Archive for September, 2008

Is it a good time to buy Australian financial stocks?

Tuesday, September 30th, 2008

By the time you read this, the global financial markets will be in mayhem, thanks to Congress’s rejection of Henry Paulson’s bailout plan. Last night, the Dow fell 777 points, the greatest one-day drop since the crash of 1987. Central banks are busy pumping hundreds of billions of dollars worth of credit into the financial system as the credit market freezes up. Stock markets around the world are plunging.

Some people reckon that this is a good opportunity to buy Australian stocks, especially financial and bank stocks, which are hardest hit. After all, the mainstream belief is that the Australian banking system is rock solid and prudently regulated. That implies that the sell-off of financial and bank stocks will be overdone and lead to opportunities for value-oriented investors.

What do we think of this idea?

The problem with this idea is that it is only half-right. This half-right idea is dangerous. Sure, it may be true that the Australian banking system is strong. But this is based on the premise that the current situation will extend into the indefinite future. This leads to the very crucial concept of Black Swans. Due to a quirk in the human mind, it is very easy for one to understand Black Swans nominally, but when it comes to decision-making, act as if one has totally lost that understanding. To understand the concept of Black Swan, we highly recommend our earlier article, Failure to understand Black Swan leads to fallacious thinking. We must stress that it is crucial that you understand the content of that article before reading the rest of this article.

Now, what’s wrong with Australian banking and financial stocks?

Well, the issue is not with their future earnings. Based on statistical probability of the past, there is no reason to doubt the forecasts of their future earnings. The more cautious analysts may even adjust their forecasts downwards to account for the expected reduction in earnings due to the credit crisis. Thus, a sell-off in banking and financial stocks may lead to their prices looking very undervalued.

This is where the fallacy such thinking begins. As we said before in Two uncertainties of valuing a business- risk & earnings,

Between earnings and risk, the latter is the most subjective of all in the business?s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness.

In other words, earnings are very much ‘visible’ and taken into account. But risks are ‘invisible’ and therefore, get ignored and overlooked. That is where the grave error lies. Risk is the playground of the unknown unknowns. The problem with such stocks is that at this stage of the credit crisis, they are particularly vulnerable to the unknown unknowns. In other words, these unknown unknowns will have a massive and colossal impact on their earnings. As we explained before in Common mistakes in failing to see economic turning points,

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Why do we say that?

A simple word answers this question: leverage.

Due to the amount of leverage (in the Australian economy, banks balance sheets and the global financial system), when the unknown unknowns pops up, earnings can go terribly, utterly, totally and massively wrong (we are running out of adjectives here). For example, as we quoted Brian Johnson in How safe are Australian banks?,

?We?re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,? he said.

The Australian economy itself is highly leveraged. As we explained before in Outlook 2008,

Currently, Australia?s total private debt is around 160% of GDP, which is at a unprecedented level even exceeding the Great Depression (when it was just 80% of GDP). Australia?s economic prosperity is financed by debt. However, it is such high levels of debt that can accentuated the inevitable bust.

As we refuted Shane Oliver in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small.

The global financial system is still highly leveraged, particularly with derivatives (see How the CDS global financial time-bomb may explode?). As we said before in Potential global economic black hole: credit default swaps (CDS),

Currently [January 2008], the CDS market is valued at around $45 trillion, which is three times the GDP of the US.

The notional value of derivatives world-wide is said to be at the range of hundred of trillions of dollars.

Australian banks are highly leveraged to a highly leveraged economy in a highly leveraged global financial system. To put it simply, there is only a razor thin margin for ‘error.’ When there’s no ‘error,’ all will be fine. But if there’s an ‘error,’ there can be a colossal bust. Please note that we are not predicting financial Armageddon. For all we know, maybe there will be no ‘error.’ But should it slips in, the last thing you would want to hold are the banking and financial stocks.

Two uncertainties of valuing a business- risk & earnings

Monday, September 29th, 2008

In our previous article, Measuring the value of an investment, we learnt about the theory and mathematics behind the valuation of a business under artificial conditions that are clearly defined. Under such conditions, we know exactly the business’s future earnings and its risk relative to government bonds. Therefore, valuing artificial businesses is easy and straightforward. But in the real world, earnings and risks are the very things that cannot be so easily and clearly defined and quantified. As we said in that article,

So far, this is the theory behind value investing. In practice, in a world of uncertainty and Black Swans, it is not possible to know the exact amount of future cash flow of any business. Also, risk is not something that we can easily quantify nicely in order to derive a value for the discount rate. That is the ?art? of investing.

Thus, we should not be under the impression that the dollar number that is produced from the valuation of a real-world business is a scientifically precise number. Rather, no matter how precise that number is, it is just an estimate. And it is far more important for that number to be accurate than for it to be precise. If you are confused with what this means, we suggest that you read our previous article, Confusion between precision & accuracy and Example of precisely inaccurate information.

First, we will discuss the earnings of a business. Stock analysts spend a lot of effort trying to divine the future cash flows of the business that they are analysing. However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates. For some, they can even be unpredictable or volatile. To be a successful investor, you will do better to avoid businesses that you find difficult to come up with accurate earnings estimates. We will explain the characteristics of businesses that favour accurate earnings estimates in future articles.

Next, we will discuss the risk of a business. The mainstream finance uses volatility of prices to define risk. As we said before in How do you define risk?,

In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is. This definition of risk arises from the fact that retail investors tend to perceive the safety of an investment in terms of how much of its value can be preserved within a given period of time.

But we see risk differently. As we explained before in Measuring the value of an investment, the risk in value investing is a relative concept. The payments of government bonds are assumed to be completely risk-free whereas the earnings of a business are not so certain. Risk relates to how secure the future earnings of a business is. To illustrate this concept, let’s suppose there are two different businesses with identical earnings estimates. One is located in a geologically stable place (e.g. Singapore) while the other is located in an earthquake prone area (e.g. Tokyo). We can say that the latter one carries more risk because its earnings can be cut due to an earthquake. Therefore, it will carry a higher discount rate.

Between earnings and risk, the latter is the most subjective of all in the business’s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness. For earnings, all we have to do is to compare earnings estimates with the actual earnings to have a gauge of the estimate’s accuracy. But you cannot do so for the discount rate. Thus, in any valuation of a business, the discount rate is the first to be fudged by analysts.

Bear that in mind when you look at analyst reports on the price targets of stocks.

Where is Paulson going to get $700 billion for his bail-out plan from?

Sunday, September 28th, 2008

There’s news of a (yet another) tentative deal for Henry Paulson’s US$700 billion bailout Plan. There is a lot of public discontent and anger over the plan. After all, why should Main Street pay for Wall Street’s stupidity and greed? What about the millions of dollars of ‘golden parachutes’ for executives? The idea of the Plan sounds good in principle, but there are a lot of unanswered questions.

First, as Congressman Ron Paul grilled Ben Bernanke, if the free market has no idea how much these dodgy assets are worth, then how on earth can the Treasury and the Fed work out their value? Ben Bernanke gave a very unconvincing answer. As we explained in How much to pay for toxic debt?, if the government is too stingy in the price it pays (so as to act in the interests of tax-payers), then the Plan will become completely pointless. It’s an either all or never situation. Half-baked measures are worse then no measures.

This leads to another question. Even if it’s possible for the authorities to work out how much these toxic stuffs are worth in due time, where on earth did they come up with the figure of $700 billion? As this article reported,

“It’s not based on any particular data point,” a Treasury spokeswoman told Tuesday. “We just wanted to choose a really large number.”

In other words, that figure was just a ‘large’ number plucked from the sky.

Next, is that ‘large’ figure, $700 billion enough? We are doubtful. Total private debt in the US is a cool $41 trillion and that does not include the many trillions of dollars of public debt. Estimates of the US public debt that includes the unfunded medicare and social security liabilities ranges between $40 to $55 trillion (see How is the US going to repay its national debt?). Therefore, $700 billion is really chicken feed. Marc Faber estimated that $5 trillion is a more realistic figure.

Then, the next question to ask is this: where on earth is the money going to come from? If the US government issues new government debt, this will increase the debt-servicing burden of the US government, which in turn means that the tax burden of the American people will have to increase. But after listening to yesterday’s McCain-Obama debate, we couldn’t believe our ears when both of them were talking about tax cuts! With a national debt so astronomically high, nationalisations, bailouts and the Plan will increase it even further. How on earth could these two presidential hopefuls talk about cutting tax?

Regardless of the wrangling due to the Plan, this fundamental fact remains: the entire nation has no means to pay for its public and private debt. It’s either debt default or crushing tax for their current and future generations. If both outcomes are out of the question, then there’s only one way left. As we said before in Bush?s mortgage relief plan- who pays? back in December last year,

Bush could tax the American people to pay for his plan. But this will be politically impossible because in a democracy, the mob always want something for nothing. The next best alternative will be through stealth tax- ?printing? of money (see How to secretly rob the people with monetary inflation?). This way, the American people will pay through price inflation. That is, they will pay through the further loss of their dollar?s purchasing power.

Do you think the US will eventually resort to the monetary printing press?

Interviewing Steve Keen for the upcoming property forum debate

Thursday, September 25th, 2008

In Upcoming forum debate: ?Property 2009: Crash, Boom or Stagnate?!?, we announced that for the upcoming property debate on 15 October 2008, we will be “inviting the various high-profile experts to this debate.”

Today, we would like to announce that Associate Professor of Economics and Finance from the University of Western Sydney, Dr. Steve Keen, will be one of the special guests in this forum debate. For those who have yet to know about him, we have conducted a short interview with him:


What are you currently doing in your line of work?
Currently, I’m revising a paper on how money is endogenously created by the financial system for the journal Physica A- the journal of interdisciplinary physics, where the so called “econophysics” school has evolved.

Once that’s done, I will start work on my magnum opus “Finance and Economic Breakdown”, a book-length development of Hyman Minsky’s “financial instability hypothesis” which will be published by Edward Elgar Publishers.

So, can you share a bit about your life journey that brings you to what you are currently doing?
I began as a believer in conventional neoclassical economics while doing my undergraduate degree and then had my confidence in this theory shattered by exposure to Lancaster’s “theory of the second best” in my first year at Sydney University. This theory, which shows that a move closer to the neoclassical nirvana of competitive markets everywhere may actually reduce welfare, made me aware of the theory’s fragility and I then embarked on my own learning odessey to work out why.

In the process I started the Political Economy movement at Sydney University.

After my student days I worked as an overseas aid education officer, a computer programmer, computer journalist, conference organiser, and then finally was employed by one of the Accord bodies under the Hawke Government. The way the Accord was hijacked by conventional economists within Treasury and the bureaucracy in general convinced me that I had to return to academia and take this nonsense theory on on its home turf.

That led to the publication of Debunking Economics, which was commercially successful, and made me a prominent member of the non-orthodox fringe of the economics profession.

It has been noted that your viewpoints on economics are very much different from the mainstream economics. In a nutshell, can you explain how and why they are different?
I reject the equilibrium modelling that dominates conventional economic analysis, and since I did mathematics as an undergrad and postgrad student, I knew how to apply nonlinear dynamic modelling methods to economics–basically using Differential Equations and Systems Theory. I also use Hyman Minsky’s “Financial Instability Hypothesis” as my fundamental model, supplemented with lashings of Schumpeter and a unconventional reading of Marx.

What is your stand on the current state of Australia’s debt levels?
We have reached a level of excess that is historically unprecedented–literally twice the level (compared to GDP) that caused the Great Depression. I have zero confidence in our ability to avoid a serious downturn as the great de-leveraging begins.


We will have another special guest for this forum debate. We will reveal who he/she is next week. Keep in tune!

Property 2009: Crash, Boom or Stagnate?!

Bernankeism and hyper-inflation

Wednesday, September 24th, 2008

Today, we will shed another light for our readers in this highly polarising inflation/deflation debate. Since this debate is highly divisive and polarising, there is little wonder that many of our readers are very confused. This article can be seen as a continuation of:

We will assume that you have read and understood the content of these articles. Also, the source of today’s article comes from here at one of Marc Faber’s Gloom, Boom, Doom reports. That article was “originally given as a talk at the Burton S. Blumert conference on Gold, Freedom, and Peace, a benefit for” Lew Rockwell is the former congressional chief of staff to Ron Paul and founder and president of the Ludwig von Mises Institute (an institute of the Austrian School of economic thought).

First, as we quoted Ben Bernanke in Peering into the soul of Ben Bernanke,

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

This speech gave Ben Bernake the nickname of “Helicopter Ben.” He is a student of the Great Depression and is convinced that deflation must be prevented at all cost. Particularly, he is obsessed with something known as the “zero bound problem.” Japan is a case in point for this zero bound problem. As we all know, Japan infamously cut its interest rates to zero in the 1990s and yet, still failed to win the war against deflation. As we explained before in What makes monetary policy ?loose? or ?tight??,

… remember that the central bank cannot control the demand for money and credit. It can supply whatever amount of them that it wants, but it cannot force business and people to desire them. Put it simply, you can lead a horse to the water, but you cannot force it to drink.

When deflation forces interest rates to be zero, that is the point when monetary policy becomes totally impotent in inflating. Therefore, Bernanke will want to avoid this zero-bound problem by making darn sure that inflation will happen.

But the question is how? The case of Japan showed that it is impossible. In that sense, the deflation argument is right. In the current credit crisis in the US, it is impossible to win the war against deflation.

Well, it is impossible unless unconventional means are used. The word “conventional measures” appeared prominently in much of the Fed’s discussion. According to Bernankeism, when the

… powers of a central bank are limited to “conventional measures,” the central bank may not be able to prevent deflation, nor to fight it once it has taken hold. In the Fed’s view, Japan tried conventional inflation measures to their utmost.

What are the unconventional measures that Bernanke advocated? If you read the Fed’s papers and speeches, you will find a series of “increasingly exotic plans,” from the “merely unsound to the bizarre and terrifying.” For your information, these are not something we invented from our imaginations- they are available in the public domain at the Fed’s web site. The list of references can be found here. Below are the unconventional measures:

  1. Expand the menu of assets that the Fed could purchase through its open-market operations. This measure is already implemented- see New tricks required to bail out financial system.
  2. Purchase of long-term US Treasury bonds.
  3. Writing interest rate option contracts.
  4. Purchase foreign exchange reserves in order to devalue the US dollar.
  5. Loan money into existence, accepting as collateral almost any private-sector asset whatever.

So far, the above measures depend on the willingness of borrowers to borrow the cheap money that the Fed prints. What if the private sector refuses to borrow? Well, no worries! The Fed will print and distribute the money (note: this quote is straight from the Fed’s mouth):

One tool commonly attributed to the Federal Reserve, at least in theory if not by the Federal Reserve Act, is that of conducting ?money rains?.

Money rains are a clean way to study theoretically the effects of increases in the supply of money. In practice, it seems a bit difficult to envision how the Federal Reserve could literally implement a money rain ? that is, give money away either through directly disbursing currency to the public or by disbursing it through the banking system. The political difficulties that are likely to arise from the Federal Reserve determining the distribution of this new wealth would be daunting.

Now, what if the Fed prints and distributes but the people are unwilling to spend? Well, the “next weapon in their arsenal is to make money pay a negative rate of interest.” While that sounds difficult, the Fed has actually written a paper to explain how they are going to do that:

The strategy for eliminating the zero bound, therefore, is to make money pay a negative nominal interest rate, by imposing some type of ?carry tax? on currency and deposits

The technological difficulty lies mainly in imposing such a tax on currency. In the 1930s, Irving Fisher of Yale University, one of the greatest [sic] American economists, proposed such a system, in which currency had to be periodically ?stamped?, for a fee, in order to retain its status as legal tender. The stamp fee could be calibrated to generate any negative nominal interest rate that the central bank desired.

What if this still fails to inflate? There is another weapon- the direct monetisation of goods and services (note: this quote is straight from the Fed’s mouth):

Why not have the Fed just conduct an open market purchase of real goods and services? Even more so than exchange rate intervention, this strategy would represent a direct stimulus to aggregate demand.

These unconventional measures are “absurd, bizarre, and preposterous monetary crank schemes ever proposed by anyone calling themselves an economist.” Some of them are even downright illegal! But is illegality an obstacle? As we said before in Recipe for hyperinflation,

Therefore, watch what the US government is doing with the monetary ?rules? in its attempt to fight deflation.

Now, as you are reading this, you may find it incredulous to see these crazy ideas mentioned by Ben Bernanke and his accomplices. Are we making them up? No, you can download this article here and check out the list of references at page 11. They are all straight from Ben Bernanke/Fed’s mouth (or pen).

The question is, are they really crazy enough to do it?

When ‘cash’ becomes confetti, inflation/deflation becomes irrelevant

Tuesday, September 23rd, 2008

The financial and economic events of this month is amazing and history will one day judge September 2008 as one of the major turning points.
Today, if you follow the inflation/deflation debate on the Internet forums, blogsphere, etc, you will find this issue to be a highly divisive, polarising and at times, rather emotional debate. No wonder it is a highly confusing time for investors and traders.

For investors, it will be a big mistake to take sides in this debate. You may have certain inclination towards one or the other side of the fence, but do not dig in and get permanently committed to an opinion/idea. From our observations, some people have become too religious and emotionally involved to one side of the debate. They have become so religious that whoever belongs to the other side is regarded as an infidel. Such loss of objectivity will cloud your judgement.

First, for our newer readers, please take a read at What is inflation and deflation? for our definitions of inflation or deflation. They are not the mainstream idea of price rise/falls.

So, will hyper-inflation or severe deflation be the endgame of this financial crisis?

We don’t know which one will be. But our guess is that it is probably the former. But that does not mean we are loyally committed to that position and bet our entire life and wealth on that. After all, life is more subtle than that either black or white. Because we cannot know with certainty what the future will hold until time has passed, it becomes a game of probability for the present.

Now, take a read at Understanding the big picture in the inflation-deflation debate,

So, the world?s fiat money system works under the ?mechanism? of credit. Because money has to be returned, it acts, in theory, as a check against abuse and rampant monetary inflation.

The fact that the global financial system is facing acute deflation threat shows that this credit-system ?mechanism? is working to protect the integrity of fiat money!

At the root of the deflation argument is the fact that we live in a credit-based economy. As long as this credit-based system is in place, any inflationary bubble will be ultimately deflationary. Please note that the word “ultimately” in the previous sentence is bold. The word, “ultimately,” is a very important qualifier. This implies that before the ‘ultimate’ deflation, we can have inflation in the interim.

So, to illustrate the point of this qualifier, let us conduct a thought experiment. For the purpose of argument, let’s assume that the credit mechanism is firmly in place.

Say, the US nationalisation of its financial sector transfers most of these toxic private sector debt into the public debt. Given that the US government already has a huge amount of debt, this means they have to raise even more debt. The only way for the US government to issue more debt is to issue government bonds, which is still borrowed money that has to be returned. We can see why this is still ultimately deflationary because no matter how much the US government borrows, it has to return them eventually (e.g. by raising taxes).

Now, let?s take a step further and say that the US government monetises its debt by selling the newly issued government bonds to the Federal Reserve. That?s in effect printing of money. Even then, some will argue it is still ultimately deflationary because it is still credit i.e. the government has to eventually buy back the bond from Federal Reserve.

Let?s take a step even further. Let?s say the government pays off that expired monetised debt by monetising even more debt. That?s like an individual borrowing from one credit card to pay off another credit card. Imagine what will happen if the government do that! Its debt will grow exponentially, which is hyper-inflationary. Still, it can be argued that it is still ultimately deflationary because all these government debt has to be returned.

At this point, let’s pause and think.

In such hyper-inflationary environment, it’s doubtful whether people will see government legal tender ‘cash’ as money any more. In Zimbabwe, during an auction of a car, ‘cash’ no longer function as money. Instead, petrol vouchers (denominated in litres of petrol) were used as a unit of account for the bids. In Vietnam, the recent high inflation of the Vietnamese currency leads to some instances whereby people no longer uses legal tender ‘cash’ as money in buying/selling land.

The point we are trying to make is that by the time the situation becomes that bad, all talks about inflation or deflation is irrelevant because, ‘cash’ no longer function as money for practical purposes. They become as good as confetti. Who cares about the inflation or deflation in the supply of confetti?

Please note that the purpose of this article is not to make an inflation/deflation forecasts in the prediction sense. Its purpose is to show you how dragging an idea to the extreme can lead to erroneous thinking. In this example, while it is true that deflation will ultimately happen theoretically in the context of a credit-based system, it is pragmatically irrelevant.

How much to pay for toxic debt?

Monday, September 22nd, 2008

Now that Henry Paulson has already announced of a plan to bail out the US financial system with a US$700 billion (to $1 trillion) slush fund, the next devil is the detail. In this plan, the US government will buy up unwanted toxic debts from financial institutions and then sell them to the market quietly in a few years time. Because these toxic debts are unwanted, no one wants to buy them and hence, their value are priced laughingly low. As a result, the solvency of these financial institutions are threatened.

The first problem is, how much should the US government pay for these toxic debts?

First, let’s refer to the hypothetically simplified bank balance sheet in our earlier article, Effect of write-down on bank balance sheet. As you can see from that article, depending on how highly leverage the bank is, even a small write-down means that it has to either raise that amount in the equity market or sell a lot of its remaining assets to keep itself within the right side of banking regulations.

What if the the government pays a price that is better than laughingly low but still quite a distance from the book value? Banks will still have to write down the value of its asset. Then it has to raise money to patch up that hole. Given that the credit market is quite frozen up, this is quite unlikely. Therefore, its only other choice will be to sell its other surviving assets.

What if other banks are in the same predicament? Then there will be mass selling in the markets, which will then depress prices of assets even further, which then… it’s depressing to repeat the vicious cycle here.

The basic idea is that banks will still fail anyway if the US government is not generous enough in opening its wallet to pay for junk assets. Our feeling is that $700 billion may turn out to be too conservative an estimate. The government may end up spending more money than it intends to.

Is this the beginning of the loss of confidence in fiat money?

Sunday, September 21st, 2008

Events from the past week are tumultuous. It started from the nationalisation of Freddie and Fannie (we were mulling about the implication of nationalisation 2 months ago in How do we all pay for the bailout of Fannie Mae and Freddie Mac?). Then came the bankruptcy of Lehman Brothers and takeover of Merrill Lynch. Then we have the nationalisation of AIG. Gold prices surged by more than US$100 in two days (it had declined since), which was the most rapid surge in 26 years. At the same time, the Dow plunged by more than 400 points. It looked as if there was a panic from stocks straight to gold, which meant even cash was distrusted.

Then we have another massive rally in stocks for the past two days when there was hope that the US government, in conjunction with the Federal Reserve are doing something to solve the root of the rot in the financial system. Reports come out that they are planning to use taxpayers’ money to buy up bad assets at sale price. As always the case, the devil is in the details. At this point in time, there is no definitive figure on the cost. Make no mistake about this: this is no trivial task. As this New York Times article reported, Ben Bernanke warned the Congressional leaders,

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program ?Good Morning America,? the congressional leaders were told ?that we?re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.?

Mr. Schumer added, ?History was sort of hanging over it, like this was a moment.?

When Mr. Schumer described the meeting as ?somber,? Mr. Dodd cut in. ?Somber doesn?t begin to justify the words,? he said. ?We have never heard language like this.?

By now, it should be clear that this global financial disaster has the potential of even surpassing the Great Depression of the 1930s!

Is this crisis a surprise? If you listen to the mainstream economic schools of thought, central bankers, mainstream financial media, captains of the financial industry and so on, it looked as if this looming financial disaster is something that no one can see coming. The common underlying excuse (that was un-said, un-written but implied) goes something like this: “No one could ever foresee this! It’s impossible! Only hindsight can tell!”

Now, we would like to make it clear that this is completely false. Please note that we are not accusing individuals of lying. Instead, our point is that this excuse is a sign of collective mass delusion. If you look at the 6000 years worth of the history of human civilisation, you will find that humanity is repeatedly capable of mass delusions. Always, only the minority could see through the lie. In this case, students and practitioners of the non-mainstream Austrian School of economic thought SAW IT COMING. Some of them sounded the alarm as early as 2004! To press our point further, let’s us show you the chronicle of our warnings in this blog since 2006…

  1. In May 2008, when the world was in denial about the precarious state of the global financial system, Satyajit Das warned that the credit crisis was just the end of the beginning (see Is the credit crisis the end of the beginning?).
  2. Back in November 2007, if you look at the list of major US financial institutions that was compiled by Nouriel Roubini at How solvent are some of the major US financial institutions?, only half of them are left standing. Interestingly, Merrill Lynch was the safest among the insolvents and today, it failed to live. If Merrill Lynch was insolvent, what about the remaining ones today (i.e. Goldman Sachs, Morgan Stanley, Citigroup)?
  3. In June 2007, in Epic, unprecedented inflation, we warned that

    How much longer will the roaring global economy fly? We do not know the answer, for this boom may last longer than what we anticipated. However, please note that in the entire history of humanity, all bubbles (and we repeat, ALL) burst in the end. Thus, a global painful hangover will ensue?the greater the boom, the more painful the eventual bust. This is the theme that we had repeated many times.

    Thus, do not be surprised if a second Great Depression were to strike.

  4. In the same month, the Bank for International Settlements (BIS) warned that the world was in danger of another Great Depression (see Bank for International Settlements warns of another Great Depression).
  5. Back in January 2007, in Spectre of deflation, we wrote that

    But we smell danger.

    It is a danger in which many in the finance industry failed to fully appreciate?deflation. Such complacency is beyond our belief. In the 1990s, Japan experienced it, with dire consequences for their economy. At least, the ordinary Japanese had their savings to fall back on. For many Americans, with their negative savings rate, what can they fall back on? Have they not learned from the mistakes of others in the past?

  6. In the same month, Trichet, the president of EU central bank warned of a coming asset re-pricing (see Prepare for asset repricing, warns Trichet).
  7. Back in November 2006, in How will asset-driven ?growth? eventually harm the economy?, when the global economy was still booming in apparent ‘prosperity’, we quoted the late Ludwig von Mises (the in which the Mises Institute of the libertarian Austrian School of economic thought is named after) and warned that

    That collective error in judgement resulted in the economy misallocating scarce resources into housing sector?in the case of the US, a significant proportion of the jobs created during the asset-driven ?growth? was related (both directly and indirectly) to the housing boom. Since economic resources are always scarce, any misallocation of it implies an opportunity cost on the other sectors of the economy. The result is a structural damage to the economy that can only be corrected through a recession.

    This is the reason why we believe a recession is on its way.

  8. In October 2006, we quoted the late Dr. Kurt Richebächer (an Austrian School economist) and questioned in The Bubble Economy,
  9. These are some of the serious questions we would like to ask:

    1. As the US spends its way into economic ruin, its economy is being damaged structurally. How much longer can the US sustain its colossal debt?
    2. Right now, the US housing bubble is deflating. Will it eventually burst and wreck havoc on the rest of the economy?

Other contrarians who sounded the alarm long ago (and we quoted often) include Marc Faber, Jimmy Rogers, Robert Shiller, Peter Bernstein, Nouriel Roubini and our local Aussie economist, Professor Steve Keen.

Our readers should, by now, appreciate the colossal magnitude of this financial crisis. When you listen the media, the phrase “since the Great Depression” is often mentioned. Make no mistake about this, this has the potential to be worse than the Great Depression (note: we are NOT predicting that it will happen).

The world’s stock market is rallying in the hope that the US government’s plan to nationalise the financial industry will be successful in stopping the core of the rot. New legislations has to be rushed through Congress by the end of next week to change the rules to make the plan legal. As in everything done in haste, we believe there will not be enough thought put into them to understand the long-term ramifications. It is probable that once the changes are in place, they will not be revisited again.

As we warned in Recipe for hyperinflation,

There is no way any politician can sell the message that America needs a severe recession (or even a depression) to cleanse the economy from the gross excesses, imbalances, blunders and mal-investments. Thus, it is very likely that they will have to fight deflation till the very bitter end, till the last drop of blood from their last soldier. Since the current structure of ?rules? will be too restrictive in such a war against deflation, there will be popular momentum towards the bending and rolling back of these ?rules.? If they press on relentlessly till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilisation.

What’s happening to Australian bank’s trust with each other?

Thursday, September 18th, 2008

One of our readers asked in Chained together, for better for worse,

Could you please find out what happened with the interbank lending spread lately? I heard of reports that the overnight LIBOR rate has spiked 100% just 2 days ago. How would this affect the funding cost of banks in Australia? Do you think banks would increase their mortgage/credit rate again after putting them down recently?

In Australia, banks’ lack of trust for each other has risen to almost the same level as in March 2008, just before the bailout of Bear Stearns. One good measure of the level of distrust is the difference between 3-month bank-bill rate and the overnight indexed swap rate. Today, the difference stood at 0.7783%.

Let us take a look at the 1-month and 3-month bank bill rate over the past year:

Australian 1-month & 3-month bank bill rate

As you can see, the bank bill rate was at the highest in March 2008. It remained relatively high until August, when there is a sharp drop. It dropped because the market was anticipating a cut in interest rate by the RBA, which finally happened. Then in the final few days, there is a sharp rise, thanks to the collapse of Lehman Brothers and the bailout of AIG (see Test for credit default swaps (CDS) begins…).

What does this imply for Australian mortgage/credit rate? Well, if banks are already not willing to lower their mortgage rate (see Why are Australian banks not willing to lower mortgage rates?), then this will make them even less willing to do so. That’s why the RBA is busy pumping billions of dollars of liquidity into the financial system.

Chained together, for better for worse

Wednesday, September 17th, 2008

As the drama unfolds in Wall Street over the past week, you may wonder what the big deal is. So what if Lehamn Brothers collapses? So what if AIG and Washinton Mutual go down the grave too. Why are the financial markets, central bankers and governments all over the world so jumpy about all these failures?

One word to explain it: contagion.

As we explained back in Financial system?messy, tangled ball of yarn,

All these ?wonders? of the modern financial system, namely debt and derivatives, enabled the creation of a complex tangled mess of linkages between participants (e.g. financial institutions, funds, investors, banks, etc). The former (debt) allows the use of leverage while the latter (derivatives) allows risks to be transferred like a hot potato from one hand to the other. That sounds good, does it? But what if the derivative that you used to hedge your risks become useless because the counter-party of that derivative could not honour its obligation? In that case, you may not be able to honour your obligation against another party. Imagine repeating this scenario countless times over, forming a yarn of complex entanglements. What if a small section of the yarn catches fire? What will happen to the yarn as a whole?

To give you a more concrete idea of what’s going on in the financial system, consider this hypothetical scenario from this excellent article, The Ultimate Wall Street Nightmare:

Here’s the great dilemma: The tangled web of bets and debts linking each of these giant players to the other is so complex and so difficult to unravel, it may be impossible for the Fed to protect the financial system from paralysis if just one major player defaults. And if Lehman is not that player, the next one will be.

To understand why, put yourself in the shoes of a senior derivatives trader at a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital).

Let’s say you’re personally responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline.

By itself, that would be a huge risk. But you’re not worried because you have a similar bet with Bank B that interest rates will go up.

It’s like playing roulette, betting on both black and red at the same time. One bet cancels the other, and you figure you can’t lose.
Here’s what happens next …

  • Interest rates go up, reflecting a 2% decline in bond prices.
  • You lose your bet with Bank A.
  • But, simultaneously, you win your bet with Bank B.
    So, in normal circumstances, you’d just take the winnings from one to pay off the losses with the other ? a non-event.

But here’s where the whole scheme blows up and the drama begins: Bank B suffers large mortgage-related losses. It runs out of capital. It can’t raise additional capital from investors. So it can’t pay off its bet. Suddenly and unexpectedly …

You’re on the hook for your losing bet.
But you can’t collect on your winning bet.

You grab a calculator to estimate the damage. But you don’t need one ? 2% of $500 billion is $10 billion. Simple.

Bottom line: In what appeared to be an everyday, supposedly “normal” set of transactions … in a market that has moved by a meager 2% … you’ve just suffered a loss of ten billion dollars, wiping out all of your firm’s capital. Now, you can’t pay off your bet with Bank A ? or any other losing bet, for that matter.

Bank A, thrown into a similar predicament, defaults on its bets with Bank C, which, in turn, defaults on bets with Bank D. Bank D has bets with you as well … it defaults on every single one … and it throws your firm even deeper into
the hole.

During the 2nd century AD, just before the official end of the Han Dynasty, China was broken up into warlord’s fiefdoms. One warlord, Cao Cao, was amassing a large navy to defeat the combined forces of Liu Bei and Sun Quan. Cao Cao, used a misguided strategy to protect his navy from being scattered by chaining the ships together. His enemies launched an incendiary attack. Because his ships were chained together, fire spread from one ship to another and none of them could scatter to escape. The result: a massive defeat that paved the way for China to be split into 3 kingdoms.

This is the same for today’s financial system. They are chained together by derivatives.