Was it only last week I was expressing outrage that US taxpayers would have to pick up the check for Greek profligacy in the form of IMF guarantees? This morning we wake to up the sound of $250 BILLION in IMF guarantees for a European rescue fund, most of which will go to countries that are eventually (in my opinion) going to default. That is $50 billion in US taxpayer guarantees. Not sure what that translates into for Britain or Canada or Australia.
I can swallow the Fed dollar swaps to the ECB. Don't really like it, but I can deal with it, as I don't think it will ultimately put US tax-payers at risk, as long as the swaps are in dollar terms. But the IMF bailout is just wrong.
Interestingly, the euro shot up on the announcement in what was now clearly short covering. As I write this, it is almost back down to where it started. That seems to me to be a vote of "I don't believe you." We will see. But if the ECB actually goes ahead and floods the market with liquidity, that will be very good for all types of risk assets.
Note that in last Friday's letter I quoted Trichet where he said we would not do what he agreed to do over the weekend. What a turn-about. So much for ECB independence. The European leadership must have realized the wheels were coming off and brought out the nuclear option in order to stave off a very serious crisis. In my opinion, this buys time but does not solve the problem.
The eurozone leaders assume that this is a liquidity problem. It is not. It is a solvency and balance sheet problem. You do not solve a debt problem with more debt. This only shoves the football a few yards (or maybe I should say meters) down the field. And it is going to cause a MASSIVE misallocation of capital once again which will create more imbalances that will have to be dealt with. Ugh.
Now, with that off my chest, let's turn to this week's Outside the Box, which is an essay by a name that is familiar to readers, Michael Lewitt. He has written a brilliant book, the Death of Capital, which should be on your short reading list. I asked him to give us a note for Outside the Box and he graciously complied. It is a thoughtful and fun read with wonderful lines you will want to read again peppered all the way through this all-too-short piece. The book is a ringing indictment of both the regulatory and money management worlds. Get it at Amazon.com.
Your how can I get even more outraged analyst,
My long time readers are familiar with Jeremy Grantham of GMO as I quote him a lot. He is one of the more brilliant and talented value managers (and I should mention very successful on behalf of his clients). He writes a quarterly letter which I regard as a must read. I have excerpted parts of his recent letter, where the chief investment strategist really takes the current financial system follies to task. Typical of his great writing and thinking is the quote from this week's Outside the Box selection:
"I can imagine the company representatives on the Titanic II design committee repeatedly pointing out that the Titanic I tragedy was a black swan event: utterly unpredictable and completely, emphatically, not caused by any failures of the ship's construction, of the company's policy, or of the captain's competence. "No one could have seen this coming," would have been their constant refrain. Their response would have been to spend their time pushing for more and improved lifeboats. In itself this is a good idea, and that is the trap: by working to mitigate the pain of the next catastrophe, we allow ourselves to downplay the real causes of the disaster and thereby invite another one. And so it is today with our efforts to redesign the financial system in order to reduce the number and severity of future crises."
You can get the full letter at www.gmo.com (You will have to register).
Your glad to be back home at least for a week,
General reader, today's Outside the Box is one that you are going to want to put your thinking caps on for. My good friend Woody Brock has kindly allowed me to present you with one of the sections from his quarterly comments. In his chapter "Deconstructing Today's Ongoing Revolution in Finance," Woody has written a particularly interesting and somewhat controversial section titled "Why the Economy Needs Vastly More Derivates, Not Less."
An all too common myth is that the total value of derivates is in and of itself dangerous because they are a form of leverage...but that is not the case. Derivatives, per se, are not a form of leverage; rather they afford the opportunity and make it easier and less risky for others to use leverage across many different assets and instruments (i.e. - mortgages, insurance, etc...). It is the leverage which is then the issue, as paradoxically, the decreased risk (hedging) aspects of derivatives allows investors to feel more comfortable with increased leverage, which sends a variety of signals to market participants.
The problem lies not in the instruments but in how the risk is distributed. While many of the larger, institutional players have used the offshoots of derivates to better hedge themselves, much of the smaller investor community has unwisely used the medium in a speculative manner. If a small homeowner is in trouble because of leverage on their mortgage, there just isn't anyone left to bail them out. Just as in the greater fool theory, the party only continues while someone is more foolish and irrational than the last fool.
Again, this is one of the more insightful articles featured in an Outside the Box. I believe it to be very important as its implications tie into what we are now seeing in the subprime mortgage market. May you enjoy Woody's insights and analysis.
For the last two weeks in my regular Thoughts from the Frontlines, we have been looking at inflation. In keeping with that theme, we turn to today's note from Stephen Roach, Chief Economist of Morgan Stanley, who talks about the nature of what he calls the New Inflation. I think this is one of the more important insights Roach has had among a career with many of them. We close with a few paragraphs on Alan Greenspan from Martin Wolf, who writes for the Financial Times in the US version of the London business daily. Wolf is a jewel of a writer and makes a subscription to the FT worth it all by himself. The Financial Times is now delivered daily in many cities. You can find out more by going to http://news.ft.com/home/us.
These two articles offer us different views of the inflation, asset targeting and the critical role of central banks. They do help us think Outside the Box.
And I should note, I have been writing for some time that I thought Bush would nominate Ben Bernanke as the new Chairman of the Federal Reserve Bank. Now, we will see a lot of people critical of nominating a man who talked about dropping money from helicopters, but let me suggest to critics that they go back and really read that speech and some of his more recent ones. He did not really propose dropping money. It was tongue in cheek.
Bernanke writes and speaks in very clear terms, and I hope this fosters an era of a more transparent Fed. Which, I should note, Bernanke has argued for. I hope he does not adopt of policy speaking in opaque terms such that non one understands what he is really saying. I think a more open, transparent, collegial Fed board, with a very defined mission, would be good for the markets, rather than the guessing we all have to do now.
This week we take a look again at my good friend Peter Bernstein, the venerable editor of Economics and Portfolio Strategy. Peter is the dean of economic writers. (Actually, he is more like the Pope of economic writers, except of course, that he is Jewish.) The first and long time editor of the prestigious Journal of Portfolio Management (now serving as a consulting editor), Peter has been observing the investment world for almost 60 years, after serving as a captain in the Air Force in WW2. During his career, he has rubbed shoulders and influenced the movers and shakers in our world. He is the author of nine books in economics and finance plus countless articles in professional journals such as The Harvard Business Review and the Financial Analysts Journal, and in the popular press, including The New York Times, The Wall Street Journal, Worth Magazine, and Bloomberg publications.
His book, Against the Gods - the Remarkable Story of Risk is one of my top five, you gotta read it books. (www.Amazon.com) His latest book, Wedding of the Waters is a powerhouse of historical economic story-telling about the Erie Canal.
Several weeks ago in Outside the Box we looked at Paul McCulley's piece called "Phyrric Victory" and Bernstein offers his views on the subject by critiquing McCulley. Bernstein sees the expectations on inflation being much different than in the past and adverse surprises may be in our future. It is the risk we don't see that always causes the problems and that is why this article became this week's Outside the Box.
You can find out more about my friend Peter by going to http://www.peterlbernsteininc.com/. His newsletter is a must read for serious investors and institutions.
Readers know that Paul McCulley of Pimco, and his cohort Bill Gross, are two of my must read economic analysts. Pimco is in Newport Beach, California, and oversee more than $400 Billion in assets, predominately in fixed income.
This is Paul McCulley's August 2005 Fed Focus letter. Several weeks ago I talked about Greenspan's remarks that the Fed was targeting asset prices. There is nothing more he would like to see than the ten-year bond yield rise, but to this point it has been flat or down. McCulley looks at why the ten-year yield has not gone up, in what he calls the "Greenspan Put" and why an inverted yield curve may be in our future. That is why this was picked for this week's Outside the Box.
This week's commentary comes from Douglas Greenig of RBS Greenwich Capital in Greenwich, CT. I have been reading his material over the years and always find it solid and thought-provoking.
In this piece, we get one more look at Greenspan's "Conundrum." Douglas looks at some of Greenspan's arguments for the strange behavior of the bond market. He then offers up his own theory of why long rates have stayed low and why they are likely to remain there. Many market watchers, like Bill Gross of PIMCO, are starting to look at why long rates have stayed low and predicting they could go much lower. Douglas offers up some new ideas and that is why it was picked for this week's Outside the Box.
This week's letter is by Richard Duncan who is based in Hong Kong and is one of the brightest financial analysts I know. Richard is the author of one of my favorite books called The Dollar Crisis: Causes, Consequences, Cures. A new paperback edition that is revised and updated is now available at Amazon for under $14.
Richard said this piece is really an updated version of one of the new chapters in The Dollar Crisis. It looks at the federal deficit, the dollar, Greenspan and offers another explanation for why the longer end of the yield curve has stayed low while the Fed is raising rates on the short end.
Can the current account deficit undermine the Fed's ability to control US interest rates? Let's find out in this week's Outside the Box.
Last weekend I had my second annual Strategic Investment Conference in La Jolla, California. One theme that interested me was that several speakers, including Rob Arnott of Research Associates, Paul McCulley of PIMCO and Richard Russell of Dow Theory Letters, were all negative about Alan Greenspan.
One of my favorite economists, Stephen Roach, of Morgan Stanley gives us a similar opinion. Roach takes a look at the last 6-7 years and the effect that the U.S. Federal Reserve has had on interest rates and bubbles. At some point we must work our way out of the imbalances and hopefully it can be done with a Muddle Through Economy and not a severe depression. That is why I picked Original Sin as this week's Outside The Box.