Category Archives: Financials

Woof!

Sadly, the last hope for avoiding financial catastrophe is disappearing as Powell steps back from reining in the credit bubble.

Caveat Emptor

Bond guru Jeff Gundlach observed that the stock market has become a market for high-risk CDO residuals.

I must admit that I had not thought about this but he is exactly correct. CDOs (Collateralized Debt Obligations) were at ground zero in the last financial crisis. A CDO is constructed from a collection of assets, for example mortgages, and is divided into slices (“tranches”) which receive income in a priority sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. So for example, if $100 comes in, then slice 1 may be entitled to the first $25, slice 2 the next $25 and so on. But if only $10 comes in, slice 1 gets it all and nobody else gets any money. The last or lowest priority slice is called the residual, which receives whatever is left over after the other slices with fixed entitlements have been satisfied.

Gundlach’s point is that companies which have bought back shares with debt now have a capital structure essentially identical to that of a CDO, where the debt obligations have first claim on the company’s income and the equity investors must be satisfied with the crumbs. They are in the same position as the owner of the residual tranche of a CDO. So long as earnings are high and interest rates are low, all is well and there will be yachts and jets. But when the tide goes out, there will be naked swimmers as the ugly side of leverage becomes visible. Read Jeff’s piece and be very very scared.

Loose Cannons

In the days of fighting sail, the ship’s main armament typically consisted of rows of cannons lined up on each side of the ship. These cannons fired through ports in the side of the hull and were mounted on wheels so that they could be pointed and able to recoil when fired. Normally, they were constrained by heavy ropes. But from time to time one or more would get loose. Each cannon could weigh as much as three tons and would then roll around the gun deck as the ship pitched and rolled, crushing anything or anybody in its way. The gundeck would be crowded most of the time – each gun on a large ship had a crew of 14 men who not only worked but ate and slept near their gun. Needless to say, a loose cannon could do much more damage than any broadside from an enemy ship.

In the market, the black boxes or “algos” are the equivalent of the loose cannons of yore. They are out of control and roll around in herds, as many of them share similarly programmed rules. You can watch the “herding” in the stock market by watching the “Tick” as it moves to extremes in both directions – that’s the herd. You hear about “flash crashes” – that’s a herd of algos running over some security or asset class. They pose a huge danger to the financial system, and need to be reined in. The mistake that the regulators make is to only consider them as single entities, without comprehending the emergent phenomena arising from unintentional herding behavior.

Too Tight?

Reportedly, President Trump is considering firing Fed chair Powell, blaming him for the recent stock market declines.

Ironically, in Sept 2016, Trump accused the the Fed of “keeping the rates artificially low so the economy doesn’t go down so that Obama can say that he did a good job. They’re keeping the rates artificially low so that Obama can go out and play golf in January and say that he did a good job. It’s a very false economy. We have a bad economy, everybody understands that but it’s a false economy.”

Of course, he then adopted the “false economy,” even though he apparently well knew that it was a bubble, going on to extend it with spending increases and tax cuts. Of course, this simply increased government’s value destruction and we will all reap the consequences. In my mind, this is the biggest disappointment of Trump’s presidency – that he knowingly continued to inflate the bubble.

Yellen was “too short.” It seems Powell is “too tight.” Firing Powell would probably precipitate a crash.

The right thing to do is to acknowledge that the Fed’s ability to control the economy is a myth. Their attempts just lead to an endless series of booms and busts, as anyone who has the least understanding of control systems theory could predict.

Close To The Event Horizon?

From ECRI’s Lakshman Achuthan:

Notably, the combined debt of the US, Eurozone, Japan, and China has increased more than ten times as much as their combined GDP [growth] over the past year.

Remarkably, then, the global economy—slowing in sync despite soaring debt—finds itself in a situation reminiscent of the Red Queen Effect we referenced 15 years ago, when tax cuts boosted the US budget deficit much more than GDP. As the Red Queen says to Alice in Lewis Carroll’s Through the Looking Glass, “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

Blockchain RIP?

The blockchain technology is a partial solution to the Byzantine generals problem. A full solution to the problem has been mathematically shown to be impossible. As a result, blockchain systems are vulnerable to attack by introducing enough fraudulent voting power to improperly modify the blockchain.

Apparently this is now happening to some of the smaller networks.

The potential prizes on the larger ones are rich enough that it is probably just a matter of time until one of them is compromised for serious money. Then we’ll see what happens.

Two Easy Pieces

Another excellent piece by Matt Tabibi – The Great College Loan Swindle.

The education industry as a whole is a con. In fact, since the mortgage business blew up in 2008, education and student debt is probably our reigning unexposed nation-wide scam.

One for the history file from zero hedge – The ‘Hyper-Crash’ Is Coming – It’s Not The Everything Bubble, It’s The Global Short Volatility Bubble

  • Instead of being an external measure of risk, volatility has become a tradeable input – making it reflexive in nature;
  • As volatility falls, investors (using leverage) take bigger bets in the same direction, so lower volatility begets lower volatility.
  • The global short volatility trade is more than $2 trillion;

Making volatility easily tradeable will, IMO, turn out to have been the biggest regulatory error in history. It has long been possible to trade volatility by the use of long out-of-the-money put options, but this trading was never large and does not seem to have been pernicious.

Risk and volatility are equated in the algorithmic trader’s lexicon. But risk never goes away – it can be moved around but not eliminated. Tradeable volatility is giving the illusion that this axiom is false, that risk can be eliminated with a few taps of a magic wand on the VIX futures. I don’t think so.

Illinois And The Tsunami

Apparently the standoff between Governor Rauner and Speaker Madigan continues. As it should. Madigan’s willingness to dispense unfunded largesse to his supporters is largely responsible for the state’s financial woes. Today also the state was ordered by a Federal court to pay its backlog of Medicaid bills, which will be interesting as the state is already cash flow negative.

However the biggest issue is the unfunded state employee pension obligations. This article from Bloomberg contains a nice graphic ostensibly showing the funding levels of most states (no data for California? Really? just check this blog)

These reported funding levels are a cruel joke. These funds continue to assume 7-8% returns, despite the fact that they have not achieved them for years. Just look at the column showing the decline in funding ratio from 2014 to 2015. Not only are the assumptions high, but they are for long-term averages, so that they adjust future return estimates higher to compensate for below-average realized returns. John Hussman’s work shows more or less zero returns for the next 12 years, with the high likelihood that there will be a major drawdown in that period. Drawdowns are lethal to pension funds because the payment of benefits continues, sapping the capital base and making recovery to previous levels nearly impossible.

Pension funds used to invest in bonds. The trustees would meet once a quarter, review the actuarial forecast of liabilities and approve adjustment of the laddered bond portfolio’s maturities to exactly meet the liability schedule. Then there would be lunch and golf. The future returns would be locked in and the contributions needed to fund the bond portfolio would be obtained from the sponsor. Everyone got to sleep at night.

Then Wall Street decided that pension funds had a lot of money, and not enough was being siphoned off into Wall Street pockets. So the sales force went out, armed with charts showing that stocks had historically offered higher returns than bonds. Higher returns mean that less contributions would be needed, so fund sponsors bought the pitch. Yes, stocks have offered higher returns but for a reason – much higher risk. Well, we’ll just assume a long-term average return and surely it will average out. GLWT.

The End Of Hope

I had hoped that Donald Trump’s presidency would see some change in Washington. The attack on Syria finally dashed this hope.  The neocons’ campaign to demonize Russia has shaken his confidence to the point that they are now back in charge. This is a catastrophe, for which there is no one to blame but Trump.

Almost as seriously, presumably at the urging of the Goldmanites, he has not only failed to even attempt to slow the financial bubble, of which his pre-election statements show he is well aware, but has cynically relished it as proof of his success. This failure is likely to be his downfall.

We are so screwed. Sauve qui peut.

Ouch

Well the Trump bond slaughter has not been good to the portfolio. However, the strong dollar and the rapidly falling oil price are both powerful deflationary forces. Dr. Copper spiked, but was rapidly crushed today. Foreclosure filings increased 27% MoM in October, the largest increase since the run-up to the last property crisis. All of this bodes well that, once the powers that be feel that they have achieved their goal of getting the unwashed out of bonds and into equities in time for the real slaughter, happy days will be here again. In which light, it is amazing to see that the Russell 2000, an index with an undefined PE – due to aggregate lack of positive E – is the stellar performer. This smacks of a massive degree of (emotional?) retail participation in the Trump stock rally.

So I’m sitting tight.

BTW, my target for oil is $15-20, EUR is $0.80-0.85 and CAD $0.60-0.65.