ES -- DX/CL -- isee -- cboe put/call -- specialist/public short ratio -- trinq -- trin -- aaii bull ratio -- abx -- cmbx -- cdx -- vxo p&f -- SPX volatility curve -- VIX:VXO skew -- commodity screen -- cot -- conference board

Friday, February 29, 2008


how now brown cow?

volatility envelopes on the s&p are ambiguously positive. there's a positive demand divergence in the recent test of 1390, but a very slight supply divergence on the recent higher lows. the supply is at such a low level that i'm not sure it shoudl be recognized, however -- signals here tend to carry more validity at higher readings. ambiguous.

the NDX volatility envelopes are also a bit ambiguous. there's clearly declining peaks of supply, but we're in the last couple days getting the first hints of rising troughs. demand has been in a pattern or rising peaks and troughs. in spite of a couple weaker days, the trends look pretty good, really -- but could change quickly.

20d hilo is not less ambiguous. the situation resembles the last emergence from a panic low in august -- where expansion in the lows is a function of the panic moving out of the 20-day window. but highs are not exuberant here -- just keeping pace, really, not leading.

it's easier to see the lack of actual new low activity by changing timeframe, here to a quarterly window. highs are more clearly expanding here and lows doing nothing. not indicating an imminent collapse, at least.

in volumes, net points and net volume are keeping pace, but the advance-decline line is showing a slight positive divergence on the test. mcclellan remains positive. 10-day participation is showing a declining double-top, but 30-day continues to expand.

on the whole, it looks like the pullback should be short-lived -- perhaps driving the 10-day participation down to oversold levels? seems likely. dropping to 1336 would get that done. but indications of a bigger pullback don't seem readily evident.

could it retest 1270? certainly.

UPDATE: on a sentiment note, the 50-day average of the ISEE all securities set a new dataset low at 102.30. the previous record, 102.76, was set on october 16, 2002.

of course, the lowest low in the nasdaq 100 was plumbed six days earlier, on october 8, at 795.25 -- which was a revisitation of support from april 1997.

that means that (by one measure, anyway) the last time options sentiment was this persistently dire was at the lowest low of the last 11 years, at the last gasp of a the worst bear market since 1974 if not 1933. amazing.

UPDATE: it appears that the CBOE equity put/call ratio closed at 1.16. the last higher close was august 6 2004 (1.28), which marked the low point of that year.


Thursday, February 28, 2008


real housing declines and price-to-income

i continue to think the macro monetary bugaboo that the united states is most likely to have to face over the coming quarters is deflation fueled by a steep contraction in bank lending at all levels. we're already seeing it to some extent in the money center banks, where balance sheet growth has become the enemy and virtually every expansion of credit is forced and unwanted. as commercial real estate turns tail and follows residential down, the impact on local and particularly regional banks will manifest in an even more visible tightening of credit and monetary velocity.

but, in the meantime, the transition period has offered increasing inflationary pressure. and the effect on the housing decline in real terms is noted by calculated risk.

In nominal terms, the index is off 8.9% over the last year, and 10.2% from the peak.

However, in real terms, the index has declined 12.9% during the last year, and is off 14.6% from the peak.

Inflation is helping significantly in lowering real house prices. If prices will eventually fall 30% in nominal terms, then we are only about 1/3 of the way there. But if the eventual decline is 30% in real terms, then we are about half way there.

better than taking guesses at static targets, i think what we're witnessing is a normalization of the financing behind housing. house prices are of course about supply and demand. early in this decade, a combination of negative real rates and wall street initiative to expand securitization into the mortgage market changed the credit dynamic behind demand -- more buyers found they had more resources at their command for the same debt service payment/income level. increased demand drove up prices. higher prices signalled the supply side -- that is, homebuilders -- to expand operations, which they did.

i think one can say the mania took hold when expanded supply could not meet increasing demand -- prices continued to rise as financing and underwriting standards fell through the floor in an effort to keep the securitization machine growing and the fee revenue coming in to the banks, creating ever greater housing demand. speculation took hold in many markets, creating a new class of real estate "investor" who serviced multiple houses on the skimpy financing vehicles being offered by banks. many confused reasons for the surging prices were contrived, but in the final analysis this is 95% of what happened to home prices between 2001 and 2007.

the whole mechanism seized beginning in february 2007, when the first investors began to realize that default rates on mortgages originated in 2005 were not behaving normally -- the first sign that the shoddy underwriting standards of the boom had included in mortgage pools a significant slice of mortgagors who were not going to pay back their loans. as end investors began to shun securitized mortgages, banks found that they could no longer sell the mortgages they were making. without room on overstuffed balance sheets to take on the mortgages themselves (as they would have in the days before mortgage securitization), they essentially quit making mortgages of any kind that could not be sold on to fannie mae and freddie mac, quit making loans to lower quality mortgagors, quit making loans with payment-reducing features like negative amortization and teaser rates. with as many as 9 in 10 mortgage applicants that would have been approved in 2006 now being declined in some areas, demand fell precipitously and prices began to decline.

this is what i mean about the normalization of the financing behind housing. the tricky loans and blind underwriting that fed the financial engineering of the boom allowed a certain amount of income to support more house than it ever had before. the longstanding national relationship of median house price to median income since the advent of the 30-year mortgage and the 20% downpayment expanded by something like 30% during this period. now, with the loans no longer being offered and underwriting standards returning, that relationship is re-establishing itself at its old level.

what is that old level? it depends on a number of factors -- average home size, mortgage rates, average down payment required -- but traditionally the price of a home on a national view has been something like 2.7 times gross household income per goldman sachs' jan hatzius, with some variation. (this can vary by metropolitan area, but happens to be approximately true for chicagoland.)

worse, for so long as banks remain under terrible balance sheet stress, the likelihood is that the relationship of price-to-income will undershoot the mean of the old relationship and find bottom somewhere near the low levels seen in other recent times of bank distress -- something like 2.2 times income.

moreover, this has caught the homebuilders out on the thinnest of branches. with the debts of forthcoming massive developments already incurred, they have had little choice but continue to build in an effort to liquidate assets in an effort to at least pay off as much of their financing as they can. new home supply has, therefore, expanded spectacularly. and with the collapse in demand, there have not been enough buyers to absorb the existing houses being put up for sale by their current owners (many of them recently bought on variable or fraudulent terms and now under duress of impending foreclosure), compounding supply problems. calculated risk has estimated that homes for sale in the united states will rise to more than a year's worth of sales at some point this summer, a post-depression record.

so what should one expect in terms of prices, then? median household income in the united states is currently about $48,500. the median price for a single-family home in the united states in 4q2007 according to the national association of realtors was $206,000. (condos are reported separately and are more expensive at $221k.) this ratio of 4.25 implies that housing on a national scale in the united states is as much as 36% overvalued as compared to a historical ratio of 2.7. compared to a trough ratio to income of 2.2, they could be as much as 48% overvalued.

in chicago, the 4q average price of an SFR was $261,000. median income in the metropolitan statistical area (MSA) is probably about $74,000. that is a ratio of 3.53, or some 24% overvalued from a long-term ratio of 2.7 -- and 38% above a trough ratio of 2.2.

listing times indicate that house prices in chicago haven't fallen nearly far enough to start resolving inventory issues, i.e. bring supply in line with traditional-finance demand to work off the overhang of unsold homes.

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Tuesday, February 26, 2008


walking away cont'd.

the phenomena of mortgagors walking off their purchased properties -- the quaintly euphemized "jingle mail" -- has been a hot topic in residential real estate circles. but there has been considerable debate as to whether it is really happening.

we may now be getting unfortunate clarity on the issue. housing wire highlights this commentary, which cites mish.

GEA poses an interesting question as to whether the FICO system has lost its mind or if maybe there’s a larger issue at work. Although it’s hard to imagine borrowers with a 20%+ equity stake (albeit phantom like) and strong credit scores defaulting at a rate that would lead any servicing portfolio manager to jump out of the nearest window, the numbers seem to indicate that borrowers may be walking away when they are 30 or 60 days delinquent, not even waiting for foreclosure. In December 2007, the 90 days delinquent category stood at 3.79%. Even if every one of these delinquencies became a foreclosure, the figure should only double to 7.58% in January. Instead, the foreclosure figure is 13.17%.

What does it all mean? Until recently, I may have been one of the last holdouts on the FICO bandwagon. I’ve seen enough delinquency reports to make me believe in the ability of FICO to accurately predict performance. But something is terribly wrong with this picture. Credit scores north of 700 have not, in my experience, shown such poor performance levels so quickly. ...

If there was ever a doubt that the phenomenon recently dubbed as “jingle mail” actually exists, wonder no more. It’s alive and well. Hopefully, it won’t be still be around around come Christmas time. But given the recent trends, that may be wishful thinking.

meanwhile, the data coming in is having its effect in the ABX indeces.

I've seen a summary of the ABX Remittance Reports (not public), and as one Investment Bank wrote, as they increased their loss projections again: "Another month of disappointing data ..."

in my earlier take, i said:

it's no secret that personal responsibility, interconnectedness and identification with common institutional aims has been on the wane in the west -- on both sides of the civil equation. the business of institutional lending, particularly, has developed into a commodity that is managed not by intimate knowledge of counterparties and two-way character evaluation but by statistical distillations of rates of return on the one hand and presumed protections of government on the other. now, with neither impersonal evalutation holding up under scrutiny and stress, models which operate on presumptions of the old relationships still being in place are breaking down -- with fear, anger, loss and a deepening reinforcement of irony, disillusionment and defeated apathy the widespread result.

i've sometimes called the american boomers the most destructively narcissistic generation to walk the earth since the decadence of the romans -- the type represents the essence of western social collapse in my view.

but jim jubak in this video nails down one of the most material undercurrents of the entire crisis -- it's time for the profligate and irresponsible boomers to finally reap some of what they have sown. a pity that their leadership (or lack thereof) led the western world down this dark path, but the consequences have become unavoidable.

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great video gm. I always learn something on this page.

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I'm personally very worried that in the coming years, while the Boomers have exhibited no ability to exercise good judgement and leadership, they will likely prove themselves dangerously good at exercising political power for personal gain.

Some optimists have suggested that they would never wage such a war on their children. I'm not so sure, and the evidence thus far give me little hope.

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updating the risk appetite index

i mentioned in passing some time ago jonathan wilmot's credit suisse global monthly risk appetite index, and in writing the last piece caught an update (in chinese, translated thanks to google) which indicated that it had fallen below the critical (-3) "panic" level by january 23.

As for the survival of the fittest-the timing of how to pick? 28 years has been recorded related to the Credit Suisse Global Risk Preference Index (Credit Suisse Global Risk Appetite Index) (see figure), on 23 January, the index fell to negative four -time ‧ February 2 standard,二○ ○ hit the lowest in the three years since, that the world market entry "panic", in a non-market has been rational Chaotu stage.

"see figure", indeed, but i saw none. but i did find a link to this excellent pdf authored in part of wilmot on january 21 -- just after the registraton of the panic reading. thanks to the be early aggregator.

The basic pattern is quite clear. By the time Risk Appetite enters the panic zone (1.5 standard deviations below average), the worst is usually over for world wealth and global equities; small declines tend to occur between entering the panic zone and the ultimate trough; and very strong performance is typical in the three and twelve month periods following the risk appetite low. Note that the buildup to this panic episode has been close to average, although the distribution is different, with emerging equities doing a lot better than average, Japanese equities much worse, Germany a little better and the US a little worse. Absolutely in line with the real economy.

... Other episodes confirm this historical pattern: it is usually a lot safer to buy US stocks immediately after entering the panic zone than to buy Germany, Japan or emerging equities.

Second, risk appetite briefly bounced out of panic soon after its first entry, before plunging back in again, a pattern that occurs in a few of the longer panic episodes documented below. Clearly, therefore, entry into the panic zone is not a perfect market timing signal, merely a very good one most of the time.

but they urge caution:

So what about this time round?

Our best guess is that the ultimate low in risk appetite may not occur for several weeks, and that there may well be a brief bounce out of the panic zone along the way. (note that this was written four weeks ago. -- gm)

First, we think there is a very good chance that global industrial production momentum will trough around April/May unless global demand absolutely craters. This is largely an inventory cycle point, and we would expect risk appetite to trough around then, or more likely a month or two before.

Second, valuation is ultimately more important than market sentiment. At today’s bond yields, for example, equities would arguably still be good value versus bonds even if earnings were to decline as much as they did in the last two recessions. In which case, we are in effect already discounting a recession, and we are hardly very likely to see a larger than normal bear market.

this would be sympathetic to the idea of a retest or pair of retests such as i outlined earlier.

the key theme is clearly that not until the divergence of new lows became clear did the subsequent longer-term rally hold -- but also, that there was already very little material risk of deeper price lows from the time of the initial new low spike.

UPDATE: mark hulbert with a pretty interesting view on market timers -- the best are vastly more bullish than the worst.



case/shiller 20-city off 2.1% in december, 9.1% YoY

per bloomberg:

Prices may fall further as would-be buyers hold out for bargains and foreclosures add to the glut of unsold properties, extending the worst housing slump in a quarter century. Shrinking home values and credit restrictions threaten to reduce consumer spending and push the economy into a recession.

``Home prices are headed lower,'' Michael Moran, chief economist at Daiwa Securities America Inc. in New York, said before the report. ``With demand soft and inventories still high, there will be pressure on prices to keep declining.''

indeed, calculated risk here, here and here analyzed existing home sales data yesterday. to summarize: sales are off 25% from a year ago and are still collapsing; inventory is stubbornly near all-time highs, both in absolute terms and as a ratio of sales, in spite of the fact that this is january; and seasonal patterns suggest inventory will hit new all-time highs well before the summer selling season.

perhaps no surprise then, that the FDIC is preparing for a wave of bank failures.

"Regulators are bracing for well over 100 bank failures in the next 12 to 24 months, with concentrations in Rust Belt states like Michigan and Ohio, and the states that are suffering severe housing-market problems like California, Florida, and Georgia," said Jaret Seiberg, Washington policy analyst for financial-services firm Stanford Group.

as noted, regional bank concentration and overleveraging in commercial real estate has made for a very dangerous situation, particularly coming on the heels of the worst residential bust at least since the great depression, if not all american history. another FDIC warning note was issued today. this chart notes the crazed overdrive of commercial lending that took place as securitization relieved regional banks of the need to keep residential mortgages on their balance sheets. if economists like martin feldstein are right, this could be a very difficult period for banks and therefore the economy generally.

as CRE weakens with this debt bubble collapse, so will local and regional bank lending. with the securitization window having been shuttered tight with the collapse of shadow banking, that means non-conforming home loans are going to become very hard to get. and that will very probably drive both sales and prices down further.

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Monday, February 25, 2008


vanguard of social unrest

there's been plenty of talk in the financial community about the unfolding disaster in real estate -- first residential, now increasingly commercial -- but very little talk about what it means. the problems of bank balance sheets and government interventionism have been dissected endlessly, to be sure, but i'm referring to the social impact of our economic problems.

periods of true economic duress are often accompanied by social unrest as shaken faith in social institutions as protectors and guarantors of social good often translates in one of two ways: increased militarism by the subordinate of society, and increased anarchism by the deviant. the subordinate are often the ingratiated, as one would suspect -- proponents of the virtue of social order are invariably those who currently control and derive disproportionate benefit from that order.

this cycle may be more violent than any we've seen in some time. the reasons i say so are not complex, but i should lay them out explicitly.

real wages as a percentage of gdp have been in decline since 2000, and indeed since 1972, falling some 15% in that time. (please note that this decline is significantly understated, as inflation is indexed to CPI, which is itself significantly understated in an effort to reduce the real obligation of government entitlement payouts.) this has manifested in a middle class that, to meet expenses, no longer saves any money at all -- where personal savings peaked at nearly 15% in 1974, the current rate is approximately zero. further, the death of savings has been accompanied by massive household liability growth, meaning that household debt service costs have grown immense in spite of prevailing record low interest rates.

these are trends that have an endpoint. americans can not forever go on living beyond means which are, year after year, continually diminishing. the pressure being placed on median-income people to reconcile the consumer excess continually reinforced by advertising regimes such as television with declining incomes and massive debt costs will force a change -- and with that change will inevitably come some chaos.

the housing bust -- which may be the most significant socioeconomic event in the united states since at least the oil crisis of the 1970s -- seems initially to have the mass and power to force these trends to a possible reversal and the accompanying lawlessness. to wit:

calculated risk highlights the robbery of a georgia bank motivated by a foreclosed homeowner. this sort of robber populism is as old as robin hood, and has made cyclical appearances in the national consciousness with every severe economic downturn. the most famous recent examples were the depression-era gangsters -- bonnie and clyde, john dillinger, et al.

the american mythology typically plays down the extent to which lawlessness pervaded the american midwest during the period. but a more interested reading of the history of the period reveals that integral elements of the society were agitating even for revolution. foreclosures were periodically suspended in many midwestern states during the height of the hardship as much to prevent open rural revolt as any other reason. the roosevelt administration incited anti-juridical sentiment for populist political purposes from 1932 onward, in part to get constitutionally-questionable aspects of the new deal passed; this had the effect of reinforcing the prejudices of many afflicted people against the entire financial and legal establishment which had arranged the preconditions of the depression in the first place. eventually, those trying to enforce bank contracts were taking their lives in their hands. military police were often needed at foreclosure auctions to avoid violence. martial law was intermittently enforced by the national guard. fear in the end drove worker against worker -- the iowa farmers strike of 1932, perhaps inevitably, turned brutally violent.

further, some more ideological anarchism was recently evidenced in bremerton, washington, last week in vandalising some banks. the origin of ideological anarchism can be traced to proudhon writing his seminal treatise in 1840 paris -- a city wracked with financial hardship stemming from the 1837-41 global depression. the change in socioeconomic currents culminated in the railroad boom-bust financial crisis in 1846-47 and finally the revolution of 1848, whereupon proudhon proposed democratizing credit by transferring ownership of the financial sector to the workingman. moreover, anarchism became a major social force in western civility in the periods of sporadic financial tumult that broadly characterized europe between 1868 to 1896, sometimes called the long depression.

the sort of incidents aforementioned will merit and demand ever more attention over the coming decade, i suspect. these incidents are small beer, i think everyone would concede, and the financial condition of the american middle class has not (at least not yet, if it sometime will) reached a point that has them broadly questioning their faith in capitalism and its institutions.

but -- if the crisis continues to deepen -- a change in social attitude about banking and lending may well be underway now, one which could (if history is any guide) lead to populist social violence on the one disenfranchised hand and increased authoritarianism on the other entrenched hand. as government policies and bailouts proceed, as the problems of negative equity and foreclosure multiply, and as some banks begin to fail, the impetus of these trend changes in attitude will grow.

conversely, this is transpiring at a time when the dominant minority in the american society is near a new highwatermark of paranoia regarding the security of their elevated role. this is amply demonstrated in my view by the sustained militant reaction following the 2001 world trade center attack. since that day, the elements of power which attempt to sway public opinion have relentlessly reinforced a culture of fear which, it must be supposed, is seen as necessitating allegiance to the established political order. living in the united states today means in part being constantly reminded that you are about to die horribly at the hands of some faceless terrorist. this has been associated with a reckless expansion of the domestic police state, from increased funding for all manner of law enforcement however absurd to the establishment of widespread domestic surveillance and wiretapping. though spartanism has been on the move in america since the first world war or earlier, the recent acceleration highlights the increased tension.

accompanying this has been a belligerence in foreign policy that, whatever its mundane goals are, represents a further manifestation of the insecurity of the leadership class as a whole with respect to its empire. it is typical of powerful and secure states to exercise the quiet control of diplomacy through coercion (often economic but also cultural) to attain desired ends; the exercise of expensive (and often ineffective) military power is best viewed on this perspective as either an admission of actually insufficient coercive power or evidence of a fearful perception of powerlessness among american leadership. i frankly suspect the perception of american powerlessness is more operative than the actual condition, and where the actual might be focused on certain problem areas the perception is very likely omnidirectional, i.e. felt inwardly as well as outwardly. as the perception has grown, a sort of madness has taken hold of the highest offices of american power -- a commitment to lawlessness in the face of a perceived or even contrived threat of lawlessness, the rise of the rule of heroism.

a leadership demonstrating these signals of deep and universal insecurity could react to outbreaks of domestic lawlessness in any number of ways. this is, after all, a complex situation. but the example of the resuscitated "war on drugs" that dates back to the nixon administration of 1969 -- a watershed period in establishing postmodern fears of the american leadership class for their privileged status -- bodes ill for those hoping to avoid civil confrontation in the face of any serious challenge to order. the recent synonymous situation of france reinforces a glum outlook.

the confluence of these two socioeconomic trends leads me to believe that we may be faced with a prominent period of civil violence in coming years in the united states. this needn't mean the end of the society, of course -- 1968 changed the west but did not kill it, and as much can be said of the 1930s or the 1890s as well. but it is something to monitor as the debt crisis unfolds.

a further consideration would be something like the opposite of violence -- a deep-seated desire to move beyond the physical world entirely, to disengage from reality and delve into the transcendent idealism of religion. i originally discussed the rise of heroism in the context of christian cultism, and one might see correlation between past "great awakenings" in america and periods of economic crisis. the first began around 1731, intensified in the 1740s and continued through the 1750s; the second in 1800 through the 1820s; the third from 1850 to 1900; the contentiously-designated fourth from the late 1960s to the early 1980s.

i doubt it is a coincidence that these are also periods encompassing significant financial strife. the first blossomed dring the trade-depressing global war of the austrian succession (1740-48) and died out shortly thereafter. the second emerged alongside the napoleonic wars and the massive shocks that accompanied the first decades of american independence, including the continental hyperinflation, the war of 1812 and the depression of 1819-24. the third is roughly contemporaneous with the american civil war and long depression. the fourth aligned with vietnam, watergate and the inflationary depression of 1965-82. it should be further noted that religious fundamentalism experienced a lesser revival in the great depression as well. obviously, not all periods of economic or military strife were also periods of religious intensification; but it might be suggested that economic strife is an accelerant to conditions predisposed of world despairing.

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Excellent commentary, weaving together many interrelated factors.

I've given this considerable thought and concluded, at least for the time being, that due to the lack of political consciousness in the US, a progressive populist movement is doubtful.

Another aspect worthy of consideration is the likelihood of the search for scapegoats. As I see it, there exists a lack of adequate targets for this, except possibly the 'threat' posed by immigrants (especially of the illegal variety), which may fit the bill. Laced with this would be a degree of racism. However, I doubt here too that immigrants as scapegoats will be sufficient to meet the task of identifying and mobilizing the necessary hatred.

Time will tell.

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Friday, February 22, 2008


the hard trade

there are positive noises emerging on the credit front from some sources. david merkel, for example:

Now we may have an opportunity as some CPDOs are forced to delever, credit spreads are being forced higher. I commented before (all too recently) that it was time to dip our toes into the waters of credit, and buy 25% of a full position, with carefully selected credits. I think it is now time to raise that allocation to 50%. It is time to begin taking some credit risks; spreads are discounting a lot of unfavorable future news, and it is time to take advantage of it. Is the current news gloomy? You bet, and I can tell you that at the end of many days in mid-2002, I would hold my head in my hands in disbelief at the carnage. But good credit investors must invest when the spreads are wide, and give up income when spreads are tight.

this backs the expressed view earlier stated at accrued interest that the high-yield market has priced in any likely recession. spreads across the credit default market have since continued to widen -- here is the investment grade picture, here the high yield.

i've posted repeatedly about how the equity market should turn if technical history is an indicator. but let there be no doubt -- i am scared. the animal within wants to sell. this is a very hard trade for me to hold.

jeff miller passed on today via the kirk report exerpts from an interview with william eckhardt.

"It's much easier to learn what you should do in trading than to do it. Good systems tend to violate normal human tendencies."

"There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you'll gravitate toward the majority and inevitably lose."

there is a lot of fear in the market now with massive negative newsflow and i'm feeling some of it. it is easy to advise oneself that hanging on is not only the sane but even safe thing to do; but it is very hard to listen and take the advice.

if savvy investors are starting to wade back into the credit markets on the basis of heavy discounting, it could be that the credit market is on the brink of turning. when it does, the major worry in the equity market -- a credit market collapse -- will abate.

UPDATE: a massive late day reversal higher on news that a bank-led ambac bailout plan will be announced early next week.



comparing this rally to past examples

the biggest technical reason, in my opinion, to think a bottom is in place as of january 22/23 is the new annual low spike that took place on the 22nd. i took a look at past examples on january 10 as the indicator started to reach high levels.

so how has the price movement compared to past examples? sluggishly, through the first 21 days. the s&p closed last night 5.4% over its intraday low of the 22nd, having peaked at about 9.5% on february 1. this is most comparable to past instances in 1990, 1996 and is particularly similar to the 1998 pattern.

what might that mean going forward? of course we're speaking anecdotally -- this is and will remain a unique instance in spite of any technical qualitative similarities to the past. but expanding the window out to 50 days for these past examples, there's indication of further testing to come.

at this juncture, i haven't really seen the kind of deterioration in indicators that would lead me to believe that a retest is really imminent -- but such retests can surprise.


Thursday, February 21, 2008


plenty of liquidation in the quarterly window

one of the most interestingly researched indicators i've run across is the concept of the 90% day -- when both volume and points exhibit and extreme 9:1 bias in one direction or another. these represent, as one might suspect, climactic periods, particularly when grouped together. the leader in research to my knowledge has been the lowry report, which has remarked recently on the large number of 90% days recently as unusual.

i track such days independently as well. looking back, i wondered about the incidence of such days and what they might indicate about the market going forward.

my software setup tracks (through telechart) the stocks of the current s&p 500, meaning that -- as we go back in time -- fewer and fewer of the 500 were active. by the time one gets back to 1985, about 275 of the current membership were trading. and of course many were very different stocks and companies then. that means my data is less valid going back long distances. but -- with that important caveat -- here's what i found.

using a rolling quarterly window, the current activity in 90% days is rare, but certainly not unprecedented. it is characteristic of just a few periods in the last 20+ years -- and these periods were the climactic bottoms of major bear markets.

the recent peak on september 7, 2007, of 13 90% days (of either direction) is a level that was not exceeded even in the depths of 2002 -- where the mid-october bottom of the 2000-2002 bear maxed out at 11. notable financial crisis periods in 1998 and 1997 topped out at 8 and 9, respectively. the 1990 bear market also peaked at 9 within a month after the final price low.

the disaster of 1987 is the outlier by my flawed data -- in the aftermath of the crash, the count peaked at 21 and stayed elevated (though not exceeding 10) until november of the following year (1988). this is of course colored by the reduced count of stocks in my index and their (much smaller) capitalization at that time.

the key notion here, i think, is that these periods of intense market polarity represent forced liquidation and panic. it is as notable that, during the entire dot-com rise and decline from 1999 to early 2002, the count never rose over 2 -- in spite of dramatic price movements in both directions. it wasn't until the terrifying final plunge in the second half of 2002 that 90% days (up AND down) began to appear in large numbers.

how much forced liquidation is enough? there's always room for more, i suppose, but the count has been declining as the calendar advances -- it's now down to 7 -- and in the past similar declines from high readings have indicated that the panic is past. this has normally been platform for explosive subsequent gains.

bca research points out that the market is sitting atop a big pile of kindling -- but there needs to be some kind of catalyst to send it up. i've no idea what that may be or when it would come -- but it will eventually come.



prediction markets as sentiment indicators

a brilliant and proper application of "predictive" futures markets by bill luby at vix and more. this is the correct window through which to view markets, and not as some kind of crystal ball.

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Wednesday, February 20, 2008


the nature of the recession

via calculated risk, NBER's martin feldstein:

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. ...

... [T]hese past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast ... [a] key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

the upshot is that feldstein is calling this nascent recession a different animal than any we've seen in a long time. it isn't just that the fed, having not started the bust, can now not stop it -- rate cuts will have some effect. it's that housing is a critical rate-sensitive transmission by which low policy rates can be converted into real economic activity -- and it is broken and will stay that way for some years under a mountain in liquidating inventory. and that banks, the engines of ordinary credit creation, are already capital impaired and staring down the prospect of further writedowns yet unwritten -- significant lending expansion short of recapitalization is very unlikely. and that the shadow banking system is broken, in what prudent bear's doug noland calls the breakdown of wall street alchemy -- the credit bubble was made possible by a securitization boom that will not be repeated. even after the credit market paralysis that dominates the current state of affairs passes, these things will continue to be true.

all these things combine to paint a highly deflationary picture -- a realization that is slowly gaining traction -- with potential catastrophic episodes interleaved.

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Register to win an adventure in Ontario. Thanks for you time guys. Good Fishing.

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the disaster that wasn't in level 3?

dash of insight has been taking a well-grounded contrarian view of the panic that has set in over the last several months in the financial sector. jeff miller does some gloating with respect to FAS 157 here and here.

i myself worried at length over the growth of level 3 assets, paticularly noting that many CDOs were held as such, and mentioning FAS 157. fears of CDO losses are material, of course -- many CDOs are in fact worth far less than was once supposed. and it would be an obvious mistake to interpret prof. miller's comments as a total exoneration of CDOs.

however, he chides alan abelson a bit for this. abelson's mention of level 3 is, on further inspection, pretty sensible:

More specifically, Janjuah predicts that U.S. banks and securities firms are looking at perhaps $100 billion of write-downs on so-called Level 3 assets, as the new Financial Accounting Standards Board rule 157, slated to go into effect this week, takes it inevitable toll.

... According to Janjuah's calculations, Morgan Stanley, which is still grimacing over a recently disclosed trading loss of $3.7 billion, has 251% of its equity in Level 3 assets. At Goldman Sachs, the Level 3 commitments run 185% of equity. At Lehman, such assets are the equivalent of 159% of equity; at Bear Stearns, 154%.

Citigroup, which owns up to something like an $11 billion hit from subprime and other bum loans, a dismal total that occasioned the exit of its top man, has Level 3 assets equal to 105% of its equity. Rather ironically, Merrill Lynch, which is upward of $8 billion poorer after taking its bitter medicine to purge itself of overvalued subprime and assorted other loans, and whose CEO also was shown the door, has Level 3 loans equal to 38% of its equity. That makes it the least vulnerable of the major lenders.

We're not suggesting, need we say, that every Level 3 security on a bank's books is at risk or will have to be written down. But in total, they represent one massive pile of uncertainty, of which the lenders and the credit markets already have more than a surfeit, thank you.

if i recall correctly, banks have in fact taken writedowns amounting to $115bn so far, a number that is still growing weekly. i've come to consider that mr. miller, insightful as he is, sometimes exhibits a tendency (as do we all) to attack a strawman -- and this might be one such case. some people were literal where abelson's headline came across as a bit of cheek, and if those are the target of prof. miller's sarcasm then well so. however, that's not abelson.

however, he is exactly right to say:

No one wants to think about FAS 157. It is over the barrier of complexity. If things get too technical, everyone tunes out, no matter how important the topic. ... This myopia is empowering for those who take each issue to the lowest common denominator. FAS 157 was a big story when the bearish bloggers saw last November 15th as a doomsday date like Y2K. When it did not happen, the powerful writers in mainstream media did not point this out. There is no accountability.

i think it's too much to say that those who were concerned about the growth of level 3 pricing were barking up a phantom tree -- subjective abuse of mark-to-model pricing exists, as it always has, and we have in fact seen steep writedowns emerge from CDOs as auditors force compliance. yves smith relates an article from ft's john dizard which in fact expressly fingers FAS 157 as the vehicle of the logic and social dynamic of efficient market pricing -- and which is aggravating a downward spiral in the credit markets that is "discounting the end of the world".

but it is also important to note that there are more optimistic voices in the financial world with respect to the ultimate losses. prof. miller cites tom brown, tiger cub and manager of failed financial services fund second curve capital. (mr. brown also weighs in on the bull side of the monolines.)

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Friday, February 15, 2008


moving to a monoline resolution

governor of new york eliot spitzer issued a five-day ultimatum to the bond insurers to raise capital or be taken over and broken up by the state of new york. FGIC, having been downgraded from triple-a earlier in the day by moody's, subsequently contacted new york commissioner of insurance (and spitzer appointee) eric dinallo and acquiesced to a state-managed breakup of the firm which will separate the original municipal bond insurance side of the company from the later structured credit underwriting side.

that latter fraction will likely need a bailout, as ft points out:

A break-up of the bond insurer model holds grave implications for financial institutions that face writedowns on insurance and derivatives contracts entered into with bond insurers.

MBIA and ambac were granted some more time by moody's -- two weeks, perhaps -- as the ratings agency believes them to be better situated.

spitzer and dinallo are likely accelerating the process at the development of illiquidity in the auction-rate securities (ARS) market. accrued interest here and here has explained the mechanics of what is going on.

Most commonly, a bank is brought in to provide liquidity support [for ARS auctions]. In general, the bank provides full credit support, assuming the issuer hasn't already defaulted. As a result of this, investors in ARS don't have to worry that the issuer will have enough cash on hand to handle sales of their bonds. As long as the issuer is current on its interest payments, the bank will provide cash for normal redemptions of bonds. Think of it like a line of credit.

Here is where things get a little weird. Sometimes the issuer of a ARS was a little more sketchy credit. The bank was only willing to provide liquidity if there was some additional credit support. No problem, thought the municipal bond bankers! We'll bring in a monoline insurer! The bank would therefore agree to provide liquidity so long as the bond insurer was rated at some minimal credit rating level. What that level is depends on the deal. Might be AA, might be A. I haven't seen any that were actually AAA but they could be out there.

But what happens if the unthinkable happens? A monoline insurer gets downgraded? Well, the bank's liquidity agreement becomes null and void. Where does that leave bond holders? It leaves them with no credit support at all. Only the issuer itself would remain.

For most ARS buyers, that's not acceptable. ARS buyers tend to be money-market like investors, who have zero desire to take on credit risk. So what are those bond holders doing? They are selling the bond back to the remarketing agent!

that flood of sales in anticipation of monoline downgrades has driven the banks from their liquidity arrangement prematurely, resulting in failed auctions. this is a pure liquidity problem of contagion from the monolines, one which may result in issuers calling their ARS and refinancing into fixed-rate municipal bonds. this has forced spitzer into the fray and pushed the monoline problem closer to a state-managed resolution.

splitting the monolines, much as with the earlier berkshire hathaway pitch, is not the bailout wall street banks need to have in order to avoid writing down instruments to which the monolines are counterparty, such as credit default swaps. but dinallo thinks MBIA and ambac will be rescued before they are downgraded.

``I wouldn't view that as being an empty threat,'' Havens said of Spitzer's comments. ``I interpreted that comment as basically being a shot across the bow of the banks and other parties with skin in the game to come to the table and come up with a solution.''

New York's regulators last month organized banks to begin plans for a rescue and are talking to private-equity firms and sovereign wealth funds, Dinallo said. The companies probably need about $5 billion and a line of credit for $10 billion, he said.

``We are encouraging them to resolve these transactions quickly within a finite number of days,'' Spitzer said today. ``If they're not going to happen, then we need to act quickly'' to find other ways to offer capital relief.

... Banks, which bought protection for collateralized debt obligations, stand to lose $70 billion if bond insurers are stripped of their to ratings, Oppenheimer & Co. analyst Meredith Whitney in New York said last month.

... Moody's analyst Jack Dorer said yesterday that he plans to complete a review of Ambac and MBIA by the end of the month.

here's the video clip of dinallo. i personally find it impossible to believe that, if the monolines "probably need about $5 billion and a line of credit for $10 billion" in order to run off their obligations -- which dinallo clearly thinks they can do over time, if not perfectly -- that they will not get that provision.

yves smith with more. david merkel doesn't think splitting them can be done and forecasts lawsuits.

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Thursday, February 14, 2008


still pointing positive

emotionally, i'm nervous as hell. but here's the rational side of things, near as i can discern them.

first the nasdaq 100. new lows and highs less lows show a really positive retest of the january 22/23 low. issues near new highs are leading price as well, although actual new highs haven't broken out. this is a good-looking picture of a retest.

i've been messing around with dr. steenbarger's ideas about volatility envelopes, which i consider a really interesting idea. so far, the indicator looks very useful -- and straightforwardly bullish.

the net points, issues and volumes give some pause -- they could be indicating more dowside left to come. but there's more evidence still here of increasing participation as issues over 30dma is leading price. mcclellan oscillator also looks really good, with the summation coming off a very low level. note too that february 13 was a 90% upside day in the nasdaq 100 by my data -- things are looking up here.

nwo the s&p. less bullish, more tepid. no real outstanding divergences, except possibly near-highs leading price. but no outstanding bearish signs either.

this looks more positive, though one cna argue from here that the divergence in supply is very short (two days, january 22 and 23) and insuficient. but supply improved considerably on the turn down to 1320, even though that wasn't a proper retest.

because of the shallowness of the 1320 "test", volumes of all stripes are at least mediocre -- no leading divergences, but no breakdowns short-term. no 90% days either. but participation again is growing and the oscillator looks bullish.

sentiment, as previously noted, is about as bollocks up as could be by many measures. equity put/call closed over the magical 1.0 level tonight. the 10-day average of the ISEE all securities is a putrescent 93 -- a level seen around tradable bear market lows (january 22/23, also august 15 2007 and march 14 2007, but then back to mid-august and mid-october 2002). this headline from traders narrative captures the mood, i think. it disturbs me that jim cramer is pointing it out, but it is what it is. this looks like fertile ground for a continuing rally.


Tuesday, February 12, 2008


american mortgages to infect japan

the telegraph:

Americans and Europeans have so far confessed to $130bn of the estimated $400bn to $500bn of wealth that has vanished into the sub-prime hole. Somebody, somewhere, must be sitting on a vast nexus of undisclosed losses. We may find out soon enough whether the hold-outs are in Japan. The banks have to come clean under the country's strict new audit codes by the end of the tax year in March.

"We think this is where the next big problem is going to pop up," said Hans Redeker, currency chief at BNP Paribas.

"We know from Bank of Japan's lending survey that the banks are already tightening hard, so something is brewing. Right now, we are in the lull before the second storm in global markets, and Asia is going to be the source of the nasty surprises," he said.

just as interesting:

What we know is that Japan's economy - still the second biggest in the world by far - has fallen over a cliff since October. ... Japan's machine orders dropped 2.8 per cent in November and a further 3.2 per cent in December. January housing starts fell to the lowest in 40 years, down 18 per cent on the year. Tokyo property was off 22 per cent. ...

"Recession is a clear and present danger in Japan," said Tetsufumi Yamakawa, chief Japan economist for Goldman Sachs. "The leading indicators are deteriorating very sharply. Inventory is piling up at a rapid pace. There are clear signs of deceleration in exports of steel and semi-conductors to China," he said.

... Hong Liang, Beijing economist for Goldman Sachs, is not much more hopeful about China's prospects this year. "The combination of a US slowdown and monetary tightening in China is never welcome, but the accumulated problems have to be resolved this year," she said.

Inflation at 6.9 per cent is getting out of hand. The root cause of overheating is the weak yuan. The central bank has piled up $1,500bn of foreign reserves trying to stop it rising. The longer this goes on, the more inflationary it becomes. So Beijing has begun to step up the pace of revaluation, letting the yuan rise at an annual rate of 20 per cent in January. There will be casualties. Large chunks of China's manufacturing export industry have wafer-thin margins. A rising yuan tips them into the red.

China's mercantilist drive for export share is a double-edged strategy. The trade surplus has risen at $80bn a year, increasing tenfold since 2002 while the economy has merely doubled. The result is that China is as dependent on the US economy as Mexico.

i'm already suspicious of china, but it sounds more and more like what is transpiring is a significant global slowdown -- one which is following wall street's toxic mortgage-backed securities around the world.

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systemic financial crisis

i'm not forecasting it -- i can't. but that the scenario is being bantered around is sign either of a bottom or some really smart economists and commenters.

the estimable nouriel roubini blogged recently about what a sytemic financial crisis would look like, and clarifies that he's talking about something in league with what carmen reinhart and ken rogoff are examining. forbes relates the outline.

minyanville too hasn't been shy about drawing the perimeter of the worst case. satyajit das, bennet sedacca and rob roy all addressed credit default swaps today, with a view toward this being the end of the debt supercycle. mish shedlock thinks the worst, while perhaps not imminent, is unavoidable and squarely before us.

most everyone posits the downgrade of the monolines as the trigger that sets powerful accounting mechanisms into motion. but the power of the event is now so well telegraphed -- is there anyone in the marketplace that doesn't understand what could be coming? -- that it's probably become unlikely. jeff at dash of insight again says what is likely true.

The issue of the monoline insurance companies is a key question for markets, as we have noted. The process of "solving" this problem seems very slow to market participants. Daily trading reflects each twist and turn.

This problem will be addressed, either through private action or more aggressive moves by government agencies. The reason is simple. There is so much systemic risk.

Our opinion does not mean that specific companies or their investors will profit. In fact, the solutions may involve major dilutions of interest. Government is less interested in saving investors in the individual companies, but much more interested in stabilizing the economy and the markets.

what came today from warren buffett is not a fix for this problem -- indeed, it may be an aggravation. but the eventuality of a bailout, be it public or private, to fortify the credit default swap market remains a likelihood.

what comes after that -- particularly if a severe recession hits the united states and, as mish postulates, actual defaults start triggering CDS claims... that's another issue entirely, but at least it is one that remains down the road.

UPDATE: more talk of systemic risk reflected in the CDO market through ft and alea.

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I disagree. The monolines are economically irrelevant. Municipalities are selling bonds without insurance. If the monolines disappeared tomorrow, the only people who would notice are the rating agencies, bank regulators and some frightened old people who buy insured muni bonds.

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i completely agree, ia, that in the longer run the muni insurance industry is something of a scam. i think bill gross pointed out recently the fundamentally ludicrous nature of the idea that a company like MBIA can insure the bonds issued by the state of california, for example, with all its taxing power. there may be a role for it, but a much smaller one going forward and i suspect one which will be dominated by berkshire hathaway.

monoline downgrades will have an effect in munis, however, insofaras insurance took the legwork out of muni investing for a lot of people. people will have to differentiate between issues again, which is probably a good thing. a number of money and pension funds are also restricted from holding less than triple-a, and so will have to sell into illiquidity, probably at significant short-run realized losses. some poorly positioned money funds may have to break the buck.

but where the systemic risk lies is not in the muni insurance element of the book for these companies but in the CDS book. the monolines are counterparty to an estimated 70% of the CDS held by money center banks. if they default and cannot be expected to pay out on corporate defaults, the banks are faced with unbalanced derivative books and will have to start taking writedowns on them with one hand while furiously trying to engage in new CDS to restore their net credit position. that would be a very turbulent event in credit markets, and is indeed a potential trigger for a systemic collapse.

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yves smith at naked capitalism (now added to blogroll) has been doing an excellent cover of this issue -- this is a post i dug up over there outlining the nature and extent of the problem.

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it may be time to exit commodities

a pile of fed rate cuts, a dollar that has been falling for years and an almost-unquestioned belief in the imminent arrival of china and india as consumption powerhouses has bolstered, it seems to me, a consensus that global commodity inflation -- oil, gas, agricultural products, metals -- is inevitable. and maybe it is.

but how many times has something like this happened at what ended up being a good long-term buy point?

Matt Pierce, Futures International Inc. says there is an absolute run on spreads right now. "It's the scariest thing I've ever seen on this floor," Pierce says.

... Pierce, a wheat trader, says people are getting blown out as the March/May carry went from 13 cents yesterday to a 43 cent inverse, overnight.

"There's blood in the water. People are being forced out of major positions. And when you're coming into a market like this, there is nothing there to buy. It's getting out of control."

Because of a lack of sellers in the market, the commercials that got caught short are being forced to bid up the market, Pierce says.

"This is a commercial/supply-side issue right now with a few wheat mills in northern Minnesota completely out of supply. They have no wheat and have had to shut down."

Pierce adds, "There is no wheat no matter how high the price is getting."

Pierce says he knows of some locals in the wheat futures pit that were blown out of spreads yesterday for losses in the millions of dollars.

"The market is getting so high, no one wants to play with it. As a result, we are losing our liquidity," Pierce says.

Meanwhile, Joe Bedore, FC Stone's CBOT floor manager, says one of the problems is that people have violated a golden rule of the trade.

"You should never be short the lead month," Bedore says. "It seems there are enough short positions in wheat that have narrowed these spreads. The effect has moved over into corn and soybeans now."

Bedore adds, "I've seen panic here before, and this is almost worse."

The solution to get the market back to normalcy would be to get the commercials out of the market, he says.

"Personally, and this is just me talking, the commercials will have to liquidate their position or declare bankruptcy. So, the government is going to have to tap the funds on the shoulder and say it's time to sell."

At that point, the commercial will be able to cut its losses and liquidate. "When that point is, I don't know," Bedore says.

wheat futures have exploded and commodities generally have been on a terrifying run. this is a classic buying panic, and may very well represent the blowoff top in wheat. it certainly has some basis in reality, with chinese winter wheat having been crippled by storms and american acerage being sunk into the government-subsidy-fiasco of corn-based ethanol. but gains of this speed and intensity are rarely sustainable.

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not a bond insurer bailout

the wire is full of warren buffett this morning as berkshire hathaway has pitched an offer to the troubled industry to take on the entirety of their $800bn in municipal guaranty book.

If the municipal debt was reinsured by AAA rated Omaha, Nebraska-based Berkshire, the municipalities would also retain the top rating, Buffett said.

``The insurance in the market is not doing bondholders any good and is in some cases penalizing bond investors,'' Buffett said. ``Our proposal puts the municipals at the front of the line.''

The downgrade of a large bond insurer would force some insurers to sell any municipal debt that didn't have an underlying AAA rating.

``It would solve it in one stroke of a pen,'' Buffett said of the plan.

it would be very good news for the entire muni bond market. but the monolines are questionable, even unlikely to take the deal.

``If you gave up your entire municipal business, that's the book of business where the value in the companies is right now,'' said CreditSights Inc. analyst Robert Haines. ``You'd essentially be ceding that whole book to Buffett and what you'd be left with would be the book of business where all the troubles are.''

while it would very likely put the increasingly illiquid muni bond market at ease -- and remove all kinds of investors from money market funds to pension plans from the jeopardy of forced liquidation when the monolines are downgraded and their insurance goes worthless -- this does little to "fix" the issues MBIA, ambac and FGIC in particular. they'd still be saddled with their CDO claims, and that in and of itself is enough to sink them over time. and they'd be sacrificing the income stream from their stable book of businsess which could in the end help them ride out CDO losses and CDS defaults.

as tanta at calculated risk noted:

That would be precisely the kind of "bailout" that leaves the consequences of moral hazard in place. Who could dislike it, except those who engaged in reckless insuring in the first place?

those are, for better or worse, exactly the people who would have to like it to get the thing to go forward.

for what it's worth, i have to imagine buffett has some very powerful regulatory forces at his back, and the monolines may be heavily pressured to take the deal for the good of the muni market. but it would actually seem to destabilize the market in credit default swaps and CDOs, as these companies might be less likely to receive a private or public bailout without some good in their portfolio to go with the bad.

UPDATE: initial and more from yves smith.

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Monday, February 11, 2008


independent confirmation of the decline of ghawar

some time ago i relayed the heady analysis of the oil drum as relates to northern ghawar, the oil field which has produced some 6% of global oil consumption in recent years, as identifying a likely realpolitik cassus bellum for iraq that could get oil-oriented politicos like george w. bush and dick cheney on board with neoconservative utopianism through a harmony of interests. it's further a probable driver of american antagonism of iran.

in the main, i think the american foray into the middle east -- surreptitiously cloaked in the post-9/11 dogma of fighting "terrorism" and spreading "freedom" to make it palatable to an inherently populist and moral electorate -- has been quietly all about these two things: 1) maximizing production from what large under/misdeveloped fields in the mideast there are, and 2) negating possible political bottlenecks that would constrict such development. is there a more realistic (in the sense of 'realpolitik') course of action for the suzerain of the global economic empire?

there have since been some fairly candid commentaries that oil production will not meet demand. potential economic and social consequences in the west could be hard-hitting and sudden as the export problem becomes an issue by as soon as 2010.

the reality of a production capacity peak, whether the reason is hubbert's peak or chronic underinvestment in capacity, is being bolstered by OPEC. some ministers have recently said that the cartel is running flat out, and in any case have refused to increase production quota in spite of massive demand increases and $90+/bbl pricing. the president of the united states is on the record implying that saudi arabia, at least, cannot expand production.

moreover, oil companies themselves have been quietly giving credence to the imminency of hubbert's peak.

Dr Jim Buckee has just retired as President and CEO of Talisman Energy, a major independent Canadian oil company with a market capitalisation of $25-billion. On the phone from Perth, Dr Buckee told me that 'peak oil' was now either here, or very close.

[... just last week the Chief Executive of Shell came out and said that easy oil was coming to an end.]

... I think it was only a matter of time before one of them had to say that and the pronouncements of the majors are inscrutable at best and I believe they often have a very political overturn. Always the line of the major oil companies, Exxon, Shell, BP has been, 'there's plenty of oil, you know technology will overcome shortages; we'll find it'.

They changed a little bit to, 'there's plenty of oil, but access is difficult' and then this is a change again saying, 'well actually, it looks like it's finite and you know we're looking over the hill'.

now comes this via econbrowser -- an analysis of well drilling over ghawar which indicates that earlier analysis regarding ghawar's decline are probably accurate.

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Sunday, February 10, 2008


reinhart/rogoff paper getting traction

calculated risk notes that this paper is getting quite a lot of notice in economic circles. the upshot is that the current financial crisis in the united states shares some important characteristics with the "big five" post-ww2 crises -- spain 1977, norway 1987, finland 1991, sweden 1991, and japan 1992.

The “Big Five” crises are all protracted large scale financial crises that are associated with major declines in economic performance for an extended period. Japan (1992), of course, is the start of the “lost decade,” although the others all left deep marks as well.

japan is the most familiar example -- with more than a decade of deleveraging from 1990 on, with zombie banks and cleanup costs well over 15% of gdp -- but a little looking around the internet gives more extensive context.

spain's banking crisis ran from 1977 to 1985, with losses equivalent to some 17% of gdp. 52 banks representing 20% of total system deposits were liquidated, rescued or nationalized.

in finland leading up to 1991, economic growth averaged 4.5% a year; in the three years following, the economy contracted by (-4.0%) a year. with the government eventually taking stakes in banks controlling 31% of national deposits, which cost 11% of gdp to rectify.

the crisis of norway from 1987 to 1993 saw the government take over the three major natioanl banks, controlling 85% of system assets. recapitalization costs tallied 8% of gdp.

sweden from 1991 to 1994 saw five of the largest six banks approach insolvency, with two (accounting for 22% of system assets) actually become insolvent and end up rescued in a government-backed bailout plan. recapitalization costs amounted to 4% of gdp.

but a lot remains open. the united states is far more financialized than any of these predecessors -- that is, finance, banking and trading account for a greater proportion of gdp than any of these comparables did at the times of their crises.

one can use purchasing-power-equivalent gdp data for all these crisis periods to contextualize the economic damage. as noted by reinhart/rogoff, "Growth momentum falls going into the typical crisis, and remains low for two years after. In the more severe “Big Five” cases, however, the growth shock is considerably larger and more prolonged than for the average."

  • sweden in the two years from 1991 to 1993 saw ppp gdp decline (-3.2%).
  • norway saw ppp gdp stagnate from 1987 to 1989, and the same measure grew just 10% over the five years 1987-1992 (1.9% per year) after having grown 22% in the preceding five years.
  • finland saw ppp gdp from 1990 to 1993 dive (-10.6%) or (-3.6%) per annum.
  • spain from 1978 to 1985 grew at a rate of just 1.7% annualized in ppp gdp terms.
  • japan between 1990 and 1999 grew at just 1.1%, with ppp gdp flat in 1993 and actually falling (-2.1%) from 1997 to 1999.

reinhart/rogoff note that asset bubbles in all these cases included real estate -- indeed, called runups in real housing prices one of the best leading indicators of financial crisis -- and one suspects that the dynamic approached by calculated risk eslewhere is a key part of the failures of these economies to recover quickly.

in each case, unemployment became a major concern. spain saw unemployment jump from the mid-single digits into the 20% range and eventually peak at 25% in the early 1990s. the rate of unemployment in the three nordic economies are shown here -- norway jumped from below 2% in 1987 to 6% in 1992; sweden from 2% in 1991 to 8% in 1993; finland from under 4% in 1990 to 18% in 1993. even in japan, where unemployment was kept low by structure, it peaked at 5.5% in 2003 -- three times the pre-crisis level -- and examinations of the heavy social cost of maintaining employment became common.

UPDATE: barry ritholtz at big picture, by way of discussing the reinhart/rogoff paper, was led to more information on norway 1987, including a timely chart of norwegian negative real interest rates in the early 1980s.

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negative bank reserves: a non-issue?

caroline baum of bloomberg sheds different light on the arcana.

Reserves can be borrowed (from the Fed's discount window) or non-borrowed (supplied via the Fed's daily open market operations). It matters not one whit to the Fed where the banks acquire the reserves they require. If they borrow directly from the Fed, they don't need to tap the interbank, or fed funds, market.

It isn't a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Loans made through the TAF are categorized as borrowed reserves. The Fed had $50 billion of loans in place at the end of January, which ``caused the borrowed reserves figure to balloon and the non-borrowed figure to decline by a corresponding amount,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, in a Feb. 6 commentary. (He's on the same e-mail lists I am.)

the Fed is ``a monopoly provider of reserves,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. ``This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply.''

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. ``And any one bank can have a problem'' funding itself, Glassman said. But in a world where ``the Fed can print money, there is no shortage,'' he said. ``The banks get the reserves they want.''

in other words, what is happening would not at all be this:

american banks in aggregate have burned through all their free capital

or rather, it may be something approaching that as losses are gradually realized, but it is essentially unrelated to this data. moreover, this:

the fed is literally maintaining the static solvency of the system at this moment

... would be true everywhere and always in a fractional reserve banking system. though this:

if it were to withdraw its anonymous auction facility, it's likely that asset sales and bank failures would begin more or less immediately

... could only possibly be true, it isn't necessarily -- if the TAF were withdrawn, suggests baum, banks would very probably instead obtain needed reserves through either the discount window or the fed funds interbank market (with the attendant dangers) but at a higher price than the TAF affords.

ergo, another object lesson in support of the point jeff of dash of insight made recently. baum might agree that there's plenty of things to worry about in american banking at the moment. however, she would say that this isn't one of them.

mish strongly disagrees and he rightly points out that banks are paying punitive rates for capital.

the problem with mish's argument seems to me to be that capital is not the same thing as reserves. reserves are simply some fraction of the deposits in a bank set aside with the federal reserve bank -- an asset that offsets the liability of deposits.

mish is making really strong points about bank capital being under pressure from unexpected losses on the asset side and lending capacity being under pressure from losses, increasing loan loss reserves and the anticipation of more to come -- but they don't translate to reserves per se.

banks borrow large over a small base of equity, and borrow cheaply (and usually short) to lend expensively (and usually long). this dynamic is what makes them profitable, when it works.

banks can temporarily borrow from the federal reseve against some of their assets, and use the borrowed cash as reserves -- translating portfolio loans or securities (an asset) into cash (an asset). the fed charges a discount for doing so. this is one way the fed can liquify banks against a run, known as a repurchase agreement (or repo), through the discount window.

banks can also sell hgih-quality securities from their portfolio (an asset) to the fed in their open market operations for cash (an asset). this is another way the banks can be liquified by the fed.

banks can also borrow from other banks, generally at the fed funds rate, which the federal reserve dictates. normally, the fed funds rate is cheaper than the discount rate, which encourages interbank lending. this avenue has, however, been a partial casualty of the credit crunch, which has increased the necessity of borrowing from the fed.

reserves held at the fed can consist of funds borrowed through repos, funds borrowed at interbank fed funds rate, or funds obtained by selling securities to the fed by open market operation. all three are essentially transformation of asset type conducted by interaction with the fed, but the fed accounts for repos as "borrowed reserves", whereas interbank funds and cash derived from asset sales placed with the fed are termed "non-borrowed".

when the TAF -- a different kind of repo -- was introduced in december, participating banks were being granted a chance to borrow more cheaply and anonymously against a wider range of collateral (ie, a larger part of their portfolio) than they could through either the discount window OR the fed funds market.

so many of them chose to borrow funds via the TAF -- enough to drive net non-borrowed reserves negative by the mechanism described by baum, as repos grew significantly and interbank fed funds lending sank.

NONE of this is to say banks have no capital. it is instead to say that banks have gone from borrowing on the interbank market to borrowing from the fed in a big way, encouraged by the very low rates on offer through the TAF.

there is a limit to what the fed can do to liquify the banks. as mish points out, banks must have high-quality assets to sell or provide as collateral to the fed. when a bank has sold or offered as collateral all it can, it has hit the limit of what the fed can do to help it and faces insolvency. but few banks are anywhere near that point right now -- though that may change as asset quality deteriorates, particularly if a heavy CRE bust follows a deepening residential housing bust.

moreover, this is not a capital issue -- it is a liquidity issue. the capital issue arises when losses on assets cause liabilities (eg, deposits) to exceed assets (eg, loans). then it is the FDIC, not the fed, which steps in.

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Friday, February 08, 2008


a context for sentiment

the ISEE series only dates back to 2002, so there isn't really data for comparison over long periods. but what comparison that can be made to the past of the series is interesting.

the trailing 50 day average of the all securities reading has fallen to 109.1 -- a level worsted only in the sample in the period of october-november 2002, which of course marked an epic low.

the rejoinder there might be that things can get worse. and they can, of course, always. but even if current sentiment simply holds, what should be understood is that this ratio will continue to decline. the data that are falling out of the back end of the timeframe are also the highest -- the average of the last 40 days is just 106.8, and of the last thirty 102.3. there needn't be a price collapse and attendant option panic from here for 50-day ISEE sentiment to plumb new all-time lows. just holding neutral, with put writing offsetting call, would do it.

this is far from the only indicator, particularly sentiment indicator, showing that current prices are abyssal -- and that expectations should be for at least an intermediate term rally. another i gleaned from IBD today: the ratio of public short sales to specialist short sales (a figure published weekly with a two-week lag, relayed here by barron's) had risen to 21.00 on january 18, the most recent available report -- the five-year high.



research idea

via adam at daily options report:

... you can boil index volatility down to two basic factors. One is the volatility of the component stocks, the other is the correlation between those very stocks. And they can very much offset each other. Imagine a world where half the stocks were moving violently and basically trending in one direction, and the other half was moving violently the other way. Index volatility would be very low as the moves would pretty much offset each other.

What we have now is the opposite. Stocks aren't that cosmically volatile, but they are all moving in relative unison. Ergo index volatility is theoretically *high* relative to individual stock volatility.

the sum of individual component absolute volatility -- such as true average range, for example -- and index volatility are different by the extent of cross correlation across the components. one could study the difference with an eye toward describing the degree of cross correlation, a high degree of which is sometimes described as a characteristic of troubled markets (though this would have to be shown or refuted empirically).


Wednesday, February 06, 2008


the coming monoline bailout

surely one of the hot-button issues in this market has been the status of the monolines and their triple-a rating. any time news about ambac or MBIA hits the wire, it seems shares and treasuries jump this way or that depending on the jist of the news. the first rumors of the monoline bailout helped put a bottom in, whereas the first monoline downgrade (following many weeks of forbearance) and speculations on an unfolding potential credit default swap disaster had helped throw the market off a cliff in the first place.

via the financial times, s&p has estimated that the monoline bond insurers are counterparty to credit default swaps held by commerical banks against just their CDO portfolios valued at something like $125bn, and the need of loss reserves at the banks as they reassume default risk would be considerable. and of course failure would have knock-on effects in the muni bond market as well, which could roil the risk-averse capital pools (such as money market funds) that invest heavily in munis.

in spite of this, it is speculated that any bailout may not come soon enough to prevent further ratings downgrades, and the event may give the markets another reason to sell off.

``Given the number of competing interests and levels of commitment of participants involved, we think it is unlikely that an agreement sponsored by Dinallo could be hammered out within the appropriate timeframe,'' CreditSights analysts Rob Haines, Craig Guttenplan and Joe Di Carlo in New York wrote in a report. ``In the offchance that any deal could be solidified, the rating agencies are likely to have already taken action.''

some thoughtful commenters have even implied that a deal may be difficult to arrive at due to the conflicting interests of the parties to the bailout.

but an insightful posting from accrued interest on the detail of what is happening sheds considerable light on why a bailout of some kind is certainly in the cards well before the bitter end of a terrifying CDS market unwind.

No one is claiming that the monolines are actually running out of cash today. The actual cash paid out on structured finance deals to date has been small. In fact, based on the way the insurance contracts were structured (called a pay-as-you-go credit default swap), its likely that actual cash payments would occur slowly over time.

I'm not dismissing the impairments in Ambac or MBIA's portfolio just because little cash has actually been paid out. The write downs are real. But if the AAA rating were not so key to their business, if it were merely a cash flow business, the situation would be vastly different.

And that's just the thing. If a group of banks could put enough cash into Ambac and MBIA to maintain the AAA, then it really would become a cash flow issue. The write downs today would turn into in real cash losses over many years. The banking system would have time to absorb those losses, rather than suffer large write downs right now.

No wonder regulators are pushing such a plan. The question for any bank considering involvement is how big the capital infusion has to be. I've heard numbers ranging from $3 billion to $15 billion. One of those numbers would be easy for Wall Street to take on. The other would be tough given today's capital constrained environment.

in other words, a relatively small capital infusion will keep money center banks from having to confront a massive problem in the immediate future, allowing them instead to spread larger (bloomberg cites estimates of up to $65bn in the long run) losses over several years in a manner that will allow them to be offset by future income. wall street can certianly cut off its nose to spite its face, but with so much on the line one has to expect better.

there's no doubt these companies have been greedily and disastrously managed. that's the only way for a company like MBIA to end up with $8bn in CDO-squareds. but a bailout should come and very likely will come.

UPDATE: via housing wire, more on the bond insurers.

Back in the States, New York Insurance Superintendent Eric Dinallo has been trying to orchestrate a rescue of some of the troubled insurers, and media reports suggest he may be having more success now than when he first started the effort.

Bloomberg reported Wednesday that Ambac Financial Group, Inc. — who already lost its AAA rating from Fitch — is being targeted for one bank-led bailout effort, including Citigroup Inc. and UBS AG. The Wall Street Journal also reported Wednesday that a unit of Credit Agricole SA is mulling a separate bailout of Financial Guaranty Insurance Co.

UPDATE: more from msn money on what the ramifications on the municipal bond side might look like -- more significant that i had considered, a run on the tendered option bond market could be a scary event for all kinds of muni holders, including money market funds.

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