Designing better futures

No Euro please, we are Americans.

It is now official, the US deficit of $490b is roughly 3.4% of GDP $14.2 trillion.  This means the US fails the second requirement for entry into the Euro as we have already failed the Debt to GDP ratio.

Perhaps a currency block with Mexico and Canada, assuming we could sweet talk them into it. 

The black helicopter and tin-foil hat conspiracy theory set already assumes there is a pile of Amero's already out there. I would prefer Nafto's, they sound more snack like and wallet friendly :)  I still suggest farmland and Norwegian Krone as interesting stores of value.

Friday night Fight night is now Friday night FDIC night

The ring side seats may not be available and the knock outs sure won't bring much cheering, but this is the biggest new show for Friday nights.

The FDIC closes banks on Friday nights so they have the weekend to run through the files and open the doors on Monday.  Expect this to become a bit of a ritual for the coming months.  This is not good as it costs all of us.

Here is the play by play of failed banks from the FDIC.

I guess we will know it is bad when they hook the list up to an RSS feed or start Tweeting about it.

There is plenty of blame to go around.  Both the FDIC and OCC were asleep at the swtich and the usual suspects greed and stupidity made an appearance.  Read about the $32 billion Indymac rottenness here.

I alluded to this potential back in September 07.  We can only hope we aren't looking at a replay of the panic of 1893.

As an anthropologist I look at money and currency as a socio-cultural phenomenon and a system of shared beliefs.  These things ebb and flow, in the end we all progress along.  I have been a currency trader for one of the world's largest banks in London and watched Thai Bahtilism spread in 1997.  I have an MBA and quantitive background in finance, but at the end of the day, behaviour trumps all. Here is what the market has been saying about US chances of default, very low, but a little jumpy.

For the person truly interested in how often the failure of monetary beliefs occurs, I would recommend reading and truly thinking about this book by the esteemed economic historian Kindelberger.

Thousands of currencies have come and gone, to my knowledge the longest lived one is the British pound.  Any thought or comments.

Gott's theorom would indicate the current USD which has been around since 1785 has a 50% chance of being around another 73 years.

Two things I learned from anthropology:

1. All things change
2. Everybody dislikes change

Some quality euro cheese

When I lived in Paris a long time ago, I listened to a lot of Euro cheese.  Thanks to youtube, you to can sample this, or not. 

and some quality deep house.

I always liked the Buddha bar in Paris. Nice place, probably passe by now.  I lived in St. Germaine de pres in the 6th Arrondisement.

Moody's cheer up for the weekend.

Some people thought I was a little out there predicting a 25% decline for US housing last summer.  It wasn't that tough to do.  Neither was my call for a decline in Chinese equities of 70% last summer, we still have 20% to go on that one. 

On that cheery note check out Moody's latest.

• Default rates on mortgages will fall to normal in 2012-2013. Thats only 1,300 days more to go.
• Within 1 year, 1 out of 4 prime borrowers will be in negative equity. 
• Anticipated bottom of the housing market is 25% decline in spring 09.

We can't even get into the Euro...

 The curent US debt of $9.5 Trillion to GDP of $14.2 trillion equates to a ratio of 66%, that means we are not eligible to meet the Euro entry criteria of 60%. Geez even Italy squeezed by albeit with a total fudge.  I still recommend Norwegian Krone.  Those American Peso's just won't get a fella very far in the world these days. 

Oh and that S&P 500 is still effectively flat after 10 years.  If one factors in inflation the average consumer has lost 26% since 1998 in purchasing power terms, and most investors don't beat the index.  I know many are pointing to the S&P 600 and S&P 1500 as being better performers over the period, but that just sounds like arm chair quarterbacking to me. 

The sad story is Joe and Jane Six pack probably have a pension fund that underperformed the S&P 500 by at least 1.2% year for a decade if they were lucky.  That works out to a 37% decline in purchasing power.  Are we winning yet? And hey what is it with those Europeans working less than we do and taking a month vacation each year plus time off for child care.  We have to get smarter about this stuff as a culture.

I like this guy, he has his stuff together.

As someone who is rhythmically challenged and has size 15 feet, I admire this guy, good spirit, good intentions and takes some action.  Don't know about the final outcome, but we need more like him.

Back to breakeven for equities in 2012-2013

20% bear market declarations are pretty much useless, but they give journo's and TV types something to sell ads with.  Mathematically speaking, the hurt starts at 13% losses.

Losses over 13% require gains of greater than 13% for recovery.  The graph below highlights how this works.  The blue line approximates the intuitive relationship of losses equaling gains.  The red curve is the reality. 

Rule #1 in all investment allocation decisions is don't lose money.  Risk management is the name of the game at the asset and portfolio level.  If you are a European and invested in US shares you have lost 50% of your money after the currency conversion.  You would need a 100% return to break even.  
 
The acceleration point for losses requiring greater gains is around a 13% loss.  Think of it as inverting the power of compounding returns.  Currently the S&P is 26% below it highs.  To get back to the previous high point for domestic investors, the S&P 500 needs to gain a little over 35%.  The long term +80 year historical average return for equities is around 7-8%, so back break even is in around 4 years based on historical average returns would be 2012-2013.

The ex dividend annual return for the S&P for a dollar based investor since 1998 has been roughly .3%.  When one factors in an inflation estimate of 2.5% per year, one ends up with an effective loss of purchasing power of 25% over the last decade.  Welcome to the lost decade.Download returncurve.xls

P.S. I am not such a buzzkill in real life, I am just pointing out some facts.

P.P.S .  Found this at Wolfram Research.  This phenonomon is know as Siegel's Paradox.

CDS chain netting risk

In epidemiology, risk of contagion spread is sometimes modeled using a chain model approach.  The chain approach involves a continuous chain of risk from a single entity spreading through a network of contacts with various rates of success.  Break the chain, break the spread.  CDS exposure to netting failures can break the chain of cascading liquidity crisis with a buffer of excess capital. 

CDS Notional amounts get a lot of headlines, but few really understand the nature of the risk and why it so large.  Netting risk is rare and unusual.  Bankhaus herstatt is the only institution I know of to have failed due to a failed netting where the other side was actually good for the deal.

Settlement is boring in terms of risk, most people like to talk about models, VaR, Swans etc.  But netting is the plumbing that keeps it all going, failed CDS netting could lead to systemic risk on a significant scale.  This risk is heightened due to the following factors:

1. Large Notional amounts outstanding
2. Low Tier 1 capital in place
3. Liquidity challenged environment
4. Crude netting, reporting and tracking in some institutions
5. Sometimes subjective EOD or delayed agreements of an EOD
6. An environment where EOD's are becoming more likely or concentrated
7. An environment where a netting counterparty failure may become more likely
8. Counterparties offsetting risk elongate settlement chains and therefore could amplify netting risk

Here is a simple graphic model that shows nettting exposure growing as OTC (non exchange traded participants each try to minimize risk by offsetting position with other counterparties.  the transactions are identical in terms of reference credit and notional amount.


We can consider this a Chain of settlements that all have to fall in sync assuming "no excess cash buffer".  The Chain runs from A to D
Here is an example of exchange traded settlement as a centralized netting agent with the same behaviours of the institutional participants.

As we can see these two settlement systems have very different netting risk exposures in the event of default events.  The nature of CDS's which act a bit like extreme barrier options is that these settlement chains rarely get tested or stressed.  They haven't evolved robustness from a network perspective.  Most organically evolved networks are formed and behave structurally in something called a scale free network topology.  Basically this means the number of connections or relationships is logarithmically scaled.  Imagine the 80-20% rule in action.
Here are some crude assumptions with absolutely no empirical data behind them.
  My general hope is that the efforts of ISDA to accelerate standardized terms for netting and the efforts of the major banks to establish an automated netting facility happen soon.  I don't know what the capacity of the financial system is for a failed chain event, but it is certainly cause for concern.  We certainly don't want any grad students writing theses with titles such as "CDS netting failure, the day money disappeared."

If anyone has data or a model on the "capacity" for a network to handle these failure it would be interesting to see.  Assuming a 0.05% annual failure and clearing rate of 3 business days. with an 80-20% concentration of failure could lead to the system needing to clear $420billlion in a cycle.  Assuming the same 80-20 rule for institutional concentration means the top 50 institutions would need a liquidity buffer of $336b. 

Again these are made up numbers using the crudest of assumptions, but highlight the risk of failed netting even if the counterparty is good, that or a lot of bank holidays to stretch they cycle thereby increasing the netting capacity of the system. 

I won't even touch on the component of an institutional failure being used as the reference credit.  I call that recursive failure in the system and it is nasty indeed.

Girls make things better.

The singularity gets nearer and we get anxious

 Intel is going to be shipping chips with thousands of cores in the near future.  You can now purchase a graphics card that performs a teraflop (1 trillion calculations per second) for your PC.  Today's breakthrough is tomorrow banal trinket or play thing.

The singularity which is kind of a rapture for geeks is approaching.  The ebb and flow of politics and economics are going to become more driven by technology than we have ever imagined. 

I used to work in an institute designed to discover applied science for 100 years in the future.  I toiled away as Chief analyst for 70 PHd's working to create the technologies in nanoscience, bioscience, artificial intelligence, energy and materials science that would shape the future.  We had 2 noble laureates and Nicholas Negroponte of the MIT media lab on our board.  It was a powerful learning experience about science and applied research with fascinating and brilliant people.

What does all this technology mean?

In my mind, the book that highlights what the technical progress will become most effectively is the singularity by Ray Kurzweil.  Trained as an anthropologist, I can guarantee that how these technologies are applied and used is impossible to predict, but the sheer power and magnitude of change will be overwhelming and culturally transforming.  The singularity is Utopian, I constantly remind people we are only apes with opposable thumbs and the gift of language.  To fully appreciate this read The Third Chimpanzee by Jared Diamond author of Guns, Germs and Steel.

The great science fiction writer William Gibson once said the future is already here, it just arrives in different places at different times.  If you have ever experienced telepresence in a halo room or felt in awe watching the graphics in the latest video game or some new technical breakthrough, expect to have the sensation more often as the future starts showing up in more places in your life.

Change is one thing that seems universally loathed by all cultures and people in general.  We are creatures of habit and social caste, the rate of change which is now taking place will drive many further into thier core ethnocentric beliefs.  I anticipate the pursuit of greater ethnocentric ideals within many cultures as the pace of change accelerates.  This is not necessarily a good thing.  This could mean greater chances for misunderstanding and conflict among self identified groups.  Let's hope the anxiety induced by rapid change is overcome by a sense a shared humanity.  The record among groups of third chimpanzee's for this is not great.

Einhorn's hedge fund highlights the symptoms...

David Einhorn's book is an interesting introduction into the birth and life of a successful fund.  Greenlight Capital doesn't trade so much as it invests in a thesis and is willing to take a longer term approach, a refreshing approach similar to my day job.

Einhorn's book is really a tale about managers, money and how things are wrong in so many parts of the industry.  His book is most interesting for providing looks at the symptoms of a diseased system. 

Einhorn tells the tale of someone trying to do the right thing and making a buck at the same time.  His agenda and motives are clear.

Einhorn digs deeps like an investigative reporter cross bred with a forensic accountant.  He discovers fraud and acts on it.  The response to his actions from many institutions designed to engender faith in the American financial system are deeply disconcerting. 

Caveat, I have only read Einhorn's book and so make these statements with limited knowledge.

The failing institutions include:

• SEC
• Wall Street Journal and many business journalists
• SBA (small business administration which throws your tax money away)
• NYSE (New York Stock Exchange, which is appears to be mostly a pimp for paper profits)
• Mr. Spitzer's term as NY attorney general (which did some good, but was also a dangerous one man ego trip)

These failures appear to be symptoms of a disease of apathy and the lowering of ethical standards at the institutions that are designed to protect the integrity and thus the growth of financial markets and our economy.  The sheriffs are asleep and corruption is seeping in, even worse people don't care or believe anymore.

WIIFM rules.

WIIFM (pronounced wifm) is a powerful acronym taught to me by a friend named Gina Budde.  WIIFM stands for What is in it for me.  This is psychology 101.  No news, self interest dominates behavior of individuals and groups, it always has and always will.  Rarely does someone steps outside of a WIIFM mentality to "do the right thing".  As I tell friends, ethics don't count until they cost.  Talk is cheap.

Unfortunately Einhorn's motivation of making money and uncovering the truth is seen to be mistrusted by the very operators who are supposed to uphold the integrity of the markets.  Journalists, regulators and government officials decide it is easier to go with the flow than to do the right thing.  Accuse the accuser becomes an all too frequent episode in these pages.

:WIIFM over Ethics

Independent actors behaving fraudulently to increase their own WIIFM's is nothing new.  What is highlighted clearly in this book is that many institutions by failing to uphold their intended charters fail to make ethics easy.  In successful economies and cultures doing the right thing and WIIFM align by design.  This is the basis for a stable growing economic and cultural system, think whistle blower laws. 

When institutions fail ethically and rot from inside, markets eventually become less efficient and we all lose.  Einhorn's book is less interesting for the story itself.  The roles of rogue, thief and sad bureaucrat have been around since Sumerian's started recording grain shipments on clay tablets.  The roles are  the same only the names change. I am an anthropologist first and foremost.

What is most interesting in the book is the picture of the sorry state of our "soft" cultural institutions.  It is my belief that "soft" cultural assets such as trust, integrity and belief in cultural institutions and pursuit of truth are what drive long term economic stability and growth.  They are leading indicators.  Ethics only count when they cost, and the prevailing attitude among some of America's most important cultural, government and financial institutions appears to be WIIFM.

This scatterplot below sums up why Americans should be concerned about the symptoms highlighted in Einhorns book.  Slipping institutional integrity could be a negative leading economic indicator.  Click on the image to see the raw data from nationmaster.com