First published 8th August, 2008
When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Citigroup CEO Chuck Prince, FT Interview, July 2007
How things have changed in the short space of a month.
For, right up to the second half of July, world equity markets were still raging ahead in utter denial of the spreading cracks in the credit boom, with both the S&P and the emerging markets indices making new highs in that time .
This was despite the fact that all the technicals were signalling the need for caution – elevated sentiment readings; record high margin longs on the NYSE; record low mutual fund liquid asset percentage holdings; a turn in the breadth of the market (that for the Nasdaq has, indeed, since hit multi-year new lows); volatility indices climbing with – rather than against – the rise in stocks.
More crucially, there was still an attempt to downplay the magnitude of the problems finally coming to boil in what has arguably been the most spectacular mass hysteria in the whole sorry history of financial market manias – the multi-trillion Ponzi scheme of credit we have created since the collapse of the Technology frenzy.
We have long told anyone arguing that commodities have occasionally displayed bubble-like behaviour that they were no more susceptible to this kind of infection than any of a number of other asset classes – both conventional and ‘alternative’ – and that this was unlikely to pass until the we had removed the cause of all this mischief, namely, the credit bubble which had continuously been inflating prices everywhere you looked (though, ironically, everywhere the central banks were choosing not to look, at the same time).
The real bubble, we maintained, was in credit: all others – whether in lead futures, LBO targets, Patek Philippe watches, or Modernist daubings – were ancillary to what the woefully uncomprehending ex-Fed Chairman once called a ‘conundrum’, but which was, in reality, all too understandable a phenomenon.
In saying this, we would be assailed on the one side by starry-eyed mining promoters (many of whom had increasingly only come across a ‘mine’ in the reference section of the Harvard library) who would insist on telling us that our caution was misplaced; that we ‘didn’t get it’ because we didn’t understand China’s influence on the supply:demand dynamics of the metals concerned (sic!).
On the other hand, we have been haughtily dismissed by institutional investors who could very well scoff that, say, nickel might be overstretched in the near term, but who were still perfectly content to buy yet another gallimaufry of dubious, rag-tag credits from their over-eager investment bank account managers, each secure in the belief that the hocus-pocus which purported to value these baskets afforded him a wide margin of safety.
As the events of the past few weeks have begun to reveal, however, this last presumption has proved just as fatal as all of its many less-than-illustrious predecessors in the perpetration of mathematical hubris.
Indeed, it is a compelling testimony to our capacity for pseudo-rational self-delusion that so many could still cling to the idea that something as intensely self-reinforcing as the financial markets – institutions in which those highly non-linear and inherently unquantifiable actors known as ‘human beings’ are at play (and largely with Other People’s Money, at that) – can ever yield to the same statistical calculus as a laboratory vessel full of inanimate gas particles.
Without delving into the wide chasm between ‘risk’ (a realm where models can be made to work) and ‘uncertainty’ (one where they decidedly can not), without drawing upon the insights of Austrian epistemology, without citing Nicholas Taleb’s famous metaphor of the ‘Black Swans’, did no-one stop to think that if their model was supposed to be so hot, then so, in all likelihood, was everyone else’s?
Had they done so, they would have realised that not only must buying assumptions have become claustrophobically crowded (i.e. very efficiently irrational!), but that – far worse in its implications – once the market turned, all these blessed computers would be revealed to be disastrously mispriced in one horrible unison.
After all, if everyone was running much the same CDO-analytical version of Deep Blue, did no one ever ask themselves whether they were really enough Gary Kasparov’s out there on whom to unload the junk once the models all began to flash, “Sell!”, at the same time?
Obviously not. And yet, even now there is a current of denial still insidiously at work in the minds of people who don’t wish to acknowledge that their own deeds, as members of the undiscerning Herd, have given rise to what they insist on misconstruing as just one more ‘six sigma event’.
Apart from “the problem is fully contained” school of hopeless little Dutch boys and the usual crowd of “buy the dips (preferably from me)” chancers, the air is filled with the dreary strains of that eternal Chorus intoning “the economic fundamentals are sound”, even as all manner of high-falutin’ investment schemes implode around us.
Have you ever remarked upon the strange fact that when asset prices are rising, their ascent is the inescapable consequence of a solid ‘fundamental’ underpinning – no matter how unrealistic have become the valuations of the assets the pundit himself is touting. The market is, after all, a ‘discounting mechanism’, don’t you know?
Now, contrast this with the reaction once that same market suffers one of its periodic bouts of vertigo. Far from being an unbiased reflection of disembodied knowledge, the reversal can now only be ascribed to an access of the vapours on the part of a few ill-informed neurotics!
What is more, this asymmetrical mental ratchet effect (in part, the sort of ‘model arrogance’ discussed above; in part, wishful thinking; in part, cynical salesmanship) misses the fact that just as financial market conditions exert a clear and undeniable influence on the real economy in the upswing (we do mostly direct our efforts toward the prospect of monetary gain, remember), they can hardly fail to do so in the downleg as well.
To those who would here interject that this is all irrelevant because ‘”for every loser there is a winner”, we would point out another glaring asymmetry – not that which exists between sellers and buyers, so much as that between assets and liabilities in our highly-interconnected world.
To aver that the gains made by the man who sold a since-fallen stock at the top constitute a zero sum with the losses of the man to whom he sold is a statement which only holds at an immediate and individual level: at the systemic one, the truth is never so reassuringly self-correcting.
For a start, our self-congratulatory high-seller will probably have plunged straight back into the market and bought some other claim on Dame Fortune with his gains. Being still exposed, therefore, he may well see his notional profit eroded as his new holdings are, in turn, pulled lower – perhaps as a direct consequence of his original counterparty’s distress.
More importantly, the top of the market for this particular asset was unlikely to have been reached thanks to a calm shifting of a greater proportion of a finite pool of money preferentially from its alternative outlets: alternatives which therefore had to cheapen both relatively and absolutely and whose countervailing decline must, accordingly, have exerted a genuine, intrinsic mechanism of restraint on the game.
Instead, the system in which we must operate is inherently unstable, like the moisture-laden, summer air over the warm tropical ocean.
Only let a share, or a group of bonds, or a new-fangled class of derivative instruments puff up, lazily, into the view of speculators and their avid lenders and, before you can say “the ghost of John Law”, the hot winds of credit are filling it and driving it higher and higher into the troposphere – an ascent which not only induces more and stronger currents of air to lift it yet further, but which catches all other asset classes willy-nilly along with it in its swelling updraught.
In this regard, what we have lived through, these past few years, is nothing less than the genesis of a Category Five, super-cyclone – one whose terrifying eyewall is a screaming vortex of collateral-debt-derivative feedback.
Once such a storm breaks, our asset-liability bind will be seen to be the critical weakness, the Mississippi levee whose failure could well swamp us all.
Granted, it is the case that every debit has somewhere a corresponding credit, but this also means that everyman’s fate is intimately bound up with that of his neighbour.
As Fritz Machlup pointed out in the 1930s, if A lends to B who lends to C, who in turn lends to A, it is indeed the case that – at the aggregate level – everything seems to match up, but this does not mean that it also cancels out. If C encounters difficulties and informs B he is broke, B will default on A and A will then be unable to meet C’s call for the cash with which he hopes to disembarrass himself. All will be ruined together.
Therefore, even if we personally have not been knowingly playing the ragged edges of the credit game, the fact that the mighty hurricane which looms above us made its first landfall in the sprawling, plasterboard suburbs of sub-prime is no reason for complacency for, as is just beginning to be glimpsed, sub-prime is itself no more than a particularly indefensible subset of the far more widespread dangers we all now face.
No, the world is not going to go into a tailspin because of the travails of fifty-odd thousand poor fools whose painful desire to make a fast buck flipping condos met a none-too-choosy lender with similarly short-sighted motives.
The plain fact is, however, that Hurricane Cassandra (so named because no one would heed the many warnings given, instead of carrying on frenetically dancing the Chuck Prince Charleston) never limited herself to such a low-rent corner of the world.
Rather, the whole colourful motley of hedge fund gunslingers, private equity barons, bond insurers, CDO traders and fixed-income investors – the whole, out-of-control business of M&A, of vast share buybacks, and hence of main market equity outperformance, as well as emerging market re-rating – the whole self-aggrandizing swagger of the Bulge Bracket bonus bonanza – all of it – every last red cent of it – has been, in turn, cause and effect of the build-up of the storm system which now threatens to sweep this Big Easy of false prosperity away, leaving little but the matchwood of shattered dreams and disabused expectations in its wake.
If all of the foregoing doesn’t strike a cautionary enough note to give you pause, Dear Reader, when you hear the Siren whispers telling you to dive back in now that things are ‘cheap’, there is one last sobering question to contemplate.
In our Austrian vision of the world, the business cycle IS the credit cycle. Overeasy credit encourages too much investment in too many false projects. Financiers become reckless and entrepreneurs are mislead en masse to see real opportunity where there is only the shimmering mirage given off by hot money.
What is more, the cycle tends to manifest itself in a lengthening of the productive structure, in undertaking investments increasingly removed from the immediate provision of consumer goods, and especially of consumer staples. Another crushing asymmetry comes to bear here, as a result.
This lies in the fact that it is far easier to lengthen the structure – to use easy money and expensive shares to build plant, lay pipelines, and fill the factory with banks of gleaming, new, highly-specialized machinery – than it ever is to shorten it again – retooling the assembly line for a different use, bringing a different ore out of the mineshaft, even breaking the equipment profitably up for scrap – when the premises on which these bold steps were taken prove to be mere falsehoods spun amid the prevailing mood of financial incontinence.
If, therefore, the credit cycle really has turned here – and this is surely the best candidate for marking that decisive change of phase we have had for some years – we cannot fail to reckon with serious, real world implications as the squeeze progresses, as returns on investment falter, as orders are cancelled and jobs begin to be lost.
Accordingly, as we try to extricate ourselves under from the falling masonry of financial foolhardiness, what we must be asking ourselves is which company (or, indeed, which resource) has received the greatest short term boost from the recent asset inflation and has therefore become the most over-extended and vulnerable to its subsequent evaporation.
Conversely, we must also try to identify those who have been conservative enough, or who will hence react sufficiently rapidly (or for which resource we will still find the matching of physical supply to genuine, end demand a considerable challenge) and who or what will therefore best weather the onrushing tempest, offering real, long term value, no matter how beaten down the traded price becomes in the interim.
Answers on a postcard please, but we suggest you draw the lesson from sub-prime and start by looking for the corporate equivalents of those who took out – as well as those who looked like geniuses for extending – larger and larger chunks of ‘NINJA’ loans (‘No Income, No Job or Assets’), even as the ship was visibly heading for the rocks.
If you do, you’re sure to find more than enough candidates to keep you out of mischief for some good while to come.