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Investing through Insanity

”There is no salvation in becoming adapted to a world which is crazy.” Henry Miller(1891 - 1980), "The Colossus of Maroussi" (1941)

Sometimes truth is stranger than fiction.

If we stand back and take a good look at the financial system and the main institutions involved, fairly soon you will find your head spinning with the majestic wonder of the whole construct. As glorious as it is, the real miracle is that it holds together at all, but somehow it manages to work, or at least it has until recently.

Any human construction will, of course have its imperfections. Taken to the limit these fault lines can become critical, and this is where we find ourselves. The structure and mechanics of the financial markets has now become a major issue, perhaps the major issue. Let’s take as short a route as we can through the financial system to describe the enormous tensions that have only just begun to be exposed.

The first thing we can see is that everything is leveraged. Bear Stearns was leveraged 37 to one when it went bankrupt. What this means is that a 3% adverse move in its assets would more than wipe out its entire equity capital. It does not take that much to make a company like this bankrupt. However, just because Bear Stearns has now dissolved don’t rush to the conclusion that all is now well. The other largest investment banks have similar levels of leverage, ranging from 32 to 45 times.

Compounding the problem is that these enormous risks are not even managed very well. I was a Managing Director on the proprietary trading desk at J.P.Morgan in London, and had first hand experience of this, but why not just consider the remarks made recently by the most succesfull investors on the planet. Warren Buffett and Charlie Munger run Berkshire Hathaway, the most succesful investment company there is:

Buffett on investment banks: "For the most part, investment bank CEOs cannot fully manage their balance sheet risks."

Munger on investment banks:

"It was crazy to allow the investment banks to get too big to fail. It was demented to have allowed trading activity to get so out of control. In the process of cleaning up Salomon Brothers' balance sheet, we had $250 million in 'good until reached for' assets. The accounting industry utterly failed us."

Munger on Wall Street's mentality that risk can be precisely quantified: "The job role of a chief risk officer at a Wall Street firm: the guy who makes you feel good while you're doing something dumb."

Of course, leverage and poor management does not stop just there. It is pervasive. Hedge funds often leverage up to extraordinary levels, commercial banks are at least 10 times leveraged, and even Fannie Mae, with its imputed government backing was 30 times leveraged before the crisis. Now in response to the crisis, the government needed to act, so of course it decided to increase the leverage of Fannie Mae to 33 times. I’m sure that more leverage is just what we need!

While we are on the subject of solving excessive leverage, with, guess what, more leverage, let’s turn to genius of the Federal Reserve. Remember that this institution talks all the time about providing stability, both to the economy and the markets. Is that really true? Is it heresy to suggest that in fact the Federal Reserve could actually be the cause of all this instability?

The Tragic Federal Reserve

“A truth’s initial commotion is directly proportional to how deeply the lie was believed. It wasn’t the world being round that agitated people, but that the world wasn’t flat. When a well packaged web of lies has been sold gradually to the masses over generations, the truth will seem utterly preposterous and its speaker a raving lunatic”.

Dresden James, Author.

The Federal Reserve has decided that for the first time in living memory to open its balance sheet to leveraged investment banks. Apparently, if there is a financial crisis with over leveraged businesses, it’s clear to the Fed that the remedy is capital support to hold up their levels of leverage. How much capital will be extended? We don’t know. What collateral will investment banks provide? We don’t know, although the types of loan acceptable to the Fed seems to be broadening at a rapid rate. Given that the Fed is now handing over the “people’s money” what restrictions and regulations will be imposed on the investment banks? We don’t know.

Even if the Fed would like to return to some fiscally conservative policy, that does not appear to be a realistic option today. Instead, the Fed hopes to be expedient today, avoiding economic collapse, and perhaps return to being virtuous at some point in the future. The problem is, you can’t get there from here, as the local yokel said when asked for directions!

The extraordinary actions taken by the Bernanke Federal Reserve reflect acts of desperation rather than long-term policy solutions. Somehow keeping the system intact is the clear priority, rather than getting round to fixing the now glaring errors of the recent past.

The tragedy is that this short term expediency merely compounds the errors of the past. Beyond any short term relief, in the longer term the current solutions are simply making the overall system even worse.

The key is to understand how we got here in the first place. Really it is a simple matter. Like an over indulgent parent, who always provides candy to their children when anything seems to go wrong, the Fed has become increasingly over supportive of the financial markets, and the economy with its monetary interventions. At some stage the child becomes cronically overweight and unfit, and at risk of diabetes. In the same way people have come to believe that the US economy will always be strong, as another injection of the sugar of cheap and plentiful money, can solve any short term adversity.

While the Fed’s interventions provide a short term boost, if overused they start to change behaviour. Without natural economic conditions, the natural rules of self-discipline seem unnecessary and even penalized. Increasingly, enormous risks can be taken with balance sheets, as leverage is more highly rewardly, or at least punished less severely.

The consequences are easy to understand:

1. The savings rate in the US has collapsed over the years.

2. The growth of hedge funds has been exponential in recent years.

3. The growth of derivatives has been exponential in recent years.

4. The levels of leverage of commercial and investment banks in general is clearly excessive.

5. Standards of lending fall. For example, NINJA (No Income No Job or Assets) loans became commonplace.

In short, over time, there was apparently no restrictions imposed by regulators on poor standards, or excessive lending. Market participants have been left to find their own limits, which are higher than natural levels as they can operate in the knowledge that the Fed, and the government, will backstop the overall market in the way that it now has, and in the mean time bad behaviour seems to generate enormous benefits. Whether an over abundance of consumer goods in the personal sector or enormous bonuses in the corporate sector, which are kept almost regardless of the longer term outcome.

What happened in the mortgage market in recent years serves as a great example of the current insanity that somehow became the norm at least for a time. Here is description written by Porter Stansberry of Stansberry and Associates:

“Who in his right mind would make a loan to someone with hardly any down payment or any proof he could repay it? And what kind of a bank advertises its underwriting as "Fast and Easy"? The kind of bank that can turn around and immediately sell its liar loans at a profit to a ready and willing agency of the federal government - Fannie Mae. Fannie bought these "prime" loans eagerly during 2003-2006, with full knowledge of the underwriting. But now, Fannie is calling Countrywide's actions fraudulent because "Fast and Easy" loans are 50% more likely to default than documented loans. Congressman Barney Frank's idea to "solve" the mortgage crisis is to let Fannie buy even more mortgages...

The actions of all the parties in this fiasco strains credulity. It's surprisingly difficult to figure out who was more greedy and stupid, the lenders, the borrowers, or the mortgage agencies (Fannie Mae and Freddie Mac). And liar loans weren't even the most preposterous mortgages. Many loans were made to borrowers who could positively not afford the debt service. For these buyers, who were known not to be able to afford their mortgages, a new type of mortgage was created, an "option" adjustable rate mortgage (ARM). The "option" was to pay or not to pay your monthly interest and principal obligation. If you chose not to pay your mortgage, the interest you did not pay would be added onto your existing mortgage, up until you owed 125% of the value of your home, at which point you would have to begin making a vastly higher monthly payment.

It won't surprise you to learn that folks who don't pay their mortgages usually can't pay their mortgages. And a growing mortgage balance doesn't make them any more likely to pay or be able to pay. In fact, owing far more than a home is worth makes it vastly more likely for a mortgage to go into default. Nevertheless, roughly 50% of Washington Mutual's "prime" mortgage portfolio is made up of option ARMs. So far, about 10% of these loans have gone bad. Far more will spoil when payments actually become due in 2009 and 2010. Keep these facts in mind when you hear the government talking about the good people who are "losing their homes" to ARM resets. When it comes to option ARMs, the people never actually owned anything, except a mortgage they clearly couldn't afford. These are the folks our government now wants to bail out. It's a new kind of socialism: stupidism.”

People need to start asking questions about how such an absurd system could ever come about. Perhaps ask even deeper questions about the whole structure of the financial system. For example, what exactly is the Federal Reserve? And if they are doing such a great job, how could all this absurd nonsense be happening?

Only then will it become more apparent that our current financial problems are deeply imbedded in the institutions that make up the financial system and their behavior. These institutions have become essentially the cause of the instability, not the cure.

Fire and Ice

There is no getting around the dilemma we are facing at the current time. The “crazy” structure of the financial world has only just begun to unravel. It took decades to develop, so it is absurd to believe that it can be resolved in a few months.

We are now confronted with two powerful forces that will be struggling for dominance over the next few years. These forces are best described as fire and ice.

Returning to our analogy above, there comes a time when even the child realizes that the last thing he needs is more candy. Confronted with ever deteriorating health a new regime has to be implemented. The candy is turned away and healthy living habits become a necessity.

Financially, the system remains absurdly overleveraged, with far more derivatives than could possibly make any sense (with a total nominal aggregate value of 8 times world Economic activity or GDP), and still an unknown quantity of right offs yet to come. With a lack of confidence and unknown balance sheet risks there is a substantial risk that the markets just freeze up, as participants shy away from risks that they are now unwilling to take, and this occurs at a time when deleveraging becomes a survival necessity.

The overall impact of this dramatic change in behaviour, however, is that the natural and normal flow of credit, becomes overwhelmed by deleveraging. The deleveraging has to take place over time to restore natural stability, but given the extreme degree and scale of the leverage, there is clearly a non-trivial risk of the credit flow turning to ice.

The Fed knows that this is the risk that it wants avoid at all cost, as it would cause enormous damage not just to market participants, but most likely also to the economy more widely. Also the Fed has becomed conditioned to believe that its role is to support the markets and the economy, even if in this case it now sees it role more as a savior with extreme measures, rather than merely as a constant supporter.

However, the Fed has only a few tools with which to fight the ice. More leverage, more credit and capital, and lower interest rates. Essentially more money which they can create at will in a fiat currency system. This is the fire that is the Fed’s only strategy. The risk with this strategy is that if used excessively it will light the fires of inflation.

To believe this is the solution is to believe that when the doctor detects that the child has diabetes, the doctor is right to prescribe higher doses of candy.

Summary

“Predictions are rarely wise, and it is usually wise not to make predictions”

In a fire and ice world the forces at play are opposite and extreme. On the one hand deleveraging simply has to take place to restore the natural flow of credit and risk taking. Yet, on the other hand, this could get out of hand if it happens too quickly.

The Fed’s remedy of extreme measures sets a very dangerous precedent in accelerating the measures and intensity with which monetary support can be injected into the financial system. Although this can provide short term relief, these actions are simply an acceleration of the interventions that got us into so much trouble in the first place.

Making predictions in this environment is more than usually hazardous. Investors simply need greater awareness of the situation, and more extensive stress testing of their portfolio, as well as clear rules for the risk management of their assets, as instability becomes a greater risk.

The key change is that now the financial structure itself has become a major issue. I will not pretend to know the timescale over which this situation will unfold, but the historical precedent is clear. Fiat money and central banking has never worked well in the long term. There was a good reason why the constitution tried to make it illegal.