Janus at the Inquest

By Daan Joubert

In Roman mythology, Janus . . . was the god of gates, doors, doorways, beginnings, and endings. Janus was usually depicted with two heads (not faces) looking in opposite directions, and was frequently used to symbolize change and transitions such as the progression of past to future, of one condition to another, of one vision to another . . . (From Wikipedia)

An inquest is a judicial investigation . . .

Larger inquests can be held into disasters, or in some jurisdictions into cases of corruption. (From Wikipedia)

In this report that, like Janus, looks both backwards and forwards, I am very blatantly going to be blowing my own trumpet. The reason for doing so has however nothing to do with excess hubris rushing to the head, but with, to me, an important question – which I am not able to answer with any confidence – to be stated later. An answer, if someone should care to hazard one, that IMHO should be interesting and relevant for the future.

The ‘Inquest’ part of the title refers to the need to evaluate and review why we all find ourselves in the wholesale mess that envelops the financial world, in particular in the US. The Janus reference is to a look into the past, primarily at things I have written over the years. Some new comments are added, as appropriate. The other face of Janus looks into the future in an attempt to take a peek at what lies ahead.

To begin, we go back almost 9 years to December 1999. In an article at the Gold-Eagle website http://www.gold-eagle.com/gold_digest_99/joubert121399.html

the implications of the fact that ever since 1981 US households have increased consumer spending faster than the increase in their disposable income, were explored.

Herb Stein’s Law states that something that cannot continue indefinitely has to stop. Here the problem was that if households of necessity had to stop their deficit spending – more so if they also started to repay their debts – it would result in a recession, at best, given that consumer spending had increased to more than two-thirds of GDP.

That article was the first in a series that examined the Wall Street and Nasdaq bubbles of the 90’s and it concluded that the trend was unsustainable and thus had to stop. Which it did, not too long after the series had appeared at Gold-Eagle.

But the trend to keep on spending faster then rising income did not falter; addiction to the good life made affordable by taking on ever more debt was difficult to shake. The idea of going “cold turkey”, to refuse more debt and paying off what was owed was unpalatable.

In an essay on “When Systems Fail”, it is described that if a system is exploited beyond its natural ability and capacity and without doing the required maintenance to ensure that it can continue to function at full effectiveness, a day will come when the system fails in a catastrophic manner. http://www.gold-eagle.com/gold_digest_00/joubert103000.html

The article ended with a direct reference to the US economy where it seemed that the way it was being ‘managed’ reflected an attitude of maximum exploitation of debt gearing and a minimum of the needed maintenance to ensure a healthy and vibrant economy based on sound economic principles. A paragraph towards the end of that essay warned:

“And, as with pressure cookers and submarines, there is no predicting when it [the catastrophe] will occur or what will trigger the event. There might be a lot of creaking going on for some time, to warn that the crisis is imminent, but then, too, the creaking could well last longer than anyone expects.”

On the US mortgage front there was quite a bit of creaking going on for a good while, starting even before Bear Stearns announced last year that two of its hedge funds were in deep trouble. But, of course, by then it was too late, even if anyone was really listening to the creaks and not to the assurances right from the top that the mortgage mess will never affect the wider economy. Everyone was too busy making money or buying property to be concerned about strange new noises coming form the markets.

In March 2006 a series of five essays compared the Japan of 1990, when their bubbles burst and what then happened, with the USA in 2006 and what lay ahead. These essays are archived at http://www.freebuck.com/articles.shtml

Discussion of the problems that faced the US, focused on the fact that the US financial system had changed from one where negative feedback ruled to an over-geared system of positive feedback. Readers who are unclear about these engineering terms can read Part 5 of that series where the difference as it relates to the US is fully explained.

All engineers know that a system operating under positive feedback is in run-away mode. The faster the system runs or the harder it works, the more it speeds up, or the more the load on it increases. In the US, a major factor of the positive feedback system dealt with the creation of debt; the more new debt was made, the more money the main players earned and the more the system geared itself up to create even greater amounts of debt.

The problem is that any economy, any corporate sector and, in this case, any household sector, can legitimately and affordably carry only so much debt. Exceed this limit and the debt bubble has to burst sooner or later, with disastrous consequences.

The fact that on top of new debt taken on by original debtors the system had created a whole pyramid of derivatives, made the problem ten times worse. Instead of spreading risk throughout the markets, as per Greenspan, risk became concentrated in a relatively small group of ‘debt insurers’. At long ago as 2006, the following was written with reference to the increasing load of debt:

“Because of risk, investor peace of mind has to be secured either by a guarantee from the seller – not very likely, except in rare cases, such as by Fannie Mae and Freddie Mac – or by means of insurance from one of the credit insurers. The ABS practice thereby assumes a cloak of respectability and apparent safety – which may well be valid for normal times, but becomes a meaningless farce when a major discontinuity in the credit market should happen and nearly all holders of ABS ‘investments’ run to the credit insurer for relief; all of them at the same time”.

Today we know Fannie and Freddy had to fall back onto previously denied government guarantees in order not to precipitate an even worse crisis than already existed and that that action was part of ‘the major discontinuity’ that has bled the insurers dry. The ‘cloak of respectability and apparent safety’ was also ripped off when households increasingly found that they could no longer service the debt they had taken on.

The fact that the authorities as well as the markets were surprised by these developments is itself a surprise.

As an aside, in that essay is also written:

“It will be very interesting to see what happens in the US when property prices finally fall to where many home mortgages are under water. It would be quite surprising if US home owners do not follow the Japanese example and stop paying their installments.”

In June 2006 in an essay entitled, “Are We Approaching The End Of The Binge In US Consumer Debt “ at Freebuck.com, spending patterns of US households relative to their income was analysed. The conclusion included:

“American households have, in a steadily accelerating spending spree, now spent almost all of the increase in household income of the past 46 years. It implies that, nationally and should the trend remain intact, the US household sector is on the verge of going bankrupt. Of course, many household[s] have saved a good part of their income over the years. These households are counter-balanced by those that have sunk deeply into debt in order to keep the spending flag flying high.

These households are very poorly prepared to weather any financial headwind, let alone a significant rise in interest rates.”

As we now know, the financial headwind arrived when interest rates on mortgages had to adjust from the initial ‘teaser’ rates to market related rates and when the ‘liar mortgages’ caught up with reality. That pricked the property bubble and started a train of events that is a long time still from passing through the station.

The question

The question alluded to at the beginning is:

If a near ignoramus in economics, such as an ex-physicist turned systems programmer turned technical market analyst can identify, well before any problems become visible, trends in the US economy that can and must lead to financial disaster, why is it that the more accomplished economists in private and public employ did not raise a chorus of warnings that the economy is on its way to an inevitable catastrophic collapse?

This by no means imply that the author was alone in seeing trouble ahead; far from it, but the relatively few Cassandra’s were a small group compared to the large main chorus of economists who somehow saw a perpetuation of the Goldilocks years. While the powers that be were for all intents and purposes willfully and presumably knowingly pushing the pedal to the floor in order to get more gearing and mileage out of the debt engine.

The only elaboration on this matter that the author could dream of was in the form of the following quote from Part 5 of the essay on Japan and the US:

“A different perspective comes from author Guy de Maupassant who long ago commented the prospect of growing old is most unappealing, but that the alternative is completely unacceptable. Very similar sentiments, I believe, today concern the powers that be in US. Continuing along the current path, for households and the government, piling on more debt on top of an already top heavy credit system to keep it from collapse, is unappealing; most unappealing. However, the alternative – to end the debt spree and to begin working down the outstanding debt – will trigger very serious consequences for the GDP, for US business, for the home property market, for the dollar and US interest rates, for jobs and for investors – both the local variety and, horror upon horror, also for the foreigners. This is – as de Maupassant will understand so well – politically completely unacceptable.

Political suicide, no less.”

Two things come to mind on reading this: the lemmings of Norway which under the force of population density set off on a migration in which they persist even when it takes them jumping off sea cliffs in an attempt to swim across the ocean, with dire consequences. In the case of politicians of whatever nation, the pressure to please the voters of today at the risk and cost of the voters of the next generation – when a new generation of politicians will be playing the same game – is overwhelming. The fact that following such policies have sunk many economies in the past in disaster, is a lesson that lemming-like has to be learnt afresh by each new generation of politicians.

The other and closely allied answer, is a version of the widely know dictum that the mark of insanity is to persist in performing the same actions, but with the hope of a different, more desirable, outcome. The fact that the same policies have never been sustainable in the past is no deterrent to the politicians of today, who somehow seem to believe they can change history.

Which, in the absence of another, perhaps rational explanation, leaves US powers that be as either insane or so deluded by the forces driving them that they implement policies and allow practices that inevitably lead to national financial catastrophe. It happened at many times in history; in the US in the 1920’s and now it has happened again, at the latest since 1994, when Clinton brought Bob Rubin in from Goldman Sachs to pressure boost the US economy, thus to ensure his re-election. Or perhaps one should turn further back, to the peanut era when Jimmy Carter first fiddled with the CPI calculation. Perhaps it was the Reagan era, with the vast increase in the national debt during his two terms in office that set off the new trend to increased indebtedness, with households and corporations eagerly following the example set by government.

The other face of Janus

Let us again begin with a few quotations:

Thus, prediction of whether or not the capitalist order will survive is, in part, a matter of terminology.

--Joseph Shumpeter, Encyclopedia Britannica, 1945

Capitalism survived its crisis and went on to great successes. But the capitalism that survived and succeeded was not the capitalism of 1929.

--Herbert Stein, The Triumph of the Adaptive Society, 1989

From: http://www.slate.com/id/2561/

To the above one can add

“The New Capitalism of 2008 is not the capitalism of 1929 nor is it the capitalism of 1989; it closely resembles the fascism of Germany in the 1930’s.”

It would be a pity to find that if the crisis continues to deepen, despite the new (at time of writing) desperation measures that are being proposed and adopted in a great hurry, the New Capitalism might even come to resemble the Russia of before 1990, when all the productive capacity of the nation belonged to the state.

The magnitude of the current problems is IMHO still far from revealed. There have been massive write-offs at many large financial institutions, in the USA and in other countries – of a size, as we well know now, to put these major institutions at risk when their capital is depleted by their losses. These institutions are in the public eye; when their assets are written down, as has happened with much of the ‘toxic waste’ derivatives they carried on their balance sheets, they are in deep trouble.

A first matter of concern relates to the masses of ‘toxic waste’ generated by these major financial institutions in their gearing up of the debt engine, but that they no longer have on their balance sheets. Large volumes of this near worthless junk have been sold over the years to provide their top management with magnificent bonuses for their efforts – work that they should have known and some probably did know, would be threatening the actual existence of the firms that employed them, and others too. Yet the managers could proceed to do so without fear that they will have to return money they have taken home. Or will class action suits later address that question?

Now one wonders what has happened to the alphabet soup derivatives that were sold to unsuspecting fund managers all over the world? Those that ended up on the books of some European and other foreign banks have largely been acknowledged as worthless and the banks have taken their knocks.

But what about pension funds and those operated by insurance companies; so far there has been little if any public knowledge of a manager of a pension fund coming clean and saying that they carried $x hundred million of now worthless toxic waste and that, in pursuit of additional income, the fund had wallowed deeply and profitably in the credit default swap (CDS) market, which unfortunately have turned sour. Now the fund faces claims for billions of dollars arising from the credit insurance that was written. The fund manager now recommends that members make timely arrangements to work for another 5 or 8 or 10 years after the anticipated retirement age and pray every night for a repeat of the equity bull market of the late 90’s during that time.

In similar fashion, there has been little headline news about securities based on financial assets other than mortgages – on credit cards, home equity and other bank loans, student loans, corporate loans by the many small businesses that now face very difficult times and can no longer meet their loan obligations. All of these surely were bundled as various kinds of asset backed securities (ABS) and sold quickly in order to keep the financial merry-go-round twirling away so that the CEO and his colleagues could earn magnificent bonuses. When are we going to hear about the empty holes, voids, on balance sheets of smaller banks and funds when these erstwhile ‘assets’ have to be reported as liabilities?

With the total nominal value of global financial derivatives now exceeding one thousand trillion dollars, as per the BIS, how much of that vast amount will turn up over the next year or two as having no real value, either because the underlying asset has vaporized or because that was the fate of the counter-party?

There has been rumours of large players in the CDO and ABS markets coming out quite clean from this recent mess, largely because they remained outside this market as far as their own investments were concerned – or even while they were shorting these markets – at the same time as they were eagerly marketing toxic waste they were not prepared to keep for themselves to their trusting clients. How long will it be before their now very unhappy clients band together and seek restitution of some kind in the courts? It would surprise if this did not happen in the not too distant future and it would be even more surprising if the then CEO’s of these brokerages and banks and their colleagues were not asked to return some of the ill-gotten bonuses they have received while practicing these scams as a means to fund in part the restitution of their clients’ losses.

How long before class action suits spring up all over the place in pursuit of some degree of compensation from financial institutions already on the brink of collapse and ready to topple under the least provocation, for valueless toxic waste sold to them as AAA rated investments?

The over-all picture when one thinks 3-6 months ahead seems pretty dark, with not much of silver lining, if any. The measures being suggested might be able to reassure local and foreign investors that the current problems are being dealt with; but what happens when the next wave of bad news and defaults hits the markets – the mortgage wave is expected to peak only in about Q1 of 2009 – while credit card and bank loan and vehicle finance and student loan waves are probably still building up.

It is very difficult to be optimistic and if enough investors feel that way, the foreigners in particular, developments in the equity, bond and forex markets over the next few weeks may well pre-empt any bad news that could be on its way.

Interesting times indeed.

Conclusion

This is still too early to evaluate the possible success of the measures announced by the Treasury et al during the past few days; there are too many unknowns, such as the price that will be paid to banks to relieve them of their load of utter junk securities – will it be face value, and sink US taxpayers under an extra heavy load of debt? Or will it be true market prices for over-valued assets, in which case the banks have to write of their newly realised losses and then begin their panic search for rescue capital all over again?

Whatever happens, though, the author will not be taking any bets that the recent cycle of bad news and market turmoil will not repeat going into 2009.

A final comment – Preferred Gradients

All of the thousand trillion dollars of derivatives rest on the pricing model of Black and Scholes and Merton for their valuations. A report by the author, which is now appearing at www.freebuck.com, shows that a basic assumption on which the B&S valuations are based is in error.

Market prices do not behave in a manner close to fully random, a critical assumption for the B&S model; prices obey a form of symmetry – there is a degree of regularity in the way prices change over time, which invalidates the pricing model and provides important advantages to those who are aware of the nature of this regular behaviour.

The symmetry presents as Preferred Gradients – a tendency of all prices to repeatedly change direction along certain gradients, identified by trend lines, where each gradient can appear many times on the same chart. The fact that these gradients quite consistently display the same characteristics makes it less likely that the phenomenon that is observed can be due to mere chance.

Should other researchers confirm the existence of the Preferred Gradients, as well as their features, it will have a marked effect on the degree of confidence with which the owners of these $trillions of derivatives view their investments. Uncertainty will escalate when it is realised that some market players may have a significant advantage over those who are not aware of preferred gradients; which is the last thing one wants in the kind of financial climate we are likely to be in for the foreseeable future.

daan joubert

chartsym : gmail.com