Wednesday, November 26, 2008

The Econolypse, The Dollar, And Gold

I think we need a name for all this. "Credit Crisis" is lame. "Great Depression 2" is not only lame, but it misrepresents what is happening. It keeps us in the mindset of fighting the last war. For me, we are in "The Econolypse" (must credit my good friend V.R. on that one).

The Econolypse will twist our heads off. It is the The End of an era, and therefore a massive disillusionment is in store. No, it's not the disillusionment you thought was coming because that wouldn't be a disillusionment, would it? Unless you are already insane, the Econolypse will make you doubt what you know, who you thought you knew and why you ever believed you knew either of them. People who read economics are always modelling everything. This is that thing you can't model. Look, you're smart. If you could have modelled it, so could other smart people. And if they could have modelled it, it wouldn't have happened.

Nobody consciously chooses an Econolypse. Believe me, if anyone were to choose an Econolypse, it would be socialists. I know socialists - real, actual socialists, not liberals or Progressives - and they are very, very unhappy with what is going on. Oh, and if you think this was all caused by Greenspan and that the government is acting outrageously by bailing out all these firms - so do they. That's right. You probably agree with socialists.

I agree with...almost nobody, I guess...but such an attitude can help one pick one's way forward in this kind of darkness. It's a pretty simple algorithm: you go completely contrarian. Look at the pervading beliefs. List them. Now list their opposites. Now try to stitch together a world where all those things are true at the same time. Looks weird, huh?

Fortunately for you (and unfortunately for me) I have already been living in this dark world for some time. I've been waiting for you. Others of you think you have a good idea what this dark world looks like. No, you haven't. I dare say this because vast majority - or even all - of the people who are as least as smart as you are and who predicted the downturn also predicted something else - something big - that not only did not come true, the opposite came true. And that was the "Fall of the Dollar". This summer, they thought they were seeing it unfold before their eyes. Finally the imbalances had become too great. Finally it was all coming apart. The new Weimar Republic was here. Hyperinflation was just days away.

They thought this as the dollar (here I use the Dollar Index) went from 88 in 2006 to 78 in 2008. They were sure of it when the dollar went from 78 to a miserable 72 in just a few months. They still thought it when the dollar went from 72 to 80 (just a blip). They were sure of it when the dollar went from 80 to 76 (that's more like it) and they were still pretty sure of it as the dollar went from 76 to 88, although they were starting to put together some caveats like "flight to safety". Now that the dollar has fallen from 88 to 84 (and may head down even more), they are sure once again that they know what's going on.

If only it was true.

Because even a rip-roaring dollar inflation would be welcome right now. It would ease a lot of minds and show that we were in just the kind of plain, old stagflation we're used to. It's probably not going to happen and that is pretty frightening. The Fed and Treasury are doing literally everything they can think of to re-inflate the dollar and it is just not working. The fundamentals are just too strong and the dollar shortage is just too acute.

It's simple supply and demand. The market needs dollars, the world's credit system is no longer producing them and even the U.S. government cannot supply enough right now. The huge Fails To Deliver in the Treasuries market are no accident. The demand is enormous. The market has spoken. Treasuries are where the large players want to hold their money. So after this pause, it pains me to predict that the dollar will head much higher - like to 97-100.

Along with this breakout, we should expect panic and disorientation. Actually, the cause for the breakout - the bankruptcy of yet another huge firm (I'm worried about Banco Santander, personally) or some major collapse of yet another credit market - will cause the panic. Things will move from bad to incomprehensible. That should help gold. You have to respect the fact that gold is a highly emotional market that can move 10% in any given day. Gold could easily go through $850 and even spike to $900 intraday. Or, maybe, gold is done here at $820. Either way, gold is a commodity and in a deflation, it will deflate. The deflation of gold is long overdue. Gold is radically overpriced in terms of silver, oil, the dollar and even the gold lease rate. Basically people across the world will be given a choice among three things: U.S. dollars that can buy anything, their own currency that buys less and less, or gold that might hold value but can't really buy anything on its own. Once gold stops holding value, there is no investment thesis for it.

I hope I'm wrong. I really do. As scared as people are now, they are going to be even more scared when they find they have to sell a commodity they do understand - gold - and buy a currency they know, but don't understand - the dollar.

Will it happen tomorrow? Probably not. Will it happen in the next few months? Look, we are only at the beginning of this thing. It will happen and, much sooner than we would like,...

...We will all live in very interesting times

Friday, November 21, 2008

The New "Four Horsemen" of the Econolypse


Berkshire Hathaway



To quote Jim Rogers from an October 31 interview on Bloomberg:

" I wouldn't lend money to a guy with phony bookkeeping and you wouldn't either."
I disagree with a lot of what Jim Rogers says (his call to buy agricultural commodities in that interview was an absolute tragedy), but this is a simple, accurate analysis of the problem. Citigroup is a three-headed monstrosity of phony bookkeeping - call it "The Three C's." Commercial Real Estate + Credit Cards = Citigroup. The bank is a black hole about to get on its black horse and ride out into the world on Monday.

The next "black hole" is unemployment. It's not black because we don't have the information. It's black because we're all ignoring it. You keep hearing that unemployment will "possibly go as high as 8% by the end of 2009." Ridiculous. Add up just the announced layoffs (if you can) and you will see that we'll be lucky if unemployment isn't 8% by the end of January (although the number may have to be revised upwards in February or March). There is 8% unemployment in California already and California has led the nation in economic trends - good and bad.

The Horseman of Unemployment has Citigroup is on its horse and when those two are mounted, Berkshire Hathaway is next to ride. Unemployment will insure that the companies behind Berkshire's "investment" in junk bond CDS suffer devastating losses and default. Citigroup's debacle will kill worldwide averages and insure our insane levels of volatlity stay nice and high. Buffett bet long the averages and short volatility in 2007. Nice trade, Oracle.

Therefore will the Banshee of Berkshire ride, causing terror across the land.

With all the panic, gold should do nicely - maybe $850/ounce, maybe a bit higher. But as she mounts that next rise, beware, the Golden Goddess also mounts her horse and prepares to ride - fast - down Mt. Econolypse into the tiny and ever-shrinking town of Deflationville in the valley below - and then on to the valley below that and then the valley below that.

That will not be a nice time. People will be a little confused then.

But I predict this is an economy which will require total capitulation in all the financial markets before it turns. We must all be terrified and frustrated before the Econolypse will pass.

...And then things will start to turn around.

May you live in interesting times.

Wednesday, November 19, 2008

The Smoking Gun

By 2004, the FICO system was gamed.

It was the final step in the destruction of Wall Street, a destruction engineered by the rapacity and dishonesty of American mortgage and fixed-income firms. Here, on, Michael Lewis reveals the mechanism of that destruction in the best article I have yet read on the origins of the Credit Crisis. Mr. Lewis hasn't hipped to the FICO story yet, but he'll get it. He covers all the rest. The article is absolutely a must-read for anyone who wants to understand what really happened.

I first realized FICO got gamed while reading a paper by the American Enterprise Institute's Peter J. Wallison. Mr. Wallison is the principal author of the Republican talking points on Fannie and Freddie. Wallison has been carrying Wall Street's water for many years in their jihad against the GSEs. If you think Fannie and Freddie are to blame for it all, Peter J. Wallison earned his money. Like all good con men, Mr. Wallison sticks to the truth as closely as possible for as long as possible, but he slipped up with one simple sentence:

There are many definitions of a subprime loan, but the definition used by U.S. bank regulators is any loan to a borrower with damaged credit, including such objective criteria as a FICO credit score lower than 660.

Emphasis mine, but those words "objective criteria" jumped out at me.

Obviously the most objective criterion of credit risk is the actual default rate. Wallison talks about the default rates in the GSE portfolio coming largely from private-lable RMBS, but he does not cite the default rates for the actual borrowers to whom he objects most. I wondered why. If you read the paper and then look at the data (as best you can), I think you'll find something surprising.

First, it turns out that Mr. Wallison is correct that Fannie and Freddie DID take on borrowers with FICO scores lower than they should have - although not in the way he implies. But I found that the borrowers to which Mr. Wallison attributes so much damage actually defaulted at LOWER rates than that same FICO cohort defaulted for private banks. Moreover, because Fannie and Freddie bought Alt-A mortgage paper, Alt-A mortgages and even guaranteed a few Alt-A borrowers (but a very few), one can glean from the data that the farther away a borrower of a given FICO score was from the GSE's full due diligence process, the more likely that borrower was to default. Relative to the private sector, the GSEs were better judges of default risk and their default rates prove it. Even the private-label Alt-A paper bought by the GSEs has a markedly lower rate of default than the industry average.

Still, it was strange. Relative to how it worked in the private-sector data, FICO significantly OVER-predicted defaults in the GSE portfolios (when taken as a whole). If FICO is an "objective" measure, this should not have happened.

And then there is the question of the vintages.

That question became very intriguing to me when I read a much-quoted working paper published by the St. Louis Fed entitled: "Where’s the Smoking Gun? - A Study of Underwriting Standards for US Subprime Mortgages." I've long ago learned that people who have something to hide generally hide it in the title and the appendices. So, I went looking for the smoking gun the authors said was not there and quickly found it.

The authors boldly claim that:
Our results indicate that there is no evidence of a dramatic change in underwriting standards in the subprime market, particularly for originations after 2004. Given the multidimensional nature of ex ante credit risk, it is difficult to emphasize weakening in terms of some attributes as a decline in overall underwriting standards. The results show that while underwriting may have weakened along some dimensions (e.g. lower documentation), it also strengthened in others (e.g. higher FICO scores).

So, I immediately looked at their FICO data. It was shocking. To make the claim they make, you have to completely ignore the performance of the FICO cohorts and the fact that people in the business know that data. If you look at Table 12 (which divides FICO cohorts very suspiciously, but, that's another question) you will find that for the FICO cohort 660-720, first-year mortgage default rates went up a bit in 2004, doubled in 2005, quintupled in 2006 and were about eight times higher than normal in 2007. The numbers were terrible for all FICO cohorts, but that big one with SO many borrowers was just appalling.

So in 2004, bankers had suspect data and kept lending. In 2005, they had alarming data and kept lending. In 2006 they had shocking data and just kept right on lending faster than ever. In 2007, it was a travesty and they still kept lending until the whole thing blew up. Now these Bozos writing for the St. Louis Fed have the nerve to claim that underwriting standards didn't fall? Lenders knew that FICO has already failed. They knew it was gamed. Their data showed it conclusively. As if the data weren't enough, they could see the sudden profusion of new "Credit Reporting Agencies" and all the "score borrowing" and "rapid readjust" nonsense going on.

They didn't want to see it. The FICO cohort that was falling apart represented the bulk of their profitable borrowers. This was not the sub-620 extreme or the low-profit Prime book. This was the thick part of their bell curve. FICO was gamed. FICO was junk. But question FICO and you yanked the emergency brake on the Gravy Train. So not only did they not question it, they started to rely on FICO almost exclusively. They started to insist on having as little OTHER data on borrowers as possible. When they asked for the Equifax reports, they stopped asking for the employment and income data. They started pushing "low-doc" and "no-doc" paper out the door as fast as they could. See no evil, hear no evil and make a buttload of money.

You'll find that all lenders - including the GSEs - raised their FICO score standards in the later years of the crisis - to no avail. FICO was no longer "objective". It had become the foundation of a scam. As Michael Lews writes of one of the people who saw through the scam:

[He] knew subprime lenders could be scumbags. What he underestimated was the total unabashed complicity of the upper class of American capitalism.

A crisis like this is not an "'or' crisis". It's not a question of looking back and deciding whether this happened "or" that happened. It's an "'and' crisis". This happened "and" that happened but the "this" - the malplactice and fraud - predominated. Yes, there were stupid borrowers and stupid buyers of these securities (including the GSEs) at both ends of the line. But the cause of this crisis was pervasive malfeasance by the people in the private-sector, non-GSE business of selling American mortgage debt to borrowers and customers. Starting with the FICO, there was fraud at every step of the way up to and including the derivatives on the stuctured products. The willful ignorance and stupidity of borrowers and customers were just the whipped cream and cherry on top. We are living through the results what is the largest case of financial malpractice in human history - "malpractice" at best.

I'd call it "fraud".

This is why Paulson's plan's won't work: You can try every excuse in the world, but you can't fix this problem until you admit what it was and is.


May you live in interesting times

Thursday, November 6, 2008

The End of The Era Of The Martingale

What do Barack Obama's election and the credit crisis have in common? They are both signals of the end of an era. They called it the "End Of History", and they were just as wrong as the phrase alone would lead you to expect they would be. But that didn't stop them. They were so sure of themselves that in the face of adversity, they just kept doubling their bets.

Didn't work out so well.

It was not just the now-central follies of ignoring the Kurdish Question, having too much confidence in Musharraff or the total blind faith put into the insane notion that somehow bankers would always tell the truth and be responsible that led us to the state we're in. It was a Culture War against doubt and intellectual skepticism itself. It was an iron-clad belief that what worked yesterday would always work. And in the waning year it became the nothing more than a Ponzi scheme depending on the emotional camouflage of the martingale.

The conservative business and political elite gave the world the message that they would back down to nothing short of total repudiation and that is very nearly what they've gotten. That is how martingale's always end: bankruptcy.

Tuesday, October 21, 2008

Does Socialism Make Smarter Capitalists?

I think that to understand the present crisis - I mean even to wrap your mind around it - you have to have been schooled in Marxism for at least some time. I really do. It's not that Marxism itself is so informative here, although highly selected and re-interpreted portions can be. It's that to understand what is happening now, you have to have learned - at some time - to look at the capitalist system from outside of it. You have to have wondered "what's next?" and tried to come up with something positive, rather than just catastrophe.

And it really helps if you have had the experience of rejecting doctrinaire Marxism and thus developing a deeper appreciation for capitalism. I theorize that this is why Jim Cramer has had such good instincts about this crisis. He was a red for a while back in his college days, I understand. And of course George Soros - another devout capitalist schooled, if unwillingly, in Marxism - has done really, really well.

Meanwhile his old partner Jim Rogers is floundering. High-powered investment bankers - like Henry Paulson - are confused. America's greatest living expert on deflationary crises - Ben Bernanke - has been slow to react after making an entire academic career around the observation that people in government - in his very position - were too slow to react in the 1930's. But European leaders - schooled in socialism, whether right wing or left - are acting with increasing clarity. Meanwhile high-powered people who have gotten so many things right - like Brad Setser, Nouriel Roubini and even Warren Buffett - seem increasingly baffled.

What they seem almost unable to really understand is simply this:

...and why it's happening.

That is a chart of the Dollar Index - a measure of the value of the U.S. dollar against major currencies. During this period, the U.S. government and now other governments have been pouring an supply of dollars and dollar credit onto the market that is not just unprecedented, but previously unimaginable. And these governments are doing nothing but announcing plans to keep on providing dollars as fast as they can for the foreseeable future. And during this period, the value of the dollar is going up - fast.

The law of supply and demand seems broken when it comes to the U.S. dollar. They supply and the world just keeps demanding.

I think the misunderstanding is based on some fundamental misconceptions, but who am I to explain things to the smart set? Let them figure it out for themselves, the big show-offs. I'm just going to predict that it's going to keep happening for a while and that is going to be really scary and bad. At the same time, the dynamic is forcing us to re-think the structure of our financial system and put some solid government backing behind it, which is a good thing. I think most of the major traded commodities and currencies are probably going to fall versus the dollar for quite a little while. Maybe even the renminbi will fall, although that is a currency highly subject to government intervention. Maybe even the yen will fall, although that is the currency of arguably the most-productive nation - person for person - in the history of the world. And, yes, maybe even gold will fall, although panic-buying gives gold the potential for incredible volatility, as we've seen. If you're not looking at the system from outside the system - questioning some of the common assumptions - I just don't think you could even be expected to see this coming.

Brad Setser has a wonderfully informative article about the "End Of Bretton Woods 2." on his blog. It's very good, although I'm not sure it explains why we've seen the reverse of some of his most important predictions. But in economics the same dynamic can have effects that seem the opposite of each other, particularly if they involve foreign exchange. He did get the timing of his crisis call very right. Nouriel Roubini did also and Roubini doesn't really need to get mechanisms quite right. He observes so many things about the world that he's incredibly informative and flexible. And Warren Buffett? I dunno, maybe his call on stocks isn't so bad, although I'm not sure his predictions of record profits in 5 years for some American corporations is necessarily all that meaningful if the majority are in the soup. Certainly unprecedented volatility looks like something we're going to have to get used to and people don't usually like having so much of their principal at risk.The point is that even people who saw a lot of risk in the American economy have consistently misidentified the likely results or come to make predictions that seem to ignore obvious risk.

To me, what looks clear about the world looks very clear and it's a strange experience. Every morning I wake up expecting everything to reverse course, but it doesn't. I'm usually terrible at making specific calls on markets and now even my call on gold doesn't seem so bad. Even the yen looks like it might be turning. That's pretty wild.

I hope I'm not right. I hope I'm really not seeing something important. Although the future does ultimately look bright to me, it's going to be pretty scary and people will be hurt. What can you do, other than... in interesting times

Tuesday, October 7, 2008

The Panic of '08

Well, that's it. This is one of those "history book" moments. The weird part is that it will all be blogged

I almost wasn't going to write this story until I read a piece from Bloomberg that made it clear to me we were truly in the soup. The relevant paragraph is here:

Banks and investors who are losing money on the record $1.7 trillion of high-yield, high-risk loans made in 2006 and 2007 are charging borrowers an average of 1.64 percentage points more in interest to amend borrowing agreements and avoid default, according to Standard & Poor's. That's the highest since 1997 and almost eight times more than the first half of last year.
On the face of it, it doesn't seem like much. But if you know the history of this crisis, it's very disturbing indeed.

The break in the credit markets came first in the market for leveraged loans. These are loans made to companies that already have a lot of debt so there is very little capital backing them up - hence the leverage. The secondary market for leveraged loans was actually a pretty quiet place until July-August of 2007 when it just blew up. It was, Wall Street later told us, the financial equivalent of a 500-year flood. The first levee-breaks at the end of July 2007 was taken to be the first sign that subprime mortgage loans were destabilizing the credit markets.

But hang on, what's the connection between loans to companies and mortgages to people with poor credit? Well, the explanation that came out of Wall Street - very quickly - was that losses in the subprime market were forcing banks to reign in their lending and so they started this reigning-in in the leveraged loan market. The economy was doing well. The companies were sound. It was a credit crisis in another place that was causing the trouble in these loans. We didn't know that could happen. Interesting

First, Wall Street told us of a global market for debt. Then they admitted that the labyrinth of mutual bets the banks all made with each other in the derivatives market - particularly the Credit Default Swap market - made it so that trouble in one area of credit could quickly go to another. Then the story got wonkier. It was all about "mark to market accounting" which had been a very good thing the industry was pushing governments to adopt but was now a very bad thing the government was forcing on them. Wonkier still, they admitted that "actively-managed balance sheets" were moving credit losses from one area of business to another. In retrospect, they came up with all of it a little too fast. It should have struck me how quickly came the explanations, all supporting the story about how German banks were being sunk by California mortgages because we have all been made one big, happy family, by - yes, over-exuberant and certainly geeky, but business-sound - financiers....except that American mortgage borrowers are a bunch of deadbeats and ruined everything. I should have been even more skeptical and - given the people telling the story - even more cynical

Now it turns out that these maniacs in the financial industry were not only setting records in mortgage lending and derivatives, they were also setting records in risky loans to businesses. It's now becoming clear that the crash in the leveraged loan market has had quite a little bit more to do with the underlying soundness of those businesses than their banks first admitted. It looks like leveraged loans were the Business Class version of subprime.

If so, that's that. We're screwed. And I think it's so.

The only saving grace is that because these loans were made to businesses with plenty of lawyers and accountants, there was probably a lot less outright fraud than there was in the mortgage market. At the end of the boom, I'm not sure there were always even existing houses underneath some of the mortgages people wrote. We know for a fact they lent to dead people in some instances. It's harder to do that with a leveraged loan - but I'll bet they came as close as they could.

And I say we're screwed because it looks like - on top of all the other insanity - the genius-idiots of The City and Wall Street loaded up our most economically-sensitive businesses with piggy-back debt they were at pains to repay in good times. This assures us that as soon as the real economy turns down significantly, a wave of defaults from that supposed "500-year flood" will crash onto the financial sector. I had heard something about corporate loans having hurt one of the large banks recently in the news, but I thought it was a smokescreen for their mortgage losses. Now it looks likely they were getting killed by both mortgages and corporate loans.

And now so are we all.

May you live in interesting times

Tuesday, September 30, 2008

From Bloomberg:

"There's a dollar shortage globally,'' said Alan Ruskin, head of international currency strategy in North America at RBS Greenwich Capital Markets Inc. in Greenwich, Connecticut. ``Demand for liquidity trumps the fundamentals. Fundamentally, the U.S. is awful, and Europe is awful. Fundamentals are irrelevant today.''

May you live