Economaton

Automakers Seek $34bn Bailout: the Free Market at Work

2008-12-03T16:19:36Z

They formally requested $34,000,000,000 from the government yesterday. I don’t recall that they ever offered to share their excess profits with the government during their boom years. Privatized profits, socialized losses.

The free market is punishing them for lack of innovation. Not a single fundamental change in the design of the car has come out of Detroit in 50 or 60 years. (Superficial changes such as adding or removing fins or sticking a Land Rover-esque shell onto a 2 wheel drive sedan and calling it an “SUV” do not count as innovations.) Fuel injection and anti-lock brakes (ABS stands for “Antiblockiersystem” in German) came from Mercedes-Benz. Efficient cars that get good gas mileage and hybrids came from Japan. My 1991 Honda Civic got 33 mpg in the city. Now, I’m seeing 2008 model year Ford commercials where they talk about getting 21 mpg like it’s some sort of huge accomplishment.

Detroit has largely lagged behind in engineering, always playing catchup, taking profits rather than reinvesting in innovative engineering. This has only been possible because of massive protectionism that shielded these companies from the free market. But even that couldn’t protect them forever. This is corporate welfare on a grand scale. And nobody complained about the cruel vagaries of the free market when they were taking out and assimilating Hudson, Cadillac, Lincoln, Oldsmobile, etc. How many of those old American carmakers could have survived the Big 3 onslaught with a few billion dollars’ worth of credit from the government?

If we are to bail out banks, airlines, and carmakers with tax money to shield them from their own unwise economic decisions, then we must drop this pretense of having a “free market” in the United States and come up with a new ideology that explains it. Continuing to call this system “market capitalism” is hypocrisy at best. Adam Smith must be spinning in his grave right now.

Deflation Fears Overblown

2008-11-30T05:27:09Z

Deflation is everywhere in the news now. This seems to be on analogy to Japan. Treasury bond yields are at their lowest since 1981, attributed to deflation fears. Yet the Fed is spraying cash with a firehose at the banks, and they’re sitting on it, afraid of whatever bogeymen lurk behind counterparty risk and illiquid worthless paper. Stockpiling cash is the order of the day.

But deflation is very unlikely with Helicopter Ben at the helm. We are, essentially, printing money 24/7 to inflate our way out of this crisis. It’s just temporarily being stockpiled because of short-term fears over where the next bank failure will be. Once we go a few months with no more blowups, lenders will relax and credit flows return to normal levels, we will have the opposite problem once again as they disgorge their huge cash reserves onto the market, and all those Treasury buyers sell out to get back into equities, which are already perceived as historically extremely cheap. When the credit is there to grease real-economy operations once more, investors won’t be able to resist.

So… what then …. short Treasuries.

WaMu Fails; McCain calls for LESS regulation. WTF?!

2008-09-26T05:53:22Z

Washington Mutual just failed, upping the ante. The Republican plan is unbelievable. They call for EVEN LESS regulation of financial markets?! According to the WSJ, McCain is responsible. Evidently, he’s trying to fire up his conservative base.

This stuns me. To think that that base does not see some connection between 10 years of financial deregulation and the current crisis? Moreover, they expect that nobody else does, either?

The rest of the plan is vague and equally absurd. It seems calculated to appeal in some abstract sense to armchair libertarians come next election cycle, rather than solve anything today. Some highlights:

“Limit Federal Exposure for High Risk Loans: Mandate that the GSEs no longer securitize any unsound mortgages.” Err.. Immediately? Long-term, this is a great idea, but pulling the backstop out right now would make the credit freeze worse.
“Require participating firms to disclose to Treasury the value of their mortgage assets on their books, the value of any private bids within the last year for such assets, and their last audit report.” This is rather vague. If these disclosures are public, it would only induce bank runs.
“Create a blue ribbon panel with representatives of Treasury, SEC, and the Fed to make recommendations.” This is their plan? Refer it to a committee? I think we are long past that stage.

More political posturing. The House Republicans evidently fail to grasp the gravity of the situation, or they would be getting something done rather than preening for their political bases. Paulson and Bernanke know what the stakes are, and it appears that the Bush administration is listening: the House Republicans were not invited back to the White House for tomorrow’s contiuation of negotiations.

Six Steps to End the Crisis

2008-09-26T05:39:49Z

The government bailout for private investment firms amounts to a blank check written by the taxpayers to cover their disastrous years-long orgy in Vegas. I came up with some points that I hope could both mitigate the present circumstances and avoid similar future situations.

I can only hope some legislators will read them and appropriate them as their own.

Ban OTC Derivatives. Ban them altogether. People may still trade any derivatives they like, but they must be publicly specified, exchange-listed (i.e. also available to the public at large to trade), and cleared by a well-regulated third party. This ensures transparent accounting and allows regulatory authorities to require reasonable margins. There will be no surprises in the future from masses of unmarkable derivatives hidden in banks’ books.

Sliding Scale Margin Requirements. Futures contracts and derivatives in general should operate on sliding scale margins. That is, the amount of margin required should increase with overall position size. (Exceptions might be made for legitimate hedgers of physical commodities.) This would allow reasonable quantities of contracts to circulate freely with minimal margin, permitting price discovery, while making it prohibitively expensive to over-lever. Combined with the ban on OTC derivatives, this will act as a brake on excessive speculation in both commodities and financial instruments.
Hard jail time for bailout executives and market manipulators. If a company requires a bailout and it can be demonstrated that executives believed they were “too big to fail” and took actions based upon an explicit or implicit assumption of a government bailout guarantee, then they should be sent to prison for stealing from the government (and potentially treason and many other creative charges.) Not six months in a minimum security country club jail with tennis courts, but years of hard time. This should be easy to demonstrate with full access to the failed institutions’ records; the situation could not possibly have grown so dire were the executives not relying upon some implicit assumption of a federal bailout in the event of their failure.

Likewise for anyone found to be manipulating markets, such as organizing a concerted shorting of financial shares. As AIG and Merrill and Bear failed, every TV in America should have been broadcasting live feeds of FBI agents in body armor driving tanks through the front doors of the Greenwich hedge fund managers who organized their downfall. This will deter future manipulation much better than any new set of regulations.
Do not remingle commercial and investment banking. This is touted as a way to shore up the capital base of the two remaining investment banks by allowing them to accept relatively stable deposits, and a way to place them under more stringent federal regulation. More regulation is indeed good and required; but this is actually a permanent guarantee that the Feds will always be required to step in and provide capital in case they come near failure again through heretofore unknown dubious investment schemes.
Have the Fed deal in commercial paper to buy time. Do not merely offer them loans from the discount window, require them all to accept loans and also require them to re-lend them. They can use broker-dealers if they must, which must be forced to provide credit to the open commercial money market rather than sit on their Fed loans or only loan interbank. This will ensure that the “real” economy still has access to credit in spite of general mistrust in the financial sphere.

Thus, they buy the time needed to dig through the banks’ books — all banks’ books — and determine exactly who is exposed to what. (A good deal of it must cancel out.) Once exposure is known and there are no more surprises, the credit market will unfreeze naturally and further government dealing will not be required. Announce that any efforts to hide things from regulators will be met with criminal charges and hard prison time, and furthermore that any hidden assets will not be eligible for any future bailout.
After that, nationalize firms that cannot carry their debt. There should be no blank check written by the taxpayers to any private institution. At the same time, it is true that certain institutions cannot be allowed to fail without triggering a depression. Therefore, they must be nationalized. Rather than assuming only their debts, the government should also seize their assets. The share- and bondholders of these companies should get absolutely nothing if they require a bailout of any kind. Some of their executives and employees should be jailed as per above.

If you think this is reasonable, please circulate it. It must filter upwards fast before they finalize the “blank check plan”.

Brett Arends’ Call for Food Hoarding

2008-04-24T23:51:18Z

Brett Arends published an incomprehensibly crass article in today’s Wall Street Journal calling on Americans to hoard food. Not because he expects a shortage, but because “food prices are already rising here much faster than the returns you are likely to get from keeping your money in a bank or money-market fund.”

This is exactly the sort of unconscionable speculative greed that turns a bad but temporary situation into an all-out crisis and famine.

I’m not against making money; I’m against starving other people to make money. Arends has the privilege and the luxury to direct millions of investors from his perch at the Journal, and with such a position comes a great responsibility. His words move markets, and he does not appear to appreciate the magnitude of what he is doing. He is telling his readers from his comfortable environs that some faraway people in poor countries are starving, and they can make a few bucks by making it worse for them.

We are experiencing record high prices for all manner of foodstuffs. Riots are erupting around the world (not that one would know this by following mainstream US news sources.) And Arends’ advice is to exacerbate the situation by hoarding — and not even to ensure that his readers can provide for their families, but because food will appreciate 2% faster than a money market fund. He is brazenly and openly calling for food profiteering and price gouging.

This level of cynical greed is shocking, even by the raw capitalist standards of the Wall Street Journal.

The Food Crisis Is The Energy Crisis

2008-04-23T23:06:53Z

The Economist’s treatment of the food crisis, “the silent tsunami”, is as riddled with self-serving contradictions and convenient omissions as one would expect; and sadly, it is by far the most reasonable and balanced analysis to appear in the mainstream media. They cover the symptoms, but in uncharacteristic style stop digging before they reach the true root cause, our failed energy and “free trade” policies, predicated on massive petroleum imports and ongoing sacrifice at the altar of the multinational corporation. The food crisis is but a symptom of the larger disease: corporate profits now dictate social policy. We need to realign our energy policy away from merely serving the interests of large energy corporations and shift to government subsidized nuclear power, to provide cheap and clean energy for all.

In one breath, the ever-anonymous Economist author advocates emergency funding of $700 million to the United Nations’ World Food Program (and rightly so) to ease the food crisis. He also proposes that the WFP expand aggressively into nontraditional activities: beyond simply distributing food to famine victims, the WFP ought to be “supporting (and sometimes inventing) social-protection programmes and food-for-work schemes for the poor” that will cost “tens of billions of dollars”.¹ Two paragraphs down, he then writes “In general, governments ought to liberalise markets, not intervene in them further. Food is riddled with state intervention at every turn…” It appears that two different articles were unwittingly pasted together. One wonders how the editors’ and proofreaders’ heads did not explode from the cognitive dissonance.

Setting aside, for the moment, The Economist’s lack of a coherent proposal for a way out of the current crisis (we should spend “tens of billions of dollars” on new programs to stabilize world food markets, and at the same time “not intervene in them further”?), their analysis of the causes spends only about one sentence mentioning, in passing, the most direct causative culprit of the crisis: ethanol, and first world government subsidies thereto, in the midst of a characteristic neoliberal tirade on how big bad governments fiddling with the beauteous magic of market mechanisms is the source of all evil in the world.

The misguided idea that the developed world ought to free itself from dependence on foreign oil by manufacturing fuel domestically from plants, converting vast swathes of farmland into gasoline rather than food, was the Bush administration’s token renewable energy project, at the same time a grudging admission that hey, climate change might be real after all, a nod to nationalists who are grumbling about our ever growing dependence on foreign oil, and a windfall subsidy for large agribusiness interests who grow the crops and the oil companies who refine them. Worldwide food prices spiking to their highest levels in recorded history was an unforeseen side effect. It is hardly surprising that they do not go into much detail here, as The Economist’s interests and views are generally aligned with the Republicans who proposed the plan and the large corporations who benefit. Another story in the current edition mentions ethanol in passing, once. The cover story of this week’s edition deals with the food crisis, and we have about two sentences in the whole issue mentioning “ethanol”.

The magazine has offered² noncommittal³ lukewarm⁴ indifferent support⁵ to ethanol⁶ in the past. They affect a progressive social and environmental posture when possible but still generally seem to function as the mouthpiece for conservative politicians and large multinational oil companies in terms of geopolitics and energy policy — they must tread a thin line on the topic of alternative fuels. Indeed, in most issues it seems like half the display ads are paid for by Exxon and Chevron and Shell, used to tout their questionable green credentials to The Economist’s international A-list audience. The ethanol proposal seemed to have something for everyone, but it was too early to say for sure. To their credit they did belatedly agree that perhaps turning all our food into fuel isn’t such a great idea⁷ a year ago, long after the writing was on the wall. They are undoubtedly now glad that they didn’t put their weight fully behind the ethanol plan earlier.

Open Markets: From Demon to Saint

Globalization and “free trade”, the broader underlier of the present crisis, is also transformed in a masterful stroke of Karl Rove-Joseph Goebbels style propaganda from the biggest weakness of their position into a purported strength. Shortsighted and self-serving trade policies contributed in no small part to the present situation. They are anything but “free”; the only freedom is for large corporations in the US and Europe to grossly damage their own national economies bys shutting down local production when possible to exploit faraway third world workers in places without pesky first world laws regarding acceptable standards for treatment of labor and the environment. For decades, successive Presidential administrations in the US have publicly touted the benefits of unfettered “free trade” while at the same time strengthening massive protectionist subsidies for domestic agriculture run by politically powerful agribusiness.

That extends to ethanol, as well: cheap and efficient sugar ethanol from Brazil⁸ and other tropical countries is excluded by tariffs from the American market to subsidize local inefficient corn-based production. Our voracious demand for energy at any price has been been fused to hypocritical agribusiness protectionism and our very food supply on a large scale, with unforeseen and disastrous results.

This places The Economist, perennial champion of both the environment and unfettered trade (except when either would be financially undesirable to powerful business interests), in a sticky situation, and explains the utter lack of castigation for such policies in the current issue on the food crisis. Calling for serious change from the status quo now during a crisis might actually produce results that harm The Economist’s high end advertisers and political patrons. They thus focus on Band-Aid symptomatic solutions to the food crisis, while turning the fundamental causes around to incredulously propose that the present crisis erupted simply because large multinational corporations have not been allowed to do whatever they please in the world’s agriculture markets.

The Solution: Solving Energy Solves Food.

The solution to the food crisis rests on a fundamental and sweeping philosophical reanalysis of the goals of our society. Do we exist as a wealth engine for large corporations, indifferent to all but their balance sheets, or do we exist to create a better future for ourselves, our children, and the generations to come? Raw, unfettered capitalism is a remarkably efficient economic engine precisely because it is utterly amoral and cares only about the production of value and wealth. This has indeed served well for many years, creating unprecedented levels of technological and economic growth, but we have now passed the stage where this unfettered capitalism has diverged from our own best interests. Continuing to shortsightedly cling to unqualified free market liberalism at this stage will prove our undoing.

Our modern economy requires an unfathomably large input of energy in whatever form every single day to function on the level to which we have grown accustomed over the past hundred years. To even hold steady at the present level, much less continue this astronomical rate of growth, we need, above all, a long-term sustainable energy policy that provides vast quantities of energy stably, cleanly, and cheaply. It cannot depend on burning fossil fuels, to avoid baking ourselves with greenhouse gases. It cannot depend on the goodwill of any foreign government, to avoid becoming entangled in endless wars and morally corrupting geopolitical machinations. And it cannot divert our food supply into our cars, which has the obvious effect of making food very expensive and causing massive social unrest.

The large corporations that presently serve our energy needs are making more money every year than most small countries do. They are obviously loath to make any modifications to the present system which effectively prints money for them 24 hours a day. Yet we must force them to do so or we shall all suffer; the very survival of our society is at stake here. If they are willing to adapt themselves with us and help us, all the better; but they must accept that their years of fat are past.

Nuclear Power

The grand irony is that the energy question was solved in every respect but one 60 years ago. Nuclear energy “too cheap to meter” can produce more energy than we can possibly use. But that is precisely why it has not, so far, been adopted as our main energy source: there is no profit to be made in it. Oil, on the other hand, is a goldmine. Here we see where the profit motive and the overall benefit to society have grossly diverged.

Nuclear plants have a large upfront capital requirement and then run almost for free thereafter. There is just not much profit to be made in providing limitless free energy, so not many private corporations will invest money in their construction when they can get a far better return on their capital elsewhere. Governments have, by and large, not lined up to pour money into nuclear plant construction because the political will to convert our nation to nuclear power was sapped long ago by deep-pocketed oil interests looking to protect their cash cow — two oilmen are even today in the White House.

Environmental concerns are a curious objection to nuclear power. Since when do environmentalists substantially affect public policy, particularly before the present? Environmentalism has only very recently entered the public discourse in the United States as a serious concern, and even today it is still more lip service than anything else. Certainly 50 years ago, few policymakers cared about environmental impacts. It is only on the rare occasions when their arguments coincide with large corporate interests, as in the case of nuclear power, that anyone pays the environmentalists the slightest bit of notice.

This is not to say that there are no real environmental concerns with nuclear energy, of course, but these are eminently more addressable than the myriad environmental problems resulting from burning imported hydrocarbons all day and night and dumping the exhaust into the air. We can run nuclear fission reactors today, generally considered safe and nonpolluting, with an infintesimal risk of a nuclear meltdown — which could be offset by simply building them deep underground in remote areas. Spent radioactive fuel can be reprocessed into more fuel. If half of the $513,000,000,000 or so that has to date been spent on the oil war in Iraq had been spent instead on research into how to cleanly dispose of nuclear fission waste, the problem would have long since been solved.

Nuclear Fusion

Still more compelling is the case for nuclear fusion research. Nuclear fusion produces no toxic waste and has no chance of a catastrophic meltdown, but it is amazingly hard to get right. The German government estimates that €60-80 billion is required over 50 years to produce a viable fusion reactor. The Iraq war has cost well over six times that amount, at a conservative estimate. If, instead of spending €80 billion over 50 years on fusion research, we spent $100 billion every signle year, we could have the problem solved in perhaps 15 or 20 years.

Further, any commitment by the United States government to spend $100 billion a year on fusion research would undoubtedly be met by similar commitments from Europe, Russia, and China; how long would nuclear fusion take if all the major powers of the world were collectively pouring $400 billion a year into research?

Energy is the key. Energy is the solution to the food problem, to globalization, and to continued American preeminence in the world, and energy (more specifically, expensive ads bought regularly by oil companies) is the reason The Economist is shying away from tackling the roots of the food crisis, and the reason why The Economist tows the globalization and free trade line so diligently.

If we invest in clean nuclear energy generation, big oil companies will lose their cash cow, but we as a society will be far better positioned to continue expanding our own economy, to remain at the top of an expanding and peaceful world economy, to avert environmental disaster, to take the wind out of terrorism by stemming the tide of petrodollars flowing to the Middle East, and to obviate the need for painful, expensive and reputation-sullying wars of conquest to control oil resources. The solution is already there for anyone who wishes to take it. I hope we can do so before it’s too late.

“The silent tsunami”, The Economist, April 19th-25th, 2008, p. 13 ↩
“Woodstock Revisited”, Mar 8th, 2007 ↩
“Investing in clean energy”, Nov 16th, 2006 ↩
“Ethanol: Even in Texas”, Jan 4th, 2007 ↩
Biofuels: Stirrings in the corn fields, May 12th, 2005 ↩
“Ethanol: Life after subsidies”, Feb 9th, 2006, etc. etc. etc ↩
“Ethanol: Castro was right”, Apr 4th, 2007 ↩
“Castro was Right”. ↩

Financials Frying

2008-04-15T18:50:49Z

Financial pain is lasting longer than I thought. I’m reducing my bets. I sold Merrill Lynch and Lehman and MBI and Citibank today, and I’m buying more IYT - an ETF tracking the Dow Jones Transportation average. IYT has been stunningly resilient lately in the face of high oil prices and a stagnating economy.

I also took a bet on AAPL to drop via a long put. Check out the chart. There’s a resistance zone at roughly 160, marked by the brief consolidation before January’s MacWorld selloff, by the Nov ‘07 bottom, and less strongly by the Oct ‘07 bottom / consolidation zone. Last week, AAPL bounced off of that resistance and made a nearly perfect shooting star formation on good volume at resistance. We’re snagging a bit on a minor consolidation zone from a few weeks back today, but I’m not worried. I plan to hold this put at least through earnings on the 23rd. I expect that sales of the MacBook Air will underwhelm in the thinning economy, just as its presentation at MacWorld did.

I should note again that risk management seems to be absolutely key. Though I was pretty sure of myself when I made the call on financials, I didn’t dive headlong into it, I bought a few shares here and there to test the waters first. As it turns out, conditions were worse than I expected, and I can now get out without serious damage to my account.

WFR, MEMC Electronic Materials, is also on my radar. I was looking into solar energy and alternative energy in general, as I believe reliance on fossil fuels is unsustainable. The solar panel industry seems to be pretty cutthroat right now, though, and half of the manufacturers are in China, where they don’t have to comply with the labor, environmental, and antitrust standards of the United States. I imagine 75% of the solar manufacturers will be gone in 5 to 7 years, but I don’t know which ones, and I don’t have the cash to bet on all of them (apart from ETFs.) WFR manufactures raw materials used to make solar panels, rather than the final product. This should let them survive and prosper even as the end-line manufacturers take each other out. They’ve recently had a 20% loss of capacity at one of their plants, which has depressed their stock. If it’s not permanent, and I see no reason to think it will be, they should bounce nicely when that is taken care of.

The biggest risk in the short term is oil — alt-energy value seems to correlate highly with oil value. When oil is expensive, people (irrationally) assume that the high prices will continue and put money into alternative energy stocks. When oil drops, they then assume that cheap oil is here to stay and so alt-energy won’t be economically competitive, so they sell. Over the long term, I am going to slowly build a position in alt-energy companies I think are strong by buying on such dips. The problem is that we don’t know for sure when the oil lows are, except retroactively…. So I’m just going to spread my bets and split the difference.

Sirius Satellite Radio and the XM merger… I picked up some SIRI calls for a song last August, and I’ve been adding to them slowly. I’m hoping for a big bounce once they finally wade through the bureaucratic morass and get the deal approved. I was rather surprised that there was no such bounce when the Justice Department cleared the antitrust aspects, but I suppose that even with that, the deal is worthless without the FCC’s approval.

I’ve also been easing into emerging market sovereign bond ETFs. I think their risk is overstated in the context of the current credit crisis, but it will be a while before the market realizes that, so I’m going slowly.

I’m still bullish on the Euro. Forbes is calling the end of the Euro, and I think they make great arguments. It seems not unlikely that Spain and Italy and maybe Ireland will just unilaterally withdraw from the European monetary union within the next few years in order to cut their interest rates. If they do, Germany and the eastern European countries will surely stay, and Germany will finally have the freedom to hike rates and crush its internal inflation, with obvious effects on the Euro. I’m in Deutschmarks if it does collapse.

Update, April 15th: I sit down today and see “Stocks in U.S. Advance, Led by Financials on Earnings; Tech Shares Retreat” on Bloomberg. Fortunately, I didn’t scale completely out of financials I am beginning to see why Livermore said he made the most money by doing nothing.

Bear Stearns’ Moral Hazard

2008-03-16T02:24:50Z

The Bear Stearns bailout has set off a wave of posts complaining of the moral hazard involved. Why should the taxpayers rescue an investment bank from its own greed and stupidity? Why should they not be allowed to fail? This is corporate welfare for the wealthy and powerful. Profits are kept private, and losses are socialized.

A bailout is, unfortunately, the lesser of two evils. I’m pretty sick of bailing large companies out with my tax money, but in this case, the alternative would be an economic collapse 100 times worse than the Great Depression. Bear Stearns indeed occupies a special position in the economy; they are indeed “too big to be allowed to fail”. What is lacking in the present equation is the great responsibility that ought to be required to hold such a special privilege and position.

If Bear is taking public money, then there needs to be a thorough and public investigation into the innards of their business and why they need public money to save them. Air out all their dirty laundry. The managers of Bear Stearns need to be held materially accountable for the actions that led to this point. I don’t mean a slap on the wrist for a few scapegoat “rogue traders”, I mean major public scrutiny of every single manager and department there, and major jail time for those who deserve it. The government needs to delve deep and look hard, and any wrongdoing uncovered needs to be used as an opportunity to set a severe example for other investment banks in the future. Such ought to be the price for their privileged status above the free market.

Credit — Economic Grease

Would you Prefer a Cash-Only Agrarian Economy?

The economy runs on credit. I don’t think most people really realize how critical the availability of credit is to keep all modern businesses functioning smoothly. As a basic example, vendors (of anything) routinely ship products on “net 30″ or “net 45″ terms, meaning that their cost must be paid in full in 30 or 45 days. But the vendor’s own employees still need to be paid at regular intervals rather than when the invoice is settled; the vendor’s electric bill and phone bill and insurance premiums need to be paid regularly, the vendor’s raw materials (purchased a month before on similar terms) must be paid for, etc. This is not a problem, because the business can establish a credit history and get a line of credit with a bank. The bank issues them a loan for a short period of time so that they can meet their recurring financial obligations, and they pay it back plus interest when their customers pay their invoices, which happens irregularly. This system works quite well in practice, and allows far greater flexibility and efficiency in moving products and services through the economy than would be possible in a cash-only economy.

Many people have a problem with the notion of debt per se. Such a company, they say, should simply build up cash reserves over time so that it can pay its regular bills out of its pocket, even when the customers still haven’t settled their outstanding invoices. But consider the competitive landscape — consider two companies that are otherwise identical. One pays for expenses out of its cash position, the other has the same amount of cash, but also establishes a line of credit. If the cash position is large enough (i.e. huge relative to the monthly expenses), there won’t be much difference. But most companies don’t have a huge amount of cash to fall back on like that, especially small and medium sized ones. In such a company, if a customer is a week late paying, or any one of a hundred other things goes wrong, the cash-only company will be out of business, while the credit-using company will not suffer major ill effects. In other words, in an environment where most of your competition is using credit to leverage their cash, you have to do it, too, or you’ll be out-competed and put out of business.

The same thing happens at a more abstract level between banks themselves. They are required to keep some percentage of their deposits on hand, and can lend the rest out. This increases the money supply and allows value to flow through the economy faster. Of course, they want to loan the most possible so that they can make more on interest. But when dealing with millions or billions of dollars worth of loans each day, and the unpredictability of customer withdrawals, it is impossible to map out exactly how many dollars can be loaned out each day while still meeting the regulatory reserve requirements. Some banks wind up with an amount in excess of their required reserves; others wind up with less than what they are required to have. So, the ones with more money than they need lend it to the others overnight.

Bear’s Blowup

Or, “Value at Risk” Doesn’t Work With Complex Derivatives

This brings us back to Bear Stearns. Extend that concept even further — in the real world, banks, hedge funds, pension funds, and other financial institutions have all kinds of (often extremely complex) positions beyond simple deposits and loans. Bear Stearns is one of the major investment banks in the world, and had the highest possible credit rating until very recently, when they were bailed out. If they are allowed to default on their obligations to other institutions, nobody will trust the credit ratings of anyone. The entire financial system will freeze up.

The effect will be that nobody will trust anyone else anymore. Interbank lending will dry up, or only be available at extremely high interest rates. If banks can’t use that to cushion their unpredictable reserve requirements, they’ll vastly reduce the amount of money they loan out. Businesses that had nothing to do with the subprime scandal or any other Wall Street malfeasance will be either completely unable to obtain credit, or only able to obtain it at prohibitively high interest rates (depending on their size and credit history.) They’ll be forced to do less business because of the lack of credit. Many will default on their prior obligations due to lack of available credit and go bankrupt. Most will lay off workers, who will then spend less money themselves. This will cause a second wave of failures in service-oriented businesses that cater to those workers, and so on. It will ripple throughout the entire economy, and everyone will suffer.

The downside is the moral hazard involved. If banks know that they’re too important to be allowed to collapse, then they’ll take on stupid risks. This is a serious problem, and it’s exactly what led to the current financial market crisis. In 1929, the federal government decided to avoid the moral hazard and simply allow large banks central to the economy who had gotten themselves into bad situations to fail. Secretary of the Treasury Andrew Mellon recommended that they be allowed to collapse: “It will purge the rottenness out of the system… High costs of living… will come down. People will work harder, live a moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.” The Great Depression and a world war resulted.

The problem is, adopting a utilitarian tone, the bad effects upon society from the moral hazard are not as severe for most people as the bad effects that would result from a complete seizure of the financial markets and a resultant depression. Bailing Bear out is the lesser of the two evils.

Avoiding Moral Hazard and Staying Solvent

So are we then doomed to periodically bail out big banks forever? Corporate welfare, the government rescuing the fat cats who deliberately make bets they can’t cover, keep the profits for themselves when they win, and stick the taxpayers with the losses when they lose? I don’t think so. The Fed acted appropriately in rescuing Bear Stearns in this case. It’s true that they are too intertwined in the fabric of our economy to be allowed to fail.

However, that is a very unusual privilege in our system, and it has hitherto been given with very little concomitant responsibility. In order to receive such a privilege, these banks ought to be forced to accept responsibility for their actions, both at a corporate level and at a personal level. The executives and managers must be held to account for their situation and for the necessity of invoking this extraordinary measure of a taxpayer bailout.

This move should have severe repercussions for the executives. At the very least, any Fed bailout should include mandatory and retroactive forfeiture of all bonuses by management personnel. Very likely, some of them should wind up in prison, and not a country club prison with tennis courts. If proven to have had a hand in the situation that led to this, they ought to all do hard time in a real jail. The entire internal operations of the bank should be thrown open to public scrutiny, since they now require public money. The FBI and the SEC should have their offices and computer systems locked down; home offices should be raided.

The managers of this and other banks must be made to realize the gravity of their situation, and the taking of public funds the benefit of a private institution, to cover its losses, should be viewed by all as an extraordinary event that will carry severe repercussions for those who put the bank into such a situation. Only in this way can their privileged status of being effectively above the free market and market consequences of their actions be reconciled with the moral hazards involved and the danger to the entire economy risked with their failure.

Bear Stearns Blowup

2008-03-15T23:05:08Z

Bear Stearns blew up, and the Fed is bailing them out. Their stock closed down almost 50% lower on Friday (and I picked up a few shares as a highly speculative bet.) What we have here is a form of corporate welfare — profits are private, and losses are socialized.

That is neither here nor there, however. Whatever the (lack of) philosophical merits of this system, so it is, and within it we must manage. Take a look at this weekly chart of the S&P 500. Despite the high volatility and the BSC blowup, we didn’t make a lower low last week on the S&P — though, ominously, other indices such as the NASDAQ Composite and the Russell 2000 did, and bounced back. (The Russell 2k even closed slightly up for the week.) I would have expected much more selling on the news of a major bank bailout by the government. That we didn’t close on a lower low is a positive sign.

I can see two possible interpretations of the weekly activity from January to March. Either we are looking at a double bottom setup, as I outlined last week, or we are looking at a triangle consolidation pattern. The upcoming Fed meeting will deal us a major wildcard.

Last week did not prove to be the conclusive decision-enabling test that I had hoped for; the market is still waffling. I bought a SPY put earlier in the week as insurance through the current decision period. This is not a long-term strategy, but it buys me a little more breathing room — and, as it turned out, vital breathing room. As each week goes by with no resolution up or down, the pressure builds, and the move will be all the more spectacular, whichever way it goes.

The market still hasn’t made any conclusive move, and I actually wound up slightly up for the week, on that put and on record high prices for gold and Euros. My long bets on financials stand; indeed, I slightly increased them by buying into BSC after Friday’s drop. This is, as I mentioned, a very small bet made with extremely speculative, pure risk capital. I think it is possible and even likely that I’m going to lose every penny I put into BSC; however, I’m getting great odds — if they don’t blow up and rebound, I’ll make a killing.

I’ve been pondering the secondary effects of this event. In particular, emerging market bonds were badly spooked by the Bear Stearns rescue. This does not appear to be linked to any particular relationship between Bear and these bonds, but rather to generalized investor panic. Notably, market interest rate benchmarks such as Euribor, Libor, and the AAA banking and finance rate didn’t increase substantially. I took the opportunity to buy some ETFs that invest in emerging market sovereign debt. Ideas here include TEI, EMF, and MSD, among others. If I had the cash, I would be buying emerging sovereign bonds directly. I invite you to post your own ideas here.

Interesting times to be investing.

Financials Getting Slaughtered; Transports Holding Up

2008-03-11T00:34:34Z

I’m getting sick of reading “the markets are volatile and will remain so” articles and posts, but that’s about all that can be said with any certainty about the current situation. Anyone who says otherwise is either selling something or crazy.

I’ve got slaughtered the past few days. I have a large position in financial stocks, based on my earlier calls for a bottom. Financials, as you know, are getting crushed. However, I also have large positions in gold and in Euros, which are also depressed. This is new. Previously, down days in equities were always offset by gains in gold and Euros. The past few days, however, it looks like the money is moving into Treasury bonds and oil. I have a small bond position, and I won’t touch oil since it’s insanely volatile and speculative relative to anything else. Some transportation stocks are weathering the storm nicely. Is it too late to get in?

I should note that when I say “large”, I mean “large relative to my account size”. My account size is tiny by Wall Street standards. Infintesimal. Risk management is key, as you undoubtedly already know. For those readers who may not, I’m not learning to trade with rent money; this is pure risk capital that I can afford to lose, and even at that, I’m taking on tiny tiny positions to test the waters. Like, “buying 5 shares at a time” positions. I can hear all the professional money managers chuckling and reaching for their mice to click to some other page. The thing is, I am acutely aware of my own ignorance and inexperience when it comes to the markets — which puts me way ahead of the punters who plunk their life savings down on a single “sure bet” futures contract, win randomly, and then think they’re a market god. They’ll be gone in six months. I’ve been at this for over two years, and I still haven’t busted my account. Not that I’ve made any outsized gains, but I’ve learned volumes, and I continue to do so. I’m patient.

The choice I’m faced with now is the perpetual market forecaster’s dilemma: either I was wrong about the bottom, and I should accept the loss, sell out, and staunch the bleeding; or I was right and it simply hasn’t been enough time yet. It’s still too early to say; I’m guessing and betting no matter what I do.

The amazing thing about financial markets is that, no matter what your view, you can find reams of erudite commentary from prestigious MBAs and PhDs supporting your view. I have read many articles written in the last week calling for doom, and many others (though fewer, since the market has been going down) pointing current firesale prices out as a great buying opportunity. I think the truth of the matter is that nobody has any clue what’s going on or what’s going to happen. Everyone’s laying their bets now, hence the volatility.

Looking at this Dow daily chart over the past year, I am hoping (yes, hoping, I know) for a double bottom at 11,500 or so. Volume on this recent decline has been average, indicating less certainty on this selloff. Further, financials rallied at the last minute on Friday, just before close, after a brutal day. My theory is that the recent media blitz has upset the public, who are now panicking and selling en masse while the pros snap up their shares. Edwards and Magee’s classic definition calls for a level to be reached with high volume, retreat on diminishing volume, and then increase to the previous extreme on increasing volume that is not as high as the first time. By this definition, we qualify. BUT…

Edwards and Magee state that the double bottom formation is “exceedingly rare,” very obvious in hindsight, and “referred to by name perhaps more often than any other chart pattern by traders who possess a smattering of technical ‘lingo’ but little organized knowledge of technical facts” (134), but if any set of circumstances warrants the label “exceedingly rare”, it is the state of the markets today. They put the frequency of double tops at “two or three” monthly charts and double bottoms at “one or two” out of “several hundred” charts. The problem, they say, is that the early stages of certain consolidation formations, triangles and rectangles, are virtually identical to double tops/bottoms.

They offer some general heuristics for distinguishing true doubles, while cautioning that there are no hard and fast rules. The extreme points in a consolidation pattern will be closer together than in a reversal pattern. The intervening area of a true double will be “long, dull, deep, and more or less rounding;” they admit that these are vague criteria and offer that at least a month between extremes makes it unlikely that they’re part of the same consolidation formation. That qualifies us so far. They also posit a 20% change between the extreme and the retreat. On my chart, the January Dow low was about 11,500; the highest point of the intermission was about 12,900, giving us a difference of only 12%. This doesn’t invalidate the “double bottom” theory, since they stress that these are general guidelines “not without exception”, but it decreases our odds.

The S&P appears more grim, and we don’t have volume to help us out. Look at that big, fat down candle today. At least we’re closer to the previous low; this can give us a heads-up for the market.

The Russell 2000 is even worse. It’s already breached the previous low. This is a big flashing red neon sign reading “DANGER”.

The strangest thing I’m seeing in this market is the Dow Jones Transportation Average. Charles Dow’s original Dow Theory placed great emphasis on the relationship between the Industrial Average and the Transportation Average. I don’t know what to make of this. It’s not even close to the January lows, while everything else is down.

This could be a sign. This is an anomaly. The Transportation Average is up while almost everything else is down.

I can think of a few explanations: US-based airlines make up a large portion of the average. A weak US dollar naturally encourages foreign tourism to the US; anecdotally, I’ve read several articles yesterday stating that foreign tourism is up. Given the usual chronic problems of the airline industry weighing them down and the market context, airlines are doing remarkably well. The remainder of the average is shipping and railroads. Some shipping companies are getting pummelled (EXPD), but others — Ryder, in particular — are riding high. Ryder has lots of international operations.

Now, let’s get a read on financials. I’m going to use XLF as a proxy. That’s nasty. Oooh, that’s nasty. Lower volume on this low, but it looks even less like it’s trying to work its way back up. We can see a pretty clearly defined channel, and it’s pointing down.

I am starting to sense that I’ve been beaten, that I’ve bet on the wrong horse here. The focus is on financials in the financial media; transport has been quietly weathering the storm. Over the next week or so, I’m going to start scaling down out of financials, booking losses, and getting into transport stocks with strong international components. There is still a chance that financials will pan out, so I’m not going to scale completely out, just reduce my bets and shift that capital elsewhere.

The previous local lows have already been breached in many of my key watch-charts, making my double bottom theory less and less likely with each passing day. I expect the issue will be much clearer by this time next week. In the meantime, I’m going to start realigning my bets.