Curr€ncĄ Current$ - Monday, August 20, 2007

In perverse market conditions, beware logical arguments.

Key Reports Due (WSJ):

10:00a.m. July Leading Economic Indicators. Previous: -0.3%.

“I believe there is something out there watching us. Unfortunately, it's the government.” - Woody Allen
FX Trading – “A great deal of stupid people have a great deal of stupid money…”

“There is nothing new on Wall Street,” was the lament of legendary trader Jesse Livermore, back in the 1930’s. And this is the summary of a panic written by Walter Bagehot, influential economist/banker and editor of The Economist, during the mid-Victorian era in his essay on Edward Gibbon:
“Much has been written about panics and manias…but one thing is certain, that at particular times a great deal of stupid people have a great deal of stupid money…the money of these people, the blind capital as we call it, of the country is particularly large and craving; it seeks someone to devour it, and there is plethora, it nds someone, and there is speculation, it is devoured and there is panic.”
Human nature hasn’t changed much. Our action and reaction to too much credit seems consistent. We consistently handle it badly.

Now that panic and fear have subsided a bit, and we can get back to the business of raking in easy money and easy profits via our carry-trades and new derivatives offerings (just kidding), everyone is second guessing the Fed. A thankless job indeed it is. What have you done for me lately Mr. Bernanke, seems the cat call from your average Wall Street type and their cheerleaders in the financial press.

This headline from Bloomberg News we noticed this morning:
“Bernanke's `Rookie Mistake' Forces Fed to Shift Focus to Market”
No matter where one stands on the Fed’s performance, all have to marvel about just how fragile our global financial network really is. We go to the brink and snap back. We’ve seen it again and again. But what seems surprising this time is the fact that so many people seemed, well, surprised.

The Fed and ECB seem to have at least stemmed the wave of selling. Criticisms over the intricacies of policy are now being debated instead of worrying just how low one’s 401K can go. “Should they signal this or that with there FOMC statement…was it a mistake to emphasize inflation concerns…blah, blah, blah..."

Everyone is so smart in hindsight. None of those meticulous machinations of proper policy matter in the midst of crisis (though of course it can be argued Mr. Greenspan’s 1% emergency Fed funds rate and counsel to US home buyers to load up on those variable rate mortgages did a lot for the derivatives manufacturing industry and helped create the mess. And of course his 1% emergency FF rate was the result of a prior orgy of speculaton—the Nasdaq…and so it goes).

Only the lender of last resort matters in the midst of crisis.

That’s because at a certain level the crisis morphs from a realization of prices being bid beyond fundamentals i.e. overshoot, which should lead to selling, into a crises of confidence in the system. Even though we are told during the boom, by new-era journalists and hedge fund heroes that the Fed just doesn’t matter anymore—it all rings hollow when the Fed is the only institution capable of any modicum of success by sticking a finger in the dike.

The key question on the table: Is it over? Our guess is no. Simply because of the size of the “primary object of speculation” (as Mr. Hyman Minsky defined it), credit spawned by derivatives. It is so vast that it will likely take more to wash the dead wood out of the system.

For those not familiar with Mr. Hyman Minsky, below is a Currency Currents we wrote back on June 5th, 2007, titled, “We’re betting on Minsky!” It summarizes his view of the unstable system in which we operate and why panics and crashes seem to be in our nature, no matter what the bell curve tells us.

We’re betting on Minsky!
Tuesday 5 June 2007

“The global derivatives market grew by 25,935% since 1987 to US$415 trillion last year. Globalization is not just about outsourcing production operations to countries with lower labor costs, but also involves greater financial openness. In the last two decades, the world economy has indeed experienced a wave of financial integration, leading to lower home bias and the emergence of innovative instruments. For example, according to the Bank for International Settlements, the outstanding notional amount of exchange-traded and over-the-counter derivatives contracts increased from US$1.6 trillion in 1987 to US$5.7 trillion in 1990 and then surged to US$71.9 trillion by the end of the decade. That may look like an astonishing growth, but it is nothing compared to what has happened in the years of abundant liquidity. The latest survey shows that the global derivatives market grew at an annual rate of 68.5% to US$297.7 trillion in 2005 and US$415.2 trillion at the end of last year. In other words, the global pool of structured financial products ballooned from 8.7% of global GDP in 1987 to 246.1% in 2000 and then to 789.2% last year,” writes Serhan Cevik, of Morgan Stanley.
Potent punchbowls fuel wild parties.
“Positive feedback develops, as new investment leads to increases in income that stimulate further investment and further income increases. At this stage we may well get what [Hyman] Minsky calls ‘euphoria.’ Speculation for price increases is added to the investment for production and sale,” writes Charles Kindlebeger, in his classic, “Manias, Panics, and Crashes.”
Of course the usually driver is money and credit. The global punchbowl of $415.2 trillion in derivatives dwarfs anything our speculative brethren before us could have ever imagined.

Would it be fair to say we have entered the “euphoria” or “overtrading” stage of the Minsky model? Here is the basic pattern laid out by Mr. Minsky so we can all follow along:
  • Displacement – New profit opportunities i.e. commodities, emerging markets, new era stuff, etc. (read China and real estate)
  • Overtrading/Monetary Expansion—Pure speculation driven by too much credit and overestimation of profits leading to euphoria (read Private Equity Masters of the Universe and hedge funds; but none of us are innocent as we stretch for yields and rush headlong into all markets emerging.)
  • Revulsion/Discredit—Fall in the price of the primary object of speculation (displacement stuff) as the players begin to recognize it is “over priced.” Liquidation ensues. Sometimes liquidation is orderly—but usually it manifests in panic form when the money expansion behind it is unusually large. Lenders stop lending in order to salvage some of the collateral initially supporting the credit expansion. This can be swift, as lenders at this stage realize the collateral, they thought they had, was bid up by the very money they lent.
If we were to venture a guess, we’d say we are somewhere in the later stage of Overtrading/Monetary Expansion. Unfortunately, we are just not sure how long this stage lasts. It reminds us of the Nasdaq in 1999. Many knew it would end badly, but no one seemed to know when it would end. And some very smart people such as George Soros and Julian Roberts new it too, but capitulated near the end. That should be a lesson to all of us mere mortals about just how powerful this stage can be.

Watching the lack of impact from the sell off in China over the past couple of sessions (though it was higher this morning) is yet another signal from the market that this thing isn’t over—yet. But, if I remember correctly, that “little” problem emanating from Thailand back in July 1997 didn’t get much attention then either. Sure, things are different. Emerging markets are in much better financial shape than they were. They are creditors instead of borrowers, derivatives risk is parceled out and spread more evenly, Private Equity is squeezing inefficiencies, and oh yeah, there really is a Tooth Fairy!

It’s the stuff that gives weight to a phrase we seem to fall victim too in every investment cycle: Things are different this time! Our bets are on Minsky.

Things ain’t different this time! About 30-years ago, I had an old accounting professor who understood what it meant to live a world of double-entry booking. His favorite phrase was, “Sooner or later it all comes out in the wash.” It’s unlikely he knew much about derivatives; but how true his phrase still rings in a world of crumbling credit and undercapitalized counterparties.

USDJPY Weekly – So far we’ve seen about 10% clipped off $-yen. About 20% in just over a month evaporated when yen carry came unglued thanks to the Asian Financial Crisis back in 1998.


Jack Crooks
Black Swan Capital

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