Forget $4 Gas – Can the US Handle $6 at the Pump?

The short answer is likely no, at least not at any time soon. That’s not to say, however, that middle east contagion fears are completely overblown.  The fact of the matter is that I believe that potential worst case scenarios are not as bad as many have come to believe long-term; but short-term, as we all know, anything is possible.

In the short run:

  • Muammar Gadhafi is a deranged lunatic, believed capable or anything from setting his nation’s oil reserves ablaze to genocide.
    • With sanctions having been imposed against Libya, their assets frozen, and the nation effectively divided in two, further escalation in violence may be imminent.
  • Saudi Arabia – given their enormous reserves, and that they have stepped up oil production to offset losses from Libya, concern of stability in Saudi escalates anytime the youth of the region so much as sneeze’s in its direction, it is understandable that the world’s eyes are focused turmoil in nearby Bahrain, Oman, and the country’s Shiite minority.
    • Bahrain and Oman will both be focal points in determining potential swings in crude, as worries of unrest spreading to Saudi grip the market
  • Algeria strikes many as a likely candidate for contagion due in large part to being situated in North Africa, near Egypt and Libya, considering it’s extremely high unemployment rate amongst the youth, and after having been run under a state of military emergency for 40 years – not to mention large oil reserves.
  • Though Egypt has been somewhat removed from our radar we must remember that they are essentially leaderless as a nation (with no president), and no elections scheduled until September of this year.
  • Iran. Appropriately one of only two ‘four-letter’ words on my list.  We know they’ve had issues, and we now know (courtesy of Rajat Gupta) that it’s easier to get information out of Goldman Sachs than it is from Iran.  Over the past two weeks rumors of Iranian warships entering the Suez tore through worldwide oil markets intra-day.  It is hard to assign credibility to any breaking news from Iran, and therefore I assign Iran as my ‘sleeper’ major headline-risk from the middle east (with Saudi being the 800 lb gorilla).

Of the above issues the most pressing is clearly that of Gadhafi in Libya, as history shows it’s difficult to assign probabilities to the potential actions of madmen – they’re literally capable of anything.  On the other hand, the President of Saudi Arabia was recently greeted with jubilation as he returned from medical treatment abroad, promptly instituting further benefits for the unemployed, and pledging to increase oil production to offset losses from other key mid-east nations.  Meanwhile, Algeria preempted many fears of further contagion by ending its 40-year old military sate of emergency – a state of control that Egypt had been under, until after their uprising.  This past week, further protests in both Tunisia and Egypt proved both successful and peaceful.

Though the future of the region as whole may be much brighter than many might believe, that doesn’t negate a few other pressing issues we’ll have to deal with.  With US forces having approached the shores of Tripoli amidst reports of Gadhafi  loyalists massing near rebel strongholds, and with substantial sums of Libyan assets having been frozen, full-scale escalation appears imminent if the US is unable to dangle their $30 Billion ‘carrot’ of seized assets and execute some sort of negotiated exile.  While any escalation would likely come in the form of a UN led security force (or at least for once a UN approved one), it will set an interesting precedent of supporting such uprising.

If Gadhafi has to go the hard way everything changes, and I mean everything.  If Gaddafi choses not to leave I believe that verifies that he is devoid of any logic or sound reason, and they since he doesn’t care about his money he therefore may no longer care about his oil reserves – if Gadhafi pulls a Saddam and starts lighting oil well on fire I don’t want to think about filling up my gas tank, let alone where crude might trade.  Longtime Gadhafi friend and Libyan ally, Hugo Chávez of Venezuela, has recently made news calling for negotiation with the Libyan madman, and has historically stood at his defense.  Rather then speculate further, suffice it to say that it is more than disconcerting having a Gadhafi supporting dictator with his own sizable oil reserves on this side of the planet.

Given the number of oil-producing nations currently, and potentially, experiencing upheaval it is not difficult to imagine crude surging to its previous highs; even if contagion does not spread further, if we were to get a meaningful and prolonged drop in production (or in the case of Egypt, transportation) of oil in most of or all of these nations, it would have a profound impact on oil prices in the short run – particularly in Brent crude, and with a disproportionate effect on the European economy as compared to the US.  Excess US supplies have been able to hold back WTI crude, and may very well continue to, but a prolonged shock could stifle recovery here as well.

Increased margin requirements at commodities exchanges (like CME) have curbed leverage that traders may use, and while in theory this should limit overall speculation, in practice, during times of heavy speculation, volatility may be heightened (particularly when requirements are altered during said speculative period) – so oil may not trade as high, but boy is it going to trade! The last time around when oil peaked we didn’t see gasoline prices above $4.00 f0r long, and that’s because oil prices didn’t stay that high for long (nor were they expected to, if you look at futures) – had oil prices even just hovered at $147  longer, gas would climbed further.

As a general rule always remember that for every $25/barrel of oil you can add $1.00 gallon at the pump.  Long story short, oil may or may not go higher than the famed $147  per barrel high in the next few months, but I can tell you that if prices stay at or near $150 per barrel for more than just a few months that we’ll see US gas at the pump surge to near $6.oo per gallon.

In the long-run:

This could be the best thing to happen to the middle east since air-conditioning.  The eventual outcome might be the best that Americans (though not necessary Dick Cheney) could have hoped for in the Middle East.  If we, as a nation, were actually trying to do anything more in Afghanistan and Iraq than playing “where’s the WMD?” then I think we waned Democracy to be contagious.  OK, yes to be fair let’s acknowledge that in a couple of instances here we have rebellions against US sponsored (or at least funded) dictators/monarchs (Egypt and Bahrain) – but if any President in US history was ever going to be able to look the Middle East in the eye and honestly say “that was then, this is now – we’re different” it’s probably the one named Barack Hussein Obama.

Oil production?

These people aren’t mad (again, with the exception of Gadhafi) – they don’t want to stop producing and selling their most valuable asset.  Understand that, if anything, you could argue that all of this turmoil is centered on dictators and monarchs who hoard, and do not distribute or utilize effectively, their vast oil wealth.  If anything I would believe that after a new government is installed, Libya will be capable of producing more oil with a competent government and improved infrastructure, for example.

The enemy of my enemy is my friend…

One thing worth noting in the negative column might be Gadhafi’s own comments this week that Osama bin Laden was to blame for the uprising in his country, and that Al Qaeda had drugged the youth of his country.  This gives me pause in the same way a parent might expect their child to spend time with the exact people they had told them not to associate with – to be spiteful.  I’d be at least mildly concerned that the youth of a country who hates their leader (Gadhafi) might be drawn to the person/group he seems to fear most, Al Qaeda. Whether or not they’re the ramblings of a lunatic, I pay some heed to the fact that someone with that much to worry about right now is having delusions about Bin Laden and his effect on the youth of Libya.

A crude reality

While I would characterize almost any continued spike in oil prices as just that, a spike, I am certain that the future of crude prices is elevated. Though we continue to improve fuel efficiency and are beginning to offer alternatives, it is not enough – and certainly not considering the forecast for increased global energy consumption. Without an energy policy the US is unlikely to make much headway and, even when we make the necessary switch to using more of our abundant natural gas resource, oil prices are likely to remain elevated.  Given global supply, geopolitical concerns, and that after shale is exploited most of our sources of crude will be more and more costly, I believe that in the next few years we may see oil below $100 per barrel for the last time in our lives.


Internet Revolution Strikes, Again: Both in the Streets, and on “The Street”

Every analyst on the street already seems to be on the bandwagon, and every pundit on TV believes we should be scared by so many analysts being in agreement: tech stocks are cheap. Many of them have been cheap for a decade – and they were cheap for a reason.  The explosive growth of bubble wasn’t a total farce, much of that growth was simply robbed from the future – countless companies experienced a decade of growth in 18 months……and then the wheels came off.

Less than 4,000 days later……

The growth of the internet bubble was unprecedented; with companies’ valuations sorry virtually overnight, despite an internet still in its infancy and no profits at many companies.  Companies like Global Crossing and JDS Uniphase spent billions laying fiber optic cable and acquiring companies for growth.  The result: so much bandwidth, a glut, that it would take us a decade to work off the capacity.  And so, much like the very stocks that led the boom, both the internet and it’s companies had grown wildly faster than people’s ability to connect to internet, to do so with a high-speed connection, and be able to stream content.  Much like the prices of these very stocks, these companies had grown the internet (in terms of supply of bandwidth) much faster than the growth in demand for bandwidth.

And on the market side, perhaps more than ever, valuations finally caught up to stocks.  Then the seemingly infallible Alan Greenspan (after all of his talk of ‘Irrational Exuberance’) killed the ‘Golden Goose,’ raising interest rates perhaps one too many times….and Enron was exposed as a fraud (and with it Arthur Anderson), Investment Banking and Research were flipped on their head……September 11, 2001…..the Dennis Kozlowski episode at Tyco….and sprinkle in some Sarbanes Oxley – the golden age of stocks had ended.

Accordingly, nearly the entirety of tech-land has languished for the better part of a decade (not withstanding standouts like Apple): value (cheap) companies like IBM spent an entire decade getting cheaper, and cheaper – with its stock price never surpassing $135 (for 10 years) all the while steadily growing its earnings and revenue (much like Intel, though it is nowhere near its’ highs).  Recently, in fact, IBM was finally able to break-out above that very $135 level – technically, this amounts to a break-out from a 10-year consolidation.  No wonder that only days aver surpassing $135 , IBM was able to trade north of $160 (likely on its way to north of $200).

What happened?  Many things have happened….though there are a few key factors that demonstrate that this is the break-out tech investors have been awaiting since the dawn of the internet age.

A dearth of bandwidth meets soaring data demand……

Fast forward 10 years, 4 iPhones, not even Google nows how many Androids, 3 prominent social media sites (Friendster, MySpace, then Facebook), two incarnations of high-speed mobile networks (3G & 4G), and a President elected by the social-media age, and we find ourselves in a brave new world.We finally have the streaming content, mobile access, and are so socially connected that we, as a people, have completely overrun the entire internet infrastructure.  Just weeks ago the last IP address available was used.  In New York City, where I live, my iPhone has been reduced to a paperweight during times of high data-traffic.

Governments around the world are in a race to provide the vast majority of their populations access to high-speed digital internet, while mobile carriers struggle to upgrade their networks to meet demand.  Right in the middle of at least the second worst financial catastrophe in modern civilization, we are witnessing the equivalent of a ‘digital’ New Deal.  With the world on the verge of what could be considered a long-term structural unemployment problem we are witnessing  the mass reconstruction and build-out of the entire information super highway – and many of the broken companies of the past boom are back again to reap the rewards.

Make no mistake there are, and will be losers.  Some companies did not (or not yet) adapt to the changes of the second coming of the digital age (we’ve all seen Cisco’s last few quarters).  In other areas there has been a changing of the guard; Apple is one of the rare exceptions that never skipped a beat over ten long years, and Google appears to be he new Microsoft, but better – by being the leading software provider to the ‘new’ hardware (mobile devices), all the while using their search business to literally ‘print’ money.

The Revolution will not be televised……

From President Obama to the recent uprisings in Tunisia and Egypt, we have also seen the power and scope of the internet revolution we are in the midst of.  This social revolution has created a kind of momentum, social, political, and technological, that cannot be stopped and the will forever change the course of history.  Every day we are more and more connected, and those who are unable or unwilling to adapt will be left behind; people, companies, and countries alike.  This was perhaps no  more evident than when [former] President Mubarak of Egypt spoke the world this past Thursday; he adamantly implored his people, the youth of Egypt, not to listen what the people on TV were saying/telling them what to do.  In that moment it was so obvious. This movement that began with a Google executive’s post on Facebook, a movement against a President/Dictator that, despite weeks of protests, was completely oblivious to the root of the riots and, to what the world had become.

This is a lesson not just to other nations that might rise up in peaceful democratic protest, but to all of us.  It’s been called a ‘tipping point,’ or wildfire, even cancer, but, like or not, the digital proliferation of humanity can no longer be stopped.  Perhaps more now, than ever in history, the people of the world, the masses, have the loudest voice.

The bottom line, is exponential……

This translates to a world where the most valuable infrastructure is digital, the most important security is cyber, and the majority of the world’s capital flows through fiber optic cables and is then transmitted through the air – and the rate of the proliferation of any and all of these digital trends is more rapid than anything in human history.  Faster than anything the ‘old world’ could muster other than perhaps cancer.  This past year social networking/group-coupon company, Groupon, grew from literally $0 in value to a valuation of over $1.4 billion – in less than 8 months! The company’s value literally grew at the speed of ‘word of mouth.’

Whether it’s the growth of the conservative ‘Tea Party’ or the youth of Egypt throwing their own ‘Cairo tea-party,’ we can literally see the proliferation of the internet revolution on the street.  If we look at IT spending, or at productivity, or at the growth in profits and revenues at tech companies, we can literally see the proliferation of the internet revolution on The Street.  And this time, they’re growing at almost the same rate.

The Day the Market Stands Still

Several years ago Warren Buffet proclaimed derivatives to be akin to ‘financial weapons of destruction’ – if only he knew the half of it. True that derivatives are opaque, illiquid, and often exotic.  Their very nature is both inherent to the way we do business and to the fear of how business is done today.  However, May 6th may point to a much more dire concern – how fragile is our market structure, really?

On the day of the Flash Crash one of my thoughts, on a day when most of us barely had time for a few, was that we had just seen a terrorist event.  Maybe it was (I’ve been told it wasn’t), maybe it wasn’t but, whether we like or not we were clearly exposed.   For the purposes of this discussion we will make an assumption; either May 6th was a planned mini-attack (let’s call it an incursion), or it wasn’t (a completely random perfect storm) – it cannot be both.  Either way one fact remains, certain vulnerabilities in the way business is done have been exposed.  Their have been advancements since the Flash Crash, particularly the single-stock circuit breaker that holds trading when an individual stock moves more than 10%  within 5 minutes.  Lack of uniformity was placed as the chief cause of the wild events that day, and ‘slowed’ trading on the NYSE was credited with lessening the damage. What has been exposed here is at the core of our financial system; our markets ability to operate and do so electronically, to provide liquidity regularly, are integral to our economy.  Detailed information of tick-by-tick information, not just of trades, but true market depth, called market-latency information is used, among other things, to decipher market activity and to improve quantitative models.  This information is available to anyone who can pay for it (namely hedge funds) and may most certainly be used to exploit the weaknesses of our system, but one integral ingredient is missing.

Why is that terrorists are often so difficult to overcome?  It is nearly impossible to defeat an adversary who is willing to take his/her own life; they are willing to inflict a kind of damage that no one who possesses the instinct of preservation can conquer – people willing to die to kill you are tough to beat; people with money to burn are similarly dangerous.  The markets would prove a devastating parallel to that conundrum.  Is an efficient market prepared for extremely large participants (by sheer size, or by derivative leverage) that do not care if they lose?  The market is supposed to be a zero-sum game, but I am reminded of a Keynes quote, “If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.” From ‘Long-Term Capital Management’ through AIG and Citigroup, that principal has been reinforced – be careful who owes you how much money.  What if someone deliberately created a LTCM, a ever-expanding web of leveraged bets upon leveraged bets, designed not to be bailed out (or to be bailed out, whichever you prefer)?  This is my point.

Now allow us to bifurcate.  We have two separate, yet not necessarily distinct issues; one is that, whether intentionally or not, our system has been tested and we can expect future tests, and two is that we don’t know how a market with a LTCM designed to disrupt the market would behave.  Either, in and of themselves, are completely terrifying.  What I suspect, however, is that the two need to be thought of as more intertwined, in the sense that derivatives are designed to be whatever they are designed to be – little else.  I am not saying that derivatives would be how a hypothetical financial cyber attack might be packaged.  What I am saying is that given the derivative exposure borne by the market today, that if and when such an attack were to occur it would be devastating.  An attack sever enough to close US markets for “an extended period” (as Doug Kass recently suggested) could bring renewed strain to global, and particularly US and European, markets still weak from recession.

In the absence of significant changes to market structure, and without addressing the portion of market activity comprised by automated trading, their remains reasonably high-risk in any short-run period due to market structure and possible liquidity crisis’.  With the leverage available on the futures and options offered on the myriad of financial products available today it becomes more than plausible that a, or a group of, participant(s), that may or may not care about preserving capital (they may be using capital as a weapon), could deliberately and effectively disrupt our entire market structure.  Moreover, if one combines the principles of what I’ve discussed with a breach in security, a cyber ‘hack’ if you will, they would likely discover an equally chilling prospect.

Kick the Can; Ponzi Schemes, QE2, and the Beauty of an Unbalanced Budget

Just yesterday the Fed announced the size and scope of their much touted QE2 program; the systematic (re) inflation of our currency – and the continued inflation of the US bond-market.  I understand that deflation is very scary, and the Fed is targeting a higher level of inflation (more dollars swirling around, and worth less than they are now) in order to help stimulate some recovery. Though the principal of what has been done, and what is being done, seem logical in a classroom (or a controlled experiment); we face a different kind of reality today.

I haven’t heard many people ask about all of that stimulus that was supposed to flood the system many months ago.  The answer is that (we won’t get into how poorly spent it was) much of the money was either hoarded by companies (largely by banks) or shipped overseas to take advantage of favorable investment opportunities and rates abroad (that money is now sitting in foreign banks).  You see, for inflation to really occur we need something called increased ‘velocity of money’ (money being loaned, deposited, loaned again….creates a multiplier effect that helps create inflation [more money]); but no one loaned much (any) money.

Presumably if QE2 works we will see lower interest rates in the future (from all the bond buying) and yet the US is, all the while, running a $1 Trillion + annual deficit through next year – so we’ll also be selling more bonds to pay for the budget deficit.  This is a ponzi scheme, plain and simple.

There are so many (potential)  ulterior motives at play here it is incredible:

  • Other nations have balked at continuing to hold our currency in their reserves in recent years, and it is the interest of the US to add buying the Treasury market (keep rates low) as they keep selling more debt – it will cost less.
  • The fed insists on buying as much short-term ( that will expire in the next half-dozen years) debt as possible; essentially buying back substantial portions of debt, that our country would have had to pay back fairly soon, with newly printed money (as supposed to paying with money we actually ‘have’).
  • Since we run a ‘trade-deficit’, the US (and it’s companies) routinely owe substantial sums of money to foreign countries/companies; if we print more money it will be worth less, and if our ‘bill’ is in dollars than we (the government at least) gets to settle the score with same number of dollars though they are now worth less (bankrupt countries do this and it’s called ‘currency devaluation’).
  • More often it isn’t that we owe, it is that we pay for our goods in dollars; it is all these dollars that we use to buy good overseas that are then used to buy US debt – what else would they do with it?  They often trust our currency more than their own.
  • Our country assumes that our deficit (and our economy) is a bigger problem now than it will be in the future; why else would we push rates so low, particularly in the short-term, but sell almost all of our debt in the short-term so we have to pay it back very soon?
    • We have already overestimated the pace of our recovery; accordingly our current strategy is the same one that a country might use if it had realized that its’ economy wouldn’t be strong enough to pay its’ bills when they were due – and we don’t/won’t unless we print.
    • At some point the world’s appetite for our debt will relent; at that point the rates the US pays on newly minted debt will begin to rise ( the end of a 30-year bull market in bonds); almost everyone who owns bonds (especially mid to long-term) will be compelled to hold their bonds until maturity – they seem safe,and who’d want to take a loss when they can hold: but what will those dollars be ‘worth’?
  • We have been kicking the debt ‘can’ down the road for 30-years; at every kick it seems to pick up a few trillion and the Fed creates a bubble to save-off an impending recession; and every-time we have the recession we can’t believe the bubble we just saw (and how we didn’t see it coming).

A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. …

–  If you’re able to print money, then you’d be able to replace (some of ) the above  ‘new’ investors; otherwise, the process remains the same.

It’s not that it’s not the right move, it’s not that it isn’t good, sound, monetary policy, it is because the largest holder of US government debt is actually the American people!  This is a game of musical chairs, essentially, and at this rate if the music ever stops (it always stops), we’re going to be the ones without a seat.

Our Grave Economic Reality: Of Reserve Currencies and Trade Deficits; Of The Oxymoron that is The ‘Service Economy’; and Of Our Planet’s Economic Carrying Capacity

-“The only way the rest of the world will hold your currency is if you run a trade deficit.  Economics is the opposite of religion, it’s better to receive than to give.”  – Warren Mosler, economist

What a fantastic notion; unfortunately we Americans prefer to purchase seemingly infinite amounts finite commodities which we deplete and can never use again.  The US seems determined to export its’ sovereignty in exchange for foreign crude oil, placing more and more of our dollars in reserve at Central Banks around the world; and we’re purchasing a single-use asset which we must continually replenish.  This is not merely the ‘national security risk’ that most pundits speak of, but also represents the mass-exportation of our wealth overseas in exchange what amounts to handfuls of magic beans (or, no-so-magic beans).  Translated: The ‘Emerging Market’ is something of an oxymoron, we’re merely allowing a great deal of economic activity that ought to take place in the US to occur overseas instead; in exchange we’re either borrowing their money (China) or relying on their commodity-rich economies (Brazil, Russia).

Being that our economy is now service based (meaning most of our economy produces nothing tangible, and that may be worth nothing in future, but certainly has no certainty of having any value for resale), we find ourselves the perpetrators of our very own self-fulfilling Ponzi scheme; we keep moving around greater and greater sums of money, but no new value is necessarily being created.  e.g. If the massage-therapist I paid recently chose to fill her gas tank with my payment, surely most of that money has now left our economy for good (who buys American anymore, that is not American?) – and, I will never be able to resell my massage.

Economic Growth, and International "Self-Delusion"

GDP Growth versus Inflation, and the Farce of a Service Economy:

For whatever reason (I’m sure an economics professor, or charlatan, once told me) no one seems to consider the rate of inflation alongside measurements of our, or any country’s, GDP growth.  To me that seems rather ‘convenient.’  In my mind, in a year where the US grows GDP at a rate of 3.0%, annualized, and the rate of inflation is 3.0%, annualized, that our economy’s GDP did not in fact grow at all.  I will not endeavor the validate that notion mathematically (I dare you to negate it in such a manner) but I will do the much more heroic thing, and be so audacious as to apply logic to an economic debate (if Congress could only see me now).  Of course GDP as we know it is adjusted for inflation, but the manner in which we adjust subjects to a suspicion of the validity of both figures – ultimately.

-‎”By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”  – John Maynard Keynes

Clearly the Fed’s recent determination to create inflation (hey, they’ve been saying for years that part of their dual-mandate was to target inflation) could have the positive effect of  making it easier to repay our foreign debt, but apparently no one responsible for US fiscal policy understands that this will only be effective if we were actually to brand China a “currency manipulator” – because most of what we owe is to them.  Thusly, as Keynes so astutely said, the true effect of the inflation we aim to create will be the mass-robbery of wealth from the American people in the form of a rapidly depreciating currency, but without a meaningful reduction in national debt.

“If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.” – John Maynard Keynes

If we were Greece, we could use the above to our advantage.  Clearly, we have little to no real interest in using the depreciation of our dollar to our advantage with regard to our national deficit as it pertains to foreign economies – such as China.  What everyone seems to forget, is that a huge portion of our deficit is owed to the American people (ah yes, all those Treasuries you own – in Mutual Funds, etc) and, as Keynes so astutely put it, this destruction of the value of the dollar is tantamount to the ‘secret and unobserved confiscation’ of the wealth of the citizens of the United States; by the United States, but not to the enrichment of the United States (as perverse as that sounds).

With regard to the trade-deficit itself (and what a deficit it is), there seems there is little that we can do in light of our never-ending quest for increased productivity and our lust for ordering and owning goods built by the lowest bidder.  What I can say on this topic involves immigration; those of who believe that illegal immigrants in this country are taking jobs from  you obviously haven’t come to grips with the fact that most of the jobs performed my illegal immigrants are simply undesirable to most Americans.  For those of you who say these immigrants are unjustly taking jobs from Americans for less money than an American would work for, obviously don’t see the cruel irony of a country, 10% of which is unemployed (though it very well is more), playing a game of ‘beggars can be chooser.’  What’s that?  You say you don’t like that these immigrants save their money and send it overseas?  Well, as I described, even if those monies were made by Americans, many of those dollars would be finding their way overseas anyway.

Economic Carrying Capacity:

While I may or may not have coined this phrase, its’ definition should escape no one.  We have all heard the notion that, for example, our planet has a carrying capacity; a limit, by virtue of space and, more importantly, resources available for the inhabitants of our planet on which to exist.  I say that there is just such a limit to the ‘real’ potential economic activity of our planet.  Clearly we know that our resources are finite.  Yet, as I described previously, we are clearly very good and creating the semblance of economic activity, as if by our divine will to make money.  If we have learned anything from our recent crisis’ (surely if we have, it is not much) then we should know by know that this type of economic activity, in the long-run, amounts to little more than an economic game of ‘musical chairs.’ – When the music stops someone will surely be left with no seat.

I am not here to say what the capacity of our planet is to produce economic activity (I don’t believe anyone could – and, I am certain we would not know it even if we were there).  What we need to realize is that, in many cases, our expectations do not align with what is possible, or even probable, in terms of economic growth – we must be skeptics, to an extent.  In a world of limited space (even if we colonize the ocean-floor) and finite resources, it stands to reason that there is a finite amount of legitimate economic activity that can be affected – the rest is either inflation, or smoke and mirrors.  Look at the past decade, for example; nearly the entirety of the US’ post-9/11 economic expansion can be explained by an easy-money fueled real estate boom; the problem is that it was a zero-sum game, lots of money changed hands and plenty of people made or lost money – but nearly $0 dollars of new wealth was actually ‘created’ (see my 1st comment, below).  Furthermore, with globalization, this notion of reaching a maximum-threshold of economic capacity allows us the delusion that we can find the growth elsewhere: Well I’m here to tell you that the growth elsewhere certainly appears to be at the expense of growth ‘here’ (insert developed nation in lieu of ‘here’).  Money managers are often accused of (or credited for) chasing growth; the reality is that we are just as much leading growth away, as we are chasing it.

The clear point is that it is likely that there is a finite amount of legitimate economic activity that can be produced on this planet, given the resources that we have.  Of course, with the beauty of inflation we will continue to delude ourselves with notion of  growth in economic activity – in reality what we will be seeing won’t be growth, but the devaluation of our currencies and appreciation of commodity assets that create the appearance of further growth.  Yes, there will be innovation.  Yes, things will be invented that I haven’t thought of that people in fact want to buy – but that doesn’t necessarily equate to legitimate increases in economic activity – gains in productivity are likely to further reduce the employability of our lower, and lower-middle classes; increasing the drag on unemployment, government programs, and socialist tendencies within governments (see Obama care).  Simply put; in addition to what I believe are the obvious (if eventual) constraints on the global economy, we will continue to see an ever-increasing role of government spending as a percentage of the global economy; and, if not, we will have to realize that there must be a limit to how many new gadgets and services can be created that we can convince the citizens of the world they cannot live without.

We’re All Naked, No One is at The Wheel, and How Much Was That Check Anyway?

Recently I encountered data showing the US derivatives holdings are at the greatest level in history (yes now, in Oct, 2010 – not in Oct, 2008).  Now Americans my ask “why,” they may ask say ” how could this happen, “why aren’t these things illegal?”  I’d wager that almost half of Congress might still think that, and that is the problem – they still don’t even understand what they just regulated! Many people still seem to think that the phrase ‘toxic derivatives’ somehow refers to something akin to a perishable good, perhaps some bad fish from the market.

The ideas I most often encounter, generally, fall into two categories:

  • They were perishable; at one point they were (the derivatives) edible, and later – not so much.
  • The banks were making crazy outlandish bets, and missed. (Close, but they didn’t know it)

These weren’t crazy bets (well, they were, but not in the sense you would think) in that there was no ‘swing for the fences mentality’ – they (most of them) were just looking for cash flow, not upside, and were oblivious to the risks (they confused minimal probability with minimal ramifications). It just so happens, in the latter part of the sub-prime bubble (say late ’06 – ’07), that these derivatives weren’t perishable – they weren’t meant to be consumed.  But, not for the reasons you might think.  You see, the houses that were sold during that time (for the most part) ought not have been sold.  You heard me.  People who weren’t qualified and didn’t know what they were spending, or at what terms, bought real-assets at prices that did not reflect their true value.  We’ll get in to more detail shortly but remember this key point: When a homeowner goes bankrupt the primary lessor (1st mortgage) will get the property and may fare well in foreclosure, the secondary lessor (2nd mortgage) – not so much.

For your derivatives, would you like ‘paper’ or ‘plastic?’

Derivatives are so named because, as an asset class, their prices are determined by the prices of another asset (derived from).  There are many derivatives in our lives; the jet fuel hedging of the airlines, a farmer selling his crop a few months before harvest (he’s really selling a contract to buy his crop at a later date), a ‘put’ option on a stock position, a CDS to hedge a bond position, and even your own insurance policy.  The notion that derivatives are, in and of themselves, some form of toxic, or treacherous, device is simply wrong.

All the types of derivatives that I have described (really all that exist, but let’s keep it simple) represent an obligation. They are a contract promising purchase or delivery of an asset, at (or up to) an agreed upon date, if certain conditions are met (time and price).   Now, understand that a ‘Credit Default Swap’ represents a contract insuring the value of a bond (perhaps mortgage-backed) and that the swap buyer will make regular premium payments to the seller of the insurance.  If the bond were to default the company who sold the insurance bares [theoretically] the risk of the entire value of the bond (say $1mm).  [If an insurance company insures your house they collect premium from you, and in exchange if something covered by your insurance destroys your home the insurance company owes you a new home (essentially) – the bear the risk of the entire value of your home]

A few things to understand:

  • CDS were usually created to insure entire bond offerings, often in denominations of $1 Billion
  • In 2005 the CDS market was in its’ infancy, and the public was convinced they could do know wrong in housing
  • As a consequence, there weren’t many buyers of CDS’s and prices were low (they thought risk was low)
  • Therefore, there were many willing sellers (like AIG)
    • Remember, the sellers get paid steady premiums (as if they owned a bond)
    • If the bond defaults – the CDS seller has essentially bought the farm
    • I have read quotes that in 2005 Bear Sterns was willing to insure $1Billion in Mortgage Backed Securities for $20Million/year (2%)
  • Even after people (AIG) got the drift, realizing that they were carrying much more risk than they thought ($200Million in premium income came with $10Billion in liabilities) – they did not unwind the trades
    • In the above example, even if AIG had never owned any MBS they would have $10Billion in exposure by selling the insurance.
  • Why would they sell the insurance?
    • They’re AIG, they sell insurance
    • They did not understand that entire mortgage bonds could become worthless – almost no one did

A few large buyers came into the market to buy CDS (like John Paulson), and they were not hedgers (no one was back then).  They wanted to capitalize on the impending catastrophe in real estate and they saw this cheap insurance not just as a tool to do it, but as evidence that the crisis was coming – the price of risk was very low.  In their effort to bet against the most toxic of mortgages, there simply not enough new horrible mortgages to bet against.  Enter financial innovation and exactly what Warren Buffet meant when he called derivatives “financial weapons of mass destruction” – The synthetic, sub-prime, mezzanine, negative amortizing, adjustable rate, stated income Collateralized Debt Obligation.

I’ll explain.  We know that a person who sells a CDS gets premium income, and we know that people who buy CDO’s (the bonds) earn income as well.  Now if there weren’t enough of these new bonds to go around, that means that there weren’t enough bonds for people who wanted to own them and for people who wanted to bet against them (at this point, every new issue was matched with buyers of the bond and the swaps – and then they sold the swap liability to AIG [as if AIG sold the swaps themselves]).  There was also another issue; AIG had been a big hole to shove CDS liabilities (all the risk) in to, now there was a need to find more people to take the other side of the CDS trades (sell the insurance).  Naturally, the banks kept some for themselves (as if they didn’t own enough of the bonds).  And then they did what was brilliant – they realized they could take CDS contracts (which pay a premium to the seller) and bundle them together into a kind of synthetic bond.  Every CDS calls for someone who will take the risk of the bond and for someone to sell that risk to them, just like a bond.  The great thing is they could pick any other bond to buy a CDS on, then they put the insurance contract into this ‘synthetic’ (it’s made of insurance contracts) bond, and those insured bonds could already have had insurance (CDS) sold against them.

What I am saying is that we’re now creating risk out of thin air – let’s see how:

  • Here we have a $1Billion mortgage-backed bond (XYZ) and there has been $1billion in CDS insurance sold against it (for $20Million/year)
  • There are no new bonds to insure.  I create a new bond called ABAC – ABAC has no mortgages in it to produce cash flow
  • I sell CDS insurance on XYZ to ABAC.
  • ABAC has now insured XYZ for $1Billion, in exchange for $20Million/year in income
  • ABAC (a bond) is sold to investors [desperate for yield, and knowing their bond is made synthetically], their bond yields them $20Million per year

Now let’s stress test our new model:

  • Home prices stop rising
  • Some adjustable rate mortgages reset, other homeowners are unable to refinance  as planned because their homes haven’t risen in price
  • Homeowners begin to default
  • The $1Billion of mortgages in the XYZ mortgage-backed bond default
  • ABAC and XYZ bond holders lose $2Billion – $1Billion in assets create $2Billion in losses
    • That’s a bubble

Why we haven’t really regulated derivatives?

The first notion I want to put forward is that of ‘arbitrage.’  Arbitrage is the practice of simultaneously buying and selling the same asset to capitalize on a difference in price.  We’ve already discussed that derivatives derive their price from the price [movement] of other assets.  Now, realize all derivatives and/or derivative exchanges are not treated equally under Fin-Reg.  This creates an opportunity for arbitrage – Regulatory Arbitrage.  In this practice let’s say that there is an exchange that is strictly ‘regulated’ for derivatives under Fin-Reg – then we could create a derivative that trades on an unregulated exchange, and whose price is derived from the price of an asset on the ‘regulated’ exchange.  We know have an asset (derivative) that is technically unregulated provides the full exposure of the ‘regulated’ exchange, just without any of those pesky rules.

We still can’t price these things?

To the true issue with this notion of ‘toxic assets,’ we can’t price them – more importantly, in the height of the prices it was difficult to price the bonds that the CDS’s insured; making it impossible to price the insurance.  Stock options are one of the most known types of derivatives, and they came into use in the 1970’s after the development of the Black-Scholes option pricing model.  Today you still see wild irregularities in the option prices of stocks that trade sporadically (like many of the bonds on which CDS are traded), and traders will tell you that option-pricing is an imperfect science – perhaps more an art than a science.  This is a problem when it comes to derivatives as a whole. Theoretically in stocks there can only be so many options contracts as there is stock to be delivered (I’ve seen rare exceptions in ETFs, this year UUP issued more shares following an extremely large call position being purchased), and that limits the potential losses to, says, the market cap of the stock.  In the example of synthetic CDS we learn that we can lose more money than there are assets, by orders of magnitude.  There is no specifically adopted ‘derivative pricing model,’ and if there were it certainly isn’t standardized (firms may not agree on what one asset [or liability] is worth).

Perhaps the greatest danger is that derivatives allow us to create more financial risk that what exists in the world – if there were only derivatives on ‘actual’ assets, bubbles would be infrequent, harder to inflate, and collapse more slowly.  Now imagine you made an investment, but you couldn’t track its price regularly, and you’re surprised to find that after many months you find one day that your investment is worth 30% less than what you thought it had been the day prior.  This was the issue with many of the illiquid bonds those infamous CDS contracts were based on; they traded infrequently, they were believed to be default-proof, almost no one knew what the bonds held, and therefore it was almost impossible to value the bond.  Remember we said that the people who sell the CDS insurance (AIG) look a whole like owners of the those bonds, and the people who bought the ‘synthetic’ bonds knew they were really selling insurance – but those guys thought they were selling blizzard insurance to people in Ecuador – and did so happily.

In Reality….

The fact of the matter is we (as human beings) ignore ‘unlikely’ events in our models, and then manage to be surprised when something “unexpected” happens that lies outside our model.  It’s how insurance companies work, for example; do you think insurance companies have enough capital to pay out all of their policies at any given moment should they all be called simultaneously?  Of course not.  Do you have enough money to pay all of your creditors should they call your ‘marker’ right now?  You don’t have to answer that, but you see my point – when the tide recedes you’ll see whose swimming naked.  The problem today is, almost everyone’s naked and even the people in the water don’t realize that everyone around them is naked too.

On Probability, Risk, & Outliers; Fantasy Sleepers, Exogenous Events, Upsets,and The Next Big Thing

In a ‘streaming’ world of trending-now topics, flash crashes, upsets,underdogs, hurricanes, earthquakes, and tsunamis, many of should be questioning; “what is it exactly that we ‘actually’ do know?”  In short, the answer is not much.  But that does very little to help any of us get out of bed with anymore certainty about what to expect ‘today,’ as opposed to any other day.  The issue, I believe, is that the one thing that has eluded us, after a century of rapid innovation, is that we don’t really know all that much.

We are conditioned to look at past events, statistics and forecasts and draw some kind of conclusion about what the future of may hold, based on that information.  I am here to tell you a number of things, not the least of which is that what you think is ‘information’ often isn’t.  Nassim Nicholas Taleb has discussed this at length in his books (‘Fooled by Randomness’ and ‘The Black Swan’), but some of  the reasons his books are so profound are that: 1, they are so in-depth and intellectual that the majority of society will never derive any benefit from them and, 2, that those who can derive benefit from them are unlikely to comprehend the vast applications of this knowledge in their day-to-day life.

This is primarily a consequence of ‘what we think we know’ as opposed to ‘what we know,’ the difference between information and noise, and the notion that what we do ‘know’ about is that history can mean little to nothing as it pertains to ‘predicting’ our future. Secondarily, our failure to understand the difference between ‘low probability’ and ‘low risk’ is perhaps the greatest flaw, and the defining characteristic, of mankind. And, thirdly, our problem of assuming low probability/high impact events are somehow more likely once we’ve experienced them (think 9/11), when the likelihood of them occurring again may actually be remote even as compared to their original probability (The notion that, by virtue of having happened, a repeat of 9/11 occurring is far less likely than the probability of it having occurred in the first place – originally we couldn’t imagine it, now that we can imagine it, it would be harder to surprise us; because we can now actually contemplate that type of attack now.  Think to yourself – Given what we know now, would someone in ‘intelligence’ again dismiss the chances of such an attack if they had a warning?  Of-course not, but the first time they did).

Probability versus Risk:

People have a habit of confusing an events’ probability (The likelihood of an occurrence) with the risk of said event (the impact of its’ affect).  As human beings, we seem hard-wired to associate low-probability events as having low risk – because, there is less ‘risk’ of that event coming to pass.  Unfortunately, however, the reality is; that which we do not expect usually ends up defining our lives.

Now, for a more practical (or philosophical) description of these concepts I will defer to Taleb but, I want to broaden the scope of areas to which we typically attribute this phenomena.  Some of the obvious areas we might expect to find low probability events that carry tremendous impact are:

  • Weather (Hurricanes, Tornadoes)
  • Geological (Earthquakes, Tsunamis, Volcanoes)
  • Financial (Crashes, Depressions, Bankruptcies, Bubbles, and the occasional Divorce [See Tiger Woods])
  • Social (Facebook, Twitter, Civil Rights, Prohibition, and the LA Riots)

There are, however, an ever-growing number of additional areas where we can be increasingly (or world is accelerating faster than we are) clueless as to the impact of what we don’t expect:

  • Financial (Counter-Party Risk, Layoffs, Leverage, and the occasional Divorce [See Tiger Woods])
  • Consumer (Penicillin, Blood-Letting, Viagra, Napster, Laser-Disk, 3-D (The 1st time), Brandy, LSD, Teflon, and 8-Track tapes)
    • Note: I include not just accidental discoveries and unforeseen successes, but also ‘the next big thing’ that wasn’t.
  • Sports (Fantasy ‘Sleepers,’ 2008 NY Giants, Tom Brady, Kirk Gibson, and the 1980 USA Men’s Hockey Team)
  • Political (Elliot Spitzer, the ‘Tea-party,’ Barack Obama, and Marxist Communism)
  • Geopolitical (The Roman Empire, Christopher Columbus can’t drive, Mussolini, Hitler, Fidel Castro, and Osama Bin Laden)
  • Media (Radio, the Phonograph, Napster, the iTunes store, Howard Stern, Mary Tyler Moore, ‘The Jeffersons,” YouTube, and the Internet)
  • Religion (the very fact that this looks like it doesn’t belong here is why it does – we’re human beings, we blame everything on religion – if a highly unlikely, cataclysmic event occurred, that was man-made, a substantial portion of the population would attribute it to religion [or rather, God]; either to blame it on or to justify it)
  • Social (the 1960’s, Disco, Google, the Beatles, and Paris [Perez] Hilton)
  • And, I’m certain, many more

What we must realize is that in a world where we can derive a measurable benefit from ‘predicting’ a fairly likely event (Super Bowl Winner, company earnings, or next week’s weather) based on observation/study of past events, that we would derive an immeasurable benefit by being able to understand that the most important events [trends, catastrophes, plagues, or inventions] in our lives will be relatively unpredictable. My fiancée told me a few months ago that on our Wedding Day the sun would be setting at precisely 6:29pm, and that pictures needed to be complete before then. Today I learned that, 4 days before my Wedding, that a computer error had somehow left us without a suite for the eve of our Wedding, and that our florist/decor-person somehow did not recall on what day of the week our Wedding is to take place.  The point is, no matter how much you plan, that whatever can go wrong will go wrong (Murphy’s Law) and, more importantly, is what you least expect (e.g. something you thought you planned for).  What I am more concerned with, however, are those things so ‘random’ that they cannot possibly be expected from our past experience. (e.g.  ‘The sun never rises on my Wedding Day.)

Final Thoughts:

We have been conditioned, in part by our very nature to conform and by the globalization of our minds, to over-expect that which we can conceive of (my friend was in a car accident, so I ride in anything with wheels) and under-expect  that which we have no reason to contemplate (the Bubonic Plague, 1929, Dec 7th, 1942, JFK, 9/11, flash-crash, stock prices in late 90’s, real estate prices in mid 2000’s, our opinions of newly elected officials, and the 2008 Giants – what can I say? I bleed blue).  What does second category have in common?  They were things that, for those who were/are most affected, were barely imaginable to most people before the fact – some could have been foreseen, and some not.  What we should consider is that if we could conceive that any of the events I mentioned were even plausible before the fact, that even if they were to occur the ramifications would be reduced by virtue of the fact that we were able to contemplate such a thing.

We did not understand disease at the time of the plague, had we understood how sickness spread then the effect of the outbreak likely would have been reduced.

On the morning of Pearl Harbor some people knew that there were planes inbound, but no one believed there was a way foreign aircraft could have had enough fuel to reach that outpost let alone launch an attack.

Yes, market crashes have happened famously a few times but, it’s always the speed that surprises – we always convince ourselves we know what to look for, and the reason we crash is partly because we didn’t think it could happen that way.

I won’t try to discuss Kennedy, but I will say this:

When the NY Giants met the New England Patriots in the Super Bowl most pundits favored the Pats in a veritable landslide. Bookies across the country fielded odds grossly favoring the unbeaten Pats over the upstart G-Men.  I was baffled.  While I saw that the Pats were far superior, and I knew that if they met 10 times, with those rosters, that the Giants would be lucky to win more than once.  But what I also knew was this: As far as I was concerned there was an extremely low probability that one NFL team could beat another 3 times in one season. The Giants had played and lost to the Patriots not only in the epic Week 17 the clinched an undefeated season for the Pats, but they also were defeated by  the Patriots in the preseason that year.

  • If you viewed that game as a lone event –  a best of one series, then you would not likely contemplate that the odds of the Super Bowl weren’t ‘will the Patriots beat the Giants today?’ But rather, ‘Can the same Patriots coaches, players, and playbook beat this Giants team for a 3rd time in 3 games (in one season)?’
  • Having extra information, such as knowledge of the ‘odds’, seems to prove to be only a danger to ourselves and others.