterparty. This hardly ever happens in the CDS market because there are so many different players its unlikely that you will find the best price twice in the same place. Imagine a situation in which I buy a CDS on IBM from JP Morgan and then the next day I sell if for the same price to Bank of America. With respect to IBM and interest rates I have no more risk. If IBM defaults JPM pays me and I turn around and pay BofA. And if no default occurs I just take the LIBOR payments from JPM and send them to BofA and I take the premiums from BofA and send them top JPM until 5 years from now the trade comes off. But of course what this means is that despite having to exposure to IBM, I do have exposure TO BOTH JPMORGAN AND BANKOFAMERICA FOR THE LIFE OF THE TRADE. Because if either one of them defaults I still have to make the payments to the other and I have my exposure one way or the other to IBM back on my book.

The heart of the matter.

And this is where we find ourselves. There are about $40 trillion of CDS outstanding. 80% of them are issued by the top 10 players. Many of the top 10 players are candidates for potential nationalization. If they were nationalized as Krugman suggests with the depositors made whole but the stock and bondholders wiped out you would also create a massive default in the CDS market which would ripple throughout the entire banking system. Tactically it would have the effect of forcing a lot of people to take back onto their balance sheets risks they thought they had hedged and would likely force many banks to seek to raise capital simultaneously. Strategically it would call into question the whole idea of the CDS market and thereby the riskiness of the banking system altogether. What would happen if all of a sudden life insurance could not be relied on? People would save more. A similar thing would happen if you wiped out the default insurance mechanism.


As a result we are stuck with the Geithner plan.

Monday, March 23, 2009

TARP II redux

What is the government doing?

The government announced more details on their plan to relieve banks of troubled assets. The plan is divided into two parts depending on the type of asset involved. The assets are bank loans and securitized products. The treasury will partner with private sector actors to buy up the assets. With regard to loans the government partnership will work in the following way: the Treasury will put up a dollar of equity for every dollar of equity that the private fund puts up. Then the FDIC will lend $5 to the fund to further gear it up to buy loans. The securitization purchases will be done through an expansion of the TALF and this will be a more complicated process. Most importantly the leverage allowed for securities will be ½ to one or at best 2 to one.

Will it work?

This depends on your definition of the word “work.” The leading danger right now of any government program is the potential it has to backfire politically. These programs seek to defuse that potential issue by making the government and equal equity partner in the funds. So it’s not possible for the the funds to make more money than the government. Of course in the event of losses the government bears the lions’ share of the loss, nonetheless except for large management fees the government is not likely to come under too much fire for the program. My guess is that people will be happy to participate in the program. The issue will be whether the banks wish to liquidate their troubled assets. Very likely this liberal application of risk free leverage will encourage these funds to bid aggressively for the assets which banks may wish to sell and therefore make them more likely to do so. It remains to be seen whether this will actually arrive at asset values that make sense for the taxpayers, investors, banks or some combination thereof. The markets clearly like the plan.

What does it all mean?

Whether it works or not in the big picture depends on whether or not the actual problem of credit is the fact that bank balance sheets are overburdened with bad assets or that many assets are systematically underpriced. You could argue that these are the only problems and if you believe that then this will probably go a long way toward restoring credit in the economy. There is a case to be made, however, that what has just happened has demonstrated to the worlds lenders generally that the levels of credit that have been extended lately are unlikely to be sustainable and will therefore result in a lower level of credit being extended generally. If that is the case then these programs will help but we will not go back to the status quo ante.

What does this mean for the markets?

The S&P is up 7% today to 822. Analysts estimate that the S&P 500 will earn $65 dollars in 2009 implying a P-E ratio of about 12.5, lower than the historical 16 but not unreasonable for where we are in the economic cycle. If you think this is over with and you agree with the $65 estimate then with a 16 PE you get to 1040 so there is still quite a lot of upside. Personally I think the $65 number is high and so far I don’t think the macro-data justifies a 16 PE. It is also my view that though the government’s plan will at least partially achieve the goal of freeing up bank balance sheets and restarting some closed markets I think the level of credit that will be extended in the economy generally will be limited. Given the big move we have had and the potential there is for things to go wrong I think the greater risk is to the downside.
I would prefer to stay on the sidelines until either 1.) the macro data indicates that things are turning around, or 2.) the first few auctions come off successfully and in such a way as to convince me that this is actually addressing the problem.

Thursday, March 19, 2009

It’s not Rock Scissors Paper, it’s Chess

I’m not sure whether the Obama administration knows it or not but it is painting itself into a corner by getting behind the anti-bonus rhetoric and I think this is a serious problem. This is not to say that Wall Street compensation has not been excessive. It has. This is not to say that there should not be consequences for poor judgements and decisions. There should be. But by hopping on the populist bandwagon and encouraging congress to vilify the rescue of Wall Street the Obama administration is closing off options for itself in the future that it may come to regret.

Here’s why.

Over the past two weeks or so there has been a parade of bank executives in America and abroad who have announced how well their banks are doing in terms of revenue and how much money they are making. This should surprise no one. If the government insures all the loans you made that will never be paid back and funds you at the risk free rate no matter how much risk you have on, you can make money.

But generating revenue is only half of what banks do. The other half is managing the risk and the balance sheet and this is where it gets tricky. Whether because they are now making money again or because the government puts together a program to move toxic assets off the balance sheets of banks sooner or later there is going to be a lot of questionable assets for sale. This will mean that the value of a lot of what the government has insured on the balance sheets of AIG, Bank of America and Citibank will finally be known, that is we will know what the government will have to pay out on those guarantees. There’s a good chance the number will be high. So the US taxpayer will wind up holding the bag for the Pandit rally.

At the same time as the taxpayer finds out what his losses are so will all the other banks, which do not have government guarantees as yet. Then what will the government do? Having spent all this time railing about the outrage of the AIG bonuses and the greed on Wall Street what will the appetite be for yet another package to repair the capital of the damaged banks? What if, as seems likely, the lesson drawn is not that bankers should take Grasselys advice and kill themselves but rather that the taxpayers should sit on their hands and let the banks go under.? Sure Obama & Co. have already asked for $750 billion in their new budget but Congress is a capricious thing and when the constituent mail starts pouring in 10 to 1 against further bailouts what will the government do then?

It won’t have a lot of options. It will have to let a lot of financial institutions be wound up or force merged into other financial institutions. This will in turn shake the confidence of taxpayers and investors both that we are really out of this mess and the whole thing could begin again.

I think generally what bothers me is that so many people involved seem to think that this is a one turn game. By one turn game I mean a game like rock scissors paper. You choose a move, your opponent chooses a move, you reveal, one of you wins: game over. The financial crisis, however, is not a one turn game. It is a multi-turn game more like chess. Each action a given market participant takes sends signals to all the other participants which they then take into consideration when they take their own actions. This is true of all participants, CEOs, traders, investors, but most particularly of the government because, though not omnipotent, it is the single strongest actor.

When people in the government make a decision they need to be thinking about how other participants will interpret their actions, how they will react to them, and how that will constrain or enhance their field of action in the future. I would say that what has actually been happening is that the government is behaving as if this were a one turn game. They think that this or that action is the last one and that’s it. With the possible exception of Ben Bernanke they all seem to focus on the here and now rather than the later and then.

There has been a lot of criticism of the Obama team lately for this but the Bush team was just as guilty of it. The people in government are acting this way not because they are Democrats or Republicans but because they are human. It is human nature to see the world as you would have it be rather than it is and to imagine that your capacity to affect outcomes is greater than it actually is. I recognize that the Obama administration probably feels as though it has been unjustly attacked for its handling of the crisis so far and I can understand their very human desire to score points by joining the populist outcry. But they have a bigger job to do and the only way they can really do that is to overcome their human impulses and try to think a few moves ahead. This is why most are asked to follow and only the few are called to lead.

Wednesday, March 18, 2009

FOMC to PRC, "Guess what, we don't need your money. We can print our own."

Once again we have had an interesting day in the markets. Today the Federal Reserve Open Market Committee announced that they would expand their purchases of mortgage backed securities and more importantly they announced that they would purchase long dated Treasuries outright. This is a very interesting development. The treasury achieves several things with this at one stroke. Firstly they lower longer dated interest rates which are important for mortgages. They do this by buying up treasuries which makes the interest rates go down on government securities. The US Government is generally considered the least risky investment you can make so by lowering rates on US government securities the Fed lowers rates on everything else. This should bring down corporate borrowing rates and indeed there was a rally in corporate bonds as well.

The government achieves a number of political objectives as well. The government is going to have to sell a lot of treasuries to pay for the stimulus package and the bank bailout packages as well as more normal funding needs. Very importantly they are doing it at a time when the total volume of world trade is falling off a cliff. Many countries with trade surpluses with America used to recycle their surpluses by buying US Treasuries with the dollar proceeds of their sales in the US. As the price of oil has declined along with world trade flows those surplus countries now have much smaller surpluses and therefore would not have been buying as many treasuries as they had been before. Now the Fed is coming out and telling people it is going to pick up the slack.

Now this is not free. There is going to be a cost to this. In big picture terms what is really happening here is that the Federal reserve is printing money and then lending it to the government which will then spend it on the stimulus package. We are effectively financing government expenditures with a printing press. It is likely that someday these chickens will come home to roost in the form of higher inflation. Some people disagree saying that asset price destruction is deflationary so some money printing is not a big deal. The markets don’t agree, which is why gold which began the day down about $20 ended the day up about $20. TIPS also had a good day.

Personally, I think it is interesting to look at this as a sort of conversation with China. Last week the premier of China publicly expressed concern about American treasury securities. To be frank this is an insult to the United States but one that China might rightly feel itself in a position to make. It is the largest non-US holder of Treasury securities. So why not tell your debtor what to do. It might be reasonable to think that given the massive levels of Chinese purchases of US treasuries if the Chinese went on a buying strike they might be able to single handedly raise US interest rates. This would make potential investors in US Treasuries nervous. This is why Hilary Clinton went to China right away and why the US government has been at pains to talk about reducing the deficit. That’s the nice guy approach.

Today the FOMC outlined the other approach. You could look at todays decision as a message to China: “We don’t need your money, we can print our own.” This is an interesting rebuke to China for two reasons. Firstly the US basically said today that the American central bank would print a sum about equal to 15% of Chinese dollar GDP and buy treasuries. Politically this is a rebuke but it is economically also a threat. America is basically telling China “If you do not buy treasuries with your surplus we will print money and buy them. If we do that we devalue the dollar, the currency in which most of your savings are held.” The fact that gold and oil spiked on this news is very important. Remember how the Chinese economy works. China is labor rich but resource poor. It has to import most of the raw materials that it uses to make things which it then sells abroad. Those raw materials are priced in dollars. As we devalue the dollar to make up for the bond purchases they are not making their margins are squeezed. So this could be read as economic brinkmanship with China and the stakes could not be higher.

Wednesday, March 11, 2009

The strong do what they can, the weak accept what they must. In that case, be strong.

I was recently at a party held at a country western bar in, of all places, Rockefeller Center in the middle of midtown Manhattan. For the most part except for some kitschy decor the bar was indistinguishable from any other Manhattan yuppie hangout, with one exception. In the middle of the bar, in the middle of a ring with a padded floor was a mechanical bull. I had never actually been to a place where they had one and my friends and I were seated at a table next to the bull so we had a front row seat for the action and it was fascinating to watch.

Firstly the bull is not automated, there is a person manually manipulating the controls of the bull. Second, I had assumed that the way the game worked was that everyone got some fixed amount of time and the object of the game was to stay on the bull through your time and if you did you “won.” This was not the case. You could ride the bull for a long as you could stay on but sooner or later the bull threw you off and it was the turn of the next person.

Something about this bothered me. The game was fundamentally unwinnable. You could only lose more slowly than someone else. This seemed to me very unfair. Then it occurred to me why this bothered me so much, it is because this is what it seems to many people like what the markets are. They are a rigged game that you cannot win but you can only lose at a different pace to other people. Another friend has said to me that the thing about bear markets is that the foolish lose their money first and the prudent lose their money later but that sooner or later everyone loses.
I think this kind of mentality is unhelpful so I want to make a few points about how people should think about their savings and their future in the crisis.

1. Know Thyself
Far more important that knowing what will go on in the market in the future is to know what will go on in your own mind. This is surprisingly difficult for people to do. Many people do not consider how they will feel if they lose money. Look at your portfolio of assets and ask yourself how you would feel if before they could double they had to be cut in half but that you would not know when either would happen and it could be years before both or either would happen. Would you have as much invested as you do? Do losses bother you more than gains? Are you going to need your money soon? One of the problems with people listening to financial advice is that there is no one size fits all solution because every person has a different psychology about loss. The best example of this is Warren Buffets advice to buy stocks back in October. Over a 10 or 20 year time horizon, he’s almost certainly right but if you took his advice then you have lost 30% of your savings. Warren Buffet can wait it out, can you? So before deciding what to do with your savings you need to decide what kind of person you are, how much risk you want to take and how much time you have. Only then can you make rational decisions about what is right for you.

2. Acknowledge that there are things beyond your control
Something I see a lot of people doing is worrying about things that are fundamentally not in their control. This is a bad thing because by focusing on the things that go wrong that are beyond your control you are less likely to take actions that might help you. The analogy I use for this in my mind is what if you were an engineer responsible for building a bridge across a river. There are some things you cannot change. I call these the landscape. You can’t change the width or the depth of the river, the quality of the bedrock in the soil. These are things you have to take as fixed. There are some things that change and whose changes are beyond your control like the currents or the weather. The same is true about the markets and the economy. As an individual person you have no ability to delever the economy, you cannot affect government policy. You cannot make the stock market go up or down. Many people worry about these things and they are worrying and it is helpful to have an opinion about what the outcomes and timing of big economic trends are but excessive focus on things beyond your control can blind you to the things which are in your control.

3. Stay focused on the things that are in your control.
One of the best quotes from an Thucydides, “Peloponesian War” was given by the Athenian commander at Melos who told the Melians that “the strong do what they have the power to do and the weak accept what they have to accept.” What he meant by this was that might makes right but I think it is permissible to take it out of context for what it says about the mindsets of people. If you find yourself thinking of yourself as someone at the mercy of forces beyond your control you are actually less inclined to take actions which might limit the effects of those forces. If you focus on the things that are within your power and do them then you can put yourself in a much stronger position.

You cannot stop the stock markets from going down, but you don’t have to own stocks and you can buy puts. You cannot make the economy recover but you can limit your spending and pay down debt to prepare yourself for a downturn. You cannot stop the government from printing money but you can own real assets to protect yourself from inflation. You may not be able to prevent yourself from losing your job but you can always be planning for that contingency and mentally preparing yourself for it. These are very uncertain times.

The Athenians were right. The strong do what they can, the weak accept what they must. Be strong. Do what you can.

Tuesday, March 10, 2009

We want to believe

The markets are up huge today, the S&P is up 6.4% today. While this is indeed a huge intraday move and in normal market times might take an entire year this time around all it is really doing is taking us back to where we were last Wednesday. Many people have been calling for a bear market rally and this may well be the start of it. That may well be the case, especially if Geithner lets the market build on this with an announcement about the public-private partnership or some other batch of details about what will be done with the remainder of the TARP funds.

Still, I am inclined to be a but skeptical personally. This rally is built on comments by the CEO of Citibank saying that they are thus far having the best quarter since 2007. To be frank this is not really saying a lot given what has happened to Citibank since then. I find the power of this rally somewhat surprising as I would have thought that the credibility of Bank CEOs had been so damaged that it would never recover, but here people are taking the market up as much as it moved in 2006 in a single day.

Personally I think this may have to do as much with the incentives of the bonus cycle as with the actual performance of the Citi business. Imagine a world in which you manage a $2 billion book of illiquid or long dated assets where you are allowed some discretion as to how precisely it is marked. Not a lot of discretion but some.

Now imagine that it is mid December 2008. Your book is down $200 million, people consider you to have done a good job because given your risk people were expecting you to lose $400 million and you made $600 million last year. You may not have been fired but your bonus will certainly be zero. What is the difference to you between loosing $200 million and $240 million in 2008? None. Your bonus is still zero. But what is the difference to your bonus in 2009 if you start with a $40 million safety net in January of 2009? Probably a lot. Can you see where this is going?

If the notional value of your book is $2 billion, a $40 million mark adjustment will not set off any serious flags so you might be tempted to make such a mark adjustment "just to be conservative," thereby enabling yourself to make the opposite mark adjustment in 2009 and thereby transferring a loss no one will notice in 2008 into a profit everyone will in 2009. And so across Citibank many of these decisions have had to be made. Some people probably chose to mark things fair, other may have chosen to mark them conservative, and now the marks are "coming back." This leads Mr. Pandit to issue an "internal" memo which is promptly leaked and takes the market up 5%.

Rally's have been started on flimsier things in the past but it remains to be seen if this has legs. I think it will need an assist from some economic data or our man Geithner to have any. You can see however how earnestly people want this to be over by how aggressively they take the market higher on this.

Thursday, March 5, 2009

How This Ends

The S&P fell 4% today and is now down almost 30% from the pre-inaugruation 2009 high, almost as much as it fell after the collapse of Lehman Brothers and of course this is only the most recent of a series of legs down from from the 1400s back in October 2007. It has been a long road and people have been asking for a long time "When and how does this end?"

I had a boss who, during the internet collapse used to say "if people are still asking if its the bottom, it's not the bottom. The bottom is when people stop asking and just start screaming sell." This is a good rule of thumb but it isn't nuanced enough for what I want to talk about today.

So the question lingers, "How does this end?"

I'm going to tell you.

First we have to decide what we mean by "this" when we talk about how "this" ends. There is a lot of talk in the press about what to call the current crisis. Technically it's a "Recession." Is it deep enough to be called a "Depression?" Should there be some middle term like "Repression?" I think this focus on terminology actually obscures the real issue, so I am going to begin by talking about what this is not.

  • It is not a housing crisis. Foreclosures are sweeping the country and millions are losing their homes. House prices are falling and will likely to continue to do so until house prices are more in line with historical norms for thier ratios to rents (the alternative to purchase) or incomes (the capacity to purchase.) When I say this is not a housing crisis what I mean is that solving the housing crisis is no longer enough.
  • It is not a banking crisis. The housing price deflation struck bank balance sheets hard and brought some firms down altogether. Today there are serious problems with the balance sheets of American banks and the constriction of bank lending has choked off the flow of capital to the general economy. But this is not a banking crisis in the sense that the real economy is declining so rapidly that simply solving the banking issues is not enough to turn things around.
  • It is not a budget crisis. On account of the stimuls package and extraordinary measures to protect the banking system the US deficit will be 12% of GDP, twice as much as it has been at any time since the World War II. This is a problem and will either lead to higher interest rates or higher inflation depending on how the government chooses to finance it. This is not a budget crisis because even closing the deficit as the administration is promising to do will not solve the problem.
  • It is not a trade balance crisis. America as a $700 billion trade deficit with the rest of the world. Decisions by our trading partners to invest thier surpluses in the US rather than convert them to local currency exacerbated our housing bubble and a persistent deficit will make it difficult for us to export our way back. But it is not a trade crisis in the sense that even narrowing the trade deficit will not be enough to stop the declines.
The real problem is that all four of these things are attacking the old order of the economy simultaneously. The government is trying mightily to defend the old order. The TARP, the TALF, multiple stimulus packages, promises to refrain from protectionism, promises to narrow the deficit. The government is doing everything that it can to try to preserve the old order but I think that the markets, and the economy is telling us that the government, funamentally, has already failed. Even if we succeed in reparing the housing market and the banking system and narrowing or closing the trade and budget deficits. The old order will never return for a very simple reason.

The simultaneous housing, banking, budget, and trade crises have made it clear to everyone who might consider lending money in the US that the levels of credit that have been extended over the past 30 years are no longer justified by the income being generated in the economy. This is regardless of whether those assets are investment banks, houses, the government or industry. It is not a micro issue, it is a macro issue. The US has $53 trillion in debt against a GDP of $14 trillion and it has been shown that under stressful conditions like those now occuring that debt cannot be bourne. So even once the micro crises are resolved it is unlikely that similar levels of credit will be extended in the future. I believe this will be true even once the banking system is repaired and functioning again. We may get the rifle working again, but we'll still have fewer bullets.

Monday, March 2, 2009

No One Volunteers to Catch a Falling Knife

So the market dropped 4.7% today on what seemed to be a relatively slow news day. Warren Buffet wrote that the economy was likely to be weak for 2009 and perhaps 2010 but he continued to be optimistic long term. The EU refused to bail out Eastern Europe or car companies but this should not have been a shock to anyone becuase the EU itself does not have the $200B that was being asked. The US government continued to prop up AIG despite the largest loss in American history but this is widely acknowledged as necessary. Keeping AIG alive is a convenient way for the government to insure $300 billion of bad assets ala their C and BAC plans through the CDS that AIG is short. There were economic data on consumer spending and the ISM manufacturing index but these numbers were inconclusive, you could cheer or fear them.

I think the markets went lower because generally investor sentiment is darkening. 2009 is going to be worse than people expected. The recovery may not come till late 2010 and then could still be anemic. I think that the government's lack of consistency has eroded their credibility to the point where I think that people are less inclined to rally the markets on new announcements of government programs than the have been in the past. There has been a lot of thought that when a rally came it would be violent because of all the cash on the sidelines. I believed this theory myself but I think that it might have been overstated. The cost of coming in early has been very very high. Look at Buffet, his call to buy American on October 16th was 25% ago in S&P terms. If Warren Buffet can be wrong by 25%, how confident can the average investor be about calling the bottom?

I think that what this means is that people won't attempt to front run the recovery. They'll wait to see it in the data. That could be a long time coming.