Posts Tagged: derivatives

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16
Mar 10

The Failure of Extrapolation

The human mind loves linear extrapolation over time.  We build 5-year plans.  Graphically, five-year plans look like hockey sticks: first, slow and minuscule income, revenue growth in the first year, and then spectacular growth by the fifth year.  I have sat through a dizzying number of presentations for start up businesses which rarely, if ever, achieve their predicted spectacular growth.  For every Apple or Google there is a Pets.com and bankruptcy. ­­­ However, hope springs eternal.

Rosy Scenario and Her Evil Twin

Investment analysts, CEOs and government officials constantly project questionable positivity.  Prosperity is always around the corner, green shoots of recovery are everywhere, and a chicken will appear in every pot.  We pillory realistic if negative analysts as pessimistic naysayers, prophets of doom or worse.  But we ignore reality at our peril. More often than not Rosy Scenario often clashes with her evil twin Dashed Expectation.  The results are often calamitous.

Ignoring Reality

The last decade has brought ignoring reality to a high art form.  Linear extrapolation has brought the following prophesies:

  • Dow 36,000
  • Internet businesses with no customers and unrealistic business plans worth several times the value of established companies (IBM, DuPont)
  • Ever-rising housing prices
  • The FIRE economy (Financial, Insurance, Real Estate) supporting the entire American economy
  • Sustained non-problematic leverage ratios of 30 and 40:1
  • Debt growth several standard deviations greater than GDP
  • Counterparties to derivative contracts always making good
  • Never defaulting on sovereign debt
  • Pension fund assets always earning between 7-9%
  • Federal debt growing faster than tax receipts
  • Public sector wages growing faster than GDP and tax receipts
  • Aggressive accounting (Enron, Lehman) considered good financial engineering
  • Zero interest rates restoring economic prosperity.

Past is Not Always Prologue

We are prisoners of our past experiences.  We expect the Federal Reserve to cut interest rates and the economy to magically recover.  We are surprised when the nominal unemployment rate is at 9.7% and the actual is 17%.   We are surprised when Wall Street bonuses soar and Main Street suffers.  We are surprised when Moody’s threatens to downgrade US debt from AAA rating. See Moody’s Says U.S. Debt Could Test Triple-A Rating

Rarely do we say that this time is different.   As a society, we have incurred debt far exceeding our capacity to repay.  Balance sheet recessions/depressions are far worse than previous inventory recessions.  Just as the Vietnamese fooled our World War II trained generals, the Federal Reserve and Administration are intent on fighting an outdated economic war.

It is time for some nonlinear thinking.  Instead of posturing, Congress should be asking Ben Bernanke for a Plan B.  Averting financial Armageddon is not enough.  JP Morgan CEO, Jamie Dimon, projected a banking crisis every five to seven years.  See Elizabeth Warren Exposes Jamie Dimon. As a society we can ill afford another year like 2008.  Reality is gaining on us.

How well did the five-year plans work out for the brittle Soviet system?   Is it time to ditch Rosy Scenario and deal with reality?

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27
Jan 10

We Can Handle the Truth

“You can’t handle the truth!” Col. Nathan R.Jessep in A Few Good Men

After his election President Obama had the opportunity to educate the public on the causes of the financial crisis and the necessary steps to help us emerge from it.  Over this past year, he has squandered this chance, and in so doing has created the political backlash that is occurring today.

Policy Making and the Truth

With great fanfare, we inaugurated President Obama against the backdrop of the greatest financial crisis since the Great Depression.  In any new Administration, policy making is never easy and advisors at times seem to operate in virtual echo chambers, hearing only themselves.  They presented Obama with a range of options: nationalize the banks; let them fail and let the bankruptcy courts sort it all out; continue the Bush/Paulson bailout policies.  From the beginning, Obama advisors took the middle of the road policy to continue the bailouts.  As voters and participants in a democracy, we can now see the missing piece in this scenario. President Obama owed the public an explanation of this policy choice.  My guess is that his advisers warned against candor.  I would further conjecture these advisers felt that candor would have made the crisis worse.  Elites always worry about scaring the masses. This was confirmed at today’s Congressional hearings on AIG.  AIG was viewed by both Timothy Geithner and Henry Paulson, as the “end of the financial world as we knew it.”  The Administration and we are now suffering the consequences of this subterfuge.

Back to the Future

President Obama could have made a few simple points that would have educated the public, built a consensus for his policy choice and left open future policy options if the bailout approach failed.

President Obama could have made these simple and direct points:

  • We are facing the greatest financial crisis since the Great Depression
  • We got into this problem by borrowing too much, and producing and saving too little
  • At the center of this crisis are the large money center banks and Wall Street investment firms
  • Using inappropriate levels of borrowing and creating non-transparent products, derivatives, which could not be accurately valued or traded, these banks and firms gambled with our money.
  • Banks, however, are the transmission mechanism for getting money into the economy through check clearing, making loans and other services.
  • We are going to provide enough support for the banks to continue their necessary and transparent functions.
  • There will be a consequence to any bank for needing this ad hoc and unusual government support.
  • Shareholders and creditors of the banks must share in some of the losses.
  • Bank employee bonuses will be severely limited or eliminated until the banks recover.
  • The government will take part ownership in the banks until they return to financial health.
  • I have asked my Attorney General to investigate whether these institutions committed any crimes.  I will ask him to hold indictments in abeyance until we are on our way to recovery.
  • Let me assure you that the government will punish wrongdoing.

We Build Prisons of our Own Making

We know this fictional address to the public did not take place.  The Obama Administration now owns the policies of failed bailouts.  The recovery is precarious and now the government asserts that the health of the stock market hinges on re-appointing Ben Bernanke as Federal Reserve Chairman.  The Massachusetts senatorial election was a wakeup call that the middle class is “mad as hell and isn’t going to take it anymore.” See The President Wakes Up and Smells the Election Results.

In tonight’s State of the Union Address, President Obama scratched the surface of candor. He stated that he hated helping the banks, but that failure to do so would have led to greater unemployment, business closure and lost homes.  President Obama, it is not too late for complete candor. It is not too late to commence investigations and prosecutions.

Col. Jessep was wrong: the American public can handle the truth!

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8
Dec 09

War on Prudence

Dear Prudence, won’t you come out to play
Dear Prudence, greet the brand new day

“Dear Prudence” – The Beatles

Lately, “prudence” is a virtue which has been in short supply.  Prudence is defined as “care, caution, and good judgment, as well as wisdom in looking ahead….”  This virtue has fallen into such disrepute that the American political and financial establishment have undertaken a war on prudence.  Closely allied to prudence are the virtues of thrift and savings.  Alas, these two handmaidens have also fallen on hard times.

Ignoring this virtue will only prolong the recession and economic malaise.

How We Got Into the Current Mess

Economic policy makers have exceptionally short memories.  We are in financial crisis because Americans took on too much debt and over consumed housing, autos, plasma televisions and stocks.  Americans also failed to save. Wall Street behavior made the crisis worse though reckless lending, highly leveraged trading and esoteric derivatives.

In short, we spent and borrowed too much and did not have the incomes to support the residual debt load.  We entered into what the late economist Hyman Minsky referred to as Stage 3 Ponzi finance.  That is, lenders knew that the debt could not be repaid based on the borrower’s income, yet they speculated on being repaid from presumed, ever increasing asset appreciation. For a longer discussion see Hoisington Investment Management, Quarterly Review and Outlook, 3rd Quarter 2009

Have the past two years ended the Ponzi finance system?

Back Doing Business at the Same Old Stand

The Obama and Bush administrations faced clear policy choices. Government could have encouraged savings, debt repayment and reductions in consumption.  Un-payable debts would have defaulted and yielded whatever the market would bear in negotiated settlements or bankrupt proceedings.  The choice would have been painful.  But markets and the economy would have reset.  Prudence on a personal and national level would have been restored.

Government’s alternate choice is now clear: reflate the bubble economy so we can party again as if it were 2005.  Mark to market accounting was suspended.  The Fed bought mortgage backed securities and other dubious debts at or near full value.  The large banks, credit card companies, GMAC, AIG and others were bailed out.  Where was Prudence?  Nowhere to be found!

Keeping interest rates at near zero punished the thrifty and encouraged an ill-equipped public to return to an overvalued stock market and speculate in commodities or high yield debt instruments.  On the consumption side the government encouraged home purchases through tax credits for new homes and cash for clunkers.

Prudence in Hiding on Wall Street

Prudence remains in hiding on Wall Street.  After accepting (and we now learn needing) government funds and guarantees, Wall Street is back to high risk, highly leveraged trading.  Goldman Sachs lost money on only one day in the last quarter.  Instead of thanking taxpayers by demonstrating proportionality and humility in compensation practices, Wall Street will pay itself record bonuses this year.  Perhaps the prudent course would be for these firms to reduce compensation levels and retain some of these record profits before the next storm.   In addition, why not force executives to have some personal risk through mandatory deferrals of compensation to incent more prudent long term behaviors.

Sometimes it is Characterological

Prudence is one of those old-fashioned values that have fallen out of favor.  Prudence requires delayed gratification, the acceptance of occasional loss and the accumulation of wealth slowly based on hard work and careful consumption.  But our current government policy is a reflection of us:  wanting a “quick fix” and a “do over” for the imprudent who lent and invested recklessly.  In sparing Wall Street pain, we have managed to inflict pain on the entire American economy: barely any growth in GDP, unemployment still at 10% and ever growing deficits which will tax future generations.

Maybe when the current course of action totally fails, we can get Dear Prudence to come out and play.

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