Not over yet

A new consensus is seeing the end of World Depression II sometime in 2010. As a matter of fact, the list of positive elements is not negligible:

• - The very existence and the conclusions of the G20 show the existence of a fast global public response to the events, certainly going in the right direction
• - The US stimulus plan has had an initial favorable impact, paving the way for the other plans
• - Europeans plans are not as small as they look, considering the fact that social protection mechanisms mechanically increase public spending each time unemployment levels rise
• - The banking system has now ceased to crumble down, and the main pieces are back in place
• - Protectionism is being discarded as a solution
• - Destocking is reaching its material limits
• - Most commodities are back to reasonable prices
• - Confidence is being restored
• - Key currencies are stable: the ‘Chinamerican’ system protects the dollar, while the Euro structure prevents members to freely print money for their own selfish benefit
• - A reinforced IMF can be of assistance gain in the most disastrous areas
• - Last but not least, the US administration, having ceased to be an arsonist force, is now a factor of global appeasement .

Now, on the other side of the balance sheet, still lies a list of liabilities of such importance that the 2010 target remains a product of wishful thinking:

• - The financial system is by no means limited to the banking system, and it will take a long time (years) to monitor, fix, regulate and control the non-banking part which had become the largest part. This requires a better understanding and monitoring of securitization, another revision of corporate accounting, multilateral as well as bilateral negotiations for the creation of appropriate regulation entities, and adjustment of tax laws
• - Stimulus plans, limited by a dominant ideology against public deficits, are being set at an order of magnitude below actual needs: the financial wealth recently destroyed (stock markets, real estate, commodities, leveraged securities, for a total of perhaps $ 200 trillion) had been fueling growth, and must be substituted by public injections (today in the range of $ 3 trillion). In the meantime, business will lack funding and growth will stall.
• - Toxic assets are not yet entirely eliminated (CDS, and weak real estate based securities) and not even entirely identified
• - The global real estate crisis has not by any means reached its climax, and in many places (such as Spain or Dubai) drops in prices are still expected to reach 80% from currently already discounted levels
• - The West should continue to keep for several decades the largest consumer markets, and is also the place where unemployment shall keep rising: the gradient in technology capabilities which had separated East and West for the last two hundred years, creating the global system of economic specialization which in turn did sustain the extraordinary economic growth rate observed along the same period of time, is now reduced to very little. Countries like South Korea can produce basically anything the West can produce (except in the fields of airspace, nuclear energy, and armament), and can produce what the West cannot efficiently produce (e.g. consumers electronics). When China –which is a subcontractor of the West in about every sector) inevitably reaches the same situation than Korea, then Western and Eastern salaries will have to adjust. If they don’t, unemployment in the West will reach unprecedented levels, triggering an attrition of Western consumers markets, in turn preventing the East to generate resources for their own new consumers markets. If they do, social unrest in the West will contribute to the depression. In any case, the substantial cause of the economic crisis (not the occasional cause which was the financial crisis) is still in place for a while
• - When such stubborn facts appear in public view, further stimulus plans shall come. This time, however, they will have to be funded by deficits that only inflation can cure. For a short while stock market’s rallies should multiply. One could even use the opportunity to invest in the most protected sectors (let’s talk about them some other day). Yet, better miss a rally that hit the next crash sooner or later.

This is how the world goes. Please stay tuned.

Corporation, MD

The present economic scenery does not allow for narrowness in the search for diagnosis and remedies. It may very well be the case that our macroeconomic illness also plunges some of its roots into microeconomic malfunction.
Let’s therefore put aside for now both (i) the regular macroeconomic cycles, although one of them definitely just ended, and (ii) the long term decline in the technology gradient between East and West, although it threatens the foundations of the entire international trade model, as well as (iii) the leverage bombs which triggered the depression. Let’s focus instead on business management at corporate level.
Business administration theory is essentially teaching how to fight Schumpeter’s concept of inevitable corporate death. The mainstream idea is that, given enough goals setting, planning, focus, hard work, diligence, persistence and disciplined execution, corporations can follow a perpetual ‘S curve’ from fast growth to maturity, from start-ups to cash-cows. The transition to maturity is recognized as a critical phase, which calls for new managers and business consultants, in order to regenerate income, in spite of reduced growth. The task of the consultant is to recommend and the task of the tough (=good) new managers is to implement the recommendation of trimming the fat, i.e. eliminating any product line, market segment, supplier, channel, employee or investment, which either does not fit the historical success profile of the company or does not produce the best income. This method has proven itself, and it is a certain fact that the deliberate trimming of the business to the core, does indeed create a short- or mid-term improvement of income in the so-called ‘mature’ companies, i.e. companies large enough to be in the first tier of their own sector and now probing the limits of their core market.
On the other hand, it is a dangerous medicine the one that guaranties the death of the patient. If the trimming logics are pursued to their end, as a matter of fact, the company will find itself with only 1 product, 1 client, 1 employee and no investment, another name for sheer disappearance. There is no practical escape from this theoretical conclusion: large companies die. The more the mainstream management cure is applied and the better the managers are in implementing the recommendation, the more in fact the company is doomed.
With the temporary exception of oil companies, almost no corporation listed on the US stock market at the time of WWI is still in existence today; and the handful of survivors is mostly in bad shape. The biggest, strongest, and best managed corporations according to standards are dead or in agony. There is no space enough here for the endless obituary they would deserve. Just think of PanAm and most airlines, Polaroid, Kodak, Kmart, Dell, GM and most automakers, AT&T, ITT, DuPont, all banks, DEC, Bell-Lucent-Alcatel, Bethlehem and most steel titans, Tribune and most newspapers companies, AOL, Marlboro and most tobacco companies, etc, etc, etc.
The main reason behind the mass slaughter is that while companies tend to stick to what made their success and eliminate the fat around their core business, markets have a life of their own. Few assertions are more certain than the following: there will always be a market change capable of killing any company.
Based on these facts, one would think that the best management method is not the ‘trimming to the core’ but the preparing at all times for market change. The problem here is twofold. First, stock markets are not inclined to sacrificing sure short-term improvements by trimming for unsure long-term investments for survival.
Second, the risk, as usual, is to underestimate randomness. It takes many entrepreneurs to get a successful one. God and Evolution, with their 50 million spermatozoids per ejaculate, are in fact much more conservative than venture capitalists with their acceptance of a 90% average rate of failure. Moreover, the established business management theory is wrong in confining randomness at the level of start-ups. Randomness remains a reality after the initial stage. Even if an exceptional business genius was capable of anticipating most of the future market changes and designing the appropriate product solutions, he or she would still be confronted to randomness under the form of timing. Timing is determined by such a complex combination of factors, that it can almost never be forecasted and can only be guessed. Wrong timing is yet the worst of all outcomes, having consumed vital resources to no avail.
Under these conditions, is it possible to design the kind of meta-corporation it would take to continuously self-reorganize in order to face market change? A couple of entrepreneurs, like Jack Welsh (GE), Steve Jobs (Apple, Pixar) or to a lesser extent Richard Branson (Virgin) and Lou Gestner (IBM) have shown it can be done on an individual basis. But can this be done on a global basis?
In what is possibly one of most stimulating books ever written on Business Management (Create Marketplace Disruption: How to Stay Ahead of the Competition FT press, 2009), Adam Hartung gives a positive answer, and explores various ways for a corporation to manage its success formula to achieve adaptative success: such as stop the ‘Defend & Extend’ old habits through trimming, generate controlled disruptions of the corporate personality, and create an autonomous ‘White Space’ to continuously create revised success formulas.
Although I am not sure any business organization can overcome Schumpeter’s spell forever, Hartung’s suggestions may certainly increase their longevity. If he is right, the good old ‘best practice‘trimming will give way to a much healthier type of management. Successful corporations would probably not only survive longer, but they would also be likely to do a much better job than venture capitalists at attempting new success formulas , having more resources to do so and a portfolio of potentially synergetic technologies to leverage. Last but not least, consumers’ markets would be filled with a smaller number of laid-off employees…
This is how the world goes

Maalox for Madoff

You are inevitably aware of the nature and magnitude of the fraud: $50b lost in a Ponzi scheme, according to Madoff’s own confession, the exact amount remaining to be determined. The scam is different from any of those which were recently revealed, as it is based on an absence of due diligence rather than an absence of regulations. The most interesting aspect is that a man, for over 20 years, was able to convince most members of an entire profession he could fulfill their dreams, and maintain their unwilling complicity, by offering high and constant returns insensitive to market conditions and generating high fees.

Asset managers – a motto in this blog – are totally unable to produce – as advertised – long term returns for their clients at higher rates than economic growth corrected by inflation, while grossing for themselves between 2 to 4% of the mass under management. They know they cannot achieve this by themselves individually or as a profession globally. They are ready, however, to believe in exceptions in others, and prefer to leverage such exceptions for their own profit rather than question their reliability. Although betting on exceptions made into an average phenomenon is certainly not the soundest of ideas, it seems a good way for average people to reach impossible goals.The most reckless and/or naive  among money managers started doing this in the 80s. The 90s turned it into an industry trend.

It is true, after all, that at any given moment, a handful of asset managers have beaten the market for a long time and made an impressive fortune. The best known are Warren Buffet and George Soros, others are Louis Bacon, Paul Tudor Jones, Julian Robertson and …Bernard Madoff. Obviously, not all are crooks like the later. Most are simply lucky. Some are even lucky and shrewd. Luck is a very important element in what is essentially a random distribution of outcomes. It is a well known fact that the ‘Monkey’ investment (i.e. random stock picking with positions held over a long period of time) produces results that are strictly superior to those of average professional asset managers. One of the reasons for this is that the Monkey is not concerned with generating fees by a fast turnover of portfolios, and carries fewer costs. Shrewdness cannot hurt: Warren Buffet has shown that Grand Pa’s type defiance against anything sophisticated, together with a witty wording of principles, can be good for business. Shrewdness may also reach some rationality when arbitrating between market discrepancies over identical assets. This last method – the best one – is unfortunately limited in scope and self-cannibalizing, as the more discrepancies are used the less remain to be exploited.

In any case, as these exceptions do exist, the advertized concept became: our bank (or financial entity of some sort), is formed of professionals capable not of outstanding results (something as a matter of fact difficult to believe) but of identifying outstanding independent asset managers. Asset managers picking soon replaced ‘stock picking’. The hunt was supposed to be so difficult and tricky that funds of funds had to be created and a whole new profession of distributors of funds invented. These new distributors of funds did not need any specific training, except in hunting, golfing and/or gourmet dining. Most came either from banking mid-management or impoverished aristocratic families. All they had to do was to be lavish enough in their invitations and jolly enough in their conversations to become your friend (if you are a ‘high net-worth individual’) and your banker’s friend (if you are not). In this way they could foster trust, a necessary item when dealing with expensive opacity.

From this moment on, bankers enjoyed a wonderful streak. Salaries paid to well trained asset managers for managing your money according to your own actual needs could now be eliminated. Younger, better looking and less paid account managers were in charge of convincing you to accept the new products: house funds mimicking successful funds, funds of funds, and ‘alternative’ funds that few could understand and less could explain. Not only these products came to the bankers at no cost, but they also started receiving kickbacks (more politely called ‘retrocessions’ from brokerage fees), on top of the fees you were officially paying (entrance fees, redemption fees, management fees, performance fees, custody fees). Your banker friend being your friend he could be nice with you and lift one of these many fees generated by your own money.

All such funds were supposed to have long track records showing steady returns and outperforming markets. When the emphasis is on performance, the track record is usually limited to an ad hoc selection of the best performing among a series of sister funds. When the emphasis is on the duration of the track record, a scarce item, a promise is made to provide funds by the most successful managers. This is where Madoff played his best cards. In order to create the proper hype, he made people believe that his funds were ‘closed’ and would not accept any new investors. In other words the most open of funds (what can be more open than a Ponzi scheme?) were sold as closed. Letting you in was a favor made to friends.

In a way, you can consider it good marketing: against all expectations, the ‘Dom Perignon’ is the best sold champagne in the world (it really is). Yet, this has had far reaching consequences. One cannot be too picky with favors. Illiquidity (redemption notice on the last day of each month, 35 days to redeem, then 30 days to obtain payment) was overseen. Complete opacity of the underlying assets was accepted as an effect of a necessary confidentiality (after all funds of funds have even more opacity as they refuse not only to disclose the nature of the assets – your assets- but even sometimes the name of the asset managers). Absence of understanding of the techniques being used was partly an effect of opacity. Absence of real guaranties, by the formal waiving of most rights, seemed a natural condition for products reserved to ‘sophisticated investors’. Absence of alignment with the client‘s interests was hidden, as most banks would prefer to cash-in their fees rather than include such products in their own portfolio, or simply denied (‘the managers have their own money in the fund’). Market risks involved were covered by distortions in the terminology: sheer speculation was called ‘arbitrage’, build-up of leveraged open positions were called ‘hedging’.

Facing such hype and making money at every step, the financial industry forgot all diligence: money managers trusted their bank, banks trusted distributors, distributors trusted custodians, and custodians trusted auditors. All trusted their own fees to come, and no one checked. This confederation of dunces became so powerful that regulators and authorities had to look somewhere else.

This is how an average man who certainly started his career with reasonably good performances, based on a right combination of luck and insider’s information, could then become a crook when his investments started going array. He is probably not alone in the present state of the financial industry. But we shall know quite soon, as no scam can resist for long the current storm. Attorneys are likely to be the only winners when one of the largest class-action ever starts, including the SEC among the many defendants. Last but not least, beneficiaries of a Ponzi scheme are liable to give their returns back to indemnify the last comers and victims. Considering the exceptional duration and magnitude of the scam,  it is going to be very messy.

There is little doubt that the money management industry is going to change dramatically after such events.  After a period of attempted resistance, bankers who had cautiously stored their profits in Treasury bonds while their own (now infuriated) clients are the first victims of their policies, will have to take some commercial (or legal) losses. Insurance companies, custodians, auditors and governments will contribute. Most hedge funds boutiques will have to shut down. Funds of funds will slowly vanish . Regulations will be drastically reinforced. Opacity will be banned and kickbacks will disappear. Bankers’ and managers’ responsibilities will be increased. Asset management will cease to be the cure-all for banks who had opted-out from lending. Risks awareness will be somewhat restored. Bankers will start playing serious golf or  kill less game.  Perhaps, the day will come when the best offer on the market will be a guarantied loss of 1% per year in real terms: a serious improvement indeed.

This is how the world goes.

 

Back to the Future

In 1992, a very famous book announced the End of History. For the better or for the worse, current events may be pulling us back to the future, i.e. to change under incertitude, the old feature of human condition. One of the foremost economic crises in modern times is not only blurring the vision of a triumphant capitalist market, but is also reopening the possibility of a political eschatology somewhat different from the everlasting parliamentary State.

While governments minimize by a full order of magnitude the quantities of financial medicine they should inject into the arteries of a chocking world trade, entire populations get closer everyday from feeling personally the pains of new poverty. The higher the recent growth their respective countries had reached, the harsher the depression will be for them. The most dependent zones on foreign trade are likely to undergo a severe social turmoil. For once, Western Europe is not the weakest link. Equipped with the strongest social infrastructures and relatively good reserves, the area is also protected by its dominant inner trade, as well as a long habit of bad news and of lagging in economic growth. “Chinamerica” should be the seismic zone, together with Eastern Europe. The United States cannot solve all issues by simply playing with an overwhelming currency, as in the good old days, and the Chinese armed forces are not strong enough to fight a violent resentment against so great lost expectations.

What’s really new is that domination of the State is not as much at stake as the State itself. We are not confronted with the prospect of opposition parties taking over, but with the one of a pervasive distrust for States in general. Tax boycotts could very well appear in America, and riots in many places. Young people raised in false hopes will show their anger. Nihilistic sabotage, rejection of intellectual property may also join the symptoms. Such disorders, not being driven by a structured vision of society, are among the most difficult to fight by anything else than extreme ideologies. Even Islam may prove unable to capture a negative energy essentially indifferent to geopolitics.

You may smile at this kind of doom saying and you may be right in only one case: if we can rebuild the system nearly as fast as we destroyed it, if the economy can take a fresh start on the basis of a fraction only of the assets which were annihilated. If you do not believe this is a real possibility, then better get ready to meet History again.

Bertolt Brecht had a say for the optimist and one for the pessimist. You can now make your choice: ‘The worst is never certain’ and ‘The belly is still fertile from which the foul beast sprang’. Personally, I would pick both.

This is how the world goes.

GDII?

The Great Depression II (or Great Recession for the optimist) has taken most of us by surprise. Its most astonishing feature certainly is the speed with which the financial crash has been hitting trade, way beyond the global credit crunch generated by the interbank crisis. The credit crunch should have been more moderate after the recapitalization of major lenders and the injection of liquidities which took place almost immediately and on a massive scale. Even if we take into consideration the additional force of the end-of-cycle recession which was due in any case, both the magnitude and velocity of the impact on trade could not have been expected at this level. This means that most economic actors (even those who were not yet directly affected in their current production capacity and did not observe a sharp decline in demand on their own segments) overreacted in their anticipation of a market crunch, creating a self-fulfilling prophecy. In other words, negative expectations went much faster than the negative mechanical effects which are unfortunately still to come as a direct consequence of the ongoing stock market crash, e.g. reduced offer from undercapitalized corporations and declining consumers’ demand from both unemployed and retirees.

In front of such a disaster, even the nationalizing of major financial institutions and industrial leaders, together with a continuation of the lowering of interest rates (possibly even briefly to negative levels, which can become an option if governments and central banks start being considered as the only reliable borrowers), is unlikely to be enough for the job. Large public deficits now look inevitable, in order to both reflate the system and amortize the social turmoil to start anytime soon. Governments shall be tempted by the ‘wise’ approach of new infrastructural investments. They are yet bound to take care of consumers if they want to avoid the collapse of the two pillars of the entire modern growth: automobile and real estate (the growth of services being ultimately associated to the one of final products). New technologies are unfortunately not well placed to be chosen as the core of reflation: bio techs represent for the time being an insufficiently productive additional burden for governments, while green techs are temporarily competing again against low cost traditional energies. As to renewed military spending, no one in his own mind can consider it seriously, at least until the main mistakes of the Bush administration are repaired.

In theory, stimulating demand by large public deficits can be done without uncontrolled inflation as long as the previous level of liquidity is not substantially restored. It has been done in the past, but not on the scale to consider now. We are thus entering unknown and probably stormy waters. Let’s hope for the best as

This is how the world goes.

Suave mari magno

Unusual as it is to mix finance with philosophy, yet large events may call for ancient wisdom.

For the weekend, here are from Lucretius, the most rationalist of Roman thinkers, a few lines on being happy in troubled times:

’Tis sweet, when, down the mighty main, the winds
Roll up its waste of waters, from the land
To watch another’s labouring anguish far,
Not that we joyously delight that man
Should thus be smitten, but because ’tis sweet
To mark what evils we ourselves be spared;
’Tis sweet, again, to view the mighty strife
Of armies embattled yonder o’er the plains,
Ourselves no sharers in the peril; but naught
There is more goodly than to hold the high
Serene plateaus, well fortressed by the wise,
Whence thou may’st look below on other men
And see them ev’rywhere wand’ring, all dispersed
In their lone seeking for the road of life;
Rivals in genius, or emulous in rank,
Pressing through days and nights with hugest toil
For summits of power and mastery of the world.
O wretched minds of men! O blinded hearts!
In how great perils, in what darks of life
Are spent the human years, however brief!—
O not to see that nature for herself
Barks after nothing, save that pain keep off,
Disjoined from the body, and that mind enjoy
Delightsome feeling, far from care and fear!
Therefore we see that our corporeal life
Needs little, altogether, and only such
As takes the pain away, and can besides
Strew underneath some number of delights.
More grateful ’tis at times (for nature craves
No artifice nor luxury), if forsooth
There be no golden images of boys
Along the halls, with right hands holding out
The lamps ablaze, the lights for evening feasts,
And if the house doth glitter not with gold
Nor gleam with silver, and to the lyre resound
No fretted and gilded ceilings overhead,
Yet still to lounge with friends in the soft grass
Beside a river of water, underneath
A big tree’s boughs, and merrily to refresh
Our frames, with no vast outlay— most of all
If the weather is laughing and the times of the year
Besprinkle the green of the grass around with flowers.
Nor yet the quicker will hot fevers go,
If on a pictured tapestry thou toss,
Or purple robe, than if ’tis thine to lie
Upon the poor man’s bedding. Wherefore, since
Treasure, nor rank, nor glory of a reign
Avail us naught for this our body, thus
Reckon them likewise nothing for the mind:
Save then perchance, when thou beholdest forth
Thy legions swarming round the Field of Mars,
Rousing a mimic warfare— either side
Strengthened with large auxiliaries and horse,
Alike equipped with arms, alike inspired;
Or save when also thou beholdest forth
Thy fleets to swarm, deploying down the sea:
For then, by such bright circumstance abashed,
Religion pales and flees thy mind; O then
The fears of death leave heart so free of care.
But if we note how all this pomp at last
Is but a drollery and a mocking sport,
And of a truth man’s dread, with cares at heels,
Dreads not these sounds of arms, these savage swords
But among kings and lords of all the world
Mingles undaunted, nor is overawed
By gleam of gold nor by the splendour bright
Of purple robe, canst thou then doubt that this
Is aught, but power of thinking?— when, besides
The whole of life but labours in the dark.
For just as children tremble and fear all
In the viewless dark, so even we at times
Dread in the light so many things that be
No whit more fearsome than what children feign,
Shuddering, will be upon them in the dark.
This terror then, this darkness of the mind,
Not sunrise with its flaring spokes of light,
Nor glittering arrows of morning can disperse,
But only nature’s aspect and her law.

(De natura rerum, II.1 sq, transl. William Ellery Leonard)

This is how the world should go

The Crash for Dummies

Although brokers are doing most of the crashing for us, a crash course in crashonomics seems more urgent today than any ‘Ms Office for Dummies’ or ‘Family website creation for Dummies’. As passive crashing represents the largest part of a crash, it should be interesting for almost anyone to understand the mechanics of crashes and learn how to talk to bankers rather than listening to what they are paid to say.

- Can one make profits during a crash?

Basically no (see exceptions below), for a crash is precisely a massive loss with no or little counterpart. In regular situations and according to the laws of physics, whenever people lose money, others simultaneously make money. In a crash, on the opposite, wealth is annihilated, not captured by anyone or stored anywhere.

- What are the exceptions?

Obviously some people get luckier than others by losing less than most others. These are the ones who, for some reason, held a larger percentage of liquidities at the beginning of the crash (unless, of course, the crash is a monetary crash, in which case people holding the wrong currency get busted). There are many random reasons for this to happen: some may not have had time to make the specific investments they were preparing for, others may suffer from a maniacal fear of investing, and some others may have had a bad feeling about the health of the markets, thus divesting before the crash. All of these in fact increase their own net worth, even if they take losses on the invested part of their portfolios, for their cash assets would now allow them to purchase more of the discounted assets on the market. A much smaller group may even have increased their cash holdings, having used special financial instruments to sell the market instead of buying it, and getting paid as the market declines. Please note however that selling the market being a very dangerous exercise, past gains can quickly turn into major losses during oscillations of the market, which always occur, no matter the trend. In any case, winners in a crash are a minority by definition.

- Are these exceptions a sign of genius?

Nope. Nobody can forecast accurately and with certitude the behaviour of unbiased markets. A theorem exists to prove it, but it should be enough to realize intuitively that if anyone could, he or she would accumulate the entire wealth present on the markets. People may have good or bad reasons to anticipate the behaviour of a market the way they do, but they cannot overcome incertitude. Astrologists as a matter of fact obtain on the long run equivalent results to Nobel Prizes’. Globally, winners and losers are distributed at random. It is mathematically inevitable that some investors make more accurate (although no less random) anticipations than others, even over very long periods of time. The illusion than such people have a secret and profound understanding of the markets is also inevitable. As they tend to be treated as pundits or even oracles, masses of average investors imitate their investment decisions, giving them a small edge, and reinforcing – up to a certain point- the influence these gurus can have on the markets. Asset managers, whose are supposed to make more enlightened investments recommendations than astrologists, always find an unlimited number of arguments to explain why they made you lose money, their main excuse remaining, however, that on the average they did not make any worse than the other average asset managers. In the best case scenario, one can become a savvy investor, cautious when others get frantic and capable of spotting opportunities (when they can be double checked).

- Does this mean that markets are irrational?

Not at all. Markets accomplish rationally what they can accomplish. However, markets do not have any knowledge of anything; they simply match offers and demands from actors who have various levels of knowledge and yet all share in the overall incertitude. For instance, in March 2000 most investors started underestimating the positive implications of the Internet, not realizing it was the most important industrial development in the last part of the XX century. A sudden panic seized them and the notion of a ‘dot.com bubble’ emerged, wiping out many technology companies. In October 2002 $ 5 trillion had been destroyed. It took about 5 years for the average actors (summed up as ’the market’) to understand they had been wrong, and for market indexes to reach unprecedented highs. If the savvy anti-internet oracle nicknamed ‘Bluffette’ had been as insightful as he suggests he is, he would have purchased technology shares over the crash and become not the second but –by far – the richest investor on earth.

- Do crashes destroy ‘nominal’ or ‘real’ wealth

No matter how we call it, wealth it is (or was). At any given time, there is no difference between nominal and actual wealth. The underlying substance of wealth – buildings, companies, commodities, pieces of art, etc – is not economic wealth in itself: these things are wealth only as much as they have a price tag. When their price goes down sharply, destruction effectively occurs.

Against certain appearances, stock markets are not primarily gambling houses. They are tools for corporations to obtain financing (a vital necessity) and for individuals to maintain some of their savings. After a crash, the average corporation cannot produce as much as before and the average consumer cannot consume as much. Therefore economic crashes entail or reinforce recessions.

- Is it good or bad to destroy nominal wealth based on wind?

Yes and no. Phony assets, like many of the securities which just exploded in flight, must be eliminated, no doubt about it. On the other hand they were very useful as currencies. Without them the world would never have reached its recent level of growth and globalization would have taken much more time. Now that this phony and yet useful currency is getting eliminated, it must be replaced.

Here is an example. Let’s say that I purchase your shoes for $ 100 million dollar, while you purchase my watch for an equivalent amount. This is something we can do as I can pay you in paper from my company, and you can do the same. Each one of us now has $100 million in our books, and together we have created about $ 200 million. Let’s assume now that for some reason our banker accept these values (for instance we have convinced him that the watch is capable of predicting bad crops and that the shoes are made from an extra-terrestrial material with amazing properties which will become obvious in 10 years from now). He will lend us cash against shares of our companies as collateral. As the banker is otherwise very conservative, he ‘only’ lends us 2/3^rd of our nominal assets, i.e. about $ 133 million. Now, we can use this cash to build a solar energy platform in China and a hotel in Spain. Our suppliers are getting more work; they hire people who in turn spend their income. We have contributed to the worldwide growth. When suddenly it is revealed that we were nothing but crooks, the banker refuses to renew his loans and we go bankrupt. Yet, we are not the only ones in trouble: the banker himself has probably lost a part of the loans and must restrict his credit policy for a while; our suppliers must lay off workers who in turn will spend less than before; the price of hotels in Spain shall decline, and China will lose some resources, among many other repercussions. If we want the global economy to recover, someone has to inject brand new money to turn around our failed ventures. This is called ‘reflating’ the economy. After a crash, it is always a good idea to reflate the economy in order to attenuate the coming recession.

- Is it easy for governments to reflate the economy after a crash?

First of all, it must be done; otherwise the risk is to transform a recession (i.e. a short term decrease of production) into a ‘depression’ (i.e. a long term decrease of production). This is not a problem as long as governments and central banks use the money they have to invest or lower taxes, and lend (or guaranty loans) based on assets they have. The thing is this may be insufficient to fill the gap, in which case the only solution is to ‘print’ money at the risk of triggering inflation. For instance, as of today, the gap between the worldwide hole (certainly more than $ 100 trillion) and the current available public resources (certainly less than $ 10 trillion) is gigantic. ..

- How long can the downturn last?

What matters in not so much the length of the crash, measured as the time it takes for the markets to reach their bottom, than the duration of the subsequent recession which lasts as long as the pre-crash amount of wealth is not recovered. No economy can regenerate wealth in a ‘natural’ manner anywhere as fast as a crash can destroy it. The 1929 crisis, not so long ago, lasted almost 2 decades.

- As the pace of economic changes is now much faster, should not a recovery come earlier?

Apart from the global amount of money available , economic velocity depends mainly on the rate of innovation and the size of consumers’ markets. We are currently in a phase of relatively slower innovation (see the many previous posts on this). Energy would be the core of innovation today. Unfortunately, the recession entails a decline in prices of energy, in turn hindering new developments. The positive element is globalization.

- How deep can markets crash?

Nobody knows exactly, but possibly very deep. The final magnitude of crash cannot be extrapolated from observed trends, as any number of thresholds can be crossed before things eventually settle. Market oscillations are normal, and rallies certainly do not seal the end of the turmoil. Temporary rallies mostly mean that investors like to ‘average’ their losses by purchasing the same assets that declined at a lower price.

The best approach is to compare the main causes of the crash with the simultaneous capacity to reflate. The 1987 crash had been triggered by what investors had perceived as an excess of so-called junk bonds (which were basically corporate obligations). The total amount of such bonds which had been issued in 1986 was $ 200 billion only. No wonder the recovery was fast. We are dealing today with an unheard of level of uncontrolled leverage forming a completely different order of magnitude of bad assets. Rescuers are on the job but with very limited means compared to the phenomena they are dealing with. Next to so many uncertainties, we are left with at least one certitude: the crash was not irrational and will carry long lasting consequences.

This is how the world goes.

Elements of Speleology

How deep? That is the question. Stock markets have now lost 25 to 30% globally in less than a month, which represents a destruction of nominal wealth of approximately $25 trillion.

Announced bailout packages amount globally to about $3 trillion. The largest portion of such packages is made of temporary loans from central banks and guaranties, as opposed to long term transfers of liquid assets from national treasuries. A significant part has already been used to cover the losses from subprime loans, as well as the immediate consequences of Lehman’s failure under the double form of defaulting receivables and defaulting Credit default swaps. Assuming the packages can be doubled in size (which is probably the upper limit before entering into stormy monetary waters), they cannot cover the reasonably expected defaults within remaining CDS net positions ($ 37 billion). If we add to theses amounts the destruction of nominal wealth in real estate to be expected over the next 6 months (perhaps 30 % globally) and in other real assets such as mineral reserves, it is hard to imagine how governments could reflate the system at the appropriate level fast enough to avoid a depression.

If stock markets are rational they should drop further. More likely, some cash-holders will start believing they are soon reaching the levels of new opportunities for a reentry into the market, triggering volatile rallies, yet unable to steadily reverse the trend at least for a while.

Obviously the world economy will be craving for a recovery and there is little limit to what can be invented in terms of money creation to soothe social injuries and calm down unrest. Risky times, by all means.

This is how the world goes

No explosion, Turkish-style strangulation

Quite a lot was learnt yesterday from the settlement of Lehman’s credit default swaps. First of all, we were all relieved to see the process complete with no major incident. Simultaneously, the reasons to continue worrying were made clear: (i) the main losses had already been taken and gradually paid for over the last weeks, under the form of both margin calls or “stop loss” returned positions; (ii) payments were made using the recent giant bailout packages as well as the central banks’ new credit facilities; (iii) and such packages and facilities had precisely been precipitated in order to allow the settlement. We also learnt the exact amount of CDS contracts now registered in the Depositary Trust and Clearing Corporation’s clearing warehouse, totaling approximately $34.8 trillion at this time (as opposed to the previously estimated $ 60 trillion, which was based on surveys, and down from an actual $44 trillion in April).

The residual funds transfers that took place yesterday were only the last ones to complete an actual monster loss of about $400 billion. There was basically no difference between nominal and actual losses: margin calls are not a free ride, nor is returning one’s position (unless this can been done way before the event and in a none-volatile environment). Instead of one-day explosion, death took therefore the smoother form of a slower Turkish-like strangulation.

One has to remember that Lehman’s CDS were nothing but a first test of the process, representing a minute portion only of the total outstanding Credit Default Swaps. It is true that the percentage of loss was extremely high in this specific case due to an underlying bankruptcy. It is yet fair to say that very few net positions on all other CDS are winning, in a global situation when almost if not all credit ratings are crumbling down fast.

Regulators are of course scrambling to take some control over CDS. All they can do, however, is limit the creation of new ones and give them more transparency. They cannot reduce by 1 cent the present amounts of further losses to settle which should reflect in the quarterly reports to come, at least for listed companies.

This is not good news for the stock markets and yet

this is how the world goes.

Bloodbath aftermath

A quieter week was wrongly expected after the interbank pacemaker was put into place and before October 21^st, the day when the general public discovers the meaning of the three letters C.D.S.

Leveraged investors are now forced to sell and the professional wishful thinkers (e.g. your account managers) are losing drive, leading markets to nervously slide down to the levels reached 6 years ago (2002). This is much steeper than the 87 crash, the oldest memory of most traders, and the main obstacle to their comprehension of current events. As they were raised to believe that stock markets downturns are short-lived, they took immediate comfort in a ready-made solution: just wait for recovery while only the panicking fools are selling. These ideas led them to ignore 2 important facts: thresholds can be reached beyond which situations do not repeat themselves; and this crash has causes (uncontrolled financial leverage on a giant scale) that the 87 crash did not have. Even the optimist is now aware of the recession to come (it has hardly started yet), under the impact of the inevitable crunch of consumers’ markets which shall follow mechanically a universal loss of net worth, leverage and employment The only debate is how deep? How long?

This depends on various factors, such as the intensity with which leveraged real estate shall blowup, the magnitude if the CDS blast and the capacity of governments, which are already drained of blood, to ‘reflate’ the economy. Concerning real estate, prices have not yet declined in percentages anywhere close to those of the early 80s. Thus the risk is high in many places, including Europe and emerging countries, where a 50% decline is not unrealistic at all. For the CDS, better not talk about them until October 21, where we shall know the proportion of net exposure in the due $410 billion for Lehman only (i.e. 0.6% of the total), who are the main victims and if they can survive. As to what’s left of the capability of governments to compensate all the losses, no one has the slightest idea at this time.

Let’s fasten our seat belts (before tightening our own belts)

This is how the world goes

Multiple organ dysfunction syndrome

Considering that the lead physician in the intensive care room was, by far, the most incompetent of all, we are very lucky a proper treatment was eventually applied. Following the bold plan designed in UK, Europe has mobilized enough resources to reestablish interbank confidence, and driven a clumsy US administration into following (more or less) the same path. Theoretically things should improve for some time: guarantying interbank credit is like inserting a pacemaker to make a failing heart continue to beat. Recapitalizing major institutions is also a good remedy: it is not only a better way of injecting liquidity than adding to the total amount of debts, but also leaves some hope of getting part of the taxpayers money back once the markets are completely cured.

No doubt governments will use the opportunity to treat the very origin of the disease, i.e. uncontrolled leverage. Most financial institutions should be submitted from now on to banking rules, and especially the Cook ratio. Exposure will become more explicit and subject to surveillance. New equivalents of the good old Glass-Steagall Act, which had protected generations of depositors against the hidden risk of seeing their own money burn under the form of mindboggling securities, should be put into place. There is no need of a world government to achieve this; any local regulator of a market large enough to be indispensable to global investors, can impose it worldwide.

Everything would then be fine if the banking system was the only failing organ. Unfortunately the volume of wealth destruction which has occurred goes far beyond the $ 3 (or perhaps 5) 000 billion governments can possibly gather to reflate the economy at a proper level, and goes far beyond banks. The sepsis has reached industrial corporations, both as stockholders and as suppliers of markets. It has reached pension funds, as well as consumers directly. Even if the real risk represented by CDS (see previous posts) did not turn out as disastrous as it could be (we’ll know for sure before the end of year), a consumers’ market crunch is inevitable, which cannot be adequately compensated by sufficiently massive injections of additional cash. Even if some confidence was to be restored for a while, a deep recession would still be inevitable.

This recession will be dangerous for fragile stock markets and for depleted public treasuries. It should also bear large-scale social consequences. The average person is still stunned and silent. Scared for his (or her) family‘s future, he cannot believe what he is witnessing, and hardly realizes he will be the main payer of other peoples faults, the same people who just kicked him out of his home and his job or threaten to do so anytime soon. It will not be long before he awakens to the fact he has been playing an unfair game for the profit of an unreliable, reckless and somewhat criminal elite. Then what is likely to happen?

This is how the world goes.

Good Sunday

Today is Sunday; most stock markets are closed except in the Gulf area; it’s time for a pause. My recent posts have be depressing friends and giving nightmares to my son. So, let’s sit down for a minute and look and at the bright side of things. Yes, there is a good side.

Free markets, as opposed to planned economy, are as important and useful an invention as writing. They allow people to exchange any services (the so-called ‘goods’ are in fact services) they are capable and willing to exchange, and thus to benefit from the existence of other economic agents also capable and willing to exchange. As such, free markets are definitely a good thing and should be preserved.

Free markets, however, must always be regulated. Aristotle, who was the first theorist of markets, explained it very well: without a public control of weights and measures, people could not possibly know what they are actually exchanging, and would end up being cheated most of the times. Indeed, a large majority of goods cannot be checked at the time of purchase: how would we know what molecule is in the pills, if the pilot of the flight we are about to take has been properly trained, if the securities we intend to buy correspond to real assets? Two millennia later, Adam Smith, who was not a communist, insisted on the importance of public infrastructures, including courts, to make the system work.

An essential aspect of globalization is that a significant part of the financial markets was able to evade public regulations and controls. This is the main cause of the major problems we are currently confronted with. Things could have gone otherwise: it would have been relatively easy for the regulators of either or both the two most important economies, the USA and Europe, to impose global regulations. Exactly in the same way that the USA were able to efficiently pressure Switzerland (and other countries with ‘offshore’ banking) into submitting themselves to certain US rules (the deadly threat being to ban their banks from US markets), it would have been possible to prevent the global trading of uncontrolled securities, such as subprime loans and CDS. Ideology was the sole obstacle: 20 booming years of reagonomics and thatcherism had convinced many – against the constant opinion of free markets thinkers- that markets could self-regulate. We now realize that this was nothing but magical thinking. The good news is that, after we are finished paying the tremendous price, we know the cause and we know the remedy. No doubt it won’t happen again for a very long while.

Toxic securities are not the only issue the current crisis can help solving. The price of assets had reached ridiculous levels. Some companies were selling for 100 years of profits, when we now know (see Adam Hartung’s excellent blog on the blogroll) that no company has ever been able to anticipate the necessary market disruptions for any such length of time. The same applies to real estate which had been reaching price levels which would have made sense only if the earth was overcrowded, whereas millions of square miles can still be build (most of London is underused), and whereas most office space in the world is empty at least half of the time. It will take a long while before a closet should reasonably be worth $50.000, a price recently reached in several cities, including Mumbai…A world with cheaper enterprises, real estate and commodities can only be a better world.

Last but not least, the economic comeback will be centered on high-tech sectors, including green techs. This is also very good news. Feeling better now?

Have a nice Sunday. Worries on Monday. Perhaps also a quieter weather for a few days… until October 21, date of the first test for the CDS blast.

This is how the world goes

How will the world look like when the shock wave hits?

It has been fashionable for some time now to distinguish between ‘finance’ and the ‘real economy’. This is not very sound as finance is nothing but the cardiovascular system of the economy (made of goods and other services). The heart is now in surgery room, surrounded by physicians with limited knowledge and – above all – limited means. All they know is not to repeat the same mistake that was made in 1929, which consisted in adding a liquidity crisis to a stock market crash, and putting the overall activity close to a standstill. Governments and central banks are now pouring all the cash they have and soon all the cash they don’t into the failing arteries, in order to keep liquidity at a par with the massive destruction of wealth which is now occurring on stock markets. They definitely try their very best to save the banking system from complete crumble, by guarantying and nationalizing one after the other major financial institutions. Even after their current reserves are gone, they should be able to continue doing this by using their status of ‘least bad’ borrowers: sovereign obligations (close to having null interests’ rates) shall allow them to pursue this exercise for a while.

There is however a quantitative limit to the number and scope of entities they can bail out. Financial institutions are one important thing, and yet not the only components of the financial system. Corporations, pension funds, high net worth individuals are also facing almost unprecedented financial losses. Even massive tax cuts cannot compensate such losses (tax cuts are more or less automatically granted as losses are not supposed to be taxed in any case). For the economy to work, corporations and high net worth individuals must invest and pay salaries, while pension funds must pay pensions to consumers. Globally, they will not be able to do it at previous levels for a long while. And this is precisely how the shock waves hit the rest of the economy.

At this point, even if both causes and treatments are different from what they were in the 1930s, the phenomenology of the crisis shall look pretty much the same: massive plunge in the price of assets, massive unemployment, and massive physical poverty. As during the 30s, there will be some winners too: these are basically the owners of cash, now able to purchase the massively discounted assets as they come, provided however their cash is in safe currencies placed in a safety deposit boxes or nationalized banks. Opportunities, as a matter of fact, should multiply for them when the stock market goes down to 25-30% of its peak values, and real estate (or contemporary art) 50 to 20%. The problem is obviously that most people and corporations not only have little cash but are carrying heavy debts. Leveraged assets (many exist in the private equity sector) should go bust, and consumers’ markets will violently contract, fueling the vicious circle of recession. This should happen even if the CDS shock wave does not hit (see previous posts). If it does, you’ll see your attorney offer to work for food, and fascism come back.

Many people do not realize this. As few of them were directly exposed to the stock market, they are happy to see the ‘traders’ and the rich in general pay the price of their own mistakes, and believe they won’t have to pick the tab also, while governments are finding a solution. How wrong. They should start discovering the ugly truth sometime in 2009, and feel the consequences for a while (5 or 20 years?) afterwards.

How will the final relief come? As usual instant experts will promote gigantic schemes involving new ‘Bretton Woods’ (to achieve what as this is not a monetary crisis?) and ‘Marshall Plans’ (how can this be done in the absence of the equivalent of the 1945 USA?). As usual also, the military will attempt to be the new trusted economists, pointing at strategic hotpots (Iran, Taiwan) and lurking at weaker countries were money is left.

Let’s hope Obama can resist and someone comes up with better ideas.

This is how the world goes (sorry about that)

Don’t bother to be pessimistic: things are much worse than you may think

Remember my last post on the Credit Default Swaps? Dubai just obtained a 15 billion $ bailout from Abu Dhabi to face a default of their own Credit Default swaps. Dubai…

Let’s look again at the issue. The outstanding amount of subprime debt is about of 1,300 billion $. The outstanding amount of CDS is about 50 times larger. The good news is that a large part of this amount is made of offset positions by players reducing their exposure or netting their own contracts. As it is currently impossible to know the net total amount of outstanding CDS, let’s make the most unrealistically optimistic assumption, and consider 90% of the positions as offsets. The bad news is we are still left with at least 5 times the total amount of subprime debt.

Another element to be taken into consideration is that subprime debt is somehow based on real assets: even if they are worth a fraction only of their nominal value, buildings and apartments are still worth something. This is not at all the case with credit default swaps which are based on nothing else than gambling, a very special case of gambling, indeed. Casino gambling is regulated, CDS are not. Casinos have money to pay their own losses; this is not the case with CDS issuers. Casino’s risks are stable; CDS’s risks are not. Quite the opposite in fact: Credit Default Swaps are bets on the credit quality of third parties, at a time when the credit quality of all institutions in the world (including governments) is crumbling down under the effect of the financial crisis. Therefore most (net) CDS are doomed.

Just as the explosion of an H-bomb is initiated by the explosion of an A-bomb, the subprime crisis is getting ready to trigger the CDS crisis.

How many crises are we dealing with? Let’s count. 1 is the end of cycle which started last year and was accelerated by the surge in the price of commodities. 1 was strong enough to entail a recession that the general public would have started feeling in any case by the end of 2008. 2 is the subprime loans crisis, which already turned out to be big enough to shake the world banking system. 3 is the CDS crisis which has not started yet but looks inevitable, considering the combination of 1 and 2. 3 is definitely capable of destroying a large part of the global financial system. 4 is the subsequent mega recession which should logically follow, with major expected unemployment levels and market crunches.

Oh my, enough for today (to be continued though if you can still face it)

This is how the world goes.

From Financial A-bomb to Financial H-bomb

On the A-bomb (i.e. subprime securities meltdown), please see the March 11, 2008 and March 20, 2008 posts.

As if things were not bad enough, a financial H-bomb is about to explode in Wall Street. The name is CDS for Credit Default Swaps. Please get ready for the blast.

Subprime securities and Credit default securities have a lot in common: i) they were designed for the sole purpose of generating fees, ii) they are submitted to no control, regulation or authority whatsoever, iii) they appear as assets from the outside, iv) they are in fact instruments of credit deprived of guaranties or collaterals, v) they are worth a small fraction only of their book value, v) they contaminate any other assets they are combined with, vi) they are the product of a collective crime (by financial institutions and absentee- regulators), vii) they have generated unheard of amounts of fees for the culprits, as well as vast quantities of ideological exhilaration for the self-restrained regulators, viii) their necessary elimination may represent the strongest blow ever on the world economy.

The technical difference between them is minor. Subprime securities consist in postponing as long as possible the built-in default of borrowers, by lending (third party’s) money to people who cannot pay it back, and differing installments for a while. CDS consist in being paid to guaranty the credit quality of any entity, with no obligation of offering a collateral. You do not have to be an insurance company to do this, not even a bank, but simply licensed to sell securities. You do not have to tell the market how much risk you are taking, as these securities do not appear on your balance sheet, except as generated fees. Of course you do not need to have the money to fulfill your commitments. Best of all, you can get rid of the risk by selling the securities (confusingly mixed with other derivatives or assets) to your victims. I know, it sounds like a joke or a mistake. If you do not believe me (how could I blame you?), just search the web for “Credit Default Swaps” and see by yourselves.

Now the main difference between them is not technical. It is their magnitude. Subprime securities are in thousands of billions of dollars. That is certainly a lot of money, and enough to create a recession when taxpayers have to pick the tab. But it can still be handled somehow.

So, what about CDS? Their total outstanding value this morning was close to (hold your breath) 60.000 billion dollars, i.e. slightly more than the total of all bank deposits on earth or 10,000$ per living human being (including infants in Ethiopia) . If any significant fraction of them go bust, then we’d better have kept a few rolls of cash in our drawers.

What can I say?

This is how the world goes.