Vigilant Investor

There’s no doubt the dollar is feeling pressure from currency traders. More records have been broached in declines against the Euro, while the dollar slides vs. other major currencies.

Here’s the USDX on the last year — Not promising as it nears a heavy support point of 80.

The Euro has been doing well against the dollar as well:

As for the important Yen carry trade, the Yen’s broader trend continues to weaken, although the last few weeks have showed it strengthening. Given so many trades are based on hedge funds and others borrowing in Yen and converting to Dollars for leveraged trades, that’s a lot of rooting for the Dollar against the Yen — with so many trades depending heavily on the Yen not gaining strength vs. the dollar. Should the Yen gain in strength vs. the Dollar, the cost of the trade will increase because it will take more dollars to pay off the borrowed yen. Consequently, quantitative risk formulas will require a rebalancing of risk to reflect the loss — which translates into selling of securities for liquidity.

Which leads us to one of the concerns folks should have in this era of high finance — systematic risk in the credit system and the unintended correlation of traditionally non correlated assets.

When it comes to high structured finance — the stuff invented by Ph.D.’s and MBAs coming out of MIT and Carnegie Mellon’s finance departments (also known as “quants”)– there’s a lot of fancy footwork going on in order to slice and dice up traditional portions of risk. This gives a lot more headroom for the system to absorb additional credit risk (loans or otherwise) that it might have been previously rejected or priced more expensively. There’s no doubt this does a lot of good. However, there are two factors that are underweighted when measuring what’s actually going on.

The first is the more obvious of the two. All this new high finance has fundamentally changed the known traditional risk relationships between asset classes, sectors and securities, while newly invented structures really don’t have much of a track record to be used in evaluating possible outcomes. The former happens simply because the newly invented means of dispersing risk have fundamentally changed the dynamics of the playing field on which the quants are left to evaluate the sectors and securities themselves. Yet the latter can only be measured in a theoretical sense based upon the historic nature of the securities and sectors of which they are derivative.

So, in other words, there’s a bit of a chicken and the egg thing going on: how can we truly know what risks are being assumed and priced? That raises questions about the pricing of hundreds of billions (if not trillions) of dollars of securities and derivatives. Throw in the prolific use of leverage, and you have a serious stew that could cause all sorts of problems in the real world. Doubters need only look at the recent fiasco at the now worthless (formerly $1.6 billion) hedge funds run by Bear Stearns for the perfect example of how these things can be mis-valued and blow up; these were not stupid people running those funds.

Moving on, Bear Stearns’ situation is the perfect lead-in to the second factor that is likely very under estimated when it comes to the overall system: the inherently corrosive nature of massive credit-expansion-induced economic activity.

Now, amazingly there are folks like Kenneth Fisher (Forbes 400) of Fisher Investments who are out there lumping an argument together suggesting not only that debt is always a good, but that currently the United States is under-indebted — if you can imagine. But he is far from alone, lest we remind folks that many on Wall Street and at the Fed believe in the derivative theories (and implied policy actions) of Keynes’ Paradox of Thrift. But as to an ever increasing debt load created by an ever expanding system of credit and money supply, Fisher points out that folks should be happy when GE & Apple load up on debt — it means good things are to come.

But what of poorly used debt? Debt ala the debacle now unwinding in the sub-prime mortgage market where flippers went hog-wild? Fisher argues that even stupidly (his word) used credit (e.g. that spent by, say, a heroin addict) ends up, soon enough, in the hands of the legitimate economy where it quickly gets to work for economically productive uses, thus benefiting the economy, nonetheless.

Ahh — if only such ’stupidity’ were so easily laundered out of the system. Fisher’s suggestion might actually make sense were this a closed-cycle, free market system of debt, where the mistakes happen once and that’s it; those making the ill-advised loans actually are reprimanded for their ’stupidity’ with a big, fat loss!

But, today, that’s not really the system we live under — with every lending institution having some sort of federally insured, backed, or guaranteed stamp applied to its actions. Moreover, those same institutions are the beneficiary of money being invented from thin air — literally printed no differently than would any lowly counterfeiter, except that it is done legally and by using a computer to digitally create the money in a bank account. With such an environment, outright reckless and stupid loans are the inevitable consequence of an endless supply of expanding credit that serves to distort the relationship of prices to one another. Absent the natural regulating mechanism of free market interest rates, an environment of artificially low interest rates overrides inherent checks and balances, subsidizing prices and activities away from normalcy, and into “stupid territory” otherwise unsupportable.

Which leads us back to the subprime fiasco and Bear Stearns. The housing bubble is a perfect example of credit run amuck — where legitimate loans slowly turned over to slightly unwise loans, which turned into very risky loans, which turned into downright stupid loan after stupid loan. (Warren Buffet noted that the subprime mess was a situation of dumb meeting and doing business with dumb!) With the short term history as the only evidence they required, many homeowners believed the new era of rising home values would continue indefinitely - egged on up until the end (and even into the decline), of course, by everyone from Fed Governors and Wall Street, to the National Association of Realtors and many of their mortgage broker cousins.

With each passing month, easily available credit drove prices higher, often encouraging folks to assume risky mortgages they otherwise might have passed on. Others had to use the risky mortgages just to afford a home. All the while, the flipping crowd was jumping into the fray head first to make a fast buck. Higher and higher the values went - supported, of course, by ever more stupid loans.

That was, until, on one end, rates could go no lower to drive prices higher, and on the other end, rising default rates raised a red flag among lenders. At that point the gig was up to all but those knee-deep in the machine, too close to the trees to see the forest for what it was. All of it, however, seemed entirely normal to those deep in the game - which included everyone from builders, to suppliers, to anyone - service, retail, or manufacturing –who supported housing-related industries. But their perspectives had become entirely perverted by the reverberating actions of tens of billions of dollars being spent in housing by the equivalent of Fisher’s aforementioned heroin addicts.

Few give any credence to the Business Cycle and Credit theories of the Austrian School of Economics, but even a basic understanding of both would give an observer a clear insight into what was in store for those who had committed themselves to the housing portion of the gargantuan global credit bubble. The entire economy had become distorted around this sector. Hence, it came as no surprise to most Austrian types that high-flying mortgage lenders would implode, or that hedge funds dabbling in mortgage lending would start to blow, lead of course by the most risky asset class - sub prime.

Moreover, many of us expect further carnage to unfold further given that the massive credit expansion didn’t just create dislocations and encourage stupidity (to use Fisher’s term) in the housing and mortgage markets. This problem is far from “confined” as so many in high places understand. The situation is contained only so far as the other shoes have yet to drop - as they seem to be with increasing regularity.

All that ties back into the crazy system of structured finance we have today, which is all very dependent on expanding and low priced credit to support higher valuations, which, in turn, are necessary to pay for the vast amounts of leverage being used in the system. As for the systematic risk dispersed across the world, nobody can truly quantify what it really means with conventional accounting terms - especially since so much of it, like the subprime instruments held by Bear Stearn’s hedge funds, have never been marked to market; they’re valued only to their quant models.

And, so, we’re back to the Yen carry trade and the Dollar. Just as a stronger Yen vs. the Dollar could trigger modeled program trades to jettison unrelated assets, the same can be said for other valuations supported by credit. For example, suppose several large funds borrowing in Yen with partial exposure to U.S. dollar subprime debt, now find their risk models suddenly out of line due to Moody’s, S&P, etc., dropping the ratings on subprime debt. This would force an offloading of other unrelated securities to create liquidity. After all, you wouldn’t want to push subprimes lower by selling them into a downdraft as a plan to cut back on risk.

Such a situation might also force a partial unwind of their Yen carry trade - a Dollar sell / Yen buy proposition, pushing the Yen up and the Dollar down. Meanwhile, the securities sold for liquidity drop in value, potentially forcing another round of programmed risk rebalancing, likely brining other hedge funds without subprime exposure into the mix. And around, and around we go.

source: John Williams

Is that a plausible scenario? Many will tell you its very unlikely. Yet in that group, far too many suggest it can’t happen based on the evidence that it has never happened before. My favorite dismissal of this risk is one that points out that, despite dire warnings from folks like us, Warren Buffet, and on down, the problems have remained isolated events, and not systematic. This, they say, is proof there’s not a serious problem. That logic, of course, reminds us of joke about the man who fell off a building at the 85th floor who concluded as he passed the 30th floor that, based on his experience so far with this new situation, he clearly didn’t have a problem.

Likewise, you’d expect the quants designing the programs or structured finance products (derivatives, or otherwise) to have confidence in their models. But, don’t forget, these are the same folks who were running Bear Stearns’ hedge funds, and Amaranth, and Long Term Capital Management — and other more recent hedge funds being forced to halt investor liquidity in an effort to prevent catastrophe. These are the same people who applied investment grade debt ratings to structured products that were worth half or less than their issue price within a year.

Given the vastness of the credit expansion and the rapid growth of the gargantuan derivatives market, it is anyone’s’ guess as to what is actually lurking beneath the surface. Let it suffice to say, the recent shots across the bow don’t give us tons of confidence about what lurks below - its very likely valuations are quite disengaged from reality.

But, as any Austrian economist knows, in the wake of massive credit and money supply expansions, the pricing mechanism eventually breaks down. The consequent economic distortions can either be allowed to clear, or they can be papered over and exacerbated with more freshly minted credit and money supply. The latter has been the policy makers’ solution. But there never is a free lunch: excess credit is the problem, and the eventual breakdown will herald the opportunity to clear the air. Unfortunately, those running the system are hell bent on preventing the former from ever happening, hence they continue short circuit the latter from taking place - much as they transplanted the tech equity bubble into a housing bubble with such policy. And so we will continue on such a path until the economic perversions and dislocations becomes so severe that they can no longer be supported under their own weight.

Hence, we watch the dollar and its relationship to other currencies and hard assets such as energy and precious metals. The indications are not good, with the dollar having dropped steadily since 2000. We also watch interest rates and spreads. Spreads are feeling a pinch, albeit minor in relative terms. Rates have not yet broken out, although foreign lenders - on whom the U.S. economy is now entirely dependent upon to fund its massive $2.5 billion a day deficit - appear to be tiring of accumulating generational low interest rates in the face of an increasingly anemic U.S. economic situation.

Invariably what this means for ordinary investors is the potential increased volatility - especially given how little volatility they’ve seen in recent years. Additionally, vigilance demands we consider what formal policy solutions might be pursued to ward off the eventual day of reckoning. With that, we encourage investors to be vigilant in measuring inflation in terms related to money supply and credit expansion and not just by the dollar and CPI. Prepare for the situation to worsen.

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