Posts Tagged ‘Lehman Brothers’

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 Richeb├Ącher (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.

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.

Test for credit default swaps (CDS) begins…

Monday, September 15th, 2008

We are supposed to continue from yesterday’s article, What is the meaning of ?oversold?? Part 1: Technical analysis perspective, today. But the latest news on the financial markets takes precedence over the continuation of yesterday’s article.

As you will probably have heard by now, Lehman Brothers, one of the biggest investment banks in the United States has just gone bankrupt. Its peer, Merrill Lynch was bought over by Bank of America at a fire-sale price. Central bankers all over the world are bracing for vicious reactions from the financial markets. In Australia, the RBA had already injected extra liquidity into the financial system (see Reserve Bank injects extra liquidity). The Federal Reserve is intending to already made preparation for accepting stocks as collaterals for loans, as this news article says,

One of the biggest changes the Fed made was to accept equities as collateral for cash loans at one of its special credit facilities, the first time that the Fed has done so in its nearly 95-year history.

As we said before in Central banks and pawnshops,

Traditionally, the Fed would only accept the highest quality assets, US Treasury bonds, as collaterals. But due to the credit crisis, the Fed (along with other nations? central banks- see Reserve Bank of Australia entering the landlord business) is lowering the standards of collaterals to include top-rated residential and commercial mortgages. The Fed?s most recent statement indicates that they are lowering the standards even more (to auto loan and credit-card bonds). Using the pawnshop example, it?s like the pawnshop lowering the standard of the pawns that it will accept, say from gold jewellery to silver jewellery.

By accepting equities as collaterals, the Fed is lowering their standards even more. The central banks may be preparing and bracing for devastating fallout in the debt and equity market, but the question still remains: will the derivatives markets able to stand in the coming test? As we quoted Satyajit Das in How the CDS global financial time-bomb may explode?,

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

This introduces systemic problems to the financial markets that have yet to be tested. Here are the technical difficulties with CDS:

  1. Who problem– As we explained before in Potential global economic black hole: credit default swaps (CDS), CDS is like insurance against default by a specific entity. Let’s call this entity the reference entity. The problem is, modern companies work through a complex web of entities mainly for tax reasons. What if the reference entity in the CDS does not match exactly with the defaulting entity? Furthermore, what if there is a restructuring, merger, de-merger, sale of divisions, break-ups takeover, etc. The definition of the reference entity becomes murky.
  2. What problem– What events constitutes a “credit” event? The common ones are (1) failure to pay, (2) bankruptcy, (3) repudiation or moratorium, (4) restructuring. But sometimes in real life, “credit” event may not be that straightforward. Restructuring may follow further restructuring, followed by even more… Different countries may have different laws regarding the form, definition and handling of bankruptcy that is at odds with local laws, which in turn put the CDS contract into a conundrum of definitions. As we quoted Satyajit Das in Potential global economic black hole: credit default swaps (CDS),

    The buyer of protection is not protected against ?all? defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan…

    A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract.

    Imagine the economic mayhem it will create as companies push and jostle each other into bankruptcy at the slightest excuse to protect their own cash flow!

  3. How problem– How do you get paid the insurance payment in a CDS contract? Should you rely on publicly available information and use it as a basis to get paid? What if the reference entity makes a partial payment and then the news wire reported that it defaulted when it is going to pay the rest later?

By now, you can see how the idea of CDS can be mired into complex legal entanglements. This will have systemic ramifications for the financial markets. We will be holding our breath to see how the drama will unfold in the weeks and months to come.