Something Strange is Afoot in Financial Markets

Sometimes markets do very strange things. When they do, it's always important to figure out why. Right now we have just such a puzzle on our hands, and we have a good theory as to what's going on.This is slightly technical, but we believe very important.

Yesterday, the 10-year swap spread went negative for the first time in history. For those of you outside the financial world, the swaps market is where global banks borrow, effectively, from each other. Right now, if one bank borrows from another for ten years, it pays 3.73%. On the other hand, the U.S. Government currently borrows 10-year money at 3.82%. Banks, in other words, can now borrow more cheaply that the United States of America.

How is this possible? Are AA-rated banks more credit-worthy than the U.S. ? Despite our government's profligacy, this explanation doesn't seem credible. Banks, after, have no ability to print money or tax. If the U.S. goes under, banks would likely get buried first.

The explanation for the phenomenon, actually, is both more subtle and more alarming.

In analyzing any market anomaly , it is always helpful to construct, at least as a thought experiment, a trade that purports to take advantage of that anomaly, and follow through its practical implications. Bear with me here. Right now, we can buy all the 10-year treasuries we want at a yield of 3.82% (they are plentiful, to say the least). We can also, theoretically, finance this trade by borrowing in the swap market (using an interest rate swap) like a bank at 3.73%. This is the kind of trade you dream about, a riskless arbitrage where the long side of your trade is the best credit in the world. 

When there's zero risk, you want to back up the leverage truck. 100:1 gives you a risk-free 11.73%. 200-1 nets 19.73% Yippee! Happy days are here again.

Not so fast. The problem with the constructed trade is that we can't borrow money at Libor flat. Who can, nowadays? Banks! The only entities that can borrow some of their money at Libor flat are banks. Their overall cost of a bank's borrowing is of course a blended rate, subsidized by explicit government guarantees such as the FDIC insurance program, a forest of bailout acronyms, winks, nods, and penumbras. The bank's job is to take that relatively low-cost liquidity and recycle it into the economy, slapping appropriate spreads on it to reflect the specific credit quality of their obligors.

Now imagine that instead of accumulating assets through the practice of loaning money, banks just started accumulating Treasuries. Well, for one, their balance sheets get less risky, which will please the regulators. But other seemingly pleasant things happen as well. With higher quality assets, they can increase leverage! Access lower-cost funding sources! Reduce earnings volatility! All nice things, whose cumulative effect, however, is to squeeze the private sector off the bank's balance sheet in favor or the U.S. government.

So where are the non-government borrowers going to go? To some extent, they go away -- the proportion of non-government borrowers accessing liquidity via the banks ends up shrinking:

Source: Barclay's

Excessive private-sector leverage gets squeezed out, a healthy phenomenon if it sets the stage for a future credit expansion to fund future growth. Remember, these things are cyclical and we will eventually want more private credit.

But what happens if that shrinkage is concurrent with an accelerating expansion in government debt? Government debt is safe in the sense that its repayment will always be screwed out of the taxpayer or a government printing press, but here's the problem. The public sector, well, sucks at allocating capital in ways that fuel economic growth (see: ethanol). Unlike private sector debt, government debt tends to fund the misallocation of economic resources, and as it grows, it stifles the very economic growth that can generate the taxes to repay it.

What we have meanwhile is a classic bubble -- the pustule this time is "riskless" assets on bank balance sheets.

The growth phase of the pustule can be deceptively pleasant. Low-risk, low-volatility earnings streams bolster the prices of financial shares. Plentiful liquidity engineers the illusion of low credit costs - illusion, because credit is rationed by lender caprice, uncertainty, and confusion, rather than price. This gets us to the heart of the matter: why aren't banks lending? Because they are confused and, frankly, terrified. Lots of loans went bad on them, of course, but on top of this, the bank regulators are in complete disarray and are providing little clarity, other than, "You better not screw up, and by the way if you make too much money, we might just take it from you." Welcome to the world of regulation, Obama style.

What we have is the next bubble -- Treasury debt ballooning on bank balance sheets, lending to the government, whose activities distort the allocation of resources and hobble economic growth, crowding out lending to private borrowers, whose activities generate economic growth. The moral outcome is that systemic risk increases even as financial firms appear safer.

Social Security Goes Cash Negative

The front page of the New York Times today reports that social Security will go cash negative this year, years ahead of projection. The irony of this report coming two days after Congress passing a massive new entitlement program is no doubt lost on the Gray Lady.

If you don't already know, the original intent was that your social security taxes would go into a trust fund, but politicians long ago raided it. Social Security is now a pay-as-you-go program. The baby boom starts retiring next year.

On another subject, a college friend, one possessed of a different world view, chided me for blaming the whole financial crisis on Fannie and Freddie. This was certainly not my intent, nor can blame be limited to F&F. For my entire take on the crisis, you can look at my post called "Crash Test Dummies" from March 2009.

Yaaaaaawn - A Few Words About Business Writing

My brother worked at Salomon Brothers back in the John Gutfreund era (as did I, somewhat later). He toiled as a junior guy in the utilities group in corporate finance, and one of his responsibilities was to write a weekly roundup of financial activity in the utilities industry. If you think this sounds like an unbearably dull task, you would be in agreement with my brother. English major that he was (yes, you could get a job on the Street as an English major in those days), he decided to spice his reports up humor and the occasional quote from a Shakespeare or Henry Miller.

At the time, Henry Kaufman was the head of Salomon’s “publications” committee. In case you’re not familiar with him, Kaufman was the most powerful private economist in the country and known as Dr. Doom for his sunny disposition as much his bearish predisposition. That my brother was being puckish in official Solly publications stuck in the craw of some senior executives, and Kaufman was one of them. The controversy ended up on Gutfreund’s desk, where Gutfreund, an English major himself, responded with two words, the second being “Henry.”

So my brother lived to write another day, and struck a small blow against the forces of tedium. But let’s face it, most writing that comes out of Wall Street offends on two levels: it is bad, and it is boring. Boring is perhaps the greater offense, but let’s start with bad. This begs the question, what is bad English, exactly? Are there rules? Forgive me while I digress a moment.

Well, of course, we all know there are rules, but it turns out not to be that simple. English, unlike French or Italian, is an unregulated language. There have been unofficial efforts over the centuries to impose some linguistic discipline, a history of which is wonderfully told in The Lexicographer's Dilemma: The Evolution of 'Proper' English, from Shakespeare to South Park, by Jack Lynch.

Time was, English was thought even by the English to be the unwanted mutt of languages. The dons at Oxbridge brooked no spoken English in their classrooms, and students could even be fined for speaking English casually. (Sorry, did you just yell, “Toga!” Five shillings, please.) English was a mongrel language inferior to the dignity and permanence of Latin, Greek, or even the romance languages. Permanence was a key notion for the intellectuals who fretted about this sort of thing. A proper language must be a static one with rules that don’t bend to fashion. Linguistic change equates linguistic decay.

As usual, the intellectuals got it wrong. The English language is the most democratic of languages. It welcomes and incorporates change almost constantly. By some estimates, we recently surpassed one million words. French, a language tightly regulated by the Academie Francaise, has about 43,000 words. It is the very openness of our language that has made it the success that it is (with a very large assist, of course, from the openness of our economies).

On the grammatical front, we have rules, as we all know. Where did they come from? Sometimes rules are written by whoever writes them first, which in our case happens to have been by a number of rather stern Latin grammarians between the 16^th and 19^th centuries. But these rules change too. For instance, does one say, “It’s me,” or “It’s I?” The correct answer is, “It is I,” but unfortunately my ten-year old would get beaten up if he went around saying, “Hello, it is I.” As a result, “It’s me” is on the verge of being accepted as proper English (although it’s not there yet). This will be news to the 99% of Americans who already thought it was.

I can remember walking along a New York street around 1997 and hearing one teenage girl say to another, “I am SO not going to that party.” I remember thinking how stupid and vapid that sounded. Now I wouldn’t flinch. In fact, I think I said the same thing to my wife just the other day when she showed me a black tie charity invitation. Of course, using so like this isn’t anything close to proper grammar or syntax, but the point is it might be soon. In thirteen short years it went from physically hurting my ears to me – er, my - saying it, however ironically.

Those who read these letters know of my disdain for centralized command-and-control economic models. They aren’t adaptive enough to deal with large, complex economies. Independent market forces are always more effective and lead to higher growth rates. It is fascinating to me that this also appears to be the case with language.

This guy is probably as much fun as the average financial industry writer

Where does this leave all the would-be scribes of the financial industry? Well, there is way too much jargon, for one, and an overuse of certain words that offend the ear. Liaise is not a word, nor is there any such thing as a net net.  Impact has become accepted as a verb (as in, “The new model at Ford will positively impact earnings”), but that doesn’t mean I have to like it. The worst sin, though, is to be boring. Have you ever read a research report? Stultifying stuff, more effective than Nyquil. Most writing on Wall Street is guilty of this. The words simply do not dance off the page.

There are exceptions, of course. I have always liked Barton Biggs and James Grant, for instance. They are frequently wrong as prognosticators, but they do the two things any good writer should do: engage the reader and provoke the mind. I’ve also read some Michael Cembalest from JP Morgan lately, and am impressed.

Do I write correctly? Nah, not even close. I’m overly fond of parentheticals (really!), not to mention the dash. I have no problem with colloquialisms, and I sometimes even start sentences with the a conjunction. But at least I know I am not putting myself to sleep, and therefore – perchance – not the reader as well.

A Sad, Sad Day

So, this is what happens when you vote for someone for president because it makes you feel good, but you don’t ask any hard questions, like what is meant, exactly, by change? Now we know. It is almost unthinkable that at this precise moment in history when it has become clear around the world that this model – socialism – is the road to ruin, we are embarking on the largest ever expansion of U.S. entitlements.
The thing is, we know how this movie ends. Think Greece, because that’s where we’re seeing the final act play out. Everyone feeds off the government, there’s no one left to tax, and lenders pull the plug. Meltdown follows. Public rioting. No one wants to actually work hard for a living because they’ve become quite used to 35 hour work weeks, thank you, plus twelve weeks of vacation, retiring on three quarters benefits, etc.
But hey, Scott, what about all of capitalism’s problems! Didn’t capitalism get us in this mess?
I have two responses to this. First, many of our recessions were the direct result of bad government policy, not unfettered markets. The latest recession is no different with the federal government – via Fannie and Freddie – actively trying to extend home loans to those who couldn’t afford them. The history of the last century or so with examples of the government creating bad laws that lead to crises, and then "riding to the rescue" with more bad laws. Obamacare is a classic example.
Second, no one ever said capitalism was supposed to produce unwaveringly consistent growth. American history is littered with financial panics, recessions, and depressions. Ever hear of the panic of 1893? No? I didn’t think so. It led to the second worst depression in U.S. history with one in six Americans unemployed. How about the Panic of 1907? The stock market dropped 50% and banks failed across the nation.
And yet…and yet, we emerged ever stronger as a nation each time, with growth rates that no country in the world could match. And it was a moral growth, not simply one for rich men. As a nation, we practically invented the concept of a middle class, and it grew relentlessly for two centuries as the poor bootstrapped their way up the ladder.
Most significantly, the world’s poor all wanted to be here. They voted, by the millions, with their feet. Some of my own ancestors made the trip from Ireland in the 19th century by boat to New York. Did they do it because they knew a vast social safety net awaited them? Of course not, because no such thing existed. They did it for the opportunity reap the benefits of their own hard work in a place where no one told you what you couldn’t be.
I am an optimist by nature, but I find myself harboring a greater level of unease about our future than ever before. There’s much more to say on this, but for the moment I’d rather focus on things that don’t depress me so much.

Buy Florida Real Estate...and What Not to Say as a Pilot in a Storm

Flew down here to Florida for some r&r with the family this past Friday. Without a doubt, it was the most frightening flight of my life (fortunately for my family, they came down the prior week). We took off in a storm up north, and flew into an even worse one in Florida. Now, having been airborne something approaching 1000 times, I am little bothered by turbulence. But this took it to a different level.

The final two hours of the Jet Blue flight were non-stop, bone-rattling, amusement park ride-like turbulence. No let up. I remember trying to turn on the little air nozzle above me but having trouble connecting my hand to it. The Chinese woman beside was quietly praying, while the woman across the aisle dealt with it by talking constantly, trying to be analytical.

Another woman yelled, "I can't take this anymore!" while others cried quietly.

The problem was that when we got down to roughly mid-Florida, after an hour of pitch, rattle, and roll (and a good dose of yaw), the pilot, who had been silent the whole time, came on by saying, "Well, I hope you all have been having a better flight than I have."

What? This is not what we want to hear. We want unflappable. We want I used to land F-16s on the decks of aircraft carriers in the middle of typhoons, so this is a cake walk. I can do this in my sleep. What we got instead was nervousness, and then the news that Miami and Ft. Lauderdale were closed, so we were in a holding pattern. Not to worry, though, we're monitoring fuel levels. This was the part that concerned me. Unpleasant as the turbulence was, I knew that turbulence rarely knocks planes out of the air. But I had just finished reading Outliers by Malcolm Gladwell which has a whole chapter on a commercial jet going down in New York because they hadn't properly monitored fuel levels, and now we were being told, half an hour after our arrival time, that airports all across southern Florida were closed. We were in a broad holding pattern, at an altitude that was maximizing the effects of the storm.

We continued to circle, bouncing around and burning fuel, while many of us wondered how much fuel it would take to get to Orlando (our destination was Ft. Lauderdale). Orlando was sounding good.

Of course, I'm writing this, so we made it. The weather broke over Ft. Lauderdale, and the pilot got the damn thing on the ground. Loud applause ensued.

But, we all agreed, when things aren't going well, a pilot should:

1. Communicate more, not less

2. Never, ever, acknowledge the slightest concern

Now, about Florida real estate. When I think about where to put money, not a lot of options jump out right now. Stocks? No, given public policy right now, they scare me, particularly after the giant year-long rally. Bonds? Yuck. That same public policy is likely to produce inflation. Cash? At zero? Hmm, not with my whole portfolio.

I like hedge funds (for the same reasons I outlined in January), but not everyone has an easy way to invest in this asset class.

So what about real estate? The answer is highly dependent on location. I would not touch California or New York, for instance (where of course, I own property). The fiscal situation in both is too dire, with no visible way out. These states are controlled by public sector unions that will take down the ship before they bend on even minor points. New York's pension obligations, for instance, are beyond imagining, which is why most of politicians don't bother trying. They merely hope the day of reckoning will come after they have feathered their nests.

The tax situation, already horrible, will get worse. This will further trash real estate values, and promote taxpayer flight. The data show emphatically that state populations are highly sensitive to taxation. New York and California have each lost a million and a half people in recent years. Delaware imposed a "millionaires" tax a few years ago and - surprise - the millionaires split.

Florida, though, is a compelling story. We own a small place down here and it's an investment I'm very comfortable with. Florida is one of only seven states with no income tax, the others being Alaska, Texas, Wyoming, Tennessee, South Dakota, Nevada, and Washington. This alone will attract people in large numbers, particularly at the higher income levels (people who have a disproportionate ability to drive the economy, in other words). I have personally listened to a number of New Yorkers strategizing on how to stay out of New York for six months (plus one day) each year while declaring Florida their residence.

But there's more to the Florida story than simply the tax haven angle. The baby boom began in 1946, which means the first boomers are hitting retirement age right now. More often than not, people retire where it's warm. I believe this is a powerful demographic wave that will drive Florida (and maybe even Texas) home prices far higher. This is a trend that will last for years.

Finally, because of the national real estate meltdown, everything is on sale. Florida development, in particular, got way ahead of true demand. But the market is in the process of clearing. Here in Key Largo, transaction volume is way up over last year.

Florida real estate. Sounds like a cliche, I know.

Real Money Movie Futures Market to Launch

Big news for prediction market junkies such as yours truly. The CFTC looks like it will give final approval next month to a real money movie futures market run by Cantor Fitzgerald. Cantor currently owns hsx.com, where one can bet paper money on box office results. Industry insiders frequent the site to see which way the wind is blowing, and to see the market reaction to new trailers and so forth. It's a fascinating site, but it's all pretend.

(For a more in depth look at prediction markets including hsx.com, see my post from October 2009.)

The way the Cantor Exchange will work is one can "bet" $1 per $1 million of movie gross. So, for example, let's say the upcoming Robin Hood movie is trading at $100. This means the market says the film is likely to gross $100 million (domestically). If you buy at $100, and the movie actually grosses $125, you make $25. Very straightforward, and very cool.

This market will likely draw an interesting combination of industry insiders and punters. It will give production companies the ability to hedge their bets if they don't like the way a movie is coming along, the way an orange juice grower can use the futures market to hedge weather risk. It will also give other production companies a way to participate in films they were shut out of.

I am curious as to what insider trading regs will apply here. For example, let's say a producer has just learned that his leading man has a serious drug problem and it's interfering with production. This is knowledge the general public does not have. Can he then use this information for profit? I suspect under current regs he can, and I don't think this is necessarily bad. But punters should know that if they're not at the table, they're on the menu.

All in all, this is potentially great news and I hope we see the CFTC consider other areas as well.

ObamaCare Now 60/40

This is getting uncomfortable. Passage would be a lurch towards socialism at the precise moment in history when we can see exactly where the endless expansion of entitlements (aka "socialism") leads, namely the looming bankruptcy of Greece.

Yesterday Obama gave a fiercely partisan speech imploring (warning?) his fellow Democrats to just pass the damn thing, regardless of the method, public opinion, or political cost. It strikes me that the successful packaging of this man as a moderate during the presidential campaign was one of the great con jobs of modern history (right after global warming - see my piece on "Intellectual Bubbles" from December '09).

ObamaCare is 50/50

The passage of ObamaCare is currently trading at a 50% probability on Intrade:

Note that the graph above is closing prices only. The current market is 50, meaning that the "crowd" says passage is a coin flip. Yesterday, in the wake of Obama's remarks (see: "to hell with the Republicans") the market traded briefly at 90. So the volatility around this is exceptional.

I put the odds around 25%. This still has to go through the House again where it first passed by only 5 votes. Since then, there's been a death, a resignation, and a Republican - the lone yes vote from the GOP - who has reversed himself. Then you have the Stupak Twelve who won't vote for the Senate measure on abortion grounds. It gets worse from there. Tough sledding for Pelosi and the Majority Whip, although no one is suggesting she's not tough.

I wrote a piece in January called "How Now, President O?" that took the view that the president would not tack to the center, a la Bill Clinton circa 1995, to salvage his presidency. I think the jury has come back on that one: ideology has trumped public image.

How Milton Friedman Saved Chile

Interesting piece in today's WSJ with the above title written by Bret Stephens. He notes that in the mid-70s, Chile was in economic shambles, with a 1000% inflation rate, no foreign reserves, and a per-capital GDP that trailed the likes of fellow basket-case Argentina. Enter Milton Friedman and the "Chicago Boys." They made a number of recommendations for liberalizing Chile's economy (aka "common sense") that included big reductions in government spending and the money supply, privatizations, more free trade and foreign investment, etc.

Chile actually listened. The result? They are now Latin America's richest country. In a more immediate sense, the reforms saved lives last week. Chile's wealth made possible stricter (i.e. more expensive) building codes possible, which has kept the death toll from the 8.8 earthquake to under 1000. Contrast this to Haiti, whose earthquake was five hundred times less powerful, and yet they lost 250,000 lives.

On a somewhat related note, one of the greatest YouTube videos I've ever seen has Friedman debating an unctuous, intellectually unarmed Phil Donahue about the nature of greed. You can see it here:

http://www.youtube.com/watch?v=RWsx1X8PV_A

Ohh, Canada

Great Olympics topped by an incredible hockey game. Brought back memories of watching the 1980 Miracle on Ice from my dorm room with about 20 classmates.

As usual there were lots of "color" segments, including one on all the Canadians who had come to the U.S. to find fame and fortune. My question is, where was the segment about all the Americans who went to Canada to find fame and fortune? (That was rhetorical.)

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