Thursday, September 20, 2007

You just watch yourself... We're leveraged men.

Liquidationists... You might want to hide your eyes, because what I'm about to say might be a bit disturbing.

The bond market needs liquidity in order to efficiently price securities. Specifically, it needs leveraged investors to have access to leverage.

Wait, wait. Don't fire up that outraged comment just yet. Hear me out.

Let's imagine a world where there are four investors and three asset classes. The three asset classes are...

  • High quality bonds, which we'll just call "Quality" from now on.
  • Low quality type A, which we'll just call "Type A."
  • Low quality type B, which we'll call "Type B."

These three bonds types are perfectly correlated within each class, such that all Type A bonds move exactly the same. They have no fundamental correlation with each other, however. Therefore a credit event in one type doesn't necessarily have any impact on the other types, at least not directly.

The four investors have specific "preferred habitats." This is a term used in several academic works on the bond market. All it means is that investors tend to be involved in certain types of bonds (or certain maturities of bonds) because of their investment objectives. The relative value between the investor's preferred habitat and other types of bonds does not enter into their investment decision. In our case, we will assume that each investor only has expertise in certain bonds, and therefore will not venture into the classes where they have no expertise. I think in the short-term, this matches reality.

  • The first we'll call "Mutual Fund." This is a non-leveraged investor, who invests in all three asset types. Mutual Fund's demand for bonds is a function of flows from outside investors. Therefore Mutual Fund's short-term demand curve is perfectly inelastic. By this I mean, it doesn't matter how cheap bonds get (or how rich) Mutual Fund can only invest what it has.
  • The second we'll call "BSAM," just to make up an acronym. BSAM is invested equally in Quality and Type A assets and is maximum leveraged at 10x.
  • The third we'll call "NLY." NLY invests in Quality assets only. They are currently 10x leveraged, but could be as much as 15x based on current lending conditions.
  • The fourth we'll call "Alpha." Alpha invests in equally Type A and Type B assets and is 5x leveraged. They could go up to 8x.

OK. So now let's say there is an exogenous shock to Type A assets, causing them to lose 10% of their value. Nothing has fundamentally changed about any of the other assets.

So BSAM immediately becomes subject to margin calls. 50% of their assets are now down 10%, so to put it in dollar terms, they've suffered $5 in losses for every $100 in assets. Of course, they only had $10 in equity to begin with, so now they're down to $5 in equity. In order to get them back to 10x leverage, they have to sell half their assets. Because liquidity in Type A is poor, most of the sales are in Quality.

Alpha has suffered as well, but they had much more equity. They lost $5 for every $100 in assets, but they had $20 in equity. In order to get down to 8x leverage (the max allowed) they only need to sell $2.50 per $100. Again, since Type A is illiquid, Alpha sells Type B bonds.

So now we have selling in both Quality and Type B assets, but the question is, who is going to buy?

Let's put this in a supply and demand context. The supply of Quality and Type B has shifted outward. Note it isn't a move along the supply curve, because there has been no change in the price of either.

The demand curve is completely flat for Type B assets. Mutual Fund is the only potential buyer, and they have no assets with which to purchase bonds.

What about Quality assets? We know that NLY has some room to add, so there is potential demand there. Unfortunately, NLY's ability to add bonds is no where near the supply BSAM is dumping. NLY has $8.33 in equity for every $100 in assets. They could add about $25 in assets by levering up to 15x. But BSAM needs to sell $50 in bonds.

So in both cases there aren't enough investors capable of buying the bonds that are for sale. So there is no clearing price. At all. I guess the hard core mark to market crowd would write it all down to zero, but that's another topic.

In real life, Wall Street would serve as market maker, so the bonds would clear. But the prices would all be lower. But now it becomes self-feeding. Prices on Quality and Type B fall because of the technical of BSAM liquidating. That puts pressure on Alpha and NLY's leverage levels. Both then continue to sell more assets, and the Street soaks them up, but at still lower prices. Now the Street is over-leveraged themselves, and stops extending their repo lines. Now everyone is in trouble.

Notice that it took one heavily leveraged buyer to take a relatively modest loss to touch off a serious liquidity crunch. The other players had much more responsible leverage, and yet they got caught up in the liquidity crunch all the same.

OK. Now let's say that the Fed wants to try to deal with this. What the system needs is more cash to absorb the forced selling. Once that is absorbed, the extra cash can be taken away. What should they do?

  • Extend loans to banks and brokerages. This gives them cash to continue making markets. It also prevents them from pulling credit lines away from investors with performing assets. The Fed actually did this by opening up discount window borrowing as well as allowing Citi and Bank of America to lend money to its brokerage unit through its bank unit.
  • Force short-term rates down. This increases carry for banks and brokerages, which increases the profitability of market making. It also discourages investors from leaving money in cash, which over the intermediate term should increase demand for higher-quality bonds. Again, this helps absorb the overhang of bonds for sale.

I know some of you are just busting at the seams to write a comment along the lines of "Let 'em suffer! Why should the Fed bail these people out?!" But who's getting bailed out here? In my example, BSAM saw 50% of its capital wiped out, and the Fed's actions aren't changing that. The Fed has merely made it possible to sell those bonds at some price. In fact, under the scenario I developed, all three leveraged players wound up getting hurt to varying degrees.

I contend that if the Fed cuts rates down 75-100bps for a few months, then rapidly reverses course, the impact on inflation will be minimal. And the bond market is able work through this deleveraging process without too many innocent bystanders getting hurt.

56 comments:

NewSigma1420 said...

TDDG -

Agree with Extend loans to banks and brokerages but not with Force short-term rates down. Yes, there may be some liquidity issues with some of the more illiquid mortgage bonds, but at the end of the day, collateral is crap. Investors should know better than to buy bad collateral, if it means losing a boat load of money - hope they learn their lessons. Right now, Bernanke looks like Wall Street's bitch. Come next FOMC meeting, if there's any turmoil, Wall Street will again demand rates cut to inflate market valuation. Conclusion: Fed is lender of last resort through discount window. Cutting Fed Funds rate will lead to inflation and only delay the painful inevitable. Com'on someone has to pay the piper for shitty credit work

Anonymous said...

Like your blog. Like the analysis.
Nit: Are you sure you got the math right around Alpha? If they are equally invested in Type A and Type B assets they shold lose $5 for every $100 of assets.
Keep up the great posts.

EC

Anonymous said...

Wow, even after seeing the dollar get trashed and oil soar-- you still want to make the absurd argument that inflation is not a problem.

Your analysis is a bit self justifying-- it is all predicated on the dubious assumption that whatever funds should have been that leveraged in the first place. If this was before LTCM, you might be forgiven. Meriwether didn't figure it out, and many of the rest of us didnt see it either. But after watching how completely uncorrelated assets could suddenly become correlated and take down a "sophisticated" trader like LTCM -- it would be just plain bone headed to reach anywhere near the leverage multiples in your example. The fact that many people were/are doing it does not make it smart.

I was on the phone with various trading floors in the moments after the Fed lowered rates, and was shocked to hear so many people *cheering* that "we got our 50bp!" as though this was a good thing.

Today, they are belatedly realizing that saving this year's p&l isn't much good if your profession is selling certificates of confiscation.


Your suggestion that the Fed should step in and allow "some price" to be set assumes that there is a price. A lot of this stuff is garbage-- and the correct price is less than zero. If I take the bond off your hands for zero, I have to contend with all sorts of headache to repossess someone's house and then either find a buyer (not likely soon) or have to carry this house (at my expense). And I am not even factoring in the political risk that Congress might not allow me to repo at all! When there is a lot more political certainty, and real estate prices become affordable under "normal" loans (20% down, payments less than 35% of income) -- then and only then could you make a case for some sort of "vulture" investing. But right now, there is way too much uncertainty. It is legitimately a bad bet, and no smart trader would take a bet when he can't even blindly guess the odds never mind make a educated guess. The correct price right now *IS* no price.

How much would you pay to enter a bet where I give you something in return? I am not going to say what the something is. It might be a million dollars or it might be a rusty paper clip. Place your wager now, find out later.

No smart trader would take that bet, irregardless of where Fed Funds are.

Darth Toll said...

"But who's getting bailed out here?"

The Fed knows very well that the actual cut is not going to bail out anybody in and of itself, but the bailout is not what you think it is. Essentially the Fed cut is a false-flag operation that gives pigmen an opportunity to unload their mark-to-make-believe fictitious capital on unsuspecting bubble chasers. A similar event happened in 2001 when the Fed cut, the market rallied hard (5%) and then proceeded to crater over 20% in the next two months.

Put more simply, the pigmen have a lot of (near) worthless paper that they desperately need to offload on retail investors and this is a lot easier to do when the DOW is making new highs or is getting near those highs. Classic strong hand to weak hand Ponzi unit transfer using the CNBC agit-prop perma-bull pump machine.

If the pigmen can't pull it off adequately, then they will beg the Fed and the government for various crony capitalist bailouts. Privatize profit and socialize losses.

Anonymous said...

Tom, would you entertain the argument that everyone in your example is too overlevered precisely because they did not anticipate the possibility of one asset class going down 5% and the system itself being overlevered, thus causing a chain reaction you've described.

so - how should the market itself encourage people to be more rationally levered in the future? seems the answer is to let them all take a bath and learn their lesson.

alternatively, you can bail them out because you simply attribute the liquidations to "technical factors" and not to overleverage in the system as a whole, which will just encourage future overleverage.

psychodave said...

"wretched hive of scum and villainy"
Sorry I didn't notice this headline change sooner.

@anon 6:23PM
What he said about overleveraged. That and Type A don't conform with two criteria of earning assets.
#1 The collateral wasn't sound
#2 The borrower never had a chance of being able to pay Principal & Interest.

Congrats on yer SEEKING ALPHA appearance today.

psychodave said...

Mr. Mutual Fund needs to put up a big banner on its Bond Fund website to the effect that they're having a BIG SALE !!!!

That would generate liquidity without leverage. We're a little wore out with leverage right now, thanks.

Anonymous said...

All this stuff can't be garbage! Come on guys it has AAA ratings from S&P, Moody's and Fitch...

Whoops my bad it's just an opinion.....

Achal said...

Quick question - can you complete the example when the liquidity is reversed a few months out. Wouldn't that create the same "deleveraging" later on, thereby merely postponing the inevitable?

James I. Hymas said...

One interesting thing - to bring in an actual example - is that Freddie Mac is increasing its leverage far beyond what the private sector could do - buying $4.6-billion AAAs from CIT will almost certainly make them a ton of money from current levels - given that they have the security of capital to be patient.

I've been on the institutional side too long. I recently heard an opinion on a particular bond in which the argument was made that because the price was low it should be sold because then there would be no more worrying to do. Self-feeding, indeed! I wonder if there are any studies of the momentum vs. value investor characterization for retail vs. institutional.

Anonymous said...

I appreciate the attempt to simplify the market into 4 investor types to make a point, but there are two other HUGE investor types that have a major effect on the bond market, and have different abilities to lever or hedge (or not).

#5. Broker/dealers themselves. They could purchase Low Quality types A and B, and then hedge the rate risk with a Treasury short position, and hedge the credit risk with CDS. The desk and prop traders carry inventory all the time, albeit for varying periods of time depending upon their firms' risk controls.

#6. Foreign central banks and sovereign investment funds. They've shown a willingness to buy more corporate bonds, equity stakes in firms (e.g. China & Blackstone, Dubai and stock exchanges), and have plenty of dollars to invest. I don't know what, if any, leverage they might use. I would guess they're unlevered, so they could go into the Type 1-Mutual Fund camp. The difference is that the FCBs have oil and export dollars rolling in daily, and don't have to worry about fund outflows, like a high yield mutual fund manager does.

mshuffma97 said...

Excellent post and comments. To a semi-outside observer like me (I mostly live in the equities world), these kinds of discussions are tremendously valuable.

TDDG said...

Thanks for all the comments. Almost all of them are thoughtful and contribute to the valuableness of the blog.

Let me make one quick point before I address some of the comments. Obviously the "market" I built here was an over simplification. The only point I was trying to make in the post is that if you take away all the leverage, you wind up with inefficient pricing.

Some of the comments are focusing too much on what happened to Type A, which is the "problem" asset. I was more interested in showing how the problem asset can impact non-problem assets without the need to inject some kind of risk repricing into the equation.

I know many readers don't catch every post, but I've said many times that I wouldn't touch non-agency MBS or ABS CDOs at any price. That's because I don't believe investors can get enough information about the collateral to be comfortable with the credit. Fraud was so incredibly rampant as to render all reported information about a pool questionable. Plus I believe HPA will be negative in real terms for several years. That will result in sub-prime borrowers struggling for a long time. I also am not touching credit card or auto loan deals. I think too much of that stuff was paid off with MEW, and I expect default rates to soar in the coming years.

TDDG said...

Some of the commeters are pointing out the elephant in the room, which I conveniently ignored: BSAM (and maybe others) were over leveraged in the first place.

I grant this point, at least in terms of BSAM. In a perfect world, Type A asset would get pummeled, BSAM would go bankrupt. Alpha may or may not go bust, but would get seriously hurt.

What concerns me is the outcome for Quality assets. If quality assets are hurt enough to drive NLY into trouble, what's the lesson? I contend that NLY was basically playing the same game community banks play: borrow short and lend long. Banks have been playing that game since the days of the Rothschilds. I have a hard time calling that irresponsible leverage.

Except the bank gets access to Fed Funds and the discount window to allow them to weather a liquidity crunch. NLY doesn't. Isn't the system better off if NLY retains its ability to pledge quality assets to get capital? And I mean actual quality assets, not nominally AAA assets of dubious quality.

We know the real life BSAM is, in fact, bankrupt. We also know that the CDO market is on life support. I personally blame the CDO market more for the sub-prime mess more than someone like BSAM. But that's a post for another time.

TDDG said...

Anon with the "nit" is right. I'm going to edit it just so its not confusing.

TDDG said...

Psychodave: On the "BIG SALE" idea, I think given enough time, that will work. I view this as a Keynesian "in the long run we're all dead" situation. The Fed should cut exactly long enough to prevent this contagion from hurting higher quality assets too much, then take back the cuts. If they keep rates low for an extended period of time, then I'll have to eat my words in support of this cut.

TDDG said...

Anon @7:50: I'm tired and bored of people trying to claim that EVERYTHING is garbage. That's just a ridiculous claim. When I was writing the post, I had agencies, agency MBS, and investment-grade corporates in mind for the "quality" asset. You can't seriously claim that's all garbage.

TDDG said...

Anon @11:03: Again, my example is a simplification. I was hoping to show that the limits of market makers ability to make markets would be tested, and some assistence from the Fed is warrented. I also think that any long-only investor, including foreigners, would eventually soak up the bonds, we just need a little more time to allow that to happen.

TDDG said...

James: Retail... sigh...

Back in 2005 (which was when GM was getting downgraded every 3rd week) I happened to win an endowment account that had just recieved a huge donation. They decided to move away from the retail broker they had been using and hire investment managers. My firm got the bond assignment. When we got their current portfolio, it was literally 80% GM bonds, like 1-2 callable agencies and a GECC bond.

Some of the younger analysts were aghast that a portfolio would be built like this. But anyone who's seen enough retail operations knows how this can happen. When it comes time to buy a bond, the broker looks down the firm's corporate bond inventory. S/he looks for the highest yielding item, which in inevitably something like GM. Remember that as recently as 2003, GM was rated A, and GMAC hung on longer than that.

So the broker calls up the client and says, "I recommend this GM bond. Its the highest yielding A-rated bond we've got, and hey, its GM! They aren't going anywhere!"

And you thought the credit analysis in the CDO world was poor!

TDDG said...

Achal:

Note sure I follow. I think that if the deleveraging can happen slowly, maybe even just over 6-months or so, then the contagion will be limited and there is no threat to the system. Does that answer your question? Please post again if not.

Anonymous said...

Good example, great analysis of how the shocks work through the system.. unfortunately, I disagree with your fundamental premise.

Why should you "get" extra money to deal with the problems you created by being greedy?

Ultimately that extra money comes from taxpayers. Your improper risk analysis is not my emergency. Because you incorrectly analyzed the market, you should be forced into bankruptcy rather than given more of my money.

If this was the first instance in the history of time a credit crunch had ever occurred, you would be correct in stating that you had no reason to plan for this contingency. However, this is the real world -- your failure to plan for it means you planned to fail.

Anonymous said...

TDDG,

Any thoughts on what the dollars gonna look like if the Fed cuts another 75-100bps? Any concern the Foreign bid for FI assets fades? Flows in July looked awful....One month does not make a trend...

psychodave said...

"I view this as a Keynesian 'in the long run we're all dead' situation."
As always, the gentle patience of your helpful response is noted.

Is it naive of me to prefer an NLY that is 0x to 4x leveraged, rather than one that is 10x - 15x? If I owned the Fed Reserve System, I would still consider 15X perilous.

"I personally blame the CDO market more for the sub-prime mess more than someone like BSAM."
This went right over my head, which means I'd love to hear more.

Couldn't you just quit your day job and devote your entire working life to answering questions for free? No, really!

If its any comfort, your efforts at educating the public have not been in vain. Thanks to your numerous posts I am slowly coming to view the recent FFR cut as a Neutral Stance , not a stimulative one. This makes the fall in longer term Treasuries more of a speculatively oversold situation due to a false perception of a debauched currency.

Perhaps the dollar's fall is a nice piece of Bernanke Brinkmanship, to test how the rest of the world likes a devaluation and reduced U.S. demand for their export production.

Anonymous said...

Just to clarify, tddg.. since I'm sure you can IP-check with the best of them.. I do enjoy your blog greatly, I've read every word!

Could you please explain why, even if your market finds a way to deleverage slowly, you believe some of your colleagues at riskier trading houses shouldn't lose their jobs?

Plus.. if everyone's leveraged and now needs to un-leverage, who are you un-leveraging into? The central bank of China can't buy everyone's bonds!

Do you have any thoughts / comments on the following article:

http://tinyurl.com/2gylh5

Thanks!

venkat said...

ttdg,
You have very clearly explained that the losses in 'Type A' assets should not affect the 'Quality' and 'Type B' assets and that Fed should intervene so that these assets retain their value. I am convinced with your argument that Fed intervention was good to increase liquidity though I would have liked the Fed to just stick with the discount rate rather than meddle with Fed funds rate with out a real economic reason. I agree that Fed’s intervention was good for the financial markets but may not be a good decision for the economy in general. I believe that even in the short term, the Fed’s decision hurts the general public in terms of reduced purchasing power and reduced real interest rates. (I could not immediately remember a single good manufactured in the United States that I use everyday :) ).
The question that begs your reply is what is the effect on Type A asset because of Fed intervention? You did mention that there need not be a direct correlation among these different asset classes but will that be the case in the real world? If the Fed’s intervention stops the bleeding in Type A assets too, then will the whole effort be not self defeating?

I know you must be tired of answering all the questions so I would not mind if you choose to ignore my comment. Thank you for this great effort.

TDDG said...

Anon @7:47: Again, I don't think driving ALL leveraged players into bankruptcy is logical. I'm with you that any hedge fund that takes credit losses deserves its fate.

I also don't agree that tax-payers are on the hook for rate cuts per se. The cost of rate cuts is inflation, which impacts the economy in a more generalized sense that, say, a direct government bailout supported by tax payers.

TDDG said...

The dollar is getting a little scary. I need to do more work there. My view is that the weak dollar is merely a reflection of low U.S. rates and a poor inflation outlook here. But I could be convinced that the dollar is a bigger problem. Its my primary area of research right not.

flow5 said...

"if the Fed cuts rates down 75-100bps for a few months, then rapidly reverses course, the impact on inflation will be minimal."

TDDG - You are correct in theory. There is a window of opportunity & the "trading desk" could seize it. If the FOMC waits, the trend rate of inflation will eventually supersede the liquidity problem.

As long as the "trading desk" "washes out" the excess reserves within a short time frame (by the beginning of Nov07) an accommodative policy won't contain an inflationary bias. And if monopolistic powers “administer” an upward shift in a price, the long-term effect will not be inflationary, but will be deflationary unless monetary flows (MVt) “validate” these specific price changes.

Such a “relaxation” in monetary policy, resembles the current accommodative procedure used during the "seasonals/holidays".

Essentially, this is how the "trading desk" increases bank legal reserves at the end of the year. They add reserves, then "wash out" the reserves, over about the same period you recommend lowering rates.

However, I doubt the Fed could string together an expansion of bank credit that would also overlap the seasonals, and allow inflation build, and interest rates to rise, which would effectively abort any recovery in the capital markets.

Even if the monetary authorities try to compromise the situation and reduce the rate of inflation, we end up with stagflation in 08 But this is preferable to an all out monetary effort to bail out the money markets, irrespective of the inflationary effects. For if the rates of inflation increase, so will interest rates; and high interest rates alone are a sufficient factor to compound our problems, and induce a severe recession or even a depression.

Anonymous said...

If the market players are so highly leveraged that they A) have no opportunistic capital available to pick up firesale bargains and B) violate their leverage ratios when market prices, then they are too highly leveraged.

Say I bought GE $100 stock at 10:1 leverage, and some huge mutual fund somewhere blows up due to some extraneous event, dumps its GE stock, causing it to go to $90. I'm wiped out by the margin call. Can I go to the Fed and get a loan to tide me over, because it's not like there's anything fundamentally wrong with my GE stock, I just need to buy some time for the dislocation to work itself out? Oops, no, I'm a retail investor.

Why should institutional investors at 30x leverage, who should know better, get a safety net ("Fed put") to ride out price drops? Talk about moral hazard.

Perhaps what needs to be developed is a bond options market that would allow holders to purchase hedging puts as insurance against *market price* drops (as opposed to outright defaults a la CDS). Then there wouldn't be any excuses, although you'd still have problems if put sellers are caught overleveraged.

Anonymous said...

I think there are more than a few basic assumptions here:
1. If good assets suffer for no fault of theirs, then that is Correlation. It may not be there when the 3 assets start off, but hey, one ultimately gets it.
2. In a market, there are no "innocent bystanders".
3. "The bond market needs liquidity in order to efficiently price securities." I dont think if everything gets dumped, prices go to zero, nobody's willing to hold your "quality asset", then all this implies that the securities are inefficiently priced. Nobody wants it, period. U are holding duds. Quality is what Quality does.
4. Hey, what is a Bond? Stock? CDO? I just wanted some gas for my car.

I read your blog quite often. Just wanted to write that.

TDDG said...

Look for my next post to be on CDO's role in creating the sub-prime problem. The more I think about it, the more I think that's the biggest problem.

As far as people getting fired, hell yeah. I'm all for it. You want to talk about moral hazard? Have someone retain their job after blowing up all their clients!

The article on credit derivatives has a lot of what I was going to say about CDOs being part of the problem. I'm planning on being a bit more technical than MSN, but that's my luxury.

Where I differ is that I don't see the CDO collapse as a permanent impairment in the economy. I mean, I think its a more-or-less permanent impairment in the sub-prime mortgage market, but I think we'd all agree that 2004-2006 was the real period of divergence. If we go back to a time where sub-prime mortgages are hard to underwrite, I think we're really better off.

TDDG said...

Anon @12:48: I was trying to build the scenario where one investor was taking inordinate leverage, while others were using more responsible levels of leverage. Then the "responsible" ones get burned by the "irresponsible" ones.

But my point was less about who blows up and who doesn't. I really don't care. What I care about is that assets are more or less efficiently priced. Here one truly bad asset class causes other assets to be poorly priced, and that causes capital to be misallocated.

TDDG said...

Anon @12:50: When I said the assets had no "fundamental correlation," I meant that the underlying credit quality was not correlated. Or put another way, if we ran default tables for Type A and Type B that there would be no correlation. Obviously as I played out the scenario, there was indeed correlation.

And in my story, it wasn't that no one was willing to hold Quality. It was that no one was capable of buying it. That's very much what was happening in August. All my salespeople would call and say "Man, Fannie 6's sure are cheap." And I'd say "Yup. Too bad I have nothing to sell you to buy more, because every damn thing is cheap right now."

I don't think I'm unique either. Only 16% of all bond funds beat the Lehman Agg in August, and only 10% YTD. That's attrocious.

TDDG said...

Venkat:

Ask away, baby. Ask away.

I seriously doubt sub-prime MBS improve much over the next several months. Maybe there is a small techincal bounce off the "no bid, no way" level, but most of that stuff is seriously impaired, and will remain seriously impaired.

I believe that the Fed's actions are aimed at higher quality assets, and bank solvency. Not improving the bid on sub-prime MBS.

flow5 said...

I reviewed my data and changed my perspective. We had a “restrictive” monetary policy for the 23 months after Greenspan’s irrational exuberance played itself out (stocks peaked).

Since Bernanke was appointed, we will have had 22 months (by Dec) of the “tightest” monetary policy ever conducted by the FOMC (the ballooning money multiplier not withstanding).

Actually under Bernanke, the money multiplier increased at half the pace of that during Greenspan’s tenure.

We should have a robust economy next year.

James I. Hymas said...

As far as people getting fired, hell yeah. I'm all for it. You want to talk about moral hazard? Have someone retain their job after blowing up all their clients!

The more I look around, the more convinced I get that performance is irrelevant. OK, maybe not completely irrelevant, but largely irrelevant. It's all about sales and the ability to tell a story in a likeable manner.

anon 12:48: Options on CDSs? I love the idea of CDSs and may find a way to use them at some point in the future, but I have real difficulties with the idea of using them a lot. They're liquid now - so I'm told; I haven't actually gotten on the 'phone and tried to buy a block in a fast market - I'm not convinced they'll be liquid in the future.

The problem I have is that they are, as currently structured, too idiosyncratic. A big selling point for them is the idea that you can get exactly the exposure you want, regardless of whether the corp. has an actual bond, or the dealer has an actual inventory. Sounds great. It's like a $4,000 tailored suit - fits perfectly. Fits so perfectly, in fact, that it's only worth $50 to anybody else but you. Which causes problems when it's time to sell.

And options will be worse.

Remember bank perps? They don't trade any more. CARS and PARS (synthetic corporates reconstituted from higher coupon issues)? Never did trade. CDOs? Well, there are some people who are finding out right this minute that they don't trade.

Options on an index ... OK. But make sure it's exchange-traded and has a history before you take a position!

With respect to the leverage issue anon 12:48 raised ... I don't think it's just a question of all the opportunistic capital being already leveraged to the max. It's a question of using that precious leveragability to its most precious extent. If "Type B" in the post is not very liquid, I don't really care if it's $10 cheap. How am I going to sell a big position once the price has gone back up because some guy in Saskatchewan bought a bond? If I have to face the prospect of holding until maturity to realize that $10 cheapness then the deal is, at the very least, less attractive than otherwise ... I've got funding risk for starters and opportunity cost on my dead money as well. Ick.

Oh yeah ... our host has opined that the Fed could chart a V shaped course without impacting inflation too much, and he's probably right. But I wouldn't like to see the Fed market timing to that extent. Actually, in fact, I was expecting a 25bp cut and hoping for tough inflation talk in the statement. Whoopsee!

Anonymous said...

tddg- so if I go and buy GE stock and leverage myself 10-15x, and the stock drops 5%-- now my "fund" is impaired even though the underlying asset is "sound".

Am I entitled to a loan from the Fed?

Now that the Fed has set precedence, should I sue the Fed if they don't give me a loan?

Why would a functioning capital market make a distinction between an individual and a fund run by the same individual? The legal structure determines whether or not to extend a loan?

I have no doubt lawyers can come up with some legal hairsplitting on this, but explain the economic justification why a legal entity determines who gets a loan of last resort.

James I. Hymas said...

anon 9:32 -

Mind if I butt in?

If my bank won't renew my mortgage - perhaps because they won't be able to sell it - or slash my line of credit, I will be severely inconvenienced.

I couldn't care less whether or not you're in a position to lend me five bucks 'til payday.

Anonymous said...

James I. Hymas -- if you were irresponsible and got too leveraged, I could care less if you get inconvenienced. The Constitution spells out many rights -- but none of them entail a right to borrow money even when you are not credit worthy. If that's your idea of capitalism, move to Cuba or Venezuela. How arrogant and cocky can Americans get? You live beyond your means and now you think the world owes you.

Anonymous said...

The debt addicted dead beats of America are feeling "inconvenienced"... It probably wasn't hymas' intention, but the ugly truth about tddg's so called "credit crisis" is revealed. The druggie is lashing out because he can't get his fix

Anonymous said...

TDDG,

Agreed on your view of that Agency MBS is being "punished" disproportionately, if only FED can do repo with all world market participant not just US bank do you think the spread over UST will plummet?

In the spirit of simplification if say someone deconstruct the CDO say the best tranche and put individually as a loan book do you really still assign the value of that all individual loan at zero?

James I. Hymas said...

Anon 3:09 ... I don't think anybody yet has argued that those who are not creditworthy should have the ability to borrow.

The point is that during a panic, credit will be refused to creditworthy and non-creditworthy alike.

In the Panic of 1907, JP Morgan acted as the USA's central banker to calm a panic; it was subsequently decided that such a function was so central to an efficient capitalist system that it should be socialized; a bulkwark against crony capitalism. Like almost everything else in a functional system, central banking has been arrived at not by the application of doctrinaire principles - either those of socialism or laissez-faire capitalism - but through a hard headed, intellectually honest process of trying to figure out what works - and then tinkering with it.

Incidentally, you may be amused by the following quotation:
This considerable borrowing, followed by the economic downturns of the late 1830s and early 1840s, led eight states and the territory of Florida to default on their debts, much of which had found its way into the hands of British investors. At the time the British writer Sydney Smith, who had invested in the bonds of Pennsylvania, railed against the Americans for refusing to raise their taxes sufficiently to honor their obligations, condemning them as ‘a nation with whom no contract can be made, because none will be kept; unstable in the very foundations of social life, deficient in the elements of good faith, men who prefer any load of infamy however great, to any pressure of taxation, however light’. John J. Wallis, Richard Sylla, and Arthur Grinath III find that at least in the case of Pennsylvania Smith was correct; the state should have been able to avoid default if it had ‘imposed a realistic property tax’.

It was this set of defaults that led Charles Dickens to describe something as being 'as worthless as a United States bond' in one of his books. I think it was Christmas Carol, but I can't verify that; geez, there's 40-bazillion pages on the internet and I can't quickly find a proper reference to this fact! Honestly! But I suppose that if the framers of the United States Constitution did not specifically say so, then I have no right to expect such a thing.

Fear not, Anon 3:09! The reckless and irresponsible will be punished! If the market is given a little time to think, however, the market will be better situated to mete out correct punishments - much like the difference between a lynch mob and a proper trial.

One punishment - applied irrespective of culpability - is showing up already in the exchange rates. European holidays next summer will be foregone or foreshortened at current rates; and Toronto's theatre district is going to take another kick in the teeth, much to my chagrin.

Probably still not enough to turn around the American fiscal situation though. In Canada, we hit the wall in 1994 and governments have shown an acceptable level of fiscal restraint since then. When America hits the wall, things will not be pretty.

Anonymous said...

hymas- OK, so JP Morgan had to jump in to prevent crony capitalism from ruining us. That was 1907, before the creation of the Federal Reserve. He was betting *HIS* money. If any private citizen wants to bail out his fellow man, go for it.

That is a huge difference from the current situation, where a bunch of crony bankers debase the currency of everyone to bail out their buddies on Wall St.

I could care less if "the guilty get punished". I care that those of us who were prudent and fiscally conservative don't get punished along side. Don't throw out the baby with the bath water.

As you point out, the dollar has tanked since early September, right about the time the markets decided they were "entitled" to a bail out.

The Fed's tools are way to broad-- they cannot bail out the "quality" debt (to use tddg's terms) without bailing out everyone. Further, they really can't bail out anyone without cost. The *COST* is my issue. If JP Morgan takes a cost on his personal books, its his personal choice. When Helicopter Ben cranks up the printing presses and debases everyone's savings in a vain attempt to mindlessly salvage the good, the bad, and the ugly -- that is the problem.

The moral hazard of all this, even though His Majesty Tddg has decreed that their is no hazard, is that every time some crony capitalist on Wall St gets absurdly over-leveraged and threatens the whole system -- the idiots at the Fed debase everyone's currency in order to bail them out. The Greenspan Put (or Bernanke Put now) is irresponsible.

Since you like to research things on the internet, go look up what the BIS said about Greenspan's ideas. Go read the transcripts from this year's Jackson Hole meeting. No one had anything nice to say about the Greenspan Put. They were all diplomatic, but they all said it was a foolish idea.

Anonymous said...

The problem that tddg doesnt want to see is that, when you have a repricing of credit risk-- all else equal portfolios need to be a bit *less* leveraged.

Since credit spreads (and LOAS on MBS pools/CMOs) were all at historical lows, the only way for portfolio managers to get the same extra kick was to buy a lot more on leverage. That pushed spreads lower, which forced more leverage -- a non virtuous circle. By this year, MBS and ABS portfolios were pretty much all leveraged to the max, and many were leveraged beyond reason.

So now we have a credit risk repricing-- everyone has to deleverage at once. Not everyone can leave the theatre through the fire exit at once. Every single balance sheet is strained, no one has extra capacity-- everyone needs to sell a bit to bring their leverage down.

How is it surprising under this instance that "quality" assets can't be used as collateral? "Well Duh!!"

If these Wall St guys were banks (under the Fed's jurisdiction), they would have minimum capital ratios -- which in effect limits their leverage. They also have reserve requirements, which limits credit expansion (the money multiplier is infinite if there is no reserve requirement).

So these non-bank banks get irresponsibly leveraged -- way more than the Fed would allow a member bank.

And now the Fed goes and debases the currency -- punishing every single USD holder indiscriminately for the behavior of the few.

That is not what JP Morgan did in 1907.

James I. Hymas said...

anon 8:24 - I care that those of us who were prudent and fiscally conservative don't get punished along side. Don't throw out the baby with the bath water.

Five hours ago somebody - perhaps you - was ecstatic at the idea I might be inconvenienced through having the misfortune to hold a mortgage and credit line through a bank that was suddenly in need of liquidity.

It is to avoid throwing the baby out with the bathwater that the Fed has eased. This will give the over-leveraged non-banks time to unwind their investments and extend the term on their financing without harming the rest of us.

I'm finding it very difficult to find a common thread in the arguments - perhaps if you signed your name I could keep track of the case you appear to wish to build.

This would also assist me in looking up your thoughts on the Fed Rate of 1%, as published at the time, under your own name, putting your own reputation behind your case.

The view that 1% FFR led inevitably to a sub-prime mortgage crisis is by no means unanimous. The other mechanism is that the Fed had been so successful at taming the business cycle that some players did not take sufficient account of the possibility of a downturn.

I'm having a little difficulty determining what your policy prescriptions are. You're complaining that the non-banks were not subject to Fed capital rules. Are you suggesting that all borrowers be regulated as banks? That will not only be expensive, but will stifle innovation.

Above all, I don't understand what you're so angry about. As financial crises go, this one's pretty small - so far, anyway. I'm hardly the oldest guy in the business, but I've seen half a dozen of these things. Keep your head down, trust your analyses, be alert for bargains ... you'll do just fine.

There will be bubbles and crises for as long as there is capitalism. It's part of the game.

I really came back to the site so soon to announce with great pride that I found the Dickens reference - Christmas Carol, Stave 2:`Why, it isn't possible,' said Scrooge, `that I can have slept through a whole day and far into another night. It isn't possible that anything has happened to the sun, and this is twelve at noon.'

The idea being an alarming one, he scrambled out of bed, and groped his way to the window. He was obliged to rub the frost off with the sleeve of his dressing-gown before he could see anything; and could see very little then. All he could make out was, that it was still very foggy and extremely cold, and that there was no noise of people running to and fro, and making a great stir, as there unquestionably would have been if night had beaten off bright day, and taken possession of the world. This was a great relief, because "Three days after sight of this First of Exchange pay to Mr. Ebenezer Scrooge on his order," and so forth, would have become a mere United States security if there were no days to count by.

Anonymous said...

hymas -- I don't know who was inconveniencing you or your bank five hours ago. I certainly understand his argument that you are not entitled to a loan just because you want one. Credit is a way to expand your business, it is not a requirement nor an entitlement. Much of the world operates without a proper banking system. They are worse off for it, but its not the end of their world. Their governments often print money wildly -- and that brings about poverty and dispair. You can't save for a rainy day (or to expand your business) if the currency you are saving is fast becoming worthless.

You and I may be neighbors (Monroe county, NY). I used to go to Toronto a few times a year.

The problem I have with Bernanke's prescription is that he cannot give extra time to your bank to deleverage without giving extra time to a CDO deal, an SIV, a hedge fund. His rate "tool" is much too blunt.

The bluntness of his tool also means that the precision in tddg's scenario (lower rates for 6 months, then raise them) isn't possible. Even if we assume Bernanke and Co have some sort of omniscience that has been well hidden -- the tools at their disposal do not allow the fine tuning that would be needed.

Throw in a Congress that likes to meddle and change rules retroactively -- and Bernanke is absolutely guaranteed to fail.

When LTCM blew up, Meriwether's big position that did him in was a spread between the current 30yr bond and the old bond. Two US Treasuries-- quality assets in tddg's example. Meriwether was way way way too leveraged, even with "quality" assets.

The Fed didn't bail out LTCM. It strong armed the Wall St morons that allowed the leverage to happen to bail him out at their expense (I think they eventually made money). LTCM was destroyed. My savings and yours were basically uneffected.


This time, the Fed decided to use inflation to solve the problem. Everyone's savings are effected. People who have no clue what a CDO or SIV is find they cannot afford to go to Toronto for the night.

If you want to bail out today's LTCMs, knock yourself out. Dig up JP Morgan's body and let him do it. But don't destroy my life savings in the process. Don't lie to yourself and say Bernanke's all-knowing all-seeing Fed is going to fine tune the economy's clock using a 50 pound sledge hammer.

Anonymous said...

Tddg, great blog - good perspectives and good comments.

Not sure I agree your point that Type A being garbage, etc. leads to mispricing Quality. That assumes Quality was priced correct to begin with - before the Type A credit event. Given the level of leverage around Quality in the example I would disagree. Is is garbage - No. Was it priced correctly - Unlikely.

I believe this is the same point that Anonymmous @8:32 makes - though it a some what different way.

James I. Hymas said...

Geez, I'm almost sorry I ever brought up the name of JP Morgan! I consider him not only one of the most successful crony-capitalists that ever lived, but when he quelled the Panic of 1907, he did so with the aid of $25-million in Treasury funds - not his own money at all.

I do not claim that I have a "right" to credit. "Right" is a much overused term in any case. But I will suggest that the primary rationale for having a government in the first place is to provide ourselves with some comfort that we have the ability to plan.

Planning can take place on different levels: whether it's a plan to go to the office on Monday without being delayed by militia checkpoints or a plan to plant olive trees to produce olive oil in twenty years. Whatever it is, if we have a reasonably predictable environment we can undertake long term projects.

I contend that one reason behind the success of the US economy is simply the absence of a major war on its territory for the past 140 years and - terrorism notwithstanding - the unlikelihood of such a war for the forseeable future. If I'm on the board of directors of Intel and I'm asked where to spend $1-billion on a chip fab, I'm more likely to say Idaho than Iran for that reason alone!

Which is why I think (a) the Fed is doing the right things (mostly, anyway) in the present crisis and (b) that there should be no tinkering attempts with V-shaped Fed Funds rates. The first opinion is because the actions are allowing credit-worthy borrowers to come to market and not punishing them for having had a plan; the second is because such volatility makes it harder to plan.

I'm not convinced that the current policy stance is inflationary - although I am concerned that it could quite easily become so. If we are willing to accept that a FFR of 5.25% was non-inflationary in July, then I suggest a FFR of 4.75% is non-inflationary in September.

Consider: two-thirds of US growth this century has been housing related (this isn't the best source in the world, but it's the first one I found, anyway - I've seen other estimates in that ballpark. Dr. Housing Bubble is another ... tertiary? quaternary? source, with a bit more colour). There ain't going to be much growth from that department in the next couple of years - put a GDP drag of 1% into your Taylor Rule and out pops a rate cut of 50bp.

Even the drop in the dollar is discounted by the CBO as a major source of inflation:Although the decline in the value of the dollar will put some upward pressure on price growth, CBO’s forecast assumes that the effect will be small. ... Even so, studies havefound that the CPI-U inflation rate is only affected slightly by changes in the value of the dollar. Estimates range from a negligible effect to about 10 percent of the change in the value of the dollar..

At any rate, monetary policy is only part of the equation: fiscal policy is a hot potato - but I suggest that those who want to plan for foreign travel in twenty years' time would be well advised to lobby aggressively for a balanced budget. Either raise taxes or cut spending, whatever you like, but interest payments on the national debt will take their toll eventually.

Anonymous said...

tddg

I would also like to add my thanks to you and you commentors for the great job you are both doing in informing and educating us semi-informed outsiders on what is going on in the financial world at the moment.

Your blog is the perfect example of the true power and utility of the blog. Allowing informed industry insiders to communicate what is going on in their world to interested outsiders without the inevitable distortions and filters introduced by the ill-informed gatekeepers of the MSM.

From those of us who do know the difference between a CDO and a zero-coupon bond but dont work in finance and who are just trying to make some sense of what is going on at the moment - a sincere thank you and keep up the good work.

flow5 said...

TO PARAPHRASE THE LATE JOHN MAYNARD KEYNES WHO WROTE IN HIS GENERAL THEORY (1936) THAT CUTTING INTEREST RATES IN A WEAK ECONOMY IS LIKE PUSHING ON A STRING.

Have you ever heard of disintermediation?

Commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals.

The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its "open market power", to prevent any outflow of currency from the banking system.

The commercial banks can force a contraction in the size of the financial intermediaries, and create liquidity problems in the process, by outbidding the financial intermediaries for loan- funds. This process is called “disintermediation”, an economist’s word for going broke. The reverse of this operation, as implied in the analysis above, cannot exist. Transferring loan-funds through the financial intermediaries cannot reduce the size of the commercial banking system. Deposits are simply transferred from the saver to the financial intermediaries to the borrower, etc.

However, disintermediation for the financial intermediaries is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); banks with a significant portion of their earning assets acquired consequent to the global savings glut peak (artificially low interest rates).

The financial intermediaries have operated with lower fixed rate and longer term structures during a period of very easy money. And the competitive need to “borrow short & lend long” led lending managements, who responded to apparent economic necessity, or because of greed and//or incompetence, to engage in reckless financial practices.

The severe penalty attached to holding idle cash balances puts pressure on loan officers to seek higher & higher rates. Not only are marginal loans acquired by this process, but also many otherwise good loans becaome marginal at these lofty rates. Default it the inevitable consequence.

And the participants involved tried playing “hot-potato” and attempted to transfer both (1) the interest rate risks, & (2) the credit rate risks, to the investors, borrowers, & speculators, while leveraging their bets. And a tight monetary policy has forced the individual bankers to pay higher and higher rates to acquire, or hold, funds. Who would have thought - the lenders lost on both accounts. And thus, contrary to Keynes, reducing the fed funds rate will minimize some of the collateral damage created by Alan Greenspan.

flow5 said...

TO PARAPHRASE THE LATE JOHN MAYNARD KEYNES WHO WROTE IN HIS GENERAL THEORY (1936) THAT CUTTING INTEREST RATES IN A WEAK ECONOMY IS LIKE PUSHING ON A STRING.

Have you ever heard of disintermediation?

Commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals.

The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its "open market power", to prevent any outflow of currency from the banking system.

The commercial banks can force a contraction in the size of the financial intermediaries, and create liquidity problems in the process, by outbidding the financial intermediaries for loan- funds. This process is called “disintermediation”, an economist’s word for going broke. The reverse of this operation, as implied in the analysis above, cannot exist. Transferring loan-funds through the financial intermediaries cannot reduce the size of the commercial banking system. Deposits are simply transferred from the saver to the financial intermediaries to the borrower, etc.

However, disintermediation for the financial intermediaries is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); banks with a significant portion of their earning assets acquired consequent to the global savings glut peak (artificially low interest rates).

The financial intermediaries have operated with lower fixed rate and longer term structures during a period of very easy money. And the competitive need to “borrow short & lend long” led lending managements, who responded to apparent economic necessity, or because of greed and//or incompetence, to engage in reckless financial practices.

The severe penalty attached to holding idle cash balances puts pressure on loan officers to seek higher & higher rates. Not only are marginal loans acquired by this process, but also many otherwise good loans becaome marginal at these lofty rates. Default it the inevitable consequence.

And the participants involved tried playing “hot-potato” and attempted to transfer both (1) the interest rate risks, & (2) the credit rate risks, to the investors, borrowers, & speculators, while leveraging their bets. And a tight monetary policy has forced the individual bankers to pay higher and higher rates to acquire, or hold, funds. Who would have thought - the lenders lost on both accounts. And thus, contrary to Keynes, reducing the fed funds rate will minimize some of the collateral damage created by Alan Greenspan.

jf said...

The fed testified last week that they are not creating a moral hazard by lowering rates as long as inflation is contained. Ergo, lowering rates is a moral hazard if inflation is not contained.

The govt. provides “official” data that verifies inflation is controlled. We, who try to save are acutely aware of the extremely high inflation rate directly affecting essentials for our personal and/or professional lives. One of many examples is my company paying over +30% more for office supplies than last year.

Since my personal inflation costs are real, how can I not feel the fed has created a moral hazard?

Anonymous said...

hymas - think you may want to look into your buddy JP Morgan a little more. He "solved" the run on the United States in 1907 by importing a huge pile of his own personal gold from the UK to the US. Not sure there even was $25 million in US Treasuries to play with -- prior to the Fed, most private banks issued there own currencies; and prior to 1911 (when an amendment allowed for an income tax), Uncle Sam's debts were by necessity much smaller.

While I find most of your commentary very educational-- even when I disagree with it I learn something -- but are you going to try to bamboozle this blog by quoting official government statistics on inflation? The CBO is nothing but a propoganda machine for Congress. What possible reason should I believe a bunch of self serving politicians have the first clue what causes the dollar to go up or down? They can't even balance a checkbook.

I suspect the BLS guys are a lot more objective, and I suspect they are calculating CPI "correctly", which is to say they are following the procedures to the letter. But between hedonic adjustments, owner equivalent rent and assumed goods substitution -- CPI is designed to show nothing. When I look at my own bills, when I read about healthcare going up 8-10%, college costs up 6-7%, secondary schools up 7-8% (that's where the bulk of property taxes go), food costs, gasoline prices-- there is no way CPI is right. Earlier this summer, Hilton and Starwood reported good earnings because hotel rates were *UP*, but CPI said they were down. One of them is lying, and my last hotel bill says it is the BLS.

According to several academics who have tried to calculate CPI with pre-Boskin Commission formulas, CPI would be around 6% -- which may not be right either, but at least approximates what Joe and Jane Public are seeing in real life.

There is no way you can be taken seriously if you believe actual inflation is 2-3%.


If you do want to quote official government sources, I would love to hear your reaction to the head of the GAO, who recently made all sorts of comparisons between the US and the Roman Empire in its declining days...

Anonymous said...

Here is some hard data to support the whole inflation/not debate.

Voting Fed member Fred Miskin recently put out a research paper claiming that central banking is becoming more of a science (and less of an art) because central banks have accepted a number of guiding principles. The first principle Miskin lists is: "Inflation is always and everywhere a monetary phenomenon" (right from the lips of Milton Friedman). See Miskins paper here

So based on Miskin's (and Friedman's) supposition, here are links to see the Fed's own calculations of M2 and MZM year over year growth:
M2: M2
MZM: MZM
(note that the M3 series has been discontinued)

Using M2 (my preference), inflation is running 6-7% year over year. Using MZM it is more than 10%.

James I. Hymas said...

Thank you anon 1:07 - I'm enjoying this thread myself!

My source for Morgan's use of $25-million in Treasuries in 1907 is the Boston Fed and Wall Street, A History, Charles R. Geisst 1997, ISBN 0-19-511512-0.

The gold while important was used to back up Clearinghouse certificates which had already been issued. I don't have a source saying how much of the gold was JPM's.

The inflation thing ... all I can say is, I see no evidence of 6% inflation in my own life. Coincidentally enough, inflation was discussed at Econbrowser today, which referenced Howe Street in dismissing major fears. What do you think of the Shadowstats analysis?

Thanks for bringing up the Roman Empire thing, I'd missed that.

As I mentioned earlier, there are striking similarities between America’s current situation and that of another great power from the past: Rome. The Roman Empire lasted 1,000 years, but only about half that time as a republic. The Roman Republic fell for many reasons, but three reasons are worth remembering: declining moral values and political civility at home, an overconfident and overextended military in foreign lands, and fiscal irresponsibility by the central government. Sound familiar?

I think he's wrong about the reasons for the fall of the Roman Republic - I think he's confusing the issue with the fall of the Roman Empire, a different kettle of fish altogether.

The military wasn't over-extended at the time of the fall of the Republic - Caesar had just finished conquering Gaul for no other reason than to finance his political ambitions. Fiscal irresponsibility by the central government ... a matter of interpretation, but I don't believe it was a major issue.

Political civility - that I'll buy. The factions in Rome were barely on speaking terms and I can quite easily see a parallel there.

I'm not an apocalyptionist myself. I've seen it too many times. In the '70's everybody thought Germany and Sweden were perfect. In the '80's, Japan was going to take over everything. Now China is the bogeyman. Somehow the States manages to adjust and betting against America is a pretty risky bet!

Which is not to say I think it's perfect! Fiscal policy is weak, and I don't think it's going to get fixed any time soon. In Canada, we didn't fix ours until there were actual rumours that bond auctions might fail (in 1994) and the US is a long, long way from hitting that particular wall.

TDDG said...

Thanks to all who posted comments, even the guy who called me "our Majesty," because I think this discussion is among the more civil on the entire internet.

I want to reiterate one more time that I'm very concerned about the inflation risk. Hence why I'm going short with my portfolios. I think the Fed can avoid a large inflation spike by doing the V-shaped move I suggest. Remember, they did it in 1998-1999. But the risk is certainly to higher inflation here. That's what the dollar is telling you, I think.