Wednesday, August 24, 2011

A Tale of Two "Safe Havens"


As gold sells off sharply today after hitting a nominal intraday high of $1911.46 yesterday, a reminder of the global fiscal and monetary events that powered gold up into this point is useful. The attached chart shows the path of gold compared to another "safe haven," the US 10-year Treasury note (normalized price, inverse yield). Both have a story to tell, and both reflect market uncertainty on issues of inflation, deflation, debt loads and economic growth.

During the fall 2008 market turmoil created by the credit and housing market crises, investors and traders piled into Treasuries and the dollar, while gold sold off in a technical basing pattern. As markets recovered in 2009 due to massive Federal Reserve injections of monetary liquidity (including "QE1"), gold climbed above its previous high of $1011.30 hit March 17, 2008 (the day Bear Stearns died). Fed liquidity drove a selloff of Treasuries and the dollar, with money flowing into equities, commodities and gold.

The late April 2010 flare up of the European sovereign debt crisis from fears of defaults from Greece, Portugal and Ireland sparked a "safe haven" trade into US Treasuries from May-August. In the same period, gold rose less steadily, but put in what market trading technicians call an important "base" by weeding out short-term sellers from the long-term buyers. Gold resumed its climb briskly from $1200-$1400 on inflation expectations following Bernanke's Jackson Hole speech, where he announced Fed plans for more monetary liquidity injections.

Like gold today, the 10-year Treasury has had its woes, namely a brisk selloff after the Fed embarked on its "second" round of quantitative easing last year (QE2). [By highlighting "second" I mean to dispel the idea that this was really a "second" round — the Fed engages in quantitative easing continuously through its permanent open market operations (POMO).] When inflation expectations heat up, the prospect of negative real yields prompts a selloff of lower yielding Treasuries into commodities and higher yielding equities and bonds, as evidenced by market action between September 2010-April 2011. Markets were also expecting real economic growth, but an alternate reality has since crept into market psyche.

As the European debt crisis flared again alongside US debt concerns in April-June 2011, investors chose both Treasuries and gold as "safe havens," and they have been remarkably correlated ever since. The acceleration of the trend throughout the US debt ceiling blowoff, S&P US credit downgrade and the Fed's declaration of a 2-year moratorium on zero target interest rates (ZIRP) should give observers pause. Is this a rational market or an irrational search for economic sanity?

Sunday, August 21, 2011

National Debts, Debt Monetization and Inflation

U.S. Natl Debt and Money Supply vs. CPI

This last week marked the 40th anniversary of Nixon's move to break up the international gold standard, set by the Bretton Woods Agreement among 44 nations in 1944. The move represented a post WWII culmination of a U.S. balance of payments crisis, including a run on U.S. gold reserves that would trigger an insolvency event:

"Recently the markets had panicked. Great Britain had tried to redeem $3 billion for American gold. So large were the official dollar debts in the hands of foreign authorities that America's gold stock would be insufficient to meet the swelling official demand for American gold at the convertibility price of $35 per ounce." [1]

This insolvency event was chiefly driven by the unbalanced fiscal spending of the Johnson administration (e.g. the "Great Society" welfare state and other profligate spending), Nixon's inability to deal with rising deficits, and the growing shift of the U.S. from a creditor to a debtor nation, with a trade deficit that would likewise increase in coming years.

While Bretton Woods was a flawed international monetary system in many respects - imposing currency pegs and encouraging intervention by monetary "authorities" such as the IMF - the decision to make the dollar the reserve currency backed by gold was among the positive aspects that supported the growth of the U.S. as a net creditor nation.

It is worthwhile to review what has happened since Nixon declared a fiat end to the gold standard, allowing the dollar to float. By removing the restrictions of a dollar-to-gold conversion, debt monetization by monetary authorities (in particular the Federal Reserve) could ensue without check, under pretense of the "full faith and credit" of the sovereign.

The figure at the top depicts the geometric growth of the U.S. national debt, the broad M3 money supply metric, and price inflation as represented by the original Consumer Price Index (CPI) calculated before 1984 [2,3], resulting in an 82% decline in the purchasing power of the dollar. Such national debt growth does not take into account the 'unfunded' liabilities faced by the U.S. government through Medicare, Medicaid and Social Security programs, which exceed $100T.

Keynesians and Post-Keynesians have misguidedly supported deficit financing and debt monetization to stimulate aggregate demand and to prevent deflationary or disinflationary relief during debt deleveraging cycles. When will they wake up to the damage caused by such fiscal and monetary policies, chief among them financial instabilities that occur due to the unsustainability of perilously high debt loads, the understated risks due to artificially low interest rates, and the growing lack of confidence in the dollar?

[1] "The Nixon Shock Heard 'Round the World," Lewis E. Lehrman, WSJ, August 15, 2011.
[2] Graph is taken from "Modern Monetary Madness and King George III," May 8, 2011
[3] The pre-1984 CPI is tracked by HERE.

Saturday, August 13, 2011

Vintage Greenspan and the Lessons of LTCM

"There are some who would argue that the role of the bank supervisor is to minimize or even eliminate bank failure; but this view is mistaken, in my judgment. The willingness to take risk is essential to the growth of a free market economy...[I]f all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realized." –Alan Greenspan, November 1994 [1]

In reviewing these words from "the maestro," one gets an insight into the mind of Federal Reserve (Fed) actions from 1994 to 2008, in particular the dichotomies that promoted risk-taking and investment-driven growth, yet allowed for the rise of moral hazard. In driving an environment of increasingly low interest rates through easy monetary policy, Greenspan manipulated market driven risk-reward and ignited a series of rallies and crashes in the bond and stock markets that distorted normal capital market function.

The private hedge fund Long Term Capital Management (LTCM), one of the first major casualties of the 1998 global bond and stock market swoons, had bet a near 100-to-1 leverage on a risky portfolio mix of directional trades, bond arbitrages, swaps and equity volatility shorts [2]. Though LTCM thought it was "diversified" and "hedged" according to its academic models, it was anything but, placing large bets in markets that became distorted by its very presence and dislocated when the selling started; it didn't help that instead of an early divestiture of a portion of its holdings and a decrease in leverage, LTCM doubled down, falling for the Casanova's Martingale, a betting scheme that provides an eventual win as long as there is enough capital to keep doubling the stake.

After a Fed-orchestrated bailout of LTCM by a plethora of Wall Street firms that had lent LTCM money, had been its counterparty or investment partner, a Fed official issued a telling statement that was ignored by the banking establishment, the Fed and regulators as a whole thereafter:

"LTCM appears to have received very generous credit terms even though it took an exceptional degree of risk...Counterparties obtained information from LTCM that indicated that it had securities and derivative positions that were very large relative to its capital. However, few, if any, seem to have really understood LTCM's risk profile, especially its very large positions in certain illiquid markets. Instead, they appear to have made credit decisions primarily on the basis of LTCM's past performance and the reputation of its partners. LTCM's counterparties...required little or no collateral to cover the potential for future increases in exposures from changes in market values...[and] appear to have significantly underestimated those potential future exposures. Their estimates simply did not make adequate allowance for the extreme volatility and illiquidity of financial markets that surfaced in August and September [1998]. Furthermore, they failed to take into account the potential for credit exposures to increase dramatically if LTCM had defaulted and they and other counterparties had attempted to liquidate collateral and replace derivatives contracts in amounts that in some instances would have been very large relative to the liquidity of the markets in which the transactions would have been executed. Because the counterparties did not take these risks into account, they granted LTCM huge trading lines in a variety of products, and LTCM took advantage of those lines to achieve its exceptional degree of leverage." [3]

The December 1998 testimony in [3] goes on to offer numerous recommendations on risk management and prudential oversight, and in particular on OTC derivatives. Yet this working group and its findings were largely ignored, LTCM bailed out, and the easy credit-moral hazard derby in play.

In bailing out LTCM, major Wall Street firms (Goldman, J.P. Morgan, Merrill, Chase, Salomon, Lehman, plus a number of foreign creditors) agreed to a settlement that would provide in excess of some $4B to cover LTCM's losses, in large part to cover counterparty exposure and to prevent further losses among the counterparties that lent LTCM money or invested with LTCM. On the seemingly positive side, it was the Street and not the Fed that would provide the bailout, but this is not entirely true. After LTCM's failure, the Fed embarked on a series of interest rate cuts to ease jittered markets affected by LTCM's failing positions and hit with the contagion fear of LTCM's fate. The Fed was now catering to the idea of staunching what it thought was systemic risk with monetary intervention, and thereby providing a market-wide bailout.

A decade later, Bear Stearns (LTCM's clearing broker) would experience a more massive failure fate from subsisting on repurchase agreements (repos) and additional short-term funding obtained on favorable credit terms from JPM and other lenders to double down on mortgage debt and derivatives. Bear, like LTCM, thought it was diversified and hedged, when it was anything but, and instead of reducing leverage and positions it too doubled down, especially on securitized mortgage debt (CDOs, or collateralized debt obligations) that it thought could recover in value. When Bear could not sell such illiquid CDOs in an increasingly hostile market, and when its capital positions withered along with its credit lines, Bear received a Fed-orchestrated bailout by JPM, except this time taxpayers received exposure via a $30B backstop from the Fed of increasingly toxic mortgage debt instruments.

Within 6 months, AIG would receive a direct $85B bailout (and later over $100B more) from the Fed, for much the same serial infraction of risk taking as LTCM and Bear. AIG would extend CDO insurance (in the form of credit default swaps or CDSs) to Société Générale, Goldman, Merrill, Deutsche Bank, and many other firms that invested long in the CDO market, without anywhere near the proper capital to cover losses from CDO defaults, should they occur (and they did, en masse, in tail risk fashion). Lehman, like Bear, relied on repo lines and the commercial paper markets to fund its Martingales on CDOs and off-balance-sheet entities such as structured investment vehicles (SIVs) that in turn invested in CDOs to get around regulated capital requirements. Though Lehman succumbed to bankruptcy fate instead of a Fed/Street bailout, Citigroup and Merrill would receive large infusions from the Fed and Treasury, with Merrill taken over by Bank of America.

Many financial pundits today blame the November 1999 repeal of the Glass-Steagall (G-S) Act as the cause of exploding risk taking and moral hazard stemming from systemic risk among large financial institutions. I disagree. In parsing the history of LTCM's failure (which occurred well before G-S was repealed) and the Fed's summary monetary policy response, we didn't need a repeal of G-S to set the stage for exploding risk and moral hazard. The Fed provided plenty of fuel in its cheap money policy for firms to borrow short on cheap terms and invest leveraged long in highly risky assets for their carry interest. Regulation and regulators are obviously not the panacea here. Government needs to quit rewarding moral hazard, to allow firms to fail, and to not intervene with monetary policy bailouts to markets. Financial firms will then get the idea that risk taking does indeed require prudential management and oversight. Business investors in the main who are willing to take on the calculated risks that Greenspan called "essential to the growth of a free market, capitalist economy" know, accept and manage such risks, otherwise they are out of business.

[1] "The New Risk Management Tools in Banking," Alan Greenspan, Address to the Garn Institute of Finance, University of Utah, November 20, 1994. Everyone should read this address, which contains some very persuasive arguments. The tragedy is the actual history that followed, negating Greenspan's credibility. 
[2] Two outstanding books that have documented the rise and fall of LTCM are of note: (a) "When Genius Failed," Roger Lowenstein, c.2000; (b) "Inventing Money," Nicolas Dunbar, c.2000. 
[3] Testimony of Patrick M. Parkinson, Associate Director, Division of Research and Statistics of the Federal Reserve Board, Progress report by the President's Working Group on Financial Markets, Before the Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, December 16, 1998.