goldman sachs

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This Time It’s Different 2013 Edition

A small note on the frankly hilarious news that the Dow Jones Industrial Average smashed through to all-time-highs.

First of all, while stock prices are soaring, household income and household confidence are slumping to all-time lows. Employment remains depressed, energy remains expensive, housing remains depressed, wages and salaries as a percentage of GDP keep falling, and the economy remains in a deleveraging cycle. Essentially, these are not the conditions for strong organic business growth, for a sustainable boom. We’re going through a structural economic adjustment, and suffering the consequences of a huge 40-year debt-fuelled boom. While the fundamentals remain weak, it can only be expected that equity markets should remain weak. But that is patently not what has happened.

In fact, it has been engineered that way. Bernanke has been explicitly targeting equities, hoping to trigger a beneficent spiral that he calls “the wealth effect” — stock prices go up, people feel richer and spend, and the economy recovers. But with fundamentals still depressed, this boom cannot be sustained.

There are several popular memes doing the rounds to suggest, of course, that this time is different and that the boom times are here to stay, including the utterly hilarious notion that the Dow Jones is now a “safe haven”. They are all variations on one theme — that Bernanke is supporting the recovery, and will do whatever it takes to continue to support it. Markets seem to be taking this as a sign that the recovery is real and here to stay. But this is obviously false, and it is this delusion that — as Hyman Minsky clearly explained last century — is so dangerous.

There are many events and eventualities under which throwing more money at the market will make no difference. Central banks cannot reverse a war, or a negative trade shock, or a negative production shock, or a negative energy shock simply by throwing money at it. And there are severe limits to their power to counteract financial contractions outside their jurisdiction (although in all fairness the Federal Reserve has expanded these limits in extending liquidity lines to foreign banks). Sooner or later the engineered recovery will be broken by an event outside the control of central bankers and politicians. In creating a false stability, the Federal Reserve has actually destabilised the economy, by distorting investors’ perceptions.

But, of course, some analysts think that this time really is different. Here’s a chart from Goldman showing the S&P500 by sectoral composition:

screen shot 2013-03-06 at 4.50.16 am

The implication here is clear — with no obvious sectoral bulge like that of the late 1970s, the tech bubble, and the financial bubble — there is no bubble. But what if the bubble is spread evenly over multiple sectors? After all, the Federal Reserve has been reinflating Wall Street in general rather than any one sector in particular.

Wall Street leverage is, unsurprisingly, approaching 2007 levels:

2005

Is this the final blowout top? I’m not sure. But I would be shocked to see this bubble live beyond 2013, or 2014 at the latest. I don’t know which straw will break the illusion. Middle eastern war? Hostility between China and Japan? North Korea? Chinese real estate and subprime meltdown? Student debt? Eurozone? Natural disasters? Who knows…

The wider implications may not be as bad as 2008. The debt bubble has already burst, and the deleveraging cycle has already begun. Total debt is slowly shrinking. It is plausible that we will only see a steep correction in stocks, rather than some kind of wider economic calamity. On the other hand, it is also plausible that this bursting bubble may herald a deeper, darker new phase of the depression.

With every day that the DJIA climbs to new all-time highs, more suckers will be drawn into the market. But it won’t last. Insiders have already gone aggressively bearish. This time isn’t different.

thistimeisdifferent

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The Unsustainable US Financial Sector

According to Bloomberg, the vast majority of the Big Five banks’ profits consisted of a taxpayer subsidy — the Too Big To Fail guarantee. If the Too Big To Fail banks had to lend at the rates offered to their non-Too Big to Fail competitors, their profits would be severely shrunk (in some cases, to a net loss):

ia0wsBOXgNcU

What does that mean?

That means that the American financial sector is a zombie, existing on the teat of the taxpayer.

It means the huge swathes of liquidity spent on saving the financial sector are ultimately good money chasing after bad.

As Bloomberg notes:

The U.S. financial industry — with almost $9 trillion in assets, more than half the size of the U.S. economy — would just about break even in the absence of corporate welfare. In large part, the profits they report are essentially transfers from taxpayers to their shareholders.

Neither bank executives nor shareholders have much incentive to change the situation. On the contrary, the financial industry spends hundreds of millions of dollars every election cycle on campaign donations and lobbying, much of which is aimed at maintaining the subsidy. The result is a bloated financial sector and recurring credit gluts.

This is extremely prescient stuff. The Fed since 2008 has reinflated the old bubbles, while allowing the same loot-and-pillage disaster-corporatist financial model to continue.

It is insane to repeat the same methods and expect different results. This credit glut, this new boom that has seen stocks rise closer and closer to their pre-crisis high (which may soon be exceeded) will just lead to another big 2008-style slump, just as the Fed’s reinflation of the burst tech bubble led to 2008 itself. This time the spark won’t be housing, it will be something else like an energy shock, or a war. Something that the Federal Reserve cannot directly control or fix by throwing money at it.

America (and the Western world in general) post-2008 needed real organic domestic growth built on real economic activity, not a reinflated bubble that let the TBTF financial sector continue to gorge itself into oblivion. 

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Is the Gold Price Dependent on China?

China now buys more gold than the Western world:

Gold_Demand_China_WGC

Does that mean, as some commentators are suggesting, that future price growth for the gold price depends on China? That if the Chinese economy weakens and has a hard landing or a recession that gold will fall steeply?

There’s no doubt that the run-up that gold has experienced in recent years is associated with the rise in demand for gold from emerging markets and their central banks. And indeed, the BRIC central banks have been quite transparent about their gold acquisition and the reasons for it.

Zhang Jianhua of the People’s Bank of China said:

No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.

Indeed, this trend recently led the Telegraph’s Ambrose Evans-Pritchard to declare that the world was on the road to “a new gold standard” — a tripartite reserve currency system of gold, dollars and euros:

The world is moving step by step towards a de facto Gold Standard, without any meetings of G20 leaders to announce the idea or bless the project.

Some readers will already have seen the GFMS Gold Survey for 2012 which reported that central banks around the world bought more bullion last year in terms of tonnage than at any time in almost half a century.

They added a net 536 tonnes in 2012 as they diversified fresh reserves away from the four fiat suspects: dollar, euro, sterling, and yen.

The countries driving the movement toward gold as a reserve currency by building their gold reserves is that they are broadly creditor nations whose dollar-denominated assets have been relatively hurt by over a decade of low and negative real interest rates. The idea that gold does well during periods of  falling or negative real rates held even before the globalisation of U.S. Treasury debt.

The blue line is real interest rates on the 10-year Treasury, the red line change in the gold price from a year ago:

fredgraph (15)

The historical relationship between real interest rates and the gold price shows that it is likely not “China” per se that has been driving the gold price so much as creditors and creditor states in general who are disappointed or frustrated with the negative real interest rate environment in dollar-denominated assets. What a slowdown in the Chinese economy (or indeed the BRICs in general) would mean for the gold price remains to be seen. While it is widely assumed that a Chinese slowdown might reduce demand for gold, it is quite plausible that the opposite could be true. For instance, an inflationary crisis in China could drive the Chinese public and financial sector into buying more gold to insulate themselves against falling or negative real rates.

Of course, this is only one factor. That are no hard and fast rules about what drives markets, especially markets like the gold market where many different market participants have many different motivations for participating — some see gold as an inflation hedge, some (like the PBOC) as a hedge against counterparty risk and global contagion, some as a buffer against negative real interest rates, some as a tangible form of wealth, etc.

And with the global monetary system in a state of flux — with many nations creating bilateral and multilateral trade agreements to trade in non-dollar currencies, including gold — emerging market central banks see gold — the oldest existing form of money — as an insurance policy against unpredictable changes, and as a way to win global monetary influence.

So while emerging markets and particularly China have certainly been driving gold, while U.S. real interest rates remain negative or very low, and while the global monetary system remains in a state of flux, these nations will likely continue to gradually drive the gold price upward.

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Too Big To Understand

One thing that has undergone hyperinflation in recent years is the length of financial regulations:

Too Big To Understand

The Dodd-Frank regulatory hyperinflation crowds out those who cannot afford teams of legal counsel, compliance officers, and expansive litigation. Dodd-Frank creates new overheads which are no challenge for large hedge funds and megabanks armed with Fed liquidity, but a massive challenge for startups and smaller players with more limited resources.

As BusinessWeek noted in October:

The law requires Hedge Funds to register with the Securities and Exchange Commission, supply reams of sensitive data on trading positions, carefully screen potential investors, and hire compliance officer after compliance officer.

So, is this expansion in volume likely to improve financial stability? No — the big banks are bigger and more interconnected than ever, which was precisely the problem before 2008, and they are still speculating and arbitraging with very fragile strategies that can incur massive losses as MF Global’s breakdown and more recently the London Whale episode proves.

Andy Haldane laid out the problem perfectly in his recent paper The Dog and the Frisbee:

Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity.

Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a Doctorate in physics. It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans.

So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the
frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.

Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among them innovation and risk appetite. Were an economist to write down crisis-catching as an optimal control problem, they would probably have to ask a physicist for help.

Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a Doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities. No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.

So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity.

Big, messy legislation leaves legal loopholes that clever and highly-paid lawyers and (non-) compliance officers can cut through. Bigger and more extensive regulation can make a system less well-regulated. I propose that this is what the big banks will use Dodd-Frank to accomplish.

I predict that the regulatory hyperinflation will make the financial industry and the wider economy much more fragile.

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Bullish News For Gold?

Goldman Sachs says that gold is poised for a fall in the medium term:

Improving US growth outlook offsets further Fed easing
Our economists forecast that the US economic recovery will slow early in 2013 before reaccelerating in the second half. They also expect additional expansion of the Fed’s balance sheet. Near term, the combination of more easing and weaker growth should prove supportive to gold prices. Medium term however, the gold outlook is caught between the opposing forces of more Fed easing and a gradual increase in US real rates on better US economic growth. Our expanded modeling suggests that the improving US growth outlook will outweigh further Fed balance sheet expansion and that the cycle in gold prices will likely turn in 2013. Risks to our growth outlook remain elevated however, especially given the uncertainty around the fiscal cliff, making calling the peak in gold prices a difficult exercise.

Gold cycle likely to turn in 2013; lowering gold price forecasts
We lower our 3-, 6- and 12-mo gold price forecasts to $1,825/toz, $1,805/toz and $1,800/toz and introduce a $1,750/toz 2014 forecast. While we see potential for higher gold prices in early 2013, we see growing downside risks.

Goldman’s model boils down to this chart, that posits that gold prices are supported by a low real interest rate environment:

GoldvsRealInterestRates

Goldman’s forecast is based on the idea that real rates will rise due to stronger economic growth in the second half of 2013 and beyond.

But the notion of strengthening economic growth in the second half of 2013 and beyond is deeply problematic. The total debt to GDP ratio is still above 350%, far, far far above the historical norm and a huge burden on the economy. The service costs of all that debt (sustained only by Fed liquidity helicopters — without the bailouts and liquidity lines, the unsustainable debt would have all been liquidated in 2008) is keeping the economy (and thus, real interest rates) depressed.

This means that the supposed recovery — and any such attendant dip in gold prices — is extremely unlikely to materialise.

In fact with Goldman’s track record of giving bogus advice to clients and then betting against it, this call could very easily signal that we are on the edge of another seismic upswing in the gold price.

US mint data shows gold demand is strengthening:

20121201_Gold_0

There is history here. Goldman’s previous bearish calls on gold locked their African gold-mining clients into money-lossing derivative deals.

GhanaWeb tells the full story:

In 1998, Ashanti Gold was the 3rd largest Gold Mining company in the world. The first “black” company on the London Stock Exchange, Ashanti had just purchased the Geita mine in Tanzania, positioning Ashanti to become even larger. But in May 1999, the Treasury of the United Kingdom decided to sell off 415 tons of its gold reserves. With all that gold flooding the world market, the price of gold began to decline. By August 1999, the price of gold had fallen to $252/ounce, the lowest it had been in 20 years.

Ashanti turned to its Financial Advisors – Goldman Sachs – for advice. Goldman Sachs recommended that Ashanti purchase enormous hedge contracts – “bets” on the price of gold. Simplifying this somewhat, it was similar to when a homeowner ‘locks in’ a price for heating oil months in advance. Goldman recommended that Ashanti enter agreements to sell gold at a ‘locked-in’ price, and suggested that the price of gold would continue to fall.

But Goldman was more than just Ashanti’s advisors. They were also sellers of these Hedge contracts, and stood to make money simply by selling them. And they were also world-wide sellers of Gold itself.

In September 1999 (one month later), 15 European Banks with whom Goldman had professional relationships made a unanimous surprise announcement that all 15 would stop selling gold on world markets for 5 years. The announcement immediately drove up gold prices to $307/ounce, and by October 6, it had risen to $362/ounce.

Goldman pocketed a shitload of money; clients ended up getting socked in the mouth.

Goldman publicly turning bearish, may be a pretty bullish sign for gold.

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Mark Carnage

The greater story behind Mark Carney’s appointment to the Bank of England may be the completion of Goldman Sachs’ multi-tentacled takeover of the European regulatory and central banking system.

GS1

But let’s take a moment to look at the mess he is leaving behind in Canada, the home of moose, maple syrup, Jean Poutine and now colossal housing bubbles.

George Osborne (who as I noted last month wants more big banks in Britain) might have recruited Carney on the basis of his “success” in Canada. But in reality he is just another Greenspan — a bubble-maker and reinflationist happy to pump the banking sector full of loose money and call it “prosperity” before the irrational exuberance runs dry, and the bubble inevitably bursts.

Two key charts. First, household debt-to-GDP.

household-debt-to-gdp-chart-canada

Deleveraging? Not in Canada.

The Huffington Post noted earlier this year:

Household debt levels have reached a new high, increasing the vulnerability of average Canadians to unexpected economic shocks just at a time when uncertainty is mounting.

Despite signs that Canada’s economic recovery is fizzling, data released by Statistics Canada Tuesday shows that the ratio of credit market debt to personal disposable income climbed to 148.7 per cent in the second quarter, surpassing the previous record of 147.3 per cent set in the first three months of this year.

Second, Canadian house prices:

2001-after-years-of-moving-sideways-home-prices-took-off

Famed analyst Jesse Colombo recently wrote:

Booming commodities exports and skyrocketing housing prices are encouraging Canadians to spend far beyond their means, while binging on credit, mimicking their American neighbors’ profligate behavior of six years earlier. (They’re thinking, “Canada is different!”) RBC Global Asset Management’s chief economist warns that Canada’s record household debt could “spell its undoing,” while Moody’s warns that Canadian banks face significant risk due to their exposure to overleveraged Canadian consumers. Maybe things really are different in Canada, where a group of under-21-year-olds got caught by the police for racing $2 million worth of exotic supercars, including Ferraris and Lamborghinis. Or not.

The age-old misperception that this time is different, that Chinese investors will continue to spend millions on crack shacks in Vancouver, that an industrial boom in East Asia will continue to support demand for Canadian commodities, that Canada’s subprime slush isn’t vulnerable, that hot inflows from capital rich low-interest rate environments like Japan and America will continue forever.

In the short term what is going on is that the ex-Goldmanite Carney has pumped up a huge bonanza of securitisation and quick profits for big banks and their management who are laughing all the way to the Cayman Islands (or in Carney’s case, Threadneedle Street). Once the easy money quits flowing into the Canadian financial system from abroad, defaults will begin to accumulate, cracks will quickly appear, and Canada will spiral into debt-deflation. Taxpayers in Canada (and in other similar cases like Australia) may well end up bailing out the banks profiting so handsomely now, just like their American and British and Japanese cousins.

The appointment of Carney is a disaster for Britain and a disaster for the Bank of England. Carney has already singled out Andy Haldane for criticism, an economist at the Bank of England with a solid understanding of the dynamics of complex financial systems, and a champion of simple and clear regulation. 

In a hundred years, people may be taking out zero-down mortgages against building geodesic domes on Mars or the Moon, and flipping them off to greater fools for huge profits. Because this time is different, right? And another crash and depression will follow.

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The High Frequency Trading Debate

A Senate panel is looking into the phenomenon of High Frequency Trading.

Here’s the infamous and hypnotic graphic from Nanex showing just how the practice has grown, showing quote volume by the hour every day since 2007 on various exchanges:

It is a relief that the issue is finally being discussed in wider venues, because we are witnessing a stunning exodus from markets as markets mutate into what we see above, a rampaging tempestuous casino of robotic arbitrageurs operating in millisecond timescales.

The conundrum is simple: how can any retail investor trust markets where billions of dollars of securities are bought and sold faster than they can click my mouse and open my browser, or pick up the phone to call their broker?

And the first day of hearings brought some thoughtful testimony.

The Washington Post notes:

David Lauer, who left his job at a high-frequency trading firm in Chicago last year, told a Senate panel that the ultra-fast trades that now dominate the stock market have contributed to frequent market disruptions and alienated retail investors.

“U.S. equity markets are in dire straits,” Lauer said in his written testimony.

One man who I think should be testifying in front of Congress is Charles Hugh Smith, who has made some very interesting recommendations on this topic:

Here are some common-sense rules for such a “new market”:

1. Every offer and bid will be left up for 15 minutes and cannot be withdrawn until 15 minutes has passed.

2. Every security–stock or option–must be held for a minimum of one hour.

3. Every trade must be placed by a human being.

4. No equivalent of the ES/E-Mini contract–the futures contract for the S&P 500 — will be allowed. The E-Mini contract is the favorite tool of the Federal Reserve’s proxies, the Plunge Protection Team and other offically sanctioned manipulators, as a relatively modest sum of money can buy a boatload of contracts that ramp up the market.

5. All bids, offers and trades will be transparently displayed in a form and media freely available to all traders with a standard PC and Internet connection.

6. Any violation of #3 will cause the trader and the firm he/she works for to be banned from trading on the exchange for life–one strike, you’re out.

However, I doubt that any of Smith’s suggestions will even be considered by Congress (let alone by the marketplace which seems likely to continue to gamble rampantly so long as they have a bailout line). Why? Money. Jack Reed, the Democratic Senator chairing the hearings, is funded almost solely by big banks and investment firms:

It seems more than probable that once again Congress will come down on the side of big finance, and leave retail investors out in the cold. Jack Reed opened a recent exchange on Bloomberg with these words:

Well I believe high frequency trading has provided benefits to the marketplace, to retail investors, etcetera.

Yet retail investors do not seem to agree about these supposed benefits.

Retail investors just keep pulling funds:

Reed failed to really answer this question posed by the host:

Senator, US equity markets are supposed to be a level playing field for all kinds of investors; big companies, small companies and even individuals. That said, how is it possible for an individual investor ever to compete with high frequency traders who buy and sell in milliseconds. Aren’t individuals always going to be second in line essentially to robots who can enter these orders faster than any human possibly can?

The reality is that unless regulators and markets can create an environment where individual investors can participate on a level playing field, they will look for alternative venues to put their money. It is in the market’s interest to create an environment where investors can invest on a level playing field. But I think the big banks are largely blinded by the quick and leverage-driven levitation provided by high frequency trading.

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The Biggest Conflict of Interest in Finance?

Maybe this is a naive question, but as Goldman clients get skinned again and again and again and again and again by Goldman’s failed calls — while Goldman itself continues to rack up prop trading profits — I keep wondering just why anyone would take investment advice from a trading firm?

And beyond that, why is it even legal for trading firms to advise clients? Isn’t this the biggest conflict of interest possible? We know firms including Goldman have advised clients to buy junk that the trading arm wants to get off its books.

A few months back former Goldmanite Greg Smith wrote:

What are three quick ways to become a leader at Goldman?

a) Persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit.

b) Get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them.

c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.

It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus, God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.

How is intentionally misleading clients to offload junk not illegal? Is this not a huge regulatory oversight? And why — when there is ample evidence that this has happened before and continues to happen — are so few people talking about making it illegal?

And beyond that is it not blazingly obvious that the supermarket megabank model that puts clients’ interests under a single roof with the bank’s own trading book breeds fraud? Should there not be a new Glass Steagall not only to separate retail from investment banking, but also to separate prop trading from flow trading?

Or are we going to leave the world to the vampire squid?

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The New European Serfdom

So let’s assume Greece is going to leave the Eurozone and suffer the consequences of default, exit, capital controls, a deposit freeze, the drachmatization of euro claims, and depreciation.

It’s going to be a painful time for the Greek people. But what about for Greece’s highly-leveraged creditors, who must now bite the bullet of a disorderly default? Surely the ramifications of a Greek exit will be worse for the international financial system?

J.P. Morgan — fresh from putting an LTCM alumnus in charge of a $70 trillion derivatives book (good luck with that) — is upping the fear about Europe and its impact on global finance:

The main direct losses correspond to the €240bn of Greek debt in official hands (EU/IMF), to €130bn of Eurosystem’s exposure to Greece via TARGET2 and a potential loss of around €25bn for European banks. This is the cross-border claims (i.e. not matched by local liabilities) that European banks (mostly French) have on Greece’s public and non-bank private sector. These immediate losses add up to €400bn. This is a big amount but let’s assume that, as several people suggested this week, these immediate/direct losses are manageable. What are the indirect consequences of a Greek exit for the rest?

The wildcard is obviously contagion to Spain or Italy? Could a Greek exit create a capital and deposit flight from Spain and Italy which becomes difficult to contain? It is admittedly true that European policymakers have tried over the past year to convince markets that Greece is a special case and its problems are rather unique. We see little evidence that their efforts have paid off.

The steady selling of Spanish and Italian government bonds by non-domestic investors over the past nine months (€200bn for Italy and €80bn for Spain) suggests that markets see Greece more as a precedent for other peripherals rather than a special case. And it is not only the €800bn of Italian and Spanish government bonds still held by non-domestic investors that are likely at risk. It is also the €500bn of Italian and Spanish bank and corporate bonds and the €300bn of quoted Italian and Spanish shares held by nonresidents. And the numbers balloon if one starts looking beyond portfolio/quoted assets. Of course, the €1.4tr of Italian and €1.6tr of Spanish bank domestic deposits is the elephant in the room which a Greek exit and the introduction of capital controls by Greece has the potential to destabilize.

A multi-trillion € shock — far bigger than the fallout from Lehman — has the potential to trigger a default cascade wherein busted leveraged Greek creditors themselves end up in a fire sale to raise collateral as they struggle to maintain cash flow, and face the prospect of downgrades and margin calls and may themselves default on their obligations, setting off a cascade of illiquidity and default. Very simply, such an event has the potential to dwarf 2008 and 1929, and possibly even bring the entire global financial system to a juddering halt (just as Paulson fear-mongered in 2008).

Which is why I am certain that it will not be allowed to happen, and that J.P. Morgan’s histrionics are just a ponying up toward the next round of crony-“capitalist” bailouts. Here’s the status quo today:

Greece no longer wants to play along with the game?

Okay, fine — cut them out of the equation. In the interests of “long-term financial stability”, let’s stop pretending that we are bailing out Greece and just hand the cash over to the banks.

Schäuble and Merkel might have demanded tough fiscal action from European governments, but they have never questioned the precept that creditors must get their pound of flesh. Merkel has insisted that authorities show that Europe is a “safe place to invest” by avoiding haircuts.

Here’s my expected new normal in Europe:

After all — if the establishment is to be believed — it’s in the interests of “long-term financial stability” that creditors who stupidly bought unrepayable debt don’t get a big haircut like they would in a free market.  And it’s in the interests of “long-term financial stability” that bad companies who made bad decisions don’t go out of business like they would in a free market, but instead become suckling zombies attached to the taxpayer teat. And apparently it is also in the interests of “long-term financial stability” that a broken market and broken system doesn’t liquidate, so that people learn their lesson. Apparently our “long-term financial stability” depends on producing even greater moral hazard by handing more money out to the negligent.

The only real question (beyond whether or not the European public’s patience with shooting off money to banks will snap, as has happened in Greece) is whether or not it will just be the IMF and the EU institutions, or whether Bernanke at the Fed will get involved beyond the inevitable QE3 (please do it Bernanke! I have some crummy equities I want to offload to a greater fool!).

As I asked last month:

Have the 2008 bailouts cemented a new feudal aristocracy of bankers, financiers and too-big-to-fail zombies, alongside a serf class that exists to fund the excesses of the financial and corporate elite?

And will the inevitable 2012-13 bailouts of European finance cement this aristocracy even deeper and wider?

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Double or Nothing: How Wall Street is Destroying Itself

There’s nothing controversial about the claim— reported on by Slate, Bloomberg and Harvard Magazine — that in the last 20 years Wall Street has moved away from an investment-led model, to a gambling-led model.

This was exemplified by the failure of LTCM which blew up unsuccessfully making huge interest rate bets for tiny profits, or “picking up nickels in front of a streamroller”, and by Jon Corzine’s MF Global doing practically the same thing with European debt (while at the same time stealing from clients).

As Nassim Taleb described in The Black Swan this strategy — betting large amounts for small frequent profits — is extremely fragile because eventually (and probably sooner in the real world than in a model) losses will happen (and, of course, if you are betting big, losses will be big). If you are running your business on the basis of leverage, this is especially dangerous, because facing a margin call or a downgrade you may be left in a fire sale to raise collateral.

This fragile business model is in fact descended from the Martingale roulette betting system. Martingale is the perfect example of the failure of theory, because in theory, Martingale is a system of guaranteed profit, which I think is probably what makes these kinds of practices so attractive to the arbitrageurs of Wall Street (and of course Wall Street often selects for this by recruiting and promoting the most wild-eyed and risk-hungry). Martingale works by betting, and then doubling your bet until you win. This — in theory, and given enough capital — delivers a profit of your initial stake every time. Historically, the problem has been that bettors run out of capital eventually, simply because they don’t have an infinite stock (of course, thanks to Ben Bernanke, that is no longer a problem). The key feature of this system— and the attribute which many institutions have copied — is that it delivers frequent small-to-moderate profits, and occasional huge losses (when the bettor runs out of money).

The key difference between modern business models, and the traditional roulette betting system is that today the focus is on betting multiple times on a single outcome. By this method (and given enough capital) it is in theory possible to win whichever way an event goes. If things are going your way, it is possible to insure your position by betting against your initial bet, and so produce a position that profits no matter what the eventual outcome. If things are not going your way, it is possible to throw larger and larger chunks of capital into a position or counter-position again and again and again —mirroring the Martingale strategy — to try to compensate for earlier bets that have gone awry (this, of course, is so often the downfall of rogue traders like Nick Leeson and Kweku Adoboli).

This brings up a key issue: there is a second problem with the Martingale strategy in the real world beyond the obvious problem of running out of capital. You can have all the capital in the world (and thanks to the Fed, the TBTF banks now have a printing-press backstop) but if you do not have a counter-party to take your bets  (and as your bets and counter-bets get bigger and bigger it by definition becomes harder and harder to find suitable counter-parties) then you are Corzined, and you will be left sitting on top of a very large load of pain (sound familiar, Bruno Iksil?)

The obvious real world example takes us back to the casino table — if you are trying to execute a Martingale strategy starting at $100, and have lost 10 times in a row, your 11th bet would have to be for $204,800 to win back your initial stake of $100. That might well exceed the casino table limits — in other words you have lost your counter-party, and are left facing a loss far huger than any expected gains.

Similarly (as Jamie Dimon and Bruno Iksil have now learned to their discredit) if you have built up a whale-sized market-dominating gross position of bets and counter-bets on the CDX IG9 index (or any such market) which turns heavily negative, it is exceedingly difficult to find a counter-party to continue increasing your bets against, and your Martingale game will probably be over, and you will be forced to face up to the (now exceedingly huge) loss. (And this recklessness is what Dimon refers to as “hedging portfolio risk“?)

The really sickening thing is that I know that these kinds of activities are going on far more than is widely recognised; every time a Wall Street bank announces a perfect trading quarter it sets off an alarm bell ringing in my head, because it means that the arbitrageurs are chasing losses and picking up nickels in front of streamrollers again, and emboldened by confidence will eventually will get crushed under the wheel, and our hyper-connected hyper-leveraged system will be thrown into shock once again by downgrades, margin calls and fire sales.

The obvious conclusion is that if the loss-chasing Martingale traders cannot resist blowing up even with the zero-interest rate policy and an unfettered fiat liquidity backstop, then perhaps this system is fundamentally weak. Alas, no. I think that the conclusion that the clueless schmucks at the Fed have reached is that poor Wall Street needs not only a lender-of-last-resort, but a counter-party-of-last-resort. If you broke your trading book doubling or quadrupling down on horseshit and are sitting on top of a colossal mark-to-market loss, why not have the Fed step in and take it off your hands at a price floor in exchange for newly “printed” digital currency? That’s what the 2008 bailouts did.

Only one problem: eventually, this approach will destroy the currency. Would you want your wealth stored in dollars that Bernanke can just duplicate and pony up to the latest TBTF Martingale catastrophe artist? I thought not: that’s one reason why Eurasian creditor nations are all quickly and purposefully going about ditching the dollar for bilateral trade.

The bottom line for Wall Street is that either the bailouts will stop and anyone practising this crazy behaviour will end up bust — ending the moral hazard of adrenaline junkie coke-and-hookers traders and 21-year-old PhD-wielding quants playing the Martingale game risk free thanks to the Fed — or the Fed will destroy the currency. I don’t know how long that will take, but the fact that the dollar is effectively no longer the global reserve currency says everything I need to know about where we are going.

The bigger point here is whatever happened to banking as banking, instead of banking as a game of roulette? You know, where investment banks make the majority of their profits and spend the majority of their efforts lending to people who need the money to create products and make ideas reality?