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Saturday November 28, 2009 - 16:13:16 GMT
Black Swan Capital - www.blackswantrading.com

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Oh the nasty "tail" risk and lending "reflexivity"...

Key News
The central bank of the United Arab Emirates is closely watching events stemming from the Dubai debt crisis to ensure no harm results for the national economy. (Reuters)
 
Quotable 
“Credit is a system whereby a person who can't pay gets another person who can't pay to guarantee that he can pay”
                 Charles Dickens
 
FX Trading – Oh the nasty “tail” risk and lending “reflexivity”…  
 
Gosh, it was looking so good.  All those buildings, fancy shaped islands, money, and oil wealth.  Who would’ve thunk it?  Well, not the credit analysts, we know that now. 

Nov. 27 (Bloomberg): “One cannot rule out -- as a tail risk -- a case where this would escalate into a major sovereign default problem, which would then resonate across global emerging markets in the same way that Argentina did in the early 2000s or Russia in the late 1990s,” Bank of America strategists Benoit Anne and Daniel Tenengauzer wrote in a report.
 
We’ve seen this all before.  Since the day credit through the art of lending was created, many years ago.  
 
“There seems to be a special affinity between reflexivity and credit.  That is hardly surprising: credit depends on expectations; expectations involve bias; hence credit is one of the main avenues that permit bias to play a causal role in the course of events. But there is more to it.  Credit seems to be associated with a particular kind of reflexive pattern that is known as boom and bust,” Mr. George Soros tells us, in his masterpiece on investing, The Alchemy of Finance.  

“The pattern is asymmetrical: the boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic.”  
 
This Dubai situation would seem to have two major implications for the broader global economy:
 
1) It shows that lending is still flowing from the center to the periphery despite all those reserves and savings we are told reside in emerging markets i.e. the center, being Western banks and capital markets, provide credit to the periphery, being emerging markets of the world.  This is why the word “contagion” and “tail” risk are used in association for this type of boom-bust event.

2) It is a lesson that goes beyond emerging markets and to the “at the margin” declining stimulative impact of additional lending by governments of the world.  Increasingly the players are realizing all that so-called lending hasn’t created all that much stimulus.
 
Back to Mr. Soros for help, “The act of lending usually stimulates economic activity.  It enables the borrower to consume more than he would otherwise, or to invest in productive assets.  There are exceptions, to be sure: if the assets in question are not physical but financial ones, the effect is not necessarily stimulative.  By the same token, debt service has a depressing impact.  Resources that would otherwise be devoted to consumption or the creation of a future stream of income are withdrawn.  As the total amount of debt outstanding accumulates, the portion that has to be utilized for debt service increases.  It is only net new lending that stimulates, and total lending has to keep rising in order to keep net new lending stable.”
 
Problem number one in this current precarious process: Right now governments are playing that role of lender of last resort.  Yet they are running out of our money (Mr. Taxpayer’s hard earned bounty so legally confiscated).  
 
Problem number two is this: Private lenders (banks) are not playing the role intermediary i.e. lending the money received from government (our money) to the people from which it came, who live and work in the real economy. Key question: Wouldn’t massive tax cuts have been a much simpler and more effective way to create real spending power for the people you wish to spend it?  Sorry, we can’t mention the word tax cuts to liberals—those are class-warfare fighting words—how dare we utter such nonsense!!! Three deep bows of apology to our current “governing” regime. 
  
Problem number three: Financial assets (stocks, bonds, risky assets, emerging market anything) has been sucking up all the lending flow that has not gone into the real economy, and held on said intermediaries balance sheet i.e. resources have been diverted for financial speculation instead of building futures streams of income, for the most part.  Thus, the growing disconnect between reality and perception.  Any wonder why the Government of Goldman Sachs is embarrassed about its bonuses.  [Chart not available in text format.]
 
Can you say Dubai?  Sure, I knew you could! Have a nice weekend boys and girls. 
 
Jack Crooks
Black Swan Capital LLC
www.blackswantrading.com 
 
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