Global Markets: An Advent to the Minsky Moment and the Kindleberger Paradigm?

``The object lesson is that whatever convincing arguments politicians may advance to justify yet another piece of draconian legislation, you can be certain that the authorities will misuse and abuse it for totally different and repressive purposes.”-Martin Spring, analyst

Well if you think the equity markets are simply undergoing a normal corrective phase then think again.

Figure 1, tell us that in spite the previous collective central bank actions to mitigate the emergent strains of financial stress, we are seeing these developments spread to almost the entire spectrum of the financial market universe.

Figure 1: The Problem Looks like System-wide Deleveraging

This has not been solely confined to the subprime space as we also now see a massive unwinding in the Carry Trade phenomenon, where as the Japanese Yen breaks out massively from its resistance level (horizontal line) seen in the main window, as the Australian Dollar, seen in the upper pane, a key beneficiary of the carry trade, collapses. The Australian Central Bank had to even intervene to shore up its currency last week!

Coincidentally as the Japanese Yen spiked way beyond its key resistance level, we also note that the JP Emerging Markets Debt fund (upper window below center) or an index of sovereign bonds from emerging markets have simultaneously accelerated its declines, alongside the Dow Jones World Index (lowest panel). The vertical line underscores the timeline of seemingly synchronous activities.

So what appears to be a synchronized deterioration in market action from corporate bonds to sovereign bonds, to money market instruments to derivative markets to the currency markets seems symptomatic of a financial system wide phenomenon called “DELEVERAGING”.

Christopher Wood, a respected strategist at Credit Lyonnais Securities Asia who recently scoffed at the interventionist activities of global central banks made a piquant remark which I quote (highlight mine), ``The grim analogy that most resembles securitisation run amok is a body ravaged by a spreading cancer”.

The clear and present danger is the vulnerability of today’s Fiat Based Currency system to inflationary abuse, fraud and to excessive leveraging and speculation, which American Economist and the Father of Financial Instability, Hyman Minsky described as the Ponzi Finance model, (we touched on this, see March 5 to March, US Markets: Risks of Ponzi and Speculative Finance).

Minsky’s model actually basically depicts of the credit cycle underpinning the business cycle, where credit transforms from a function of HEDGE financing (ability to pay principal and interest) to SPECULATIVE financing (ability to pay interest only, which needs a liquid market to enable refinancing and debt rollovers) and finally to PONZI Financing (basic operations cannot service both interest and principal and strictly relies on rising asset prices to service outstanding liabilities).

Minsky’s model likewise accompanies the loosening of credit standards by lenders, intermediaries and regulators as a consequence of a boom, aside from financial engineering that allows for more credit creation and intermediation.

Mr. Martin Wolf of the Financial Times has a fitting boom-bust cycle interpretation of the Minsky model (highlight mine),

``The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with “displacement”, some event that changes people’s perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.

``The fourth stage is over-trading, when markets depend on a fresh supply of “greater fools”. The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry “bubble” are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.

Essentially the culmination of the Minsky Model is the ensuing COLLAPSE of the Ponzi finance system, prompted by the drying up of credit even to creditworthy borrowers and a Panic. George Magnus of UBS once coined this as the “Minsky Moment”. In other words, the house of cards built upon by too much credit fundamentally falls under its own weight and the repercussions constitute a massive selloff to pay down obligations which results to a system wide panic. Some of signs these we are indeed seeing today.

The important question facing us investors is that “are we facing the crossroads of the Minsky Moment”? Will the present actions by global central banks be sufficient enough to mitigate the unraveling of current highly leveraged conditions?

Another of our favorite independent analyst, the once bullish BCA Research has manifested a whiff of alarm in their latest outlook as shown in Figure 2.

Figure 2: BCA: FED Rate Cuts Imminent?

This from BCA Research (emphasis mine), ``Illiquidity has spread beyond subprime-related markets. Banks are wary about lending each other money. Speculative-grade corporate bond issuance has ground to a halt and the asset-backed commercial paper market has seized up, even for high-quality investors. It is when even high quality borrowers lose access to capital markets that alarm bells ring for central bankers. Our financial stress indexes are higher than they were in 1998. True, policymakers do not wish to be seen as bailing out poor investments. Nonetheless, in the end they have no choice if credit markets begin to freeze. Bottom line: unless market liquidity improves in the coming days, the Fed probably will provide an inter-meeting rate cut. The Bank of Canada will likely follow suit, given similar financial strains. The ECB will likely wait to see if Fed action calms the markets.”

So interim reactions by the global financial market will essentially determine the chain of responses from global monetary authorities, if today’s purported measures of elixir don’t work.

To further illuminate on the anatomy of a crisis, we’d like to quote Charles P. Kindleberger on his 1976 book Manias, Panics and Crashes anent the “ONSET of a CRISIS” p.92 (highlight mine),

``Causa Remota of the crisis is speculation and extended credit; causa proxima is some incident that snaps the confidence of the system, makes people think of the dangers of failure and leads them to move from commodities, stocks, real estate, bills of exchange, promissory notes, foreign exchange-whatever it may be-back into cash. In itself, causa proxima may be trivial: a bankruptcy, a suicide, a flight, a revelation, a refusal of credit to some borrower, some change of views that leads to a significant actor to unload. Prices fall. Expectations are reversed. The movement picks up speed. To the extent that speculators are leveraged with borrowed money, the decline in prices leads to further calls on them for margin or cash and to further liquidation. As prices fall further, bank loans sour, and one or more mercantile houses, banks discount houses, or brokerages fail. The credit system itself is shaky, and the race for liquidity is on.”

Doctors diagnose the ailments of their patients based on exhibited symptoms. The patterns seen in the Kindleberger Crisis paradigm and the Minsky Model uncannily parallel a brewing crisis at hand. Could it be a full blown financial crisis? We don’t know and we hope not. Yet we are uncertain if this juncture will simply just breeze over.

Some institutions think that we are at the levels of maximum “uncertainty” and advocate the Rothschild maxim of “buying when there’s blood on the street”. We doubt so.

In determining whether it would be the propitious time to invest, there is supposedly the distinction between risk and uncertainty from which we may consider when evaluating. To borrow from economist Frank Knight’s (Risk, Uncertainty and Profits) definition, which we will quote economist Nouriel Roubini in his blog (highlight mine), ``In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”…Risk can be measured and priced because it depends on known distributions of events to which investors can assign probabilities. Uncertainty cannot be priced by markets because it relates to “fat tail” distributions and extreme events that cannot be easily predicted or measured.”

Learning from the recent events, the initial stand by the mainstream market participants was TO DISMISS the contagion risks from the US mortgage crisis citing its limited share to the overall markets and as share to the GDP. Suddenly, the credit spigot seemed to have been turned off, where from one markets to another, global financial markets essentially felt the tremors escalate, sold off steeply and then central banks stepped in with liquidity injections and NOW the FED’s discount rate cuts.

In other words, what was initially viewed as a “contained” problem turned out FAR from mainstream expectations. Markets reacted way beyond what participants expected. Many got hurt and this has YET TO SHOW. Consequently, the financial industry beseeched to be bailed out and appears to have gotten what they wished for. Question is, has the present bailout been adequate?

Given the huge underestimation by Wall Street, and given the embryonic symptoms of a financial crisis, these represent the prospects of an “incalculable outcome” or “uncertainty” in the Knightian terminology. Remember, financial crisis have far reaching effects. Take the impact to the Phisix in 1997 as shown in Figure 3.

Figure 3: Asian Financial Crisis: Phisix lost 70%

The Phisix in 1997 to 1998 REACTED VIOLENTLY to the Asian Financial Crisis. In over one year and a half, the Phisix fell by nearly 70% from 3,400 to 1,076. As you can see the overall trend was DOWN but had a couple of bull traps in between the general trend. This is where “knife catchers or bottom pickers” thought they had “timed” the market’s bottom when they actually were false dawns. One can just feel the pain of miscalculation.

We don’t know if another crisis would occur. We sincerely hope it does not. The point is, when we are faced with a LIMITED upside relative to the risk prospects with an immeasurable downside or earning opportunities is limited relative to greater opportunities for losses, we simply don’t take the trade.

While we can’t control what happens to the financial markets or economies, we have CONTROL over our portfolios.

We don’t mind buying higher for as long as the “uncertainty” prospects abate. So far this hasn’t been the case.