Global Markets: From “Minksy Moment” To The “Mises Moment”

``In their haste to be wiser and nobler than others, the anointed have misconceived two basic issues. They seem to assume: (1) that they have more knowledge than the average member of the benighted, and (2) that this is the relevant comparison. The real comparison, however, is not between the knowledge possessed by the average member of the educated elite versus the average member of the general public, but rather the total direct knowledge brought to bear though social processes (the competition of the marketplace, social sorting, etc.), involving millions of people, versus the secondhand knowledge of generalities possessed by a smaller elite group.-Thomas Sowell, "The Vision Of The Anointed: Self-Congratulation as a Basis for Social Policy"

It has been a most eventful week! Looking at the end numbers won’t do justice to the drama that had unfolded. And we should expect this to continue. And for the first time, even Philippine broadsheets highlighted the ruckus in the global financial sphere on its headlines, giving the oblivious public the opportunity to attest of the ongoing dynamics at the “macro” framework of global finance. Unfortunately, many of these reports only focused on the “surface” than of the “genuine” pressures which has been rattling the “core” of the system.

None of these have been new to us. We’ve dealt with the risks of evolving finance (structured products, derivatives, etc…), since we became bullish in GOLD in 2003 (The Rip Van Winkle in Gold series.)

Warren Buffett’s Philosophical Victory

We even subscribed to the views of Mr. Warren Buffett, the world’s premier investor, on his advocacy against the menace of newfangled exotic financial products or as Mr. Buffett has repeatedly warned, the “financial weapons of mass destruction” (see Figure 1) and of the follies of “squanderville” economics or conspicuous debt driven consumption as manifested by US current account deficits in November 2003 Fortune Magazine “America's Growing Trade Deficit Is Selling the Nation Out From Under Us”.

Figure 1: US Global: Derivatives In Perspective

And as always and contrary to the mainstream, in the fullness of time, Mr. Buffett has once again been utterly validated. As a reminder, Mr. Buffett’s themes have almost always materialized from a LONG term and NOT ticker (short term) based perspectives, as commonly espoused by the public.

And recent events only have only reinforced such theme where market forces have been wracking at the pillars of the much maligned world’s monetary (financial) system.

And this has not just been foretold by Mr. Buffett but also by the Austrian School of Economics.

The “Minksy Moment” At its Finest

“Minsky Moment” has been coined by the distinguished UBS Economist George Magnus. It refers to the illustrious American economist Hyman Minsky (1919-1996) who is known as the father of Financial Instability Hypothesis, from which he gained popularity over the theory of “stability leads to instability”.

In our August 2007 article, Global Markets: An Advent to the Minsky Moment and the Kindleberger Paradigm?, we described Minsky’s credit cycle as,

``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).”

Or said differently, complacency tends to foster greed, via the transition mechanisms of the credit cycle where people imbue more risks by adopting unsustainable arcane credit instruments, which eventually culminates to a break point known as the “Minsky Moment”.

So the perturbation you have been witnessing from today’s financial sphere is exactly how the late Minsky described all these to be; the diverse alphabet soups of highly leveraged complex instruments-slice, diced and repackaged, stamped with investment grade ratings by credit rating agencies and sold to investors all over the world.

Banks and Investment Banks which traditionally held on the mortgages they underwrote and took the underlying credit risks morphed into “originate and distribute” models from which disseminated credit risk to investors, who instead of conducting their own credit scrutiny to establish the viability of these products, almost entirely depended on the seal of approval from credit rating agencies. For global investors faced with a “savings glut” and institutional requirements to match investments with liabilities, in behaving like lemmings, it became an “in” thing to get into these papers on the assumption they were safe as determined by the Credit Rating Gods.

With capital freed up from warehousing credit risk, these institutions worked to assume more risk by the extension of credit facilities to a wider scope of the population who were less creditworthy or “subprime” on ultra-favorable loan terms in order to generate additional returns via the economies of scale.

Moreover, these institutions piled into more dubious loans from the real economy (real estate mortgages) which were recycled with more leverage and wrapped into complex financial labels into the financial economy underpinned by the creation of off balance sheets vehicles (SUV) from banking institutions from which emerged the Shadow Banking system. Aside, derivative instruments as credit default swaps (CDS), originally meant as an insurance against company defaults was likewise utilized as another tool for obtaining leverage (CDS issuance vastly greater than underlying bonds), whose mind boggling size further enhanced counterparty risks.

Thus, the full scale transition towards the Ponzi structure.

Who can forget the infamous quote from Citibank’s Charles Prince, ``But as long as the music is playing, you've got to get up and dance. We're still dancing.” Yes, almost every participant knew this was bound to happen, but assumed that they could get out ahead of the others. Unfortunately like cartoon character Wily E. Coyote, who runs off the cliff and keeps going on until he looks down and realizes that he’s been running on air, the industry plunges to the ground!

Nonetheless when the Minsky Moment emerged, the risk distribution on an international scale revealed that risk weren’t really reduced but instead, as vividly shown last week, had been spread and became the source of the tremors which rippled throughout global markets.

From the effects side, Minsky was absolutely correct. Stability created conditions for greed which allowed for more risk taking appetite backed by a pyramid of unsustainable gearing.

The Emergence of Mises Moment?

We have been saying for so long that the entire premise of today’s suspenseful episode has been centered on the structure of the prevailing monetary system- the Paper Money US dollar standard operating on the fractional banking reserve platform as defined by wikipedia.org as ``only a fraction of their deposits in reserve with the choice of lending out the remainder while maintaining the obligation to redeem all deposits upon demand.”

It means that it is the intrinsic nature of global central banks to foist boom conditions derived from leveraging (modeled after the banking system) or by means of expanding money and credit to the point that it becomes unsustainable. From which the ensuing bust will tend to prompt liberals or interventionists to unjustly brand such cyclical inflection as “market failure”, when market forces had been repeatedly tweaked and distorted to the extremes by constant policy based interventionism.

Besides, had there been automatic adjustment mechanisms meant to curb excesses by allowing market forces to determine the resource allocation process (e.g. gold standard), boom bust scenarios would have greatly been reduced.

Unfortunately while many articulate voices cite the lack of regulation or its ineffectualness, a large part of this laissez faire blaming has not been consistent with reality; this noteworthy quote from George Mason University Professor Tyler Cowen from the New York Times (highlight mine),

``But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That’s dysfunctional governance, not laissez-faire.

``When it comes to financial regulation, for example, until the crisis of the last few months, the administration did little to alter a regulatory structure that was built over many decades. Banks continue to be governed by a hodgepodge of rules and agencies including the Office of the Comptroller of the Currency, the international Basel accords on capital standards, state authorities, the Federal Reserve and the Federal Deposit Insurance Corporation. Publicly traded banks, like other corporations, are subject to the Sarbanes-Oxley Act.

``And legislation that has been on the books for years — like the Home Mortgage Disclosure Act and the Community Reinvestment Act — helped to encourage the proliferation of high-risk mortgage loans. Perhaps the biggest long-term distortion in the housing market came from the tax code: the longstanding deduction for mortgage interest, which encouraged overinvestment in real estate.

``In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong.”

We’d like to add the implicit guarantees of Fannie & Freddie Mac and Community Reinvestment Act of 1977-forcible lending to minorities as additional unintended consequences to the present boom bust scenario. Of course as we earlier brought up, the most compelling dynamics of the recent tragedy arose out of the policies to expand credit or money.

At this point, events are proving to be strongly in transition towards our “Mises moment”,

From Ludwig von Mises’ Human Action (highlight mine), ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Our “Mises moment” assumes that governments faced with a crisis will run the printing presses to reflate the system at the expense of its currency system.

Why?

Because for governments, credit is the only panacea for any economic or market ailment. This from Ludwig von Mises from Human Action, ``Credit expansion is the governments' foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.”

“Too big to fail or too interconnected to fail” has been the overwhelming justification for recent government actions to inject massive doses of credit into the global financial system for the implicit aim to stave off a financial meltdown. Of course, with it comes the unintended consequences which will reveal itself overtime.

As for “inflationary” credit expansion, here is a list of the recent activities…

-The US took the Fannie Mae and Freddie Mac into conservatorship ($200 billion).

-The US rescued its largest insurer AIG with an $85 billion in loan package (three-month Libor plus 850bp) collateralized by its assets with the US government assuming 79.99% in equity through warrants and has the right to veto payment of dividends and preferred shareholders in condition that it pay the loans by orderly liquidation of its assets.

-The US through in coordination with global central banks have made available nearly $300 billion ($180 initial and $100 additional) for short term loans (New York Times) see figure 2.

Figure2: Wall Street Journal: US Running the Printing Press To Save the System

-U.S. will insure money-market funds from a backstop of $50 billion from an emergency pool (Exchange Stabilization Fund) against losses for the next year as it seeks to prevent a run on $3.35 trillion of assets that average investors and institutions rely on as a safe alternative to bank deposits. (Bloomberg and Wall Street Journal)

Other prospective courses of actions include the following (From Danske Bank):

“-Setting up an entity that would take bad assets off financial companies’ balance sheets: As in past financial crises the plan is to set up a fund that could take over troubled assets from the balance sheet of financial companies. This is in many ways similar to the RTC fund set up during the savings and loans crisis.

“Such fund would create an investor of last resort in troubled assets and remove the significant black box element from balance sheets of banks. In turn, this should increase downside visibility and thereby confidence among banks.

“-The creation of federal insurance for investors in money market mutual funds: As investors have become increasingly worried about money market mutual funds, otherwise thought off as one of the safest investments, insurance akin to the one currently safeguarding bank deposits could hinder a massive outflow from the money market funds currently under scrutiny

As of this writing, the US Treasury has appealed to its Congress to be granted with $700 billion to buy on a carte blanche basis ``bad mortgage investments from financial companies in what would be an unprecedented government intrusion into the markets.” (Bloomberg)

Will Systemic Socialization Be Successful?

With the US Federal Reserves finally opting to expand its balance sheets, the response from the gold market has been breathtaking as it has been with global equity markets, see figure 3, but to a lesser extent.

Figure3: stockcharts.com: Gold Smells Bloody Inflation!

The extraordinary run up in gold prices comes even in the face of the raising of margin requirements on Comex gold and contracts by 47% and 20% respectively. (Bloomberg) This is another sign of government intervention to halt spiraling precious metals. Notice that the turn in the US dollar index could mark an inflection point.

Again this hasn’t been unexpected since we noted in our June article, Global Financial Markets: US Sneezes, World Catches Cold!, “Maybe if all the above measures cease to work then the last ace for Mr. Bernanke would be to expand the Fed’s balance sheets by printing money or otherwise the US economy could succumb to deflationary recession!”

Obviously with the recent accentuated downside volatility in the equity markets, aside from the freezing of the credit markets, Mr. Bernanke’s (aside from Treasury Secretary Paulson) actions reflected the aura of desperation enough to utilize their last ace; the shifting role of the US Federal Reserve from a lender of last resort to a BUYER of last resort or the socialization of the important aspects of the US financial markets, which was once the embodiment of modern capitalism!

Many have argued that the socialization of the financial sector is needed to save the system. We aren’t so sure.

Why?

-Prohibition of short sales has temporal effects. As we argued in our recent post Will The Proposed Ban of Short Sales Support Global Markets?, a ban of short sales is a form of price control which inhibits price discovery and leads to even more inefficient and volatile markets. Instead, since socialization seems to be the thrust why not simply ban the stock market altogether?

-It is unlikely for the US to save the entire banking industry or let alone the $47 trillion debt markets.

-Government will essentially compete with private funds for financing affected or bailed out or “nationalized” institutions. Aside from the risk of driving up interest rates, it could lead to more inefficiency in capital allocation within the economy resulting to a loss of productivity.

-Since the US government is entirely reliant on foreign financing (about $2 billion per day), it may be at the risk of having difficulty to borrow or raise money for its funding requirements.

As an example, just last week even when US treasury yields where at historic lows from the credit seizure, credit default swaps (CDS) on US treasuries rose to its highest level! From Reuters, ``Credit default swaps on 10-year Treasury debt widened to a fresh high of 27.9 basis points from 27.7 basis points late on Thursday, according to CMA, a specialised data provider.”

Figure 4: Casey Research: Foreigners Pull Plug on Dollar Recycling?

The Fannie and Freddie debacle led to an outflow or significant sales in agency holdings by major foreign public and private institutions last July (CBS marketwatch). Although some portion of the sales had been offset by inflows into US treasuries, which seemed as the only asset the foreigners were willing to buy, aside from the reduced net purchases of foreign assets by US residents, which equally reflected the forcible liquidations abroad, it wasn’t enough to account for to reverse the net outflows.

Overall, in times of heightened risk aversion, state owned Sovereign Wealth Funds or central banks don’t seem to be totally immune to the previous conventional pursuit of the acquiring US dollar assets (or recycling dollars) for political objectives as seen in Figure 4.

What this means?

It raises the risk of the skepticism over the viability of the “full faith and credit” upon which the US dollar and the world’s monetary system has been founded upon.

While we are seeing some participation of forex currency reserve rich countries as China in the ongoing negotiation to acquire distressed US financial companies as the brewing CIC-Wachovia- Morgan Stanley deal (newsdaily.com), it isn’t clear that the previous incentives for foreign financing will always remain the same.

Besides, it would necessitate a substantial portion of the US assets to be acquired by foreign investors, if the present system is to be maintained, which implies a shift in the balance of geopolitical power.

Yet, we appear to be seeing some signs of cracks on the seemingly inexorable faith over the US dollar system…

From the New York Times (highlight mine),

``The nonstop deluge of bad publicity for American investments seems to be seeping into the consciousnesses of the rich and middle class across Asia.

“I do not believe in U.S. financial institutions anymore; I don’t think any U.S. bank is safe anymore,” said Wang Xiao-ning, a Hong Kong homemaker. Even after the Federal Reserve had taken control of A.I.G., she waited in line with dozens of other anxious policyholders at one of the insurer’s customer service centers for the chance to close her investment account….

``Changing Asian sentiments have not yet eroded the value of the dollar — although market reaction to the A.I.G. bailout seemed to be doing that Wednesday. Asian skittishness has coincided with heavy selling by Americans of their holdings of stocks and bonds in foreign markets.

``“It’s almost a case of everyone bringing money back home,” Americans and Asians, said Ben Simpfendorfer, an economist in the Hong Kong office of Royal Bank of Scotland.”

This implies that the US has been more at the urgency to bring home its currency enough to have prompted for the recent US dollar rally, which evidently had been indications of the deleveraging process.

However, as Asians may become more skeptical, they could begin entertain the idea of possibly reallocating more of their investments to ex-US dollar denominated investments or tangible assets, albeit the alternatives aren’t large and liquid enough.

For Asians to withhold if not abandon the US markets in exchange for other potential markets would be a disaster for the US.

And it is not just in the financial world but also seen in migration flows.

From AsianInvestor.net, “We are seeing not only ethnic Asians seeking to return to Asia from Europe and the US, but also professionals without any personal link to Asia,” says Executive Access’ Eisenbeiss. “Asian markets still offer more opportunities than elsewhere for selected, experienced professionals.”

Does this represent an unwarranted concern? Not if you ask New York Mayor Michael Bloomberg, from Hedgeco.net, ``"Who’s buying our debt? It’s these overseas funds, these sovereign-wealth funds, these overseas hedge funds. They are in trouble now. So it’s not clear who is going to be buying" US Treasury bills, he said.”

Some Mises Moment Scenario

So what do we see from the Mises moment?

More US assets will probably be acquired by foreign institutions unless the US government resorts to increased financial protectionism. Yet there is could be a political policy dilemma over the prospective crossborder acquisitions of key US industries, as Brad Setser rightly points out ``Bailing out US banks is one thing. Bailout out a Chinese-government-owned US bank is another.” With more of the foreign buying of US distressed assets, the balance of geopolitical power would have clearly shifted. Yet if state owned institutions were to take such a lead role then, we could be seeing nationalization of US assets from governments abroad.

It is likely too that on the account of massive dosages of central bank money for rescue programs, the prospects of “higher inflation” could be signaled by the continued rise in gold and precious metals.

Furthermore, the US dollar may be pressured from government instituted policies that is likely to weigh on the fiscal equation. We cannot compare the past experience of nationalizations simply because the scale of government intervention will likely be the largest the world has ever seen.

With government weighing in heavily on the markets, the rules have been changing almost daily to the point of triggering credit events for CDS, which means even more losses.

Now, if the degree of US financials systemic losses are much more than anticipated by the regulators, then I think the appropriate question to ask is, who will then bail out the US treasury and the US Federal Reserve?