The Rise of Value Investors Amidst A Prevailing Fear and Loss Environment

``If stocks are attractive and you don't buy, you don't just look like an idiot, you are an idiot.'' -Jeremy Grantham, Baron Buys, Grantham Spots `Once in Lifetime' Chance

It is a curiosity to occasionally hear questions about profitability in today’s market similar to “Are you up or down?”

Because for as long as people have positions in the financial market whether directly (equities, fixed income, currencies, commodities) or indirectly (mutual funds, hedge funds, ETF, UITF and etc.) the unequivocal answer is that given today’s downside volatility-losses are the rule, not the exception.

Today’s Fad: Losses Everywhere

Think of it; nearly $30 trillion of market capitalization wiped out from global equity markets year to date alone. Banks have written off about $680 billion and still counting. As we earlier argued in Spreading the Wealth? Market IS Doing It!, the political morality polemics about income inequality has been in a wash since market losses appear to have sizably narrowed the controversial gap.

Still world real estate market continues to bleed; in the US estimates of losses have been at $1 trillion (globeandmail.com). We don’t have the collateral damage estimates or casualty figures from the fallout in other markets, most especially in Europe and in some other parts of Asia, which includes China or Japan or Australia.

Nevertheless, we have also enormous unaccounted for losses in the derivative, currency (a roster of emerging market victims from Reuters), commodities, bonds, structured finance and other financial markets.

Retirement accounts of baby boomers have been nursing some $2 trillion in the deficits (msnbc.com), thereby putting in jeopardy the retirement plans of many Americans. With Americans likely to work longer, apparently the incoming Obama presidency would have to deal with policies related to health insurance costs, Social security and Private Pensions and flexible work arrangements to address the challenges of the coming transition.

Moreover, the losses have now been spilling over to the real economy enough to impact corporate bottom lines and dividends. In the US, according to the Howard Silverblatt of S&P (Businessweek), earnings growth which had originally been optimistically forecasted at 14.2% for the third quarter have so far posted 13.9% in the red with 77% of companies reporting.

And by corporations we also mean major pension funds and retirement institutions.

As an example many Filipinos are familiar with the US largest retirement fund, The California Public Employees Retirement System, known as CalPERS, which accounted for a total portfolio value of $185 billion on Friday, down 23% from $239 billion at the start of its fiscal year. (latimes.com). The CalPERS fund is down by nearly $54 billion.

According to the same article, ``CalPERS "is taking hits across all asset classes," Feckner said. But the losses would have been even greater "if we had not spread our money out" by diversifying investments….For now, working with interim executives, CalPERS is sticking with a strategy that leans heavily on stocks, which account for about 40% of its holdings. No decision has been made about shifting the investment mix -- possibly toward bonds and other fixed-income assets, Feckner said.” (emphasis mine)

The point is; much like the CalPERs experience, investing in markets is NOT about “trying to time the markets”, as to literally assess one’s portfolio as being “up or down”, but applying portfolio management across the company’s risk profile and time horizon objectives.

In addition, President Rob Feckner underscores the viciousness of the present bear market as impacting “across all assets” meaning that the collateral damage has been broad based and severe enough for most investor’s to escape its wrath.

Warren Buffett Has Been NOT Immune

Figure 1: stockcharts.com: year-to-date performance of Mr. Buffett’s Berkshire Hathaway

Because of ferocity of the bear markets, not even gurus are immune.

We have spilled so much ink about the wondrous feat of the world’s most successful investor Warren Buffett, but viewed from real world developments, Mr. Buffett’s investments have not been entirely unaffected see Figure 1.

On a year-to-date basis, Berkshire Hathaway has fallen victim to the powerful grip of bearmarket forces with its share prices down over 20%. And it is not just in share prices, but likewise reflective of corporate bottom line performance, with most of the damage emanating from derivatives related losses.

Some important highlights from CNN Money, ``Warren Buffett's Berkshire Hathaway Inc. on Friday reported a 77% drop in third-quarter earnings, hurt by declining insurance profits and a $1.05 billion investment loss…

``Berkshire began the year with an unrealized $1.67 billion loss on its futures, options and other derivative contracts. The value of those derivatives, which are tied to the value of the overall markets and the credit health of certain companies, improved in the second quarter by $654 million. But in the third quarter amid unprecedented market turmoil, their value fell by $1.05 billion, leaving a loss of $2.21 billion through the first nine months of the year…

``Berkshire finished the third quarter with $33.4 billion cash on hand. That is up from the end of the second quarter when the company had $31.2 billion cash on hand…

``Year to date, Berkshire's net worth slipped to $120.15 billion from $120.73 billion, but during October, price declines in investments and increased liability for equity index put option contracts accounted for a $9 billion decline in net worth.”

So similar to CalPERs, the troubles of Warren Buffett’s flagship in Berkshire Hathaway have been mainly due to the downside repricing of its asset holdings than from the direct impact of the economic downturn to its operations (yes, insurance and Berkshire’s Mid American subsidiary Constellation Energy has suffered from losses).

Remember, Berkshire Hathaway isn’t just your typical fund manager, but is an active investor to manifold diversified industries tacked into the company’s portfolio as subsidiaries, unlike CalPERs which functions principally as passive investors.

A second observation is that as we wrote in Warren Buffett Declares A BUY!, the recent months have shown Berkshire increasing its cash portfolio but over the year have plunked some $11 billion into the markets. Its cash holdings is still a significant 30% relative to the company’s overall net worth, but down from 40% at the start of the year when using the present net worth figures as basis.

Nonetheless, investments in the market doesn’t have to come directly from Berkshire as some of its subsidiaries have been doing the dirt work of expanding via acquisitions such as office furniture CORT which recently acquired Aaron Rents Corporate furnishing for $72 million (bizjournals).

So yes, while Mr. Buffett’s long term holdings are temporarily “down”, influenced by the gyrations of the market, aside from escalating impact from economic variables, overall, his portfolio’s direction has not been driven by the ridiculous idea of “ticker based” assessment but from the perspective of portfolio risk distributed allocation!

In Berkshire’s case, 60% exposure to market risks and 40% cash at the start of the year has changed to the direction of increasing exposure in market risk given the present conditions.

Betting Against Warren Buffet’s Oracle?

Figure 2: US Global Investors: Track Record of Warren Buffett’s Major Calls

Mr. Buffett hasn’t been your stereotyped market timer, figure 2 from US global investors shows how the legendary Warren Buffett has incredibly “TIMED” the market with his publicized calls to a near precision or perfection during the past 43 years!

Put differently, Mr. Buffett doesn’t exactly “time” the markets in a literal sense as market technicians are wont to do. His selling call in the late 90s didn’t come with outright liquidation of the entire Berkshire’s portfolio simply because some of his portfolio holdings had been designed as a “buy and hold forever”.

Although he did express some regrets for failing to do so, Mr. Warren Buffett quoted at PBS.org in 2004, ``We are neither enthusiastic nor negative about the portfolio we hold. We own pieces of excellent businesses -- all of which had good gains in intrinsic value last year - but their current prices reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I.” (emphasis mine) So if the Oracle of Omaha had been subject to regrets, how much more the mere mortals of the investing world?

To reiterate, in periods where he believes markets are conducive for selling Mr. Buffett raises cash in proportion to his allocation targets and positions defensively. On the other hand, in periods where he thinks opportunities for greater returns with a margin of safety embedded on his risk profile, as he does today, he raises his market risk exposure gradually.

Yet, the Mr. Buffett’s rarified but highly prescient audacious landmark calls can be construed from a combination of his interpretation of economic cycles, fundamental valuations and importantly sentiment, the seemingly indomitable “simple-but-hard-to-apply” Buffett doctrine- ``be fearful when everybody is greedy and greedy when everybody is fearful”.

Given his formidable track record, betting against him isn’t going to be a prudent choice.

The Illusion of Bull and Bear Markets

It also to our understanding that gurus don’t see markets the same way ordinary market participants view them, like in the manner which we typically label as Bull or Bear Markets.

Mr. Nassim Nicolas Taleb, the famed iconoclastic author of the best selling book The Black Swan, wrote in Fooled by Randomness ``I have to say that bullish or bearish are often hollow words with no application in a world of randomness-particularly if such a world like ours, presents asymmetric outcomes.” (highlight mine)

Incidentally, Mr. Taleb has been one of the recent exceptions or outliers, whose managed funds have remarkably been up during the recent gore in the financial markets. This from Wall Street Journal, ``Separate funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October, according to a person close to the fund.”

While Mr. Taleb’s magic seems to work best with market crashes as he has done so in Black Monday of October 19^th 1987, he hasn’t been as effective when markets are going up, ``Mr. Taleb's previous fund, Empirica Capital, which used similar tactics, shut down in 2004 after several years of lackluster returns amid a period of low volatility.” (WSJ)

In parallel, Dr John Hussman recently wrote of the pointless exercise of classifying markets as bullish or bearish, ``From my perspective, the whole issue of bull market versus bear market doesn't get investors anywhere. Asking whether stocks are in a bull market or a bear market is like asking Columbus what kind of trees are planted along the edge of the earth. The question itself makes a false assumption about how the world works. My view is that bull markets and bear markets don't exist in observable reality – only in hindsight. What gain is there to investing based on something that's unobservable when you can manage your investments based on directly observable evidence? What we can observe directly is the prevailing status of valuations and the quality of market action.” (underscore mine)

In short, such gurus tend to view markets strictly in the context of fundamentals than from sheer momentum.

Conclusion

To recap, the sharp volatility in the financial markets has been the prevailing trend such that anyone exposed to the market has been subject to losses in the market directly or indirectly.

Even the biggest institutions or the best investors have not been immune from current adverse market developments.

While this is not to justify present losses in the essence of John Maynard Keynes’ famed pretext, ``It is better for reputation to fail conventionally than to succeed unconventionally", the point is to learn from the perspective of übermarket professionals that investing is not about attempting with futility to catch undulating short term waves but of shaping one’s portfolio based on risk distributed time preference profiles amidst observable evidence of market action and fundamental and or economic parameters.

Yet since the prevailing trend of losses has become a mainstream bias, a mounting chorus from value investors seems to have surfaced.

Warren Buffett’s recent contrarian buy calls may have either generated a momentum or provided justifications for the rising incidences of converts (from former bears into current bulls). We formerly listed Dr. John Hussman, Jeremy Granthan and Mohammed El-Erian as the early apostates.

We are adding to our list prominent market savants are Vanguard’s founder John Bogle, Fidelity International’s Anthony Bolton, former Merrill Lynch’s Bob Farrell, Steve Leuthold, Research Affiliates LLC’s Rob Arnott and others.

Even Dr. Marc Faber believes that the low is near but in contrast to the others believes global markets will ``stick at this low point for a long time.”

Yet, some of the rabid high profile hardcore bears whom have basked in the recent glory of market collapse seem to remain stuck with idea of market Armageddon.

But there seems to be one stark difference between the former (converts) and the latter: the former are full pledged money managers while the latter appears to be ivory towered ensconced members of the academia or publishers who aren’t money managers.

Reflexivity Theory: Japan Banks Victims of Prevailing “FEAR” Bias

In George Soro’s theory of reflexivity, the concept basically deals with two way psychological interaction or a feedback loop between the participant’s perception and the situation in which they are engaged in.

According to George Soros, “Financial markets are always wrong in the sense that they operate with a prevailing bias, but the bias can actually validate itself by influencing not only market prices but also the so-called fundamentals that market prices are supposed to reflect in.”

In other words, where the conventional thinking of establishing market prices has been premised on the anticipation of changes in the underlying fundamental conditions of a security or market, on the contrary markets can do the opposite- they can actually shape the fundamentals via the prevailing biases (market momentum).

For instance, the sharp selloffs today, which is the prevailing bias, have brought share prices down enough for some companies operating under regulatory capital ratios to raise capital even when corporate fundamental conditions are healthy.

We are referring to Japanese banks, according to the Economist (highlight mine),

``UNTIL recently Japanese banks had largely avoided the agonies of the credit crunch that had caused such difficulties in much of the rest of the world. Now the misery has well and truly come to Tokyo. The culprit is not toxic derivatives and swaps, but ordinary shares held by banks in Japanese companies. These cross-shareholdings, a peculiar feature of Japanese capitalism, are having pernicious effects. As share prices fall, banks are force to revalue their assets, which in turn reduces their capital ratios. The result is a need to raise capital quickly.

``In the past four trading days, the Nikkei 225-share index has tumbled by 23%. On Monday October 27th the index plunged by 6.4% to 7,162.90, the lowest level in 26 years. Mitsubishi UFJ Financial Group (MUFG), Japan’s biggest bank, plans to raise as much as ¥990 billion ($10.6 billion) by issuing new common shares of perhaps ¥600 billion and preferred securities of ¥390 billion. Mizuho Financial Group and Sumitomo Mitsui Financial Group are said to be planning their own capital increases.

``The government is scrambling to help out. It is poised to announce a set of new measures, including spending perhaps ¥10 trillion to buy shares in companies that the banks hold (in an off-market transaction, so their values do not fall further). This was a tactic used by the Banks’ Shareholdings Purchase Corporation to respond to a banking crisis in 2002. The government may also request that pension funds and life insurance firms buy equities to support the market, though whether they would respond remains to be seen.”

Courtesy of Topix Banking

So what has caused the miseries of the Japanese banks, again from the Economist, ``Share prices are tumbling fast largely because foreign hedge funds have been forced—by the need to meet margin calls and redemptions—to liquidate positions. Investors are also worried that a big global recession will hurt Japan’s exporters, just as a domestic slowdown hurts other firms. Exporters are battered, too, by the steep rise in the value of the yen. It has soared by 11% against the dollar and around 21% against the euro in October, as the yen carry trade unwinds and amid a general flight to safety.”

So global deleveraging has prompted fear which brought upon severe market price distortions enough to require compliance of capital ratios by raising capital of affected companies. And government would now step in to provide assistance. This essentially validates Soros’ reflexivity theory at work.

To consider Japanese banks were thought to be in very a good financial position, such that they were intending to regain international dominance just a few months ago with acquisitions of distressed US financials, to quote again the Economist,

``Just a month ago, fresh from MUFG’s offer of ¥950 billion for a 21% stake in Morgan Stanley, and Nomura’s purchase of operations of the bankrupt Lehman Brothers in Asia, Europe and the Middle East, Japanese bankers felt they were once again dominant on the international financial stage. They were rich with capital and willing to spend, at a time when other institutions were desperate. Now they are victims not of contagion, but of collateral damage.”

So a fear driven market has virtually thrown everything out with the bathwater.

A Fear Driven Meltdown

``A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense.”-Warren Buffett, Buy American. I Am.

As we pointed out in Another Grizzly Bear Transforms To A “Cautious Bull”: Jeremy Grantham of GMO former super bear Jeremy Grantham turned bull has been precise about the market’s mean reversions and market overshooting.

This implies that yes, even if the market is already “cheap”, there is that prospect or risk for markets to always overshoot to the downside in as much as markets can overextend upwards. It is plainly called momentum. Since markets over the short term are mostly about emotions, investing today should translate to having a time horizon expectations of at least 12 months.

Take a look at the inflation adjusted chart of the US Dow Jones courtesy of chartoftheday.com

Figure 2: chartoftheday.com: Dow Jones inflation adjusted

The above chart indicates that support levels have broken down from the 2002 levels and could likely see more downside action. This chart squares with the reaction in the Nikkei chart above suggesting for a little more downside action. But from our perspective any ensuing fall could likely signify as a “selling climax”.

Besides, considering the magnitude of the selloffs, it cannot be discounted that markets can always make sharp countercyclical reactions, which means we can’t discount dramatic rebound anytime from now. Yet short term rebounds do not suggest the end of the bear market until the technical picture materially improves.

As Societe Generale’s Albert Edwards recently wrote, ``But cheap(er) markets will not alone generate a rally. The technicals need to be aligned for that to happen. Notwithstanding the forced liquidations now taking place amidst the wreckage of catastrophic Q3 hedge fund performance link, we see the conditions as ripening for a decent bear market rally.” (emphasis mine)

The reality is that markets or even economies always operate in cycles. And the present bear market developments suggest that this has yet to reach its full maturity before a bottom can be found.

So we are delighted to see a growing band of former contrarian bears converting into contrarian bulls. Aside from Jeremy Grantham, known perma bears like Warren Buffet, Dr. John Hussman, Pimco’s Mohamed El-Erian, Societe Generale’s Albert Edwards and James Montier are some of the prominent names that have began to see “value” in markets today.

Figure 3: Pimco: Massive Risk Aversion and Cash Levels

The point is that while none of them is calling for a market bottom, as none of them are known market timers, although they see the present the market activities as opportunities to steadily accumulate in anticipation of future recovery.

They understand that the present fear levels are indicative of near market bottoms as shown in Figure 3 courtesy of Pimco’s Mark Kiesel. Where market psychology has reached panic levels (left) and equally reflected in massive cash hoards (right).

Vanishing Hedge Funds

So what appears to be the source of the present worries?

With many credit spreads seen improving except for corporate bonds, the present concerns have been directed to mainly three areas, namely, hedge funds, emerging markets and fears of global economic recession.

As we noted in It’s a Banking Meltdown More Than A Stock Market Collapse! ``So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.”

The unraveling motions of investor redemptions appear to be in full gear where the $1.8 trillion industry is at risk of substantial contraction. According to a report from Bloomberg, ``U.S. hedge-fund managers may lose 15 percent of assets to withdrawals by year-end while their European rivals shed as much as 25 percent, Huw van Steenis, a Morgan Stanley analyst in London, wrote yesterday in a report to clients. Combined with investment losses, industry assets may shrink to $1.3 trillion, a 32 percent drop from the peak in June.” That’s $500 million of asset liquidation if such projections turn to reality.

Some experts have opined that the sheer force from the stampede out of hedge funds may compel governments to even suspend markets. According to another report from Bloomberg, ``Nouriel Roubini, the New York University Professor who spoke at the same conference, said hundreds of hedge funds will fail as the crisis forces investors to dump assets. ``We've reached a situation of sheer panic,'' said Roubini, who predicted the financial crisis in 2006. ``Don't be surprised if policy makers need to close down markets for a week or two in coming days.''

Emerging Market Shoes Drop

Next we have emerging markets.

Countries which had large current account deficits as % to the GDP, those that relied heavily on foreign and or short term borrowing or have been internally leveraged have endured a beating.

Figure 4: Danske Bank: Emerging Market Credit Default Swaps

For instance, Credit Default Swaps which indicates the cost of insuring sovereign debts against a default have spiked for several countries such as Argentina, Pakistan, Ukraine, Iceland, Ecuador, Venezuela and Indonesia as shown in Figure 4 (see right-1 month change of 5 year CDS). This means that the jittery environment has led investors to see higher risks of prospective government default on their debts. Argentina’s proposed nationalization of pension funds seems to underscore such distress.

And the spate of heavy market selling in the currency and debts markets has likewise caused a spike in inflation levels of some EM economies. So while some countries have been suffering from “deflation” symptoms (mostly advanced nations), others are seeing higher inflation rates due to the lack of access to funding and falling currency values. Hence the unfolding crisis has produced divergent impacts and is unlikely deflationary as some contend.

Korea which suffered from a spectacular market collapse last week (Kospi down 20%!) is said to bear the typical emerging market infirmities, according to Matthews Asian Fund ``For many, the collapse of the won is a sore reminder of the Asian financial crisis of about a decade ago. It highlights some of the weaknesses of regional capital markets—bond markets are underdeveloped and there is consequently little long-term funding for corporations as well as an over-reliance on short-term debt. In addition, Korean bank loans are about 30% greater than their deposit base, which means that the banking system has been more reliant on U.S. dollar-denominated funding.”

Although foreign currency rich neighbors of Japan and China have been reported as in a standby mode to provide assistance. In fact, the region is reportedly in a rush to put up a contingency fund ($80b) aimed at assisting neighbors in distress. So it isn’t just a function of IMF doing rescue efforts, foreign currency rich neighbors appear to be doing the same today.

Aside, the South Korean government extended a $130 billion rescue package-guaranteeing $100 billion of external debt and provision of $30 billion loans to banks. Nonetheless, these measures have not prevented foreign investors from rushing into the exit doors.

Figure 5: Danske Bank: Last Shoe to Drop

So not only has the recent credit crunch shrunk the available capital base among international banks, it also compressed investors’ appetite for emerging market investments. The recent outperformance of emerging markets finally phased into contagion side effects (see figure 5). What used to function as a “safehaven” has now caught up with the EM asset class as seen by the huge spike.

Meltdown in Commodity Markets More Fear Related

Given that many emerging markets have been enduring financial and economic turmoil, many see this as telling signs of deterioration in the global economic front enough to justify an across the board selling of commodities as oil, copper and others.

Figure 6: stockcharts.com: Commodity selloffs signs of FEAR!

But the recent behavior in the commodity markets appears to be pricing in a steep global recession if not a depression.

The meltdown has been focused on the assumption of a dramatic decline of global demand. They seem to forget that with the current credit crisis, many of the planned projects will be put on hold or shelved or cancelled, giving way to constriction of supply. If supply falls far larger than the rate of decline in demand then you end up having lack of supply thus higher prices.

Besides, commodities are not the equivalent of opaque and complex financial papers that have triggered this crisis. Commodities essentially don’t go bankrupt.

So even the commodity markets are pricing in more fear than rationality, hence you have an across the board selling of practically all asset classes except for US treasuries and the US dollar.

Albeit we are inclined to think that US treasuries could be the next shoe to drop considering the vast scale of debt issuance needed to bailout the US financial sector and the US economy.

On our part we think that the magnitude of market deterioration demonstrates exaggeration of such concerns, especially seen from our ground levels in the Philippines.

We certainly agree with Mr. Buffett that the deleveraging process has reinforced the fear psychology to the point of excessiveness. And this level of fear means opportunities for him and those with cash.

Moreover, we think that the market, functioning as a forward discounting mechanism, has already factored in the worst outcome and is pricing in fear more than fundamentals.

And when mainstream becomes afraid, this usually denotes of a bottom.

Selling the Bailout: The Fear Factor

``For historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general." Charles Kindleberger, Manias, Panics and Crashes A History of Financial Crises (New York: Basic Books, 1989), p. 16.

Proponents of the bailout package have focused on two major concerns to advance their cause: fear and the allure of profits.

In marketing, sales pitches generally have to connect with emotions to create the necessary interests or conditions required to generate the desired outcome: sales. And what emotion could be easily trigger quick response or reaction than fear! According to marketing savant Seth Godin, ``Marketing with fear is a powerful tool. Fear is a universal emotion, it's viral and people will go to great lengths to make it go away.”

So when officials go to the extent of contriving Armageddon scenarios in order to secure the political capital required to pass their sponsored legislation as this…

From Federal Reserve Chairman Bernanke (quoted by New York Times) ``If we don’t do this…we may not have an economy on Monday.”

…we understand this as nothing but a hard sell meant to ram into throats of the Americans the notion that Wall Street and Main Street needs a “savior” by constant government intervention of the marketplace.

Think of it this way, it has been MORE than a year where the Bernanke-Paulson tandem have peddled this mirage in myriad ways to no avail: the $163 billion fiscal stimulus at the start of the year, various assorted alphabet soup of bridge financing facility some of which had been enabled by the rarely used legal authority under Section 13(3) of the Federal Reserve Act (Wall Street Journal), overseas swap lines, 325 basis points Federal interest rate cut, the takeover of Fannie Mae and Freddie Mac and AIG, the forced marriage of JP Morgan and Bear Stearns with the backstop from the Federal Reserve, tapping the $50-billion Exchange Stabilization Fund to offer insurance to money-market fund investors to stop a run on the funds (WSJ) and others…

Yet at the end of the week, global world financial markets remain under severe duress, see figure 1.

Figure 1: Danske Bank: Credit Stress and Liquidity Crunch

So even as the Bernanke-Paulson team (B&P) managed to secure the much needed mandate via Emergency Economic Stabilization Act (originally the Troubled Asset Relief Program-TARF) for the use of $700 billion at their discretion to support domestic markets (including foreign banks with domestic exposure), US equity markets fell sharply over the week: Dow Jones Industrials tumbled 7.34% (year to date down) 22.16%, S&P cratered 9.4% (down 25.14% y-t-d) and Nasdaq crashed 10.18% (down 26.58% year-to-date).

As a side comment, US markets appear to be fast catching up on the loss statistics of the Philippine equity benchmark the Phisix, whose decline has interestingly been mild (relatively speaking amidst this turmoil) and could have signified sympathy selling (down 1.19% this week and down 29.14% year-to-date) than a traditional rout.

The credit crisis seem to worsen with the apparent collapse in the US commercial paper market- (investopedia.com) “An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days” or market facilities which enables corporations to gain access or utilize short term financing (see right pane courtesy of Danske Bank). Aside the skyrocketing cost of funding seems to reinforce the indications of the ongoing stress on interbank lending or as some analysts insinuate a “silent bank run” (right pane).

According to Steen Bocian of Danske Bank, ``First, perceived counterparty risk went up as fears of other bankruptcies swept through the system. Banks therefore became even more reluctant to lend money to other banks. Second, the collapse of Lehman Brothers led to big losses for the oldest US money market fund, Reserve Primary MMF, which “broke the buck”. This means that investors experienced real losses on funds invested in the Reserve Primary MMF, as net asset value went below USD1. This was the first time since 1994 that a money market fund had broken the buck. The incident led to a flight of money out of money market funds in the US.” (underscore mine)

This is the critical link between Wall Street and Main Street. When the cost of funds shoot skyward, many ongoing or expansion projects are likely to grind to a halt and companies or institutions surviving on the margins end up filing for bankruptcy. Even states like California have quietly sought funding ($7billion) from the US Treasury.

Interventionism Doesn’t Seem To Work

So in spite of the so-called interventionist nostrums you have the markets generally rioting or becoming more dysfunctional.

This could mean one of three things:

one- measures have not been enough ($700 billion is not enough) or

two-measures don’t address the root problem but instead deal with the symptoms or

three-market could be reacting to the law of unintended consequences.

Economist and author of More Sex is Safer Sex Steven Landsburg in the Atlantic.com wrote a very eloquent poignant piece about the current banking crisis (emphasize mine),

``So what's special about banks? According to what I keep reading, it's that without banks, nobody can borrow, and the economy grinds to a halt.

``Well, let's think about that. Banks don't lend their own money; they lend other people's (their depositors' and their stockholders'). Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other.

``That's one reason I feel squeamish about the official pronouncements we've been getting. They tell us bank failures will make it hard to borrow but never that bank failures will make it hard to lend. But every borrower is paired with a lender, so it's odd to state the problem so asymmetrically. This makes me suspect that the official pronouncers have not entirely thought this thing through.

``In the 1930s, a wave of bank failures did make it hard for borrowers and lenders to find each other, and the consequences were drastic. But times have changed in at least two relevant ways. First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent. Second, as any user of match.com can tell you, the technology for finding partners has improved since then. When a firm wants to raise capital, why can't it just sell bonds over the web? Or issue new stock? Or approach one of the hedge funds that seem to be swimming in cash? Or borrow abroad?

``I know, I know, the rest of the world is in crisis too. But surely in the vast global economy, it should be possible to find someone capable of introducing a lender to a borrower. (Note that I'm not talking about going to foreign lenders, though that's another option. I'm just talking about the same American borrower and American lender who would have found each other through Bear Stearns finding each other through Barclays instead.)

``In other words, I'm not sure these big Wall Street banks are really necessary, and I'm not sure we'd miss them much if they were gone. Maybe there's something I'm missing, but if so, I think it should be incumbent on Messrs. Bernanke, Paulson and above all Bush to explain what it is.”

Or a similar thought from Bill King (hat tip Barry Ritholtz), ``The cause of our current financial morass is Big Government + Big Business = Crony Capitalism + Funny Money = concentration of wealth and risk + declining US living standards.”

``The solution is decentralization of the financial system, like the tech industry, which will lower systemic risk, foster competition and yield better ideas, services and companies.”

Like us, Mr. Landsburg and Bill King acknowledges that the banking system is no less than one huge cartel organized and operated by a network of central banks led by the US Federal Reserve living off under the platform of US dollar standard fractional reserve banking system whose basic premise is one of institutionalized leverage (legally required to keep only a fraction of deposits relative to lending). And whose boom bust policies foster banking oligopolies and crony capitalism.

The Opportunity Cost of A Wal-Mart Bank

Proof? In 1999 Wal-Mart’s attempt to buy a savings bank in Oklahoma was foiled by the Gramm-Leach-Bliley Act. In 2002 Wal-Mart was again interdicted from acquiring the California ILC by the California legislature. In 2005, community and regional banks closed ranks to defeat Wal-Mart’s application banking license on fears that it might grab away their businesses (sfgate.com).

The point is not to defend Wal-Mart attempted entry in the banking industry, but to accentuate the example of the use of laws to prevent entry of new competition.

And this has been the essence of the Wall Street bailout: to sustain the clique on the premise of the sustenance of systemic concentration-“too big or too interconnected to fail” whose functionality has been “too embedded in the economy” which requires today the poor and mid class Americans to pay for the sins of a flawed currency system based on the rule of elite.

A financial and economic model where the poor subsidizes the rich, very much in resemblance to today’s global current account imbalances paradigm (poor emerging countries with current account surpluses subsidizing rich current account deficit countries). Free market failure anyone?

Conditions That Pave Way For Greed

The fact that the essence of today’s bust is one which stemmed from excessive leverage has been principally reflected on the operating principles of fractional reserve banking system. Where one can get away with piling on more leverage to gain additional profits why then stop? “As long as the music keeps playing we keep dancing”.

Is it all about greed? Think of it, when borrowing rates offered you is at ZERO rates or money for “free” what would you do? Take up the money and speculate. You chase for yields. You lever up. You lengthen your time preference based on false signals that the credit offered have been backed by real savings. And since everybody seemed to doing the same, why not seek the “comfort of the crowds”? You chase momentum on assets that have been popularly boosted by inflation or speculation. You flip stocks or houses. That’s exactly what the public did upon the implicit prodding from government policies.

US Banks which has signified as the main pillar of the fractional reserve bank system, has essentially transmitted the same principles to the society by: overextended gearing, overspeculation, adopted computerized quant risk models, went around regulatory loop holes as the net capital rule (New York Times), morphed into a new business model of “originate and distribute” which passed the credit and repayment risks to end-users freeing up more capital to lever, utilized innovative “hedge” instruments (structured finance and derivatives) to accrue incremental gains, relaxed lending standards to produce economies of scale, and moved out of the regulated sphere to establish the Shadow Banking System.

As for government policies, responsible for twisting incentives that led to these boom: Fed policies (aside from monetary policy, remember Greenspan’s advanced the idea of Americans moving to ARMs?), the implicit guarantee of the Government Sponsored Enterprises, Mark to Market Accounting Rules and the Community Reinvestment Act (which forced lending to less qualified candidates based on the concept of expanding homeownership or protecting the American dream).

Moreover, regulatory oversight became lax when the boom flourished! This very insightful quote from Robert Arvanitis Risk Finance Advisers, Institutional Risks Analystics, Seeking Beta: Interview with Robert Arvanitis (highlight mine)``Being mortal, the bureaucrats desire to avoid pain is as dear to them as the desire by their counterparts in private industry to seek gain. And it is far more profitable to game the rules, for example, than to enforce them. And any system can be gamed.” Yes indeed why get blamed for stopping the music while everybody is dancing? (hat tip: Craig McCarty)

In other words, Wall Street under the backstop of US Federal Reserve inflated the system until it became evidently unsustainable and thus collapsed.

So what is the basic problem? Inflation, overspeculation, overvaluation, oversupply and excess leverage or having taken on too much debt more than one can afford to pay. Essentially the ongoing bust represents market forces unraveling the massive distortions imposed on it or the reassertion of the universality of economic laws.

And $700 billion would seem like a spare change relative to the degree of market distortions that need to be cleansed from the system or the current high level of debt needs to be reduced to the level where the US economy can afford to pay them.

Markets have simply been telling Wall Street and the US, particularly Bernanke and Paulson and the US leadership, that it won’t be cowered by threats, and that market forces have been revealing the truth and realities about the untenableness of the imbalances within the system.

Perhaps it is about time to reconsider accepting the non-traditional non-cartelized sources of financing.