US Markets: Risks of Ponzi and Speculative Finance

``Liquidity is the hocus pocus of the investment world. It means totally different things to different people but is often cited as being a major driver for buoyant markets".-Albert Edwards "Lies, rhubarb, poppycock, bilge, utter nonsense, caravans and liquidity", Dresdner Kleinwort Global Strategy Report

One could always argue to say that since the Phisix has been inspired by global markets, particularly the US benchmark Dow Jones Industrials, wouldn’t it be more practical to compare the directional path of the Phisix to its developed market counterparts? Let’s see.

First, speaking of risks, I’d like to first borrow PIMCO’s Paul McCulley quote of the Hyman Minsky, the father of the Financial Instability Hypothesis, where the transitory structure of the credit markets shifts from one marked by stability to another which eventually destabilizes. The Financial Instability Hypothesis was first articulated in 1974 but published in 1991, whose excerpt is quite academic yet I think presents as the real menace to today’s finance-driven economies (emphasis mine)...

``Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to ‘roll over’ their liabilities – issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.

``It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

``In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values.”

Evidence shows that “Modern Finance” has been underpinned by such transformations into the above “speculative finance” and “ponzi” spheres, such as the proliferation of “structured finance”, derivatives, and other innovative financial products.

Some hedge funds are even said to have employed by as much as 50 times leverage relative to its capital, where a 2% decline in the securities invested would effectively translate to complete or 100% capital loss! In other words, the ocean of credit creation and intermediation has led to diminished returns, more risk undertaking, narrower spreads and the seeming ambiance of low volatility, where in true dimension reveal nothing more than inflationary manifestations accommodated by the global governments. Such processes are natural offshoots to the order of Paper or Fiat money standards.

I was recently asked of what I thought would be the probable effect of former Fed Chief Alan Greenspan’s pronouncement that the US had ``one-third probability'' of a U.S. recession this year. Further, Mr. Greenspan likewise noted that the current expansion won’t have the same degree of endurance compared to its decade long predecessor, quoting Mr. Greenspan ``Ten-year recoveries have been part of a much broader global phenomenon. The historically normal business cycle is much shorter' and is likely to be this time”.

While my reply was to essentially heed the signals of the different markets, my humble opinion is that it would be better for the US to undergo such adjustment process for country to be able to cleanse the excesses built into the system.

In exchange for short term turbulence would be gains on a sounder footing over the longer term. Does it not follow in the context of economic cycles that the next phase after recession would be a recovery? So what is so bad with a recession?

Although my main concern has NOT been that of a technical US recession, but of a possible implosion of leverage that could affect the entire global financial and monetary structure and cancel out the present gains in the system.

Figure 2: Casey Research: Exploding Derivatives

Figure 2 from Doug Casey shows of the exponential growth of OTC derivatives, one of the potential epicenters for the markets’ dislocation, quoting Mr. Doug Casey (emphasis mine),

``The collective result is that our financial system has been wired up to $370 trillion dollars of privately negotiated investment contracts. They’re usually written to shift risk from one bank, pension fund, insurance company or brokerage firm to another. And many are linked together in long chains, with each contract providing collateral for the next.

``It’s all very clever, but layering the enormous size– $370 trillion dollars, far more than the net worth of all the financial institutions in the world – on top of all that complexity is downright scary. In simpler times, a home loan going bad would affect only the particular lender. Enough defaults would put the lender out of business. And that would be the end of it. But today a wave of defaults can send a shock through the portfolios of financial institutions around the globe, including hedge funds, banks and pension funds far removed from the troubled borrowers.”

Yet the optimism exuded by the bulls have been premised on the notion of a BERNANKE PUT, where the FED or the Working Group of Financial Markets a.k.a. Plunge Protection Team would intervene and provide for the liquidity of last resorts to the finance driven US economy.

For instance, Jeremy Siegel of Wharton in his interview debunks risks of emanating from hedge funds (emphasis mine), ``Could they precipitate a crisis? Not with the Fed on top of it. The Fed can diffuse any crisis. If everyone gets on one side of the market and things are out of control, the Fed is the ultimate source of liquidity. I think that they can prevent that from spinning out of control. So at this particular point, let people follow those paths that they think are most profitable.”

There are those who claim that the US government would not step in to the rescue of the US economy as evidenced by its non-intervention in the ongoing subprime woes. Past actions have not been substantiated by this claim, namely the S&L crisis, Tequila Crisis, Asian Financial Crisis, Russia Crisis, Y2K jitters, the most recent Dotcom bust or 9-11, where the FED responded with liquidity injections.

These actions by the FED have in fact spawned the overconfidence and increased risk taking appetite as denoted through by Mr. Siegel’s comments that governments are always there to cushion investors from the market’s volatilities. And reading through the present action, the recent ruckus in the markets has NOT BEEN SIGNIFICANT enough to openly prompt for any action from the FED YET (they are still quibbling about inflation!).

Whereas even if FED were to intervene both Mr. Paul McCulley of PIMCO and David Rosenberg of Merrill Lynch suggests that such meddling would be least potent or would not have much significance to mitigate on the effects of the ongoing hemorrhage in the housing industry.

In the astute words of Paul McCulley (emphasis mine), ``It is also the case that once a speculative bubble bursts, reduced availability of credit will dominate the price of credit, even if markets and policy makers cut the price. The supply side of Ponzi credit is what matters, not the interest elasticity of demand.”

From Merrill Lynch’s David Rosenberg as quoted by the Daily Reckoning (emphasis mine), ``“What drove the housing-led cycle was not as much the cost of credit, but rather the widespread availability of credit - irrespective of your FICO score [a measure of your ability to repay]...only a third of the parabolic run-up in the home price-to-rent ratio was due to low interest rates. The other two-thirds reflected other non-price influences, such as lax credit guidelines by the banks and mortgage brokers.”

In other words, the bleeding in the housing industry would not be stanched by the prospective FED intervention by the lowering of interest rates, from which the financial markets have mostly priced in their gains from. Both expect the housing woes to diffuse into the greater segment of the economy, which enhances the risks of a greater- than-expected slowdown.

Another example of Ponzi-derived leverage is the YEN Carry arbitrage. While some analysts have debunked the extent of its influence due to lack of concrete evidences from official fund flows, the coincidental effects manifested by the movements of the Japanese Yen and the global markets have been simply so compelling to dismiss.

Figure 3: Stockcharts.com: Overblown Carry Trade?

In figure 3, the initial impact of the Yen’s (superimposed line chart) surge coincided with the tremors in the global equity markets represented by the Dow Jones Industrial Averages (candlestick) and the Dow Jones World Index (lower pane) as shown by the blue arrows. Last week’s steep selloff in the Yen have likewise mirrored the rally in the Global markets (green arrows).

Many argue that macro factors as demographics (aging population seeking higher returns), as well as micro fundamentals as the tentative growth outlook have not been supportive of a sustained rally in the Yen.

Figure 4: John Murphy: The YEN on MAJOR SUPPORT

According to the Economist quoted last February, the Japanese Yen has been undervalued by 28% (!) against the US dollar based on the Big Mac Index and 40% (!) undervalued against the Euro, making it the world’s most inexpensive major currency!

As figure 4 from John Murphy of stockcharts.com shows, the Yen sits on massive multi-year support levels seen in the EURO (left window) and the US dollar (right window). Testing critical support levels of this nature could be expected to incur violent reactions of which we had earlier witnessed. Nonetheless, the YEN on both pairs have been extremely oversold and should naturally begin its ascent.

What significance does this imply to global markets? If the camp of analysts who claim that the YEN trade has not been a major factor in the recent carnage are right, then we could expect the financial markets to simply shrug off any potential rise in the Yen as it bounces of the major support area.

On the other hand, if what we observed would continue to dictate on the market’s interim actions then a rising yen could UPSET any actions initiated by the bulls which would imply for more selling pressures.

Figure 5: Economist: Reintroduction of Risks

The global contagion has reintroduced the concept of risk where it has once been thought to have gone into hibernation as shown by Figure 5 from the Economist.

Figure 6: Northern Trust: Corporate Equities: Supplies go Down, Price Rises

If you think all the tremendous money and credit generated and distributed had been channeled to “productive” investments, Figure 6 from Northern Trust reveals that the recent winning streak in the financial markets have been likewise due to the massive “retirement” in the supply side of equities emanating mostly from the idle surplus capital from corporations and private equity deals.

According to Paul Kariel of Northern Trust (emphasis mine), ``As one can see, a record $548 billion of equities were “retired” in 2006. This is not only a record retirement in dollar terms but also a record relative to nominal GDP. Rather than engaging in a capital spending boom with their recent profit largesse, corporations have been buying back their publicly-traded equity shares with abandon. In addition, the surge in private equity activity has retired shares. So, with the record contraction in the supply (in flow terms) of shares, is it any wonder that the price of shares rose last year?”

Yet Mr. Kasriel further notes that foreign buying has mainly been providing support to these share “retirements” while at the same time HOUSEHOLDs directly or indirectly have used this to finance consumption in place of a slowing mortgage equity withdrawal.

The problem is that as the housing woes deepens, source of funding for US consumers becomes more strained unless they curb their spending patterns and or grow their income faster and or the clip of supply side “retirements” accelerate and or discover other alternative sources for liquidity generation (possibly more debt). This anew poses as another variable which may present itself as more risk to the bullish premises.

The dynamics of share “retirements” or buybacks by corporations coupled with record amounts of insider selling prior to the recent selloffs can be viewed as circumstantial evidences in the light of non-productive investments in support of a privileged few. The growing income inequality gap in the US is nonetheless a manifestation of the continuing “Monetary” inflation policies and the unsound practices of the present Paper based money system.

Finally, whether the recent tumult was due to the Japanese yen, dislocation brought about by unwinding leverage, escalation of mortgage woes, decelerating earnings growth, reversal of expected “liquidity of last resort” or the “Bernanke Put” from the Fed or the lack of continued support from foreigners on the supply side of the equities equation or questions on the sustainability of debt driven consumption or inverted yield curve or the much loathed “R” word-whose probabilities appears increasing by the day, all these points to the horizon where the markets looks increasingly tilted towards heightened volatility going into the interim future.

Risk only amounts you can sleep on; buy on panics and do tighten your stops.