Wednesday, March 26, 2008

Liquidity Tug-o-War??

Many (myself included) have been worried about the excessive liquidity, both in dollar-land and worldwide. The causes have been clear: persistently loose USA fiscal policy whether through war, tax cuts, or just plain demagoguery, loose monetary policy (by any measure of Taylor-Rule or otherwise prudent exercise of monetary creation), a shadow banking system too-clever-by-half, a neutered US bond market prevented from expressing its displeasure in yield terms; pegs to the dollar by GCC and Asian mercantilists that has allowed US consumptive profligacy to exist upon the shelf long beyond its sell-by date; a complete unwillingness of America (and pointing a finger at the entire American polity) to countenance energy taxes sympathetic with other OECD nations. This is but a short-list and is by no means complete thought it is a fine place to start the search for culpability. The net result has been buoyant growth in and money and credit and hence oodles of liquidity contributing in a "virtuous" circle towards rising asset prices that emboldens both lenders and borrowers, the latter whether unsecured or against boated asset values.

This has been worrying to anyone concerned about the value of a paper chit from afar, or unluckily holding them in lieu of other assets pseudo-indexed to their rising quantities, forlornly watching their markers become more-diluted by the hour, day, year or other preferred descriptor of time. Some Moldbugs believe this dilution to be on the order of a reasonably consistent 10 to 20% per year - excluding the rare and more austere interludes characterized by tight money. Such figures, whether real or imagined - would be alarming for one need not be skilled in linear algebra or the finer points of calculus to understand that one will lose half the value of the paper every four to six years, despite the tamer prevailing rate of so-called inflation as measured by government officials and apologists for unfettered liquidity creation. Such a reality is sufficient for those with such paper to avoid its accumulation by (a) spending it immediately (b) converting it to other stores of value (c) borrowing it in order to do 'a' or 'b' or both above, the latter outcome a reflection perhaps that the archetypical cat, has escaped the proverbial bag.

Few would find significant fault with what I've recounted so far, even the most hardened of Moldbugs amongst us. But this might be the point where we diverge. And such departure is neither the result of excessive optimism or pessimism regarding human nature or a new-found desire of central bankers to be the bill amidst a rave, or The Dour Parents at a party of teenagers. Instead, the departure is driven by two theses I will posit: (1) the credit cycle resembles a lognormal distribution; (2) when we find ourselves collectively somewhere far from the normally [positive] mean [of monetary dilution], way out on the negative tail, such revulsion extinguishes existing money and credit quickly and prodigiously, and in the process creates a cascade that scars the collective human (and financial institution) pysche for what is perhaps a generation. These, together, I'll put to you, help tether an otherwise fallibly doomed system of human weakness in the hands of politicians and other parochially-selfish miscreants to something that might continue to be a useful servant of mankind, at least for the next unit of time or perhaps until the art of cold nuclear fusion is mastered.

Real monetary and credit growth significantly in excess of real GDP, resembles a growth stock that continues to increase in market capitalization above and beyond that commensurate with both the continuing fine expectation and undaunted realization of such expectations. Such robust nominal performance feels good, and doesn't hurt anyone...yet. It is a universal confidence booster, and, as a result of its price signals, draws further investment into itself in a virtuous circle, for with its heady rating, it can now easily make accretive acquisitions. But its very froth and beauty draws capital from everywhere towards everything similar. It is not an orgy - certainly not at first. It does so slowly and continuously, hence the daily and weekly return distribution has a definitively positive skew, though occasionally, when the market swoons, such small and continuous price appreciations are decimated in large and concentrated moves caused by panicked investors attempting to save profits or fearing the party is over, get out with their skin. Typically, real quality growth stocks shrug off such doubts, power ahead in their underlying business, soon reflected in share prices which eventually, at much higher levels than prevailed during the swoon, draw the moths back to the flame. This is the essence of the lognormal distribution: a mean of small positive returns, but with a fat negative tail far-departed from mean. Some have suggested that this is rooted human behaviour. reflecting the species preference for positive reinforcement before embarking upon a risky gambit. We see in it prehistory. Humans rarely hunted alone, emboldened by the safety in numbers, their success rates perhaps also lognormally distributed - the fat negative tail represented by an utter mauling of the hunting party with near catastrophic losses.

And so credit growth, fueled by rising asset prices and ever-more confident lenders, is likewise positively skewed. Like the first skaters testing the ice, they proceed slowly, whereupon confident of its integrity based solely upon the fact that they remain above the surface of the icy waters, signal to the others that all is fine in slippery Golconda. Of course this is overly simplistic. There are in reality many forces at work: agent vs. principal issues; keeping up with the jones'; and all manner of behavioural biases that serve to reinforce the alledged prudence of one's herd-like actions and penalize the questioning of the same, for no one benefits from caution, not least the individual. At least until the edifice is too large for its foundations. There are of course limits to how many can safely glide upon an ice-sheet of certain thickness. Exceeding such threshold limits results in rapid fat-tailed catastrophe with no recourse. Eschewing analogies, revulsion destroys credit and collateral values in vast quantities. It crushes the price of core asset values in real estate and equity, and cremates securities that use these assets as collateral. The size of core asset value destruction in our present case being measured perhaps, ultimately, in the double-digit trillions. This is not a matter of small-step back after a long promenade forward. It is monetarily, nearer to Jack&Jill falling off the hill back nearer to the intermediate-term bottom than the top.

But mega-revulsions do more. They scar the psyche, irrespective of whether by natural consequence of falling in under the weight of the edifice, or in response to man-made pressure such the Volcker's Saturday night massacre. Our current predicament is the former, the result of multiple attempts to prevent recession over the years, with diminishing marginal returns to the priming almost guaranteed that much of the investment would of marginal quality and ultimately wasted. Lenders, accustomed to lognormal distributions begin to rework risk under more symmetrical regimes. They reduce existing leverage to save powder and prepare for worse to come, much like the body will warm the trunk at the expense of the extremities. And like the body they do this not as opportunists but in self-preservation. Ray Dalio's Bridgewater in their latest research report makes the following points:
"The financial market unraveling is, as we've described, 'the Big One". What we have meant by this is that the implications of the last six months will impact how the financial system will work for years. Both directly and indirectly (through the literal profits and incomes associated with the financial sector) and indirectly (through the benefits of credit creation) the economy is more reliant upon the financial sector than ever. The virtuous circle of easy credit and rising asset prices leading to increased consumption and therefore increased incomes has been fueling the economy for so long that it has been taken for granted. The reverse of this cycle will have profound implications for the economy, and we have only just begun to see those implications upon the real economy."
It is a natural and logical reaction. This is what the beginning of a cascade feels like, and one that only will end with the eventual uprightness and sustainable leverage atop the system, corresponding levels of consumption related to output, and asset values that are either reasonably well-discounted or known, at the very least, to have stabilized in the longer-term. We are not there yet, and every bank - whatever their domicile - knows this, hence are reticent to lend except to all but the most creditworthy, and on terms that provide more than just compensation for there remains a reasonable probability that price discovery continues in a direction that erodes one's margin of safety. Falling asset prices, in turn, kills the speculative animal spirits. Why build a new shopping mall when the existing ones can be had for less than the cost of new construction? Time shares will trade at hilarious distances below where they were sold in the primary market. And banks, flush with assets recently foreclosed have no appetite to project-lend when they are recently - involuntarily - long the last cycles excesses. Again the chain of dependencies numerous and complex, but the end result is the same: more destruction in collateral values and hence both liquiidity and the supply of dollars.

The remedy for this is clear. Rapid Price discovery. Writedowns. Recapitalisation where required. This will return confidence, albeit upon a much diminished capital base, and much diminished risk-appetites on the part of financial lending institutions. A reordering of the deck occurs: leveraged asset holders - whoever and whatever they leveraged against lose, as do the previous financial sector shareholders. It is against this backdrop that I raise the ultimate question for Moldbugs and those in dread of helicopters and printing presses alike: Is it even remotely plausible that authorities can replenish anything remotely like what's been lost, or what will be lost? Is not "reflation", or Fed gestures to bridge recapitalizations for systemic lubrication anything more than a drop in the bucket to what has been destroyed, making inflationary fears resulting from Fed or Governmental actions a canard? The liquidity resulting from securitisation, wanton misuse of the shadow banking system and its conduits ARE ALREADY out there. Much of it having ALREADY circulated and coursed through sytsemic veins is in the hands of foreign Official entities. They can spend it, but they can multiply it, won't multiply. Moreover, the effects have already been seen in the BRICs in the form of raging economies, buoyant mercantilist exports, vaulting commodity prices, and the $1000+ Kruggerand. But that was then, and this is now. Replacing some of the destroyed credit and liquidity surely can be but a salve upon a lost limb. It will, in the end, simply be inconsequential in the grand scheme of what's gone before and what is to come.

Longer term, I will defer to Moldbugs of the world and not challenge their assertion that the probability that the current reign of fiat money will end. But here, and now, I am far less concerned with the inflationary effects of TAF, TSLF, fiscal packages or outright nationalisation of financial institutions when the need arises since I believe that the credit so destroyed by this revulsion, and the associated cascades and intermediate-term behaviour changes far outweighs the remedial impacts of authorities.


Mencius Moldbug said...

The ridge between deflationary and inflationary tomorrows, already knifelike, is definitely narrowing. Whatever the answer is, I suspect we'll know it in a year or two.

As for the deflationary revulsion, you may very well be right. The truth - and thus the choice between hyperdeflation and hyperinflation - lies in the tortuous bureaucratic alleys of DC.

On the gold standard, revulsions were inevitable and incredibly brutal. Read the history of any 19th-century panic sometime, or even the early 20th-century ones. But they also resolved themselves quickly - thus the famous advice of Mellon. I still believe that if this advice had been followed, there would have been no Depression. The comparison to 1922, for example, is quite illustrative. There was a time when Wall Street understood the value of a healthy purge.

And it is also a fine thought-experiment to imagine what would happen if the Fed simply ceased to exist, leaving M0 the only dollars in existence. The five-cent hamburger would be a reality again, I have no doubt. A Krugerrand might run you as much as $20. At most.

And then there is the experience of Japan. Which is surely motivating many of your deflationary hypotheses. I know very little about Japan, but both my parents and my stepfather were career Beltwayites and I suspect that here is the critical difference. I'm not sure who it was, but someone in Tokyo decided to let the land bubble collapse instead of diluting the yen to meet it. The thing about BB's notorious helicopter speech is that, from an economic perspective, he was absolutely right. The "zero bound" is no barrier to an aggressive Fed. See, for example, the recent feelers about buying mortgage securities. Why didn't Tokyo mop up its banks' bad debt with freshly-printed yen?

A genuinely independent central bank can mimic a gold standard in a very interesting way. If it is set up such that its bureaucratic incentive is to defend the currency, it can do so rather than succumbing to political pressures. Imagine, in the extreme case, that the Fed was a private corporation with no political links. Surely it would restrict its currency as I described above, maximizing the value of its "printing press."

While never anywhere near this extreme, the 20C system of government - cosmetic democracy and bureaucratic rule - comes close. It had a great run. Quite notably, in Japan. But what we see now in the US is a financial bureaucracy without the courage to inflict pain on the voters. And without will there is no power. The news cycle is without pity.

And there is another factor which I don't think you're considering, which is that not all assets are alike. The assets that suffer directly in a revulsion are those that served as collateral for the debts which have gone underwater, because these are the assets that must be sold. Today, of course, this is real estate - residential especially. As the inverse wealth effect of asset price falls makes everyone feel poorer, you get a general, indirect deflationary effect, but it is this general effect that the authorities are most eager to counter. Moreover, although I believe the Fed will act specifically, the tools it is most comfortable using are general. AmeriZIRP, here we come.

This favors assets which have not been leveraged by a huge pile of debt. And perhaps some hedgies have borrowed to buy bullion - somebody definitely got stopped out last week. But I think the majority of the gold stockpile is simply held as savings, certainly by nonbanks. Thus direct contagion strikes me as implausible, as does a 19C style general indirect deflation that bleeds through to grocery prices, wages, etc. I think of the Depression as an example of how untenable the transition area between these two regimes is, and probably Japan is on the same list.

So my vote is for inflation - not of the hyper type, at least not tomorrow, but definitely accelerating over time. I am hardly happy to see this, because I fear the consequences will be dire for many, certainly far worse than the temporary adjustments of a prudent austerity. The angels are with Mellon, Volcker, and you, not with Burns and Bernanke and Havenstein. Alas, we are not ruled by angels.

Anonymous said...

Whether this happens to be 'the big one', I'm in no position to say. But given that, since Volcker, economic policy and financial practice have been nothing but wholly mimetic with respect to the society in which they reside and are so indistiguishable from it as to make one question whether internally generated evolution of any form can smoothly take place in response to a crisis. The baby boom has grown six toes and responds by convincing itself that quantity trumps quality.

As for its successors, does 'lamarckian' ring a bell?

Nicely done,


Anonymous said...

Oh! And congratulations to Moldy and madame.


Anonymous said...

On the one side we have credit deflation, but on the other the greatest source of inflation (a middle-finger to monetarists!) war, be it waged in Irag or Afghanistan. The deflation? inflation? outcome might be less clear cut than the various protagonists think.

"Why didn't Tokyo mop up its banks' bad debt with freshly-printed yen?"
As recently as 2003 (or was it 2002?) BoJ did this, but in the final stages of the banks' work-out when the stock market was at or near its nadir. The reason it didn't do so earlier, or so I believe, is that there was a stand-off between BoJ and the politicians: deliver meaningful economic reform and will deliver with the monetary spigot. The meaningful economic reform never arrived and Gov. Hayami capitulated in the dying days of his tenure.

Macro Man said...

One could plausibly argue that we are at the onset of a structural shift in the relative prices of financial and hard assets.

Through the 80's and 90's, financial assets appreciated dramatically relative to hard assets- be they gold, oil, VCRs, PC, etc.

In the early-middle part of this decade, that has begin to shift; financial assets continued to rally, but so, too, did the building blocks of the price of hard assets- commodities.

Now that we've had the credit implosion, it's not terrribly difficult to see a scenario of several years of asset price deflation/disinflation, which friend cassie seems to envisage. Yet given the activities of sundry CBs, why should the value of hard assets fall if actual cash in circulation rises? The "shadow money" created by derivatives, et al was primarily used to purchase financial assets- hence its relativ price appreciaton since 1980. Why, then, should its implosion negatively impact the price of hard assets, given that it provided relatively support to them in the first place?

Anonymous said...

Will de-securitization of assets play a part in this? I am thinking of the news item about the creation of Private National Acceptance Company, which, if I understand it correctly, will be tearing apart CMOs to take possession of the actual underlying mortgages at a price that would allow them to work with owners.

Anonymous said...

"The assets that suffer directly in a revulsion are those that served as collateral for the debts which have gone underwater, because these are the assets that must be sold."


Mencius Moldbug said...


While in general I think I agree, I'd be slightly careful with this term "hard assets," which I suspect groups a few unrelated items into a category of questionable utility.

First, any asset you could imagine fitting in a portfolio probably qualifies as a "financial asset." Few people have their savings in VCRs, or so I hope.

This leaves gold, oil, wheat, etc in the same category as CDOs, CPDOs, or simply dollars themselves: all are goods which might conceivably be worth storing for people who have little or no direct use for them.

Some of the engravings on modern paper notes are quite elegant, and apparently if you're in a pinch for mousse you can style your ducktail with a few teaspoons of Venezuela's finest. Gold makes a good wedding ring, but has no other use both personal and tasteful. And as for CPDOs, I suppose you can always bring them to the gents'.

So within this weird world of stuff you don't actually want, but might want in your portfolio, do we see three main asset classes.

One, we have assets that are valued, in dollars, as streams of present or future dollars. Of course, the dollar itself is a trivial case of this class. Perhaps this is what you mean by "financial assets," but the name is quite ambiguous. "Dollar-yielding assets" might be better. At this high level there is no need to draw a line between debt, equity, and actual plant - all are valued, as streams of potential future dollars, with standard capital asset pricing.

Two, we have alternative-currency instruments. These are like dollar instruments, but in other currencies - euros, gold, etc.

At present there is no financial market denominated in gold, which means the highest-yielding gold asset is generally bullion itself. (IMF bylaws actually prohibit a member from running a gold-backed currency. There is a reason for this.) Because of storage costs, bullion's yield is slightly negative.

Third, we have nonmonetary commodities, such as wheat, pork bellies, etc. A nonmonetary commodity is one for which production generally matches consumption, and stockpiles exist only to buffer seasonal or other predictable fluctuations.

Gold is clearly a monetary commodity. Pork bellies are clearly a nonmonetary commodity - there are obvious reasons why pork bellies, or even electronic rights
to pork bellies, are not suitable as currency. (Pork bellies, for example, are expensive to store, of less than absolute fungibility, and exhibit no inelasticity in supply.)

However, there are some goods for which categories two and three are
clearly fuzzy and/or debatable. Potential currencies, such as silver, platinum, and perhaps even some of the pricier base metals, are included. So is oil, or at least underground oil. (Storage costs at the SPR, for example, are not quite into bullion territory, but still remarkably low.)

Our financial markets today have an essentially perfect understanding of how to price assets within currencies, dollar or non-dollar. They are also very good at pricing assets in class three. And they have learned some good rules of thumb for predicting price fluctuations between official currencies, which are driven of course by political calculations.

However, when it comes to competition between official and natural currencies, I would not characterize them as having an especially gigantic clue.

I don't know that anyone does. I certainly don't. And when it comes to the natural quasi-currencies - oil, silver, etc - I am really completely at a loss.

Mencius Moldbug said...


If a debt is collateralized with Treasuries, I'd like to think the lender counts himself among the lucky!

Anonymous said...

@Mencius Moldbug,

We all are waiting to the deflation of Windows_OS, but it never happens, or will PeakOil deflate everything, gold in its way?

Anonymous said...

Oh to discover the class of investable unlevered assets! Waiting for Godot would be more pleasant if mere inutility, economic substitution, obsolescence, and other risks were all that one faced.

But leverage through credit is like teenagers discovering sex - complete abstinence always looks less interesting after the first discovery. My best guess now is that in a few years there will still be credit, perhaps even surplus liquidity of a much lower level, but greater simplicity of such credit.

What if currencies were backed differently in future? Not gold necessarily, but some other measure other than the "full faith and credit" of weak politicians?

Anonymous said...

I concur with Yves that you have hit what I would call your "high water mark" with this post. I would ask one question, with regard to psychic revulsion to an asset
class. What replaces that which is being destroyed?
Certain institutions with massive long term obligations are required to meet them with SOME asset class mix.
And the choice is woefully limited. Land, buildings,
shares, hard assets above and below ground, and of course, promises, promises, and more promises.

Etz3l said...

With all the shenanigans coming from the administration, why is the cost of gubmint debt at such low levels? What's neutering the bond market?


Unknown said...

- Bravissimo -

"Cassandra" said...

Apologies for the delay in moderating as I've been away with family, and thanks to everyone who commented on this, to Yves Smith for his sympathetic remarks and to Steve Randy Waldman who provided valuable and incisive offline feedback. The point of this was more to throw the observation (i.e. that the liquidity is already out there, and so the time to worry about its inflationary consequence was BEFORE, whereas NOW, replenishments pale in comparison to what is in the process of being destroyed) out there for comment, rather than a dogmatic rant, though I will admit I convinced myself more and more to my point of view the farther into it I got.

Moldbug: My favorite analogy is indeed the ridge-line between inflation and deflation. In normal times the ridge sites atop Vermont 's appalachian hills though today the ridge-line towers above deep and sharp chasms on each side. Once drawn down one side or the other, there is no respite. This to me is the danger of overly-effusive replies and NOT the fact or talk of helicopters. For there remains the chance (as some pointed out) that since we are not entirely masters of our fate - there are lots of dollar-holders out there, flush with them, that the other enablers simply continue to buy dollars effectively making more, but also spend them and in the process float the boat in nominal terms (for the moment) leaving the potential inflation in the form of reserves etc. that are out there an ever-bigger problem. This is probably Rogoff's prediction of nasty inflation once we weather this particular episode and recession. This wouldn't invalidate my observation that n the short-term more wealth and liquidity is destroyed than replaced by authorities. But as I am not a dogmatist, I for one will be n watch for precisely such an outcome and pragmatically alter my view as required. Also, Moldbug, I believe that non-debt assets are in fact more similar than not. A house, business ownership, gold, commodity stockpiles, art, all have their idiosyncracies, and conditions under which they perform relatively better or worse, but when credit is diminishing AND core assets (and by core I mean the prime determinant of household wealth) are falling as are real estates and equity prices, the effect cannot help but be universal across asset prices - mold and silver included. I will grant some energy and some agricultural commodities greater leeway here. But I do not see it the near-universality upon asset prices as implausible, only a reflection of whether this is indeed - as Bridgewater speculates - The Big One. In answer to the extent to this and whether or not we go down with a fight, we need to watch China, Russia and large GCC accumulators more closely.

Charles - Momentum, feedback trading, mimetic behaviour generally as you aptly point out, like leverage, cuts both ways. Where will Gold and Platinum be when "the trend is broken" and CTAs puke longs and go short? $650? $550? Interestingly, even though the system is deleveraging, this doesn't effect most systematic traders, who are fine so long as they can make the variation margin calls. This is well-different from hedge funds who trade with counterparties vs. exchange clearinghouse. The former allows cross-margining, and is subject o the whims of counterparties credit committees etc. When the going gets rough there is no doubt who will get deep-sixed from a levered position. Exchanges offer some of the safest leverage in town (20x??), and now that they are public companies, it is almost inconceivable that hey would ever raise margin requirements. Ever. And that is despite my pleas and suggestions that they should.

Anonymous1 - The largest contributor to poor fiscal policy is a leveraged war, so I agree with your first point. And I wonder whether the GCCs have other agendas insofar as wanting to make sure they, ("they" being elites at the oil trough) too, are the benefciaries of blackhawk diplomacy should fundamentalists manage to make a real play. I also happen to agree with your second point (if I understand it correctly) that it was politics that stood in the way of cleaning up the mess earlier. And as Moldbug agrees, THIS one in USA will play out in DC.

Macro-Man - I think Moldbug takes you to task in the semantics of hard assets. Financial assets (to me) this mostly means debt or other promissary paper to pay. So REITs or real property equity ownership is a hard asset, whereas the CMBSs and other cute leverage granted is mere paper, albeit within a proper place in the capital structure of a firm. The latter tanks far more often than the big supercycle that Rogers et. al. trumpet, and we saw BOTH hard assets and credit tank during the last nadir. Some like Jim Grant, while seeing some temporary value in 2002 (as did Buffet for spreads for PHAT!) would perhaps argue that it was a blip amidst The Great Leveraging that began post-Volcker. But undoubtedly ALL would agree that by 2006 and early 2007, PAPER and credit was in Bubble Mode. Heck, even I speculated that at the pace of Cov-lite and all manner of free-credit, it wouldn't be long before Bonderman and Kravis LBO'd the entire S&P500 en-masse. So not only was the price wrong but the quantities were stupid too. Now, of course the whole world know how and why (SIVs, CDOs and shadow banking methods etc). This is long way of saying we agree credit was stupid. But as you know, spreads trades can converge in many ways - i.e. credit can become more aptly prices with respect to risk and its historical general scarcity, OR hard assets can in crease in value, OR credit AND hard assets can tank (i.e. 2002) with credit tanking more. As a recent industrial farmer acquiring distressed agricultural assets, I think terms of trade LONG term remain attractive for agricultural. And while you can call this a structural shift, I think it is apparent that credit tanking AND core assets are tanking understanding the correlation between housing debt and housing prices (but that this includes equity because credit is intimately related to future earnings) and the wealth effects and cascades takes everything else out in its path.

pureguesswork - desecuritisation is a symptom, I think, but won't materially impact the structure longer term. IN mid-term, desecuritisation will aid price discovery and slam collateral values by eventually depressing house prices unless Golman Sachs' Whitehall Fund comes to the Rescue, raises $1 trillion to become America's modern-day Mr Potter..

t - "The assets that suffer directly in a revulsion are those that served as collateral for the debts which have gone underwater, because these are the assets that must be sold. Treasuries?"

I know you are saying this flippantly, but it raises an important point. There ARE two bubbles. The first was credit and housing. The second is official accumulation o USD reserves. The shitbox homes with penny-wise poundfoolish 2x4 & gypsumboard construction with inefficient heating, aircond and appliances and single-glazed windows. But Treasuries serve as collateral for the second. I have been way early in calling for this second bubble to end, but it keeps going. And I am not the only one as certain academics have quantified this be on the order of 150bps to 250bps on the long rate. The two ARE intertwined since the reserve accumulation allowed low rates and facilitated the home price bubble. But technically they are separate and distinct phenomena.

Moldbug 2nd Comment - Thanks for help in the asset taxonomy. At the end, all non-paper assets (including Honus Wagner, Titian and Warhol which are paper, but not in the same sense) are potential stores of value and mediums of exchange with all their idiosyncratic advantages and disadvantages. Jews preferred diamonds cause they were inevitably involuntarily on the move, and Diamonds remain the best ban for buck, notwithstanding that the wonderful industrial uses. But impressionism, a farm, a refinery, equity in a nickel mine or zinc smelter, are equally fine and useful. The focus upon the primacy of gold only obscures the thoughtful investor's unending search for the best asset in terms of both yield and store of value amongst all the other potential assets. Was an old Patek any worse (net of Sotheby's commission) than base metals or blue-chip industrials?

Old Vet - Heck, if this IS the big one, then what's wrong with simple real estate debt on good quality real estate assets? ? There is surely debt out there at 500 to 700 over , where there remans an enormous layer equity in front of you. This would imply that the equity is mispriced. Warren Buffet got this one right in 2002, when he dove into junk on stable assets like pipelines and so forth. I am no expert in real estate finance, but debt on excellent assets that are not TOO leveraged at high yields IS inherently unlevered. You're short the put option, in disaster, but upon an asset you want to buy ayway, and you get paid in the interim. If you ended up owning the NJ Turnpike, or other essential trophy pieces at the tail end of deep recession, that wouldn't be so bad PROVIDED THE PRICE is RIGHT. Today, on many of these debt pieces, the price IS right, and if its not, then the equity piece is really really wrong.

Woland - Thanks for the nice comment. IN answer to your question What replaces that which is being destroyed?", if I understand it correctly, I would suggest that at first, its equity of lenders, and mark-tomarket collateral values of all asset that are being cut down. Though some of the riskiest will go to zero, most are not going to zero, but they will be worth less. And in fractional banking land, this further reduces he capacity to lend (provided one desired to). At the moment, not only would folks NOT want to make new loans, but they all seem to be scrambling to figure out how to make position on current position without crying uncle. These writedowns and losses are of course socialized across the enitre community from pension funds, insurrers, hedge funds, Taiwanese agricultural banks to japanese insurance companies. I am bearish, but I don;tthink we are headed back to the caves. Writedowns, price discovery, recapitalizations will happen. An you ask, where will the capital come from? Lots of the US economy are doing fine. Foreign official holders have trillions of dollars, and private savings, too are vast. Recapitalising banks has, historically been profitable for those that recapitalise them. Global private savings is vast, as are global assets. It is not impossible nor even difficult to transmute the pools from ultra low-risk to other endeavors. We've spent a generation leveraging everything in America, this much I will agree with. But there remain vast vast parts of the economy that are unleveraged or underleveraged that could be coaxed into riskier investments. That won;thappen to US bonds with US bonds at 4% and some bits, but the opportunityb to recapitalizae Merrill Lynch will draw many takers.

etz3l - As described above in the second bubble the historical accumulation of, and continued increase in foreign official holdings of treasuries has (according to folks far smarter than myself) depressed yields by roughly 200bp. More to the point, their continued willingness to BOTH buy more, and hold onto the depreciating dollars, assuages the fears of other potential nervous private holders (e.g. domestic pension funds, policy investors, individuals through, for example PIMCO), so the actual effect of the bond market may be greater. I cut my teeth at a time when the bond easily could (and did!) move 2 or 3+ points in a day, such was the fear of investors of bond market reactions to changes in fiscal or monetary policy. Today, no one shorts the bond, and all you get is a yawn. This alone might be the best reason to short the bond.....

Anonymous said...

Well shoot. I just bought 135 farm and pasture acres for half price of early 2007, from a 26 yr old MBA who was leveraged over his topnot, and got a cheap 6% financing as the opportunity cost. Counterbalancing with Puts on today's market stars ought to pay for the whole thing within two years. Now I'm going back to sleep, till next week. Cheers, hope you had a nice trip.