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Friday November 2, 2007 - 12:36:49 GMT
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Currency Currents

FX Trading – What if?

Balance sheet time bombs exploding in the night!

“Late lingerers in the office last Friday stopped and stared at the news that Moody’s had taken the ratings ax to $33 billion of collateralized debt obligations, some of which had been rated on par with Treasury bills. Astoundingly, a pair of triple-A tranches in a certain 2007-vintage, collateralized debt obligation were demoted 10 notches and 14 notches, to Ba1 and B2, respectively.  The initial triple-A was affixed as recently as April 26,” according to Grant’s Interest Rate Observer.

As usual, the regulatory system is now trying to play catch-up now that the warts have been exposed.  And that usually means we get a dose of well intention which paves the road to lower prices.

Drunk on credit we are. Check out these stats from Morgan Stanley:

1990 vs. 2006

– Total Derivatives: $5.7 trillion vs. $415 trillion

– Derivative % Global GDP: 26% vs. 789%

Yes.  Total derivative value at 7.89 times total global GDP—not a misprint! 

Simple math, for simple minds:

        Dow Jones Industrials (DJI) 1990 = 2,590       DJI x 7.89 = 20,435    DJI 2007 = 13,568

The question is not why equity markets are so high and bubble-icous; but why aren’t they are lot higher with that much credit growth?  I guess the wealth had to be spread across consumption and housing.  And not all was created in the US and not all went to the US.  So if we factor in the rest of the world, maybe the numbers on the Dow make sense relative to derivatives creation.

Okay.  Here is our basic twisted logic.

Real credit (or debt) is created (manufactured by rocket scientist toiling away in secure bunkers deep within the bowls of our elite financial houses).  This credit is parceled out to fund three things:

1) Consumption
2) Housing/Plant & Equipment i.e. real stuff
3) Financial assets

As to consumption—it’s over.  No cash flows from that to fund the debt still outstanding.

As to housing—mostly negative.  Much has been paid back, but we now have the specter of many now underwater relative to the underlying collateral.  This is default stuff which leads to further declines in existing collateral i.e. housing stock.  Thus, a deflationary impact (lowering demand) that tends to self-feed.

As to plant and equipment.  Most prudent managers tie funding to project cash flows.  But, the problem again comes in when there is a change in assumptions i.e. the underlying collateral values.  The feedback loop is the stock market, as it is the biggest repository of collateral value. 

And on the other side of the fence we have the grantors of credit i.e. our elite financial institutions.  They are now scrambling for capital themselves to protect their own balance sheets, as the relative value of their existing stock of collateral to support loans on their books declines i.e. from housing, derivatives blowing up, derivatives being downgraded, and regulatory oversight intensifying.

Thus we have the lender, or money pumper, of last resort, our illustrious Federal Reserve, now pumping and dumping a whole lot of liquidity onto the market in an effort to keep this whole thing from self-feeding (a reported $41 billion pumped in yesterday morning after already throwing the market another 25-basis point bone).  The Fed probably already knows that $415 trillion in derivatives is a VERY BIG number.

Any wonder why we’ve seen a bit of market angst lately! 

We need to listen more to the cheerleaders who emerge on CNBC and those specialist on the floor of the NYSE who show up to keep singing the mantra song to the Mr. and Mrs. Main Street.  You are in this for the long-term, don’t worry, be happy.  We can’t have that mutual fund money running, we need time to let the institutions get out of the way first.

Yeah, it’s all under control. 

One more quote from Richard Bookstaber, found in his excellent book, A Demon of Our Own Design.  Mr. Bookstaber has “been there and done that” in the derivatives world; he is the real deal. 

“I believe markets can better conquer their endogenous risks if we do not include every financial instrument that can be dreamed up, and take time to gain experience with the standard instruments we already have.  Just because you can turn some cash flow into a tradeable asset doesn’t mean you should; just because you can create a swap or forward contract to trade on some state variable doesn’t mean it makes sense to do so.  Well, in the efficient market paradigm it does, because there nirvana is attained when a position can be taken against every possible state of nature.  But in the world of normal accidents and primal risk, limitless trading possibilities might cause more harm than good.  Each innovation adds layers of increasing complexity and tight coupling.  And these cannot be easily disarmed through oversight or regulation.  If anything, attempts at regulating a complex system just makes matters worse.  Furthermore, if an innovation is predicated on behavior predicted by the efficient markets theory, then things many not operate as advertised: People just don’t behave that way.  The point is that these innovations have externalities for the entire financial system that are hard to measure but dominate their apparent value.  Rather than adding complexity and then trying to manage its consequences with regulation, we should rein in the sources of complexity at the outset.”

There is a whole lot predicated on the keeping the decoupling theme alive.  That requires first and foremost that China’s growth engine keeps revving.  And maybe that’s why jawboning is all we will get from the US; the pact with the devil seems to be, let the dollar fall and continue to juice it all. 

But as we know, markets have a way of playing some tricks now and then.  And these tricks don’t usually turnout to be treats.  What if the US is still the center of capital creation i.e. a US concentric world?  What if the balance sheet bombs keep exploding and little firms like Merrill and Citigroup continue to “come clean”?  What if mutual fund investors get nervous and decide they don’t believe the cheerleaders any longer, especially now that their primary asset—their home—is dwindling in value?  What if hundreds of billions of US-based fund managers and hedge fund assets run home for a hiding place in the US?  What if China’s market breaks big time, as Jimmy Rogers expects, and it hits the wealthiest segment and Chinese firms who we know are playing the stock market game, hard?  What if global demand and the decoupling theme screeches to a halt? 

Well, that plan for a lower dollar, and more dollar liquidity for all, goes into reverse gear and so does the trend for almost every asset class out there. For now the trend is everyone’s friend.  

Have a nice weekend.

Jack Crooks
Black Swan Capital


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