Against The Gods Print E-mail
Against The Gods



In his “Worldwide Bestseller” Against The Gods, The Remarkable Story of Risk, Peter L. Berstein glorifies risk management and its role in the advancement of mankind. “The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.” Mr. Bernstein wrote of “a group of thinkers whose remarkable vision revealed how to put the future at the service of the present. By showing the world how to understand risk, measure it and weigh its consequences, they converted risk-taking into one of the prime catalysts that drives modern Western society. The transformation in attitudes toward risk management unleashed by their achievements channeled the human passion for games and wagering into economic growth, improved quality of life and technological progress.”  Mr. Bernstein wrote these words in 1996. He has written a dozen books on investing in his 90 years on earth. He is a Harvard grad, a giant in academia and in the real world of billion dollar money management. His love of mathematics and history and his faith in financial risk modeling led him to the conclusion that despite his recurring misfortunes man has generally learned to manage risk successfully and has prospered as a result. In 1996 Mr. Bernstein held the view of derivatives as tools of risk control rather than risk creation and contagion. He surmised that no one need go broke any faster because of derivatives; “The instrument is the messenger; the investor is the message.”  In this book he lionized Myron Scholes and Robert Merton, the wizards of finance and mathematics behind Long-Term Capital Management. Two years later Long-Term Capital Management would be the subject of another great book written by Roger Lowenstein, When Genius Failed, The Rise and Fall of Long-Term Capital Management. As the title implies things did not go well at LTCM. The Nobel Prize winning theory behind the hedge fund’s investment model failed to account for the risk of a Russian debt default. In a familiar story line tremendous leverage magnified losses and forced the NY Federal Reserve and large Wall Street firms to structure a bailout for LTCM to avoid a system wide financial collapse. Is the faith of a brilliant man like Berstein misplaced? How and why do these models conceived by “genius” fail? Or do the men fail due to human frailty?


What Would Cato Say?



It is reported that more than 2000 years ago the Roman orator Cato noted,” there must be a vast fund of stupidity in human nature, or else men would not be caught as they are, a thousand times over, by the same snares… while they yet remember their past misfortunes, they go on to court and encourage the causes to what they were owing, and which will again produce them.”  As investors we must ask how the brightest minds produced by our finest universities, clutching advanced degrees in the study of math and finance, take positions of great responsibility on Wall Street only to be caught in the same trap again and again. Displaying a degree of stupidity attainable without the expense of an ivy league education our men of genius destroy an amazing amount of investor and taxpayer wealth while multiplying their own. Cato would seem to place the blame of failure squarely on the shoulders of man. We find fault with man and model.



Of Money and the Spirit of Men



A John Maynard Keynes concept of “animal spirits” has been referred to often of late. It is said that it is important to resurrect the market’s animal spirits to revive our sputtering economy and financial system. What Keynes meant and what most are currently referring to is the restoration of optimism and confidence about the future, placing the prospect for profit above concern for loss. It is what drives entrepreneurs to cast aside reason and plunge headlong into untested waters and investors to bet on the future. As Bernstein might put it; animal spirits allow us to believe that the future is a servant of the present. Animal spirits are dormant in the world today as the gloom of recession has settled over the globe. Few are willing to risk their cash on a bet that the best is yet to come. Instead an alarming number of investors have parked their cash in near zero return investments, foregoing return on principal for return of the same. Banks are hoarding cash out of fear. They fear making additional bad loans (huh) and they fear that the loans and investments containing loans already on their balance sheets will drive down their capital rations inviting greater government intervention and controls. Without the animal spirit capitalism grinds to a halt. The aim of the trillion dollar stimulus package above all else is to restore the animal spirit. Today investors and regular people around the globe are aligned more closely with Cato than Bernstein. They have lost faith in the wizards of Wall Street to manage the future with their numeric potions and black box caldrons. The spell has been broken and once again they fear the fury of the gods of nature and doubt the wizards’ powers. The distrust and fear has escalated so far as to cause many to abandon free markets and entrust the future to politicians and their appointees. We have entrusted politicians to create a trillion dollar shield against nature and the future, against the creative destruction that has been too long delayed. Only the future will tell us if the shield will encourage the spirits to re-emerge or if it will act to make investors more timid and dependant.


Dampened Spirits



In the cycles of capitalism the flame of the spirit may burn so bright as to attract participants like moths to a fire. It can also recede to a dim flicker barely perceptible to those so dependant upon it for warmth and security. Today the spirit is reduced to embers struggling to hold the promise of a flame. In the mist and fog of a financial breakdown of our making we are reduced to unsure observers hoping the wizards can bring back the flame before the coals die cold.





The Spirit, the Wizards, and Minsky



The optimism about the future and the confidence in success so fundamental to capitalism can be co-opted by one of man’s greatest weaknesses, greed. We see a good thing and we want more of it. Greed’s cousin, envy, fuels market excesses too. We see what others have and we want more than they have. Some become slaves to accumulation and turn a blind eye to their participation in schemes of self destruction. The mindset expressed by Bernstein regarding man’s ability to employ events yet to come to sate the needs and wants of today emboldens man to assume increasing powers of prediction and greater risk in pursuit of wealth. The wizards of Wall Street led investors and speculators where they so desperately longed to go. Armed with incomprehensible investment models that reduce failure to a faint whisper against the booming promise of fortune the wizards provide a trail of crumbs that lead us back to Minsky. You may recall our exploration of Hyman Minsky’s Theory of Financial Instability in the December 2007 Quarterly Review. Minsky argued that temporary but prolonged stability in markets ultimately breeds instability. The stability reinforces faith in the mystical powers of the wizard quants. A quick replay of Minsky shows us how investors become increasingly speculative moving from simple financing structures ultimately to ponzi schemes. This is known as the “Forward Minsky Journey” which culminates in the disastrous “Minsky Moment” where the bubble bursts. The” Reverse Minsky Journey” courses back from the most speculative ponzi financing to simple financial debt structures. From 2003-2007 we embarked upon the Forward Journey as the wizards used levered derivatives and the off balance sheet shadow banking system to expand capitalism through ever riskier debt schemes. The Minsky Moment arrived on September 15th when Lehman Brothers was forced to declare bankruptcy. This event began the Reverse Minsky Journey of painful delevering coupled with the realization of a frightening, spiraling debt deflation that has jeopardized the global financial system. We now endure a worldwide recession with no clear end in sight. The final leg of the Minsky journey is the “Policy Solution” where the wizards of the shadow banking system surrender the magic wand to the politicians. The politicians will attempt to reflate the burst bubble using their own shadow banking system of Federal Reserve and Treasury debt concoctions known as the TARP. This meandering set of policies of debt guarantees, de-facto nationalization and third-world national deficits will attempt to breathe life into the dormant animal spirits. The only folks to suggest that the remedy for a hangover is a little hair of the dog generally have a drinking problem themselves.



Ben Bernanke, Meet the Monk



In the 1400’s a monk by the name of Luca Paccoioli brought double-entry bookkeeping to the business managers of the day. (You’re right, I have no life.) While my astute clients need no refresher regarding the fact that for every asset there is a liability it may be of value to bring this idea to the attention of our friends in Washington . Bill Poole, the former president of the St. Louis Fed told Bloomberg readers,” The chairman (Bernanke) has a total credit-centric view of monetary policy and puts too little emphasis on the liability side and the high rate of money growth.” The trillion dollar bailout plan will add to our already ballooning budget deficits. The US entered this crisis carrying a burden created by profligate spending, two unfunded wars and tax cuts. As liabilities mount I am reminded of the words of Pimco’s Mohamed El-Erian, “When we focus on the seemingly urgent we miss the truly important.” In Washington ’s rush to save the day and the bankers they must focus on the implications of their actions. The budget deficit is now greater than 8% of GDP. With greater need for stimulation and a certain decline in GDP in coming quarters the burden is sure to rise. At some point we will reap higher interest rates, higher inflation and higher taxes. A rescue is badly needed. It is the price of grand scale failure. But this is not free money by any stretch. Tax payers deserve transparency rather than government stonewalling when it comes to accounting for these funds. And the system is in need of restructuring that goes far beyond the bailout of the incompetent scoundrels that got us here. To that end we explore the question so rife with pitfalls, “what’s next?”



Let the Battle Begin



We have written about the social structure of capital formation and distribution in the past. This refers to the institutions, the powerful players, the financial plumbing, legal structure and the regulatory bodies that combine to compose the infrastructure of the capitalist system. There are many influential people and organizations that have amassed great wealth and gained the access to lawmakers that money brings. These people and institutions have a vested interest in perpetuating the current infrastructure with as little change and government interference as possible. The myth pushed by Wall Street is that regulation kills competition and innovation. Rules do not stifle competition, they define its boundaries. Well constructed regulations are necessary to correct the inadequacies of the financial system. Financial innovation has exposed the infrastructure as obsolete, full of vagaries, conflicts of interest, redundancy and gaps. Of all the corrections that need to be made none may be more important than transparency. The lack of transparency in debt structures and company balance sheets has destroyed trust which has compromised animal spirits and caused liquidity to evaporate.

Lemons Anyone


 A gent named George Akerlof found a way to express most of what is wrong with the state of transparency in the capital markets with a little ditty called “The Market for Lemons.”  Akerlof employed the used car market, thus lemons, to explain what happens to the dynamics of markets when one side, the seller, has more information than the other, the buyer. According to Akerlof this asymmetry of information ultimately produces damaging results. First no buyer knows what the seller knows. Therefore the buyer must trust the seller. The seller has no credible disclosure technology to share information. The buyer must really trust the seller to have his interests in mind. A deficiency of effective public/ consumer protection, assurance by reputation, regulation or guarantee develops .Is there a credible product rating agency or accounting firm to vouch for the seller? It is Akerlof’s position that this asymmetry of information erodes the level playing field and creates an incentive for sellers to pass low quality products and engage in deceptive sales practices. Say it ain’t so! Consumer confidence is impaired and causes the buyer to assume that all used cars (or securities or banks) are of suspect quality prone to unforeseen breakdowns. This causes a dislocation in market values that places consumers at a disadvantage. In its worst incarnation the Market for Lemons ceases to function. Discerning a good product from bad becomes an exercise involving more risk than the suspicious buyer is willing to endure. The buyer refuses to buy, sometimes at any price. Translating this concept (however awkwardly) into the issues disrupting capital markets explains how the one-sided relationship between Wall Street and its customers has led to the breakdown of confidence that has contributed mightily to the credit crisis.


Henry Kaufman Says



Mr. Kaufman, no stranger to the ways of Wall Street predicts that the Wizards of Wall Street and Washington are embarked on a path that will lead to a greater concentration of power, political influence and financial risk. In an op/ed piece in the December 6, 2008 Wall Street Journal Henry wrote that “financial concentration will gain even greater momentum and influence” and that “this will be the most profound long-term consequence of the current credit crisis.” Mr. Kaufman continues,” these are the very firms that played a central role in creating an unprecedented amount of debt by securitization and complex credit instruments” and they “also pushed for legal structures that made many aspects of the credit markets opaque.”  He predicts that the power of these institutions will be “overwhelming”, “infused with conflicts of interest” due to roles in every aspect of capital formation and distribution. These even larger institutions will be global and transmit crisis through contagion more easily and that these “financial conglomerates will grow at the expense of borrowers and investors.” We agree with Henry on these and other points, including; that international portfolio diversification has been undermined, that risk modeling will lose in popularity, US borrowing will continue to swell, Americans will spend less, borrow less and save more and finally that regulatory reform is fraught with high stakes risks. If Henry is correct, that we are failing to heed the blistering lessons of the “too big to fail” doctrine we would seem tied to Cato’s vision of man fatalistically doomed to repeat the same mistakes but with greater risk.


Investing in the New World Order



Success in the battle against a deep and prolonged global recession will depend upon an unprecedented degree of global cooperation in the management and correlation of recovery plans. In the words of the IMF we must correct global imbalances in a process of “coordinated and simultaneous” actions that reflect “shared responsibility”. There must be re-alignment of national economies. The US must cut debt driven consumption and repudiate its role as the global buyer of first resort. Europe must expand capacity and productivity and discontinue antiquated policies that control inflation at the expense of growth. Asia and oil producers must stimulate domestic demand through tax policy and the democratization of their economies.


If these policies are not enacted in a most efficient and coordinated manner we risk a long and deep contraction of economic activity around the globe.


Interest Rates



Interest rates will be depressed by a coordinated global easing for much of 2009. At a later date, probably in 2010 interest rates will rise in debtor nations to attract bailout capital and fund deficits. In the US we should prepare for a sharp rebound in rates when economic activity shows signs of improvement as inflation will not be far behind.


Security Selection



It is here that the landscape is undergoing dramatic change. The GSE’s are facing uncertainty. Will they be nationalized or privatized? The Federal Home Loan Bank system is showing signs of stress as housing markets continue to stumble. This is a choice we expect the Obama administration to address in 2009. A new hybrid security structure has emerged combining a “full faith and credit” backstop with financial company debt, a sort of corporate bond with training wheels. This clever plan (the Temporary Liquidity Guarantee Program) provides conservative investors with an alternative to Treasury Securities at slightly better yields. The TLGP offers financial companies an opportunity to fund or roll over billions in maturing debt at greatly reduced costs. The aims of the program include resumption in investment in American companies, strengthening corporate balance sheets and the promotion of conservative management and oversight.


The TLGP has created an opportunity for investors to buy short-term non-guaranteed debt of companies participating in the program, with the Federal Government as a partner. At ICM we believe this strategy is the best opportunity to invest a prudent amount of public funds in solid companies that enjoy financial support from the US Government. Our strategy will be to remain close to the shield of government protection, not because we approve but because it is the safest road to success.



Challenging Times



At ICM we are your partners in navigating the new opportunities and uncertainties that accompany these financial times. Frequent readers know that we have been predictors of potential financial dislocations for several years. Now that our worst anticipations have materialized we anchor our attention not on the past but on the future. The rescue plans forming around the globe will have some limited, positive impact this year and next. The best read of the future will come from the interaction of public and private capital. We have faith in the return of animal spirits and await the coming changes with eyes wide open. As always we will be diligent, conservative and focused on your success.