Does Jamie Dimon Even Know What Hedging Risk Is?

May 11, 2012

Aziz Finance, Fixed Income, Wall Street , , , , , , , , 44 Comments

From Bloomberg:

J.P Morgan Chief Executive Officer Jamie Dimon said the firm suffered a $2 billion trading loss after an “egregious” failure in a unit managing risks, jeopardizing Wall Street banks’ efforts to loosen a federal ban on bets with their own money.

The firm’s chief investment office, run by Ina Drew, 55, took flawed positions on synthetic credit securities that remain volatile and may cost an additional $1 billion this quarter or next, Dimon told analysts yesterday. Losses mounted as JPMorgan tried to mitigate transactions designed to hedge credit exposure.

Having listened to the conference call (I was roaring with laughter), Jamie Dimon sounded very defensive especially about one detail: that the CIO’s activities were solely in risk management, and that its bets were designed to hedge risk. Now, we all know very well that banks have been capable of turning “risk management” into a hugely risky business — that was the whole problem with the mid-00s securitisation bubble, which made a sport out of packaging up bad debt and spreading it around balance sheets via shadow banking intermediation, thus turning a small localised risk (of mortgage default) into a huge systemic risk (of a default cascade).

But wait a minute? If you’re hedging risk then the bets you make will be cancelled against your existing balance sheet. In other words, if your hedges turn out to be worthless then your initial portfolio should have gained, and if your initial portfolio falls, then your hedges will activate, limiting your losses. A hedge is only a hedge if it covers your position. That is how hedging risk works. If the loss on your hedge is not being cancelled-out by gains in your initial portfolio then by definition you are not hedging risk. You are speculating.

Dimon then stuck his foot in his mouth even more by claiming that the CIO was “managing fat tails.” But you don’t manage fat tails by making bets with tails so fat that a change in momentum produces a $2 billion loss. You manage tail risk by making lots and lots of small cheap high-payoff bets, which appears to be precisely the opposite of what the CIO and Bruno Iksil was doing:

The larger point, though, is I think we all know damn well what Jamie Dimon and Bruno Iksil were doing — as Zero Hedge explained last month, they were using the CIO’s risk management business as a cover to reopen the firm’s proprietary trading activities in contravention of the current ban.

Personally, I have no idea why the authorities insist on this rule — if J.P. Morgan want to persist with a hyper-fragile prop trading strategy that rather than hedging against tail risk actually magnifies risk, then there should be nothing to stop them from losing their money. After all, these goons would quickly learn to stop acting so incompetent without a government safety net there to coddle them.

The fact that Dimon is trying to cover the tracks and mislead regulators is egregious, but that’s what we have come to expect from this den of vipers and thieves.

Obama Embraces Gay Marriage

May 10, 2012

Aziz Orwellian, Politics, Wall Street, War , , , , , , , , , , 43 Comments

Obama and Corzine — A Match Made in Heaven?

Unlike virtually every mainstream media commentator or political talking head I don’t care about Obama embracing gay marriage.

Now I know that a lot of people on the left — disappointed by his banker-friendly, PATRIOT Act-renewing, indefinite-detention-enabling, American-citizen-assassinating regime — are searching for any reason to vote for him, and plausible reason to defend his record. That’s the nature of tribal politics — “anti-war” Democrats will happily protest the Bush war machine, but they seem quiet when Obama is the one using drone strikes to assassinate American citizens without trial. I don’t like Mitt Romney either, but that’s not the point.

Even for those in favour of gay marriage, let’s not forget that Obama is capable of doing absolutely zero to change the law. Want to introduce a Federal law allowing homosexual couples to marry? Good luck getting it through the Republican Congress.

I’m in favour of consenting adults being able to do whatever they like with each other, but the fact that the current push for gay marriage is supported by Lloyd Blankfein and Goldman Sachs makes me very suspicious (does he want to sell securitised gay marriage debt?).

It just seems like an easy issue for Obama to posture on, while trampling the Constitution into the dirt.

When it comes to civil liberties, Obama has always talked a good game, and then acted more authoritarian than Bush. He talked about an end to the abuses of the Bush years and an open and transparent government, yet extended the Fourth-Amendment-shredding Patriot Act, empowered the TSA to produce naked body scans and engage in humiliatingly sexual pat-downs, signed indefinite detention of American citizens into law, claimed and exercised the power to assassinate American citizens without trial, and aggressively prosecuted whistleblowers. Under his watch the U.S. army even produced a document planning for the reeducation of political activists in internment camps. Reeducation camps? In America? And some on the left are still crowing that talking about being in favour of gay marriage makes him “pro-civil liberties”? Is this a joke?

Here are a few metrics that we should be judging Obama on:

People not in the labour force is spiking:

The public debt keeps soaring and soaring from eyeball-watering multi-trillion dollar deficits:

Meanwhile India, Iran, China, Russia, Saudi Arabia and Japan have all ditched the dollar for other currencies in new bilateral trade agreements — which lest us forget is America’s biggest export, and the product that keeps goods and oil flowing into America. This is an extremely dangerous time. While we cannot lump Obama with the blame for the entire U.S. economic system — the system we have was accumulated via Bush, and Cheney, and Paulson, and Clinton, and Bush, and Reagan, and Carter, and Brzezinski, and Nixon, and Kissinger, and Johnson, and Roosevelt and Wilson and Lincoln and probably most significantly of all the father of central banking Alexander Hamilton — Obama certainly has not improved matters.

And it should be obvious to anyone paying attention that Romney — who claims he would support the NDAA and the PATRIOT Act, that he wants to attack Iran, and has hired many ex-Bush staffers, as well as winning the endorsement of both Jeb and George H.W. Bush, and bizarrely claiming to want to start a trade war with China — is cut from the exact same cloth as Bush and Obama.

This is a dead election. Here’s hoping that Ron Paul — who continues to pick up delegates in the Republican race even while being ignored by the mainstream media who would rather talk about Obama’s posturing on gay rights — can cause some mayhem.

Is China a Currency Manipulator?

May 9, 2012

Aziz Current Affairs, Economic History, Economics, Federal Reserve, International Relations, Philosophy, Politics, Technology , , , , , , , , , , , , , , , , 57 Comments

Mitt Romney thinks so:

China has an interest in trade. China wants to, as they have 20 million people coming out of the farms and coming into the cities every year, they want to be able to put them to work. They want to have access to global markets. And so we have right now something they need very badly, which is access to our market and our friends around the world, have that same– power over China. To make sure that we let them understand that in order for them to continue to have free and open access to the thing they want so badly, our markets, they have to play by the rules.

They’re a currency manipulator. And on that basis, we go before the W.T.O. and bring an action against them as a currency manipulator. And that allows us to apply tariffs where we believe they are stealing our intellectual property, hacking into our computers, or artificially lowering their prices and killing American jobs. We can’t just sit back and let China run all over us. People say, “Well, you’ll start a trade war.” There’s one going on right now, folks. They’re stealing our jobs. And we’re gonna stand up to China.”

The theory goes that by buying U.S. currency (so far they have accumulated around $3 trillion) and treasuries (around $1 trillion) on the open market, China keeps demand for the US dollar high.  They can afford to buy and hold so much US currency due to their huge trade surplus with America, and they buy US currency roughly equal to this surplus.  To keep this pile of dollars from increasing the Chinese money supply, China sterilises the dollar purchases by selling a proportionate amount of bonds to Chinese investors.  Supposedly by boosting the dollar, yuan-denominated Chinese goods look cheap to the American (and global) consumer.

First, I don’t really think we can conclusively say that the yuan is necessarily undervalued. That is like assuming that there is some natural rate of exchange beyond prices in the real world. For every dollar that China takes out of the open market, America could print one more — something which, lest we forget — Bernanke has been very busily doing; the American monetary base has tripled since 2008. Actions have consequences; if China’s currency peg was so unsustainable, the status quo would have collapsed long ago. Until it does, we cannot conclusively say to what extent the yuan is undervalued.

What Romney is forgetting is that every nation with a fiat currency is to some degree or other a currency manipulator. That’s what fiat is all about: the ability of the state to manipulate markets through monetary policy. When Ben Bernanke engages in quantitative easing, or twisting, or any kind of monetary policy or open market operation, the Federal Reserve is engaging in currency manipulation. Every new dollar that is printed devalues every dollar out in the wild, and just as importantly all dollar-denominated debt. So just as Romney can look China in the face and accuse them of being a currency manipulator for trying to peg the yuan to the dollar, China can look at past U.S. administrations and level exactly the same claim — currency manipulation in the national interest.

While China’s currency policy in the past 40 years has been to attract manufacturing, technology, resources and investment into China (and build up a manufacturing base to provide employment to its low-skilled population) by keeping its produce cheap, America’s currency policy has sought to enjoy a free lunch made up of everyone else’s labour and resources. This has been allowed to develop because of America’s reserve currency status — everyone has needed dollars to access global markets, and so America has rested on her laurels and allowed her productive industries to decline. Why manufacture the bulk of your consumption when China can do it cheaper, and Wal Mart has no problem with slave labour? Why manufacture your military hardware when China can do it cheaper? Why produce your own energy when you can instead consume Arab and Latin American oil?

Former U.S. ambassador Jon Huntsman raised this issue in an article from China Business News in a cable that was eventually leaked via Wikileaks:

The U.S. has almost used all deterring means, besides military means, against China.  China must be clear on discovering what the U.S. goals are behind its tough stances against China. In fact, a fierce competition between the currencies of big countries has just started.  A crucial move for the U.S. is to shift its crisis to other countries – by coercing China to buy U.S. treasury bonds with foreign exchange reserves and doing everything possible to prevent China’s foreign reserve from buying gold.

If we use all of our foreign exchange reserves to buy U.S. Treasury bonds, then when someday the U.S. Federal Reserve suddenly announces that the original ten old U.S. dollars are now worth only one new U.S. dollar, and the new U.S. dollar is pegged to the gold – we will be dumbfounded.

Today when the United States is determined to beggar thy neighbor, shifting its crisis to China, the Chinese must be very clear what the key to victory is.  It is by no means to use new foreign exchange reserves to buy U.S. Treasury bonds.  The issues of Taiwan, Tibet, Xinjiang, trade and so on are all false tricks, while forcing China to buy U.S. bonds is the U.S.’s real intention.”

Romney and others of his ilk might brush this off, believing that China’s $3 trillion dollar reserve hoard was gained through unfair means — slave labour, cutting corners in quality, the aforementioned “currency manipulation”, etc, and that that somehow gives America the right to inflate away its debts and screw its creditors. To some degree, they have a point. If China had a problem with America inflating away its debts, it should never have put itself so deep into dollar-denominated paper. If China recognised that America’s debt position was unsustainable, it should never have put so much into something so unsustainable, irrespective of supposed American pressure.

In the short term, though, I think escalating the trade war through the imposition of tariffs is a very bad idea. America is a consumption-led economy, and with middle class incomes already squeezed, a constriction of the supply of cheap and readily available goods is likely to put a lot of downward pressure on consumption. And it’s not just consumption — in today’s hyper-globalised world, a huge proportion of manufacturing — including military hardware — at some stage flows through China.

As Vincent Fernando noted:

Most of America’s key military technologies require rare earth elements, whose production China holds a near-monopoly over.

It’s thus perhaps no surprise that China has made the threat of rare earth export restrictions a new political bargaining chip.

American corporations could gradually pull out of China and shift to manufacturing and extracting resources elsewhere including America (which has large rare earth deposits), but it would be a challenging process. Rebuilding an industrial base is hard: skilled and experienced labour takes time to develop (American labour is rusty and increasingly unemployed and disabled), and supply chains and webs have all agglomerated in China. Building up domestic supply chains takes time, expertise and entrepreneurial zeal. And any destabilisation could spook global markets.

So let’s make no mistake: in the short term America needs China far, far, far more than China needs America. The notion that China needs America as a consumer is totally false; anyone can consume given the dollars or gold, and China holds $3 trillion, and continues to increase its imports of gold.

Peter Schiff summarises:

The big problem for countries like China and India is that they still subsidize the U.S. They buy our Treasury bonds and lend us all this money so we can keep consuming. That’s a big subsidy and a heavy burden.

They can use their money to develop their own economy, produce better and more abundant products for their own citizens. It’s a farce to think that the only thing China can do with its output and savings is lend it to the U.S. government, especially when we can’t pay it back.

Mitt Romney seems intent on destabilising this fragile relationship. American policy that incentivised globalisation and the service economy has very foolishly drawn America into this fragile position where its economy is increasingly fuelled not only by energy coming out of the politically and economically unstable middle east, but also by goods coming from a hostile and increasingly politically and economically unstable power.

And make no mistake — although China has done well to successfully transform itself into the world’s pre-eminent industrial base and biggest creditor, it has a lot of bubbles waiting to burst (particularly housing), stemming from the misallocation of resources under its semi-planned regime. Which makes this entire scenario doubly dangerous. Any shock in China would surely be transmitted to America, simply because it is becoming increasingly pointless for China to continue subsidising American consumption (through buying treasuries) when they could instead spend the money raising the Chinese standard of living. That could mean a painful rate-spike.

The real problem is that Romney is trying to address a problem that is very much in the past. If Romney was elected as President on this platform in 2000, things might be different. But China got what it wanted: by keeping its currency cheap and its labour force impoverished it became the world’s pre-eminent industrial base, the spider at the heart of the web of global trade, and a monopoly on important industrial components and resources. China used American demand, technology and investment during the 00s to develop. Now the imperative is not to grab a bigger share of global manufacturing, or a bigger hoard of dollars, it’s to leverage that position toward the ultimate aim of returning China to its multi-millennial superpower status. The promise of Chinese primacy is quite simply the strongest tool for the CPC to retain its (increasingly shaky) grip on China.

However we should not discount the possibility that bursting economic bubbles may stoke up some kind of popular rebellion against the Communist authorities in some kind of Chinese Spring. A new more pro-Western regime is surely America’s best hope of containing China, while gradually manoeuvring itself out of dependency on Arab oil and Chinese goods. But that may just be wishful thinking; it is possible that a new Chinese regime may be vehemently anti-Western; the Opium War and China’s 20th century humiliation still ring deeply in the Chinese psyche.

So it is unclear what is next for China, and the relationship between China and America. But having the world’s biggest manufacturing base and a monopoly over rare earths is a strong position to be in if your ultimate aim is to manufacture huge quantities of armaments in the pursuit of an aggressive, expansionist foreign policy…

The European Union is Destroying European Unity

May 8, 2012

Aziz Current Affairs, War , , , , , , , , , , 48 Comments

So we know that the pro-bailout parties in Greece have failed to form a coalition, and that this will either mean an anti-bailout, anti-austerity government, or new elections, and that this will probably mean that the Greek default is about to become extremely messy (because let’s face it the chances of the Greek people electing a pro-austerity, pro-bailout government is about as likely as Hillary Clinton quitting her job at the State Department and seeking a job shaking her booty at Spearmint Rhino).

It was said that the E.U.’s existence was justified in the name of preventing the return of nationalism and fascism to European politics.

Well, as a result of the austerity terms imposed upon Greece by their European cousins in Brussels and Frankfurt, Greeks just put a fully-blown fascist party into Parliament.

From the Telegraph:

The ultra nationalist far right party Golden Dawn supporters celebrated on Sunday after exit polls showed them winning between 5 to 7 per cent of the vote, enough for them to gain representation in parliament for the first time in Greek history. Golden Dawn Leader, Nikolaos Michaloliakos shouted “The Europe of the nations returns, Greece is only the beginning” as he walked towards party headquaters and pledged to deal with illegal immigrants first.

For doubters of their intellectual lineage, here’s their logo:

I (among many others) have argued since at least last year that increased nationalism would be a result of the status quo, which is of course deeply ironic.

Winston Churchill famously noted that a new European unity was the path to the people of Europe forgetting the “rivers of blood that have flowed for thousands of years”.

Well it looks like some of the memories of those rivers of blood are about to be unleashed. How was it possible that a regime set up ostensibly to create more and deeper European unity seems to have sown the seeds for division and nationalism? Quite easily, really.

By designing a system that allowed for governments to spend freely in a fiat currency they could not print more of, Brussels effectively set up member states for fiscal crises. But the fiscal crisis hit at the worst possible time, one of global economic contraction. And by enforcing contractionary policies on states that were already in a depression, economies in Europe are getting to Great Depression levels:

The key here is that the Euro system is not giving the public the idea that all peoples are in the same boat. It is giving the impression that some nations are benefiting at the expense of others.

For there can be no doubting the perception on the ground in Europe that Germany (the first nation, lest we forget, to violate the Stability and Growth Pact) is sado-masochistically brutalising the periphery in the name of its own prosperity. And the facts back that up:

Certainly, the steep austerity policies have in Portugal, Spain and Greece only produced bigger deficits as tax revenues have fallen. But what really matters is that Europeans more and more are coming to see the E.U. and the policies it enforces as counter to their interests and harmful.

While Britons have long resented the E.U. and its micro-managerial regulatory regime, it is becoming clear that much of Europe is coming to distrust the E.U. and its institutions:

In the wake of WW2 there was deep and genuine grassroots concern throughout Europe for unity, and Europe should never have to go through another war. Yet the actions of this bureaucratic, centralising, technocratic institution are jeopardising that reality. This is top-down fragility transmitted throughout Europe by the actions of misguided planners.

I don’t believe that many Europeans really want to go down this path again. But as the European economies continue to bleed, as millions of youths remain jobless, those deep scars that thousands of years of war and violence created, culminating in the rise of Nazism and WW2, are rising again to the surface.

Voters become radical when they are denied economic opportunity. That’s the reality I think we should all take from Hitler’s rise to power, and that’s the reality of Europe today.

The Treasury Bubble in One Graph

May 7, 2012

Aziz Economics, Fixed Income, Musings, Wall Street , , , , , , , , , , 43 Comments

What are the classic signs of an asset bubble? People piling into an asset class to such an extent that it becomes unprofitable to do so.

Treasury bonds are so overbought that they are now producing negative real yields (yield minus inflation):


That’s right, after taking into account inflation, many investors in treasuries are standing over a drain and pouring their money down it. 

And so America’s creditors are now getting slapped quite heavily in the mouth by the Fed’s easy money inflationist policies.

I propose (much, I am sure, to the consternation of the monetarist-Keynesian “print money and watch your problems evaporate” establishment) that this is a very, very, very dangerous position. And I propose that those economists who are calling for even greater inflation are playing with dynamite.

See, while the establishment seems to largely believe that the negative return on treasuries will juice up the American economy — in other words that “hoarders” will stop hoarding and start spending — I believe that negative side-effects from these policies may cause severe harm.

There is the danger of a bursting treasury bubble. What would happen if America’s creditors decide they want to liquidate their positions? After all, they’re getting slapped in the mouth , and the Fed is promising to continue with the zero interest rate policy until at least 2014.

And we know for sure that even before real rates on treasuries turned negative that China were selling:

The Fed has been picking up the slack, and will have to continue to do so for the forseeable future (the private domestic and international markets have no reason to increase purchases assets of with a negative real rate of return).

This means that to keep the Treasury’s interest payments low, the Fed will have to start printing more money, which brings us to the second danger: the danger of runaway inflation.

Bernanke might well believe he can do this without triggering runaway inflation. He might point to his track record of tripling the monetary base without triggering hyperinflation.

But inflation has stayed (relatively) low for one reason: the money he printed isn’t circulating. The primary dealer banks are holding the money as excess reserves. Can this last?

I doubt it. As I noted last month:

So, does the accumulation of excess reserves lead to inflation?

Only so much as the frequentation of brothels leads to chlamydia and syphilis.

Excess reserves are only non-inflationary so long as the banks — the people holding the reserves — play along with the Fed-Treasury game of monetising debt and trying to hide the inflation . The banks don’t have to lend these reserves out, just as having sex with hookers doesn’t have to lead to an infection.

But eventually — so long as you do it enough — the condom will break.

This trend of amassing excess reserves (done, lest we forget, as a stability measure to protect primary dealers against another shadow banking collapse) is closer to going to sleep upon a bed of dynamite. 

But inflation is only the most obvious risk.

The greatest danger is illustrated here:

America — for most of last century exporter and creditor to the world now runs the biggest trade deficits the world has ever seen.

Let’s not forget that these creditors that U.S. monetary policy is now slapping in the face produce most of our consumption, much of our military hardware, and most of our oil. 

Of course, many neocons seem to believe that this position is sustainable; that America can slap her creditors in the face all she likes because she has thermonuclear weapons and can tell the rest of the world to go and bite the big one.

Not so fast.

As VeteransToday noted in December:

“Surprise, Surprise, Surprise”,  to quote Gomer Pyle. The secret spy mission to create photographic proof of Iranian nuclear intentions has gone horribly wrong.

China is the country of origin for many, many of the semiconductors used by the US Military. It was most likely that China provided the hardware with the secret backdoor that allowed the Iranians to seize control of the Stealth drone while the drone was on a secret CIA mission over Iran.

Working together, they captured a state of the art US Military stealth aircraft.

What this means to all US Military personnel serving anywhere in the world? It means that control of any electronics system in any type of platform, can be seized and used against the military that launched it.

I don’t doubt America still has great technological and infrastructural advantages over her Eurasian creditor rivals. But do we really want to test the limits of our power? Do we really want to try and provoke a trade war with China and the other Eurasian nations (who of course are testing the petrodollar reserve to its limits by creating their own reserve currency agreements) by obliterating the value of their dollar-denominated assets?

So now we know, beyond a shadow of doubt that U.S. Treasuries are in a historic bubble.

We know that to some degree the Federal Reserve and Ben Bernanke are guilty of stoking up this program by buying U.S. Treasuries (artificial demand) and thus constricting supply. We know that this is screwing America’s creditors who happen to produce a lot of America’s consumption, components, military hardware, energy and resources. We know that these nations are using increasingly violent rhetoric regarding their relationship with the United States (Putin for instance described America as a parasite), and are activating agreements to ditch the dollar as the reserve currency.

Do we really want to continue in this vein? Do we really want to continue screwing our creditors by forcing them to accept negative real rates on their investments? Do we really want to risk the inflationary impact of continuing to print money to monetise debt (and hiding the money in excess reserves, thereby temporarily hiding the inflation). Do we really want to find out if all those Chinese semiconductors in our military hardware have backdoors that allow America’s enemies to shut down American military hardware?

I’d call that playing dice with the devil.

Shadow Banking 101

May 6, 2012

Aziz Economic History, Economics , , , , , , , 27 Comments

This article originally appeared in the May 1st edition of The Occupied Times.

Meet James. James bought a house. It cost him $150,000, of which $30,000 had come from his own savings, leaving him with a $120,000 30-year fixed-rate mortgage from the WTF Bank, with a final cost (after 30 years of interest) of $200,000. Now, up until the ’80s, a mortgage was just a mortgage. Banks would lend the funds and profit from interest as the mortgage is paid back.

Not so today. James’s $200,000 mortgage was packaged up with 1,000 other mortgages into a £180 million MBS, (mortgage backed security), and sold for an immediate gain by WTF Bank to Privet Asset Management, a hedge fund. Privet then placed this MBS with Sacks of Gold, an investment bank, in return for a $18 billion short-term collateralised (“hypothecated”) loan. Two days later Sacks of Gold faced a margin call, and so re-hypothecated this collateral for another short-term collateralised $18 billion loan with J.P. Morecocaine, another investment bank. Three weeks later, a huge stock market crash resulted in a liquidity panic, resulting in more margin calls, more forced selling, which left Privet Asset Management — who had already lost a lot of money betting stocks would go up — completely insolvent.

Confused?

You should be. This is of course a fictitious story. But the really freaky thing is that this kind of scenario — the packaging up of fairly ordinary debt into exotic financial products, which are then traded by hundreds or even thousands of different parties, has occurred millions and millions of times. And it is extremely dangerous. When everybody is in debt to everybody else through a complex web of debt one small shock could break the entire system. The $18 billion debt that Privet owed to Sacks of Gold could be the difference between Sacks of Gold having enough money to survive, or not survive. And if they didn’t survive, then all the money that they owed to other parties, like J.P. Morecocaine, would go unpaid, thus threatening those parties with insolvency, and so on. This is called systemic risk, and shadow banking has done for systemic risk what did the Beatles did for rock & roll: blow it up, and spread it everywhere.

Deregulation

The banking system has blown up multiple times in history, when depositors have panicked and withdrawn funds en masse in what is known as a bank run. So traditional banks have become party to a lot of regulations. For example, banks must keep on hand 10% of deposits as a reserve. This reserve is a buffer, so that if depositors choose to withdraw their money they can do so without the bank having to call in loans. Of course, banks can still suffer from a liquidity panic if a large proportion of their depositors choose to withdraw their money. Under those circumstances, traditional banks have access to central bank liquidity — short term loans from the central bank to guarantee that they can pay depositors.

Shadow banking arose out of bankers’ desire to not be bound by these restrictions, and so to create more and more and more financial products, and debt, without the interference or oversight of regulators. Of course, this meant that they did not have access to central bank liquidity, either.

Essentially, shadow banking is still banking. It is a funnel through which money travels, from those who have an excess of it and wish to deposit it and receive interest payments, to those who want to borrow money. Shadow banking institutions are intermediaries between investors and borrowers. They can have many names: hedge funds, special investment vehicles, money market funds, pension funds. Sometimes investment banks, retail banks and even central banks. The difference is that in the new galaxy of shadow banking, these chains of intermediation are often extremely complex, the shadow bank does not have to keep reserves on hand, and shadow banking institutions raise money through securitisation, rather than through accepting deposits.

Securitisation

With securitisation, the financial industry creates the products which populate the shadow banking ecosystem, and act as collateral. Rather than accepting deposits (and thus accepting regulation as traditional banks) shadow banking gets access to money through borrowing against assets. These assets could be anything — mortgages, credit card debt, commodities, car loans. These kinds of products are packaged up into shares, sold and traded. There are various forms: collateralised debt obligations, collateralised fund obligations, asset-backed securities, mortgage-backed securities, asset back commercial paper, tender option bonds, variable rate demand obligations, re-hypothecation, and hundreds more exotic variants. (Hypothecation is where the borrower pledges collateral to secure a debt – i.e. a mortgage, and re-hypothecation is where that collateral is passed on and someone else borrows against it, even though it remains in the original debtors hands). The function of these assets are essentially the same; securitisation is a way of creating products with an exchange value, and bringing money into the shadow banking system; so much money that the shadow banking system in 2008 was much larger than the traditional banking system:

Plummeting Junk

So securitisation — as well as its siblings hypothecation and re-hypothecation, allowed for pre-existing securities to be re-posted again and again as collateral, sucking more and more money into the system — became a pretty significant way of funding lending. The problem in the financial crisis beginning in 2007 was that a lot of the assets securitised to bring money into the shadow banking system turned out to be junk.

Think back to the MBS bundle containing James’s mortgage: if 90% of the mortgages in the MBS were defaulted upon, that MBS would yield a huge loss for whoever was currently holding it. If that MBS had been posted as collateral against further lending, those debts would be called in. For shadow banking institutions that were highly leveraged this turned out to be a huge problem. To raise capital, they started selling just about anything that wasn’t bolted down. This meant that prices — even of securities that weren’t fundamentally weak — plummeted. And because of the problems with a lot of existing securities, the funding source for a huge part of global lending completely dried up, worsening the economic contraction.

The risk — that debtors would default upon their loans — rather than being confined to a single bank, came to be spread about the entire economy, with bad debts that had been securitised, hypothecated and re-hypothecated coming to sit on the balance sheets of tens or even hundreds of financial institutions.

Pseudo-Money

This entire system creates another problem. Securities came to be a kind of pseudo-money. In other words, they became a unit of exchange and a means for payment between banking institutions. With the 2008 shadow banking implosion, this meant that many prices, including prices of products like equities that were superficially disconnected from the shadow banking system, fell precipitously simply because there was less money floating around in the system.

Friedrich Hayek wrote about this problem long before anyone coined the term shadow banking:

There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

Thus, as the shadow banking system expanded, it caused inflation, and as it imploded it caused deflation. It was a big toxic bubble waiting to burst.

The Future

Ultimately, markets are a little crazy. People will do all manner of wacky things trying to turn a profit. All kinds of weird and wonderful systems will emerge. Some systems work better than others. And — as might be sensibly expected — the shadow banking system’s wacky idea of financing banking operations through the securitisation of debt failed. But because of the wider implications for the financial system, central banks began throwing money around in order to save these broken institutions and systems.

The Federal Reserve’s first quantitative easing program bought up tranches of defunct MBS. This stabilised markets to the extent that while securitisation virtually ground to a halt in 2009, by 2011 the shadow banking system was growing again. But this is surely just a temporary measure. Simply, there is no reason whatever to doubt that the same problem — of bad debt coming to be spread around the entire financial system through securitisation and re-hypothecation — will take root once again, causing similar turmoil in the future.

The status quo is that we have a broken and dangerous system that doesn’t really work, surviving on government subsidies. Sure, a full collapse of shadow banking in 2008 would have been painful. But we may have created a bigger and more painful collapse further down the road.

One Simple Rule To Stop Unnecessary Wars

May 5, 2012

Aziz Politics, War , , , , , , , , , , , , , 70 Comments

I’m sick of war.

Officially the cost of the war on terror has been $1.3 trillion. And military spending — especially the interest on debt to pay for past wars — keeps growing year on year:

As General Eisenhower noted:

Every gun that is made, every warship launched, every rocket fired, signifies in the final sense a theft from those who hunger and are not fed, those who are cold and are not clothed.

This world in arms is not spending money alone. It is spending the sweat of its labourers, the genius of its scientists, the hopes of its children. The cost of one modern heavy bomber is this: a modern brick school in more than 30 cities. It is two electric power plants, each serving a town of 60,000 population. We pay for a single fighter with a half-million bushels of wheat. We pay for a single destroyer with new homes that could have housed more than 8,000 people. This is not a way of life at all, in any true sense. Under the cloud of threatening war, it is humanity hanging from a cross of iron.

The cost in life was been ever steeper; over a million Iraqis died.

But it’s more than cost; this a problem of responsibility. George W. Bush and Dick Cheney live a comfortable life of wealth and leisure, four years after leaving office having started two destructive, costly and ineffective wars of choice. They didn’t fight. None of their children fought. But lots of American and British soldiers and innocent Arabs got their limbs and heads blown off.

Of course, military deterrence — and sometimes military action — is necessary.

As Eisenhower noted:

A vital element in keeping the peace is our military establishment. Our arms must be mighty, ready for instant action, so that no potential aggressor may be tempted to risk his own destruction.

The trouble is that war is a great excuse for weapons contractors to make lots of money, and weapons contractors happily fund war-mongering politicians into power. That’s the self-perpetuating military industrial complex.

So the problem then lies in differentiating the necessary actions from the unnecessary.

I propose a simple heuristic for this purpose, one that if introduced would also render the war-mongering politician — the Congressman who votes to authorise, or the President who signs the authorisation into law — personally responsible:

If you start a war, you have to fight. If you cannot fight, then your nearest fit relative has to fight.

This puts the skin back into the game. You want to risk blood and treasure to start a war? If it’s that important, you’ll put your body and blood on the line before you ask any soldier to fight, or any taxpayer to pay. If not, then it must not be necessary.

Would George W. Bush have started the Iraq war had he known his two daughters would be conscripted, and shipped off to Iraq to find Saddam’s weapons of mass destruction?

I doubt it.

Paul vs Paul: Round #2

May 4, 2012

Aziz Current Affairs, Economic History, Economics, Federal Reserve, Fixed Income, Inflation, Philosophy, Politics, Wall Street , , , , , , , , , , , , , , , , 19 Comments

Bloomberg viewers estimate that Ron Paul was the winner of the clash of the Pauls. But that is very much beside the point. This wasn’t really a debate. Other than the fascinating moment where Krugman denied defending the economic policies of Diocletian, very little new was said, and the two combatants mainly talked past each other.

The real debate happened early last decade.

To wit:

Readers are free to make up their own minds who won that one.

And so, round two. Krugman wants more inflation; Paul is scared of the prospect. From Paul’s FT editorial yesterday:

Control of the world’s economy has been placed in the hands of a banking cartel, which holds great danger for all of us. True prosperity requires sound money, increased productivity, and increased savings and investment. The world is awash in US dollars, and a currency crisis involving the world’s reserve currency would be an unprecedented catastrophe. No amount of monetary expansion can solve our current financial problems, but it can make those problems much worse.

Or, as Professor Krugman sees it:

Would a rise in inflation to 3 percent or even 4 percent be a terrible thing? On the contrary, it would almost surely help the economy.

How so? For one thing, large parts of the private sector continue to be crippled by the overhang of debt accumulated during the bubble years; this debt burden is arguably the main thing holding private spending back and perpetuating the slump. Modest inflation would, however, reduce that overhang — by eroding the real value of that debt — and help promote the private-sector recovery we need. Meanwhile, other parts of the private sector (like much of corporate America) are sitting on large hoards of cash; the prospect of moderate inflation would make letting the cash just sit there less attractive, acting as a spur to investment — again, helping to promote overall recover.

Ron Paul believes that inflationary interventions into the dollar economy will have unpredictable and dangerous ramifications. Paul Krugman believes that a little more inflation (although he forgets that by the old measure of CPI inflation is already running at 9%, far higher than his supposed target) will spur economic activity and decrease residual debt overhang. Krugman seems to give no credence to the prospect of inflation spiralling out of hand, or of such policies triggering other deleterious side-effects, like a currency crisis.

The prospect of a currency crisis is a topic I have covered in depth lately: as more Eurasian nations ditch the dollar as reserve currency, more dollars (there are $5 trillion floating around Asia, in comparison to a domestic monetary base of just $1.8 trillion — the dollar is an absurdly internationalised currency) will be making their way back into the domestic American economy, and that this may have a steep inflationary impact. Additionally, many of the deflationary pressures that existed in 2008 or 2009 (e.g. shadow bank deleveraging) aren’t there anymore.

I don’t really know how much of this is to do with the Fed’s inflationary policies, and how much is to do with the United States’ role as global hegemon coming to an end. I tend to think that the dollar hegemony has always been backed by American military force, and with the American military overstretched and its funding increasingly debt-fuelled, the dollar’s role is naturally threatened. If America can’t play the global policeman for global trade, why would the dollar be the currency on global trade?

However it must be noted that America’s creditors do believe that their assets are threatened by the Fed’s inflationism.

As the Telegraph noted last year:

There has been a hostile reaction by China, Brazil and Germany, among others, to the Federal Reserve’s decision to resume quantitative easing.

Or as a Xinhua editorial put it:

China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets.

Probably, the egg of American imperial decline came before the chicken of the recent inflationism, but that inflationism certainly has the capacity to worsen the problems rather than lessen them. After all, if America’s consumption-based economy is dependent on China’s continued exportation, and Krugman is advocating slamming creditors (i.e. China) by inflating away their debt-denominated financial assets, then surely Krugman’s suggestions imperil the already-fragile trans-Pacific consumer-producer relationship?

And this is a crucial matter — there is nothing, I think, more crucial than the free availability of goods and resources through the trade infrastructure, which is something that Krugman’s policies seem to endanger.

As commenter Thomas P. Seager noted yesterday:

[The situation today] is directly analogous to the first Oil Shock in 1973. In the decades prior, the US had been a major oil producer. However, efficiency gains and discoveries overseas resulting in an incrementally increasing dependence of foreign petroleum. Price signals failed to materialize that would caution policy makers and industrialists of the risks.

Then, the disruption of oil supplies from the Middle East caused tremendous economic dislocations.

Manufacturing is undergoing the same process. The supply chain disruption from the Japanese earthquake and Tsunami was merely a warning shot. Imagine if S Korean manufacturing were taken off-line for any length of time (a plausible scenario). The disruption to US industry would be catastrophic.

In the name of increased efficiency, we have introduced brittleness.

Time will tell which Paul is right. But I know where I stand.

Should the Rich Pay More Taxes?

May 3, 2012

Aziz Economics , , , , , , , , , , , , , , , , , , , , , 71 Comments

It’s a multi-dimensional question.

The left says yes — income inequality has soared in recent years, and the way to address it (supposedly) is to tax the rich and capital gains at a higher rate. The right says no — that the rich already create more jobs and wealth, because they spend more money, and why (supposedly) should they pay more tax when they already pay far higher figures than lower-income workers?

Paul Krugman made the point yesterday that the tax rate on the top earners during the post-war boom was 91%, seeming to infer that a return to such rates would be good for the economy.

Yet if we want to raise more revenue, historically it doesn’t really seem to matter what the top tax rate is:

Federal revenues have hovered close to 20% of GDP whatever the tax rate on the richest few.

This seems to be because of what is known as the Laffer-Khaldun effect: the higher rates go, the more incentive for tax avoidance and tax evasion.

And while income inequality has risen in recent years, the top-earners share of tax revenue has risen in step:

So the richest 1% are already contributing around 40% of the tax revenue, taxed on their 34% share of the national income. And even if the Treasury collected every cent the top 1% earned, America would still be running huge deficits.

Yet the Occupy movement are still angry. A large majority of Americans believe the richest should pay more tax. More and more wealthy Americans — starting with Warren Buffett, and most recently Stephen King are demanding to pay more taxes.

King writes:

At a rally in Florida (to support collective bargaining and to express the socialist view that firing teachers with experience was sort of a bad idea), I pointed out that I was paying taxes of roughly 28 percent on my income. My question was, “How come I’m not paying 50?”

How come? Well, the data shows pretty clearly that it’s unlikely that revenues would increase.

They may have a fair point that capital gains above a certain threshold should probably be taxed at the same rate as income, because it is effectively the same thing. And why should government policy encourage investment above labour by taxing one more leniently?

But more simply, people like King think the status quo  is unjust far beyond the taxation structure. A lot of people are unemployed:

A lot of people are earning less than they were five years ago:

28% of homeowners are underwater on their mortgages. Millions of graduates face a mountain of student debt, while stuck in dole queues or in a dead end job like Starbucks.

We live in dark times.

From Reuters:

Nearly 15 percent of people worldwide believe the world will end during their lifetime and 10 percent think the Mayan calendar could signify it will happen in 2012, according to a new poll.

With all this hurt, there’s a lot of anger in society. Those calling for taxing the richest more are not doing the same cost-benefit analysis I am doing that suggests that raising taxes won’t raise more revenue.

But they’re not unfairly looking for a scapegoat, either. While probably the greatest culprits for the problems of recent times are in government (Bush, Greenspan, Obama, Bernanke) Americans are right to be mad at the rich.

Why?

This isn’t about tax. This is about jobs, and growth.

The rich, above and beyond any other group have the ability to ameliorate the economic malaise by spending and creating jobs, creating new products and new wealth. The top 1% control 42% of all financial wealth. But that money isn’t moving very much at all— the velocity of money is at historic lows. It should not be surprising that growth remains depressed and unemployment remains stubbornly high.

And every month that unemployment remains elevated is another month that the job creators are not doing their job. Every month that the malaise festers, the angrier the 99% gets.  It is, I think, in the best interests of the rich to try and create as many jobs and as much wealth as they can. Class warfare is ugly. A divided and angry society, I think, will find it even more difficult to grow and produce.

So raising tax rates is not guaranteed to raise revenues, and cannot address the problem of deficits. America needs the richest Americans to pay more tax dollars — but only as a side-effect of producing more, and creating growth.  

The Pseudoscience of Economics

May 2, 2012

Aziz Economic History, Economics , , , , , , , , , 37 Comments

Modern economics is obsessed with modelling. An overwhelming majority of academic papers on the subject work like so: they take data, and use data to construct formal mathematical models of economic processes. Models mostly describe a situation, and describe how that situation would be changed by a given set of events; a very simple example is that as the supply of a good diminishes, its price will increase. Another is that deficit spending increases the national income. A mathematical model is a predictive tool created to demonstrate the outcome of events in a massively simplified alternate universe.

As someone who rather enjoys voyages of the imagination, the use of mathematical models in economics is intriguing. The pretension that through using formal mathematical techniques and process  we can not only accurately understand, but accurately predict the result of changes in the economy is highly seductive. After all,we can accurately predict the future, right?

Wrong. The wonderful and terrible and confounding thing about our world is that it is a deeply unpredictable place, at least in the economic sphere where each number (for instance “aggregate demand” or “aggregate supply”) in an equation may loosely refer to millions of huge, complex and dynamic events. When you’re using huge simplifications to describe reality, those simplifications may miss the important details, and your projections may go askew.

Not all modelling is equal. Newton’s model of gravitation (since superseded by Einstein’s relativity) makes relatively accurate predictions about how gravitation works, and what would happen to an object dropped 500 metres above the Earth. NASA used Newton’s equations to fly to the Moon. Of course, even in physics there are occasionally divergences and oddities (which is why there are quite often unrepeatable or anomalous experimental results, for instance the recent experiment that seemed to show neutrinos travelling faster than the speed of light). So economics — with its fixation on creating models of situations, and using these models to attempt to predict the future, mimics physics, chemistry and biology, where data is collected, and used to produce theories of physical processes which allow a modestly accurate representation of the future.

The key qualitative difference, though, is that mathematical economic theories don’t accurately predict the future. Ben Bernanke — the chairman of the Federal Reserve, and one of the most-cited academic economists in the world told the world that subprime housing was contained. That is the economic equivalent of Stephen Hawking telling the world that a meteorite is going to miss the Earth, when it is really going to hit. Physicists can very accurately model the trajectories of rocks in space. But economists cannot accurately model the trajectories of prices, employment and interest rates down on the rocky ground.

The thing that I believe modern economists are most useful for is pointing out the glaring flaws in everyone else’s theories. Steve Keen has made a public name for himself by publishing a book entitled Debunking Economics, in which he explains the glaring and various flaws in modern economic modelling (DSGE, New Classical, etc).

Economics is a complex and multi-faceted subjects. Economists must be in some measure, philosophers, historians, linguists, mathematicians, statisticians, political scientists, sociologists and psychologists, and many other things. The trouble is that at some stage in the last century the multi-faceted multi-dimensional economics (like that of Xenophon) was hijacked by mathematicians who tried to turn this huge and delicate subject into an equation. Yet economics — and economic decisions, from the macro to the micro level — is a human subject. It is subtle and psychological and sporadic. A human subject requires human language, human emotion, human intuition.

The grand theoretical-mathematical approach to economics is fundamentally flawed. Trying to smudge the human reality of economics and politics into cold mathematical shackles is degenerative.

So what to do if you want to understand the economy?

Follow the data, consider the history (similarities and differences between the past and the present) and explain your conclusions simply, as you would to a child. Consider philosophical definitions: what is money? What is demand? What is supply? What is value? How does demand affect supply? What are the global patterns of trade? Why have they emerged this way and not an alternative way? Consider possibilities. Admit the limitations of your knowledge and explore the boundaries. Stop forcing the construction of absolutes, grand frameworks, grand theories. No theory will ever be robust to everything nature will throw at it, but simple microeconomic heuristics (opportunity cost, cost-benefit analysis) combined with data-focussed historical analysis may be more robust than cold, dead mathematics.

As Heraclitus noted:

No man ever steps in the same river twice

No two situations are identical. And in this universe even tiny differences can have huge effects on the outcome of a situation. This is the butterfly effect, a term coined by Edward Lorenz, and derived from the theoretical example of a hurricane’s formation being contingent on whether or not a distant butterfly had flapped its wings several weeks before.

The pseudo-scientific school of mathematical economics hungers and craves for a perfect world, where each river is the same, where there is no butterfly effect, where human preferences are expressed in equation form, where there is no subtlety or ambiguity or uncertainty.

It is a dreamworld constructed by and for people with Asperger’s Syndrome.

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