Saturday, March 29, 2008


TANSTAAFL. A wonderfully descriptive and useful acronym. For the uninitiated, it means:

"There Ain't No Such Thing As A Free Lunch"

The Fed is taking a relatively new attitude towards asset price bubbles. The below (truncated) article represents a shift from the parochial inflation fighting guardian to something more interconnected with the global economy.

The increased regulatory authority has some interesting ramifications. Foreign countries (who have been witnessing the weaponization of the dollar for some time now) must deal with a United States Federal Reserve that reacts in an incredibly aggressive fashion to financial and real asset price declines.

Foreign owners of U.S. debt and holders of U.S. dollar denominated assets had better pay attention to what this means. There is no more "free lunch" (TANSTAAFL) by exporting goods to the United States and purchasing Treasuries and other U.S. financial assets via Sovereign Wealth Funds with the expectation that the greedy Americans will never retaliate in kind by activating the free lunch of inflation...when every cent of our foreign liabilities is denominated in U.S. DOLLARS.

So our free lunch has arrived. Foreign countries will be forced to deal with inflation while we continue to reap the benefits of low interest rates. A massive show of power by the United States.

In the Brave New World of the Bretton Woods III (or whatever you choose to call it) THE FED IS THE NEW GREAT WHITE FLEET.

(Part of) the article outlining broad regulatory powers to the Fed:

Bush Administration Proposes Most Sweeping Overhaul of Financial Regulation Since Depression

WASHINGTON (AP) -- The Bush administration is trying to confront the credit crisis that has rattled nerves from Wall Street to Main Street by proposing wholesale changes in how Washington oversees the financial system.

A plan set for release Monday would give new powers to the Federal Reserve so that the central bank serves as the system's overarching protector of stability.

The proposal would abolish agencies such as the Office of Thrift Supervision and the Commodity Futures Trading Commission, shifting their responsibilities to other federal institutions.

When Treasury Secretary Henry Paulson outlines the ideas in a speech, the changes will represent the most sweeping overhaul of financial regulation since the Great Depression of the 1930s.

Friday, March 28, 2008

Letter to a friend

Part of a on-going discourse with a friend in the financial industry, who described apprehension with this market...

Well, we like your sentiments...we get paid to take risk, and there is alot of risk out there.

So, you have a "path" that you think the economy will drift towards. How many variables have you not thought about or that will materialize randomly? Have you quantified your thoughts and affixed NUMBERS (which can be compared to other numbers) to these thoughts?

We have put quite a bit of thought into this, so let's walk through it.

First, the assumption that deleveraging alone will cause financial earnings to suffer for many years is suspect. Deleveraging among the financial sector will have a limited effect on the real economy. There is a historical precedent for this - S&L crisis as well as market behavior from the clearing of the junk bond/Milken disaster.

As for the "consumer" question. Investment-led recovery is also a possibility. It would take a one-sentence change in the tax code and billions of dollars would come home to the U.S. and can (and has) happened that quickly.

Don't fight the Fed. The Fed has made it clear: It shot the main transgressor of irresponsible financial leveraging in the face (BSC)...and now it is saying "I am a merciful deity...obedience is required" It will continue to provide the short-term funding as needed (it has gotten a good look under the hood of short-term finance facilities like the Repo market, off-shore carry fundings, etc.). We are not standing in its way.

We have been playing around with a 150 MB excel file that details the cash flows due from the derivative waterfalls. Not all of these assets are worthless. In our humble opinion, now is the time for greed, not fear.

Thursday, March 27, 2008

It had to happen.

One last comment on Bear Stearns, which I have been concerned with for a long time on this blog.

The Fed had to bail them out. Counter-party risk at that point was freezing a good part of our shiny new (well, post 1973) financial system. If Bear were allowed to drift into bankruptcy, the markets would most likely have panicked. Indeed, I wrote to clients that Sunday (after the deal was announced) that U.S. stocks may trade limit down on Monday assuming the liquidation of massive position and a mad scramble for collateral that may actually be worth 100 cents on the dollar.

Obviously, that scenario did not materialize, due to some very nice work by the Fed, who acted with the speed of a private company, and completely obliterated the authority of the SEC in the mean feat in a large bureaucracy.

Now comes the difficult part. The slippery slope of "bailout" has been greased, and at what point does the Fed say "no mas" to all the needy hands that are suddenly now raised?

The answer to that question is beyond the scope of this blog, as it concerns questions of national policy and questions of governmental power dating back to Mill and Locke.

However, confidence is returning. Again, there will be volatility in the finance sector as the pricing difficulties continue to be cleared, but this last episode has marked a turning point for global liquidity and confidence. A large player was forced to fall on his sword. The real economy is learning to live with a damaged financial economy.

Put another way, the problems that started over a year ago are now abating, and stewards of capital would be well-put to capitalize on these developments. There will be volatility short-term (next 30 days...short-term traders will do well here) but the 1320 S&P level that I spoke about here over a year ago will make a nice beachhead going forward.

Monday, March 24, 2008

On the uselessness of describing "booms and busts"

Quantification is useful, even essential for investing.

However, with computing power so cheap, it is no wonder that arb-type trades and investment strategies CANNOT continue to do well. Profits attract competition, competition squeezes what is one to do?

Answer: Leverage. Gear up your pairs trades and arb strategies until profits regain expected levels. Regrettably, this process (repeated many, many times by participants) guarantees an entirely different volatility regime. The economist Minksy has been quoted much lately. As the "Minsky moment" is bantered around by everyone seeking some explanation for the events of the past year. But ex-post explanations to me are so unsatisfying, and arguments based on "boom and busts" only tell half the story.

The other half concerns Super Levered Operating Businesses, or "SLOBS".

The SLOB explanation is more ecological and organic. The opportunity cost of firms NOT to invest in SLOBS becomes high. More capital floods into SLOBS. More leverage is required to increase returns. Then, suddenly some heroic participants begin to question the sustainability of the SLOBS profits, and decide to squeeze them into submission.

It has nothing to do with abstract notions of what "should" happen in economic cycles - it has EVERYTHING to do with opportunistic firms sensing a weak hand at the poker table. Booms and busts do not simply "happen". Capital is misallocated by chasing historical returns that can never be sustained in a competitive business environment.

SLOBS become the low hanging fruit of the financial ecosystem - their leverage screams at more nimble and astute firms: "pressure me to will not take much, and once you do, your returns (properly annualized as the gains one receives from shorting these firms comes very, very quickly) will be massive."

So, for me there are no "booms and busts", only opportunistic people and firms taking advantage of herd-following money.

Friday, March 21, 2008

The Great Moderation

With month end being so important on so many levels (Japan year end, expiry, margin requirement changes activating, etc.), and things looking so bleak, I typically recite the mantra "things are never as good nor bad as they really are." Admittedly, the sentence structure of the preceding mantra is atrocious...but the point is that the time to throw caution to the wind draws near. The balance points are beginning to shift to optimism. Fasten your seat belts in the next couple of weeks and well into the 2nd quarter, however.

Here is a wonderful example of why the above mantra holds true - Bernanke's missives from 2004 on how financial engineering and innovation is paving the way for a world where economic cycles are muted and sustainable GDP growth of 4% is a certainty.

We all know how that rather pollyanish view of the world is turning out. Most of you know I value numeracy when it comes to analysis. However, the power of anecdotal evidence must not be ignored. The same people who declare their home values will appreciate 15% per year until the supernova of our sun also scream bloody murder and the end of the United States when times are not so sanguine.

Tuesday, March 18, 2008

End Game.

Today's fed action certainly puts things in perspective. When highly volatile markets consider a 75bp reduction in interest a disappointment, then look at the prices of commodities (and perhaps glance at commodity futures prices to garner expected inflation), one has to feel for Ben Shalom Bernanke and his continued employ as a civil servant.

(of course, the cynical part of me realizes that Ben has a massive incentive to rescue wall street firms...future clients, you see.)

So now we are at the end game. The Fed has finally disappointed market expectations (100 bp cut priced in fed funds futures) because the inflationary pressures are so open and obvious that it can no longer keep a straight face when saying things like:

"Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization."

...which, according Bernanke himself, is precisely when the lagged effects of interest rate cuts will be actually be felt.

Again, this is surreal, and central planning posits perfect information and perfect execution on that information. The Fed has neither.

Sunday, March 16, 2008


Again, I will refrain from commenting on an unmentionable formerly great wall street house. Instead, lets think about tomorrow.

Fed action, BS action, and Eurodollar future settlement. This guarantees an interesting day. Let us hope a halt in trading is not the results of the Fed's once-per -century action in rescuing a non-bank institution.

It will be time to go long soon - but there is panic in the streets at the moment.


I tend to look for ways to falsify a theory prior prior to taking any action, as the confirmation bias is such a problem.

However, the following story on China is another testament to the "paper dragon" thesis I have maintained on the blog for some time. Its only a matter of time now...and the big boy professionals are only bullish because they have to have someone to sell their financial assets to.

Putting all of one's eggs in a country that has never experienced true "capitalist pig" style chaotic outflows of funds combined with sharply decreasing financial asset prices has never seemed like good a long-term investment thesis to me.

Costly leap - pressure on the factory floor
Rising inflation and wage costs are transforming the Asian giant's
industries and its role as the world's low-cost factory.
John Garnaut reports from Shanghai.
March 15, 2008

The world's second largest sportswear company, adidas, is confronting a new
and unexpected problem. The costs of labour, materials and red tape are
spiralling upwards in its great production heartland in southern China.

It used to be that money made the rules and multinationals such as adidas
could always extract a better deal by threatening to move offshore. The
company runs more than 250 factories here, after all. And each clothing
factory employs 3000 people, on average, while every shoe factory has seven
times that number.

But the Chinese Government is no longer interested. It has recently
abolished export rebates, introduced tougher environmental and labour laws
and increased the minimum wage - squeezing production margins even tighter...

Saturday, March 15, 2008

Return and commentary

First order of business is a general Mea Culpa for not posting in some time. The markets wait for no-one and this year has been incredibly interesting thus far as the Fed slouches closer and closer to capitulation.

I will avoid detail today - my missives on Bear Stearns are decidedly un-tasteful given the current straits of that once formidable Wall Street house.

So today I am going to talk about unintended consequences.

The great economist Hayek wrote extensively about this subject and elucidated the (misguided) policy formation process that regulatory agencies and governments utilize.

Instead, I will apply the "law" (I disagree that its a "law" in the scientific sense) of unintended consequences to the current status of the U.S. financial markets.

We are now in the age of financial weaponization. This, added to a completely misguided attempt by the Fed to (defacto) centrally plan the United States economy is actually causing volatility to rise.

This is all such a wonderful example of unintended consequences. Instead of bolstering the U.S. financial system, the actions from the Fed are being met with increasing amounts of frustration and skepticism. I still believe that Bernanke is attempting to counter deflating real estate asset (and financial asset) prices by inflating other asset sectors. The first difficulty with this approach is that inflation is not very discriminatory and goes where it wishes once unleashed.

But it also assumes that the Fed can engineer the consequences of its policy, and somehow knows how to do so. This is at best error and at worst incredibly arrogant.

So the Fed continues to obey its dual mandate of economic growth and guardian against inflation, and the tacit subsidization and blatant bail-outs of financial firms will continue for the time being.

Beyond my doctrinal objections to this chain of, one must take a pragmatic view and determine, within a reasonable degree of error, what causes opportunities may arise from this tumultuous time.