Oil speculation

The Economist leader this week is about oil. Clearly, at $135 a barrel the world is suffering a serious oil shock. Equally clearly, everyone is looking around for someone to blame. One of the favorites is those-evil-speculators. The Economist puts it thusly:

Stuck for answers, politicians have been looking for scapegoats. Top of the list are the speculators profiting from other people's hardship. Some $260 billion is invested in commodity funds, 20 times the level of 2003. Surely all that hot money has supercharged the demand for oil? But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of “paper barrels”, but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.

Of course, as useful and intelligent as The Economist is, it sometimes suffers from over-compression an idea in order to fit it into their bite-size chunk type of format. If you actually look at it the facts, there is every reasons to believe that speculation is in fact contributing substantially to the run up in oil prices. This is not to say that the entire move over the last four years from $35 to $135 has been caused by speculation. There is certainly a broader supply and demand trend. But to ignore the contribution of changes in the financial markets is foolish, no matter how well it sits with your market fundamentalism faith. On top of that, The Economist, while mumbling a bit about inflation, does nothing to explore the role that negative real interest rates have in all this.

In reading over this question, I often feel it can be reduced to a case of the all-powerful force and the unmovable object. On the one hand, The Economist and a lot of other people claim that there is no possible way that the money coming through index funds into futures can effect the spot market. They claim that this is just "paper oil" we'd see a huge rise in inventories, which we don't. This is impeccable logic. On the other hand, when the fund inflows into commodities are as large as they are and you can see long-time industry participants complaining about the distortions that are happening in the markets, you have to assume that this amount of new money is going to have some effect on the price.

So, in sum, there absolutely must be commodity speculation, and there can't possibly be.

Of course, as happens with most speculative manias, both are partly correct. There is always a long-term story, and it always gets over-hyped. In this case, the conclusion is that the days of $35 a barrel oil (the marginal production cost) are over, but that neither is there any reason to believe that the price will stay above $100 for very long. Half of the story is the growing demand and long lag time on new supply of an ultimately finite resource, and half is a financial bubble -- "peak oil" meets peak oil frenzy. So let's not beat around the bush. The price of oil will stabilize around $75. That's my story, and I'm sticking to it.

Second life

In a funny coincidence I just finished writing an e-mail about this very topic of what's going to happen with globalization (and of course, how to profit from that). Here is Philip Stephens in the Financial Times with Uncomfortable truths for a new world of them and us.

The world has been turned on its head. Consumers in the wealthiest nations are struggling with the consequences of the credit crunch and with the soaring cost of energy and food. In China, retail sales have been rising at an annual 15 per cent. I cannot think of a better description of the emerging global order.

In another interesting coincidence, I found this link via Naked Capitalism, who mentions a place dear to my heart in his commentary.

But the ugly fact is that the US (and the UK) has the potential to go from first world to third world on a relative basis. We've already have one developing economy trait: the emergence of a super-rich cohort that lives in splendid isolation, often with considerable security.

If you think that's impossible, remember that Argentina had a spectacularly rapid fall. Bad leadership can destroy an economy in a surprisingly short period of time. Again, the US will hopefully escape that fate, but no matter what happens, our economic strength is ebbing as others are moving forward. A severe crisis in the advanced economies could lead to a bad outcomes even in emerging economies, but that scenario has perils of its own.

I don't think there's any reason to believe that the US will be destroyed in the long-run by these changes in globalization. After all, it is beginning with a remarkable secular head-start, even if the cyclical tide is against us. But avoiding this -- avoiding becoming Argentina -- will require a certain political will. 8 more years of George Bush would probably be America's undoing.

Argentina and the US are a little bit like twin colonies separated at birth. Someday I hope they are re-united, but I definitely hope it's because Argentina comes to resemble the US, warts and all, rather than vice-versa.

Bear bottoms

One hears an awful lot about what bear market bottoms look like historically, and most of it tends to seem a bit silly to me. But the idea this Morgan Stanley analyst had to read all the WSJ copies surrounding a bear market bottom seems interesting. A couple of his points:

1. Valuations get very very low indeed. The cyclically-adjusted PE, aka the Shiller PE, represented by the latest price divided by the average earnings of the last 10 years, reaches 10 or even less at bear market bottoms, while Tobin’s Q, the price divided by the replacement value of assets (or price over net worth defined as assets minus liabilities), gets as low as 30% or less. These valuations are the biggest problem with today’s market, as the Shiller PE is more than twice that. Today’s message: Shiller PE is above 20 still, while true bear markets tend to end at less than 10 times. Equities are not cheap enough and need to decline by at least 50 percent.

2. Equities become cheap slowly. The average duration of bear markets has been 14 years, with the much more rapid 1929-32 episode, when equities went down 89%, the exception. Today’s message: we are in year 8 of a 14 year bear market.

3. Sentiment is not hugely negative at the bottom of the bear market. The popular myth that there are no bulls left at the bottom of the bear market is wrong. Many market commentators are correctly bullish right at the bottom of the bear market. Popular myth has it that talk of ‘equities are dead’ and ‘there is no future for equities’ should be widespread and are classic signals of the end of the bear market. This is far from the truth, it turns out. In related fashion, there is no climactic last and final sell-off on high volumes. Quite the contrary, the final slump is on lower and lower volumes. Subsequent higher volumes at higher levels confirm the bear market is over, with hindsight. Today’s message: do not take any ‘contrarian comfort’ from the fact that many people are quite bearish on the macro outlook, contrary to conventional wisdom, that is not a classical sign of a bear market trough.

4. Patience! Equities do trough during economic recessions, but they do not anticipate economic recovery by 6-9 months. The lead time is much shorter, and often equity and economic recoveries are coincident, and sometimes economies bottom before equities do so. Patience is key. Today’s message: indeed, this is consistent with our finding that one should be patient in bear markets as there is not much discounting of the upturn going on at the end of the bear market, after numerous failed rallies and false hopes.

7. There are some consistent early signs of economic improvement. The three best are the copper price bottoming out, auto sales improving (or at least getting less bad), and inventories being very low. Today’s message: the copper price has not even fallen yet, so we are far away from the bear market trough.

Good trading idea

I'm reading an interesting paper by Brad Delong on international capital flows, and I come across this brilliant story:

A huge amount of industrialization in the resource-rich, temperate periphery
before 1913, was financed by the willingness of British investors to commit
their capital overseas—not just to build up Britain’s capital stock, but to
build up capital stocks abroad as well. (Let’s pass over for a moment the
fact that the British investors in the Erie Railroad found that Jay Gould stole
two-thirds of their money, not least by taking a huge leveraged long position
in the stock and then announcing his retirement from the company. He
retired, the stock price boomed, and he pocketed something like 50 percent
of the present discounted value of the fact that he would no longer be around
to loot the company.)

I love it when people are willing to pay you to stop robbing them.

Friday Afternoon Phase Transition

I wonder what it will be like to look back on my life in 2042, just as the world starts to settle down into a new state. We will not even be the same species we were 100 years ago. I also wonder whether we are in the process of boiling or freezing. Probably freezing given the increasing density.

Oil Fundamentals

With all the debate over commodity speculation, it's also good to revisit the real story that got the bubble rolling. Jim Hamilton reviews the fundamentals for oil. Basically they imply consistently high oil prices. What price? I don't know that anybody has come up with a convincing way to say. But I do take seriously his point that there is simply not enough oil in the ground for China to consume as much per capita as the US.

To summarize, I think we will see some net production gains this year, and expect this to bring some relief for oil prices. But I cannot imagine that the projected path for China above will ever become a reality. Oil prices have to rise to whatever value it takes to prevent that from happening.

So yes, I do believe that speculation has played a role in the oil price increases, particularly what we've observed the last few months. But it's a big mistake to conclude that speculation is the most important part of the longer run trend we've been seeing.

Markets and oil

A few snippets from this recent post express my own consternation:

What makes markets so intriguing today is that equities seem largely immune to a combination of $120+ oil, softening housing markets and a likely collapse in western consumer spending. Arguing that several trillion currently either sheltering in money market funds or rapidly accumulating thanks to petrodollar wealth in sovereign wealth funds will ride in to support stock markets (a.k.a. greater fool theory) only logically goes so far in the face of such sizeable challenges. But some confusing short-term resilience on the part of stock markets does not invalidate the need for caution, it rather reinforces the need for patience ...

In the face of almost insurmountable doubts (over likely economic slowdown, the impact on consumer confidence of softening residential property prices, the robustness of Asian fundamentals in the face of the ongoing commodity rally, the impact of $130+ oil, and the health of government bond markets given growing doubts over the under-reporting of inflationary pressures) it makes absolute sense to assume ongoing and substantial macro uncertainties. That argues, in turn, for nuanced and highly selective exposure to equity market risk, to capital preservation strategies in bond market terms, and to a healthy degree of ‘absolute return’ (quality hedge fund) as opposed to long-only market positioning, not to mention further asset diversification. Markets may not yet be flashing red, but there seem to be more than usually strong headwinds about.

I think that pretty much sums it up -- the market does not make much sense right now in the face of what's happening in the real world. Stocks seem like they're on prozac. I would have only a couple of comments on this post.

First, I haven't quoted it, but that article mentions a Citibank analyst who has overlaid the charts of various bubbles (Japan 89, Nasdaq 2000, Saudi Arabia 2006, Shanghai 2007) with the current prices for commodities. I agree that it is difficult to value commodities and so difficult to know how much of their current valuation is speculative. I also agree that financial markets should be the subject of ethological study -- capitalism is a fascinating animal behavior pattern. But you've got to be kidding me if you think you can convince me that something is a speculative bubble merely by overlaying its chart on that of other speculative bubbles. This is supposed to be the grand new "science" of behavioral finance? Give this chart overlay stuff a rest. It's about as useful as technical analysis, or reading entrails generally is.

Second, my own experience investigating funds that bill themselves as "absolute return" is that their not. Maybe funds like this really do exist, but I think they are few and far between, and not the ones that everybody normally gets excited about because by remaining "market neutral" they get lost in the dustbin of under-performance during the good times. Now that times are tough, suggesting that investors take these guys out and dust them off is a bit ingenuous -- they've already been driven out of business by all the performance chasing redemptions during the good years. So if you don't already have some money allocated to this type of thing, I'm not sure I would rush to do it now.

Inflation

Yves (I find this guy so useful I feel like his cyber-cousin or something) has a couple of contrasting views about inflation posted today. I wanted to use it as an excuse to order my own fuzzy thinking about inflation.

I guess I'm still a monetarist, meaning that I believe that inflation (a rise in the price of almost everything, not just gasoline) cannot happen without an increase in the money supply. Conversely, an increase in the money supply will typically cause inflation, though this second proposition seems more complicated to me. I need to do some more reading on it, but I don't even see any other coherent way of looking at it -- if you're not a monetarist then what are you?

As a monetarist, I imagine the money supply of the world as a set of imperfectly communicating lakes. It's not just one giant ocean of money because each country prints its own currency, maintaining its own separate lake. These lakes do have flows between them though, determined by the exchange rates. This is why you can get increasing money supply in just one lake, or inflation in just one country. The country prints some money, the general price level goes up, but any new flows out of that lake don't increase the level of other lakes because they translate into less foreign water (so to speaks) as the value of the currency of the inflating country plummets. So the US prints more dollars, which causes US inflation, but does not cause world inflation because the value of each one in terms of other currencies goes down. The same amount of foreign currency buys more US dollars, so there's no need to print more foreign currency to compensate. The exchange rate acts like a shock absorber of sorts, that prevents 'inflation contagion' and keeps the lakes separate rather than forming one big sea. Presumably the attractiveness of a particular lake is related to its level of real interest rates.

Unfortunately, in the real world not all currencies float freely, and the lakes do not communicate in this seamless fashion. Some people (Argentina, China, Saudi Arabia, etc ...) peg their currency to the dollar. This means that when the US prints more dollars, they can flow directly into the money supply of these other countries. Currency peg countries overcome the natural communication mechanism of the exchange rate market by printing more currency of their own so that the relative value doesn't change. This means now that the level of several lakes goes up, and for geo-political reasons we end up with a worldwide inflation contagion because many people follow behind the US in increasing the money supply.

Simple, ¿no? The thing that complicates this picture for me, and that I don't yet understand, is that the newly minted money can go to pay for either products or assets. People only seem to count it as inflation when it increases the prices of products, though I'm not sure if this is justified. It seems to me that it is at this point, in deciding where the new money supply will push up prices, that you have to get into questions of the competitive landscape, of 'cost-push', of the balance between labor and capital, and the wage-price spiral. These questions seem perfectly real, I just see them as second order, logically speaking.

Shadow banking system anyone?

Does anyone really believe that we're going to manage to regulate these guys? We don't even know what a bank is anymore.

Private-equity firms have also been buying up much of the private-equity debt held by the banks—often borrowing from the bank to do so. A hypothetical example of such a deal: a bank sells debt with a nominal value of $10 billion to a private-equity firm or consortium for $8 billion, lending the buyers $7 billion towards the price. The bank takes a $2 billion write-down, but reduces its overhang of non-performing debt and gets an additional $1 billion of equity, moving it one step back towards resuming normal activities. Meanwhile, the private-equity firm buys debt at a fire-sale price, and will probably end up making a killing.

Market discipline is the only true discipline, or in the the words of Warren Buffett, "Capitalism without failure is like Christianity without hell".

Assume martians are really poor

... and they buy nothing. In that case, the economy of the earth is a completely closed system. I realize that this sounds silly, but I feel that one of the fundamental mistakes people make when thinking about economics is to forget this. Marx, for example, went astray in part because he forgot this (though also, as Kolakowski makes clear, because his economic theory was always at the service of his philosophy) even though with Marx it was perhaps excusable because "the world economy" when he was writing, only meant Europe, which was in fact able to rely on a sort of alien colonialism. But that age is pretty much over now. Unfortunately, our ability to think about whole inter-connected systems hasn't actually progressed much since Marx, and we still regularly imagine a functional role for the martians.

This is a long-winded prelude to the question of inflation, one of the hot financial topics recently, and one of the topics where the debate seems to suffer especially from this type of fuzzy thinking.

William Buiter has a post today that clarifies who or what causes inflation.

This one is easy. In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always can be offset by the central bank, given enough time, freedom to act and courage.

So, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices - in the real prices of oil, of food, of oil and of labour for instance - if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation.

There you have it. As far as I understand the terminology, Buiter would be considered a "monetarist" (a la *gasp* Milton Friedman -- who, by the way, when you actually sit down and read him, turns out to be remarkably similar to Lessig and Chomsky on a number of points. Intellectual life is so much more confusing when you actually read the original books, isn't it?). I'm hardly an expert, but up till now I have still found no coherent description of inflation that would be anything other than "monetarist". People tend to blame inflation on oil prices, or labor unions, or greedy corporations, but in a closed system, I don't see how this can constitute an explanation. If I pay more to put gas in my car, I have less to spend getting a hair cut. That's not inflation, that's just a transfer of wealth from people without oil to people with oil. No one is saying that the recent increases in commodity prices don't have importance for a lot of poor people who are paying more for food. It's just that it isn't inflation. For it to be inflation, those price increases would have to continue for the indefinite future -- that is, the price of food would have to continue to increase not simply to stay at a permanently high new level. And the only way those prices could continually increase would be to pay more to the people who are buying these things. This is the wage-price spiral one hears so much about, and it can only be facilitated by someone, somewhere printing more money.

Or by many someones, somewheres, each of whom can blame the others for its profligacy, which is what seems to be happening now. The US prints money buy holding real interest rates negative for years, and exports this inflation to the rest of the world via their willingness to support the dollar, which they do by using their own printing presses to maintain "competitive" exchange rates. Both sides blame the other, and we all suffer, with perhaps a bigger lag than in the past, from the resulting inflation.

CDS Exchange

The more I read and think about it, the more obvious it becomes that we need a CDS exchange to contain these financial weapons of mass destruction. The whole point of an exchange is that it pre-regulates leverage in a transparent way and so prevents any crisis of confidence leading to a bank run. Also, you'd think this would be a major opportunity for any of the big exchanges. Jim Hamilton has some clear thinking up on this question.

Specifically, any institution that is in this position of borrowing short and lending long needs to ensure that a certain fraction of the funds it is lending came not from borrowers but instead from the owners of the institution itself, in the form of net equity. The goal is for the size of this net equity to be larger than the losses the institution would incur from selling its less-liquid assets at steep discounts. As long as it is, no creditors ever have reason to demand cash, and there would be no need for the central bank to step in to prevent a self-fulfilling breakdown.

And the core reason we are in the mess we are today is that these equity stakes were nowhere near sufficient for this purpose. Instead, financial institutions were allowed to take highly leveraged positions whose details are largely opaque to readers of publicly available financial statements. Exhibit A here might be Bear Stearns, whose 2007 10-K reported that Bear had outstanding derivative contracts whose notional value was $13.4 trillion. Much of these were credit-default swaps, in which the seller receives a fee in exchange for promising to pay any losses incurred by the buyer on some specified asset and time interval. If every such asset lost 100% of its value over the period, then maybe Bear is supposed to pay or receive $13.4 trillion. In practice, the actual price moves and net sum owed would be a small fraction of that notional total.

Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You're doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.

Actually, I think if you follow this reason to its logical conclusion, you can start to wonder why we have banks at all -- that is, why we don't just directly allocate all capital through an exchange mechanism like the market? Why don't we just have a bond market and a stock market and dis-intermediate banks entirely? These markets could then have net margin requirements just like the futures market.

As an even more radical thought experiment, imagine what would happen if you made charging interest illegal. Instead, require all capital to be equity capital, that is, all investments are explicitly required to be a non-zero sum game before anybody gets anything. Now some people aren't going to want to take lots of risk with their capital, and they're not going to know enough to want to directly buy stock in a business, and especially not on margin. I imagine banks would re-emerge as aggregators of equity capital that then put this to work in the form of further equity, much like a mutual fund does. Their leverage would in this case be regulated by the margin requirements of the exchange, eliminating any need for futher, and as we have seen largely non-transparent, capital requirements. This is probably a delirious idea, and I'm not even sure it's coherent at the level of the entire economy, but I find it kinda interesting.

Demography is Destiny

This post from the Telegraph may be a bit gloomy overall, but I have to admit that I too wonder whether the prospects for China are quite as bright as everyone thinks.

China's workforce will peak in seven years (the delayed fruit of the one-child policy) and then go into the steepest downward spiral ever seen by a large nation in peacetime. It will, and do so long before it is rich. This demographic implosion cannot be reversed quickly.

In addition, China is hitting some major infrastructure hurdles and higher commodity prices just as demand for their products in the rest of the world slumps. Of course, I still believe that over the long-term, the BRIC economies and other emerging markets will out-pace the US, and if they doesn't, that won't be a positive for the US either. This is also why I can imagine that some of the rises in commodity prices are sustainable over the medium term. In the short-term however, I find it very difficult not to be a bear, and not to essentially agree with the idea of a spreading slowdown that gradually engulfs everything -- the world is too linked and, more importantly, too unbalanced to avoid this right now.

Oil Nonbubble

Paul Krugman dives straight in today with an accessible post about how oil prices cannot be a bubble because there's no inventory. I think his reasoning makes perfect sense -- if the current increase in prices were due purely to financial players operating through the futures market, the prooposed speculative mechanism would involve an increase in inventories, which we are simply not seeing anywhere, as commodity inventories are at multi-decade lows for almost everything. Note that the best candidate for 'speculator' here is, paradoxically, the big ETF's and futures programs of pension funds that are getting into this market as a long-term asset class investment, so the role of speculation here should be read without the usual whiff of moral stigma people give it.

One answer to this has already been proposed -- that there are inventories, but because they are not being counted correctly because of the growth of all kinds of wacky OTC derivatives and other deals that the commodities markets have never seen before. There is an interesting commentary to this effect by a veteran commodities trader here. Of course, it's very hard to validate this line of thinking, which amounts to a sort of dark matter of the inventory world, because by hypothesis, you can't count these inventories. While arousing suspicion though, that fact alone does not mean that the theory is incorrect; the paranoid also have enemies. A related idea would suggest that instead of piling up as inventories, the boom in prices has actually caused a reduction in supply to the market, as we can easily read about grain elevators not accepting more corn simply because they are now unable to hedge against the price volatility. The basic idea remains plausible -- that the unprecedented wave of purely financial money at work in commodities is having an effect on prices -- even if the mechanisms are hard to pin down.

But so then where does this leave us with respect to a price prediction? Is oil going to $200 a barrel like Goldman Sachs says? My own feeling is that there is somewhat of a bubble in commodity prices, even though, like all good bubbles, it got started for fundamental reasons, some of which are still valid over the medium-term. In other words, we are seeing exactly the combination of real and fictitious price increases that makes every bubble so psychologically difficult to identify. If this idea is correct, we could see a major pullback in prices on the basis of speculation drying up, coupled with an almost assured global demand slowdown over the next year or so. A few things complicate this picture. First, as I mentioned, speculation here is less the famous hot money (surely along for the ride though?) than these giant pension fund and endowment ships. That is, financially, the bubble may still be in the inflation phase. Second, the effect of a global slowdown may be offset by negative real interest rates, which naturally makes commodities more attractive as a store of value and an inflation hedge. Finally, commodity prices may not being going back to their 2000 levels. We really do have several billion new and highly inefficient new entrants to the global economy via the industrialization of China and India. Demography is denstiny. In addition, this is happening right at the moment when the externalities associated with commodities are (potentially) going to be internalized in the price.

In summary, while there are good reasons to suspect a correction in prices from current levels, though it may not happen as quickly or dramatically as some think. Commodities may be going through a period of overshoot before reaching a new higher stable price regime.

Unfortunately, as we all know, economics is not a science because ...

THERE ARE NO NUMBERS

Depression though experiments

Jim Hamilton has written one of the simplest and most direct explanations of what happened with the depression in the form of a thought experiment asking what would have happened if the US went back on the gold standard in 2006. The crucial point, I think, is that financial crises are inherently deflationary because you have sudden increase in the demand for money relative to the demand for other things, particularly financial assets. Money comes to be worth more in relative terms, which is the very definition of deflation.

Naturally, given that Ben Bernanke's entire academic career was founded on studying this phenomenon, the Fed is aware of this problem, and is increasing the money supply enormously, even though this means that the price of gold (which we could replace in Hamilton's story with the price of commodities generally) goes through the roof. The trick I suppose is to just balance the deflationary effects of a financial panic with the inflation of the money supply.

SWF Mania

We have all heard this story various times already, but somehow this graph made it strike home visually (I guess I secretly continue to follow Wolfram in thinking that the eye is a pretty good general purpose pattern detector). It makes me wonder as well about the history of the collapse of the British empire -- when did the US start financing the queen, and wasn't that the end for her?

What's still not clear to me is how all of this plays out. Given that these reserves are in dollars, and that these exchange reserves are in the same ballpark as the $1B IMF estimates of US credit losses (coincidence?), I find the final comment of Brad Sester's post compelling:

Felix claimed not so long ago that the US was too big to fail. Certainly many emerging markets are doing their best to finance the US through its current troubles, and thus keep up demand for their oil and goods. But a part of me wonders if the rise in inflation in the Gulf and China and the difficulties both are facing trying to sterilize the rapid growth in the foreign assets is an indicator that there is a small risk that the US also might end up being a bit too large for the emerging world to save.

The US does indeed seem too big to fail at this point. But is China going to, effectively, repossess us? These of course were Buffett's comments several years ago, even though most everyone only paid them lip service. Does this mean that we're going to see a further collapse in the dollar and even higher world-wide commodity prices and inflation? Can the Chinese really frog march themselves to prosperity by financing America's consumerism? They seem to have the cash to re-capitalize the entire credit mess, and we could go on just like before. Somehow though, I just don't see politicians being smart enough to work themselves out of this mess, and that is what is required to correct the market imbalances. In this case, the market cannot re-equilibrate itself without a political solution, which is perhaps the scariest line of thinking of all.

Long-term commodities prices

Having mentioned elsewhere what seem to me the two possible takes on long-term commodity prices:

• Prices go down because the increasing efficiency of production and consumption of basic materials outweighs the population and per capita GDP increases. This is the overall historical trend, even though it doesn't help to tell you how long the current increases can go on.
• Prices going up for Malthusian reasons, or population and consumption overwhelming production.

... I would like to add a third option that has occurred to me that I don't yet know how to evaluate, namely:

• Prices going up because the cost of commodities begins to reflect the social and environmental externalities that we have previously not included in their costs. So far, we have essentially taken out a giant loan from future generations to be able to ignore these costs. Someday it will cost real money to take better care of the planet, and that cost may be reflected directly in commodity prices. either via taxes or continuing supply constraints.

An editorial from Kenneth Rogoff speaks to this point:

... the price mechanism is a much better way to allocate natural resources than fighting wars, as the Western powers did in the last century.

The United States’ ill-considered, biofuels, subsidy programme, demonstrates how not to react.

Rather than acknowledge that high fuel prices are the best way to inspire energy conservation and innovation, the Bush administration has instituted huge subsidies to American farmers to grow grains for biofuel production. Never mind that this is inefficient in terms of water and land use.

Basically, I think that there is a possibility that we may stop letting the government subsidize these markets, and this could cause price increases.

Selling Puts

This is actually an interesting idea that I didn't get the first time around, when I read Buffet's description of it. It's strange to think that something like selling insurance on a stock index might work, but ... we already know that a lot of these financial innovations are mis-priced at first, and we know that betting against the market is over time a losing strategy, and we know that there are not a lot of people with the patience and capital to sit on the premium collecting side of this trade ... and we know you've got the money.

Vulture Investing

Having played the vulture capitalist in real estate for a few years now I would like to suggest, along with the FT, that those contemplating a similar path in the US consider one crucial fact -- you don't know what you are doing! Okay, fair enough, as the article points out, some of these people do know what they are doing:

Those entering the vulture business right now, inspired perhaps by business magazine covers, will need distractions... because they are not going to get rich quick. They may, indeed, get poor slowly, along with their limited partners.

I had an interesting conversation a week ago with a Palm Beach County real estate investor. He had moved there three years ago from suburban New York, having made some money over the years, principally in commercial properties. I was intrigued by what he and his partners were doing to take advantage of the values on offer down there on the Gold Coast.

Nothing.

Perhaps there is a sort of paradox at work in vulture investing that makes it truly profitable only for a few who really understand how it works; either things aren't that bad and will bounce back quickly, in which case there's really not that much money to be made in the recovery to begin with, or things are going to get much worse and there will be way more problems than were anticipated, meaning that many investors enter too early without realizing what they will have to sit through. This may be the same paradox of having a "liquidity crisis with a lot of liquidity".

Our Economic Moment

Tim Duy has some reflections on our current economic situation that I found worth reading. He sees a period of what he calls "economic purgatory" as the Fed bails while the boat keeps leaking -- a purgatory where interest rates remain low, the dollar weak, economic growth tepid, and inflation worrying but not oppressive. This would allow the US to gradually adjust to the macro imbalances (under-saving and over-borrowing on an overly strong dollar) that caused our problems to begin with, without having to go through a deep recession. While that sounds nice on some level, and is certainly a coherent macro forecast, I see this purgatory as way worse than hell itself. The article goes on the make much the same point, though in less polemic terms -- by keeping rates low and bailing out all the bad loans, the Fed would be indirectly fueling a commodities and inflation bubble of enormous proportions via the leverage of the Asian and Middle Eastern pegs to the dollar. It seems to me that after a lull, this would come home to roost in the US, and we'd be back in the horrendously stagflationary 70's, which would then precipitate another dollar crisis and a final re-adjustment even worse than the one we might expect if we let it happen now. After all, when has the government's monkeying around in the economy ever turned out for the best? I would prefer to immediately take the same medicine the IMF gave to Korea and the rest of the world ever time it got into this sort of trouble -- higher rates, greater austerity, let the market do its job, it's much smarter than you are.

¡Apocalypsis Ya!

Okay, so I knew that the Fed had expanded what credit it was willing to deal with in its new alphabet soup of lending facilities, but auto loans? We're accepting auto loans now? These things are like the warm pitchers of spit of the financial world.

The Federal Reserve, along with other central banks, said Friday that it was increasing the funding it is providing to banks and announced that, for the first time, it was willing to accept bonds backed by auto loans and credit cards.

It ain't easy being a bear

Actually, I hate it. In fact, I'd rather not consider myself a bear at all, and I'd like to think that perhaps it's more the circumstances of my involvement with the financial markets than any disposition of my own that has led me down this dark path. Or maybe it's just the history of the facts. Greg Ip comments in the Journal today that history suggests that while we may be late in the credit crisis game, we are sure to be early in the economic weakness game.

The economic fallout from a crisis depends on how much underlying economic factors -- such as consumption, investment and asset prices -- are out of whack with their fundamental determinants. The 1987 stock-market crash and the near-collapse of hedge fund Long Term Capital Management in 1998 threatened the heart of the financial system. But the underlying imbalances were largely limited to the financial markets themselves: stocks overvalued relative to earnings in 1987, and excessive hedge-fund borrowing in 1998. Thus, once the Federal Reserve's rescue operations had mitigated the threat to the financial system, the economic fallout was limited.

The current crisis is different. For several years, U.S. home prices and home construction kept climbing past levels considered sustainable. Homes became collateral for trillions of dollars in borrowing. That depressed savings, inflated consumption, fueled rapid lending and loosened loan standards.

When home prices stopped rising, the diciest mortgages began to default, triggering the crisis. But even now, prices are above most estimates of sustainable levels, and household saving has barely picked up. Even if the Fed's bailout of Bear Stearns Cos. in mid-March proves the apex of the crisis, as some think, the economy could still contract as consumers adjust to lost wealth and reduced access to credit.

Interestingly, all this means that we are in a special situation where we can predict the economic future. Normally you simply can't do this. We all know about the business cycle, but it's irregularity, and the complexity of the system, normally don't allow us to utter more than the truism, "Unsustainable things tend not to be sustained." It's easy to see these things getting built-up, but they always seem to go on much longer than one would expect, and it seems impossible ever to call the top just right.

Right now is different. The US economy WILL weaken. The world economy WILL weaken. We understand both the backdrop and the trigger. This is as close as you can get to predicting the future. We may not know exactly how things will play out -- whether inflation, a stock market crash, (more of) a dollar crisis, China descending into chaos, or what -- and we do not know how deep the recession will be, but we can be sure that the next year or two will not be pretty. This is exactly what the credit crisis is telling you. This crisis of confidence is the leading indicator, and happens before anyone has lost any real money.

All of this would be moot, I think, from an investing point of view, if you could show me the undervalued asset class. Who cares about the economy if you can buy assets for sufficiently less than their worth, or great assets at approximately what they're worth? But where are these assets now? You can make the US market look mostly fairly valued, but you really cannot make it look cheap without stretching the bounds of credulity. The same would apply to Europe. And emerging markets are 50% above their historical valuations, perhaps for good reasons, but certainly not for reasons of precedent. Knowing that the economy will inevitably weaken, lacking any tempting asset class, what is an investor to do?

BOE Update

Mercifully, I am not the only one who read that BOE report (see last post) and thought something was fishy. Today's FT Alphaville turns up some other folks who think the bank may be underestimating things:

Britain’s central bank is implying that the banks it regulates should perhaps mark their dud assets to model, rather than to market, on the basis that market prices are unreal.

In fact, in terms of when the ABX measure, the market is probably stone cold accurate.

It may, or may not, be right for banks to mark-to-model - but that is because they tend to be holders of the more senior tranches of triple A subprime, rather than the junior stuff currently included by Markit.

Fishy

There's a lot of confusion floating around out there about the ultimate extent of losses on sub-prime mortgages, and accordingly about whether we are (were?) seeing a liquidity or a solvency crisis in the credit markets. The debate often seems to center around whether the big bank write-downs reflect economic reality -- loans people will not be able to repay -- or whether these write-downs are just a temporary fiction created by the Basel II rules for mark-to-market accounting in banks. For example, I have heard, repeatedly, that the situation is overblown because, "the write-downs that people are taking are based 100% of the mortgages defaulting and the lender only being able to recover 50% of their money through foreclosure". The latest salvo in this debate is an article in the FT which cites a recent Bank of England study:

In its latest financial stability report, the Bank suggests that the price of some AAA securities only makes sense if you believe that the ultimate loss ratio on securitised subprime mortages will be 38 per cent. However, that loss can only occur if three out of four households defaulted on their loans and house prices tumble dramatically too.

This intrigued me of course (who doesn't want to buy under-priced AAA securities, and so, despite being totally unqualified to do this, I tried to wade into the report in question to see what some of these numbers mean. The upshot is that I think the BOE should put the crack-pipe down and back slowly away from the discount window.

The key section of the report (and what the FT was citing) is the box on pages 17-19. The idea is that there are two ways to value sub-prime mortgages.

First, you can start with an estimate of what percentage of the homeowners will default and multiply this by what percentage of the loan value you can expect to recover. That is, you can guess. You can make an educated guess based on the history of defaults for these types of loans (which have existed for all of 4 years), and a forecast for housing prices. The BOE does this and comes up with $193b in defaults, which is around 20% of the $1 trillion of total sub-prime toxic sludge that's out there. The headline of the FT article is based on this number, which turn out to be approximately the level at which the triple A 'super-senior' tranche of the typical MBS would start to see some losses.

Second, instead of guessing, you can mark these loans to market by asking people at how much of a discount they would be willing to buy them. The problem with this is that nobody in their right minds wants to buy these things right now because they'd have to guess how much they're worth (in addition to the fact that these things are really complicated). So in lieu of having any bids, what people have done is indirectly estimate what the market for these loans would be like, if it existed, by asking the market how much it wants to charge for insuring these loans against default, and extrapolating the default rate from that (this is what the ABX index in the credit default swap market represents). This is admittedly a pretty roundabout way of doing things, but if you try it, you come up with a number somewhere around $375b, or close to double the first estimate. These numbers should be seen in light of the total write-downs realized to date of around $200b.

Now, to find out which of these estimates is closest to the truth you need to dig into the numbers a bit more. And the wheels simply fall of the first estimate when you find out how they did it. It is just an extrapolation of the default rates that have already occurred on these loans, coupled with the assumption that 75% of loans that go into default result in foreclosure and 50% of the initial amount is recovered. These assumptions are ludicrous though. The past default history of these loans is less than useless, as up till now house prices were rising and credit was available to refinance these loans. The future is almost guaranteed to be much worse than this. In addition, even in the best of times the lender only gets 50% of the value of a home back during foreclosure, after taking into account the legal fees, commissions, and missed maintenance costs. Are you really going to get 50% back if prices fall another 30% from where you made the loan? Finally, throw in the negative equity phenomenon where people have absolutely no reason not to walk away from their non-recourse mortgage, and you have every indication that the $200b figure you come up with via this approach is a serious underestimate. So the BOE and the FT jaw-boneing the over-reaction of marking to market, when in fact the market has so far only been marked to a serious underestimate of the total damage, is, to say the least, wishful thinking. They are pretending, along with the rating agencies, that anything stamped with a triple AAA will suffer no losses, and it just seems completely implausible.

Should we then conclude that the higher estimate provided by the market is correct? In general I have no problem accepting that markets do strange and irrational things over the short-term, so I don't necessarily take it for granted that this estimate is correct. Unfortunately, the $400b number is in the ballpark of what other people have been talking about for a while now based on admittedly sketchy, but much more convincing, methodologies for estimating the ultimate aftermath of the great housing bubble. So the conclusion of all this is that the next time you hear someone tell you that banks have exaggerated their write-downs and that the whole credit crisis is due to silly regulations about mark-to-market accounting -- the next time someone tries to convince you to buy AAA sub-prime bonds (sounds like "fresh-frozen" or "military-intelligence" doesn't it?) because, "their priced at 100% default and 50% recovery" -- the next time someone claims that the write-downs are over and the worst is behind us -- you should remind them that when you loan people 100% of the value of a property at the peak of the market, you shouldn't expect much more than half back.