Goldman Sachs is a great vampire squid? No, more like......

Published in a recent issue of Rolling Stone is an article titled "Inside the Great American Bubble Machine" which examined how Goldman Sachs has purportedly "engineered every major market manipulation since the great depression."

In its opening lines, Matt Taibbi, the author, described Goldman Sachs as "The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money."

The description reminded me of the Alien creature in the film "Alien". In the 1979 sci-fi classic, an extra-terrestrial creature attaches itself onto the face of one crew member of the space craft. The parasitic "facehugger" is keeping its host alive by supplying him with oxygen while attempting to reproduce. Its spider-like legs grip firmly onto the host head and its long tail is wrapped tightly around his neck.


Upon further reflection, however, I think a even better analogy for GS and other industrial players from the film is "The Company" rather than the facehugger. Here is why: As the story develops, it is reveal that the commercial space craft chartered for space mining by The Company (the name of the Company was not reveal until later installment of the Alien series) has a hidden mission unknown to the crew- to return the Alien to Earth for further commercial (read profitable) development at all costs (read crews' lives are expendable).

Though the mission is not successful at the end of the film, the first in a series of four (not counting the unrelated spin-off such as Alien vs. Predator), the Aliens become a greater threat to humanity.

If financial institutions are The Company, then naturally CDOs, MBSs, CDSs etc must be the Aliens that they were breeding for achieving greater profitability. In their eyes, these creatures were perfect organisms that can be used to hedge away risks while delivering better returns and at the same time cut away excess costs. Eventually, not unfamiliar to audience who has seen it in many films from Frankenstein to Alien to Spiderman, tragedies follow as human-beings get carried away and consumed by our greed and own creations.

I believe the story of the 2008 financial tsunami has by no mean ended but merely turning over a chapter. Why so much conviction?

A few days ago, it was reported that Ridley Scott, the director of Alien, is in talk to direct alien 5, 30 years after he made the original.

The Conundum of High Treasury Yields Amidst a Strong Equity Market

10-year treasury yield has reach multi-month high in recent weeks while equity markets too were reaching year's highest levels. This seem to go against the conventional thinking that interest rates and share prices are inversely related.

I think this is not the normal business cycle that retain normal correlation. The 'Black Swan' we are witnessing is caused by the actions of the Fed. Specifically, the act of printing money, or 'quantitative easy' as a better name, has upset the system.

In a normal cycle, as economy overheats, monetary policy is expected to be tighten and treasury yields go up due to slowing money supply. Equity prices hence go down due to higher cost of funds. As economy slows, perhaps even becomes recessionary, the Fed engages in a expansionary monetary policy and money supply is growing again. All the while, the Fed is only setting a benchmark rate and letting the market decides the actual interest rates.

Presently, with the Fed directly purchasing treasury bonds, the money supply is immediately increased due to expanding monetary base. Hot money created is chasing stocks higher while bond traders are factoring in the possibility of climbing inflation by bidding for treasuries at higher yields.

Meanwhile, aggregate demand and economy's production capacity remain relatively unchanged.

Therefore, I think the debate over whether we are in an inflationary or a deflationary cycle is irrelevant- we are in both. i.e. asset prices are going up (note the price movement of crude oil) while wages and other production costs are stagnant (due to overcapacity).

It seems the Fed has not learned any lesson from the era of stagflation in the 1970s, which is to control the money supply and putting price stability at the highest priority. By control I don't mean keeping it fixed but any easing of monetary policy should be done in moderation and all the while letting the market know that price stability is top priority. Quantitative easing runs in contrary to objective of maintaining long term stability of both price level and economic activities. In addition, the direct purchase of treasury bonds and other commercial papers set a precedent and may impair the Fed's Independence. In future, Fed may be pressured politically into taking such inflationary action.

To prove my point, last week's 10-year treasury yield reached a 2009 high of 4% but subsequently retreated due to intervention from the Fed. It has purchased in total close to US$150 billion of the US$300 billion target, barely two and a half months since the start of the programme. There are already opinion by economic columnist hinting that it should raise the US$300 billion cap.

Once the expectation of inflation is out of the bottle, it is very difficult to contain.

Would the over-extended treasury market collapse and bring about a plunging US Dollar?

That would be a disaster that US government will do its best to avoid. I think that scenario will not happen as USD is still the reserve currency and all the major holders of treasury bonds, namely the central banks around the world, will be serving their own vested interest in supporting the US treasury bond market.

However, with ever-increasing supply, treasuries prices will continue on its downward trend. As yields move in opposite direction as bond prices, long term interest rate will stay high and move higher. Along the way, USD will be under pressure as US budget deficit continue to grow due to higher refinancing costs.

US equity market will be stagnant- on one hand negatively affected by high interest rate while on the other positively impacted by 1. the government spending; 2. hot money arising from expanded money supply; and 3. assured profit due to government guarantees (from TARF to bank deposits to motor vehicle warranties to commercial papers purchased by the Fed, you name it).

Not much restructuring will occurs as companies are largely above water, albeit barely, so there is no incentive to rock the boat.

I am afraid my prognosis shall be that US will be entering its own lost decade a la that of Japan.

It will take another Paul Volcker to bring major changes that will involve some level of pain to shake the economy out of the malaise.

To quote Nassim Taleb: "The Obama administration's attempts to fight the financial crisis with more cash is like treating a bad tooth with Novocain instead of a root canal."

Origin of Crisis (Part 4)

Act III

As the politicians are busy deregulating the financial sector, the dotcom bubble (touted as historical proportion at the time) was forming throughout the mid-90's (perhaps one can date the beginning with the NASDAQ listingo of Netscape) and reach a fever pitch in Year 2000.

Then it burst. The NASDAQ index plunged from its height of 5,000 level (reached in first quarter of 2000) to below 2,000 points within a year. Events that took place subsequently, though each deserves an Act of its own, happened too quickly that a montage in bullet points might be best employed in laying them out:

1. The trouble at Enron that brought itself to bankrupcy (filed for Chapter 11 in July 2001) and also led to the collapse of its external auditors, Arthur Anderson;

2. Conflict-of-interest scandals within the investment banks and stock-broking houses. Among which are those involving Henry Blodget, an Wall Street analyst who was recommending Hi-tech stocks to clients while privately rubbishing the same stocks, and Frank Quattrone, an investment banker who was allegedly allocating IPO stocks to his clients or prospective clients as favours in exchange for business engagements.

3. The September 11 Attack that depressed the stock markets further and ensured a prolong U.S. recession that began in March 2001, as later confirmed by the National Bureau of Economic Research.

4. The full weight of the events above trigger further corporate collapse and, along with the downfalls, more corporate scandals. The more prominant ones are:

Global Crossing Ltd (filed for Chapter 11 in January 2002);
Worldcom (filed for Chapter 11 in July 2002);
Tyco International (recorded US$9 billion losses in Fiscal Year 2002).

5. The Outbreak of SARS epidemic in November 2002 further depressed economic activity in Asia.

The confluence of events in Act 3 led to a notion that the global financial markets were collapsing and world economy is slipping into a severe recession. Additionally, manufactured goods coming out of China at ever decreasing prices was driving home the point that had there not been any intervention, not only was the world entering a recession, it would be coupled with deflation. It was further argued that deflation, once fully entrench, is even more difficult to get out of using monetary policy.

To slay the beast with dual heads (recession and deflation), US Federal Reserve promptly slashed interest rate at historical pace and kept real interest rate at near zero level for a long period of time. The rate was cut from 6.5% at end of 2000 to 2% by the end of 2001. By July 2003, it was already at (then) historical low of 1%. It was kept at that level for close to one year before the rate was slowly brought up from middle of 2004 to above 2% in beginning of 2005.

Reflecting on historical inflation data of the 3 years between 2002 and 2004 collected monthly, US inflation has fluctuated between 1.07% and 3.73%. Over the same period, Fed Fund Rate was managed within 1.0% and 1.75%. i.e. real interest rate during the 3 years was mostly in the negative region.

Not missing out the opportunities to push for his political agenda and win votes, President Bush launched two major tax-cut packages in 2001 and 2003.

IHT reported on the South-East Asian economies amidst the global economic slowdown. The article acknowleged that while the contagion that radiates from the West is affecting the region's financial markets and real economies, news of the financial turmoil is greeted "like news of a plague several valleys away."

I will take the analogy further: the patients several valleys away are the major consumers of the regional produces, from commodities, such as paim oil and rubber, to manufactured goods, such as IT products and sports shoes, to the service industries, such as tourism and banking. Who are to support these industries when the patients are being administered heavy dosage of austerity? The situation are especially acute when the plague is spreading across Grand Canyon, Alps and Fuji faster than Ebola virus.

Hopefully, the villagers from Yangtze ang Ganges could acquire the taste of consumerism in double quick fashion, but I won't be holding my breath.

Origin of Crisis (Part 3)

Act I

In 1998, Long-Term Capital Management failed. Its failure, well documented in Roger Lowenstein's 2000 book- "When Genius Failed", led to a potentially messy unwinding of trades and put stress to the financial system. True to form as a financial Maestro, Mr Alan Greenspan and his Federal Reserve team coordinated a LTCM bailout plan backed by several major investment banks. Though the plan involved only private capital, it is clear indication that the Fed subscribes to the "too big to fail" notion.


Act II

In 1999, after years of lobbying from the banking industry, the Glass-Steagall Act's provisions that prevented the formation of universal banks was repealed. The specific provison of the Act, enacted by U.S. Congress in 1933 with the intention to arrest the numerous bank-runs during the Great Depression, prohibited commercial banks that take in public deposits from owning and operating non-banking financial institutions such as insurers and investment banks. The idea behind was to ensure commercial banks stay focus in their main line of business and fire-wall them from any non-banking activities and related business risks.

Not long after President Bill Clinton has signed-off the Congress' bill to abolish the provision, consolidation began in the financial sector as universal banks are touted as cost-efficient providers of financial services at greater convenience. Banking groups that encompassed intermediary activities with various other financial services, e.g. insurance, brokerage, investment, are being formed through mergers and acquisitions. Some of these behemouths that exist today are: Citigroup (merger of Citicorp and Travelers Group), JP Morgan Chase (merger of JP Morgan & Co. and Chase Manhattan Corp). In order to compete, other international banking groups, such as UBS and HSBC, traditionally private and commercial banks, are setting up departments to provide investment and other banking services.

Origin of Crisis (Part 2)

In chapter one of 'Freakonomics', the authors explore the incentives behind cheatings in honour sports such as Sumo Wrestling, the national sport of Japan. It derives the conclusion that if the income distribution within specific industries varies greatly between the top and bottom, individual players have great incentive to cheat or cause the system to work in its favour. This is especially true if the industry regulators also have vested interest in tolerating unbecoming behaviours. (for more coverage of the Sumo scandal beyond the book, listen to an audio report by The Economist.)

The chapter provides statistical evidence and present the case convincingly. To solidify their proposition, the authors present in the same chapter some empirical evidence that, under the above mentioned condition, even school teachers cheat in exams- no, not exams they sat as students, but on behalf of students they teach in exams that they invigilate.

If there is a common theme between cheating teachers and sumo wrestlers- indeed if there is a common theme for the book, it is "Incentive".

And that, in my opinion, is the single most important reason behind the financial crisis that we are witnessing. The tsunami begin to gather force many years before and show of all its latent power in the past year. Over the next few postings, I will attempt to document events that I think contributed to the crescendo of financial destruction. I will begin recounting from 1998 (though it might have begun earlier)...

Origin of Crisis (part 1)

I was listening to BBC radio on Saturday and the presenter was interviewing an economist about the financial crisis. In answering the presenter's question on whether the recent episodes in the financial world has any impact on future economic research works, the economist predicted that there will be a shift away from social topics such as 'Sumo wrestlers' to more macro-economic issues.

Obviously, he was referring to the book, 'Freakonomics', in which there is a chapter on the author's research into the behavioural science of Sumo wrestlers. Indirectly, he implied that these are peripheral studies which may not mean much in steering the future world economic direction.

I cannot disagree with his view more. The ideas behind Freakonomics are extremely relevant to to present economic mess and, dare I even suggest, probably the origin of the crisis.

More later...

Crisis in Iceland- the hot soup that was boiling for a while

The collapse of the Iceland economy, sudden as it seems to those of us who reside outside of Europe, has been foretold many months ago, as reported by the International Herald Tribune in an article dated 17 April 2008.

For those of us residing in Asia and have witnessed the financial crisis in the 1990's, it is much the same- an economy built on borrowed money and time.

I wonder if Multi-Level-Marketing is recognised as unethical business model for private individuals and enterprises, why is the concept, when applied to international finance, deemed acceptable and legal?

Rescuing the Financial System: Will it work?

If the system could be easily saved by government pumping in unlimited money into the capital market, it would or should have done it much earlier.

If short selling is really the cause, why banning it only temporarily and limit the ban to financial stocks?

If naked shortselling is unethical and bad, shouldn't 'naked longbuying' be also disallowed? What I mean by 'naked longbuying' is the practice of buying on margins, in which case a market participant purchase something with resources he does not own.

It seems to me that what Ronald Reagan was purported to have said might be relevant in anticipating the consequences of the U.S. Government's proposed action to rescue the market and economy: "The nine most terrifying words in the English language are: ' I'm from the government and I'm here to help.'"

"when life hands you lemon..."

In Paul Krugman's 15 September NYT Column, he stated his alternative column title had the U.S. government stepped in and rescue Lehman Brothers: 

"When life hands you Lehman, make Lehman aid."

This pun on "When life hands you lemon, make lemonade." is one of the wittiest I have seen in a while.

And in the light of Federal Reserve's willingness since the Bearstern incident in March 2008 to provide liquidity to financial institutions not restricting to Commercial Banks, how much of such aid, I wonder, has been taken up by Lehman Brothers prior to its filing for bankruptcy protection?  Would that have meant that the Fed is also one of the creditors awaiting the sorting out of repayment by Lehman in the coming months, if any?