Roll up! Roll up!

By: Sean Corrigan | Thu, Jul 8, 2004
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Recently, the man who is arguably America's No. 1 bond investor - Pacific Investment management's Bill Gross - gave the Financial Times of London a rather disquieting vision of the future.

"Too much debt," he told the paper, "geopolitical risk and several bubbles have created a very unstable environment which can turn any minute."

"More than at any point in the past twenty or thirty years, there's a potential for a reversal... smaller movements in interest rates have a magnified effect... a small movement can tip the boat," this Cassandra warned an audience which sadly, if not totally deaf, is certainly hard of hearing when it comes to such gloomy prophecies.

Of course, our selective acoustic sense may be excused in part, for not all the experts are in agreement. Would it surprise anyone to know, for example, that at least one other giant of world finance - a man surely more widely renowned than even the estimable Mr. Gross - demurs to endorse such dire prognostications?

"During the past quarter-century, policymakers managed to defuse dangerous inflationary forces and to deal with the consequences of a stock market crash, a large asset price bubble, and a series of liquidity crises. These developments did not divert us from the pursuit and eventual achievement of price stability and the greater economic stability that goes with it," Alan Greenspan himself told a reverential audience of Senators at his reconfirmation hearings, only last week.

Though he might be forgiven for rendering such an upbeat version of his CV at what, after all, was - however much of a formality the proceedings turned out to be - a job interview, we do have to marvel at the blind conceit of a man whom near-legendary investor Jim Rogers snorted dismissively was a "fool", during a European TV interview that Friday.

In the interest of historical exactitude, let's just review some of the items on our Chairman's resumeĀ“:

Starting with the Crash of '87, the New England banking crisis of 1991 and the contemporaneous real estate bust at home in the US, we note the frequent debt and currency crises which have erupted across the globe since, such as the Tequila Crisis and the Asian Contagion, with blow-ups in Poland, Turkey, Russia, Brazil, Argentina, South Korea, Thailand and Indonesia (to name but a few); then, taking a different furrow, we plough through the Orange County-and-friends bond bust of 1994, the Long Term Capital Management panic of 1998, the Telecom Bubble, the Dot.com bust, the California utility crisis; we pause to note the unsustainable rise and consequent collapse in business investment and employment which these entrained; and we conclude by listing the record debt defaults, credit downgrades, pension shortfalls, mutual fund malfeasances, personal and corporate bankruptcies.

Despite a retelling sufficient to filling a book - one in which Chapter 11 would be by far the longest section - we should also recognize that, under Greenspan's self-satisfied tutelage, we still face a legacy of unprecedented levels of indebtedness and financial speculation.

But, though already this has been a circus performance to make P.T.Barnum sick with envy, Ringmaster Greenspan may not be finished yet, for, under a Big Top which will host him for yet another few years, this grand impresario still invites us to marvel, open-mouthed and breathless, at a truly prodigious and heretofore unrivalled act.

"La-d-ies and Gentle-men! I set before your very eyes a veritable landmark in the world of monetary acrobatics, a feat never before attempted, in the whole history of finance!"

'Here, tonight, you - and you alone - will be privileged to witness the bravura, the heroism, the death-defying courage of a clutch of international Mega-Banks, ably assisted by a team of thirty-something hired guns from the mysterious realm of the Hedge Funds, as they seek to balance an inordinate, multi-trillion dollar pile of borrowing upon the very narrowest foundation of productive or realizable equity, in a daredevil display of risk-taking which those in financial markets give the name of 'leverage!'

Well, not quite, perhaps.

Chairman Greenspan, for one, does not view this process as being accompanied by very much in the way of risks at all - in fact, he has been know to tell Congress that today's financial Titans are busy "unbundling" risk through making second, third and yet higher order bets on bets on bets (known in the trade as "derivatives" and 'structured products").

Indeed, it was only a year or so back - again before his cult-followers in Congress -that he was shaking his head in grandfatherly amusement at how these banking "unbundlers" had largely managed to relieve insurance companies, pension funds and private individuals (entities with long-term, or even no, liabilities, as he euphemistically put it) of their hard-won bundles, thus avoiding the consequences of helping fuel a mania in which, in the US alone, the top 12 corporate failures involved a staggering $400 billion (and the top 28, $500 billion) in assets between 2001-03 alone.

Aside from any such ethical quibbles as this might throw up, quite how much risk actually is being "unbundled" here and how much financial and economic "flexibility" is being engendered by all this, is also very much open to doubt.

For example, statistics released by the Office of the Comptroller of the Currency show that, as of March this year, just the top three banks - JP Morgan Chase, Bank of America and Citicorp - between them accounted for a staggering 90% of all the $76.5 trillion in derivatives held by US commercial banks and hence around 30% of all such contracts estimated to exist around the entire globe.

As an aside, do you wonder why these three behemoths feature so prominently in lurid headlines about lawsuits pertaining to the shadier side of modern "financial engineering"?

Moreover, to highlight quite what a potentially explosive game of pass-the-parcel this represents, consider that, while $73 trillion (give or take) of these bets are placed with other dealers in the casino, a mere $2.5 trillion have what the OCC calls "end-users" - corporates, pension funds and others - as counterparties; a 29:1 imbalance between deals which are outright trading-room gambles and those which may comprise potential hedges with some basis in underlying commercial reality.

Let's go back to the Big-Three and try to see what is meant by "leverage", too.

So-called risk capital (a banking entity adding shareholders' equity to various sorts of junior debt obligations, such as subordinated loans) for this triumvirate amounts to some $156 billion - a sizeable enough cushion against loss, you might think.

Well, perhaps.

But assets reported on these three balance sheets - i.e. in the old, traditional manner - come to no less than $1,944 billion, giving us "leverage" of roughly 12.5 to 1.

However, the derivatives contracts' total, to be put on top of this, comes to $69,600 billion, making a further, giant pyramid whose height is fully 433 times higher than its base.

To try to put this in some kind of context, think of our Three-headed Dog as having taken out a 92% mortgage on an imaginary house which costs slightly in excess of the current total of all sales of existing and new homes recorded across the nation annually.

That gives you an idea of the on balance sheet leverage employed by them and involuntarily underwritten by you, the taxpayer and saver, whether through the direct - but hardly sufficient - back-up offered by that New Deal miscegeny, the Federal Deposit Insurance Corp, or via Greenspan's oft-practiced powers severely to dilute your money and greatly to disrupt economic calculation in order to provide the Big Boys with "liquidity" whenever they screw up large.

But now, imagine that this conceptual property speculator next goes out and places a fantastical series of interlocking bets on not just one year's national home sales, but on all the sales until the year 2040 - that would be proportionate to these three banks' off balance sheet, derivative activities!

Anticipating the usual defence mounted by the perpetrators of this excess: Yes, it is true that many of these totals are offsets and unwinds; that they represent footprints in the sand of a man dancing drunkenly in a circle on the beach, rather than a march into the untracked wastes of the desert.

Yes, again, many more of these arrangements - being so incestuously committed - have been "netted" out, or effectively cross-cancelled, one with another, so reducing some of the intrinsic perils.

And, Yes, finally, these banks do devote a vast amount of customers' money, human sweat, and computational brute force to trying to ensure that such risks as remain after all this red-pencilling are a mere statistical infinitesimal (though this latter protestation of innocence rings a little hollow when the same three banks report that trading derivatives brings in nearly $1 in every $10 of gross revenues earned - more than $1 in every $5 for the leader of the pack, JPM Chase)

But, still, knowing, as we all too painfully do, that Man is not gifted with more than the most limited degree of foresight and knowing, too, that complexity brings its own emergent risks - the ship, proverbially being lost for an ounce of pitch - we remain unwooed by such rationalizations.

Furthermore, we are also convinced that - to paraphrase Marshall McLuhan - the "Model is not the Market" or, in other words, that an over-reliance on blind mathematics in the non-deterministic world of Acting Men and capricious Fortune is also a sure, if Ivy-strewn, road to ruin, as the all Nobel prizewinning horses and men who tried to put Long-Term Capital back together again conclusively showed in 1998!

That Greenspan himself is not to be abashed by hard facts such as these is evident.

Before the same Senate Committee on Banking, Housing, and Urban Affairs, on April 20th last, he sonorously pronounced that:

"...Better risk management has already begun to show real potential for reducing the wide swings in bank credit availability that historically have been associated with the economic cycle. Sound procedures for risk quantification generally lead to tighter controls and assigned responsibilities and to less unintended acceptance of risk during both the strengthening and weakening phases of the business cycle...."

"... Better methods for measuring credit risk have also spurred growth in secondary markets for weak or problem assets, which have provided banks with a firmer, sounder basis for valuing these credits... Portfolio risks have also been increasingly hedged by transactions that do not require asset sales, such as derivatives that transfer credit risk.

"With greater use, more-thorough review, and more-extensive historical data, risk modelling has improved in accuracy and will continue to do so.... In the United States, our leading banking organizations began the process years ago and, in many respects, were in the vanguard of the effort worldwide."

For our part, we hope that, for once, the Chairman's cheery insouciance is ultimately proven correct and that it is our misgivings which are seen to be unfounded.

But, while we put these contending views to the test of history, you will surely forgive us for conducting ourselves policy as if Bill Gross's shared worries about the "advent of financial alchemy" are the more accurate and on the grounds that Jim Rogers' opinion of the Fed Chairman will, one day, be vindicated.

That way, we can all sleep more safely in our beds.


Source: OCC


Source: American Bankruptcy Institute


Source: BankruptcyData.com and own research


 

Author: Sean Corrigan

Sean Corrigan

Copyright © 2004-2007 Sean Corrigan

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