This week in Outside the Box I strive to address an issue that I have been meditating on for quite some time. Precisely, how have we arrived at the current credit crisis that now threatens the domestic and global economy. I believe one of the underlying reasons is what is termed the "Minsky Moment," the topic of this weeks Outside the Box. If we understand how we have arrived at this crisis, we may get some clues as to how it will unfold. I am going to take up other thoughts on this topic next Friday.
Charles Whalen has written a very clear essay. He is from the The Levy Economics Institute of Bard College which is a nonprofit, nonpartisan public policy research organization. I have quoted from papers from the Levy Institute on many occasions. The Institute is independent of any political or other affiliation, and encourages diversity of opinion in the examination of economic policy issues while striving to transform ideological arguments into informed debate. I have often found their papers to be very insightful. You can read a longer introduction and the supporting notes at http://www.levy.org/vdoc.aspx?docid=961.
This week in Outside the Box we bring you the text of a powerhouse speech by Michael E. Lewitt, made at the The Bank Credit Analyst Conference last week. We have been discussing the current market turmoil in our weekly letters for quite some time, addressing the adverse effects of CLOs, (collaterized loan obligations), CDOs, (collaterized debt obligations), SIVs, (Structured investment vehicles), what have you, outlining the how these products among others have been instrumental to the market decline.
Michael Lewitt strives to show that while the downturn is by no means negligible, it is not extreme and in certain segments of the market might have been driven by emotions and technical factors rather than by underlying weakness. The conclusion you might ask? Investment opportunity.
We are in a world far different than the one I learned about in economic text books. As I have written, the shadow banking system of hedge funds and CDOs, CLOs, PIPES, etc. have created a new financing economic reality far different than the traditional banking system was just 20 years ago. Does the Fed have the tools in its toolkit to deal with the new reality?
This week, Bill Gross of Pimco fame looks at the problem in a manner that is truly Outside the Box. Bill Gross has been called "the nation's most prominent bond investor," by the New York times, managing Pimco's Total Return Fund, the world's largest bond fund.
Enjoy your week.
This week in Outside the Box, Louis-Vincent Gave, Charles Gave, Anatole Kaletsky, and company of GaveKal Research delve into the underlying misconceptions that presumes money velocity is and will remain constant, in the equation that says MV = PQ (Money*Velocity = Prices*Quantity) when M is increased. GaveKal Research strive to show that in application this relationship does not hold, and that investors ought to look to velocity to rebound to gauge market recovery or further deterioration. This is an important concept and holds major implications for the inflation debate.
GaveKal venture on to address the Banking crisis in England, how Mervin King & Co. at the BoE responded to the Northern Rock debacle, and why the appropriate response was hindered by political malaise than by BoE incompetence, though mind you there was some to speak of. Furthermore, the Fed 50bps reduction is taken to light on account of the uncertainty of whether such (and potentially further) reductions will prevent the economy from falling into recession.
GaveKal further discusses how the dollar breaching record lows, will affect the inflationary pressures in China, and how the dollar is affecting the oil markets, which happen to be denominated in dollars. I have attached below graphs of the Euro/Dollar conversion rate, and the current (WTI) cost of oil.
Finally, my publisher is running an advertisement for my friends at International Living. I normally don't think abut the ads, but this one is interesting in that it is two years for the normal one year price for a publication that I enjoy. If you travel or think about living somewhere else, this is a good place for information, or to just dream. Enjoy your week.
My friends have at GaveKal have been whale watching for some time. But not for Blue whales or in an ocean. There theory is that Central banks keep throwing dynamite (in terms of liquidity) into the ocean during credit problems, watching little fish die and don't stop until a whale floats to the surface, thereby giving a signal that the credit crisis is close to being over. They think they have spotted that whale.
This week in a very interesting and decidedly different Outside the Box, Charles Gave writes about the current liquidity crisis and the problems surfacing in England. Remember, it was problems in Asia and then Russia that created the problems in 1998. We should all pay attention to what is going on. Are there more whales getting ready to float to the top?
This week in Outside the Box, good friend Paul McCulley of PIMCO fame addresses the important topic of fed fund easing. Paul addresses the predicament the current Fed finds itself in on account of not wanting to bail out those who took excessive risk in what he dubs the "shadow banking system," - comprising an alphabet soup of levered non-bank investment conduits, vehicles, and structures. The crux of the matter as Paul highlights is that the 50bp discount rate reduction still remains a penalty to the Fed Funds rate, hence simply not an attractive source of funding for real banks, who have access to the Fed funds rate. Bernanke and company are trying to kill the notion of a Fed Put, whereby the Fed "bails out" Wall Street whenever losses increase significantly which further worsens excessive risk taking, or moral hazard. The conclusion is while many would like to think this simply is a Wall Street quant fund predicament, the reality is that Main Street shares the pain in the form of tightening terms, conditions and rates for all but conforming mortgages. Thus, the Fed needs to reduce the Fed funds rate not to bail out Wall Street but rather to save Main Street from recession on account of weaker growth, which to boot would carry serious debt-deflation consequences. I have provided Chart I below in larger print for illustrative purposes.
Who should we blame for the problems in the credit markets? This week in Outside the Box my good friend Barry Ritholtz takes on the task of pointing his prodigious finger at the guilty parties. As he notes, there is plenty of guilt to go around. This is a problem that is going to stay with us more than a few weeks. As I wrote last week, it is not a problem of liquidity. It is a problem of credibility. Until investors of all types feel safe getting back into the structured finance market water, US mortgages and all sorts of consumer finance are going to be severely hobbled. There is plenty of money on the sidelines, but it is going to take some work to make investors feel comfortable.
Part of that process is to figure out what went wrong and how do we avoid getting into this mess yet again? How do we restore credibility? I offer a few quick thoughts on this at the end of Barry's work. And if you have the time, you should click on some of the links Barry has to various research, especially the first link which shows that housing prices could easily drop 15% (or more in some of the bubble areas!).
Finally, I should note that I am going to be speaking yet again at the New Orleans Investment Conference (October 21-25, 2007). This is always one of the great investment conferences of the year. You can click here to learn more.
This week's Outside the Box is from good friend and South African partner Dr. Prieur du Plessis of Plexus Asset Management. Prieur suggests that we should not be surprised at last week's rate cut, as it is consistent with past rate cut cycles when viewed from the fact that banks are tightening up on their lending standards to both consumer and commercial borrowers. There are a number of very original graphs here with some very interesting analysis that is truly Outside the Box.
This week in Outside the Box we take look at the how the Fed acted in the last debt crisis of 1998 and what they are likely to do this time. How will the Fed address the looming liquidity crisis stemming from the subprime debacle primarily, and from the abused Yen carry-trade, lax lending practices, and excess liquidity, generally? Asha Bangalore, Vice President and Economist at the Northern Trust Company, believes that given the actions taken by the European and Japanese banks in response to credit and liquidity concerns in the markets by an infusion of €200 Billion, and ¥600 Billion, respectively, the Fed will also take the customary action of cutting interest rates to assuage the market at the October 30-31 Fed meeting.
Your humble analyst believes that a rate cut will not likely occur on account of inflation concerns, and I thought you should read an opposing and well-reasoned view. As an aside this makes the CPI numbers which will be released this Wednesday very important and any difference from the expectations will have the tendency to move the markets significantly. If inflation comes in high as it did last month, the market will take that as a sign that the Fed will have less room to cut rates. Conversely, if inflation is lower than expected, you could see a real leap. As a reference, the previous CPI (MoM) was .2%, with economists estimating it coming in at .1%, CPI Ex. Food & Energy (MoM) was .2% with no estimated change forecasted.
This Week in Outside the Box we Join Bill Gross of Pimco in his July 2007 Investment Outlook as he strives to address the implications of the Bear Stearns hedge fund debacle, the toxic waste that is Wall Streets' innovative derivative products and their respective valuation, rather, lack thereof.
If Dear reader you have not been party to the excess of the Wall Street you may have not heard of the two Bear Stearns hedge Funds focusing on the subprime market that were subsequently liquidated on account of their inability to meet margin calls, thus wiping out investors. Mr. Gross believes that while significant, we ought not to look to Wall Street to see the repercussions of our excess but to the heart lands of America and the real estate there financed via subprime loans to witness the true folly of our capitalist ways.
As I glanced over at the TV in my office this morning, the latest news on the ticker wire was that American Home Mortgage Investment Corp. (AHM) is trading down over 16%. While the company is not of any particular importance to me, it spurred my thinking regarding how the housing market will affect the economy throughout the remainder of the year. And as I have written it is not really a matter of the housing market affecting the economy so much as it is a matter of tightening credit spreads that will do the damage.
This week's Outside the Box is written by PIMCO Managing Director Bill Gross where he discusses his views regarding the correlation between housing, credit spreads, the bond market and FED policy. In his article "Grim Reality," he goes on to point out that losses on loans, in and of themselves, are not the real monster lurking in the night for this economy, but rather it's the tightening of credit standards the could have a materially adverse effect. Bill does an excellent job explaining this as he so often does with his usual great style and wit.
I believe that you will find this Outside the Box to be a good read on what the implications behind a decline in the housing market really are.