A Second Hand Conjecture

The insufferable Peter Schiff has a video going around, which frankly, is just brilliant. He may be unpleasant at times, but he nailed this thing, and took mounds of abuse while doing so. More importantly, I KNOW HOW HE FEELS!

The resentment, irritation, condescension and, at times, outright hostility to my Cassandra act makes me wish I had a video of my own. Sigh…

Oh well, it pays to remember that Cassandra was right. I was never as sure of myself as Peter, but risk management isn’t about knowing you are right, but knowing what could go wrong and whether it is likely enough to act upon.

As an aside, Peter is no big government type, and he goes to prove that despite the media focusing on Roubini and others (who do deserve a lot of credit) that people across the ideological perspective warned of this. Thus having seen this coming is not the same as being correct about what to do about it, since those who saw the oncoming train differ markedly on that score.

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Does the object of our desire tend to change during tough times?

Yes, according to this paper on men’s preferences when it comes to Playboy’s models:

Consistent with Environmental Security Hypothesis predictions, when social and economic conditions were difficult, older, heavier, taller Playboy Playmates of the Year with larger waists, smaller eyes, larger waist-to-hip ratios, smaller bust-to-waist ratios, and smaller body mass index values were selected. These results suggest that environmental security may influence perceptions and preferences for women with certain body and facial features.

For those wishing to do their own analysis you can download the data here. Tyler Cowen notes that the hypothesis is not fully supported by 2008’s selection.

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Yves Smith hits a theme I have been harping on, the Federal Reserve, and central banks in general, are making things worse in may ways by destroying the incentive for banks to lend or borrow from one another. She quotes James Bianco of Arbor Research:

The Fed’s massive and numerous liquidity facilities are making things worse. The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank. I believe it has gotten so bad that they don’t even bother to make a decent market for inter-bank loans anymore. No reason to, they don’t need them anymore as central banks have replaced them.

I would suggest more subtle factors should also be emphasized besides how this distorts rates on loans. If banks do not need each other then they don’t communicate. Thus the hard work of investigating what counterparties real credit risk is goes undone. The market is shunting that off to governments. Furthermore, banks have no incentive to arrive at a believable accounting of their assets, they can wait and hope for a bailout rather than find a way or terms that other banks will accept.

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I am often asked about individual bank stocks, especially JP Morgan. Generally my answer is that Bank of America, JP Morgan and a few others look to be likely survivors, but how profitable they will be I am really unsure.

JP Morgan is a special discussion, because I point out a rather astonishing fact, they have a notional exposure to around 90 trillion in derivative contracts, or did last March (pdf.) 58 trillion of it swaps of some sort. Probably credit default swaps (CDS) are the majority. Which means…what? I don’t know, and frankly if anybody really does they aren’t telling me. In essence I am left telling people that I have to treat that as a “black box.” Not exactly confidence raising. Personally there are better ways to make money than hoping a company with 90 trillion in derivatives exposure has a handle on it in my book, but then again, I am admitting that I have no idea what I am talking about, and cannot find anyone else who does either.

Warren Buffet often speaks of defining a circle of competency when investing and staying inside it. It doesn’t matter how big the circle is, just knowing when you are inside it. Well, 90 trillion in derivatives exposure is outside of my circle of competency to assess.

The nightmare is what if it is outside of JP Morgans circle? I suspect it is, and the massive exposure of two other banks as well (Citibank and Bank of America have approx. 38 trillion apiece.)

What makes me wonder about it today? Personally I have always felt that there was a good chance that JP Morgan was who was being saved when the Fed brokered the acquisition of Bear Stearns. Bear goes under and JP Morgan would have to come up with huge payments on CDS contracts. Also, I suspect that Bear was a counterparty for a large number of derivatives, which if Bear was insolvent might not have all been paid up. Or maybe not. Then I see this over at Barry Ritholtz’s:

“Lehman Brothers Holdings Inc.’s main lender and clearing agent, JPMorgan Chase & Co., caused the liquidity crisis that led to Lehman’s collapse, creditors said.

JPMorgan had more than $17 billion of Lehman’s cash and securities three days before the investment bank filed the biggest bankruptcy in history on Sept. 15, the creditors committee said in a filing Oct. 2 in bankruptcy court in Manhattan. Denying Lehman access to the assets on Sept. 12, the bank “froze” Lehman’s account, the creditors claimed.

JPMorgan, the biggest U.S. bank by deposits, financed Lehman’s brokerage operations with daily advances, while money market funds and other short-term lenders provided overnight loans, according to bankruptcy court documents. When JPMorgan shut Lehman off from funds, Lehman “suffered an immediate liquidity crisis that could have been averted by any number of events, none of which transpired,” according to the filing.

The creditors asked the judge in charge of the case to let them interview a witness and request relevant documents from JPMorgan and to pursue possible legal claims. U.S. Bankruptcy Judge James M. Peck is scheduled to hold a hearing Oct. 16 on that request, the creditors said.”

Hmmm, so Lehman may have been torpedoed by JP Morgan? Hardnosed but not weird, until this little tidbit in the update:

Ron Kirby notes: “I wrote about a very strange occurrence – the reporting of J.P. Morgan “transferring” 138 billion dollars to Lehman, after Lehman had already filed for Chapter 11 bankruptcy early last Monday morning…It is highly likely [or a certainty on my planet] that J.P. Morgan was INSOLVENT and was “BAILED OUT” last Monday, September 15, to the tune of 138 billion dollars. This would explain why the Fed and Treasury dictated that Lehman fail – to disguise or otherwise obfuscate the recapitalization of or illicit transfer of 138 billion to A MUCH SICKER, TEETERING ENTITY, J.P. Morgan Chase.”

The link is filled with some rather out there speculation (and I have no intention of confirming or discrediting it) but this is a very odd transaction. Immediately after sending Lehman 138 billion they received 138 billion from the Federal Reserve. What were they off loading? Meanwhile they allegedly cut off Lehman.

Back to Bear. Was allowing JPM to take over Bear and the Fed guaranteeing most of their debt a back door method of recapitalizing a banking behemoth? Are the acquisitions that JPM has been making under very favorable terms a sign of strength or weakness? Gifts from the Federal Reserve to recapitalize them? How much trouble is in that book of derivatives?

I have already pointed out the problems in Europe, problems which the failure of AIG would have exacerbated due to their massive involvement in the CDS market. Is it possible that JPM was also heavily exposed to a failure by AIG? With 90 Trillion in nominal exposure it is hard to imagine they were not. With that much exposure who could possibly be more of a candidate for the “too big to fail” label. Could the Fed be manipulating these events to save them without causing the kind of panic that Bear and the later victims have caused?

I don’t know, which is the real tragedy. Nobody knows what the exposure of anybody is, so we are all left guessing. The Federal Reserve, our government, the financial institutions themselves are all busy obscuring rather than bringing things to light. In order to avoid panic by showing us all how deep the problems are, they are busy spreading suspicion, distrust and panic by keeping everybody, including financial institutions they have to deal with, in the dark. The hope of generous terms from the government keeps banks from admitting what their books really look like, or to try and sell in an orderly manner what they have. Who needs to expose your books to potential lenders when the Federal Reserve will take a used car as collateral and at a lower rate.

How bad off are these institutions? We have no idea. We are left with our imagination and our nightmares.

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I have argued in the past that the Federal Reserve’s policies may be helping in some ways, but hurting in others. Way too much borrowing and lending is running through the Fed which is drying up lending between banks. It also reduces the need for banks to find reasons to communicate and trust each other, keeping the atmosphere of mistrust alive.

On a similar note one of Yves Smiths commenters left this comment, which is well worth pondering when thinking of the bailout plan being considered:

One of the most critical functions of the banking system is converting short-term deposits into longer-term loans for businesses. Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe’s demand deposit into a fixed-duration loan.

The problem we’re having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn’t make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.

The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight - a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it’s got to win 90 auctions in a row - a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can’t make into useful-duration loans.

Right now we have both commercial and treasury MMs. Deposits have shifted from commercial MMs to treasury MMs, and consequently we have less working capital (a commercial MM product) and better credit for the Fed (a treasury MM product). But, treasury MM rates are now very low and the gap between treasury and commercial fairly high, which creates an incentive for depositors to put money into commercial funds, producing some working capital.

When Paulson dumps out his 700 billion in treasuries it’s going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs. That means even less in the commercial MMs and thus less working credit, the eventual commercial MM product. Hence Paulson’s billions remove working capital by competing for the deposits that could get used to make working capital loans. That 700 billion is going to go to fairly long-term mortgage securities. So Paulson’s billions divert credit from working capital to long-term mortgages - from where it’s most needed to where it’s most wasted.

Even if the giveaway adequately props up the banks, which I doubt, they still can’t make working capital loans, because the raw material they used (commercial MM deposits) will be desperately short.

I think it’s very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson’s plan will increase the supply of, say, inventory loans. It’s not that every economist in the world is an idiot, it’s just not going to help. I think people have fallen into the fallacy that if it costs a lot it must be valuable. Paulson’s plan falls into the category of very expensive way to hurt ourselves.

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A new distressed debt leveraged hedge fund has been launched:

Go visit the website for all their competitive advantages!

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I do believe we should be doing something as a nation, through our government, to avoid the not insignificant chance of a total financial meltdown. I have seen several things proposed that I find interesting, and I will get into them and other longer term issues in coming days. I had hoped to address this all comprehensively, but time just isn’t allowing that, so let us do so piecemeal.

Today I would like to endorse one proposal that aligns exactly with my thoughts on this, which is we need to recapitalize banks in a more effective, less arbitrary manner while protecting taxpayers and homeowners as well.
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