The Cure Requires Some Pain

Solving the crisis will involve pain. The pain could be taken now, or deferred. The pain will involve further financial dislocation. It will hurt some more than others.

If current proposals by the Financial Accounting Standards Board (FASB) are adopted, that pain will be suffered earlier rather than later. The FASB is in the process of tightening requirements on how banks value their assets.

The stimulus packages fix the symptoms, not the causes. The financial crisis was not caused by consumers ceasing to spend. Therefore stimulating consumption does not fix the underlying causes. The underlying causes have not been widely agreed upon, let alone fixed. One of the underlying problems is the reduced ability of banks to lend money for sound business activity.

Banks have weakened their own ability to lend by making too many risky investments. Prudential regulations which limit how much risk banks take have been weakened. Much of that risk has now materialized. Regulation remains weak, and rescue programs continue to reward financial failure and immoderate risk taking.

Impaired Assets Limit Bank Lending

One reason banks are not lending adequately is their balance sheets are damaged. The amount which banks lend is limited to a multiple of their assets. Banks are reducing that multiple to more conservative levels again, so reducing the amount of credit they issue. But the value of many their assets has fallen, further reducing the amount they can lend.

Assets listed on balance sheets need valuations. Assets can be valued in many different ways, for example: purchase value; market value; theoretical value; or the expected value at some future sale date. One sensible way to measure value is “mark to market”, whereby the asset is valued at its current market price.

Some financial institutions might overstate the value of their assets. The balance sheets of many banks contain impaired assets such as CDOs, CDSs, and obligations by potentially unreliable counterparties. Some of those assets have no liquid standardized market, so it is very difficult to discover a true market value. See “A Fundamental Overview of the US Financial Sector“, in which a year ago we forecast much of how the crisis developed.

Bankruptcy occurs when the total assets are less than liabilities. You should never owe more than you have. The same applies to banks.

In April 2009 the FASB made it easier for banks to value some illiquid assets differently from true market value. It has been easy for banks to assign values to assets greater than their true market worth. Some assets were “marked to model”, which means their value is calculated theoretically using a mathematical model. Some refer to the practice as “marked to myth”, because input assumptions such as volatility can be open to much leeway and liberal interpretation.

Marking Assets Down to Market

In July, 2009, the FASB was considering reversing its April decision, so that all assets would now be marked to market. Many assets would thus be marked down to their true market value, which would become apparent during the next year as balance sheets are updated and disclosed.

Forcing financial institutions to value assets at market values will be painful. The real market value of some assets is well below the value carried on balance sheets. Some CDOs are worth as little as 16c in the dollar, whilst being marked well above that value. Marking to market will reveal some banks to be truly bankrupt. Some financial institutions will be revealed to be bankrupt.

But the alternative, to defer pain by maintaining the delusion of solvency, serves only to hide one of the underlying problems, to perpetuate bad practice, and to corrupt the “laissez faire” system. To hide a problem instead of facing up to it bravely, only perpetuates and amplifies the problem. The underpinning foundation upon which our capitalist system is built is that poor financial managers are allowed to fail and disappear to clear the way for those better able to manage finances.

There are early signs of a stock market rally. Some technical indicators are positive as we have advised in our free stock market briefings and rally courses.

Summary

If any market rally develops, it might be sustained until the shaky state of financial institutions influences wider market sentiment. So, if you trade stock options, prepare to trade the rally up, exit, then trade the next run down. It is impossible to determine how long any rally might be sustained. But if impaired financial institutions’ balance sheets turn sentiment negative, the next rally probably couldn’t be sustained for longer than a few months to a year or so.

Copyright © 2009 Nils Marchant.

[Source: OptionVue Systems]

Volatility of Prices

The prices of many shares, commodities and currencies are now very unstable. They are moving wildly out of balance. They shoot up too high. The fall too low, and very quickly. Consider the oil price shown below, for example. Surely the oil price history can not reflect the real value of oil. The real value of oil probably lies somewhere in the middle of the chart, between the recent extremes of $40 and $150.

[Source: OptionVue Systems]

Many businesses find it very difficult to operate in this volatile environment. They can’t predict prices or exchange rates, and they can’t make reliable forecasts or budgets. Many are shedding employees, reducing the scale of operations, or closing.

Trust

But businesses face an even bigger problem than volatility: many can’t borrow money. And their customers can no longer borrow money. Much international trade can no longer be financed.

The core of the financial crisis is that trust has been destroyed. The financial system relies upon trust. Banks and other lenders can no longer trust the creditworthiness of borrowers as confidently as they once did. Balance sheets, budget forecasts and credit ratings can no longer be relied upon. That’s why less money is flowing around the economy. This affects nearly everyone in the economically developed world.

Financial Over-reaction

Financial authorities seek a quick fix to the global financial crisis. In their haste they are possibly over-reacting. Rescue plans have been very large, and hasty. They seek to get money flowing around the economy again, and quickly, before too many businesses and people go bankrupt. Much economic policy is now reactive, driven by the immediate fear of deflation, recession, and short term political consequences. Longer term goals, such as the control of inflation, debt and budgets, are being sacrificed to fix financial problems in the short term. Some stimulus packages and rescue plans have been a little heavy handed because they create large debts which will have to be repaid over many years, and they are injecting unprecedented levels of liquidity into the system.

Rocking the Boat

The situation is a little like a “landlubber” family in a little boat. The children all rush to see a fish over one side. The boat tilts. The family pet labrador rushes over to join the children’s excitement. The boat tilts over dangerously more. The adults quickly shift what weight they have to the opposite side of the boat to restore balance. The fish then swims underneath the boat to the other side. First the children follow to see the fish. This is called instability. Market volatility is price instability.

The market value of many of the world’s largest corporations have risen and fallen across a very great range during the last two years. The S&P500 index, shown below, measures the combined market value of many of the world’s largest corporations. The valuations are driven more by collective mass perception than by actual underlying value. Prices are driven by psychology and sentiment about the future. What would be a natural level of the S&P500 if prices were stable? After all, the underlying values of all those companies which make up the index can’t be changing so wildly. Will prices stabilize around a realistic valuation?

[Source: OptionVue Systems]

In the little boat described earlier, when the children and the dog join the big people on one side of the boat, the boat risks tilting too far the other way. The adults would then need to quickly shift their weight back across to the other side to restore equilibrium. This alternation between extremes could go on forever.

Interest Rate Instability

We have already seen instability in short term US interest rates. To stimulate the economy rates were cut from near 6% in 2001 to 1% in 2004. Some say too low. To slow an overheated economy rates were then raised to 5.25% in 2006. Some say too high. Now they’ve been cut down to near zero to try to get the economy going again. The chart below looks a little like a boat rocking too far to either side. But that’s not low enough to create the desired stimulus. They need to go lower, but rates can’t go below zero. That’s why instead the authorities are now “printing” large quantities of new money, under a “quantitative easing” policy. They are “easing” monetary policy by increasing the quantity of money in the system. But that money hasn’t started to flow around the system yet. Many businesses still can not borrow the money they need to continue normally. The extra money and low interest rates have not restored the trust which is needed. Money doesn’t buy trust.

[Source: www.tradingeconomics.com]

When the money starts to flow around the economy again, conditions will improve. When conditions improve, more money will start to flow, and more rapidly. Improvement causes more money to flow, and the flow of more money causes more improvement. Each amplifies the other. But when all of the money flows around again as quickly as it did before, during the good times, there will be undesirable consequences. Too much money in a system causes inflation. The authorities will have to remove liquidity from the system again to prevent inflation. They will have to make a major move back in the other direction, somehow to remove from the system all the extra money which they are now injecting in unprecedented quantities at an unprecedented rate. They will need to make a weighty shift back to the other side of the boat. If they react too quickly and too heavily, they might shift too far again.

Ongoing Financial Instability

We might see significant instability in many prices for years to come. Share prices, commodity prices and foreign exchange rates might repeatedly fly too high and plunge too low, in short cycles. Each extreme causes a reversion too far to the other extreme. I would not be surprised to see a sequence of large price bubbles and busts over the coming years, until all of the disequilibria have been allowed to work their way out of the global system. The investment world may indeed be a very different place. Old investment strategies will no longer apply.

People in little boats want to be able to remain seated calmly, without getting wet, and without having to move too far too quickly. And they don’t like moving reactively or in a panic. People in little boats prefer ideally to move pro-actively and in a calm stable fashion. It seems that some of the financial moves to solve the crisis might be too much, too quickly.

Markets in the Future

Large stimulus packages might be sowing the seeds of ongoing instability. Because of the huge scale of the financial authorities’ reaction to the crisis, we might see a series of large booms and busts over the coming years. Prices may well continue to fly to wild extremes: too high, too low, and then back up too high again, as all the extra money in the system flows around the globe, essentially out of control. Some markets might swing between having too much money and then too little. Volatility may be here to stay for the foreseeable future. Stock market stability may well be a thing of the past, at least for a few years.

What do you think? We would very much welcome your feedback, discussion and comments.

It has been very difficult to understand how the price of oil could fall by three quarters from over $150 per barrel down to below $40 in such a very short time. On its way up many commentators – myself included – believed that the price was rising firstly, because demand was outstripping supply, and secondly, because of phenomenal economic growth in developing countries such as China, which have exponentially increasing oil consumption.

But how can the price collapse by 75%? Surely demand hasn’t fallen by that much. And there hasn’t been any sudden discovery of massive new reserves. In a free market, shouldn’t the price of oil reflect the value of oil? The value is determined by how much there is available, and how much is needed. Because neither supply nor demand can change by much over a short time, the price shouldn’t change by all that much.

Supply and demand have always remained roughly in balance, except for the oil shocks during the nineteen-seventies and early nineteen-eighties. Energy consumption is pretty constant. Power stations must still produce electricity. People still need about the same amount of transport. And Chinese demand is still growing. Importantly, global oil consumption is still growing, not shrinking.

The chart above shows how the world’s oil consumption is increasing year after year. Global oil production and consumption has risen quite steadily from around 20 Mbpd in 1980 to around 86 Mbpd today. Oil consumption continues to increase by about 1-3 Mbpd every year. At the right hand side the red box shows that the US will use less oil in 2008 than in 2007. But China (in green) and the rest of the world (in blue) are still increasing their consumption, guzzling more than the amount saved by the US. So total world consumption of oil is increasing, or at best consumption might remain steady. The International Energy Agency recently predicted that world oil demand will fall by 200,000 bpd, but that’s only a very small amount. Therefore world oil consumption is still as strong as ever, and increasing. Note the green Chinese boxes which show that Chinese oil demand continues to increase at a significant rate.

On average the oil supply has matched the demand. Oil consumption just can’t fall so quickly, because demand is inelastic. When one needs oil, price doesn’t matter. High oil prices don’t reduce demand by much. Inelastic demand means that small changes in the difference between supply and demand can cause large price swings. OPEC is trying to prop up the price by reducing the supply, but they seem to be failing. But the real reason for such wild price swings is that prices are not determined by supply and demand alone. Market prices often don’t make sense. Prices are also determined by psychology, emotions, and people’s expectations about the future. So a price reflects both value and market sentiment. Sentiment influences prices, and that’s what’s been happening with the oil price. If people expect prices to rise in the future, they will buy more now. It is not only speculators who do so, but also consumers such as refineries and airlines who seek to control their input costs. There have been suggestions that the oil price had been pushed so high because of speculators. But speculators only played a very small part. It was mainly commercial consumers who bought oil up in various ways.

When consumers fear the price will rise, sentiment can drive the price up to a level higher than it would otherwise be. And when sentiment is negative, it can drive a price lower than what it would otherwise be. This creates a snowballing effect in both directions causing prices to rise too high and then overshoot, and then to fall too low.

Economic growth uses energy, mostly in the form of oil. In recent years oil production capacity did not grow as quickly as world economic growth. The oil price rose because the market expected that demand would grow faster than supply, even at very high prices. Expectations about the future are embedded in sentiment. The market expected that the shortfall would persist for some time, because it takes time to increase oil production.

The chart above shows the amount of spare oil production capacity year by year. As demand for oil increased, excess or spare capacity decreased. But it is important to note that the world is still able to produce more oil than we consume, and we always have been able to.

Excess capacity started to shrink again during 2008. The tightening of spare production capacity was perceived as risk, causing market sentiment to favour higher future prices. As spare capacity gets tighter, fears of disruption are amplified. An outage will be harder to cover. If people feared a future threat to oil supplies, for example due to instability in the Middle East, then there will be a tendency to buy early to secure future delivery. These fears are reflected in sentiment. Another factor which influences sentiment about the oil price is (or was?) the “peak oil theory”. Today we consume about four times as much oil as we discover.

The graph above shows that in 2004 oil production was expected to reach its peak in 2006, and then decline. But if global discoveries and production have peaked, how can the price fall by 75%? Could such a price collapse imply that oil supplies won’t run out as quickly as claimed? Back in the early nineteen-seventies, during the first oil crisis, I chose to do a school assignment on global oil. Back then the information which was most strongly thrust upon me was that the world only had 15 years of oil supply remaining. I reported that in my school assignment. Fifteen years later, I noticed that the world was consuming more oil than ever, and it still had an abundant supply, more even than when I submitted my school assignment. I then realized that oil companies only need 15 years or so of known reserves for their development pipeline. They don’t need to explore to secure reserves further into the future than that. Therefore the world will never really have more than 15 years worth of oil left, so it will always look like supplies are drying up. So the fall in oil price raises the interesting question of whether oil production really has peaked. Is peak oil theory wrong?

Exchange rates also influence sentiment. Nearly all oil is quoted and traded in US dollars. The US dollar has been falling significantly since 2002, down by approximately 40%. The falling US dollar means oil actually becomes cheaper outside the US, and importantly, in Europe. That increases demand and consumption outside the US. And oil exporters reduce exploration because they earn less from their devalued US dollars. This tends to push the price up. So the falling US dollar creates an expectation of a higher oil price. Two thirds of the world’s oil reserves lie in the Middle East. Wars and instability fuel constant fears of supply disruption. When there is not much spare capacity a supply disruption would cause a serious shortfall, so the perception of risk is amplified. We can now summarize the four significant factors which influence the oil price.

1. Fundamental value determined by supply and demand, and the fact that demand is inelastic.
2. Fears of a growing shortfall in supply, observed as sentiment.
3. Expectations of a fall in the value of the US dollar, observed as sentiment.
4. And fears of a disruption in supply.

So why then has the price collapsed? At the time of writing oil was being sold off. Sentiment amplified the downside just as much as it did the upside on the way up. Commercial consumers who bought on the way up are now unwinding their positions, and oil investments are being redeemed as people bail out of investment funds. So it seems we had an oil price bubble, similar to the tulip price bubble. The only difference is that tulips were a luxury, whereas oil is a necessity, like an addictive drug. We can’t stop using oil. And what about the future? Should we consider buying oil and related stocks? There are rumours that we might be approximately three quarters or so of the way through the selloff, and that there might still be a little more selling to come, but no one can know that. The oil price chart certainly looks very grim. So maybe the price might fall a little further on this run down. But maybe not: this author does not know. And what about the longer term? Let’s consider each of the four factors. Demand continues to increase, demand is inelastic, and oil production has not grown with it. Moreover, the falling US dollar reduces the incentive to bring on new production. If the US dollar continues to fall there will be more upwards pressure on the oil price. New reserves will be more expensive to develop, even if production has not peaked. And development of new supply lags demand by years. And furthermore, if the “peak oil theory” is correct, there will be further upwards price pressure. Therefore the fundamentals over the longer term seem to suggest a growing shortfall in supply, and therefore a resumption of the uptrend in the oil price over the longer term. But we have already observed that sentiment can really mess up the price. The Middle East is in perpetual turmoil. Is it getting worse? It could be argued that political instability is increasing not decreasing. If that were so the fear premium is unlikely to evaporate. This author’s sentiments on the US dollar are bearish. But the sentiments of this author play no part in the oil price. What counts is market sentiment. What will market sentiment be? Some in the audience will seek a prediction about the future. This author is unable to provide one. All that can be said is that in the end sentiment will be driven by collective expectations about the future. I have attempted in this article to set out some of the ideas to think about in order to build an understanding of how the oil price might evolve in the future. I hope this is helpful. Thank-you, and I look forward very much to seeing you next time. Sources:

1. “Emerging Demand Supporting Crude Oil”, Westpac, 1Q, 2008, www.westpac.com.au/.
2. “Crude Awakening – Behind the Surge in Oil Prices”, May, 2008, www.dallasfed.org/research/.
3. “What is Peak Oil?”, Peak Oil News, //peakoil.com/.
4. “Interim Report on Crude Oil”, Interagency Task Force on Commodity Markets, July, 2008, www.cftc.gov/.
5. “IEA Predicts the First Fall in Oil Demand since 1983”, Dec 11, 2008, www.prlog.org/.

Copyright © 2009 Nils Marchant.

This is an edited transcript of a talk delivered at the Options21 Market Briefings during the 4th – 7th of January, 2009.

All times of change provide opportunities for the nimble. Recessions are part of the normal economic cycle. Recessions serve a purpose. They are necessary because they remove inefficient practice, and they clear the way for new ideas, new technologies, new ways of doing things, and new industries. These principles are fundamental to our innovative mercantile economy.

The first area which springs to mind which would benefit would be receivers, administrators and liquidators. But we need to penetrate more deeply and think further than that. I shall set out here how I would go about thinking about how best to make investment decisions in a recession. I always try to form a framework to guide my thoughts in a structured manner.

A recession means less spending in some or most but not all areas. The US is a consumer economy. Eighty percent of US economic activity is consumption. It is useful to determine which industries will reliably expand and which will reliably contract, and then identify the best or the worst stocks within those groups, depending upon the trading or investment strategies you seek to employ.

A recession means that much spending will shift from wants to needs; and from luxuries to necessities. When less is available we make more use of what we have. Therefore a recession will tend to bring about:-

• lower capital expenditure, both at a personal level and at a corporate level;
• deferral of equipment purchases;
• the prolongation of asset life;
• reduction in the size of inventory, both personal and corporate;
• the reduction of or elimination of regular services; and
• a reduction in the quality of inventory – replenishing the pantry with cheaper substitutes as it were.

It is also important to determine who decides how much is to be spent, and how expenditure is to be reduced. The budget decision makers can be classified into four levels. Decisions to reduce expenditure will be made:-

• at a personal level;
• at a corporate level;
• at a national level; and
• at a global level;

We can now think how belt tightening might affect ourselves at a personal level before we work outwards to the broader economy. I start by asking myself how I would respond to a reduction in my income, or the potential loss of employment.

In thinking about how I might regress in a financial sense, Maslow’s hierarchy of needs springs to mind. Maslow’s Hierarchy

(Acknowledgements: http://en.wikipedia.org/wiki/Maslow’s_hierarchy_of_needs)

Clearly self-actualisation and the higher developments are largely independent of financial affairs, so if we are to apply Maslow’s hierarchy to the selection of industries and market sectors, we are confined to only the lower layers. A more superficial hierarchy is required, reflecting only the financial aspects of life. The following matrix provides such a framework by listing a hierarchy of spending.

The Hierarchy of Spending

The human needs and wants are arranged vertically in a similar fashion to Maslow’s hierarchy. The bare necessities and lesser needs are at the bottom with higher level needs arranged in sequence upwards to luxuries at the top. Not all needs and wants are shown. The reader can add further rows to conduct the investigation as desired. One column is provided for each class of budget decision maker.

At each intersection in the matrix, we can now think about how each sector of the market would be affected. This approach will help provide a broad overview of how a recession will affect stock market fundamentals.

Spending will be pushed down to the lower layers, in a sense parallel with economic regression, as less money is available. There will be greater pressure to push spending patterns back into the past, into times when societies were less economically developed. Instead of progressing towards advancement, some economies will be shifted ever so slightly backwards in the direction towards barter and subsistence. Others will be thrust more robustly in that direction, like Zimbabwe.

Let’s now take the example of energy to see how the matrix might guide our thoughts.

In commercial terms, and at a personal or corporate level, renewable and clean energies are a luxury which can be deferred, at least in the short term. But in political terms, and at the global level, this might not be so. A recession increases the pressure to go back to the past instead of forwards to new more expensive and commercially risky sources of energy. A recession will increase demands for cheaper energy, both for corporations and for individuals. Therefore the transition to more costly clean and renewable sources may be delayed.

That would mean that purchases of windmills, solar panels, batteries and inverters, and investment into geothermal, carbon sequestration and other alternative energy related industries and projects would be deferred. I’m not suggesting these industries will suffer, rather I’m suggesting that the odds and the risk have now shifted a little more against those industries. Those industries probably will not reach the heights of commercial success as soon as might have been forecast a year ago.

At a personal level it means delaying the purchase of double glazing, insulation and other energy saving devices which incur a cost premium. It is possible that, as occurred during the oil crisis of the nineteen seventies in the US and Europe, people will turn down their thermostats and wear more jumpers. There might be a shift to the more basic end of the clothing and fashion market which might benefit.

There might be a shift in food consumption from value added five star and processed foods (and note that these are opposites) to basic staples. Consider the seed, fertilizer and food chain industries. Such a shift would echo the reversion from advanced economic activity to more basic lesser developed categories of economic activity. In Iceland that may well be a matter of discarding the financial dealers’ suits and donning the oilskins in order to go back to fishing and whaling.

Does poverty cause theft? My personal opinion, from experience, is that it does not. I reject that notion and I find it insulting to poor people. A failure of character and a lack of principle is the primary cause of theft, however I acknowledge that in some cases desperation might lead to theft. But shoplifting and theft does increase in recessions, and I think we are already starting to observe those effects. Therefore some security related industries might benefit from a recession: industries related to alarms, surveillance and associated electronics; fences, screens, grills, and locks; and also guards and other security personnel. In my opinion some of the increase in theft due to a recession probably results more from a lack of will or knowledge about how to live frugally rather than desperation. The western economies have enough food surplus to provide a buffer against widespread starvation.

Fewer car purchases means squeezing longer life from an aging global car fleet. That will require more gaskets, fan belts, radiator hoses, and other spare parts. If oil prices resume their upward trend, and as the relative cost of people’s time falls, it will mean more walking and cycling. That would result in an increased demand for shoes and bicycle tyres. It is interesting to note that many of the products which will be purchased as a result of reductions in spending are made in China.

The effects of the global recession upon China, and the effect of China upon the global recession, is the subject of a separate discussion, which we will have to leave for some other time.

At a national level, the recession, combined with quantitative easing anti-deflation policy, might encourage some national infrastructure spending decisions to direct more funds to public transport. Where time is not critical, and subject to the future oil price, more transport might shift from the road to railways and ships.

And recessions make time cheaper. People accept more delay because they have less money to purchase acceleration. The US and continental Europe have inland shipping and railway systems which are well developed and efficient.

In summary a recession will bring about a “depletion of the pantry”, the aging of assets, and a shift to more basic needs; at a personal level, a corporate level, a national level and the global level.

The reader can construct such a matrix and explore further by dividing the global economy into geographic, cultural, national or other sectors. Different cultures will respond in different ways.

But there is more to the economy than so called “rational” financial behaviour. We are all real people, not algorithms. So what might seem logical in terms of money will be distorted by human behaviour, at all decision making levels. We are already seeing major government decisions being distorted away from hollow economic rationalism. It is not finance alone which determines which businesses gain or lose. Decisions are skewed by political and social considerations. Governments will do all sorts of things to preserve jobs, for example by allowing accelerated depreciation and other tax concessions, by constructing infrastructure to encourage new industries in places of high unemployment; and by turning away from global free trade to protectionism.

The recession might foster specialised import replacement industries, especially where current large export suppliers cease production. Most countries will respond differently. Therefore the recession might contribute to a fundamental change in global trade. Many will put their own interests before global interests. Some inefficient industries will be supported. The BRIC countries may well account for 100% of global GDP expansion while only the west contracts. So make sure you keep your forecasts in perspective.

In considering the western economies I would be guided by the idea of economic regression and a temporary retreat from wasteful consumerism. Remember your family’s spending habits when you were a child. Importantly: remember what you did not need money for. These are the industries which might come under some pressure.

Thank-you very much. See you next time.

Copyright © 2008 Nils Marchant.

This is an edited transcript of a talk delivered at the Options21 Market Briefings during the 26th – 30th of November, 2008.

Tulip Mania 1634 – 1638

In the 16th century Holland’s maritime reach and interests were expanding around the globe. They were exploring and discovering far and wide. In 1593 Conrad Guestner imported a tulip bulb into Holland from Constantinople. Connoisseurs of exotic plants soon also came to buy tulip bulbs. The exotic bulb soon became a status symbol for the wealthy. The desire to own one spread, firstly across the truly wealthy, and then also across the would be wealthy. Over the years some tulip bulbs became infected with a virus which caused them to developed a unique colouring effect in their petals, which made them even more sought-after.

The price of tulip bulbs rose steadily through the 1630s. Speculators were attracted into the market and the price rise started to accelerate. A futures market for bulbs was even created. Big capital returns were made over shorter periods. The mania spread right across the community, including to those who weren’t that wealthy. The price of a single bulb reached astonishing levels.
People sold their entire properties – houses, farms, and stock – to acquire just one single bulb. They could see a potential return of hundreds of percent in a matter of a month or so. Those who probably couldn’t afford it entered the market, also seeking to make a fortune. It was a systemic positive feedback loop: rising prices attracted more buyers, more buyers drove the price yet further up.

Does this sound familiar? Individual greed kicked in, overriding individual prudential behaviour. Emotion dominated reason. The underlying assumption, which many never questioned, was that the price could rise indefinitely.

A drunk man in a bar started peeling and eating what he thought was an onion, while in fact it was the bar owner’s tulip bulb proudly on display. That man was jailed. Prices reached their peak around 1637, and then the tulip market crashed spectacularly. The buyers had stopped. Panic spread across Holland. Traders attempted to prop up demand, but the market had evaporated. It is not possible to create wealth out of thin air. And I don’t know how many glasses of beer I’d need before deciding to eat a tulip bulb.

The South Sea Bubble 1720

A century or so later Britain was in deep debt. In 1711 the government made a deal with a private company – The South Sea Company, whereby that company would finance Britain’s debt in exchange for a guaranteed interest rate on the stock of 6%, and also monopoly trading rights in the South Seas, including in slaves.

The shares were snapped up, more were issued, and they also sold well. Plenty of investment capital was available at the time. But financial success was less than expected during the first few years. In 1718 King George I became governor of the company, creating confidence in the enterprise. The company expected to recoup the debt from expanding trade, and from the foreseen rise in the value of its shares.

The share price soared in 1720 as a result of the company’s proposal to take on a large part of the government debt. It went from around 128 at the beginning of 1720, to around 1000 in August, 1720. But in September it collapsed, and by December they were back down below 124. Many investors were ruined. The House of Commons ordered an inquiry, and found at least three ministers had accepted bribes and speculated. Many of the company directors were disgraced. So: what’s new today?

Mississippi Bubble

Around the same time as the South Sea Bubble, France was experiencing its own bubble:- the Mississippi Bubble. In 1715 France was bankrupt and had defaulted on debt. The Duke of Orleans, on the advice of Scottish gold dealer John Law, established the Banque Generale which took gold and silver deposits and issued metal backed banknotes, like our gold backed system used to be. The banknotes were inflation proof because they were redeemable in the original amount of precious metal. John Law also established the Compagnie d’Occident in 1717 later Compagnie des Indes which had a monopoly on trade with French American territories where there were thought to be reserves of precious metals.

There’s a lot more to the story than I have time for here. However, in a nutshell, the volume of banknotes in circulation was expanded. It did not match the amount of gold and silver on deposit to back it. There were problems converting notes back to specie. Trust in the banknote was violated. The share price rose from 500 livres in 1710 to 10,000 in 1720, and back down to 500 in 1721. So: is anything different today?

President Nixon removed the last remnants of the gold standard in the early 1970s. The US dollar no longer had a gold backing. The US dollar became a fiat currency, and remains so today.

The Roaring Twenties and Crash of 1929

During the roaring twenties the US was experiencing a boom brought about by new technologies, production processes, and company management. The boom was all fuelled by the increased use of credit. It made sense to use other people’s money by putting it to better use than letting it sit idle.

The Dow Jones rose from 100 in 1926 to 381 at its peak in 1929. Two months later it had fallen back down to 145. In 1932 it was down to 45. Speculators, aided by easy credit, fuelled the “blow off”. Does this sound familiar?

Restrictions on credit by the Federal Reserve at the time dried up the money supply and contributed to the depression. This time around, in 2008, the monetary and financial authorities are not making the same mistake. Instead, they are seeking to flood the world with money, early, in anticipation of possible deflation. The chairman of the US Federal Reserve, Prof. Ben Bernanke even has the nickname “Helicopter Ben” because of his comments that deflation could be prevented by mounting a helicopter drop of money into the economy.

Other Bubbles

There have been other bubbles:

• The Japanese Bubble of 1984 – 1989.
• The Crash of 1987.
• The “Dot Com” Technology Bubble and “Tech Wreck” of the 1990s.

Opportunity for Individuals

What does this mean for us? Given the correct knowledge, experience and attitude it is possible to protect yourselves from these situations, and to profit. Right now is the ideal opportunity to learn how to trade, and to put everything in place in preparation for trading the next market phase after the market becomes more stable. Anyone who can cut their teeth during this market will have a solid foundation for great success when circumstances change again. I suspect some in the audience are recoiling in fear at the moment. But ask yourselves, and be honest with yourselves: are you of a nature who will enter the market again near the top? And sell again at the bottom? Are you driven by fear and greed?

Today

So, what is the situation we find ourselves in today? It appears that we’ve got a bubble of greed leveraged up on top of a another bubble of greed. There is the underlying US housing bubble in which inflating house prices and relaxation of bank leverage ratios, and the relaxation or even suspension of other prudential behaviour, led to the positive feedback “tulip effect”. Debt was based on the wrong assumption that house prices can only ever rise. But house prices in the US are now collapsing faster than the mathematical risk models of their securitised collateralised debt obligations.

Moreover, those who should have known better also allowed themselves to be carried away into their own bubble on top of the housing bubble:- the hedge funds; the investment banks; and even the financial insurers.

The major players were issuing credit default swaps and other “over the counter” derivatives to the value of 500 Trillion US dollars, or reportedly even more than that. And these are all off market and unregulated. There is no standardised or organised market, so these assets are so opaque that it is not even possible to determine a market price for them. (Well, it is actually, but to do so would have consequences.) These assets were created based on the assumptions of young mathematical experts who appear to believe that mathematics is reality, and, with a sprinkling of relativism permitting them to reject the notion of absolute mathematical truth, proved mathematically their own “reality”, and that their instruments were really absolutely AAA safe.

These people are really well educated. But it is easy to see that degrees in business, finance, commerce and mathematics do not prevent failure. The financial experts are falling like dominoes. Clearly, there is more to understanding bubbles than a university degree can provide. In fact this brings the whole situation into the realm of each person in the audience. Much about the current financial crisis can be understood from a basic understanding of: mankind, human nature, emotions, greed, fear, hope and despair.

As Aristotle urged: “Know thyself!”.

Can the intrinsic nature of man change? The current circumstances are simply a part of a regular cycle of boom and bust that has occurred throughout history. This is not the end of capitalism. Some of the media is becoming hysterical: emotionally out of hand.

The financial authorities have learned from the great depression, and are responding in an entirely different manner, by opening up liquidity to the tune of trillions of dollars.

Speculation mania recurs time and time again, and always will. Crashes are always needed to bring mankind back down to the reality of earth.

Thank-you.

Sources

We acknowledge the following sources.

• Encyclopaedia Brittanica http://www.stock-market-crash.net/tulip-mania.htm
• Erasmus School of Economics http://people.few.eur.nl/smant/m-economics/johnlaw.htm

Copyright © 2008 Nils Marchant

This is an edited transcript of a talk delivered the Options21 Live Market Briefings during the 15th – 18th of October, 2008.

Imagine my colleague Paul is fortunate enough to be in possession of 10 large boxes of beer, freely available from our local liquor store. Imagine also that I enjoy parties, and in an impulsive fit of haste I suddenly decide to throw a party tonight. Not having much time to organize things, I look across the office at my colleague Paul and ask politely if I could borrow his ten boxes of beer.

Paul agrees. I promise to return his beer within a month, and I take his beer home with me to prepare for my big party. Paul owns the beer, but for now at least it is in my possession. Because I don’t have enough time to get organized properly, hardly anyone turns up. The party is a failure. I no longer need Paul’s beer. But of those guests who do turn up, someone asks if they could buy my beer. They offer quite a good price. I agree to sell all the beer to the guest, I take the money, and I hand over possession of the beer. The guest takes delivery. There is a small issue in that it wasn’t really my beer. Later that week I buy an identical type and quantity of beer, and I return all the beer to Paul.

Paul doesn’t actually get back exactly to his beer. It is a substitute, but he is unable to detect any difference. It is precisely the same brand, in precisely the same packaging, and of precisely the same quantity. There is no difference between the borrowed beer and the returned beer except, maybe, if there are any little serial number markings on the sides of the bottles, the serial numbers won’t match. But who worries about serial numbers when it comes to beer? Paul assures me that he doesn’t mind that the beer is a substitute beer because it is the same brand, and Paul is happy and thankful that I’ve returned the same quantity.

Now we could ask a moral question: have I done anything wrong? I’ve sold something which I did not own, but I’ve made good. Is that moral or immoral? There is more to morality than merely deciding whether anyone suffered a loss or got hurt, but that’s the subject of a separate philosophical discussion.

My beer sale is one type of short selling. It is called covered short selling, because I had possession of the beer, I was able to deliver the beer to the buyer, and I fully intended to deliver the beer after taking the money, because I always deal “straight” and honestly.

What would happen if I placed large newspaper and television advertisements offering millions of cartons of beer for sale at a massively discounted price? People would buy less beer from their traditional liquor stores, they would defer their purchases in anticipation of lower prices, and the price of beer would fall.

But what would happen if I neither owned nor had possession of any beer, and did not intend to deliver any beer for any sale? I could for a short time influence the beer price by leading people to the false belief that huge quantities of beer are about to be unleashed onto the beer market at a great discount.

If there really was no beer available for sale the advertisements would have been false. People would soon discover that a huge warehouse full of cheap beer did not exist. The price of beer would rise again as people returned to their normal liquor stores. The beer price would have been temporarily distorted, through manipulation of perception and the creation of a false belief. Would I have done anything immoral?

Now imagine that Paul also own a significant number of shares in Google, the US internet stock.  What would happen if I borrowed 100 of those shares from Paul, and sold them into the market? Let’s say I sold the borrowed Google shares. The stock market operates on T+3, which means I have three days in which to deliver those shares after selling them. I have every intent to deliver those shares to the buyer, and indeed I do deliver them. I also have an obligation to give them back to Paul within one month.

Two weeks after I sold them, I could buy 100 Google shares back from the market, and subsequently give them back to Paul. They are probably not exactly same shares, but that doesn’t matter. Like the beer, Paul does not care that the share certificates have different serial numbers. All that matters is that Paul has been returned the same type and quantity of shares. He is grateful to have his portfolio restored with the return of his shares. I might even offer Paul a small amount of money to compensate him for renting or leasing his shares to me. Would I have done anything immoral in borrowing and selling Paul’s shares?

This type of transaction is also termed covered short selling because the shares I offered for sale were “covered” by the shares in my possession, even though I was not the legal owner of them. I had the owner’s consent to sell them. I was able to deliver the shares to the buyer, I intended to deliver, and indeed I did deliver and make good the sale.

It is legal to short sell shares on the Australian and US markets, as long as the seller has possession of the shares and intends to deliver them to the buyer. Often a broker will hold title to many clients’ shares. Brokers are able to lend those shares to other clients if they agree to return them. In that way those other clients can short sell shares. Short selling is very risky. It is possible for short sellers to lose a lot of money if the shares have to be bought back at a subsequently high price in order make good the loan and to return the shares to the broker and the rightful owner. Indeed, short selling exposes the seller to potentially unlimited risk. We strongly recommend never to short sell shares without some form of hedging or protection.

Some people short sell because they might determine that a company is badly managed and foresee a fall in value. They can exploit that forecast for profit simply by short selling the stock and buying back the stock later at a lower price. Short sellers often identify badly managed companies early, and perform a useful function by exposing bad practice and bringing to the early attention of the market useful negative information which might otherwise be concealed for a longer time. Obviously covered short sellers would only target poor quality companies. They wouldn’t short sell without a sound reason to believe that the price would be likely to fall. They might have more information, or they might have a sharper perception of the true state of the target company. The threat of short sellers helps keep businesses disciplined. Without short sellers, imprudent, stupid and bad practice within a company can be hidden and perpetuated more easily, sometimes at the expense of the shareholders.

Legal covered short selling can hasten and temporarily amplify a fall in the share price. But legal covered short selling can not sustain a fall in the share price because ultimately the shares must be returned their owner. Buying the shares back from the market tends to push the price up.

Some superannuation funds and other fund managers hold large amounts of stock which represents the investment funds entrusted to them by their clients. Some of those funds lend, lease or rent those shares to short sellers, knowing it may well drive the price down. Is that appropriate or moral for fund managers to do?

Google is a large company, and my sale earlier of 100 shares could not affect the share price. But let’s now consider a very small company, maybe like a small gold mining or exploration stock which does not have many shares on issue, for example 50 million shares or so. What would happen if I placed an order to sell 20 million shares, “at market”? What if I neither owned nor had possession of any shares I offered for sale? What would happen to the share price? It would fall. That type of short selling is called naked short selling. It’s naked because the sale is not covered by my possession of the actual stock. Would that be immoral? Does anyone suffer?

Naked short selling is illegal, both in Australia and in the US, where we do most of our trading. It falsely inflates the number of shares available, and unfairly destroys the wealth of the real shareholders. The share price of any particular stock is due in part to the scarcity of those shares. There should always be only a fixed number of shares on issue and in circulation at any one time. Naked short selling brings shares into the market which don’t exist. And because shares are interchangeable and indistinguishable from one another, like bottles of beer, the newly sold shares dilute the value of all the shares. Naked short selling creates the perception that there are more shares in existence than there really should be. That is why naked short selling is illegal. It falsely and unfairly pushes down the share price. The share price no longer reflects real supply and demand, or the scarcity, because the false short sales interfere with the number of shares available to the market.

If shares are sold, and those shares not delivered within the prescribed T+3 time limit, red lights and alarms are signalled to the exchange regulators. Even though it is illegal, sometimes, some people do try to distort the market price by offering stock for sale which they neither possess nor intend to deliver. They might want to drive down a company’s share price to acquire the assets at below cost.

In mid-2008 the US Securities and Exchange Commission made the curious announcement that it would temporarily no longer tolerate illegal naked short selling on 19 selected financial stocks. The implications are bizarre.

Options are very different from shares. Shares are issued by a company to those investors who provide equity. Although those shares are identical and interchangeable so that they can be freely traded, the number on issue is always strictly limited because each share represents a fixed share of the company. It is the fixed limit on the number of shares which creates the scarcity which supports the value and price of those shares. The shares can exist in perpetuity, and are only created or destroyed in an orderly manner to reflect capital adjustments. Only the company can issue shares. No one else can create shares in that company. If anybody other than the issuing company attempted to create a share certificate that would be fraud.

Beer is different. Beer can be consumed. In fact lots of beer can be consumed. It also can be manufactured easily in vast quantities. Scarcity is not really a factor in determining the price of beer. In the case of Paul’s beer, I wasn’t concerned that the buyer would consume it because I knew more would be manufactured. The price of beer closely reflects the manufacturing, distribution and taxation costs, at least where it is freely available. Beer is not really a good long term investment, because unlike shares, there is not normally a strictly limited supply, and it is perishable.

Options can be created out of thin air, as it were, more easily than beer can be created. And options always have a strictly limited life span. They perish with time. Options cease to exist when they are exercised or when they expire. In effect options are either consumed or wasted, just like beer.

It is more appropriate to liken options to insurance policies than to shares. Options are a contract between a writer and a taker. Any participant in an options trading market can be a writer, and write options for those takers willing to pay the premium. The value in options thus does not lie in their scarcity. When an option is written the writer is paid a premium to take on risk which the taker seeks to cover, or transfer to the writer. The writer takes on obligations to deliver or to buy stock at a fixed price on or before a fixed future date. Options are standardized and indistinguishable from one another (that is for a given stock, strike price and expiry date) and thus can be freely traded, just like shares. But the inherent value of an option is not related to its scarcity, because there is no limit on the number of options contracts that can be opened.

When a writer writes an option the terminology is sometimes used that the writer is “going short” the options. The writer is not actually selling anything which is scarce. Nor is the writer interfering with the free market price of those options. Therefore going short options is not at all the same as selling short shares. But the terminology used is similar.

There are two ways in which options can be written.  Options can be written “naked”; or options can be written “covered”.

Whenever writing options the writer should always first ensure he or she is in a position to fulfill the delivery obligations under all circumstances, regardless of what might happen, in case the taker or holder of the option exercises the option.

Writing covered options means the risk taken on by the writer is already covered in some form, or hedged, or insured. For example writing a covered call means the writer already owns the underlying stock which the writer might be obliged to sell if the call option is exercised. Moreover, the holder of an option may decide to sell that already existing option into the market, which would simply be a plain sale.

Writing naked options means the options are written without any protection, thus exposing the writer to potentially unlimited risk. Writing naked options would be similar to an insurer writing an insurance policy without setting any limit on the maximum amount agreed to be paid out. We strongly recommend never to write naked options because of the unlimited risk it would expose the writer to. However to write naked options would neither be immoral nor interfere with the fair operation of the market.

So in summary, we’ve now defined two types of short selling, and for both stocks and for options.

Covered short selling of shares means the seller possesses the shares and intends to make good the delivery of those shares for sale. Covered short selling of shares is legal.

Naked short selling of shares means the seller does not possess the shares to be sold, and therefore can not deliver them without acquiring them from some other source. Naked short selling of shares is illegal.

Covered short selling of options, or covered writing of options, means the writer has hedged the exposure to risk. Naked short selling of options means the writer is writing options without any protection against the risk taken on, so the writer is exposing himself or herself to seriously large downside risk. Both styles of options writing is legal.

Thank-you.

Copyright © 2008 Nils Marchant.

This is an edited transcript of the talk first delivered to the Options21 Market Briefing on the 31st of August, 2008.

The sub-prime crisis has been widely reported for a year now. But how on earth could the average “Joe” bring down the global credit ratings system? The answer is he didn’t. He is just the “fall guy”, along with the “low documentation” sub-prime retail lenders. They are the fall guys because they’re involved at the periphery, and some media spin seeks to divert attention away from the real problem and its causes. If the system was working properly no home borrowers could break the system. So what’s gone wrong?

Sure: it isn’t really smart to give home loans without any deposit to so-called “Ninja’s” – those with no income, no job and no assets. So it is fair to direct some of the blame in the direction of the retailers and the borrowers. They should have known better. They may well have known better.

But maybe the lenders weren’t completely silly. Especially if they could off-load the future loan risk onto other parties before the risk materialized, and be rewarded for opening those loans without being accountable for the subsequent performance of those loans.

And it would be equally unfair to claim those borrowing to buy homes were stupid. Accommodation in a nice “home of your own” for a year or two on an unrepayable loan works out way better than renting. There’s no landlord, and you’re even free to treat the property as you wish. After the introductory low interest rate period expires: simply send the keys back to the bank and walk away. And even return to apply for another sub-prime loan, if the lender ignores your credit rating, which they did in the first place.

But what is a credit rating? Well, we’ll get onto that later.

This is how the system operates. I can’t choose the word “works”, because something is not working the way it should. Home buyers, some with no income or deposit, take out a mortgage from a retail lender. The retail lender bundles mortgages together into mortgage backed securities, which they sell to other banking entities further along the chain. The investment banks have very clever young business graduates with no experience of a crash. But they do have mathematical models. They statistically predict mortgage failure rates embedded in those mortgage backed securities. They then slice and dice and reassemble tranches of those securities to create structured investment vehicles (SIVs) and collateralized debt obligations (CDOs) which have a blend of good, intermediate and risky mortgages. The theory is that there’d be enough good mortgages to cover the chances of default by the bad ones. Those CDOs would then be sold to shire councils, local municipalities, superannuation funds and other investors around the world, from Norway to Australia. When I was young I was taught that mathematics can be used as an abstract representation of reality. But for these guys mathematics is reality, not a model of reality.

Now, that class of end investor is required to invest only in “AAA” rated investments, to protect their stakeholders against bad investment decisions. Trust is transferred to the credit ratings agencies. Using their mathematical models to forecast loan default rates and projected house prices, the investment banks were able to convince the ratings agencies to assign “AAA” ratings to those investment products. They would also use credit default swaps and other derivative instruments to insure those assets, to further protect against risk. Effectively they would forego a small amount of income to buy insurance in the form of derivatives from third parties, who would guarantee the performance of those CDO and SIV assets.

The money generated from selling those assets would then be ploughed back into the system as new loans to more home buyers, completing the circular flow of money and leveraging up the amount of debt and money to many times the original loan amounts. With all that money available, borrowing remained easy. They were throwing money at anyone who wanted a loan. “Don’t have a deposit? No problem, we’ll lend you the deposit!” And so the money circle continued, grew, and spiraled up, inflating house prices and creating the housing bubble. While it worked, everyone involved was a winner. On paper, at least.

But when things spiral up into leveraged bubbles, the collapse is usually as big as the rise. You can’t create wealth out of thin air. Those who bought houses near the top now find their mortgages upside down. If they’re not being foreclosed upon, many are simply walking away. So now, not all loan repayments are flowing back through to the end investors. This triggers insurance, and calls into question the credit ratings.

The sub-prime part of the problem has not really even got under way yet. I understand that there are many more loan defaults to come than have happened so far. This is because many of the problem loans are so calls “ARM” loans – adjustable rate mortgage loans. They have a fixed term low interest rate honeymoon period, after which the interest rate resets upwards to the market rate. Most ARM loans are still on their honeymoon low rate, and are yet to be adjusted upwards. So we probably haven’t yet seen the peak in loan defaults.

The Fed’s dramatic cuts in interest rates doesn’t really fix this because they can only influence the short end of the yield curve. Home loans are based on longer term interest rates.

But home loan defaults shouldn’t affect those CDOs and SIVs because they have insurance facilities in place, and they have (or at least they had) “AAA” ratings. Everyone should be protected, and the problem should be covered. So what’s the problem?

Well, insurers earn premium income by taking on risk, in this case the risk that those investment products might fail. Credit default swaps and other derivative instruments earn income by taking on risk. But it was difficult to see exactly what the risk was in some of those investments. In a sense it was hidden in the mathematics, and the maths was wrong. It was never possible in the first place to accurately quantify the risk. And besides, they had a “AAA” rating, so on balance they were probably all OK.

Now, this is where the game has been taken up to the next level. Just about anyone can write off-market financial instruments to earn premium income. Speculators and investors came into the scene opening all sorts of derivative positions to generate income by taking on risk. Because its all off-market, its largely unregulated.

Let’s imagine a group of people living in a street. Some of them notice that one of their neighbours is looking gravely ill. They each take out multiple life insurance policies on their sick neighbour down the road, hoping to cash in if he dies. They’re all betting against the insurance company that he’s going to die. The insurance companies go along with it, because it generates and amplifies premium income. And besides, they’ve done the maths.

But let’s say he’s displaying numerous medical certificates in front of his house which prove that he is one of the healthiest people alive. He’s not ill: this guy’s got a “AAA” bill of health. So then more neighbours emerge, and because there’s no real regulation in this street, they start writing life insurance policies over this guy: left, right and centre, to anyone who wants them. This generates bucket loads of premium income. It doesn’t matter that some of them won’t be able to pay out the life insurance if the poor ill neighbour dies. All they care about is collecting premium, the future is too far away. He’s not going to die anyway. His health is triple A.

Back in the real world of finance, in some cases the value of the insurance written over some investment products has been ten times the value of the investments in existence. Not only were insurers writing those derivatives, but also a whole lot of other participants. Those derivatives and insurance instruments have themselves been massively leveraged. And that insurance is over debt which itself has been massively leveraged. And because it’s all in an off market unregulated environment, there is no clear way to ensure that the counter-parties meet their obligations. It is like building a number of large houses of cards balanced up on top of a single house of cards.

Such a system might hang together if the bets aren’t too large and there aren’t too many failures – as long as most of the insured mortgage backed investment products remain healthy. But they were never healthy in the first place. When you’ve leveraged up the insurance, it only needs a few failures to create serious problems for the insurers. The health of the underlying assets they insured was not visible. (Well, actually it should have been visible. How can anyone write a loan for 100% of the asset without requiring any deposit or sufficient cash flow? Can the basic laws of financial discipline be changed to suit the instant gratification consumer economy?) Their health was hidden by the complex way in which risk, money, liability and obligations were sliced, diced, tranched and redistributed around all the interlinked chain of parties. The chain of financial transactions is so complex that obligations and liabilities are not really knowable, let alone clearly defined. The credit worthiness of those investments is now only as good as the credit worthiness of the insurer counterparty, and because the value of this whole game has been inflated so wildly out of proportion, into the trillions of dollars, the investment assets themselves have destroyed the creditworthiness of some of the insurers.

There is the real prospect that more risk has materialized than the insurers can afford to cover. And it is big.

Some of those “AAA” rated investment products have been downgraded not just one or two notches, but by over ten notches from “AAA” to junk, in the space of 12 hours: overnight. That requires the municipalities and other investors to sell them because those assets now don’t comply with their investment requirements to hold AAA. But there is no demand for them so sales are at a massive discount to their face value, if they can be sold at all. And the value of the mortgages and housing collateral which underpin those investments has also fallen. If the recent announcement by the National Australia Bank is anything to go by, it seems like these CDOs could be worth only around 20 cents in the dollar. Of their $1.2B in holdings, NAB has written off about one billion dollars worth.

This is a bit of a worry. In putting a market price on these CDOs and related investments, the financial institutions have been finally wrenched from the comfort of their mathematical models into reality. Merrills offloaded some of their CDOs and related investments at 22c in the dollar. How could the NAB have unquestioning faith in a AAA rating without doing some basic analysis of their own?

And this brings us to the heart of the problem. One should be able to trust credit ratings. No one can trust a credit rating anymore. How can an asset have a AAA rating one day, and overnight find it ranked with junk bonds? That’s why the interbank lending system has seized up. Banks are very reluctant to lend to one another because they just can’t assess risk with confidence, so they just don’t know how creditworthy their borrowers might be, including other banks – their fellow peers. It’s not so much a sub-prime crisis. It’s a crisis of trust at the most fundamental level in the entire financial system itself – not just in the US, but globally. If you can’t trust a credit rating, you can’t lend. You can neither know to whom, nor how. And you can’t borrow.

Injection of liquidity is a difficult way to restore trust. Much of the bail out money and new equity injections will end up in the hands of lawyers who will need years to unravel this tangled mess of liabilities. About the only market sector I’d like to be in for the long term in the US would be corporate litigation.

This is no small problem. This is not about the problems of a single insurance company. It is not a problem confined only to sub-prime mortgages, although much of the financial media continues to spin it this way.

One of the more perceptive commentators in this field currently is Sam Wylie, of the Melbourne Business School. I first saw his articles in the Australian Financial Review in early April, 2008, when he clearly identified the problems. Wylie sets out essentially three contributing problems.

Firstly, he argues that the ratings agencies have become the de-facto gatekeepers of the capital markets. Regulation of the credit markets has in effect been handed to private ratings agency companies, who control the issue of capital based on their risk assessment of assets.

Secondly, in the 1990s commercial banks were again permitted to act as investment banks, and to underwrite more risky sub-prime backed securities. Commercial banks’ balance sheets now hold low grade assets and greater risk.

The third problem is that the underlying bargain between banks and government has been breached. Traditionally banks would be prudent, and the government would act as lender of last resort. But relaxation of regulations and the lack of transparency of those derivatives have allowed the banks to be less prudent. The derivatives markets have become so large, complex and opaque that no one can really determine the value of those derivatives listed as assets. Those “over the counter” derivatives have no standardized, regulated or open market, unlike exchange traded derivatives. Yet the notional value of those derivatives has been allowed to explode completely out of control to about US$500 trillion. I can’t even imagine how big that is. But I do know that the hundreds of billions of dollars which the western central banks have already injected to delay the outcome is huge by historical scales. But that’s not a drop in the ocean compared to the size of the problem. The potential problem is bigger than all the western central banks combined.

Much of this injected liquidity effectively can’t be removed. So a side effect of the cure will be compounded inflation, especially in the US. That’s one reason why commodity prices are being inflated so rapidly. But that’s the subject of a separate discussion.

The US Federal Reserve is aware of the size of the problem. That’s why they appear to have been panicked into abandoning their efforts to control inflation. There is no easy solution. In fact there might be no solution. There’s really nothing they can do. Injecting liquidity only helps in the short term, and delays the full effects of the problem.

Should the Fed have allowed Bear Stearns to collapse? It was not a commercial bank. The Fed was not obliged to act as lender of last resort. Should it have allowed the invisible hand of the market to determine which entities survive and which fail? It’s a trade off between manipulating market confidence and perception, and allowing the market to cleanse itself of bad practice. No matter what the Fed chooses to do, the costs will be large, and felt around the world. The only difference will be whether the effects will be significant and soon, or even larger and later.

By propping up those entities who hold dodgy assets, the US Federal government has effectively signalled that it is prepared to support all the banks and insurers involved, not just the commercial banks. It now appears that they’re going to somehow support the whole interlinked chain through the investment banks to the financial insurers. They can’t afford to let the insurance companies go broke, because the whole system will then collapse. That is a massive undertaking by the US taxpayer, which ultimately will put more downward pressure on the US dollar.

But in doing so, are they inviting more of the same? Could bad practice now be encouraged and amplified? Does anything prevent the continued money circle of CDOs, SIVs, credit default swaps and other off market derivatives? It takes time to change the rules. Obviously there needs to be a thorough and carefully thought through overhaul of not only financial regulation, but the whole system. But you can never change the rules in haste without making things worse. So the environment remains the same for now. By propping up those entities in the interim and accepting risky assets as collateral the US Fed only invites more of the same merry-go-round problem.

But what really needs to be restored is trust.

How can you restore confidence in credit ratings? How long will that take, if it can be done at all? Can you restore trust by unleashing liquidity? That would require many trillions of dollars. It sounds to me a bit like trying to restore trust by transferring mistrust away, and into the underlying fiat currencies. Are they really going to prop up the whole chain from the lenders, through the investment banks to the financial insurers?

And even the ratings agencies?

Copyright © 2008 Nils Marchant.

This is an edited transcript of the paper first delivered at the Options21 market briefings during the 27th – 30th of July, 2008.

In the past, and in theory, inflation would generally lead to increased interest rates. Western central banks would raise interest rates because the threat of inflation is far more serious than an economic slowdown. Inflation thus was to be avoided at all cost. But in the US, not now: not anymore.

The US had been running ostensibly two conflicting policies. On the one hand, and in accordance with accepted central bank policy, they had been controlling inflation by increasing interest rates. But on the other hand the US has been and continues to increase money supply at an outrageous rate, which causes inflation. Raising interest rates in fact had to be abandoned for three reasons. Firstly, the Federal Reserve sought to inject short term liquidity to delay the effects of the credit crisis. Secondly, raising interest rates would now only accelerate the already entrenched US economic downturn. And thirdly, interest rates don’t really work that well anyway to control inflation.

But the real reason is that the US needs to devalue its currency to reduce the value of its debt and current account deficit. They seek to do so in a controlled manner to avoid a US dollar crash. If they devalue the US dollar, they don’t have to repay as much. (Which, by the way, doesn’t impress the Europeans, who have half a trillion or so of US dollar denominated debt.)

Increasing the money supply is a well calculated programme. They are increasing M3 – the measure of broad money supply – at over 15% pa. Unless there’s commensurate economic growth, all those extra US dollars flooding around push up prices. And because the US dollar is still the global reserve currency, those dollars go flooding around the whole world as petro-dollars and in other forms, through all commodities,

So: what will be the effects? Well, obviously global inflation. Probably very high inflation in the US. But, what exactly is inflation? Well, we need to define that.

Inflation is the expansion of the amount of currency or the number of dollars in an economic system. Rising prices are only a symptom of inflation and the oversupply of money. Generally when you oversupply the market with money, prices go up. Those lessons have been learned since Roman times, notably in Germany during the Weimar Republic. For those interested, there is a humorous work of fiction describing everyday life in the German hyper-inflationary environment. Read “The Black Obelisk” by Erich Maria Remarque. It might be timely to relearn some of those lessons from history.

President Robert Mugabe in Zimbabwe has thrown away those lessons of history by printing Zimbabwean dollars to maintain power. Inflation shifts poverty in one direction, and wealth and power in another. He doesn’t appear to care about the destructive side effects which destroy his nation’s economy. Is it better to be the supreme leader of a dying state, or a subordinate player in a healthy state?

The US has been trying to hide their monetary expansion activity in a number of ways. For a period they actually suspended the release of treasury M3 data, to hide the rate at which they are increasing the US dollar money supply. But the world is not so silly as to be fooled. Intelligent people such as those at websites like “shadowstats” managed to reconstruct M3 values from other data, so effectively the US couldn’t keep it secret. They have now resumed publication of M3.

It’s all a game of spin – the manipulation of perception.

Inflation is measured by the CPI. The US has dropped various basics from their measure of their CPI. They no longer count energy and food, because those items are not what they deem to be part of “core inflation”. Those items also happen to be shooting up in price, and everyone happens to need food and fuel. But the US consumer knows the CPI figures are wrong, seeing their groceries going up by 10% or so pa, and their fuel by even more. Their incomes don’t keep up, especially now with the economic downturn.

And the effect of all this? The effect is to transfer wealth from those whose salaries, savings and loans are denominated in the currency to those who own income producing assets. Inflation is theft by stealth. Inflation transfers wealth from savers and lenders to borrowers.

The US economy is a consumer economy. Eighty percent of US economic activity is consumption. That consumption is largely funded by debt. Much of the production and supply of consumer goods has been transferred from US factories to Chinese factories. The declining US dollar makes imported Chinese consumer goods cost more, further exacerbating US inflation.

A consumer economy relying on Chinese debt to buy Chinese goods is not strategically smart. The decline of the US dollar will have serious and permanent repercussions. The US and the west is becoming increasingly vulnerable to Chinese demands. The global economic and political power balance is shifting right before our very eyes. Learn Mandarin.

Weakening consumer purchasing power will mean that the consumer can no longer continue to buy goods of the same value. When consumers buy products of lesser value, they consume less, and the consumer economy shrinks. Even though US consumers will continue to spend the same dollar value, because of inflating prices, they actually buy less. Higher commodity prices therefore will continue to feed and further amplify the already established US economic downturn.

The economic downturn won’t only be in industries affected by higher oil and metal prices, such as the automotive industry. It’ll stretch further across the board. There will be a shift down from luxury spending to essential spending. People will still eat, but they’ll eat, travel, dress and live more frugally. Profitability will shift from the luxury consumption industries – higher quality hotels, restaurants, cars and fashions – to basic necessity consumption industries – the Wal-Mart’s.

Another side effect will be in transport. Railways are an extremely efficient way to move goods. A train needs only a couple of drivers to move thousands of tons of goods, and because of the very low friction of steel wheels on steel rails, with a minimal quantity of diesoline. You’ll see US railroad stocks have been rallying since the beginning of 2008.

Inflation transfers wealth from those whose savings are denominated in US dollars to the borrower. Countries whose currencies are pegged or tightly linked to the US dollar will find food, fuels and basic resources more expensive. Hence rice, corn and other food riots, and fuel protests.

China needs to secure basic resources. Each month, more than one million people are moving from a rural environment to cities. That all needs copper, steel, nickel, iron ore, oil and coal. While we in the west are reducing coal emissions, China is building a one Gigawatt coal burning power station every week or two. So China has to take increasingly strident action to secure the basic resources it requires. China has a significant US dollar surplus: over a trillion dollars, and rising rapidly. China desperately needs those commodities – not so much to manufacture consumer goods for the US, but for its own urban and industrial growth. China is not only playing at takeovers for Unocal, and the resource giants. They are very active throughout resource rich Africa and South America, giving aid to countries, or maybe at least to those in political power. Was it a renegade Chinese group who attempted to ship arms to President Mugabe? I don’t think they have renegade groups in China. Everything in China is tightly controlled by the central party, or committee.

One must ask why China has paid for the construction of a new presidential palace and ministry of foreign affairs in East Timor. I’m sure the wiring will come free! The tropics are an ideal environment for thousands of bugs. And why China and East Timor are expanding military exchanges. The Timor gap contains potentially vast amounts of oil and gas. China needs to play hard ball to secure its resources.

Since the second world war all oil has been traded in US dollars. Those petro-dollars helped maintain the status of the US dollar as the global reserve currency. Monopolizing that oil trade in US currency gave the US global economic might. But now, with the dollar falling, oil exporting nations have to increase the US dollar oil price just to maintain the value of their revenue. Therefore another side effect of expanding M3 and flooding the world with US dollars will be to accelerate the rate at which oil exporting nations will move to trade oil in other currencies, to break out from the US$ monopoly, and trade in Euros or Roubles. Or maybe even the Yuan. But ultimately, we could see the resurrection of a pan-Arabic gold backed Dinar – a currency linked to the value of gold, unlike our paper fiat currencies whose inherent value rests on our trust in the authorities to keep money supply scarce.

It was reported that only a matter of weeks before “Shock and Awe” in Iraq, Iraq had commenced writing oil contracts in Euros instead of US dollars. The rumblings against Iran may be in response to Iran’s establishment of their oil trading exchange which allows for contracts to be traded in currencies other than the US dollar.

In a sense, preservation of the US dollar monopoly on oil trade is a matter of vital national security for the US. Oil is one of the last supports which prop up the value of the US dollar. For the US has largely destroyed the value of its own currency from within.

The US can not play the weapons of mass destruction card again. The irony is that it can not do so even if Iran really does have weapons of mass destruction. Iran’s president Mahmoud Ahmadinejad appears to have played his strategic cards better than the west.

In a nutshell, the flooding of the world with US dollars can only cause prices to rise. Whether it’s corn or oil is only a minor consideration. Everything traded in US dollars has to go up. Even transferring transport from oil based vehicles to electric vehicles will not solve the problem. All that can do is only partially shift price inflation from oil to copper and other metals used to make electric vehicles, but China already dominates demand for those materials. As long as Chinese demand continues to outstrip supply, and as long as the US continues to inflate broad money supply – M3 – these conditions will continue to worsen. Inflation in the US looks like it will increase further, and faster, causing the US dollar to lose further value correspondingly.

Copyright © 2008 Nils Marchant.

This is an edited transcript of an Options21 Market Briefing presentation first delivered on the 7th June, 2008.

Looking at the daily S&P 500 chart above, we can clearly see that the market continues to trade in a primary down trend, as defined by a declining 50 period and 200 period SMA. With the continuing bad news but a contradictory price rally, the question begs to be asked: What now?

Two weeks ago we presented a live market briefing via the internet, outlining two potential scenarios. The two scenarios are based on the premise that we are still in a down trend. See below.

Scenario 1: During the months of January and February the S&P 500 traced out a symmetrical triangle. Traditional technical analysis states that a break and close outside of this triangle, followed by confirmation the following day, constitutes a break out and should be traded in the direction of the break. As it panned, out the S&P 500 did break to the downside, but on a daily chart it closed back into the triangle, hence negating any breakdown (anticipated based on the last bar of the chart). At this point Scenario 1 is invalid.

Scenario 2 forecasted a break upward, outside the top of the Triangle but finding major resistance just above the current market level. If it does, the market has some major levels of resistance to get through before it can continue higher. There are four resistance points we can identify, which become potential failure points for the markets. The first level of resistance is the declining 50 period moving average (blue declining line). Markets can often be observed to trade slightly above this average before continuing their downward trend. The next level of resistance is taken from the previous swing high. (Pink horizontal line). The third level of resistance is the old support line in November (dark blue heavy line) which now becomes resistance. The last level of resistance is 50% of the price range A-B (in Aqua). Three of these resistance lines come together in the red box. This is a point of potential price failure in the market.

Summary: The market is in a primary downtrend. If you trade against this trend (go long) you can only do so in very short time frames (1-3 days). Otherwise stick with selecting trades within the primary trend (Buy puts). Any upward movements should be taken as counter trends for the next move down.

Before we can place any importance in statements that the markets have bottomed, we need to observe an upward 50 SMA and 200 SMA which are both a long way from pointing upward. This will be preceded by a well defined basing structure, of which there is no evidence either.

Kind Regards,
Paul Wise.