Negative Chain Effects from Regulatory Arbitrage: The AIG experience

In the Freakonomics blog, Daniel Hamermesh commented on a review of Kat Long’s The Forbidden Apple where he notes of how prohibitions have triggered unintended consequences.

Mr. Hamermesh wrote, ``The review describes a number of incidents where efforts to ban or restrict transactions in one market spilled over with negative consequences into a related market.

``To eliminate drinking on Sundays, New York City restricted it to hotels. In response, bars created makeshift hotel rooms, separated by dividers, which in turn created a burgeoning prostitution business. To avoid having men buy a drink in a bar in order to use the only publicly available restroom, the city opened public restrooms. But this created places where gay sex could proliferate.

``Both of these examples illustrate the law of unintended consequences: actions that restrict quantity or price in one market will affect them in related markets. Indeed, they may even create markets that nobody had heretofore imagined. No doubt there are many other, equally prurient examples.” (bold highlight mine)

Mr. Hamermesh’s remarks reminds us of how the “restrictions” based regulatory arbitrages in the financial sector spawned “related markets” in derivatives, the shadow banking system and other “structured finance” instruments.

As Paul Farrell wrote in the marketwatch.com in 2008, `` The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.” (bold highlight mine)

These innovative vehicles ultimately served as the principal financing conduits or the “black markets” which fueled the colossal real estate bubble that subsequently shaped today’s crisis.

Essentially the banking system which sought for higher yields took advantage of legal loopholes to assume more risks by leveraging up. Hedge instruments became speculative and Ponzi financed.

Although the actions of the "bailout cultured" banking system had been partially typical of an arbitrageur, which as Michael Mauboussin of Legg Mason says is driven by “The idea is simple and intuitive: a smart subset of investors cruise markets seeking discrepancies between price and value and make small profits closing those aberrant gaps.”

Chart from Michael Mauboussin of Legg Mason

Nonetheless Chris Whalen of Institutional Risk Analytics gives an example of how AIG morphed from an insurance and reinsurance business model to a Ponzi by virtue of “regulatory arbitrage” or “may even create markets that nobody had heretofore imagined” (Daniel Hamermesh)…

``One of the first things we learned about the insurance world is that the concept of "shifting risk" for a variety of business and regulatory reasons has been ongoing in the insurance world for decades. Finite insurance and other scams have been at least visible to the investment community for years and have been documented in the media, but what is less understood is that firms like AIG took the risk shifting shell game to a whole new level long before the firm's entry into the CDS market….

``One of the most widespread means of risk shifting is reinsurance, the act of paying an insurer to offset the risk on the books of a second insurer. This may sound pretty routine and plain vanilla, but what most people don't know is that often times when insurers would write reinsurance contracts with one another, they would enter into "side letters" whereby the parties would agree that the reinsurance contract was essentially a canard, a form of window dressing to make a company, bank or another insurer look better on paper, but where the seller of protection had no intention of ever paying out on the contract…

``It is important to understand that a side letter is a secret agreement, a document that is often hidden from internal and external auditors, regulators and even senior management of insurers and reinsurers….

``It appears to us that, seeing the heightened attention from regulators and federal law enforcement agencies such as the FBI on side letters, AIG began to move its shell game to the CDS markets, where it could continue to falsify the balance sheets and income statements of non-insurers all over the world, including banks and other financial institutions.

Read the rest here

Cartoon of the Day: US Tent Cities and President Obama

From Caricature...

Cartoon From About.com

To Reality....

Check out more pictures of the "TENT" cities from the New York Times

The Myth Of Money Flows Into The Stock Markets

``To understand reality is not the same as to know about outward events. It is to perceive the essential nature of things. The best‐informed man is not necessarily the wisest. Indeed there is a danger that precisely in the multiplicity of his knowledge he will lose sight of what is essential. But on the other hand, knowledge of an apparently trivial detail quite often makes it possible to see into the depth of things. And so the wise man will seek to acquire the best possible knowledge about events, but always without becoming dependent upon this knowledge. To recognize the significant in the factual is wisdom.” Dietrich Bonhoeffer (1906-1945) German Lutheran Pastor

I recently picked up a short remark on the cyberspace about how the most recent febrile punts from “Meralco” could have caused a “rotation” in the general markets. The idea is that those who profited from the recent upside volatility in Meralco may have buoyed the general market by using profits earned from recent trades to shift into other issues.

This seems similar to the conventional thinking where occasions of huge IPOs or other security offerings (e.g. preferred shares, bonds) in the domestic financial system are deemed as having to adversely “suck the liquidity out” of the Philippine Stock Exchange.

The general idea for both assertions is that money flows “in” and “out” of the Philippine Stock Exchange .

The fact is that money DOES NOT flow in or out of the stock market.

Why?

On any given trading day unless a publicly listed company issues new or additional securities, shares available to the market are fixed.

This means that a transaction occurs only when buyers and sellers agrees to voluntarily exchange cash for a specified security at a particular price.

Let’s say Pedro has Php 100 in cash and agrees to buy Juan’s ownership of publicly listed XYZ company shares for Php 10 a share. The transaction would prompt for a shift in ownership: Pedro’s cash will be credited to Juan’s account while Juan’s XYZ shares will be transferred to Pedro’s account.

In short, in contrast to conventional thinking there is no money flows.

The price directions in the exchange merely reflect on the aggressiveness of the buyers in bidding up the price level of a security (hence, higher prices) or of the assertiveness of sellers in selling down a security at certain price levels (hence lower prices).

As we recently wrote at A Primer On Stock Markets-Why It Isn’t Generally A Gambling Casino, ``Yet prices are always set on the margins. What you read on the stock market section in the newspapers account for as prices determined by marginal investors, where daily traded volume represent only a fraction of total shares outstanding or market capitalization, and not the majority owners.”

As in the case of Meralco, there had been buyers and sellers at recently low prices as much as there had equally been buyers and sellers at the recent high prices. Thereby the suggested “rotation” from punts signifies as “rationalization”-probably holds true for some but not all (fallacy of composition)-than of reality.

In addition, the “sucking out of liquidity” from a monster $800 million record bond offering of San Miguel Brewery , which was reportedly oversubscribed by 16 times, to exclusively the domestic market hasn’t drained liquidity from the PSE, the fact is that despite the resurgence of broadmarket NET foreign selling, the Phisix is up by about 15% from the close of the SMB bond offering last March 16^th.

The SMB offering only suggests that there is a vast pool of non-equity market liquidity sloshing in the domestic financial system.

Importantly, the recent recovery in the Phisix likewise extrapolates to local liquidity substituting for the net foreign selling which has been accounted for in the market since the credit crisis erupted in 2007.

Figure 1: PSE: NET Foreign Selling (above), Transition from Foreign Dominance to Local Dominance

Figure 1 from the PSE gives an abbreviated view of the ongoing dynamics in the local exchange.

The chart manifests of the prevalent net foreign selling since last quarter of the 2008 and the shifting regime of trading ascendancy which was previously controlled by foreign investors (grey line) to presently local investors (maroon line) seen at the lower pane entitled ‘Total Value Traded By Investor Type’.

The other vital point to consider is that the transactions in the PSE represents for as a continuing flux of the character of ownership than one of technical “money flows”. As cited above, one of the current tangible alterations in the ownership has been that of local money replacing foreign money.

Fundamentally, it would rather be irrelevant if the issue of ownership transfers will be just from speculators to market punters or scalpers whom are looking to profit from minor price fluctuations.

But it would be materially relevant if the conveyance reflects a shift from major stockholders to a wider spectrum of public shareholder ownership because a larger breadth of public participation should entail a broader cognizance of the basic functions of capital markets.

And since capital markets operate as non-banking alternative option to raise, access, avail or price in or value investment capital, it has an economically vital function of channeling society’s savings into productive investments.

Moreover, when we argue about the low penetration rates of domestic investors in the local equity markets, which according to the PSE is estimated at less than half of 1% of the population even at the peak of the market, we are thinking along the premise of concentrated degree of ownership or of the limited float on the supply side (of listed companies) and or the lack of widespread market participation from the local public savers on the demand side. Of course, here the PSE looks at only direct investments, but glosses over the indirect investments through Unit Investment Trust Funds and mutual funds-where we estimate market exposure increases to somewhere at 1%.

The point is that these glaring deficiencies essentially reflect on the severe underdeveloped nature of the local equity markets.

And these are further compounded by the dearth of sophisticated instruments to hedge on “naked” positions, the “gambling” or overtrading culture disseminated as “education” by conventional brokers and the high cost structures from regulatory compliance that serve as material barriers to entice additional listing from privately owned unlisted enterprises into tradeable or investable publicly listed financial instruments.

Market Ignorance and Political Serfdom

Let me add that it doesn’t help or do justice to the public or to society to induce “trading” assimilation programs because it “tunnels” vulnerable neophytes to believe that the stockmarket is merely a gaming platform to play with, based on a very narrow time frame expectations regardless of prevailing risk conditions.

Ironically, what is the use to study the risk reward nature of markets (or even to obtain course certificates as Chartered Financial Analyst-CFA) if only markets operate in the analogy of games played in the casino or the racetrack?

People who get burned from wrong expectations tend to shy away from a bad experience. It is out of such adverse outcome that the “casino” imprint gets etched into mainstream psyche. And worst, a tarnished image has viral (word of mouth) repercussions. So short term gain always come at the expense of long term losses (in the form of monetary loss and mental anguish) which equally poses as a considerable obstacle to economic development.

On the philosophical aspect, the paucity of exposure to the capital markets is one substantial reason for the “overdependence” of Filipinos to the government as the ever elusive elixir for societal ills.

The problem is that government as the solution has served as perpetual illusion. The problem isn’t due to the “bad” attitudes by the Filipinos, as repeatedly floated in emails, but attitudes fostered by an entitlement and welfare privileged class or the “dependency culture” which is a common trait to a society highly dependent on government.

Yet the eternal search for virtuousness can’t be reconciled with political realities, where each incidence of hope from a new beginning eventually turns out as a mass frustration.

Mr. Robert LeFevre in his The Nature of Man and His Government tells us why, ``Government is a tool. The nature of the tool is that of a weapon…government, designed for protection, always ends up by attacking the very persons it was intended to protect…Government begins by protecting some against others and ends up protecting itself against everyone."

Notwithstanding, we Filipinos have not yet to realize that entrepreneurship and its quintessential feature of risk taking serve as fundamental conditions for economic and financial progress.

The Law Of Demand And Supply Applied To Equities

Going back on how the law of demand-and-supply of equities impact pricing, two charts from Northern Trust reveals of the basic laws of economics at work in the recent collapse of the US equity markets…

Figure 2: Northern Trust: How Demand and Supply Impacts Stock Prices During the Recent Crisis

Last year’s meltdown came in conjunction with a record amount of net equity issuance which totaled $986 billion during the fourth quarter of last year, or at a seasonally-adjusted annual rate or equivalent to 6.9% to nominal GDP.

And who was doing the record issuance?

Northern Trust Chief Economist Mr. Paul Kasriel makes as an astute observation, ``it was the financial system, desperate for new capital to replace a huge amount of old “depreciated” capital, that was doing all the issuing. At a seasonally-adjusted annual rate, financial institutions were net issuers of equity to the tune of $1.4 trillion in the last year’s fourth quarter while nonfinancial corporations were net “retirers” of $450 billion of equity.

``At the same time the financial institutions were issuing record absolute and relative amounts of new equity, I think it is safe to say that investors’ demand for financial institutions’ equities was somewhat inhibited…”

So as the US financial institutions had been undertaking intense balance sheet deleveraging by selling off liquid assets worldwide to raise capital, which further crimped on general market sentiment and which similarly contained demand interests for equity assets, we also saw financial institutions flooding the equity markets with new issuance or simply supply overwhelmed demand which prompted for a meltdown.

Mr. Kasriel rightly concludes, ``In sum, there is no mystery as to why the broad U.S. stock indexes took a dive in the fourth quarter of last year. It simply was a matter of an increase in supply accompanied a decrease in demand.”

The equity demand supply dynamics in the US hasn’t been the case in the Philippine equity markets as the latter has suffered mainly from the contagion impacts, as the exposure to “toxic” assets had been inconsequential that didn’t require equity issuance to plug losses.

The Myth Of Cash On The Sidelines

To further expand the thought about the misguided “money flows” in and out of the stockmarket, this should include the misimpressions about sitting “cash on the sidelines” as potential drivers of the market.

Dr. John Hussman rightly and eloquently argues (bold highlight mine), ``savings equals investment, and new savings can finance new investment. But what investors often point to and call “cash on the sidelines” is really saving that has already been deployed and used either to offset the dissavings of government or to finance investments made by other companies. Once those savings have been spent, you can't, in aggregate, use the IOUs (in the form of money market securities) to do it again.

``In other words, the amount of cash that investors hold “on the sidelines” is determined by the amount of borrowing that has occurred in the form of money market securities like T-bills and commercial paper. It's a lapse of proper thinking to believe that investors, as a group, can move their “cash on the sidelines” into the stock market, or that companies, taken together, can turn their “cash on the sidelines” into new investment and capital spending.”

Technically speaking, money invested in corporate or government bonds account for as money having been already spent and thus a shift into the equity markets does not account for as “money flows” into “new” capital investment.

So what is commonly perceived as drivers for equity prices in terms of “cash in the sidelines” isn’t accurate. Equity prices again are driven by the aggressiveness of either buyer or seller in the marketplace.

Other than that the exercise of paper shuffling, the switching of assets simply can be construed as realignment or rebalancing of portfolio holdings.

Applied to the Philippines, this implies that a genuine measure of money flow into the equity market should translate to savings financing a new equity issuance in the form of an IPO, which generally flourishes during boom days or is pro-cyclical [see The Prudent Way To Profit From IPOs!], and or secondary listings which are meant to finance fresh projects or company expansions.

Summary and Conclusion

The point of this article is to refute the fallacious mainstream notion that daily transactions signify as some mystic form of money flowing in and out of the equity markets.

Money flows into the equity markets only occur when savings are utilized to finance new capital spending projects by virtue of new corporate equity issuances in the form of IPO or secondary listing.

Instead, the directions of equity prices are driven by the aggressiveness of buyer or seller, where daily transactions only reflect on the dynamics of changing of ownership of mostly marginal investors.

In addition, the fundamental laws of demand and supply applied to equity distribution have been shown to have a material impact on its price values. Thus it is important not only to look at the elements encompassing macro or micro environment dynamics and its impact to earnings or to the national economy but likewise on the variables that may directly influence the demand and supply allocation of equities.

Finally the population penetration level of equity investors can be reflective of the nature of a society’s understanding of how capitalism works. The small diffusion of domestic public investors seems highly correlated to the statist biases of the local populace. Since the capital markets function as an important conduit of capital accumulation through the development of the country’s production structure, the corollary of the underdevelopment of the capital markets is manifested by the nation’s suboptimal economic growth.

Hence, until the local population can materially increase their comprehension over how markets fundamentally work or how their savings can be recycled into productive investments, the local markets will remain underutilized and underinvested if the misperception that markets are simply “games” to dabble with remains.

We hope that our industry colleagues will authentically “educate” the public that sets aside short term gains in exchange for long term economic progress.

The Growing Validity Of The Reflexivity Theory: More PTSD And Periphery

``It is commonly appreciated that China has about $2 TN in reserves to go with its population of 1.3 billion. This alone provides China unprecedented reflationary capabilities. China also maintains a tight relationship between its banking system and government policymakers, and it is worth noting that recent reports have Chinese bank lending posting another eye-opening month of expansion ($234bn!). China is also now aggressively using currency swaps and other financing mechanisms to drive exports and trade, especially in Asia. There is also increased talk of the Chinese government providing global vendor financing for its major industries, a potentially huge development from both China and global perspectives. Clearly, if Chinese industrial policy seeks to elevate the status of key domestic industries, current global tumult provides quite a rare opportunity to press decidedly ahead. Moreover, if China moves to develop its northern region as it has developed the south, there is really no bounds to the amount of “money” that could be spent.”-Doug Noland, Periphery Rising

At the start of the year, we forecasted that the Asian and local markets will register gains at the end of the year.

Our idea is that this isn’t one coming out of a “valid” economic recovery but one from the tsunami of money being drenched into the financial and economic system that had been meant to offset the loses from the OECD financial sector and from the recessionary forces affecting the global economy.

Such trend seem to get reinforced by the day.

Into last week’s G-20 meeting the multinational assembly had produced a spending plan aimed to augment the resources of the IMF, funded by Japan and Europe. In addition, ``Rich countries such as America will provide a $500 billion credit line, known as New Arrangements to Borrow. This was trailed several weeks ago. Significantly, the IMF will print $250 billion of its own currency, known as special drawing rights, allocating sums to its members according to their quotas” reports the Economist (see table 1).

Table 1: New York Times: The G-20 Mission

Of course this won’t be complete without the additional promise of further inundation of fiscal stimulus programs which was pegged at $5 trillion aimed “to raise output by 4%” and “accelerate the transition to a green economy” as indicated by their official communiqué.

Politicians love to babble about promises which usually remain only as that…promises, considering that most of the agreement drawn appears to be “motherhood” statements and bereft of details.

But there is one thing we can be sure of, that which politicians love to do…spend!!! And spending we believe it would be.

From Core To Periphery

And with the augmented resources, revitalized role of a supercharged IMF, many see this as bolstering the positions of emerging markets.

Again from the same article in the Economist (bold highlight mine),

``Now the new money must be directed to developing countries, especially in eastern Europe. Many such countries have been loth to tap the fund because of the stigma involved. A pledge by the G20 to reform the fund’s governance soon may convince them that the leopard has changed its spots. This week Mexico secured a $47 billion credit line with the fund, with no strings attached, which may set a trend…

``The importance of offering new sources of funds to the developing world should not be underestimated, however. By some estimates poor countries have $1.4 trillion of debts to roll over this year alone and Western creditors are hoarding their cash. These countries have far less fiscal room for manoeuvre than rich economies. They are also areas of the world where growth could rebound quite quickly, because households are not weighed down by the crushing debts typical in America and Europe. In a further fillip to many of them, the G20 agreed to ensure $250 billion in trade finance to help reboot global trade—though it was not clear how much of this was new money.”

In short money appears as being transmitted to support growth in the developing countries as part of the collaborative efforts to inflate the system.

And some market savants seem to be looking from the same angle as we had projected.

This from Barron’s Randall Forsyth, ``Ms. Pomboy points out that while emerging economies account for 43.7% of global output, they represent only 10.9% of global stock market capitalization. China by itself makes up 15% of the global economy but less than 2% of market cap while the U.S. provides 21% of output but 43.4% of market cap.

``With so much room to grow…and so much money to flow..might the Emerging Markets become the next bubble?" she asks rhetorically. "All the ingredients are there, the persuasive story line (from their savings to their demographics), the dearth of compelling investment alternatives and, of course, the Fed's flowing font of cheap capital."

Oh lala.

More Evidence Of The Impact From PTSD

Moreover we pointed out that the severe drop in global trade had primarily been a function of a seizure in the operations of the US-European banking system, where the reemergence of barter trade belied the notion of an absolute deflationary collapse which had been propounded by deflation advocates.

For us, the disruption appears to have been a function of an anxiety disorder called PTSD or Posttraumatic Stress Disorder [see Global Posttraumatic Stress Disorder (PTSD): The After Lehman Syndrome], where a distressing shock event basically traumatized international trade flows.

Nevertheless PTSD’s seem to heal overtime.

Figure 3: Danske Bank: Global Business Cycle

And economic data appears to be reinforcing our stand, where global leading indicators and manufacturing orders of major OECD and BRIC economies appear to have meaningfully rebounded from the lows as shown in the Figure 3 from Danske Bank.

The appearance of synchronized recovery from the harrowing last quarter crash suggests that the massive decline could have been ‘overrated’.

Albeit we can’t rule out that a typical reactionary response from big crashes are large oversold bounces similar to the stock markets, our idea is that the flood of money generated by global governments to replace “lost demand” appears to be gaining traction especially in Emerging Market economies, who were disrupted not by a dysfunctional domestic financial system but by trade linkages brought about by credit freeze in the OECD banking system.

And given that EM economies have low leverage uptake, we believe that they have the potential to absorb much of the global government’s serial bubble blowing.

The Growing Validity Of The Reflexivity Theory

Importantly we believe that George Soros’ theory of Reflexivity has underpinned all these.

Here is what we wrote in Inflationary Policies Drives China’s Shanghai Market; Clues of Reflexivity Theory at Work

``…markets aren't just about traditional economics or conventional finance. It is mostly about psychology or how government inflationary policies may trigger significant "reflexivity" in market psychology….

``The reflexivity theory applied to the Shanghai's index suggests that if the course of actions (inflationary policies) succeeds to alter participants thinking, then the subsequent changes in perception will ultimately be followed by changes in the facts.

``Put differently, if the Shanghai Index's will continue to rally, it will be 'rationalized' by the public as a recovery (perception), when this is all about central banks' massive 'serial bubble blowing' inflation (fact).

``Eventually when the perception of recovery is reinforced by economic data, (fact) the market trend deepens (perception).”

And suddenly we seem to be witnessing a growing number of observers acting as what we have long anticipated…

From Harvard Professor and former Chairman of President Ronald Reagan’s Council of Economic Advisors and President of National Bureau for Economic Research, Martin Feldstein (bold highlight mine)

``China is likely to be the first of the major economies to recover from the current global downturn. Its pace of expansion may not reach the double-digit rates of recent years, but China in 2010 will probably grow more rapidly than any country in Europe or in the western hemisphere.”

Further signs of the burgeoning bandwagon from China’s repeated gains…

From Bill Witherell of Cumberland Advisors, ``Japan surely will benefit from the expected resumption of strong growth in China and the anticipated beginning of a recovery in the US in the second half of 2009.” (bold highlight mine)

From John Derrick of USfunds.com, ``We may already be seeing early signs of the initial round of stimulus having an impact. China responded aggressively back in November announcing a $586 billion stimulus package. This week China’s purchasing manager’s index (10) rose to 52.4, indicating economic expansion and the first reading above 50 since September.” (bold highlight mine)

Figure 4: Shanghai’s Reflexivity Theory At Work

While most of China’s peers, namely Emerging Markets (EEM) and the Dow Jones Asia ex-Japan ($DJP2) have only seen a belated recovery last March, the Shanghai index has significantly pulled away breaking into bullish territory-namely a breakout from resistance levels and breakout from 200 day moving averages.

The Phisix which has lagged the latest market levitation due to local controversial quirks (particularly the Meralco and the PLDT affair) seems likely to follow suit.

In short, the reflexivity theory -from fact to perception and now perception to facts-seems to be succeeding at recalibrating the market’s mood.

G20: Fueling The Inflation Drama, Reprise Why A Different Inflationary Setting

`Despite the pleas from bankers and politicians, mortgages are not plagued by a lack of liquidity but a lack of value. If sellers would be more negotiable, there would be plenty of liquidity. Who knows, at the right price I might even buy a few. The problem is that putting a market price on these assets would render most financial institutions insolvent, which is precisely why they do not want to let that happen. Simply pretending that all these mortgages will be repaid does not solve the underlying problems. It may keep some banks alive longer, but when they ultimately do fail, the losses will be that much greater. In the meantime, solvent institutions are deprived of capital as more funds are funneled into insolvent "too big to fail" institutions - hiding their toxic assets behind rosy assumptions and phony marks.” Peter Schiff, Let's Play Pretend!

As we have discussed last week in Expect A Different Inflationary Environment, we don’t believe that the US financial markets will see a renaissance during this inflationary episode nor do we believe it will lead the market out of the present bear market rut.

The stiff regulations to be imposed on the industry will be one major factor why. In addition, the G20 summit has equally accentuated the political demand to do so. Mass leverage from the system of 30 or 40 or 50 to 1 won’t be seeing the light.

Today’s leverage will mainly come from the global governments or if fortunate enough Emerging Markets or Asia whose credit system has been unimpaired from the recent crisis.

Moreover, as we discussed in Why Geither's Toxic Asset Program Won't Float spreading recessionary strains will further vitiate on the financial positions of banks, this percolating from the largest concentrated banks to regional banks.

While the recent changes in the FASB accounting standards may temporarily help alleviate the pressures to redress the balance sheets, it is unlikely for US banks to normalize the lending process in the possible understanding that gains from the overleveraged households and the financial sector may not be large enough to offset the risks of potential losses.

Next, there are regulatory concerns. The fact that the rules of the game are being changed daily and where a political backlash by the public on Wall Street has combined to turn off potential investors interests into participating in government sponsored programs.

Moreover there are major concerns like asset quality and the price discovery from the toxic assets which includes the gigantic credit default swap market and other forms of derivatives as the interest rate swap.

The issue of price discovery isn’t a figment of anyone’s imagination. The fact that bid and ask can’t meet into a voluntary exchange means that this isn’t a liquidity problem but a valuations problem. Why? To be sure, this isn’t a market failure for the simple fact that incentives driving the financial sector have been totally severely distorted by excessive government intervention, moral hazard issues, and or the bailout mentality.

Simon Nixon of Wall Street Journal hit the nail in the head with this poignant commentary (all bold highlights mine), ``In a capitalist system, prices are set in the free market and providers of capital bear responsibility for their losses. Neither of these characteristics hold true of the banking system. The price of credit, the basic commodity of the financial system, was distorted first by implicit government guarantees to depositors and other providers of capital, and second by the tendency of governments to cut interest rates at the first sign of financial trouble.

``Financial theory says the cost of capital to an enterprise should rise in line with risk. But banks during the boom were able to leverage themselves more than 50 times yet see their cost of funding fall.

``That is hardly the sign of a well-functioning free market. Those who provided funding to banks correctly gambled that governments would ride to their rescue…

``Indeed, it has been axiomatic of the policy-maker response that bondholders should be kept whole to avoid the threat that the banking system would seize up completely or that the insurance industry, with large bond portfolios, would become the next domino to fall. Most Western bank bonds are now issued with an explicit government guarantee. The result is a distorted global financial system in which the true cost of capital is obscured.

``In a fully capitalist system, there would be no guarantees. The market would ensure banks didn't become too big or too leveraged.

``At least the current crisis is sure to lead to higher common-equity buffers for all. But since removing the guarantees and breaking up the banks is outside the realm of political reality, an alternative solution is to charge banks explicitly and upfront for all guarantees. The charges would rise in line with leverage. That at least would raise the cost of funding, helping to generate a price signal to the market.

``Instead, global governments are taking the opposite tack. Unable to remove the guarantees and unwilling to properly charge for them because the banks remain too weak, they will try to limit the risks through more intrusive regulation.

``The results, if that goes too far, should be clear enough: lower bank profits, less capital generated, less credit created, lower economic growth and more bureaucratic control over the banks and the wider economy.”

In short the market cleansing process has been skewed by government’s intense efforts to camouflage real price values, which has led to lack of trust and confidence among the financial institutions. Without government lifeline all these structures are most likely to collapse.

The deflationary pressures will ensure that the US government will continue to inflate the system. And inflating the system means that it would need to accelerate the rate of inflation.

The likely scenario will be a tug-of-war between inflation and deflation. Although, inflationary pressures outside the ongoing debt deflation zone will probably take a firmer root or become more entrenched.

As we stated last week, inflation appears in stages and with the OECD real estate sector and the securitization backed structured finance out of play, the inflation process will be short circuited and likely be in rotation or in a feeback loop within the commodity sector and the world stock markets particularly in Asia and Emerging Markets.

The tug of war of inflation and deflation will ensure that debt deflation affected markets will underperform relative to those whom are least affected. Although the sheer magnitude from collaborative effort to stoke inflation may put a floor to these markets at the expense of the currency values.

While the G 20 summit declares that they “will put in place credible exit strategies from the measures”, it doesn’t say how they would do it. The tug of war between deflationary pressures and inflation suggest that they will lean towards more inflation than risks towards deflation. This would account for as the mainstream economic ideology in practice, whose results will likely mirror that of the 70s but at a far wider damage.

Moreover another dubious assertion is that they “will refrain from competitive devaluation of our currencies”. The fact that the degree of fiscal stimulus or monetary inflation will be applied differently means that the currencies involved in huge programs will obviously be ventilated through prices. Hence, refraining from competitive devaluation is an example of a fashionable political statement than to be seen in actual practice.

Finally as we appear to be seeing today, initially “boom conditions” will prevail. The next phase of will likely see a spillover of high commodity prices into consumer prices. And some central banks may apply brakes which may cause increased volatility, although such volatility may again prompt central bankers to lean towards inflation. Then we should see an acceleration of inflation.

If Emerging Markets and Asia succeeds to soak up the inflation to generate a boom in their national markets and economies then a future bust with these regions as the epicenter of the next crisis.

Otherwise, the other possible risk is one of hyperinflation where the aftermath would result to the end of the reign of the US dollar as the world’s de facto currency reserve.

Uses Of The Zimbabwean Dollar

Despite the most recent hyperinflation it is not true that the Zimbabwean Dollar has lost its entire value; it may have lost its monetary functions of medium of exchange, unit of account and store of value, but has seen a shift in the Dollar's utility in the form of...

1. Advertisement material, as below
and more below...

The ads signifies as signs of political protest by a domestic media outfit against the administration, excerpt from neatorama.com

``To protest the hyperinflation that has rendered the Zimbabwe currency worthless and to raise awareness of the dire economic situation there, the Zimbabwean Newspaper created an ad campaign featuring huge posters, wall murals, flyers, and even billboards all made out of trillions of Zimbabwean dollars. Check out the photos from the newspaper’s Flickr photostream.

"The Mugabe regime has destroyed Zimbabwe. It has presided over the brutal oppression of the opposition, a cholera crises, massive food shortages and the total collapse of their economy. Furthermore anyone brave enough to report this has been bullied, beaten and driven into exile. One such group is ‘the Zimbabwean Newspaper’. However, not content with having hounded these journalists out, the regime has slapped an import ‘luxury’ duty of over 55% on them which makes the paper unaffordable for the average Zimbabwean. In order to subsidize the paper they need to sell it in England and South Africa, to raise the foreign currency.

"A unique campaign was devised to promote the paper to raise awareness and increase readership. One of the most eloquent symbols of Zimbabwe’s collapse is the Z$100 trillion dollar note, a symptom of their world record inflation. This note cannot buy anything, not even a loaf of bread and certainly not any advertising, but it can become the advertising, it can be a powerful reminder about Zimbabwe’s plight and the need to hold someone accountable.

(hat tip: Mark Perry)

2. Tool for gold panning...
If it can't be used as money, then it can be used to pan for real "gold" money.

watch the Zimbabwe's Gold for Bread video here

3. Lastly, as an alternative use for the toilet paper...

Hat tip: Freakonomics

Nassim Taleb at CNBC: Understanding Risks From Complex Systems

CNBC's interesting interview with Black Swan author Nassim Taleb...

Some Unintended Consequences from Environmental Politics

Environmentalism today has morphed into a fad (yes...a frothy bubble) such that rampant imposition of regulations have led to undesired consequences.

And here we find some examples of the harmful side effects.

1. A ban on lead toys have halted sales of bikes and threatens a change in behavior of children...

From USA Today (all bold highlights mine) , ``A new federal law aimed at protecting children from lead in toys has also forced a nationwide halt in sales of off-road motorcycles and recreational vehicles built for young riders, killing off a multimillion-dollar industry that was thriving despite the recession.

``Thousands of powersports dealers were told to halt sales of vehicles designed for children 12 and younger because of new lead restrictions in an act of Congress that took effect Feb. 10....

``With the motor vehicle industry already hurting from recession, he said the ban means a 20% drop in sales of youth off-road motorcycles and the parts business for bikes already sold...

``The ban will have repercussions economically.

``The Motorcycle Industry Council estimates nearly 100,000 youth bikes were sold in the USA in 2008, though some were aimed at kids 13 and older and not covered by the ban. Dealernews, an industry trade publication, estimates that the value of inventory at U.S. dealers that can no longer be sold probably exceeds $100 million...

``Most cycles and ATVs are made overseas, but there are tens of thousands of jobs attached to the industry here. More than 13,000 powersports dealers sell products in the United States, according to the Motorcycle Industry Council, employing an estimated 124,000 people. Vitrano says the industry estimates the retail market value for all off-road cycles and ATVs is $14.5 billion a year, including sales, service, parts, accessories and payroll.

``Vitrano says the ban will have a perverse effect: Rather than no longer riding, kids who can't get a cycle their size may hop on a bike made for older children or adults — one inappropriate and dangerous for a smaller child...

``The economy notwithstanding, enthusiasts say the ban needlessly kills a family-oriented sport where children ride with their moms and dads and, like other sports, can induce children to behave."

2. Biking Scheme Ruined By Theft

From BBC (bold highlights mine), ``A popular bicycle rental scheme in Paris that has transformed travel in the city has run into problems just 18 months after its successful launch.

``Over half the original fleet of 15,000 specially made bicycles have disappeared, presumed stolen.

``They have been used 42 million times since their introduction but vandalism and theft are taking their toll.

``The company which runs the scheme, JCDecaux, says it can no longer afford to operate the city-wide network.

``Championed by Paris Mayor Bertrand Delanoe, the bikes were part of an attempt to "green" the capital...

``City hall has recently agreed to pay towards the costs of replacing the stolen or trashed bicycles but is refusing to bail out the company.

3. Manipulating environments have led to baneful environmental imbalances...

From New Scientist (bold emphasis mine) , ``Good intentions have rarely gone so awry. When conservationists tried to save an island's birds by culling its feral cat population, they overlooked one critical consequence: rabbits. A new study reveals that removing just 160 feral cats triggered a boom in Macquarie Island's rabbit population from about 4000 in the year 2000 to 130,000 in 2006.

``The cats were shot as they had been preying on the island's burrowing birds. But the newly rampant rabbits have devastated vegetation over 40% of the island. Clearing up the mess is expected to cost at least $16 million, and it remains unclear whether the island will ever fully recover.A landslip in 2006 that badly damaged a penguin colony has been blamed on rabbit destruction of the vegetation.

``A World Heritage Site halfway between Australia and the Antarctic, the Macquarie Island case is a tragic demonstration of why agencies in charge of conservation need to analyse all aspects of an eradication programme. "We need a culture change," says Hugh Possingham of the University of Queensland in Brisbane, Australia. "It's a generalisation, but people who do environmental work are often adverse to mathematics, and so avoid quantitative risk assessments."

My additional comment: the late author Michael Crichton has a great exposition on why attempts to manipulate environment almost always ends up opposite to the desired goal/s; see our previous post Michael Crichton And The Complexity Theory.

4. Green Policies have recently instigated a man made disaster -Australia's bushfire which claimed 173 lives ...

From theage.com.au (bold underscore mine), ``ANGRY residents last night accused local authorities of contributing to the bushfire toll by failing to let residents chop down trees and clear up bushland that posed a fire risk.

``During question time at a packed community meeting in Arthurs Creek on Melbourne's northern fringe, Warwick Spooner — whose mother Marilyn and brother Damien perished along with their home in the Strathewen blaze — criticised the Nillumbik council for the limitations it placed on residents wanting the council's help or permission to clean up around their properties in preparation for the bushfire season. "We've lost two people in my family because you dickheads won't cut trees down," he said.

``"We wanted trees cut down on the side of the road … and you can't even cut the grass for God's sake."...

``Another resident said she had asked the council four times to tend to out-of-control growth on public land near her home, but her pleas had been ignored...

``Of all the speakers who addressed the meeting, it was Arthurs Creek CFA Captain David McGahy who got the most rousing reception.

``Choking back tears he told them: "I'm so terribly sorry. We desperately wanted to protect you but we couldn't. [my comment-too late the hero... officials have always been reactive]

``"In the cold analysis of light, it wouldn't have mattered if we'd have had 200 units here, all that would have happened is we would have ended up with a whole lot of dead firefighters. I've been at this game for about 40 years and I haven't experienced anything like that, not even remotely like it."

Ben O'Neill lays the blame squarely on socialism as to why such a devastating mishap occurred (all bold highlight mine),

``Because private ownership entails the right to control one's own property, and because some people may not wish to sacrifice their lives to prevent interference with local possums, environmentalists seek to achieve their goals through government ownership of land — land socialism. In this endeavor, they have been very successful. State forests, national parks, and other Crown land in Victoria make up approximately one third of the state but contributed four-fifths of the February 2009 bushfires. And as with all examples of land socialism, the situation in Victoria has created an incentive structure that has destroyed accountability, thereby exacerbating the disaster.

``As mere caretakers of public land, bureaucrats and local politicians are not liable for any loss caused by their mismanagement. Nor do they have any personal stake in its capital value. When property is destroyed due to their ineptitude and their enslavement to the philosophy of environmentalism, their savings are not in danger. If anyone is required to pay for compensation, it is taxpayers who have had nothing to do with the whole mess. For the local councilor or the state or federal politician, what matters is getting the green vote, showing how "environmentally conscious" they are, and placating all those green lobby groups and media darlings that might say nasty things about them if they don't toe the line."

My comment: Politicians secure the power to engage in environmental socialism but hasn't be held responsible for the acts of neglect or omissions or damages accrued to the society. The irony is it is the taxpayer who suffers...as the victim (of the consequences of these perverse laws) and likewise bears the onus of indemnification of the victims.

The last word comes from Lew Rockwell who diagnosed the California bushfire in 2003 (as quoted by Ben O'Neill),

``What went wrong? The problem is in the theory of environmentalism. Under it, ownership is the enemy. Nature is an end in itself. So it must be owned publicly, that is, by the state. The state, in its management of this land, must not do anything to it. There must not be controlled burning, brush clearing, clear cutting, or even tourism. We can admire it from afar, but the work of human hands must never intervene.

``Then the brush begins to gather. It piles higher and higher. Old growth rots. Uncontrolled growing leads to crowding. When the weather gets hot the stuff combusts. Then the winds blow and the fires spread. It's been the same story for several decades now, ever since the loony theory that nature should be left alone took hold."

Lesson: the laws of nature eventually overwhelm human intervention.

Cartoon of the Day: Sons of Frankenstein

A recent headline from the Wall Street Journal says "China Takes Aim at Dollar".

Maybe this is the reason why....

Good humorous stuff from about.com