QE4VR

A new round of worldwide stimulus measures have been enacted over recent weeks. China announced gigantic infrastructure projects. EU announced an unlimited bond buying program to "repair monetary policy transmission channels" (and you thought quantitative easing was a creative term) and finally Mr. Ben Bernanke revved up his helicopter to the tune of $40B a month in MBS purchases. The party is on. Of course, all this stimulating seems more like a 'hair of the dog' variety and will not produce the euphoria that sir Alan Greenspan was able to conjure up in the 2000's.
European lawmakers, having been dragged into the festivities kicking and screaming, finally sees what we meant when we wrote (if they read our blog, that is) the following on July 1, 2010 about its attempts at being a Gloomy monetarist Gus at a 'neo-classical' synthesis party:
"Europe's attempts at fiscal austerity surely go against the grain, but I think that they will see the futility of fighting this trend (otherwise they will have to endure a useless bone-crushing recession only to finally succumb to inflation after their exports dry up). The US dollar is going to be the last to fall and is in fact likely to remain strong (relative to other currencies of course, it has been falling with respect to gold quite dramatically) for a while, because it appears as the less dangerous of the crazy bunch."
Alas, EU has taken too long to see that its choice has already been made by the previous events and that the pain of slow economic growth and high unemployment will not lead to any benefit. The best scenario is not to reach a Minsky moment, but once it is reached, the consequences are strictly enforced: inflation or deflation (and at high levels of debt, a depression). That still is the only long term choice for Europe as it is for US. Ben Bernanke realizes this better than anyone else, hence his willingness to take all kinds of criticism and mockery in starting the QE3.
As we wrote repeatedly starting in 2009, we have entered a true 'decade of crashes'. The worldwide QE4VR is not going to ensue until more pain has been inflicted. These new mini-crises (flareup of debt issues with Portugal/Spain, Emerging Markets Hard Landing...) will each ensue that Treasuries rally and a mini-deflationary event will ensue, but each of those events will serve as additional motivation for more and more stimulus and an eventual stagflationary period. As we wrote in early April 2010, :
"as the current slump continues we are likely to see other sovereign debt crises a la Greece .... These sovereign crises will produce a temporary strength in the dollar. This will likely happen before we get to the point of high interest rates in the US and a partial default by inflation. In the era of sovereign default, countries in the Eurozone are the only ones (among the countries whos debt is denominated in their own currency) likely to experience anything remotely resembling a real default (as opposed to default by inflation, which we believe will be endemic)."
Any risk manager must consider this long term need to reduce the real value of debts, as well as the global financial system setup, under which the crisis is relatively benign at the center (Treasuries as a safe haven) and vicious at the periphery. Appropriate stress tests would be:
- a stagflationary period (though the timing is unknown) 
- transient spikes in volatility (specifically originating at the periphery i.e. Emerging Markets).  
It is also worth seeing the target that Mr. Bernanke is trying to hit again and again and that is the housing market. Consumption in the US in large part depends on that market and it is likely going to be acting as a quasi safe haven for the medium term.

The Metaphor of the Bridge

We based our last post on the observation that a good metaphor is worth many equations in problem solving. Today we come to one metaphor that I find particularly useful. But before we do, let us ask: what is the best way to conceptualize risk forecasting? To many it appears as no more no less than clairvoyance, peeking into the future with the help of incomprehensible Greek symbols, fighting "Against the gods" as Peter Bernstein put it. Alas, the prophets of market risk are not very good and the critics are only happy to rub it in asking the efficient-markets guru Mr. Bernstein "Against the gods? And who won?".

And therein lies one of the bigger problems of risk modeling. It is thought of as something that looks into the future and sees the possibilities, through some magic maths; it is not by accident that "Against the gods" is filled with stories of Blaise Pascal and Gerolmo Cardano and other combinatorial wizzes (and no mean gamblers or at least correspondents of gamblers; Blaise Pascal as the first risk manager and Chevalier De Mere as an inquisitive portfolio manager, so to speak) crunching the numbers. After this setup it is only too easy for Dr. Naseem Taleb to come along and point out that possibility set is infinite results are catastrophic and human mind is quite and quite finite, so that the pretense of a number crunching wizz is drowned in endless hyperspace. The Icarus flies too high and burns his wings again and again.

Let us put an end to that nonsense. Risk forecasting is not really about reaching into the future. It is about looking at the soundness of the structure that is of your portfolio or of an asset class or of a market as a whole. I would call it financial engineering had not that word been so discredited with the witch soup of CDO^3s and so on. Wait, aren't we, as risk managers, supposed to think of all of the possible events that could occur: wars, earthquakes, flash crashes and what the Fed will do next? Not as risk managers. Some time ago we have introduced a metaphor for stress testing: stress testing a portfolio is like crash testing a car (http://www.risk.net/digital_assets/5011/jrm_v4n3a3.pdf). We are not concerned with all of the possible (infinite number of) triggers that might cause a loss, but rather with the vulnerability of the car (portfolio). When a car is crash tested, testers do not specify whether it is a tree or a pole that is being hit or if the wall is painted green or black, it is only the vulnerability of the vehicle that concerns them. All events are classified into only a few classes: frontal impact, side impact etc.. So it is with portfolio risk. 

But what about the bridge, didn't we promise a bridge? Yes, we did, and we will deliver two of them. The first very useful bridge for the mind of a risk manager comes from a fertile mind of Jon Danielsson (RiXtrema Senior Advisor)  and you can hear more aboout it on rixtrema.com. The bridge is a structure that responds to those crossing it. So, people crossing a bridge and the bridge itself form a system which generates its own measurable endogenous risk and people reacting to the bridge causes the bridge to react (hint: a deleveraging cycle at work). 

But let us take this a bit further. We already established that risk forecasting is not about considering vast set of possibilities (a finite number however large is really no closer to infinity than a zero) and assigning each of them a probability. Risk management is about looking at the soundness of a structure. If an engineer examines a bridge, some classes of dangerous possibilities can be thought of (a.k.a. stress testing) and simulated. But what if we are just looking to estimate the riskiness of the bridge (er, portfolio)? Then we need to assess the soundness of the structure without specifying any shocks.

 For those of you familiar with the RiXtrema approach for early warning systems in asset allocation, you may recall that we use two categories for assessing the soundness of the financial system: risk mispricing and loss of conviction (see the New Paradigm of Risk Management video by me on rixtrema.com). Risk mispricing is the excessive exuberance in taking risks (like when a country experiences massive short term capital inflows you can take your pick in the Eurozone for examples). This first condition is like a bridge being overloaded, carrying more load than it has ever carried historically. However, risk mispricing can go on for a long long time (bubble is the most profitable stage of the cycle), so we need a second factor, which we call loss of conviction. This looks like little cracks appearing somewhere in the structure. In the absence of the preceding mispricing, cracks could still be attended to and mended. However, if risk was mispricing (the bridge overloaded), then look out. Whenever you hear someone talking of 'soft landing', it likely means we have reached the stage or are at least very near to the loss of conviction . George Soros (one of the pre-eminent risk managers, despite not carrying that title) imaginatively called it the 'twilight zone of the bubble', when people play the game, but you can see that they no longer believe it. So, risk is high when 

a. Bridge has been persistently overloaded (risk mispricing)

b. Bridge is showing some structural abnormalities (loss of conviction)

When that happens there is no longer a possibility of a 'soft landing'. This is why our models showed persistently high risk for Greece/Portugal through every bailout along the way; why they showed elevated risk for Eurozone (but not US) corporate debt and equity in the summer of 2011 and this is why they are showing high risk for Austrian bonds and Irish bonds (again). The precise timing is never known, but the pattern is unmistakable. It repeated for centuries. And the metaphor of the bridge is only one of the ways we can visualize that.

Finding Our Metaphors

Metaphors are one of the most important sources of knowledge and understanding. Moreso, it is a metaphor that really wins the battle of ideas, not a proof. If you have doubt, think of the 'invisible hand' or a 'black swan'. However, metaphors can be taken too far or misinterpreted. A colleague recently forwarded on a great one, which certainly has promise, but also some danger. And it relates to risk.

The metaphor I speak of comes from a story released by a Bloomberg columnist Mark Buchanan. The story is called 'Economists Have a Lot to Learn From the Weather' and it outlines a view of the world that directly contradicts the neoclassical (economic) one and thus most of what is today called risk modeling. He writes: "Almost five years after a financial crash nearly thrust the world into depression, a peculiar paradigm still dominates economic thought. Known as the neoclassical school, it aims to give Adam Smith’s notion of the invisible hand its mathematical form. It asserts that markets naturally seek an equilibrium that harnesses individual self interest to allocate investment capital in an optimal way. Even if that perfectly efficient ideal is never reached, the logic goes, markets work better insofar as they approach it. Anyone who thinks our recent financial travails would have discredited this vision is underestimating the mental inertia of theoretical economics (and risk modeling - d.s.). To this day, the Federal Reserve and the European Central Bank go right on making plans using so-called general equilibrium models of the economy. In these models, financial firms don’t exist, asset bubbles are inconceivable and there’s no such thing as an international market in derivatives."

The author then contrasts the approach of the modern portfolio theory with the one taken by the atmospheric flow researchers. After all, aren't storms and hurricanes the best metaphors for market crashes? I have been through both financial crashes and some storms and must admit the uncanny similarity in the experiences. Mr. Buchanan points out that: "The weather is a tough problem, because nothing in it can be reduced to a state of balance or equilibrium (as a simple atomic nucleus can). Therein lies the key insight for atmospheric flow.
Storms and weather fronts aren’t accidental and unimportant “details” of the atmospheric flow at all. They are central to the way the Sun’s energy, once absorbed on Earth, flows about the planet. The jet streams that race around the planet at high altitude can’t remain stable... Ultimately, this phenomenon, arising from something called baroclinic instability, creates large swirling vortices of air that drift through the middle latitudes, transporting huge quantities of heat and water all over the planet, and causing our unpredictable weather.No mathematician can “solve” the complex equations for air in the atmosphere."
  Having said all that, the metaphor of natural catastrophes in relation to the financial crisis can be carried too far. Surely, air flows instability is a great metaphor for the negation of the neo-classical view. After one of RiXtrema webcasts, we actually had someone from the weather forecasting group call us to talk about the similarity of the notions of our early warning systems to some concepts in the hurricane forecasting. However, it is our opinion that replacing simple Newtonian physics as the base paradigm for financial markets, with another natural sciences based (air flow instability) paradigm, albeit a significantly more complex one, misses on the crucial social aspect of financial market risk. Quoting Dr. Schachter from our recent conversation:

"These un-forecast-able systems are much, much less complex to forecast than economic systems, because, as you say, the social aspect, which introduces strategic, adaptive behavior with feedback, is central. Grains of sand or rice don't adapt."

In this regard, I think that studies of people with free will, like the Information Cascades (see Extrema post here) research, when applied to financial markets, provide great insight.
Modern Portfolio Theory risk management can only work in an equilibrium seeking financial system, because it allows for extrapolation of recent observations into the future as risk forecasts. It is quite easy to see how economists got enamored with the idea of equilibrium - it is just so elegant. But despite the fact that it was shown time and again that this equilibrium-seeking is a myth, the economists still cling to it and so do present day risk models. When it is not flatly denied (Milton Friedman, Eugene Fama or Peter Bernstein) the problem is simply ignored (no substantive changes in risk modeling approaches) or drowned in mathematical gymnastics. In the next post, we will offer a few other metaphors which give us a useful way of looking at risk, modeling and managing it. And we will see why social aspect complicates things in the Modern Portfolio Theory framework, but can actually simplify things in a more realistic paradigm.

The next post: The Metaphor of the Bridge

Loss of Conviction in Action

We closed the last post ("US Treasuries: A Great Hedge or the Biggest Bubble of All Time?") with the following observation:" But how long can UST temp fate? The short answer is that until something we call 'loss of conviction' sets in, the UST will not be in crisis."

There is nothing like a real world example to illustrate a concept. Spanish bonds provide a great laboratory today. Yields on Spanish debt are fast approaching 6% and the new round of the crisis appears to be on. What does this have do with our previous discussion? Simply put, we are seeing investors losing conviction in Spanish debt. By itself, loss of conviction amounts to nothing more than changing opinion in the constant fluctuation of financial markets. Investors can start losing conviction in an asset class that has no fundamental problems. If this loss of conviction is severe enough, it can actually bring about deterioration in the fundamental picture it is supposed to reflect (something George Soros famously called Reflexivity).

However, as a pure case, tail wagging the dog is rare. During most volatility jumps, strong fundamentals will prevail over a fickle sentiment, so loss of conviction by itself should not lead to a higher risk forecast. The really dangerous situation is when a market or an asset class is already vulnerable to the sentiment change. What do we mean by vulnerable? We mean here exactly what we discussed in the previous post, the persistent and significant risk mispricing that creates fundamental vulnerabilities which will be exposed under stress. This concept is not invented by us, if one reads carefully the work of Joseph Schumpeter or even moreso Hyman Minsky, as well as "Endogenous Risk" by Jon Danielsson and Hyung Shin, it is possible to see the same concept from different angles. Market gets to a stage when it is overextended after massive risk mispricing and in this situation volatility jumps should not be treated as transient. To put it another way, a 'soft landing' is hardly possible when certain conditions met and one should observe turbulence as the sign of an impending crash. In other cases, turbulence could be disregarded.

Let's look at Spanish debt. From the screenshot below we see a few factor categories for the sovereign debt and currencies.

The one called Sovereign Yield Trends represents Loss of Conviction. The rest, like short-term capital flows etc. represent risk mispricing. Note that Spanish Bond has the first and last column in yellow (above median, but below the upper quartile). But it is not the only one in that company, other sovereign debt asset classes show risk mispricing of an equal or greater magnitude. The difference is that investors are not right now losing faith in Italian or Austrian bonds the way they are in the Spanish bonds. However, the vulnerability is there. And due to strong correlations between them, we conclude that the riskiness of those bonds are grossly underestimated.

What about the Treasuries, the starting point of our discussion? Note that Loss of Conviction is sitting exactly at 50, the median. Not a significant loss of conviction to be sure. That is why our models have not forecast high risk for Treasuries yet, because the Loss of Conviction has not set in. Once it does, we will be sure that we are in a "twilight stage of the bubble" to use a Soros quote one more time in this entry. Guess he knows a thing or two about bubbles. 'Til next time.

US Treasuries: A great hedge or the Biggest Bubble of All Time?

This is a question that has been repeatedly asked of me and other researchers at RiXtrema. US Treasuries is a 'spot' is where the past observations and future predictions meet and do battle. Why?

The Safe Haven Argument
It is really difficult to come up with an economically sound and clear argument as to why UST must remain a safe haven. The 'least dirty shirt' quote of Bill Gross (not one of the UST fans, to be sure, even to his detriment over the last couple of years) is really not an argument as much as it is a restatement of present realities. Kind of like, 'It is what it is'. He says: “The world is full of dirty shirts in terms of excessive debt, and the United States is one of those countries, but it still remains the reserve currency and still remains the flight to quality haven.” This argument is a bit circular, something like "UST is a save haven, because it is a flight to quality haven"; a premise presupposes the conclusion. There is no denying that historically UST has been a great hedge for instability, its safe haven status (the ultimate safe haven in the dollar driven financial system) clearly reinforced by its performance in crises over the past 4 years. If we had to come up with one solid argument for why UST is a safe haven and has remained one despite all the talk of a bubble, it would be simply that the financial system needs a safe harbor and all the liquidity must go somewhere in crisis. UST provides a big enough container for all that liquidity to flow into. There is also the psychological habit here reinforcing the 'container theory'.

The Biggest Bubble Argument
However, there is something that makes this picture increasingly blurry. The premise of RiXtrema's Allocation Model is that all financial markets go through long periods of risk underpricing (boom) to short periods of violent risk overpricing (bust). Risk underpricing is neither unhealthy nor peculiar to the financial system. There is a ton of research in behavioral and sociological disciplines showing that people overreact to crises, but then forget them fairly quickly (e.g. buy most flood insurance right after the flood when it is statistically least likely to reoccur and buy less over time, as the likelihood goes up). This behavior is actually 'healthy' to some degree, because we wouldn't be able to act otherwise and would be always paralyzed by the memory of prior catastrophes. The problem appears when risk pricing deviates dramatically from historical median levels, thus setting up the stage for the bust. This could be enabled by various financial engineering innovations that bring in the 'new era' and/or flow of cheap/free liquidity (purely hypothetically speaking, of course). The key problem of risk management is that risk can be mispriced for a long long time before a crash ensues. Thus, many investors call the crash too early, despite intuitively (or even quantitatively) capturing the problem in risk pricing. In fact, these stages of dramatic exuberance could be the most profitable stages of the boom cycle.

Has risk been mispriced in the UST in a dramatic fashion? Most certainly, yes. At RiXtrema we use a number of metrics to measure risk mispricing (all percentiles, with 100 being the most dangerous for the investor/risk manager). Some of them are:

Short Term Capital Flows/GDP (short-term capital is just about the most dangerous thing that can happen to a sovereign economy)

Real Effective Exchange Rate

Gross Leverage

Etc. etc. (see The New Paradigm of Risk Management whitepaper for more on risk mispricing and loss of conviction as applied to different markets)

According to those measures, the risk in UST is dramatically mispriced (click the picture below)

As you can see from the table US Bond is lighting up quite a bit (yellow and red indicate above median and the upper quartile). However, that has been happening for a while and yet our model never showed increased risk for UST over the past two years. That is because risk mispricing by itself is a necessary but not a sufficient condition of the crash risk.

On a related note, it is worth noting that we wrote about this almost exactly 2 years ago, on April 2, 2010:

"Though the situation of the US government is dire, it has a major asset in the US dollar, which still remains the world's reserve currency. Other countries do not have such a golden goose. Therefore, as the current slump continues we are likely to see other sovereign debt crises a la Greece (this part of the article was written before the Portugal downgrade) in the shorter term. These sovereign crises will produce a temporary strength in the dollar. This will likely happen before we get to the point of high interest rates in the US and a partial default by inflation."

Needless to say, that is exactly what we have seen. But how long can UST temp fate? The short answer is that until something we call 'loss of conviction' sets in, the UST will not be in crisis. More to follow in the next post on the concept of loss of conviction and why it is so crucial.

Extrema Risk Blog is back

Dear friends,
As you may have (hopefully) noticed, Extrema Risk blog has been left unattended for a while. And as you may or may not know, one and a half years ago I assumed the role of the Head of Research at RiXtrema, the role that took up all of my time and then some. This role is a fulfillment of my dream of creating risk models that are actually useful in real life, as opposed to those that view financial markets as a continuous and orderly system (yes, traditional risk models still assume that).
The intense period of research and development at RiXtrema is over, our risk models are released and I have some time to dedicate to discussions of risk as part of my role at RiXtrema. So, I am (drumroll), reopening the discussion of extreme risk issues that we so abruptly left nearly 2 years ago now. The last two years, unfortunately, saw the world financial system move ever closer to realizing one of our predictions from early April 2010:

"...what specifically can risk managers do to be better prepared for the decade of Black Swans? It is our opinion that the focus of risk is now in the sovereign area and multiple partial defaults by inflation are likely worldwide. The uncertainty surrounding these events is very high, but, as we argued time and again, risk management is not about estimating specific sequence of events or their timing, but rather about identifying instability potential and dangerous trends and being prepared with contingency plans."

I want to thank all of the subscribers and welcome you back. This blog will be accessible on rixtrema.com, as well through this blogspot. Stay tuned!

Daniel Satchkov

Exponential growth anyone?

After recent Extrema post called "Inflation or Deflation" my friend Dr. David Mieczkowski has suggested that despite some correct points, my analysis of the threat of global inflation may be off-target, because of the push toward global austerity. He suggested that Japan's scenario of low growth, low inflation is more likely. My response (in the comments to that post) was that this view is missing the unprescedented fiscal crisis looming for many of the world's developed countries.
Here is one interesting tidbit of information. US debt grew by $166 bln in a single day on June 30. Surely, this figure is a bit artificial and US debt does not grow at such speed everyday (though it may start to). However, the sheer number is staggering and is worth pondering for a while. Add to this the potential impact of unfunded liabilities, which could be anywhere between $30 TRLN and $50 TRLN and you get the picture. How is it possible to get out of this hole? It is not clear to me how it can be done without inflation.
The history is clearly on the side of my forecast. It their excellent book "This time is different" Carmen Reinhart and Ken Rogoff examined hundreds of financial crises and showed that sovereign debt crises quite frequently followed banking crises. It is not hard to see why. The idea that financial sector is a completely free enterprise that may be allowed to fail has been cooked up by ivory-tower ideologues ignorant of reality. Financial sector has always been and will always have to be rescued in order to avoid depressions, thus putting pressure on government balance sheet. This time is not different in anything except scale.
I would be happy to amend my forecast if someone showed a workable way to fix this debt problem. I looked hard for such an explanation, but have not found one. This debt problem is so huge, it becomes, unusually for financial forecasts, a question of simple math. This math suggests that there are really only three choices:
1. Outright sovereign default.
2. Default by inflation
3. Cutting spending by 50 % or more.

Outright default is not going to happen, because US debt is in dollars and there is no reason to create an event that can become a calamity, if the same can be achieved by inflation (not hyperinflation which is a completely different animal). Cutting spending by 50% is practically impossible, not only because discretionary spending part of the US budget is around 38%, but also because it the cost of potential social instability is simply unacceptable for anyone with a sane mind. This leaves inflation. Very rarely can one have such clear arguments in economic matters, but I believe that we are in one of those rare periods in history when we can.

Deflation or Inflation

We appear to be at a turning point of sorts, yet again. After much vigorous monetary stimulation, US economy seems to be slipping into a second leg of the recession (or the double dip). All of the efforts aimed at monetary stimulation succeeded in making the banking system solvent, by essentially subsidizing it and moving the leverage onto the government books. However, they did not restart the lending activity and banks are content to be safe, while hoarding their cash. The money supply is contracting yet again and inflation is increasing at a far slower pace. Does this mean that everything we wrote about potential worldwide inflation threat is now less likely? Absolutely not. Contrary to some esteemed critics, who misunderstood our writing, our position was never based on monetary arguments. The initial stage of expansion of money supply was quite inevitable from the perspective of even such differing schools of economics as Neo-Classical and Keynesian (though not Austrian). We also saw no problem with replacing the initially lost money supply through expansion. Our argument for inflation and an eventual dramatic rise in the price of gold and in long term interest rates was based on a very simple precept. United States, with its total liabilities anywhere between 300-500% of GDP is unable to endure deflation without a catastrophe. In fact, in the medium term (3+ years), it is unable to endure anything other than high inflation without a catastrophe. If the inflation is not allowed to happen, the Great Depression will appear to be a golden age in comparison. The same holds true for many countries around the world who are essentially banrkupt. Those that are not bankrupt will not be able to sit idly and watch the indebted ones inflate away debts and inflate currencies, simply because their trade balances will deteriorate rapidly if they do. Therefore, we are heading into an era of global inflation, as we wrote before. Europe's attempts at fiscal austerity surely go against the grain, but I think that they will see the futility of fighting this trend (otherwise they will have to endure a useless bone-crushing recession only to finally succumb to inflation after their exports dry up). The US dollar is going to be the last to fall and is in fact likely to remain strong (relative to other currencies of course, it has been falling with respect to gold quite dramatically) for a while, because it appears as the less dangerous of the crazy bunch. In the short term, we will likely experience deflationary pressures, but these pressures will only serve to ensure the now nearly inevitable inflation by increasing the debt load due to attempts at restarting the failing growth. It is already nearly impossible for the Fed to 'pop the clutch', because doing so will speed up the process of default in the US and could make the US dollar the first one to fall (we still maintain it will likely be the last). Add to this the lifelong mission of Ben Bernanke to avoid the Great Depression deflation and I think we can be sure that deflation will only serve as the gasoline, albeit a slow acting one, on the fire of the eventual inflation.
We are not here passing judgement on the moral propriety of inflation or anything else for that matter. We are merely looking at facts and pointing out the direction.

Sir Alan Greenspan sees the light at the end of the tunnel

'Curiouser and curiouser!' cried Alice
Lewis Carroll, Alice in Wonderland

It appears that Alan Greenspan is seeing the light at the end of the tunnel. Unfortunately, it is the light from a train headed down the tunnel in our direction. After calmly projecting economic trends up to 2030 in his book "The Age of Turbulence", his outlook has changed. In his new WSJ op-ed he makes a decidely un-Fed like pronouncement:

"With huge deficits currently having no evident effect on either inflation or long-term interest rates, the budget constraints of the past are missing. It is little comfort that the dollar is still the least worst of the major fiat currencies. But the inexorable rise in the price of gold indicates a large number of investors are seeking a safe haven beyond fiat currencies."
It is interesting than when his former no.2 and Time Magazine Person of the Year, Ben Bernanke, was asked about this rise in gold price, his answer was: "I don’t fully understand movements in the gold price." Perhaps, mr. Bernanke should read the new Alan Greenspan for education.
Greenspan then goes on to strike a note that would have seemed unbelievable only a couple of years ago:
"The U.S. government can create dollars at will to meet any obligation, and it will doubtless continue to do so. U.S. Treasurys are thus free of credit risk. But they are not free of interest rate risk."

Ahh, the joy of money helicopters, why did Sir Alan have to ruin it?
Of course, we have been writing about the inevitability of eventual collapse of the Treasury bubble since 2009. Others were warning about it before us. But don't look for Alan Greenspan to find fault with any of the dollar creation that was done under his charge, he generously lets bygones be bygones. According to Greenspan, US is facing following stark choices:

"Only politically toxic cuts or rationing of medical care, a marked rise in the eligible age for health and retirement benefits, or significant inflation, can close the deficit. I rule out large tax increases that would sap economic growth (and the tax base) and accordingly achieve little added revenues."
Can anyone see elected officials rasing taxes or cutting away retirement benefits? If you believe that any of those things are politically feasible, then there is not much to worry about. The rest of us must realize that current financial risk is higher than it was before the 2008 collapse. Except that it is a different kind of risk. We extensively wrote about the types of risk we are facing here. Currency stress testing, hedging and carefully monitoring any long duration exposure to sovereign debt must be on the mind of every risk manager.
It is important to note that the interconnectdness of the global economy all but precludes the possibility of only one major country devaluing the currency (unless it is a hyperinflation). Thus, currency risk is high all around and most of the countries will be forced to devalue along with US. The US dollar will be the last one to fall. In the end of 2009, we predicted that the next decade will be that of Black Swans. Of course, they look more like Grey Swans, because they will not be a complete surprise to many observers, but their timing and particular trajectory could be unlike anything we have seen to date. Buckle up!

Behavioral Finance and Extreme Event Risk 2: Price-Fundamentals Feedback Loops

The Price-Fundamentals Feedback Loops
Today, we will continue the discussion we started in a post on Information Cascades. The fundamentals may depend on prices in a myriad of ways. Soros (1987) gives examples of companies fueling their growth by acquiring fast growing companies with stock which gives them higher valuation (since they now have a higher growth rate), which in turn gives them more stock to acquire fast growing companies and so on until the bust ensues. One of the price-fundamentals feedback loops during the tech bubble was the rise of spending by tech firms on tech products, which produced a self-sustaining boom-bust sequence. The recent crisis saw a number of price-fundamentals feedback mechanisms. As the house prices grew, owners withdrew cash from the equity and used it to propel spending in the economy thereby increasing GDP growth (see Figure 1), which made people feel even more confident about the future.
Figure 1: Price-Fundamentals feedback during 2003-2007 period



To be convinced that this loop actually took place (via the owner’s equity withdrawals), see this amazing chart from John Mauldin (http://www.frontlinethoughts.com/pdf/mwo101708.pdf):



Talk about tail wagging the dog. For statistical intuitions to be useful the possibilities and their probabilities must be known and more importantly themselves remain unaffected by the decisions of the participants. These conditions are obviously violated in the financial markets. The problems of information and judgment-fact feedback loops are the central problems that plague various economic theories of equilibrium, because they make the demand for financial assets highly unstable. This is the same reason that stylized psychological experiments examining statistical intuitions in a controlled setting are not applicable to finance. This is not to say that people always act rationally, only that as a practical matter, this irrationality cannot be used in any useful way to improve the risk management.

Let us summarize what we have learned and draw some conclusions for the practice of risk management. Traditional financial models assume that decisions are made by the independent participants, who incorporate all available information to form probabilities about the future possible states of the economy and then make buy and sell decisions based on this information. This independence assumption leads to stability of supply and demand in these models. This fallacious assumption is challenged by the empirical observation of information cascades and price-fundamentals feedback loops. These sharp changes in supply-demand relationships for the financial assets produced the extreme events are ignored by the traditional financial models. Risk models now used in the industry inherit this flaw when they use exponential decay weighting to slowly change the estimates of risk. This is precisely why all of the risk models rooted in the current paradigm showed low risk estimates in the beginning of 2007. They are simply ignoring the potential discontinuities and viewing financial markets as a stable system. In the words of the Basel Committee:
"…given a long period of stability, backward-looking historical information indicated benign conditions so that these models did not pick up the possibility of severe shocks nor the build up of vulnerabilities within the system. Historical statistical relationships, such as correlations, proved to be unreliable once actual events started to unfold… Extreme reactions (by definition) occur rarely and may carry little weight in models that rely on historical data.”

Let us reiterate an important point, the issue is not the irrationality per se, but the interdependence of the decision makers, particularly in the downturns, that presents the biggest problem for present day risk management. Rational participants can act in a manner which produces highly unstable markets in the presence of information cascades and price-fundamentals feedback loops, as is shown in a 1990 article by De Long, Shleifer, Summers & Waldmann. Likewise, irrational investors can produce a stable market in the absence of those two problems.
Practical Implications
1. PFF loops can make certain kinds of fundamental data nearly useless and, in fact, more dangerous than useless. This is because analysts and risk models will treat the price rises as dictated by the fundamentals and think that the market is on a solid footing. This happened repeatedly during the 2003-2007 period. For example, in July of 2005, Ben Bernanke was asked about a housing bubble during the CNBC interview.
CNBC INTERVIEWER: "Ben, there's been a lot of talk about a housing bubble, particularly, you know from all sorts of places. Can you give us your view as to whether or not there is a housing bubble out there?"
BERNANKE: "Well, unquestionably, housing prices are up quite a bit; I think it's important to note that fundamentals are also very strong. We've got a growing economy, jobs, incomes. We've got very low mortgage rates.”

Notice the fallacy that we discussed here. Bernanke gave “fundamentals” as the main reason for the explosive growth in house prices, including “economy, jobs, incomes”. Risk managers must forget about these types of fundamentals, they will never say anything useful about risk. In subsequent posts we will outline the metrics that risk managers can use to assess risk within the new paradigm of risk management that we are proposing.


2. When the price-fundamentals feedback loop is reversed, the results can be very drastic and swift, as the investors find out that so called fundamentals are little more than the mirror of price increases. Then, we have a double whammy of unwinding of a PFF loop i.e. a deleveraging, and a vicious information cascade where market participants begin to discard all fundamentals and simply focus on the waves of selloffs and possibly news of bailouts. If one looks back to the fall of 2008, it is easy to remember that, as the markets were crashing, many GDP estimates were still positive and the EPS estimates were still reasonable, but nobody cared, because investors instinctively knew that these so-called
‘fundamentals’ will unwind and reflect the prices rather than propping them up.
3. Lastly, and most importantly, the above conclusion shows that the fallacy in the common understanding of extreme events as unique Black Swans, which teach us nothing other than humility and the value of lottery tickets. In fact, all extreme events, despite having an infinity of possible causes, have similar characteristics (we will explore this further when we get to Hyman Minsky and the Financial Instability Hypothesis). A risk modeler and a risk manager must consider extreme events as a homogenous sample, which despite all their differences, have a great deal in common (this is why people speak of ‘rise in correlations’) and carry much more information than the ‘normal’ periods. In fact, ‘normal periods’ should be almost completely disregarded, which goes contrary to the current paradigm of risk modeling.



1. De Long, Bradford and Shleifer, Andrei and Summers, Lawrence and Waldmann, Robert, 1990, “Positive Feedback Investment Strategies and Destabilizing Rational Speculation”, The Journal of Finance, Vol. XLV No.2, June 1990.
2. Soros, George. The Alchemy of Finance: Reading the Mind of the Market. New York: Simon &Schuster, 1987.
3. Minsky, Hyman P., May 1992, "The Financial Instability Hypothisis", working paper #74.
4. Basel Committee on Banking Supervision (2009), “Principles for sound stress testing practices and supervision consultative paper”.

The Era of Sovereign Default (so soon?)

Today, we will revisit some of our prior posts in light of the recent market volatility and a sudden emergence of the sovereign default as a central issue. On April 3, we published an article called "Greenspan and Bernanke (part 2): The Era of Sovereign Default" and on April 12, the one called "Implications for the Risk Management Process".

On April 3, we wrote the following:
"The volatility in the US dollar will be quite high, but the currency crisis is not imminent. The current low stock volatility (VIX is at 17) has to go up, but as long as Fed has the flexibility to inject massive liquidity any major drop in nominal equity or real estate prices will not persist."

The VIX is now at 30 after briefly hitting 42. The zero percent rate and not any fundamental indicator is what basically kept the market from continuing in a freefall.

On April 3, we wrote:
"Though the situation of the US government is dire, it has a major asset in the US dollar, which still remains the world's reserve currency. Other countries do not have such a golden goose. Therefore, as the current slump continues we are likely to see other sovereign debt crises a la Greece (this part of the article was written before the Portugal downgrade) in the shorter term. These sovereign crises will produce a temporary strength in the dollar. This will likely happen before we get to the point of high interest rates in the US and a partial default by inflation."

The dollar have strengthened significantly and US likely has some time due to its reserve currency status. However, the long run default (by inflation) of the US is nearly inevitable. The dollar may strengthen even more before its ultimate devaluation.

On April 12, we wrote:
"Currency volatility is going to be very high even in the absence of any extreme events. Avoiding unknown currency exposure, hedging, stress testing of currency rates are all very necessary."

This point is of paramount importance, since it is not clear in where the crisis will spread. The euro plunge have proven our point with a vengeance and those that did not bother to make currency stress testing and hedging a part of their process are paying the price.


On April 12, we wrote:
" what specifically can risk managers do to be better prepared for the decade of Black Swans? It is our opinion that the focus of risk is now in the sovereign area and multiple partial defaults by inflation are likely worldwide. The uncertainty surrounding these events is very high, but, as we argued time and again, risk management is not about estimating specific sequence of events or their timing, but rather about identifying instability potential and dangerous trends and being prepared with contingency plans."

These trends are very firmly entrenched and even moreso after the events of the last month and the announcement of the European stimulus.


On April 12 , we wrote:
"There are very few true hedges against these sovereign partial default by inflation scenarios (as there are few true hedges to anything). Oil, gold and commodities appear to be the only reasonable long term hedges at the cost of high intermediate volatility (disclaimer: authors do own gold and derivatives on it since November 2008). Risk managers would do well to watch the events and make appropriate decisions on hedging if the situation clearly worsens. This might be the reason such astute speculators as George Soros and John Paulson are loading up on gold (while talking it down in the case of Soros)."

Gold of course, have had a violent move upward. We are not claiming that we have predicted the timing of the event, everything we write is a probabilistic projection meant not as a direct investment advice, but as a guidance for risk managers. Gold will continue to be one of the true hedges to the increasing instability (no, the real recovery is not around the corner, unfortunately).

On April 12, we wrote:
"It is frequently said that the generals are prone to fighting the last war. Similarly, the world monetary authorities are still fighting the liquidity crisis, when there is really a worldwide solvency crisis looming. The coming decade can make 2000's seem calm by comparison."

The actions of Eurozone, preparing to inject $1 Trillion were almost inevitable, given the economic and political circumstances. However, it is quite impossible to solve the debt problem in the long run by printing or borrowing money (though the latter is possible, when a country's balance sheet is strong, not the case with Europe or US at the moment).
The bottom line is that our suggestions, some of which may have become obvious during the last few weeks (this is what happens when you are right), should really be implemented as part of a long term risk management process.
There are two things that we talked about that did not happen, yet should be on the radar of every risk manager for a long run:
1. Significant (400-500 bp) increas in the long term rates in the US and worldwide.
2. A number of global defaults by inflation culminating with the partial default by the US Government.
(not necessarily in that order)
Our advice given in the end of 2009 still stands: "Buckle up!".

Disclaimer: Authors do own gold and its derivatives.
Disclaimer 2: All this is merely our opinion, nobody has a crystal ball.

The Fun of Risk: Funny and Occasionally Insightful Financial Quotes

1. "The fact that our econometric models at the Fed, the best in the world, have been wrong for 14 straight quarters does not mean they will not be right in the 15th quarter."

Alan Greenspan


2. “You take hundreds of drunks staggering down the street, and you make them put their arms under each other's shoulders and lock hands. Then you rely on the fact that they are falling in different directions”

Anonymous investment banker on the modern idea of diversification quoted by John Cassidy in "How Markets Fail"



3. “We go about managing risk and market activity every day at this company.
It is what our clients pay us to do and, as you know, we are pretty good at it.”

Stan O’Neill former CEO of Merrill Lynch


4. “We will administer a little coup de whiskey to the market”

Ben Strong Head of New York Fed in 1927 of lowering the cost of money to fuel the markets

5. "Stock prices have reached what looks like a permanently high plateau."
Irving Fisher on October 21 1929, just a few days before the 1929 Crash


6. “Every time there's been a fire, these guys (derivative traders) have been around it."
Nicholas Brady, Secretary of Treasure of Treasury under R.Reagan and G. Bush

7. “Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called “liquidity”. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.”
John Maynard Keynes



8. “Indeed, the typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so, may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. It was a privately and socially costly waste of time and other resources.”

William Buiter, Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC


9. “The most important financial innovation that I have seen in the past 20 years is the automatic teller machine, that really helps people and prevents visits to the bank and it is a real convenience.”
Paul Volcker


10. “Chariman Greenspan might wax lyrical about the unbundling of risks, but we spend most of our waking hours rebundling the risks and stuffing them down the throats of any investors we can find”
Satyajit Das, Derivatives Expert

11. “When I think that I had some input into the creation of this product(…the type of thing which you invent telling yourself: 'well, what if we created a 'thing', which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?") it sickens the heart to see it shot down in mid-flight...It's a little like Frankenstein turning against his own inventor ;)”

Fabrice Tourre, Goldman Sachs Executive Director


12. "I managed to sell a few abacus bonds to widows and orphans that I ran into at the airport, apparently these Belgians adore synthetic abs cdo2,"

Fabrice Tourre, Goldman Sachs Executive Director

Behavioral Finance and Extreme Event Risk 1: The Information Cascades

The Rational Madness of Crowds

Alice: But I don't want to go among mad people.
The Cheshire Cat: Oh, you can't help that. We're all mad here. I'm mad. You're mad.
Alice: How do you know I'm mad?
The Cheshire Cat: You must be. Or you wouldn't have come here.
Alice: And how do you know that you're mad?
The Cheshire Cat: To begin with, a dog's not mad. You grant that?
Alice: I suppose so,
The Cheshire Cat: Well, then, you see, a dog growls when it's angry, and wags its tail when it's pleased. Now I growl when I'm pleased, and wag my tail when I'm angry. Therefore I'm mad.

Lewis Carroll, Alice in Wonderland

Behavioral finance is a field that has been gaining in importance over the past two plus decades of its existence. This growth has accelerated since the 07-08 credit crunch due to the apparent inability of the traditional finance models to anticipate or even to account for such tremendous and sudden market swings on the basis of precepts of rationality and models of equilibrium. Our goal is to look for aspects of BF that are relevant to the investors and, in particular, to the practitioners of risk management. Before we get to the useful aspects of BF, let us point out an area which we believe has been extremely overrated in terms of its applicability to the financial markets. We are talking about the field of inquiry pioneered by Daniel Kahneman and Amos Tversky, which is primarily based on the psychological experiments in a controlled setting. They are usually based on pre-defined questionnaires based on the answers to which the researchers determine some flaws in the decision making patterns of subjects. To begin with, these experiments are almost always designed with an apparent goal of achieving a specific result and as such can be worded in a somewhat suggestive manner. We do not imply any bad faith on the part of researchers; however this problem is always present in psychological testing. We intend to write a separate section with examples in the future, but this discussion is not appropriate here, since these design flaws do not play any important role in our argument. Even if we completely accept both the design and interpretation of the results of such tests, we must conclude that they are irrelevant for finance practitioners. The reason is that the stated objective of this branch of BF, as expressed by Kahneman and Tversky is to study how “intuitive predictions violate the statistical rules of prediction in systematic and fundamental ways”, see Kahneman & Tversky (1982A). As they conclude in Kahneman and Tversky (1982B), “The fundamental notion of statistics is evidently not part of people’s repertoire of intuitions”.

This powerful observation led to the development of an old line of thinking, where investors are thought of as an ‘irrational herd’ or a ‘crowd’. Popular and entertaining books on the subject have been written such as “Mobs, Mobsters and Financial Markets” by William Bonner and Lila Rajiva and “Black Swan” by Nasseem Taleb. The reality of the irrationality research is less exciting. While the study of deviations from statistical rules may be useful in some fields of study, it is not much use in the financial risk management. The problems of sharp market reversals do not stem from the impaired statistical judgments, but rather come from the lack of information or lack of confidence in the information that is available. This lack or unreliability of information is a primary cause of what is termed “information cascades”. Roughly speaking, an information cascade can form when investors, instead of basing their judgment only on the information in their possession give some weight to the decisions of others that they observe. In the financial markets, they observe these decisions most frequently as the moves in market prices, so they are immediately placed in the minority, if their views are different. The temptation to discard one’s own information and judgment is very strong in such a case.
This lack of information is severely exacerbated by the lack of separation between investor’s judgments and the fundamental market facts about which they are deciding. This is what a famous speculator George Soros in his books “The Alchemy of Finance” and “The New Paradigm Of Financial Markets” called ‘reflexivity’.

Information Cascades
We will deal with the price-fundamentals feedback loop a bit later, and for now we will focus on a pure information cascade. In one of the best empirical studies of information cascades at work during the extreme financial events, Robert Schiller (2000) sent out questionnaires asking investors what was on their minds during the 1987 Black Monday stock market crash. And astonishing result was that there were not any fundamental news or issues troubling investors, but rather they were thinking of the previous week’s market declines. It is clear that investors treated previous week’s declines as information signals coming from other participants, which prompted them to discard their own information and beliefs. In fact, Bickhchandani, Hirshleifter and Welch (1992) defined information cascade as “a sequence of decisions where it is optimal for agents to ignore their own preferences and imitate the choices of the agent or agents ahead of them”. Schiller also studied news media before 1929 crash and found very similar pattern. Clearly, the crash of 08 cannot be characterized as coming on the heels of no news, since Lehman’s collapse constituted a drastic development, which stunned the market. However, Lehman’s collapse is also an example of an cascade, albeit of a different kind, which we will discuss in the next post. The complicating, and in fact, a key factor in the crash of 08 was the unprecedented leverage taken on by the financial sector. We will discuss the crash of 08 in much more detail when we get to the price-fundamentals feedback loops and the Financial Instability Hypothesis in the next two posts. Information cascades are not purely financial phenomena, there are present in a multitude of social system settings. For example, there is a sizable literature dealing with information cascades in sales of movie tickets. The best hypothetical example of such a cascade is given by Robert Schiller in the “Irrational Exuberance”. Consider a hungry person standing before two empty restaurants with no knowledge about the quality of food in either one of them. Clearly, his choice is random. If now a second person is in the same position, she will see one restaurant with one customer and one without any customers. The single customer will serve as the only piece of information differentiating between the two choices. The odds may now be slightly tilted in the favor of the restaurant that received one random customer. If two people choose the same restaurant, the tilt toward it will be even higher. If this game repeated many times, as it usually happens in the social systems, the probability of an information cascade forming can be very high. This intriguing example makes it appear that the information problems are the sole source of the heavy tales formed as the result of the cascades and that financial markets will necessarily be more stable when more information is available. Even though this is partially true, this line of thinking disregards another problem that is even more serious than the interdependence of decisions, a problem which can magnify price moves by affecting the very fundamentals that form the basis for such independent thinking that does exist. Before we get to the price-fundamentals feedback loops in the next posts, let us spell out some preliminary implications for risk managers based on the concept of information cascades:
1. Information cascades are ubiquitous in finance and by their very nature necessarily lead to fat tailed distributions, even though these tails may not be apparent for long periods of time. This means that risk models must account for them and it also suggests that long periods of low risk premiums in any market should be a major cause for concern at the risk management departments, since the return of the tails is inevitable when the trend reverses. There are no ‘new eras’ of low risk premiums, only periods when cascades work to prop up the market and artificially dampen volatility (we are clearly in one of those periods now).
2. Another important implication is that there are very similar mechanisms at work during all extreme events. This doesn’t mean that they are identical in their details or caused by similar triggers, but it does mean that extreme samples can to some degree be treated as ‘homogenous’ for the purposes of stress testing and distribution estimation.
We will develop these conclusions further into a formidable new framework after we discuss price-fundamentals feedback loops and the Financial Instability Hypothesis.

Next Posts:
Behavioral Finance and Extreme Event Risk 2: The Price-Fundamentals Feedback Loops

Funny Financial Quotes (a break from behavioral finance to take a look at some amusing financial quotes that I have collected over the years)

Behavioral Finance and Extreme Event Risk 3: Hyman Minsky and the Financial Instability Hypothesis

Behavioral Finance and Extreme Event Risk 4: Practical Conclusions for a Risk Manager

References:
Tversky, A., Kahneman, D., 1982A, On the Psychology of Prediction, in
Judgement under Uncertainty: Heuristics and Biases, D Kahneman, P Slovic and A Tversky

Tversky, A., Kahneman, D., 1982B, Judgement under uncertainty: heuristics and biases, in
Judgement under Uncertainty: Heuristics and Biases, D Kahneman, P Slovic and A Tversky

Shiller, Robert J., 2000, Irrational Exuberance, Princeton University Press

Soros, G., 1987, The Alchemy of Finance, Simon & Schuster

Soros, G., 2008, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means, Public Affairs

Greenspan and Bernanke (part 3): Practical Implications for a Risk Management Process

Keeping in mind our discussion in parts 1 & 2 and the apparent benign view of low interest rates taken by the US monetary authorities, what specifically must risk managers do to be better prepared for the decade of Black Swans? It is our opinion that the focus of risk is now in the sovereign area and multiple partial defaults by inflation are likely worldwide. The uncertainty surrounding these events is very high, but, as we argued time and again, risk management is not about estimating specific sequence of events or their timing, but rather about identifying instability potential and dangerous trends and being prepared with contingency plans.

Some Implications for a Risk Management Process
1. Risk managers must implement stress tests shocking longer term interest rates by 400-500 bp in the US. This rise as not a Black Swan (which is unexpected), it is a virtual certainty, though the timing, of course, is not known (it could take months or years). Even the Fed itself strongly urged such stress tests (though I cannot now find the link with their memo to the banks with that suggestion).
2. Now more than ever, firms must avoid taking risks that they do not fully comprehend (and do not have a plan for hedging out quickly). Currency volatility is going to be very high even in the absence of any extreme events. Avoiding unknown currency exposure, hedging, stress testing of currency rates are all very necessary.
3. Extreme risk cannot be diversified away, it can only be hedged (especially since the counterparty risk is lower due to governments' belated realization that systemic financial institutions cannot be allowed to fail).
4. Those that invest in the emerging markets in hopes of diversifying US exposure will again learn that under conditions of global mobility of capital this supposed decoupling will provide about as much protection as an umbrella from a nuclear strike. However, the equity and housing markets in the US will likely be supported by the Fed until it is no longer able to do so and this will provide a sort of "Bernanke put". This doesn't mean that there is no downside in those markets, it just means that Fed will do its best to put some support level underneath them with liquidity injections.
5. Risk managers have to watch for signs of large scale monetization of US debt. Once it starts, there is a possibility that the events will move very swiftly. One way to follow it is to watch the Fed's custody account growth which will indicate how much the foreigners are really buying (The Martenson Report gives a very solid analysis of the numbers). Another perspective on the magnitude of the debt problem is to look at what would have to be done to reduce it to a manageable level (and even those projections are far far too rosy).
6. Every risk manager must become an expert on China, because they hold the key to how the events will unfold in the short to medium term (the long run consequences are pretty unavoidable at this point). This is not because their economy is in perfect shape (they will have a difficult time adjusting to a less of an export economy in this environment), but in the current situation it is their decision on whether to continue to be a financing supplier of the low cost consumer goods to the US is the linchpin on which the whole precarious structure hangs (absent major external shocks as mentioned above). For example, if China decides to revalue their currency upward, due to the rising inflation, as the US monetary policy spills over to China, this could signal the start of the inflation in the US in earnest. Success of US pressure to revalue the yuan upward would have a similar effect.
6. There are very few true hedges against these sovereign partial default by inflation scenarios (as there are few true hedges to anything). Oil, gold and commodities appear to be the only reasonable long term hedges at the cost of high intermediate volatility (disclaimer: authors do own gold and derivatives on it since November 2008). Risk managers would do well to watch the events and make appropriate decisions on hedging if the situation clearly worsens. This might be the reason such astute speculators as George Soros and John Paulson are loading up on gold (while talking it down in the case of Soros).

It is frequently said that the generals are prone to fighting the last war. Similarly, the world monetary authorities are still fighting the liquidity crisis, when there is really a worldwide solvency crisis looming. The coming decade can make 2000's seem calm by comparison.

Greenspan and Bernanke (part 2): The Era of Sovereign Default

In a previous post we have seen how the Fed Chairmen Greenspan and Bernanke levered up the US economy to a near Ponzi finance level and subsequently tried to steer the discussion in the direction of housing and away from the overall leverage of the economy (of which housing was only a subset). This excess (some level of leverage is obviously good) leverage for the most part did not leave the system yet. Whether for better or worse the deleveraging has been prevented by the actions of the Fed. It undoubtedly saved the economy from some major short-term pain. How serious the long run consequences will be is debatable, but that they will be serious is clear enough. Under conditions of global trade and more importantly of global mobility of capital a credit bubble in a major economy like the US affects the whole globe. As we have argued before, so-called 'decoupling' is an impossibility under existing circumstances. If the deleveraging is inevitable and only a partial deleveraging took place (and even that was mostly rescinded with the help of zero interest rate), how will the world economy deleverage? Deleveraging is essentially a process of debt reduction which can come about by the sale of assets to pay off debts and is usually accompanied by the cascading seloffs and resulting insolvency of all of the weakest and even some of the sound players (one of our next posts will deal explicitly with this process from the perspective of Hyman Minsky's Financial Instability Hypothesis). All this is simple enough, but what if the deleveraging is prevented by the money creation, as it is now? The only possible answer is that deleveraging will take a different form. This is precisely why we are entering an Era of Sovereign Default. When the government essentially socializes leverage, it has to bear all of the consequences up to and including the default risk. To be sure, we are not here arguing that government should not have rescued the financial institutions. Once they were allowed to become as big as they did and do the things that they did, a government bailout was quite necessary in order to avoid a complete meltdown of asset values and the depression (how this situation could have been prevented is a separate topic). So, if the governments took on leverage, how will they carry that burden? They can't, of course. As an example, US economy would have to grow at a double digit pace for a long long time in order to pay off the debts now accumulated in the financial system (this includes both government and private sector debt) and the same is the case with many other economies. So, there is essentially one option: inflation. Inflation is a default without the short-term pain and shame and is available to those governments who can pay off debt with their own 'printing presses'. It is interesting that inevitability of the inflation is agreed to by both the most severe critics of the Fed like Peter Schiff and Marc Faber, as well as by those who very much support the current administration like George Soros (see "Crisis of 2008 and what it means" by him). Our concern is the implications of the current situation for the risk management going forward.

Mechanics of Zero Interest Rates
To look at this same issue from a slighly different angle, let us again consider the arguments of Greenspan and Bernanke which we dealt with in a previous post.
There is a reason beyond self-exoneration for why both Chairman Bernanke and Chairman Greenspan argue that low Fed funds rate did not fuel the housing bubble and why they used the housing bubble to downplay the unprecedented gearing up of the whole US economy in the 2000's. They are, of course, shifting the blame away form themselves, but there is a bigger picture. They are, indirectly (especially Bernanke, since it is his burden now) making arguments for keeping the low Fed Funds rate (even if it is raised to 1 or 2 %, that is still extremely low) indefinitely. Very low interest rates are here to stay for a long time and that has tremendous implications for the extreme event risk.

Whether it is good or bad zero interest rates effectively prevented the deleveraging of the world economy after 2008. Much of the financial leverage had been transferred onto the shoulders of US currency. Interest rate hikes of the sort that Paul Volcker used to stop inflation are now not possible in any foreseeable future when both the US government and the US consumer are highly indebted. To compound this problem much of the US government debt is short term, robbing it of any real flexibility of action. The housing market is being propped up by the low interest rates and may collapse if the rates are raised. Despite all our criticism of Chairman Bernanke's statements, it is clear that he has very few real alternatives. The one that produces the least short term pain and is thus politically acceptable is to slowly inflate the money supply to reduce the debt burden on the economy and the government, all the while making noises about "exit strategy". Neither raising interest rates anywhere close to historic averages nor sales of the toxic assets accumulated by the Fed are even remotely feasible. Thus, inflating the money supply, while trying to keep the consumer inflation in check is the real game of the Fed. Here, they depend on the low cost producers like China continuing to play the game of exporting consumer good deflation to the US in exchange for the ability to ramp up its own productive capacity and push US further into debt. Based on the above fact some observers concluded that US may soon experience hyperinflation and China will become the main player in the world economy. All this may be possible, nay even probable, but we still have ways to go that point.

History
All these arguments are also strongly supported by the history of the financial markets. After the incredible leveraging up of the world economy that we witnessed under Alan Greenspan, some sort of banking crisis was quite inevitable. Our position here is that it will lead to a sovereign default that can take the form of the orderly inflation or of a rapid currency devaluation (i.e. a currency crisis) for many countries around in the world, including most importantly the United States. The empirical relationship between a banking crisis and a currency crisis is very strong. As Kaminsky and Reinhart argue in a fascinating 1998 paper called "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems":

"Most often, the beginning of banking sector problems predate
the balance of payment crisis; indeed, knowing that a banking crisis was underway helps predict a future currency crisis. The causal link, nevertheless, is not unidirectional. Our results show that the collapse of the currency deepens the banking crisis, activating a vicious spiral."

These relationships are further studied and confirmed in an equally superb 2010 book by Carmen Reinhart and Kenneth Rogoff called "This Time is Different: Eight Centuries of Financial Folly", where they rigorously examine hundreds of years of financial history and crises.

The Trends

1. The Fed will do everything in its power to orderly inflate the dollar supply without causing the currency crisis. China has given every indication that it will play along for the foreseeable future. Chinese are not stupid and are probably already resigned to the fact that they will have to take a significant haircut on all of their dollar assets in order to delay or avoid a global crisis and a painful adjustment to a less of an export driven economy. They appear to favor slow realignment, while keeping the duration of their US debt holdings low. If all this holds up and no external shock (a war, a string of sovereign defaults) occurs, the current situation will continue for some time. The volatility in the US dollar will be quite high, but the currency crisis is not imminent. The current low stock volatility (VIX is at 17) has to go up, but as long as Fed has the flexibility to inject massive liquidity any major drop in nominal equity or real estate prices will not persist.
2. The turning point will come when the US is forced to monetize debt on a large scale (so far, the Chinese are still buying). This can happen as a consequence of a change in China's policy, but that is unlikely in the short term (unless Geitner and Congress succeed in their suicidal push for the Chinese to revalue their currency upward quickly). It will definitely happen if the course that we are on continues to the point when servicing liabilities becomes a significant part of the Federal budget. We are still not there.
3. Though the situation of the US government is dire, it has a major asset in the US dollar, which still remains the world's reserve currency. Other countries do not have such a golden goose. Therefore, as the current slump continues we are likely to see other sovereign debt crises a la Greece (this part of the article was written before the Portugal downgrade) in the shorter term. These sovereign crises will produce a temporary strength in the dollar. This will likely happen before we get to the point of high interest rates in the US and a partial default by inflation. In the era of sovereign default, countries in the Eurozone are the only ones (among the countries whos debt is denominated in their own currency) likely to experience anything remotely resembling a real default (as opposed to default by inflation, which we believe will be endemic). This is because countries within the Euro zone do not really control their own monetary policies. In the long run, this is a strong pro for Euro, but as Lord Keynes aptly and grimly observed once: "In the long run, we are all dead".

Since this post turned out to be much longer that we originally planned, we are breaking it up. Thus, the Part 3 of the Greenspan and Bernanke series, which will contain specific suggestions on the modifications in the structure of the risk management process in light of the developments analyzed in parts 1 & 2 will come out in a few days under the title:
Greenspan and Bernanke (part 3): Implications for a Risk Management Process

The following posts will be as announced earlier:
"Behavioral Finance and Extreme Event Risk: Information Cascades"
"Behavioral Finance and Extreme Event Risk: Disaster and Interrelatedness Myopia"

Bernanke and Greenspan: Passing the buck. Part I.

“The buck stops here”
The sign on the desk of the President Harry Truman
“The buck starts here”
The sign on the desk of the Fed Chairman Alan Greenspan

Following Ben Bernanke's passionate defense(we have deconstructed the Chairman Bernanke's arguments here and here) of the Fed's monetary policy vis-a-vis the housing bubble, the Maestro himself weighed in on the matter. At first glance it seems that Mr. Greenspan has actually tried to learn from the crisis and that US monetary policy will be all the wiser for it. He acknowledges that :"In the growing state of high euphoria, risk managers, the Federal Reserve, and the other regulators failed to fully comprehend the underlying size,length, and impact of the negative tail of the distribution of risk outcome". Greenspan basically acknowledged that he was a victim of Disaster Myopia - a well known psychological phenomenon that stretches far beyond financial markets. Speaking of flood insurance Slovic, Fishhoff, and Lichtenstein (1980) quote Kates (1962) :"Recently experienced floods appear to set an upward bound to the size of loss with which managers believe they ought to be concerned(p.140)". They further say :"He (Kates) observed that individuals forecasting flood potential "are strongly conditioned by their immediate past and limit their extrapolation to simplified constructs, seeing the future as a mirror of that past" (p.88). Similarly, the purchase of earthquake insurance increases sharply after quake and then decreases steadily as memories fade (Steinbrugge, McClure, & Snow, 1969)." Memories of central bankers and many market participants seem to be purged even quicker than of those worried about floods. Even so, how Mr. Greenspan, who was heading the Fed during the near meltdown of 1998 and tech bubble crash of 2000, could be unaware of the left tail is somewhat of a mystery. Even this modest admission was partially rescinded when the Maestro added: "To this day it is hard to find fault with the conceptual framework of our [financial risk management] models as far as they go." The timing of this remark is particularly prescient for us because we are starting this blog with the explicit purpose of discussing extreme left tail events and the reasons for the inability of much of the present day risk modeling to deal with them.
A New Twist
We have written before about Ben Bernanke's fantastic claims that zero interest rates in early to mid 2000's did not affect the home prices. Mr. Greenspan unsurprisingly comes to the same conclusion but his reasoning is considerably different from that of his former subordinate. His reasoning goes as follows: "The global house price bubble was a consequence of lower interest rates, but it was long term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seeming conventional wisdom."
This argument would be understandable if a person making it had spent last 20 years on planet Mars and had no clue about any recent financial developments. Apparently, the Maestro does not understand that in the financial economy characterized by the high level of securitization the real lenders are those who are purchasers of the securitized loans. Many of the purchasers of Mortgage Backed-Securities (MBS) like hedge funds and banks' special investment vehicles (SIV) have employed ultra short term financing with mind boggling leverage thanks to the free short term money. A case in point are the two MBS Bear Sterns hedge funds that in 2007 needed to make heavy margin calls (only those that employ short-term financing need to meet margin calls, their leverage was 17:1) and thus were one of the first harbingers of disaster. The absurdity of this argument obscures an interesting question. Why did Mr. Greenspan not follow the defense of the Chairman Bernanke when he put the blame on the creative financing and ARMs in particular? Perhaps this quote made by Alan Greenspan in 2004 sheds some light on his reluctance: “Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward. …
American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.“ This is like encouraging college students on a spring break to switch from jegermeister to vodka around midnight. We all know what followed.

Stat Gymnastics
"By way of complicated multiplication and division he showed the superiority of the Soviet rule over any other possible kind of rule"
Ilya Ilf and Evgeny Petrov in "The Golden Calf"

Mathematical statistics are an immensely useful tool, but they have to be used in good faith and by those who know its assumptions and limitations. Whether Mr. Greenspan falls into at least one of those categories we have no way of knowing. But his proof of the claim that the Fed funds rate delinked from the mortgage rate in 2002 has a distinct smell that is not Chanel. He argues: "But the 30-year mortgage rate had clearly delinked from the fed funds rate in the early part of this decade. The correlation between the funds rate and the 30-year mortgage rate fell to an insignificant .17 during the years 2002 to 2005, the period when the bubble was most intense, and as a consequence, the funds rate exhibited little, if any, influence on home prices."
What are we to make of this apparently rock solid statistical argument? We get our answer in the next paragraph when Maestro writes: "The funds rate was lowered from 6.5% in early 2001 to 1.75% in late 2001...". The correlation coefficient is the standardized measure of the common variation between two random variables. As real short term interest rates were reduced to effectively zero and were not raised for years, their variation became so low as to vurtually be non-existent. Where one variable has no variation measuring covariation or correlation is as useless as the work of Sisyphus of the Greek mythology. Thus, using the same argument as employed by the former Chairman above we could prove that zero nominal interest rates from 2008 onward had no effect on any of the financial markets, because the covariation of a constant zero with anything else is zero. The relationship between fed funds rate and long term rates is strong, but correlation can be a very bad tool to measure it. Indeed, p.38 of the paper states that :"The correlation coefficient in the US between the Fed funds rate and the 30-year mortgage rate from 1963 to 2002, for example, had been a tight 0.83." When there is significant variation, the relationship can be quite high over a reasonably long period.

Losing Forest Behind the Trees
The debates about housing, however, tend to obscure the real issue, sort of like losing forest behind trees. Between 2002 and 2006 the total indebtedness of the US economy increased by roughly 13.5 trillion dollars. Only about 4.4 TRLN can be attributed to the households, of which mortgages are a subset. 2 TRLN went to various governments and 7 TRLN to businesses. Of this 7 TRLN, a whopping 4.2 TRLN went to the financial sector, see Cassidy (2010). Thus, Mr. Greenspan presided over the biggest credit binge this little planet has ever seen.
We are writting all this not with the intention of focusing on the two of the Fed Chairmen personalities, but with a real practical purpose of improving the understanding of the extreme events and the potential for instability. In the next post we will discuss the implications of our discussion on the global financial volatility in the coming decade.

Next Posts:
"Greenspan and Bernanke: Passing the buck. Part 2 - The Future"
"Behavioral Finance and Extreme Event Risk: Information Cascades"
"Behavioral Finance and Extreme Event Risk: Disaster and Interrelatedness Myopia"

References:
1. Slovic, P., Fischhoff, B. & Lichtenstein, S. (1980). Facts and fears: Understanding perceived risk. In R. Schwing and W. A. Albers, Jr. (Eds.), Societal risk assessment: How safe is safe enough? (pp. 181-214). New York: Plenum Press.
2. Kates, R.W. (1962). Hazard and Choice Perception in Flood Plain Management. Department of Geography Research Paper no. 78, University of Chicago Press.
3. Steinbrugge, Karl V.; Algermissen, Sylvester T. (1969). Studies in seismicity and earthquake damage statistics. Report Department of Commerce, Washington, DC. Appendix A, B, Summary & Recommendations
4. Cassidy J. (2010). How Markets Fail: The Logic of Economic Calamities. Farrar, Straus & Giroux.