Blowing Bubbles

The Dollars demise is well documented, and there are many sound reasons to agree with the numerous bloggers/pundits who call for the demise of the Greenback, not the least of which is the massive accumulation of debt on the US balance sheet post Bear Sterns. The Dollar has fallen impressively vs. virtually all other fungible instruments, but one stands out in particular, and that would be the Japanese Yen.

I say this because the ascension of the yen ( ~ 89 to 1 US$) is not driven by inflationary prospects in Japan (Unlike Australia). Nor is it driven by assets or balance sheet ( like Canada or Norway).
In fact, Japan has none of these attributes, and it's a net exporter to boot.

No, what appears to be driving Yen appreciation is the "switch" from yen to dollar as the worlds funding currency. Translation, borrowers are switching from Yen to Dollar to fund the massive carry trades that every market commentator is crowing about.

So where does that leave the Yen? extremely overvalued and a huge problem for Japan's trade dependent economy.

Caveat Emptor.

Why Gordon Brown's Notion of Taxing Speculation is a Very Bad Idea

Nov. 7 (Bloomberg) -- U.K. Prime Minister Gordon Brown said the Group of 20 nations should consider measures such as taxing financial transactions to penalize excessive risk taking and limit the burden on taxpayers of bank failures.

“It cannot be acceptable that the benefits of success in this sector are reaped by the few but the costs of its failure are borne by all of us,” Brown told G-20 finance ministers and central bankers at a meeting today in St. Andrews, Scotland. Tighter capital rules and pooled bank resolution funds could also be considered, he said.

The idea of putting a tax on speculation is not new. However, it is arbitrary.

Speculation is guided by two notions - intent and perception.

Ones own perception of the risk of any investment guides our beliefs as to what degree we our speculating, when we risk capital. Those who observe (or participate through loan) to our allocation of capital assign their own degree of speculation, based upon external information and their own internal risk preferences.

If we could all agree on risk in the first place prices would only move when new material information became available. The continuous nature of Capital market asset pricing has proven that this is certainly not the case. Risk is perceptual and not static.

The financial leverage afforded a borrower and the cost of capital lent is guided by the lenders perception of the "riskiness" (substitute level of speculation) of the enterprise to which lent capital is being deployed.

And here is were Gordon Brown misses the point - Capital Markets already taxes speculation through lending rates and loan terms and conditions.

Either Gordon Brown does not understand this, or he is attempting to repair his governments own speculative balance sheet with popularist rhetoric.

Crowded Trades

Shorting the US dollar has become a crowded trade.

Macro players are buying US equities and shorting dollars as an asset inflation play. My concern is that they are driving that trade by the weight of investment.

Underweighted Equity books are then forced into the equity market even though fundamentals don't support it.

CTA's and Momemtum traders are drawn in: pushing equity and currency moves further.

And finally, we hear that these equity movements are a "response to the sucess of fiscal stimuli" and "further proof that the market is re risking".

All of these lead me to conclude that:

Equities are riskier at these levels than the market believes.
The US Dollar is a less compelling short than it has been for the last year.

Look for round two of derisking.

Options, Terms and Conditions

In the Four Agreements of Terms and Conditions, a paper I wrote earlier this year, I postulate that terms and conditions can be re-characterized as the conferment of real options. Here the real in real options is the tangible asset cash. As cash is the basis of exchange and fungible into all other tangible assets, in my world it is also a tangible asset.

I claim that the ability to "game" a compensation agreement relies on the ability to exercise a real option. The grantor can confer a real option without being compensated for or realizing it, thereby creating an misalignment of incentives. "Gaming" on the part of the option holder occurs when he exercises an option to profit from a misalignment.

I claim that without the existence of an option, no arbitrage can exist. I will go one further and claim that without at least one option, no zero sum game can exist.


In either case I am available for hire on the matter.

Adapting ALM to the Private Wealth Management Process

I recently came across an interesting article that nicely summarizes one of the current shortfalls of in the Wealth Management Industry: the lack of proper constraint definition ( here focused on ALM) in the client portfolio construction process.

The Paper

The authors argue for a construction process similar to those employed by many pension funds.
To my way of thinking, this makes a lot of sense.

Too Many Savers?

Paul Krugman has stated that he believes one of the biggest challenges facing the recovery is the phenomena of "too many savers".


Here is a chart of household "savings"


And to put that in context, lets look at household "debt"



These to graphs tell the tale of easy access to capital and leverage. It was certainly the case that households were not incented to save but rather to borrow and "invest" (speculate).
If there is, as Krugman states "too much saving", then one has to wonder to what end?
It seems more the case that there is a massive deleveraging of the consumer financial system,
one that will take many, many years to reach some sustainable equilibrium.
One way the government could aid in this repair would be to undertake radical tax reform as Art Laffer has suggested.

I am not a big fan of Laffer. He's the same economist that bet Peter Schiff that there would be no recession and that the housing bubble would not burst. But as the saying goes "even a broken clock tells the right time twice a day", and Laffer's Tax argument holds water, even if he does not.

Tax breaks should come with the responsibility of each recipient to use at least 50% of the proceeds to pay down personal debt. Consumer credit rates should be subject to a one time drop to do this (only for paydowns, not new loans!!).

The Government should also force all high school students to get a personal financial certificate as a prerequisite of high school graduation (for GED's as well). This could be extended to a requisite for citizenship or even a minor tax incentive.

The only way that society will avoid the mistakes of the past, is if they are actually held accountable for learning from them.

Why its not time to take the Housing Casserole out of the oven just yet

The US economy is,was, and will be dependant on real estate values. Given the historically low level of savings rates in the United States, combined with high personal debt levels, much of the US consumer's wealth lies in their home equity.

The Case Shiller Housing chart (depicted nicely here), would appear to map nicely with US economic activity and wealth in general. At the current level of 155, houses are still ~ 25% more expensive than the peaks of all previous housing booms. Given the higher rates of leverage (less "money down") on homes today compared to past periods, it would stand to reason that their is still lots of wealth destruction ahead of us in the housing market.

Provided that home "owners" are willing to sit on negative equity, and more importantly are ABLE to sit on negative equity, a further decline in the Case Shiller index could have a minimal impact on the banking system that wrote all those home loans. More likely, MBS investors may find themselves with less assets than they are counting on.

Monetizing Truth from Fiction: The Madoff Dilemma

Madoff Investors have a right to be mad. Firstly, with Madoff for swindling them. Secondly, with the regulatory authorities for allowing Madoff to operate as he did. And thirdly, with themselves, for either investing in something the was incomprehensible, or for failing to execute their own due diligence.

Madoff investors are now left to contemplate next steps.

One such step is to go after the Federal Government for taxes paid on Madoff based investment income. This is, in my opinion, a very slippery slope. If the Federal Government was the beneficiary to ill gotten gains, the investor would be liable for the retained balance, which would also need to go back into the recoverable asset pool. This is clearly not what the investor who paid taxes would be looking to hear.

Next we get to actual amounts. Assuming Madoff compounded at ~12% per annum (which I believe is about right), and if you take Madoff's self evidenced confession, that it has been a Ponzi since 1993 (this would have to be verified) an investor from 1993 and prior would only be entitled to 29% of today's loss (assuming no damages).

For the Madoff investor to assume more, they would be forced to take the same belief position that got them here in the first place, and they would have to convince the Government as well.
The scope of the losses, while huge, are not 65 billion as reported. Fictitious gains cannot be counted as real losses.



Here is a summary of a due diligence piece I did on Madoff in 2000 for a client. By the way, the client remained invested, because "Bernie has always made us money".

The Free Call Option Imbedded in the Public Private Investment Partnership to buy Toxic Assets

I'm posting this link as there is no point in redrawing the cartoon wheel.

The free option of the Private part of PPIP (The Public part gets to be short the put!)

Going Green?

On Tuesday morning, I drove myself and my 16 yr old daughter from Princeton to the Philadelphia Airport to catch a flight home to Bermuda.

Living on an Island that only allows 1 car per house assessment, where water is collected off ones roof, and where astronomical electricity rates insure conservative use, I have become more aware of resource use and waste.

I read a lot about the green movement in the USA, the groundswell of support for "change", the tough economic times for labor and the high cost of energy. Sounds like a recipe for resource conservation, right?

I asked my daughter to count the number of cars we passed with 1 passenger and the number of cars we passed with more than one passenger ( I admit I drive fast!). We were travelling towards a major US city at 8AM, so it is safe to assume that the bulk of the traffic consisted of daily commuters.

The results: sample size 100 cars (we could have done many more but it was getting lame in the words of my daughter) 94 Single Passenger Cars 6 Double Passenger Cars 0 greater than Double Passenger Cars.

These results are more or less consistent with similar observations I've made over the last 20 years.

Carpooling is greener, and more economical than hybrid cars. If the US is really serious, they should institute a road tax on single drivers and use the proceeds to lower the enormous debt that threatens to destroy the purchasing power Americans will need to consume all that fuel.

The next reserve currency

The US Federal Reserve in in the process of debasing the US Dollar as the reserve currency.
The process of printing untold amounts of US dollars is well under way and shows no real signs of abatement. The UK and Eurozone are not far behind.

I believe the market will move toward commodity baskets as the next reserve currency. Given the steep contango for many physical commodities, The cheapest way to obtain meaningful exposure would seem to lie in holding asset rich economies (Canada,Norway,Brazil,Australia). My guess is that Canada has the most solvent banking system of the four.

The artificial strength in the dollar post Lehman Brothers was not caused by demand for the safehaven currency (as many media pundants speculate) but rather the call on capital called by the deleveraging banking system on hedgefunds and others who borrowed for carry trades ( the Icelandic trap).

While I'm not certain of the timing of a dollar crisis, the combination of demand destruction in the means of extracting many of the worlds commodities, combined with the inflationary monitary policies of western nations, desparate to "fix" the banking crisis, set the stage for a perfect storm for the US dollar.

Stay Tuned.

Bradley Ruderman: What's wrong with this picture?

Beverly Hills hedge fund manager Bradley L. Ruderman surrendered to FBI agents.

That is the tag line of most every wire house that has put out a release.

Bradley L. Ruderman was a con artist. It seems from the civil suit filed by the Securities and Exchange Commission, he convinced people that he had an investment strategy and proceeded to take their money and spend it on himself. This makes him a con artist.

Cynical jokes aside, this does not make him a hedge fund manager. It seems the press is hell bent on implying that he was a crooked hedge fund manager. If he posed as a prominent Surgeon and proceeded to murder people, would the press print that " a prominent Surgeon was arrested for murder"? Should we then be led to think that Surgeons are evil?

Bradley L. Ruderman was a con artist. He convinced some people he was a hedge fund manager. But more fundamentally, he convinced the entire media outlet that he was a hedge fund manager.

New Paper

The first draft of The Four Agreements of Terms and Conditions is now available to view. Comments are welcome.

What does to encourage lending mean?

There is a lot of talk coming from the Government about monetary policies and packages that aim to fix the current economic crisis by encouraging banks to lend.

As far as I can tell, bank lending can mean many different things.

• Letters of credit are issued against collateral.
• Lending margin, prime brokerage, to allow others to invest in speculative assets which are pledged as collateral.
• Business loans who's collateral is often collateralized by the pledge of a related (or unrelated asset)
• Lending between Banks in the interbank market.
  

It seems to me that the problem is twofold.

Firstly, banks are willing to lend, but the acceptable collateral to do so has changed. The risk aversion doesn't lie so much in the loan as it does in the collateral pledge against the loan.

Banks made a business out of speculating with their balance sheets with respect of the assets they held on their books. As a result of leverage (borrowing to speculate on assets which were then used to collateralize those loans) and the unexpected outcome of exceeding expected loss (forecast risk), banks find themselves effectively stopped out of speculation. As they experienced this outcome, it makes sense that they would prefer no to repeat it (at risk of ruin). In this sense, banks have become too familiar with collateral.

If banks are to return to the old days of being primarily deposit and loan institutions, that would imply a disavowment of proprietary investment. If banks won't do it with their own money, they sure as hell aren't going to lend you money to do it. This is the crux of the problem.

Secondly, as we saw in Japan (early 90's onward) when banks don't lend to speculation, there is still the good old business loan (infrastructure, capex, new products etc.). Speculation aside, cheap money means nothing if you can't use it, and Japan early 90's there was just not that much to borrow for. The problem which we now face is a global downturn in economic activity. Even if cheap money is available for capex, business won't expand its balance sheet unless there is an economic reason to do so.

Perhaps government is looking to thaw the credit ice age by fixing the freezer.

Framework For Risk Based Manager Compensation

I have formulated a Framework for Risk Based Fund Manger Compensation and would appreciate comments. Feel free to email me with questions or comments.

Modeling or Posing?

The notion that model based marks are a solution to the financial system's crisis of confidence, seems puzzling at best. Our entire financial system was nearly taken down (verdict still out) buy rating agency reliance on a Gaussian copula formula used to evaluate credit default probability. Now we are about to replace mark to market accounting with another set of models.

Reuters reports that there's significant tension between banks and regulators ahead of the results.
In the meantime, *bank examiners are struggling in the stress tests to get banks to accept that they are valuing assets on their books too highly, according to bank industry sources*. Many of the banks have completed their own stress tests, and regulators will soon sit down with the banks' management to reconcile the differing results, these sources said.
At issue, not surprisingly, is what tests should be used. Along the lines of their opposition to mark-to-market, the banks would like to see a stress test that assumes the crisis will abate and that we'll return to some semblance of normalcy before too long.

If the purpose of the chosen model is to give you the results you want, then at best you succeed in quantitatively supporting a subjective stance and at worst fraudulently inflate your financial health to the detriment of shareholders and the market as a whole.

It would have been much cheaper and more effective (in my opinion and others) to create an independent fund,
to strategically bid assets that are "cheap". This would be both profitable for the taxpayer and efficient. Instead we have created a structure where financial institutions burden the US balance sheet with assets that are decidedly not cheap. Institutions can now participate in the funds they are selling to. The moral hazard here is that these institutions will sacrifice their minority stakes to the detriment of taxpayer funds to benefit on the other side of the trade.