Bonus Round

Who can keep up with all the four-letter acronyms emanating from the organs of state capitalism these days? Like a bad winter bug, if you work at a "TARP Bank," TARP’s revenge made the rounds today. The House, in a spasm of populist retribution, passed legislation and the Senate considered legislation to punitively tax bonuses awarded to financial workers whose firms accepted TARP funds, willingly or unwillingly, and well, is anyone surprised? m* is not.

TARP was dumb money, perpetual capital at 5% interest plus a puny passel of warrants, as part of a dubious plan, details to be worked out later, for purchasing bad “assets” from banks. In reality it was a $700bn blank check from the Government, gifted in haste to a group of important banks whether they needed it or not, (later expanded to consumer credit firms and automakers) by an unlikely trio of ministers enthralled with the Street and their own savior complexes.

The Street played its part in the con when US markets conveniently swooned upon TARP's initial rejection, then having appropriately scared Congress into reversing its weak objections, rallied upon its passage. A self important Congress breathed a huge sigh of relief for having saved the stock market, and embarked on a surreal and nauseating string of self-congratulatory speeches for the record to empty floors of both houses from legislators with only the vaguest notions of mark-to-market, CDS, or FAS 157, touting their part for the folks back home in saving the nation from collapse.

Granted, after their near death experiences, the management of certain of those lucky (unlucky?) institutions might have been expected to behave more discreetly with the fruits of the fleecing, a bit more congruent with the act of charity dis-enfranchised and increasingly unemployed taxpayers had visited on them. But this is Wall Street folks. Greed and fear are reliably available. Forbearance has always been in short supply. And besides, wasn’t the premise that these institutions (and their bankers) were too valuable to lose?

But where Wall Street went wrong was not in taking the money and running. It was in embarrassing Congress. Having blithely signed over a large portion of the Treasury on a bill they didn’t understand to an industry they can’t comprehend, now "those same folks" (as big O. would say), reacting to public outcry over what amount to personal bailouts for financial employees, are mad as hell that the blank check they wrote was not spent how they wanted and that they didn't know. Wall Street traded securities for cash. Congress traded cash for praise. Wall Street pocketed the cash. Congress, having found praise fleeting, now wants the cash back. Bonus round.

Tipping Point

It seems like only yesterday m* was receiving angst ridden calls and despairing messages from market participants of a certain disposition over the Fed's rate deliberations earlier this week. "I can't believe they are going to do this again!" many of them went - a lament all too familiar to readers with dollar savings and insufficient appetite for the likes of China H's, Google, and Gold, not to risk capital but to protect it!

When after four years of steady decline, the dollar plums new depths against third world scrip and plain old rocks and minerals every day for two months while the official story of benign inflation, strong dollar, and credit containment continues to go un-examined as long as something is moving higher somewhere, even m* is at risk of losing perspective on the proceedings.

Standing over the sink with a toothbrush yesterday, dazed perhaps by the carnage effected on the central store of value in the whole incredible system, m* mentally reviewed the long line of casualties who clung to their rational thought processes too long in the face of this paper bull and contemplated the unthinkable, capitulation.

Were it not for this astonishing and subversive little piece entitled "Inflation-Lessons From History" from Morgan Stanley's Joachim Fels, m* might still be there, brush in hand.

"Since the anchor of the gold standard has been lost, the price level has had only one direction: up. Deflation is virtually ruled out in our paper currency system, and risks to prices are almost entirely on the upside. This is because central banks have become very averse to deflation, and because they usually don't correct for upside one-off surprises for inflation."

Now that's hardly Fiat Money Inflation in France but for a sell-side monetary strategist (as well as a pretty good sport in the old Frankfurt office) it is pretty telling. It also is exactly what m* has been thinking to make sense of the current conditions. It's not just a profligate Fed. Or the inexorable forces of Globalization. Nor a sick Japan or even a scheming China. Though it is very much all of the above. The issue is greater than all of those. It is the matter of paper money.

Mr. Fels is of course too kind to Central Bankers (he knows quite a few) in presuming that they actually have a choice. In m*'s way of thinking, under fiat money, deflation is not merely "ruled out." It is simply impossible. Only inflation, or reflation are possible developments. Or, as m* heard from one wisened FX hand talking about Citigroup today, "Everyone is talking about the banks shrinking. Banks can not shrink. They can only get bigger!" The invisible hands of the system in an open economy with fiat money are too strong for any individual institution acting independently to resist. Unfettered credit creation and socialized monetization of that credit are inevitable. The idealized notion of a Central Bank soundly managing a money supply, resisting inflation and currency debasement is simply wrong.

Right on schedule The Big Picture this week went back to first principles:

"Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth."

--John Maynard Keynes
The Economic Consequences of the Peace, 1919. pp. 235-248.

What would he make of the AMT and 15% dividend and capital gains tax relative to ordinary income at 35% to 50% after state, local, social security and those non-tax taxes medicare, and medicaid?

m* has been off kilter for weeks wondering how long the disconnect between what was perceived and what was real could continue, (Keynes got that one too) - or how to suspend judgment long enough to participate with the crowd as the bear resignations flow in. The FT's John Dizard caved yesterday: "All Elements in Place for an Equity Bull Run." Alas it was not to be. And a good thing too.

The credit crunch is indeed back and it seems awfully hard to see how more cheap money is going to help (though of course it always helps). No the bigger issue is that the long run futility of efforts to reign in rising prices, to ignore the simple reality that the enormous economic orthodoxy is built to ignore, and the little understood but fundamentally important inflation expectations are on a collision course.

For those who have paid close attention, the tipping point for the housing bubble is well past. The tipping point for the credit bubble is recently past. The tipping point for the dollar collapse is an ongoing event. Today, markets got a glimmer of insight into what it all means. The containment story is slipping away. Faith in price stability is slipping away.

When the 99% of folks who expect and rely on a stable store of wealth as fair trade for their labors come to understand that they have been had, times will get very interesting indeed. m* thinks the scene this week signals that tipping point.

It's a new world.

Rolling Thunder

The funny thing about the times we live in, and the institutions that, ahem, serve "us" is that when a stock market turn-around like the one on Wednesday is put down to rumors of a surprise rate cut, it's accepted without the bat of an eyelid. Never mind the train cars full of traders having heard how Europe was trading that day heading to the city early to face an anticipated tidal wave of sell orders. Never mind the tenuous nature of current v-shaped earnings expectations with "back to normal for '08" (as if the last 12 quarters have been anything but normal) looking more and more, well, nuts really. Never mind the chart picture that has PPT conspiracy watchers in a lather.

What should be no surprise is that the housing bubble continues to unwind. What also should be no surprise is that every dip in the market with just a hint of panic (and that's most of them now - since valuation was tossed aside for the greater fools of private equity, followed by shots of rate cut tequila) will be met with calls for more cuts. Soon enough m* thinks, even the existence of the PPT and its "interventions" will simply become accepted as fact, so cynical and so desperate for a bail out has the Street become. Public calls for the necessity of interventions will soon follow.

m* remembers well that Japan actually had a PPT during the unwind of that great bubble which served no one but the politicians who could claim to be "doing something" while owners of real estate and equities saw nominal prices decline 75% over the 90's. There are scant reasons to expect different this time.

But the Rolling Thunder in the title of todays post refers to something even more ominous and was sparked by todays utter meltdown (with tree in the forest effect) of the fantasy that the credit crisis of July and August ended with a 50bp freebie from the Fed and new equity highs.

On the surface, today's rumors of sub-prime write downs at AIG, the further erosion in Merrill Lynch (also on rumors of further writedowns - yes even with yesterdays announced $8bn writedowns), and the long overdue implosions of the "cya" facilitators who previously insured municipal debt and more recently took their thoroughly dubious business model into the structured credit space, are just echoes of the summer's difficulties, nothing much to worry about now that the Fed is on our side and earnings from the global boom will most certainly hold up . Except that developments in the credit space are continuing to unravel. FT: Mortgage bond index declines 30%.

To those former CDO manufacturers and buyers now picketing Moodys and clamoring for more Fed assistance m* asks, if the insurer of your structured CDO deal is levered 100x, is that really insurance? Forget the rating agencies, insuring structured credit deals is (was?) the ultimate "cya" business.

What's important about this, coinciding with the failure of the delaying action formerly known as MLEC - the SIV PPT, is the realisation on the street that while Merrill took an $8bn writedown, it's very likely they, like everyone else, are still holding the stuff. Moreover, to the extent they did sell some, its more likely they sold what they could (the higher quality paper with perhaps some transparency) and are left with a portfolio even heavier (on a relative basis) in the toxic unsellable stuff than before.

The July-August asset backed market crisis was actually very orderly - the market simply closed. The panic was real, the paper markdowns painful, but there was relatively little selling. It was obvious to everyone that selling would only hurt one's own remaining positions more. It was better to wait it out if possible rather than force the issue with prices in a market with no buyers.

However that situation was always going to be temporary, hence the proposed master SIV as a vehicle to delay the day of reckoning indefinitely. That moratorium is now over. Over the last few days, m* has heard of several deals that would "never never" be unwound before maturity now being shut down, their assets liquidated. The lenders need the cash. Debt is finding its way back to banks balance sheets. Asset backed commercial paper is coming due. Not much of it will be re-extended and the forced selling that the market successfully avoided in July-August is quietly spreading.

Ricardo Revisited

After last week's bleeding heart post about the downside to our absolute acceptance of the concept of free trade, m* finally got around to opening up the October issue of The Atlantic, a magazine recently suffering from a summer-long bout of irrelevance, and worse - has anyone else had about enough of Robert D. Kaplan's context-free sycophantic martial worship?

However there were two very timely items directly connected with the free-trade (or not) discussion that m* heartily recommends. (A nominal subscription to read the articles is required). First up was a lively debate in the letters section on James Fallows' partly good, partly just bizarre, July/August essay on the terms of trade with China, "China Makes, the World Takes." Peter Navarro, author of the book "The Coming China Wars" counters Fallows' rosy piece by highlighting the darkside of the industrialization and globalization picture:

"China’s competitive advantage in world manufacturing markets is largely due to a web of illegal export subsidies, rampant counterfeiting and piracy, a grossly undervalued currency, and lax environmental and health and safety regulations. While they have benefited the American firms and other multinational companies that are offshoring to China, these mercantilist practices have put tens of millions of people out of work around the world—from the American Rust Belt to Mexican maquiladoras to the markets of Lesotho."

This may be a good place to also direct readers to an astonishing piece on the PIMCO website entitled "Renegade Economics: The Bretton Woods ll Fiction" where the authors take to task both the US and China for practicing "renegade economics" but in particular lay serious criticism on China for playing the competitive devaluation card (and getting away with it) for the better part of fifteen years. In their minds, much of the seeds of the current "savings glut/credit bubble" were sown in Chinese - as opposed to Japanese or US - monetary (and political) policy. Considering the relative importance of the China bid for the $700 billion of bonds in the Pimco portfolio, m* finds this an interesting position to advocate.

Back to the Atlantic, senior editor Clive Crook writes about the current backpedaling among prominent mainstream (well, orthodox anyway) economists on the benefits of free trade and that one true idea in all of economics, Ricardo's comparative advantage, in "Beyond Belief."

He writes, "For nearly 200 years, the principle of comparative advantage, and the ideas that flowed from it, divided the world into two camps: those with basic economic literacy; and the rest." Um, Clive? m* would like to mention that it's a pretty big world out there. He goes on to note that while challenges to the thesis on technical grounds have thus far been vanquished, notable members of the profession seem to have a problem reconciling it's conclusion with their own observation of the times.

How ironic, for that is essentially the problem with economics in a nutshell. The key that Crook misses in his glib recounting of contemporary research is not that theory is necessarily wrong, but that it often has little if anything to say about the "adjustment path" to being right. In other words, those economists whose shift is "both momentous and disturbing" are taking notice of an heretofore under-appreciated intermediate term, where the frictions of adjustment between equilibria occur. Since "in the long run we are all dead," this time-frame is therefore of importance to many people, likely even a few noted economists and senior editors.

For a serious exposition (with a humorous image) of "adjustment path" see Krugman's recent paper on the dollar and the potential for what he calls a "Wile E. Coyote moment."

Globalization's Red Skeptics

For the dollar-crash pundits, one of the key drivers of the doomsday scenario where the US is suddenly cut off from the torrent of foreign capital necessary to fund it's negative savings economy (and a trillion dollar war habit) is a rather nebulously specified "rise in protectionism."

As every student of orthodox economics is taught, and the public debate on trade has accepted as fait accompli since what feels like the Reagan era, the goodness of free trade is as pure a thing as there is to be explained in economics. As the story goes, the principle of comparative advantage enlarges the economic pie for everybody. Furthermore the reduction of frictions and barriers to trade are touchstones of a modern, efficient, and open society.

However, a lot of economics is about the frictions, the sand in the gears, of theoretical purity. Ronald Coase, one of m*'s favorite old time economists, won the Noble prize for examining some of those frictions, transaction costs to be specific, and theorizing that enterprises organize themselves into corporations in order to minimize those transaction costs.

When it comes to the sacred cow of free trade however, the frictions created by globalization - the very real and serious impact on the economic well being of ordinary people, are the inconvenient truths rarely discussed openly by serious members of the profession, with some exceptions. As long as the pie is expanding, it is impolitic to ask whether and for whom the pie is shifting as well. Inequality is not a subject economics handles well, and this ideal, utterly inimicable to the economic well being of the US middle class, has somehow become the law of the land in economic thought.

Yet a strong case can be made that for adherence to an economic ideal, the manufacturing base in the US and a sense of purpose and security for a large mid-section of the population has been sacrificed. No doubt a young Chinese factory worker's life in an industrial complex resembling a city is better in many respects than the deep rural poverty that would have preceded it. And m* can well appreciate the benefits of "everyday low prices" in poor rural sections of the US as well. But those kinds of benefits do absolutely nothing to create investment or better long run prospects for our people, and our democracy.

What is surprising to m* is how little complaint there has been from the manufacturing regions of the country, as one industry after another has been packed up and shipped off overseas. Distracted by fighting the war on terror, and fooled about their prospects by the (now departed) housing bubble, the US's losers in globalization have been mostly silent. Now they are waking up.

The extraordinary article on the WSJ's front page today, Republicans Grow Skeptical on Free Trade , signals a dramatic shift in opinion that brings the Red State voter in close alignment with many Blue State voters, and portends significant pressure on the unfettered free trade the owners of capital have enjoyed (with extraordinary sized profits as a share of GDP to show for it) while real wages for the average US worker have steadily declined. While pockets of dissatisfaction have surfaced before, a two to one margin of Republican voters now believe free trade is bad for the economy.

To be clear, m* is all for fair and open trade, and abhors tariffs, subsidies, and import quotas on principle. However, the system now in place, beginning with China's accession to the WTO in 2001, has been anything but fair and open. Heavily lobbied for by corporations seeking access to a vast and dirt-cheap labor pool as well as a billion person market, the accession allowing China to maintain a closed capital account and an inconvertible currency was a grave error of short-term profit seeking behavior. The 2001 agreement focused almost exclusively on microeconomic issues, market structures, and reducing trade controls, many of which, six years later, appear to have failed. Yet the macroeconomic "global imbalances" that have resulted from an unlevel monetary playing field, including massive trade deficits, distorted risk premiums, over-investment and consumption globally, and an explosion of debt in developed nations, will have serious consequences on US standards of living as the inevitable (and thoroughly underway) inflation and debasement of the dollar gather pace.

For the moralists' case, the Red's are coming around.

Conundrum, undone

Now that markets have had a few trading days to digest the Fed's surprisingly aggressive move on rates, (and dropped into bit of a lull actually), and readers have maybe wondered about “turning points” and “watershed moments” for one thing or another, m* thought it would be good to share the one observation that in m*’s view really deserves attention.

It is that the bond market has finally woken up to all the reasons why it is overpriced.

Experience during the "benign inflationary environment," of the Greenspan era, using the usual, mmm…, interesting price indices of course, was that lower rates on the front end actually supported bond purchases on the back end. So while rate cuts might lead to a steeper yield curve, they did not lead to higher long term rates.

At the same time, and more vexing to just about everyone, higher rates on the front end did not translate into higher bond yields on the long end either, leading to flattish yield curves in most major economies. Nor did dramatic fluctuations in fiscal position seem to have an influence as they once did.

It was as though the long end had become entirely divorced from actions at the short end, fiscal positions, trade deficits, and very strong economic growth globally, thus defying a whole set of accepted economic principles. This “conundrum” has become part of the global financial landscape as a number of happy circumstances in price measures and capital flows have conspired over the last decade to hold inflationary expectations (or just the expression of them in the bond market) in check.

Globalization meant that US price measures experienced downward pressure from Asian imports of manufactured goods and concurrent pressure on wages as more and more manufacturing jobs were transferred overseas. At the same time, a measurement quirk meant that a shift in preference for home ownership over renting left the housing component of inflation indices (owner imputed rent) practically unchanged while home prices, which are not a part of the government’s inflation calculation, inflated at double digit rates nationwide. (Say what you want about the real estate bubble, but an increased preference for ownership is a pretty rational response to an inflationary environment).

Globalization also meant that US debt markets benefited from the Circle whereby the Japanese and Chinese Central Banks (and more recently the Central Banks flush with petro-profits) recycle dollars received for exports back into US interest rate markets. Meanwhile long periods of easy policy by the Fed (and generous easing during financial downdrafts) also did their part to dampen risk on the long end and attract an epidemic of participation in the carry trade and an insatiable demand for yield instruments.

In short, the risk premium, (where long term lenders demand some additional yield for assuming inflation risk) was squeezed out of bond yields.

However, that appears to be no longer. And as long anticipated, (if you’ve known m* a while), it is weakness in the dollar that is finally changing the tone of the interest rate picture.

While the global imbalances crowd has long been focused on the possibility for an abrupt spike in rates due to a cessation of purchases of bonds by the Central Banks of the nation’s major Asian trading partners, the catalyst for such a change has never been clear. Trade frictions, political crisis, or in the longer term, a greater demand for capital at home have all been possible culprits.

However the potential for the weaker dollar, to this point reflecting shifting allocations by Central Bank reserve managers (and US retail investors!), to augment the inflation concerns already afoot globally is now reaching a serious level. Remember that prior to the summer credit crisis, both the Fed and the ECB postures were most concerned with inflation pressures, while currently the Bank of China is actively and utterly ineffectively engaged in a battle with domestic inflation of its own. Expect bonds and the dollar to trade together from here on out.

Musical Chairman

Like his old boss, former President William Clinton, former Fed Chairman Alan Greenspan knows his way around a tune, both men sharing a well known love for jazz and playing the saxophone. Lately the former Chairman has been demonstrating a related talent for which he is also known, picking up a new tune when the music changes.

With his new book out in the US on Monday (m* readers in NYC can see the Chairman at the Union Square Barnes & Noble at 7pm) and front page appearances in the FT and the WSJ over the weekend, Greenspan has adapted to the new reality of the global credit environment he personally did much to foster rather well.

Speaking to the FT, Greenspan admits the housing market was in a bubble and that home price declines are likely to surprise to the downside. He also compared the yield pickup of asset-backed structured securities over treasuries to cocaine and the current commercial paper crunch to the '80's savings and loan "disaster".

As the recently departed Chairman after nineteen years of the institution charged with overseeing the health of the nation's banking system, price stability, and the path of economic progress, m* naturally wonders when exactly the Chairman came around to these conclusions?

Greenspan makes an odd celebrity. There is his age, beyond easy figuring but well into the wise old man category, the easily caricatured egghead visage with small eyes appearing behind enormous glasses, and that monotone warbling of un-intelligible but clearly highly intelligent verbiage. And he is an economist after all.

Bubble vision pumped him up of course, even while they made fun of his pending appearances with superhero antics and pre-game-show style briefcase analysis. But Greenspan more than anyone contributed to their mutual success, promoting and sustaining a bull market state of mind and an equity culture that swept the globe during his tenure.

Chairman Greenspan held the scepter of power among economic seers across nearly two decades and three presidential administrations, with a Chance the gardener-like talent for evading criticism and responsibility, while cultivating a public acceptance of the mystery of his wisdom and that of his institution.

Greenspan has always been the court's jester, adapting his performance to stay in the graces of whichever court is currently in power, as when he abandoned the successful fiscal conservatism of the Clinton/Rubin era for the budget busting Bush tax breaks for the wealthy, or filed away "Gold and Economic Freedom" to later preside over a succession of asset bubbles fueled by too cheap money and lax oversight.

Greenspan drank the Kool-aid of the internet’s new paradigm for productivity, and flinched in the face of post bubble deleveraging, fearing a Japan-style deflationary spiral was at hand. He missed the rampant speculation and rash lending that was driving up housing prices at unsustainable rates, and encouraged home loan borrowers to gamble with short term adjustable rates (and sub-prime mortgages) shortly before the housing peak and an impending rate hike cycle.

Greenspan may have gotten some of the basic calls dead wrong, or simply been working from a different set of priorities than many of his critics assume. But one thing he's always gotten correct was the importance to the role of setting the tone and massaging expectations. Greenspan understood that the true power of the Fed and its Chairman is far less than commonly perceived, and that inflated perception enabled him to wield far more power than he might have without it. That is why he was called “the Maestro.”

However the unraveling of his decisions and their long term impact on savers and the purchasing power of the currency brings to mind another image from film, that of the powerful wizard revealed to be just a fallible man behind a curtain with a distortion microphone and a sputtering smoke machine, his omnipotence an illusion. But ever the showman, Greenspan manages to somehow stay in the public consciousness long enough to sell a few books for his publisher.

It must have been a light weekend on the fashion-news front as the WSJ’s Weekend Edition led with what was technically a Greenspan "book review," making sure to tell us they did not speak to the Chairman but rather, almost blog-like, “bought a copy at a bookstore in the New York area.” Perhaps the new owner at the Journal was not happy at paying the Chairman’s speaking fee. Over at Pearson however, where they’ll no doubt be waiting for the paperback, someone got him on the horn and the quotes are juicy.

No mood

Apart from CNBC (it's not called bubble vision for nothing), it's stock centric viewers, and Chuck Schumer of course, m* has been getting a definite impression that the tone out there is increasingly in favor of a bit more suffering for the markets focused crowd. Recent comments from Fed governors, economists, and assorted letters to the editor type are very much on the side of letting the markets reap what was sown at this point.

This matters to m* only insofar as it contributes to handicapping the outcome of next week's Fed meeting. It is possible that the room the Fed desperately wants to move in a way that is not seen as caving in to pressure from stock touts and innumerate congressmen may be opening, just.

m* is quite certain that for all the high-powered research and great minds at work supporting the edifice we call central banking, what we have right now resembles nothing so much as a poker game at this point, with continued confidence in the Fed as the arbiter of the nation's economic health and the health of the USD at stake.

Then again, the prior Fed had a lot to do with setting the stage for where we are now, such that there may be nothing much the current one can do about it except try to manage the decline. m* is in this camp and while a muddle through is a possibility, the risks are most surely to the downside, that the current slow erosion picks up speed with. In that vein, gold and yen are still performing.

The always educational Calculated Risk site has a thorough tutorial on mortgage "origination" and it's myriad tentacles, suckers, and gaping maws. Needless to say, cheap capital (thanks Al), and greed make for a very corrupting cocktail - that should come as no surprise, but the perverse collective of moving parts that quickly evolved to enable the entirety of the enterprise may both enlighten and shock those still clinging to the "safe as houses" illusion.

Additional food for thought, highlighted on Economists' View, is a report of a new study on emotion in politics. The understanding that voters are frequently making emotion based choices as opposed to "rational" ones (from an economist's standpoint anyway) is now making waves. Todays item says there is evidence for brain based differences in outlook between voters described as conservative or liberal. It is an easy leap to explain red versus blue and mid-section versus coasts. Born or bred is what m* wants to know.

Press run

Quant Jock:
For a personal look at one of the top quantitative traders and all-around renaissance man, see the WSJ lede today. Three point five billion dollars later, it is clear m* was seduced by the wrong crowd at Morgan Stanley in 1992.

Seattle Slumber:
For m*'s readers in the Pacific Northwest, a WSJ article on the travails at WaMu. Despite benefiting from one of the strongest regional growth economies, WaMu's lax lending standards are coming home to roost as the real estate bubble fades.

One and Done:
Bloomberg's notorious Fed watcher says what's been on m*'s mind too.

Soft Touch:
Raghuram Rajan makes his contribution in the FT to the Central Bank debate and comes across as the most reasonable man in the room thus far, thereby ensuring that probably no one will remember any of it come Monday.

Thats How Much:
How much liquidity do the ECB and the Fed need to give the banking system right now? How about 1 trillion for abcp and 300 billion for deal commitments. The FT's Lex column gives the brief overview that puts it all in perspective. (It's big, really big). No surprise then that banks raised $53bn through the debt markets last month, a record level for the month of August.

Contained mayhem

Enjoying an early hint of fall weather here at m* gardens, the players are returning to the field for what ought to be an action packed second half. The first teams are back from the break and at full strength. Managers are pacing expectantly, latest playbooks in hand, rushed scouting videos fresh in their minds, the stage is set for ... what exactly?

Sure spreads on junk and (structured junk) are high, and loans to float them hard to come buy. But equities are back to pre-panic levels, high quality cp and debt is being sold in torrents, the dollar is still alive and kicking, and what? Still no rate cut? Hedge funds, real money buyers, and Buffet are lining up to buy the wreckage, and still waiting. What happened to the crisis?

Stephen Roach, apparently at the mercy of the Morgan Stanley mail pouch out there in Asia, rails against events today that seem months old to m* by now. And that was precisely the point behind Roach's promotion one half suspects. It's good to see him though on Bloomberg TV, fighting mad over Central Banks' "antiquated approach to monetary policy" (inflation targeting - antiquated?) that creates serial bubbles and "asset dependent real economies," "vulnerable to systemic risk" worldwide. Don't ever change Steve.

Like SR's bearishness, something else that never seems to change (they are connected no?) is the equity market's bullishness. Financial sector got you down bub? Worried over "book" value with all those rating dependent structured debt products and LBO commitments weighing on your balance sheets? Well look on the bright side bub. Global growth and decoupling will drive technology, industrials, and energy on to new highs, taking the market along with them. Or so the street mavens in the latest Barrons poll would have you believe. Throw in a rate cut or two plus the surge in foreign buying and a liquidity driven Q3 rally may not be as crazy as it sounds if it's not too late to even talk about it? Beyond the rebound, the path of least resistance seems to be higher still.

But what about all that recession talk, and the justification for those anticipated rate cuts? And what does that do to earnings forecasts? Isn't there a disconnect someplace? m* is going to go out on a limb here and say yes, but also maybe not, just not the way those mavens are thinking about it. First of all, recession probabilities aside for the moment, consider this chart from the excellent Gerard Minack of Morgan Stanley Australia, (he's obviously not dependent on the mail pouch). Here he presents real S&P earnings versus trend since 1980.



There is no question that earnings growth has been extraordinary during this period of rapid globalization but the peak-ness of those earnings (unless one believes that jazz from Lombard) is hard to ignore when presented in this fashion. Just once m* would like to hear, when bull-of-the-hour says equities are cheap on a p/e basis, if he/she is willing to buy the continuation of this deviation from trend. No really, it is different this time...

When one considers the extraordinary expansions over this period in credit (used to generate sales but also to re-purchase stock), and margins, reduction in corporate taxes, and the extraordinarily low reserves for bad debts (in the case of the not inconsiderable bank sector), it seems likely that corporate profits overall have benefited from an incredibly propitious period that, if recessionary fears are correct and tighter credit conditions are a fact, is now over.

The maybe not part? Inflation. How much faith does m* have in the CPI as an even approximate nominal price deflator? Not much. Deflated with a more real world price index, (oil, gold, renminbi, UK CPI?) those earnings may actually be much closer to trend than they appear.

But to m*'s thinking, earnings are only a part of the story. Purchasing power is the real issue. In a continuing environment of stealth inflation (or dollar devaluation if you prefer) US equities nominal earnings growth, dividend growth really, (of almost any rate) is a safety trade.

And as a foreign investor, keen to avoid overpriced US government debt in a deflating currency, purchasing equities of US companies producing things the rest of the world continues to show interest in buying makes a great deal of sense, slowdown or not. One can debate the relative skill (or lack thereof) of foreign investors' timing for sure, but the new players on the field - or soon to be anyway - have a timeframe measured in decades rather than quarters. Growth at a reasonable price can take a back seat to just maintaining purchasing power.

Think of it as the next stage in the vendor financing cycle, repossession.

Cheerios rising

This caught m*'s attention.

Wheat hits record price as bad weather prompts inflation fears

By Javier Blas, Commodities Correspondent

Published: August 24 2007 03:00 | Last updated: August 24 2007 03:00

Wheat prices jumped to an all-time high yesterday as panicked buyers rushed into the market amid extremely tight supplies, raising fears of a global food inflation spike.

Canada, the world's second-largest wheat exporter, warned output might be almost 20 per cent below last year as adverse weather damaged the crop as it had done in Europe and Australia.

Japan and Taiwan, which depend on foreign wheat supplies, bought new cargoes in the international market while India launched a large tender to boost its inventories ahead of its peak demand season.

Gavin Maguire, analyst at Iowa Grain in Chicago, said the combination of disappointing production levels and strong demand was pushing up prices. "Wheat buyers are beginning to panic."

In Chicago, wheat for December delivery surged to an all-time high of $7.54 a bushel. Prices have jumped 110 per cent in the past 12 months and have risen threefold since 2000.

Food industry executives warned that meat, poultry and dairy prices would climb in the short term as farmers and processors passed on higher feed costs to consumers.

Alex Waugh, director-general of the UK Flour Milling Association, said the cost of wheat was at an unprecedented level: "Wheat costs for flour millers in the UK now stand some £500m higher than last year. This has yet to come through in wholesale or consumer prices."

The International Grains Council cut its estimate for the 2007-08 wheat crop to 607m tonnes while forecasting demand would reach 614m tonnes, resulting in a further stock drawdown. It said global wheat inventories were at their lowest since 1979.

James Gutman, of Goldman Sachs in London, said: "Buyers are scraping the bottom of the bushel of the inventories."

Additional reporting by Chris Flood in London

Copyright The Financial Times Limited 2007

Quant factor

After a bit of shadenfruede shared with a colleague and occasional quant manager earlier this week, m* finally got around to reading the investor letters of several quant funds, as neatly collected and summarized in numerous articles of late. Collectively, they sound like no one so much as the homebuilder ceo’s, blaming other companies for building too many homes and saying things will improve just as soon as the other guy leaves the business. m* thinks these guys are missing a factor or two.

Their strategy, also called statistical arbitrage, exploits various market inefficiencies well known in academic circles. Returns to small size, value, the January effect, momentum, and mean reversion form the theoretical basis for these strategies. However it was only with the onset of electronic trading systems and large commercial databases of regressions of stock returns on various risk factors that these strategies could be implemented on an efficient scale. The low cost of electronic trading made possible vast numbers of transactions, most earning mere pennies or fractions of pennies. The risk factor regressions made it possible to create long-short portfolios positioned to exploit the inefficiencies while remaining statistically neutral to a myriad of macroeconomic, industry, and company characteristic factors. The product has expanded into global equity markets and even into markets for currencies and interest rates.

Pre-2002 let’s say, before the serious explosion in hedge fund assets, and the no-volatility-four-year-without-so-much-as-one-10%-pullback-bull-market (have you been feeling very smart in your investing until recently?), quant funds were on the whole rather small, an under the radar presence, and far from being dominant participants in equity markets relative to large mutual funds and institutional investors. However they were very successful at generating consistent returns and this, along with the intrigue stemming from the intense secrecy that shrouded their intellectual property, made them must-have investments for asset allocators.

Of course success breeds imitators and with the basic principles in the public domain, there was little to stop two guys in a garage from programming up their own systems, proving it in backtesting, and raising investor capital, often from an existing hedge fund eager to expand into the space. Moreover, as the original operations matured, more and more employees with the requisite knowledge left to start their own firms which also found ready investors. The amount of capital employed in quant strategies mushroomed from a few billion to likely in excess of $100bn in equity capital today, levered 3x to 6x, and with their high frequency transactions magnifying their influence, a daily volume estimated to be more than half the overall equity market.

The natural question to ask of course is how much alpha is available to these strategies? At what point do they go from exploiting the over trading noise of other traders in the market to being the market themselves?

The answer, the quants would say, is in the results. When the strategy stops working, then you will know the point has been reached. Except of course, if you fail to account for the influence of your collective behavior on your results, you may not appreciate having reached that point until you are in fact well beyond it.

That is exactly what happened. When you have the CFO of Goldman Sachs talking about multiple 25 standard-deviation events and hedgefund managers publicly dissecting their daily performance data like FAA crash investigators while saying things like “a perfect storm of negative events” m* is pretty certain they lack (publicly anyway) an understanding of the true distributions or their true risk, not to mention any semblance of personal accountability or embarrassment.

They seem to have mistaken the collective reinforcing effect of their own behavior on the trend for continued success of the strategy. Over time, as capital flowed in the funds poured more money into the same long and short value strategies while actively dampening volatility with the mean reversion strategies, in effect self-validating their models from the past even while the real situation had changed.

In short this most sophisticated group of investors became just another group of levered momentum traders, creating their own temporary low volatility trend. Their alpha capture became beta follow, and they were none the wiser until the infinitely creative market disrupted their somnolence with levered losses that appeared in a flash accompanied by the insight “Oh, we’re trend followers and we’re short vol!”

Except of course that not one of the letters from these managers mentions that insight, nor any explanation that demonstrates an understanding and acceptance of the true nature of the fund's risk. m* finds this amusing because in all the writhing gymnastics blaming the other guy, the market, the universe, or those darn frustrating statistics, (anything to avoid taking responsibility), a simple declarative “Yes, well, the strategy is inherently short volatility, a bit of a trend formed, and these event do occur from time to time,” would be the most exculpatory and truthful explanation.

What now for these funds and the prognosis for the strategy? Beyond this week’s easily foreseeable rebound (as they lever up again and GS puts $3bn more to work on the small cap buy list) a double whammy of diminished single digit returns and higher returns volatility is in store. How so? Lower leverage. The true alpha here is vanishingly small hence the intense focus on transaction cost and the need for considerable leverage to earn returns. Higher exogenous volatility in the marketplace, from the turmoil in credit for example, necessitates running lower leverage. In addition, as the mean reversion strategies were essentially providing liquidity to the market, acting as market makers in effect, a reduction of leverage there will lead to still higher volatility. Finally, the recent sharp losses are the clearest and loudest signal possible to investors that the strategies may not work as expected from here on out. Expect inflows and self reinforcing trends to diminish and volatility of returns to increase accordingly.

The missing quant factor is an awareness of themselves.

Quotable

Does anyone read the mutual fund stories in the WSJ? Of course not. You are too busy running to yet another story about some egomaniacal activist hedgefund manager acquiring exactly 1.042% of some ridiculous foreign company probably run by foreign gangsters that makes some hot sauce the gangsters like in that foreign country, whatever country that might be. Nonetheless, the most recent "what are they buying now, those who pretty much only buy?" report contained some real gems for the Quotable Manager Prizes. Consider this a snack before the heavy stuff.

"A lot of investors have been wanting safety -- call it the flight to quality or liquidity -- but when you can go counter to that, you have opportunities," says Edward Perks, manager of the $60 billion Franklin Income Fund. "Investment-grade mortgages have gotten sucked down with sub-prime," he says. "We think the market is treating it in too broad a brush."

$60 billion under management needs a new investment phrasebook, hopefully in time for that call from GM at the NYT.

The week that was

Of course the week has one day to go. And actually it has been a lot longer than a week for many participants, since the walls of "containment" proved somewhat more porous than officialdom cares to admit. But today had that definite "end of the beginning" vibe to it that leads m* to believe we can call this week in the bag now. m*'s mailbox is suddenly full of old colleagues clamoring to commiserate, and research galore from the bevy of moralists, perma-bears, and anti-carry-trade misanthropes, for whom there is always a warm place in m*'s heart. When m* is tapped to help run the new world financial system they will all be invited over for self-congratulatory tea and biscuits. However, while m* wholly believes (and fears) they will all be right if not rich, in the long run, in the short run, as with global warming, there is a large difference between one's circle of concern and one's circle of influence.

In that more immediate short run, long yen and long bonds, as mentioned here nearly three weeks ago, have been more than safe haven in a crisis while gold has been the deadweight m* expected and will likely continue to be until levered owners are thoroughly out or rate cuts take place. For all the commotion in US equities, with the VIX breezing through 25 like a bird in flight (volatility theme song ) the SP500 is off 10% to 1400, probably right about where a natural pull back ought to be. So automatic did that level seem that having spent the entire morning in meetings, m* was more than a bit puzzled to hear that stocks were down another 2%, and missed a golden opportunity to put some pieces in the pot on the way to yet more meetings.

It is probably a sign of the "baby with the bathwater" times that an analyst's sideways mention of Countrywide's possible bankruptcy (and of course that was always possible - why is the nation's "premier" home mortgage "lender", um, marketer, totally dependent on short term wholesale financing? Because if it were not, it would be a real lender, ie: a highly regulated high cost low p/e bank - that's why) was the main news of the day. What m* found amusing was that the analyst behind the report had a buy rating on the company only two days prior. From buy to using the word "bankruptcy" in two days is quite a switch. One can only imagine the kind of discussion that went on internally at ML (and how many lawyers were involved) to initially prop up and then expediently jettison their banking relationship with Countrywide. But then this is the same firm that rushed to seize collateral (and then on reflection, not) from those now kaput Bear sub-prime funds. How to explain? Then again, that's an awfully cheeky way of smashing bids for the collateral and the business if you plan buy it up later. Nonetheless, if even big slow-thinking Merrill can turn on you when you need them, it simply begs the question what arguments against arranging more permanent capital CFC's owner-manager with 30+ years of experience believed in.