Unconventional Gas Extraction and the Need for Water Conservation

According to the numbers released at “The World Gas Conference” held in Buenos Aires, recent advances in shale oil extraction technology have manifested from wishful dream to physical reality much quicker than even the most positive optimists could have possibly imagined. These surprising advances in unconventional gas extraction have opened up 3 trillion barrels of shale oil, which can be cheaply converted to natural gas. This extraction has been enabled by a new form of three-dimensional seismic imaging that allows engineers to find the right spots to use hydraulic fracturing (or fracking), thus freeing up "tight gas" by smashing energy rich shale rocks.

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Chinese Banking Strength

Chinese banks' non-performing loan ratio dropped from 2.42% in January 2009 to 1.66% at the end of Q3 2009. In contrast, Western banks have steadily increased loan-loss reserves. Some (such as Tony Wang and Grace Tian of ChinaKnowledge) have pointed to this change as proof that the Chinese banking sector has grown stronger during the financial crisis and is well situated to expand abroad.

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Gold as an Asset Class

My hesitancy to hop on the gold train is based on the limited use of gold as a productive asset. Unlike other precious metals, gold has little real use in a modern society apart from as jewelry. Since determining the fair value of gold is impossible, it is likely that once the inflow into the market dies down, prices will plunge with little downside support.

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When The Music Stops...

The US government's programs initiated during the financial crisis have generally died down. The exception here is the Fed's $1.25T agency and GSE-backed MBS purchase program, which has become the greatest remaining source of government intervention in the economy (see chart below). On paper, Fed emergency lending has decreased steadily from October 2008 and continues to decline. These figures misrepresent the massive amount of liquidity and credit-easing still occurring today. Furthermore, the MBS purchase program is unlikely to end anytime soon (it has already been extended once). The financial crisis has taken a large buyer of agency MBS out of the market: foreign holders. This makes the Fed's exit additionally difficult and risky.

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Obama in China

At first, it seemed like Obama's visit to China might actually be fruitful after the People's Bank of China issued a report promising an improvement in the yuan's exchange rate mechanism a few days before Obama's arrival. But this move was posturing, an attempt to lessen discussion on this topic and not a sign of coming compromise.

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European Football and Decoupling

When stocks in emerging nations declined more in 2008 than they did in the US, many saw it as proof that decoupling had not yet occurred. Recently the decade-old debate has flared back up, starting with an Economist article titled "Decoupling 2.0" in May 2009. Decoupling 2.0 is the idea that since GDP growth held up well in emerging markets like China, India, and Brazil during 2009, decoupling is real, regardless of how hard equities in these countries might have been pummeled in 2008. In my opinion, the idea of decoupling gives a misleading view of the world economy. Emerging nations may be able to sustain short-term growth, but the drivers of the world economy are still the developed nations. As an example, consider the state of world football, or soccer as it's called here in the US.

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Updates: China's Yuan Policy and Bubbles

Two news articles caught my attention this morning because they relate strongly to what I have written about recently on this blog.

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A European Natural Gas Market

Natural gas, unlike crude oil, is not an international market. The US, for example, only imports 3% of its natural gas consumption while importing 43% of its oil. As a result, markets around the world have developed much differently. The North American natural gas market is a completely separate entity that prices natural gas according to supply and demand at different locations. Asia and especially Europe, on the other hand, price natural gas by linking it to the price of oil.

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Rethinking Third Quarter GDP

Third quarter GDP grew 3.5%, beating estimates of 3.2%. Usually this indicates a healthy recover. But this quarter, the growth came entirely from one time adjustments.

3.5% 3rd quarter growth

-1.6% Cash for Clunkers

-.53% First time house buyers credit

-1.0% Stimulus

0.37% GDP growth without one time government programs

Growth without one time government spending is still anemic. No wonder unemployment is greater than 10%.

A Bubble Economy

Bill Gross' November Investment Outlook is a must read. In this piece, Gross alludes to Macbeth's "out, out, brief candle" soliloquy to describe his own fear for the future. This is a very powerful analogy. It seems there is a looming, apocalyptic mood to the markets, as indicated by the steady increase in the VIX. There is a foreboding sense that once stimulus recedes there will be a day of reckoning, when consumer spending will plummet, inflation will surge, and the dollar will crash.

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Structural Reform Is More Effective Than Regulation

The discussion on banking reform usually focuses on higher capital requirements, less leverage, and more oversight. In my opinion, this focus is misguided. Repealing the de-regulatory acts of the late 90s might be more effective because structural limitations are generally harder to bypass than something judgement-based, such as risk-weighted capital. I think history is on my side.

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Obama's Commitment to Palestine and the Stark Realities of Geopolitics

US rhetoric on Israeli settlements has shifted dramatically since President Obama's inauguration. In the first few months after January 20, Obama courted the world, successfully promoting an image of a cooperative, benevolent US. A key part of this was a sterner approach to Israel. Obama demonstrated this by unexpectedly demanding a halt to settlements during his first meeting with Netanyahu. Indeed, Obama mentioned multiple times during his campaign that he advocated a more balanced approach to Israel-Palestine. Six months after inauguration, Obama's Palestine strategy has converged with Bush's.

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China: "Give Me Balanced Trade, Just Not Yet"

China's repegging to the dollar is critically important to global trade. It gives China a free lunch: not only are China's exports protected by the US dollar's decline, they will increase as the yuan declines relative to other currencies.

Harvard economist Jeffrey Frankel uses regression analysis to determine China's yuan policy. His research shows that in 2005, Beijing de-pegged from the dollar and re-pegged to a basket of the dollar and the euro. According to Frankel, the 20% appreciation of the RMB from 2005 to 2008 was a reflection of the euro's rise against the dollar. Recently, the Chinese have moved back to a dollar peg. Frankel said that "during the most recent period, September 2008-February 2009, all the weight has once again fallen on the US currency. The regime has come full circle, virtually back to what it was in late 2005."

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Japan's Debt Trap

It's hard to see how Japan's fiscal situation is anything but a crisis. Its national debt is fast approaching 200% of GDP. Its population is shrinking, meaning transfer payments rise as tax revenues fall. Additionally, Japan's life expectancy is one of the highest in the world. Japan is in a debt trap, where interest expense increases faster than its ability to pay it off.

Though Japan's debt has ballooned, yields have actually decreased. The reason for these low yields is the commitment of Japanese firms and households to Japanese bonds. Japanese debt is very unattractive to an investor, yielding only 1.4% for 10 years. Unsurprisingly, foreign ownership of Japanese bonds is only 6.4% as of last March, down from 7.9% a year ago.

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Commercial Real Estate and Bank Capital

Lesley Deutch, VP at John Burns Real Estate Consulting, gives a very negative outlook for commercial real estate in this week's Advisor Perspectives newsletter. She argues the fallout in commercial real estate will hit commercial banks harder than residential mortgages. One of the reasons for this is that banks hold a much greater percentage of commercial mortgages than residential mortgages.

Commercial banks hold about 45% of all commercial real estate mortgages, compared to 21.3% of residential mortgages (though residential mortgages are a bigger market). Deutch expects banks to recover less than 20% of their CRE loans and predicts government involvement to exceed what we've seen so far. I doubt much of these losses will come from further declines in prices, which seem to have bottomed:

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October 19th, 1987

Today is the 22nd anniversary of Black Monday, when stocks around the world crashed one after the other on October 19, 1987. The Dow fell almost 23% and continued downward over the next week. A year later, however, it was almost back to 1987 levels. I consider Black Monday a shot over the bough, that is, a telling glimpse into the greatest problems of modern finance. Here are the lessons we should have learned from 1987:

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A "Sucker's Rally"

The Business Insider has an interesting gallery of prominent analysts who called the stock market rally since March a "bear market rally" and advised clients to take money out of equities. Here's a graphical representation:

Not surprisingly, the bears who most accurately predicted the crash, such as Nouriel Roubini, John Mauldin, and David Rosenberg, were also among the first to call the rise in stocks a "sucker's rally."

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Perspectives on America's Decline, Part 1

Have the days of US global domination come to an end? Conventional wisdom seems to believe that it has. A recent Rasmussen poll showed only 32% of Americans believe America's best days are yet to come. 62% say today's children will not be better off than their parents, up 15% since the beginning of 2009.

As a student of history, I've decided to look at historical theories on the causes of an empire's decline and assess the degree to which these theories apply to the present day US. Today, I will consider the theory of tolerance put forth by Yale Law School professor Amy Chua in her 2007 book Day of Empire.

Chua argues one of the driving forces behind the rise and fall of a hyperpower--a global, unchallenged hegemon--is tolerance of people. Chua argues that religious, ethnic, and racial tolerance (relative to other nations) is indispensable to becoming a hyperpower. Furthermore, a hegemon's power will decrease as its tolerance decreases.

The British Empire

Chua traces the root of the British Empire back to 1689, when a new tolerance for Jews, Huguenots, and Scots brought new skills that built the foundation of Empire. In 1689, France rather than England was the most likely successor to the Netherlands as Europe's greatest power. France had a much bigger population, a stronger economy, and a bigger military, but England eventually triumphed because of its human capital.

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Assessing the President

Historically, there is no statistically significant relationship between stock prices and presidential approval ratings. In fact, Richard Brody shows in his classic study of public opinion, Assessing the President, that even macroeconomic performance is more often than not an inadequate predictor of public opinion.* However, for the Obama administration there has been an unusual inverse relationship between the economy and public approval.

From today to the inauguration, the correlation between the S&P 500 and total approval of the president is -0.794. This strong relationship is the result of one of the strongest equity rallies in history and the quick end of Obama's honeymoon period.

Another interesting correlation is that between the US Dollar and Obama's approval. The correlation since inauguration is a positive .822. There is mounting political pressure in the US for a stronger dollar (the GOP has started using the dollar's weakness to attack the President), even though a weak dollar is in many ways in Obama's interest. If the weak dollar policy ends up creating jobs, we will likely see the dollar-approval correlation turn negative.


Though the relationship between the dollar, stocks, and Obama's approval rating is statistically significant (a regression indicates stocks and the dollar have a 71.6% predictive power with p-values <.0001), there is no reason to think this is a causal relationship. (If anything, I'd think higher stocks are having a positive effect on Obama's approval rating because it indicates his policies are working. Apparently this doesn't seem obvious to everyone, such as Jim Cramer, who argued Obama's low approval rating are bringing up stock prices because investors believe a weaker Obama is better for business.)

However, once in a blue moon, these correlations are significant and explanatory. The stock market crash following the collapse of Lehman Brothers was one of the main reasons Obama was elected president (which says a lot about how the American public views Obama). Gallup charted opinion of Obama during fall 2008 versus negative views of the economy:

If you look at the chart above, you see Obama only took the lead after the collapse of Lehman Brothers on Sept. 15 when negativity surged. Also, Obama's lead spiked October 8, during the Dow's most dramatic decline of the crash:


The high negative correlation between stock prices and Obama's approval rating is likely a coincidence. But there are real implications to this correlation. As stocks go up, the severity of the financial crisis declines. As the intensity of crisis decreases, the harder it becomes to push through effective reform. During the Great Depression, it took five years of misery before Congress pushed through meaningful reforms. In a previous post, I discussed how, from the perspective of some markets, this crisis looks very similar to past crises (1987) that ended up with no material reform. In electing Obama, the electorate voted for change. Now that in retrospect the crisis seems less dangerous than it was, the need for change becomes less apparent. Obama won the election more narrowly than people remember. It took one of the most unstable economic moments in US history to grant Obama his narrow lead. We really shouldn't be surprised that the public responded dramatically to Obama's ambitious changes. The response to Healthcare reform would likely have been much different had markets not recovered so fast.


* On a side note, one of Brody's findings in Assessing the President is that approval of a Democratic president increases as unemployment grows and falls as unemployment shrinks. However, the relationship between inflation and a democratic president's approval rating is negative, meaning approval falls when inflation rises. For Republicans on the other hand, inflation is positively correlated with approval while unemployment is negatively correlated (as one would expect). This might reflect the different expectations voters have for democratic and republican presidents. Therefore, when a democrat curbs inflation, he is rewarded with higher approval than a republican might otherwise get, because it is unexpected.

Weak Dollar Will Normalize Trade Imbalances and Unemployment

The best recent policy response to the financial crisis didn't come from the G20 but from the foreign exchange market. This week the dollar fell aggressively against many currencies, driven by an Australian rate increase and a report claiming Arabs, Chinese, and Russians were conspiring to stop pricing oil in dollars. But the dollar was set to depreciate anyway due to an increasing debt and a dovish Federal Reserve. A weak dollar will have a positive effect on normalizing trade imbalances, if it lasts.

A falling dollar is a great stimulus to the US manufacturing base. Historically, manufacturing profits are inversely related to the value of the dollar.

From 1990 to 1995, the dollar stayed around the same level. But in 1995, the dollar started rising steadily, eventually peaking in 2002 after rising 51%. During this time, exports decreased by half:
During this period, exports in China and Japan surged. China's reserves quadrupled and Japan's reserves almost tripled. (For more information, see Robert Blecker's paper, "The Benefits of a Weak Dollar" at the Economic Policy Institute.) The strong dollar also had a large effect on jobs. See this figure on the effect of China's artificially low currency on employment and trade:

The map below shows the damage per state (see Robert Scott's paper here). Note that politically sensitive states such as Ohio, Michigan, and Florida have suffered some of the biggest losses.
Simon Johnson from MIT wrote a recent article arguing the weaker dollar is a part of Obama's plan to win the midterm elections by stimulating the manufacturing industry. Simon says NY Fed President William Dudley's recent comment that interest rates would stay low for the foreseeable comment was timed to send the dollar lower after the Australian rate hike. If rates stay low in the US for longer than other countries, there is an opportunity for a carry trade between the dollar and a currency that is likely to increase rates sooner (e.g. Korea, Australia, China or Switzerland).

Fundamentally, the dollar has nowhere to go but down. With high fiscal debt, loose monetary policy, and trade deficits, the dollar is fundamentally unattractive. Furthermore, there is likely to be significantly less demand for dollars in the future. The second largest holder of US debt, Japan, is highly indebted (debt to GDP of 170%) and aging. The savings rate has been steadily decreasing and will continue to reduce demand. Furthermore, the number one holder of US debt, China, is actively (and publicly) trying to diversify from the dollar.

But while the dollar may go down and start to normalize trade in the short-term, there is reason to be skeptical that this will occur for longer periods of time. Asian nations will not let the dollar get too low. Already we have seen Asian countries respond to the falling dollar. Yesterday, the FT reported Asian central banks aggressively bought the dollar on Thursday. Thailand, Malaysia, Taiwan, Hong Kong, and Singapore made substantial purchases, though they merely slowed the dollar's decline. A key aspect of this intervention was that it was coordinated.

The Asian countries that intervened likely did so primarily to stay competitive with China, which re-pegged the renminbi to the dollar in July 2009. This re-pegging of the renminbi means that whenever the dollar significantly weakens, a large number of central banks must intervene if they want to compete with China. This could mean a floor for the dollar. It could also be a bullish indicator for US treasuries, as foreign central banks may buy treasuries to push the dollar higher.

Lehman Brothers' Liquidity Ratio

In my last post, I discussed the irrelevance of the G20 compensation agreement as well as why higher capital requirements are not a panacea for banks. Today I will look at some of the details of new US liquidity regulation. The FT reported last week that US regulators are working on new rules aimed at helping banks avoid the sudden funding withrawals that doomed Bear Stearns and Lehman Brothers. These regulations would require banks to operate under new liquidity ratios as well as capital ratios. Capital requirements wouldn't have saved Lehman, which had 11% tier 1 capital at the time of its bankruptcy, but what about liquidity ratios?

One ratio would compare a bank's assets to its stable sources of funding. Lehman revealed on Sept. 10, 2008 (4 days before bankruptcy) in an accelerated Q3 guidance call that its funding position was "stable." At this point, Lehman had $211bn in secured funding from tri-party repos. Comparing the $211bn in short-term funding to its 600bn of long-term assets (meaning a stable funding to assets ratio of 58%) illustrates Lehman's vulnerable position. But it's not that simple. Of those $211bn, $115bn were in treasuries and agencies, which is very reliable collateral. Of the remaining 96bn, $39bn is central bank eligible and could be used for emergency funds from the Fed. Now the $211bn has been whittled down to $57bn, of which $25bn is investment grade fixed income and liquid equities. So, we are left with a measly $32bn of risky short-term funding, only 16% of total assets. Will regulators demand short-term liquidity must be less than 16% of total assets? Who knows, but it could easily be more. 16% short term funding is not that high. This example merely underscores the drastic effect minor funding gaps can have. That's the thing about liquidity--you either have it or you don't.

This exercise shows the massive difficulties facing regulators in coming up with liquidity ratios. Much like capital ratios, the devil is in the details. Regulators must ensure companies do not find the equivalent of a credit default swap for liquidity ratios, (referring to the role CDS played in keeping bank capital ratios artificially low).

Capital Requirements and the G20

At the start of the G20 last week, Sarkozy and Merkel pushed hardest for comprehensive limits on executive compensation. However, by the end of the week, they were less insistent on strict limits to executive compensation, even stating that increasing capital requirements would achieve the same goal.

The G20's compensation agreement is irrelevant. The agreement states regulators should limit bonus payments "when it is inconsistent with the maintenance of a sound capital base." In other words, if banks don't have enough capital, then regulators can limit payouts. The second part of the compensation agreement decrees that a substantial part (40%-60%) of senior bankers' bonuses will be deferred. This part of the agreement is equally worthless because it is already standard practice at most banks.

Finally it is crystal clear: bank regulation after the greatest financial crisis since 1929 will focus on higher, risk-adjusted capital requirements. The general consensus is that regulators will increase capital requirements from 4% of total assets to 8% and hasten the implementation of Basel II.

But it is much more important to address the mechanics of regulatory arbitrage that can take advantage of "risk-based" capital. Regulators must address the arbitrary calculation of tier I capital. Allowing banks to judge the riskiness of their own assets will never be adequate because risk can easily be mispriced. The FDIC's Sheila Bair criticized Basel II in 2007 for this exact reason::

There are strong reasons for believing that banks left to their own devices would maintain less capital -- not more -- than would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.

Bair is right. Lehman had 11% tier 1 capital when it failed, more than twice the requirement. Its total capital ratio was at 16.5%, well above the 10% regulatory threshold (see here). Under the new compensation and capital regulations, Lehman right before its collapse would be able to pay its executives whatever they liked, as long as they paid 50% of it in stock. It would also have sufficient capital.

(I wonder if European emphasis of executive compensation versus capital requirements is driven by a different societal perspective or industry structure. European banks generally have much lower capital ratios than American ones. Furthermore, this capital is often hybrid debt with no real ability to cover losses, as capital is supposed to. Some European banks even include certain deferred taxes in their tier 1. How can deferred taxes ever be used to cover losses?)

Securitization and the Statement of Cash Flows

The ongoing discussion on securitization usually focuses on the role of financial institutions, who actually buy receivables, securitize them, and sell. Banks' demand for assets to securitize have been blamed for irresponsible lending by mortgage originators. While that is probably accurate, the role of financial reporting in the securitization boom is often overlooked.

In finance, when asked what the most important financial statement is, the answer must be the cash flow statement. Companies can manipulate their balance sheets and income statements using valuation accounts, off-balance sheet accounting, and other gimmicks--think of how Enron, BFA, HealthSouth, and others misled investors. In many cases of accounting fraud, the statement of cash flows was the best early indicator of trouble. But the increased importance of the statement of cash flows to Wall Street has been a curious boon to securitization.

Wall Street values companies with stronger Operating Cash Flows higher than others. A company with higher Operating Cash Flows is seen as healthier than a company with high Investing or Financing Cash Flows, for obvious reasons. Investors want a firm's cash to come from operations and not selling assets and raising capital. WorldCom took advantage of this by capitalizing operating expenses, meaning the cash outflows were classified as Investing Cash Flows rather than Operating Cash Flows. It wasn't until they had done this for $3.8bn that people noticed.

This incentive to increase OCF actually promotes securitization. By selling receivables to banks, companies can increase their operating cash flows. Since uncollected receivables are subtracted from income out of the cash flow statement, selling receivables will record these sales as cash income. I have no numbers as to how much this affected securitization, but considering the ubiquity of this practice, I would expect the effect to be high.

An interesting example in regards to this topic is how US automakers considered leasing deals and car financing arrangements as Investing Cash Flows, thus keeping Operating Cash Flows misleadingly high. The SEC finally fought back in 2005 and made automakers classify these financing deals as Operating Cash Flows. GM's OCF decreased from $7.6bn to $3bn. If GM sold these receivables rather than holding them, it could increase its OCF back to $7bn.

It's an interesting progression. Companies learned in the 90's they could record income from dubious sales to related entities. After investors shifted their attention to cash flows, management found a way to manipulate these as well. It supports my view that most financial innovation is designed primarily to bypass regulation.

(With regards to cash flows, another innovation directed towards arbitraging accounting regulation was the development of auction-rate securities, which are ultra-safe asset-backed securities whose rates reset by auction every couple weeks, allowing issuing entities to borrow long at short rates. Investment banks guaranteed liquidity in these securities (until February 2008) so companies could consider auction-rate securities cash equivalents, thus boosting their statement of cash flows.)

The Importance of Regulation for Bank Earnings

A recent study by a JPMorgan research team predicted profits at large investment banks such as Goldman Sachs, Morgan Stanley, and Citigroup could fall by a third. While I haven't seen the report, I can't envision any way financial regulation wouldn't have a drastic effect on bank earnings. Three forces will be especially powerful:

1. Higher capital requirements: Over the last decade, the balance sheets of the five biggest investment banks have surged 16.3% annually, rising from $1.27T to $4.27T. This rise in total assets was aided by innovative forms of regulatory arbitrage that will no longer be viable. Higher capital requirements as well as crackdowns on loopholes will shrink banks' total assets. As assets generated income of some sort, earnings will decline.

2. Changes to Off-Balance Sheet accounting: the FASB's crackdown on SPEs will limit banks' ability to bypass capital requirements. It will also force banks to bring derecognized assets back on their books at the end of the year, using up more capital and decreasing leverage.

3. Regulation of OTC derivatives: OTC derivatives are blockbusters on Wall Street. The fees are high but corporations still like OTC derivatives because collateral requirements are low, depending on credit rating. But if interest rate swaps, credit default swaps, and other standardized derivatives are moved to exchanges, banks stand to lose a lucrative cash cow. Fees are lower on standardized deals, plus exchanges have higher margin requirements, making derivatives less attractive to corporations. The notional value of these deals are huge. Interest rate swaps alone have grown from $29T to $328T in the last decade and account for 55% of total contracts outstanding, according to the BIS.

Armageddon in Retrospect, Part 3

The magazine pictured above is from November 2, 1987, but it could just as well be from November 2, 2008. In 1987, Time declared cryptically that the world had changed after Black Monday, when the Dow lost 22% in a single day. Oliver Stone's Wall Street and Michael Lewis' Liar's Poker predicted an end to Wall Street.

But the financial world didn't change much in 1987. There was actually less regulation after the crash. Lessons to be learned in 1987 about fat tail risks were ignored until 1997, after which they were ignored again.

Now compare that to 1929. The 1929 crash completely changed the landscape of finance. New legislation such as the Glass-Steagall Act and Securities Exchange Act effectively addressed some of the causes of the crash. But enacting change after the crash took much longer than one would expect. It took 10 years before the most significant repercussions occurred.

Its intuitive that regulation intensifies with the downturn. In the first years after the crash, sentiment was still positive. Stocks rallied, banks hired new employees, and newspapers declared the "new era" wasn't over. In Spring 1930, Hoover declared the recession was over. After the outlook worsened, a Republican-majority Senate eventually launched the Pecora Commission, but it took public pressure over time to make it effective. Even after the big wave of finance legislation in 1933, the strongest public backlash didn't occur until 1938.

It took a deepening of the depression in 1937 to spur a renewed effort for reform. From John Steele Gordon's history of Wall Street, The Great Game, "Had it not been for the return of the depression in the autumn of 1937, when all the indices that had been improving steadily, if not dramatically, for the last few years, suddenly turned down again, Douglas would have had a much harder time pursuing reform through Wall Street." This backlash led to a crackdown of illegal practices, resulting in the conviction of people such as Richard Whitney, president of the NYSE.

What will be the legacy of the 2008 crash? Dept. of Treasury issued white papers and fact sheets about future reform, but nothing substantive has emerged. Maybe the massive stock rally has something to do with it. From Sept. 25th 1987 to Sept. 25th 1988, the S&P only fell a total of 15.7% after steep losses in the beginning of that period. Over the last year, the same time frame 21 years later, the S&P has fallen less than that; it is only down 13.1%. From the reaction of equities so far, one would expect 2009 to be more like 1987 than 1929, but that has little meaning considering the similar rally of 1930. Forget the talks on regulation at the G20. Ultimately, the scope of future regulation depends entirely on the economy.

Game Theory of Hedging

It's hard to tell whether hedging with derivatives has generally benefited corporations or hurt them. It is commonly accepted in the financial world that hedging is a positive thing. Many see it as progressive and sophisticated. Recent research from Dr. Lisa Koonce from the University of Texas at Austin shows that investors reward companies that hedge with derivatives. "The results show that, holding constant the economic outcome, investors are more satisfied when the company uses a derivative. In fact, we found that investors reward companies for using derivatives by boosting their evaluation of management." Her research goes even further, showing that investors reward managers even if the company is worse off from using a derivative.

But is this justified? I think the positive aura around hedging with derivatives is misguided. It is understandable investors embrace hedging as an effective risk management tool. But hedging also has a strategic component that is often overlooked.

A firm might remove commodity exposure by hedging with futures, but from an industry perspective it is still exposed. Consider an industry that is heavily dependent on commodity prices, such as the aluminum can industry. An aluminum can manufacturer is naturally short aluminum, but it can hedge this exposure by going long in the futures market. This would be an effective risk management tool. But whether this is a good idea is ultimately not decided by the firm but by the actions of its competitors. Say Can Producer A hedges at $.8/per pound, Can Producer B hedges at $.9/per pound, and Can Producer C doesn't hedge at all. Can Producer A would seem to be the winner in this scenario since he hedged and did so before Can Producer B, ensuring less costs and a competitive advantage over Producer B. But if prices drop significantly, then Producer A is almost as screwed as Producer B, with Producer C being the clear winner. Southwest Airlines acheived much of its success because it hedged fuel earlier than other Airlines. But what if oil prices had fallen? It is likely Southwest Airlines would've gone bankrupt.

One assumption of this scenario is that companies generally have no idea where prices are going, meaning prices are as likely to go up as they are to go down. In practice, this is often not the case. For example, if oil is at $35/barrel then you have a pretty good idea it will rise. You see that now by the way firms are hesitating to use interest rate swaps to hedge variable interest rate exposure because they expect rates to stay down in the short term.

With this in mind, it is interesting to consider the current case of Barrick Gold Corporation, the world's largest gold miner. Barrick and other gold producers have historically hedged their exposure to price by selling gold forward. Barrick recently announced it was buying out its forward book, meaning it would sell gold at the spot price and would be vulnerable to a sudden drop in price as well as exposed to the upside. The FT reported the size of the industry's hedge book will drop to 200 tons at the end of 2010, down from 3,000 tons a decade ago. Barrick stated the reason for the move was "an increasingly positive outlook on the gold price." (John Dizard had an interesting article in which he pointed out that OTC derivative regulation would make it hard to maintain a large forward book anyway.)

Barrick's gold hedge is $5.6bn out of the money. I'm sure they have a good reason to buy out their contract, but they must have also had a good reason in January 1996, when it bought back its similarly sized hedge only to have gold drop from $415 to $253 three years later. From an investor's perspective, the move gives Barrick a higher beta because it will take on significantly more debt. But there should be another metric to measure Barrick's gold exposure, a hedge beta. A firm like Barrick is all of a sudden much more exposed to external prices and will behave more volatile than a competitor like AngloGold Ashanti, the largest miner left with a gold forward book. This hedge beta would be a useful tool because it would be based on industry. An industry where everyone is hedged at similar levels would mean a low hedge beta for hedged firms. An industry with wide ranges of hedges in place, like Gold, will mean a much higher hedge beta for Barrick and a low hedge beta for AngloGold Ashanti. For example, for an investor in AngloGold Ashanti, a low hedge beta would mean the investor has limited exposure to the upside and downside and therefore less risk.

This would be an interesting topic to research. I would expect to find that in industries with a wide range of hedge betas, success ultimately depended on where and to what degree one hedged rather than other factors. Either way, it is clear an investor shouldn't consider a derivative hedge as a prudent exercise in risk management. There are strategic risks to hedging. One must pay as much attention to the hedges of competitors as the hedges of the company itself.

Iran Incongruities

As the world inches closer to official and non-official deadlines given to Iran on nuclear negotiations, something in the international equation just doesn’t add up.

The relevant players here are the P5+1 (the permanent five members of the UN Security Council plus Germany), Israel, the Sunni gulf states, and Iran. It’s worth evaluating their interests one by one, since a composite view of the situation will involve an intersection of these interests with their respective capabilities.

China—not thrilled about the prospective of nuclear proliferation, but even less thrilled about the prospect of interruptions in its energy supplies. China imports almost 60% of its oil from the Persian Gulf, and its largest trading partner is Iran. This means that the odds of China agreeing to the only sanctions that would really hit home in Iran—a gasoline embargo—are slim to none, since economic weakness directly translates to innerpolitical turmoil and trouble for the Communist Party. The only worse prospect is armed conflict, which would almost certainly close off the Straits of Hormuz entirely.

France—Sarkozy has been clear that France will not tolerate a nuclear-armed Tehran. Iran’s numerous and continuing infringements against UN resolutions give the administration a legal basis to an increasingly militant posture.

The UK—in line with France and the US. Will not tolerate a nuclear-armed Iran, but like both countries, would prefer to avoid commitment of armed forces (for obvious reasons of economic and political costs and risks).

Germany—Germany is in a much more conflicted position than some of the government’s rhetoric would lead one to believe. For one, Germany (and close relative Austria) has substantial commercial interests in Iran. Secondly, although people and government are publicly very anti-nuclear-proliferation, both distrust US leadership, and have absolutely zero appetite for any type of conflict anywhere in the world, let alone in the neighborhood of Iraq, which is widely viewed as a symbol for All That is Wrong With America. The Germans have a tendency to view all conflict as fundamentally driven by self-interest, which is therefore intrinsically immoral (unless Germany’s own interests are at stake). Finally, Germany’s increasingly cozy relationship with Russia, borne both from energy dependence and diverging interests with the US, means that Germany is unlikely to form a united front with the rest of the West to exert pressure on the other stakeholders in the brewing conflict.

Russia—Russia already has extensive commercial ties with Iran, specifically in two sensitive and lucrative sectors: nuclear technology (the Buschehr plant) and armaments (particularly SU-300 SAMs). The country therefore has a vested interest in business-as-usual, except that the alternative (strict sanctions or war) have a potential to be even better for the Kremlin’s bottom line. A closing of the Straits of Hormuz would lead to an explosion in oil prices, and gasoline sanctions would allow Russia to make a killing exporting fuel overland to Iran at inflated prices. Even more importantly, Russia would like to see nothing more than to see the Middle East suck in American resources even further, since this would allow it to continue reasserting control over its sphere of influence in the former Soviet Union (particularly Ukraine and the Caucasus). The only balancing aspects are that Russia is also interested in a stable Afghanistan, meaning that a shift in US combat capabilities out of the country would require added expenses by the Kremlin to secure that border; and secondly, a nuclear-armed Iran will likely further push US ballistic missile defense system proliferation in Eastern Europe. News that the US has shelved these plans, whether true or not or for whatever reason, do not change that long-term reality. Overall, though, between its oil export capability, potential to disrupt American air attacks by the dissemination of air defense systems, and even nuclear support, Russia can make a difficult situation just that much worse.

The US—the US doesn’t really want war, and can’t afford it. The latter is not just a matter of defense appropriations and budget deficits, but also opportunity costs and the deep socioeconomic malaise that would follow the inevitable rise in crude prices following Persian Gulf action. However, the US cannot tolerate a nuclear-armed Iran, for the following reasons: 1) it is illegal under the NPT and would weaken the international state system, 2) it would constitute an existential threat to all US allies in the region, particularly Israel; 3) it could very well lead to an arms race in the Middle East that harbors immense fat-tail risks. Finally, Obama is seen internationally as young, untested, and possibly weak, and he is a Democrat, which means that at the domestic level he must constantly prove his foreign-policy steel. He cannot afford to appear even slightly weak here.

The Gulf States—America’s Sunni allies in the Persian Gulf, and chiefly Saudi Arabia, are extremely concerned about the prospect of nuclear armament in the region and its potential to shift the balance of power. Many battle with social issues around the integration of Shiite minorities within their own borders. The question, as always, is not only one of capability, but of political will—how to balance their populations’ antipathy to everything Israeli with the confluence in national interest? As is the case with Palestinian support, rhetoric will sharply diverge from policy.

Israel—has made its position abundantly clear: Iran will not be allowed to acquire nuclear weapons. Netanyahu is playing a complicated political game balancing domestic and international politics (best shown in settlements ‘freeze’). In recent weeks, he has tried to buy the Russians, cajole the Americans, intimidate the Iranians, and ratchet up the pressure as much as possible. To mount an attack across Iraqi/ American airspace, Jerusalem needs Washington’s approval. But the wild card here is Obama’s perceived coolness to the Israeli cause—if the Israelis do not predict help as forthcoming, they may feel freed to undertake radical action themselves.

Iran—is playing the usual games. They are attempting (and succeeding) and changing the debate from revolving around nuclear issues, to revolving around the debate itself. They have done this by proclaiming first that nuclear issues are not on the table during the upcoming negotiations (scoring domestic political points and adding another hurdle for foreign diplomats), then proposing Tehran as the negotiation site (which is impossible, since negotiations are at head-of-state level, but would be a major victory if agreed upon), by making small meaningless concessions. (such as letting inspectors back into an enrichment plan), and finally, by releasing a position paper. The last bit allows the more recalcitrant participants (Germany, Russia, China) to claim that diplomacy is making progress and thus oppose stricter sanctions, when really the situation has not changed at all. The hoped-for outcome is that, after a year of meetings, all players go home exhausted, and with even fewer options than before.

The point is, everyone has very different priorities, and everyone is trying to push the situation as far as possible thinking no one else will act. For example, no one thinks Israel will act without US support, and no one thinks the US will (or can) act at all; but these assumptions don’t necessarily hold true. Expecting a few months of negotiation with no tangible outcome simply does not make sense when some players simply cannot afford to let that happen at almost any cost (particularly Israel and the Arabs). Also, Obama is thinking of Kennedy and the Cuban missile crisis, and has a strong incentive to move fast. With so many miscalculations and moving pieces, the situation could escalate rather quickly.

There are a few possible accommodations that could be made to change the constellation of players. The most intriguing is a Grand Bargain between Russia and the US (of which the recent US scrapping of missile defense systems may well have been the starting gun). It would really cost the US, above all in credibility, since it would basically have to withdraw support from Georgia, the pro-western sections of Ukraine, and even to some extent Poland, and lessen its presence in Central Asia; but policymakers might well decide that this is worth it since n the long-term, these losses can be regained. If the West were truly unified—Germany being the problem here, not France—then this would be more easily achievable, since Russia would both see a bigger stick waving and could be offered more carrots.

Another possibility is a massive change in US strategy. It would take a while to implement because of the formidable logistical obstacles, but the US could shift forces right back out of Afghanistan into the Gulf region, abandon the Afghan effort altogether (thereby creating a liability for Russians), to ratchet up pressure on Iran and signal a willingness to fight.

A wild-card here, ignored in most discussions, is China. How would the Middle Kingdom react to military action in the Gulf that reduces oil imports or raises their price? For that matter, could the country be convinced to support sanctions if the only alternative is war (which would be even worse economically)? The Chinese talk like a superpower, but haven’t paid the costs yet—maybe they will begin to here?

In any case, no matter what pattern of escalation follows between Iran and the West, or Russia and the US, or whichever constellation of powers, nuclear war is not the risk. But the odds of an economic disruption of some sort are rising with every day that there is not a realignment of the interests described above. And thus, it might well make sense for investors to hedge what could be a substantial fat-tail risk. In almost any scenario, crude oil and Russian indices should do well, and the US (and most of the rest of the global economy) should do relatively worse. Alternative energies would get a boost. And given that the popular media coverage of the situation has been muted thus far, this kind of protection should still be affordable.

Special thanks to my brother (who knows much more about geopolitics than I) for his input into this article. This article is a product of a long phone conversation with him, and the ideas in it should be considered his more than mine.

Perspectives on Obama's Tire Tariff

Pres. Obama's recent 35% tax (on top of an existing 4% tariff) on tires imported from China has generally been denounced as a protectionist move motivated by domestic political factors. Bill Witherill of Cumberland Advisors called it a "cynical and dangerous move" because the US tire manufacturing industry is internationally uncompetitive anyway. Some have speculated the tariff will lead to another Smoot-Hawley effect on the world economy. With the lessons from the Great Depression hanging heavy over everyone's head, the recent trend of trade retaliation (such as competing Buy America and Buy China policies) is certainly alarming.

But while the tariff may seem ominous from an economic perspective, from a geopolitical perspective the tariff makes more sense. A recent article from Stratfor (which is unfortunately not public) argues the moves of both countries were politically motivated and are unlikely to escalate. I don't agree, but it's an interesting argument. First they point out this is not a normal WTO case, because Obama never even mentioned any unfair trade practices. Obama did it because he can. In the 2001 Chinese WTO accession agreement, Clinton insisted on including a particular section 421, which basically allows the US to sanction any product without making a case for trade violations until the end of 2013. For that reason, China cannot react in any way that will actually hurt the US, because it could provoke Obama to use section 421 again, completely legally. We have yet to see any meaningful retaliation. China declared it would probe "unfair practices" in US chicken and auto products, but that's it.

But why would Obama do this for domestic political reasons as the FT, WSJ, Stratfor, and others have claimed? Sure he's having trouble with healthcare, but why would he trade a small boost in his base for further complications in Iran? As Stratfor points out, China could easily retaliate by refusing to cooperate with sanctions or stonewalling negotiations. But this would make Obama look terrible. Obama has a lot of political capital riding on Iran. His criticism of Bush's unipolar attitude and unwillingness to negotiate was one of his main foreign policy selling points during the campaign. I think its more likely Obama enacted the duty to remind China of its economic leverage before the P5+1 negotiations with Iran. China is not enthused about sanctioning its third-largest supplier of oil.

Obama said on Wall Street this Monday,

"Make no mistake, this administration is committed to pursuing expanded trade and new trade agreements. It is absolutely essential to our economic system. But no trading system will work if we fail to enforce our trade agreements. So when, as happened this weekend, we invoke provisions of existing agreements, we do so not to be provocative or to promote self-defeating protectionism. We do so because enforcing trade agreements is part and parcel of maintaining an open and free trading system."

These words imply the US sees its ability to tariff-at-will as a right in return for opening up trade with China. While his choice of industry might have been politically motivated, his decision to raise tariffs in the first place was likely a geopolitical one. It will be interesting to see how the trade and Iran issues evolve alongside each other.

Armageddon In Retrospect, Part 2

Days away from the anniversary of Lehman's collapse, it's interesting to assess the degree to which financial markets and institutions have changed since. Today: interest rates.

Central banks aggressively cut rates after the first tremors in the financial system in 2008. Money markets at first reacted to Lehman by seizing up. The Libor-OIS spread, which measures the premium banks pay for borrowing from each other and indicates banks' perception of the credit quality of other banks, surged to 364bps from a mean of 10bps. Now the spread is back to a normal level at 13bps.

Libor also surged after Lehman collapsed. 3-month Libor peaked at almost 5% a month after the bankruptcy. Now that Central Banks have committed to maintain their low rates until recovery is assured, Libor is flirting with its record low at .30%. The low Libor rate also reflects the vast amount of government guarantees in the market. Another measure that has returned to normality is the 2yr US Swap Spread. The swap spread measures the spread between treasury yields and swap rates (Libor) for a given maturity. The 2yr swap spread is now at its lowest level in 5 years. Credit hasn't been this cheap in a long time. The new trust with which banks lend to each other, reflected in the Libor-OIS and swaps spreads, isn't healthy and organic but fake, propped up by implicit government guarantees.

The one measure that is distinctly different from pre-Lehman is the 30 year swap spread. A little more than a month after Lehman failed, the 30-year swap spread dipped to negative 25bps. Since then, it hasn't moved much as swaps and treasuries increased at a similar pace. The market is saying it views 30-year treasuries as riskier than 30-year swaps. In other words, the US government has higher credit risk than AA rated companies. This is curious because it is clearly a mispricing--the US government has no default risk. It could reflect negative sentiment about the US' ability to repay its long-term debt, but I doubt it. The FT wrote the negative spread is a result of firms wanting to hedge against deflation without paying the principal and a revival of demand for interest rate hedges. That seems plausible. But it is still a strange inefficiency. I would expect someone to be able to arbitrage the difference.

If one looks at the numbers, it seems as if the US is emerging from a deep recession and that interest rates should rise soon. But yield curves do not predict this. The amount of government intervention necessary to quantitatively ease yields taints these optimistic numbers. Libor and swap spreads indicate that the panic is gone, but yield curves indicate a large amount of government assistance is still required. There is yet something rotten in the state of Denmark.

Approaching Option ARMageddon

One idea that is fairly widespread in the blogosphere is that a slew of interest rate resets on option Adjustable Rate Mortgages in 2010 and 2011 will trigger another round of writeoffs and possibly a double-dip recession (see here and here). Recent news indicates these losses could be imminent.

Fitch Ratings stated in a report that 88% of securitized option-ARMs are yet to be reset. Considering that 94% of option-ARM debtors chose the lowest payment option and 75% of option-ARMs were made in California, Florida, Arizona, and Nevada (where housing prices are down 48%), the future doesn't look good. Loan-to-Value ratios have gone from 79% to 126% today. That means the average option-ARM homeowner is underwater by more than 25% of their homes value. For a $300,000 home, that is $75,000.

Furthermore, only 3.5% of these loans have been modified. These loan modification doesn't seem to help much anyway. 24% of modified option-ARMs default in 90 days, while 37% of untouched loans default after 90 days. The most interesting thing about the numbers, however, is that the outlook is worse than was expected less that a year ago. Loss severities on MBS have risen from 40% a year ago to 60% today. Considering that vast amount of option-ARMs that still have to reset, these losses should continue to increase. (read more here)

Personally, I don't think that the option-ARM resets will cause the armageddon some have predicted. As long as regulators remain foreberant in regards to recognizing fair value, banks will be able to spread out losses over the next five years, similarly to the early 80's Latin American debt crisis. One possible consequence of this is less lending as banks have to hold capital against these assets. This could actually benefit investment banks because it forces companies to raise capital through the capital markets.

Armageddon In Retrospect, Part 1

With the anniversary of the Lehman collapse a few days away, I thought it would be interesting to look at what has changed for consumers, the banking industry, and finance as a whole over the last year. Today I will focus on how banking has changed for the consumer, using Washington Mutual as a case study.

In 2003, CEO and Chairman of WaMu, Kerry Killinger, boldly claimed, "We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs, and Lowe's-Home Depot did to their industry. And I think if we've done our job, five years from now you're not going to call us a bank." Killinger was right for the wrong reasons. A little over five years later, I doubt anyone would call WaMu a bank anymore.

WaMu's business model focused on building a consumer friendly way of banking, without ATM fees, monthly checking charges, and so on. Its ubiquitous commercials featured young people in casual clothes rallying against the old-fashioned commercial banks, represented by old men in fancy suits often depicted counting money (see here and here). Another line of commercials used the slogan "The Power of Yes" to emphasize WaMu's "flexible lending rules", underscoring the tremendous amount of loans originated by WaMu (for a particularly funny commercial, see here). These commercials underscore WaMu's success in issuing loans and gathering deposits. But WaMu's democratization of commercial banking ended up being its downfall. Its large amount of home loans left it very vulnerable during the subprime crisis. Its "flexible lending rules" meant that half of its $119bn mortgages were option ARMs (aka POAs, see here). When depositors pulled out $16.7bn in 10 days, WaMu was left with almost no capital. Ironically, JPMorgan Chase, the archetype of an old-fashioned commercial bank, ended up acquiring WaMu at a fire sale price.

From a business perspective, Washington Mutual deserved to fail. Its lending was irresponsible and myopic. But from a consumer's perspective, the failure of WaMu represents a bank that was friendly to the little guy being taken over by a bank that was too big to fail (and a $25bn TARP recipient). A friend of mine who banked at WaMu was dismayed to hear the new owners had instated the very fees WaMu had promised to avoid.

JPMorgan deservedly came out stronger from this crisis than it went in. But from a consumer's perspective, the consolidation that has occurred in the banking industry over the last year is not a good thing. A recent WashPost article describes how the crisis has created an oligopoly of four large banks--JPM, Citi, Wells Fargo, and BoA. These banks now issue one of every two mortgages and two of every three credit cards. Remember that before the financial crisis, regulations prevented any bank from having more than 10% of the nation's deposits. Now the top 3 commercial banks all violate this benchmark.

The most striking effect of this consolidation has been the increase in fees. In the last quarter, the top four banks have raised fees related to deposits by 8%, while smaller firms have lowered fees by 12%. Data shows that large banks have the ability to borrow more cheaply because they are assumed to have negligible counterparty risk. Large banks with more than $100bn in assets are borrowing at .34% less than the industry. In 2007, this number was only .08%. For a commercial bank, this lower cost of funding is a huge competitive advantage. One consequence is that large banks are able to easily outprice smaller ones.

The consolidation in the banking industry, caused by the financial crisis, can't be undone. In economics, one characteristic of an oligopoly is that fragmented buyers will have less bargaining power, resulting in prices higher than equilibrium. This strongly supports the need for the Consumer Financial Protection Agency. But something further needs to be done to promote competition among banks of all sizes. So far, there have been no proposals addressing the massive challenges facing small and mid-size banks in the future.

Consumer Credit Plunges in July

Yesterday the Federal Reserve released its July figures for consumer credit. Looking at the numbers, it seems as if we have passed the tipping point and started our descent regarding consumer credit. This will have drastic effects on the economy (consumer spending is 70% of GDP). Over the last decade, consumer spending has been fueled by easy credit and asset bubbles. If available credit falls off a cliff, consumer spending will follow soon after. Below is a graph of historical consumer credit since 1943 (source).

What is most striking about these numbers is the rate of change. In Q3 of 08, consumer credit growth was still positive at .6%. But from Q4 onwards, consumer credit has been falling at an accelerating rate. In Q1 of 09, consumer credit fell 3.7%. In Q2, credit fell 6.6%. This decline has continued throughout the summer. Consumer credit fell 7.4% in June and a striking 10.4% in July. The July figure is the most interesting. If consumer credit continues to decline as it did from June to July, then consumer spending will be much worse than expected. July could be an anomaly, so the August numbers will be interesting to keep an eye on. If this trend continues, a double-dip recession is a certainty.

Negotiating with Iran

In a press conference yesterday, Iranian President Ahmadinejad ruled out compromising on Iran's "undeniable right" to a nuclear program but stated he is open for discussion with Pres. Obama. This statement indicates the challenges facing President Obama's Iranian policy. Obama campaigned on the premise that he could talk to antagonistic leaders without preconditions and achieve multipolar solutions. But that is virtually impossible as long as Ahmadinejad is president of Iran.

As long as Obama follows a multi-polar strategy, Iran will be able to delay by playing members of the engagement against each other. Consider the deadline set by Obama for Iran to come to the negotiating table, which is less than three weeks away. If Iran refuses to talk, the G-8 has promised "crippling sanctions." The delegation that will negotiate with Iran consists of the UN security council plus Germany (US, UK, France, Germany, Russia, and China). The UK, France, and Germany can be expected to follow Obama's lead. But Russia and China care much less about a nuclear Iran than the US. Moreover, Russia and China have a significant stake in keeping Iran stable and gain nothing from sanctions. It is in Russia's interest to keep the US occupied in the Middle East and away from its periphery. Russia also trades with Iran and will want to protect this. China depends on Iran for commodities. As long as Iran is China's third largest oil supplier, China will not be willing to get tough on Iran while Iran maintains a semblance of co-operation.

Ahmadinejad has taken advantage of this division. His recent statements were vague enough for Russia and China to claim Iran is willing to negotiate, drawing the process out further. Ahmadinejad also notably invited leaders from these countries to Tehran, something Obama is unlikely to do for domestic political reasons. If parties can't degree on where to meet to negotiate, the negotiations are likely to be just as unproductive.

On the other hand, Obama has no alternative to a multi-polar strategy. Sanctions can only be effective if Russia and China participate. The US simply has little leverage over Iran, having exhausted most of its options in the past. Whatever happens in Iran will ultimately depend on Russia and China.

Russia's Soft Power and Opel

Russia seems to have increased its use of soft power to influence former Soviet states to cozy back up to Russia. One example is an address to the people of Ukraine posted on Medvedev's blog. This address laments the current relations between Kiev and Moscow and emphasizes their common cultural heritage. Another possible example of Russian soft power in Ukraine was Russian Orthodox Church Patriarch Kirill's visit to Ukraine a few weeks ago. Both of these actions stressed a common culture and a new beginning. They are directed at Ukraine's coming elections, where pro-Western leader Viktor Yushchenko is likely to lose. Another example is Putin's recent letter to the Polish public denouncing the Molotov-Ribbentrop Pact that divided Poland between Nazi Germany and the Soviet Union.

Russia's reconciliation tour is similar to Obama's at the start of his presidency. Both countries are using public diplomacy to better relations between their states. It will be interesting to see the reaction of Ukraine and Poland. My expectation is that it will have little to do with anything Medvedev or Putin says, but a lot to do with Obama's upcoming decision on the anti-ballistic missile defense system in Poland. Especially now that Germany and Russia have established better relations, it will be more difficult for Poland to resist Russian influence. I'm wondering whether this new attitude towards Russia in easter Europe is a sustainable trend or simply due to the fact that America is preoccupied in Iraq and Afghanistan.

Another factor with surprising influence in Russo-German relations is the Opel deal. The question of to whom to sell Opel to has turned into a geopolitical standoff between Russia and the US. The issue is further complicated by private equity group RHJI continually improving its bid. It is now clear that RHJI is financially the better option for the German Government as it leaves it with much less debt to guarantee, a potential issue in the upcoming German elections only 4 weeks away. However, Russia is sure to be irritated if the Magna bid is not accepted. A recent, must-read Der Spiegel article describes how after a conversation with Obama on the subject, Merkel remarked the trans-Atlantic relationship was being "put to the test." A quote from the article:

What was probably the biggest miscalculation on the part of the German government was its underestimation of the importance of the Russian factor in American thinking. April 28, the date on which Russian carmaker Gaz announced its interest in Opel together with Magna, was for many in Washington and Detroit the day on which that consortium lost its appeal. Russian involvement is no small matter for Americans. GM is one of the biggest suppliers of foreign cars on the Russian market and wants to continue to maintain that position. At the same time, being forced to sell off part of GM "to the Russians" is something that would be seen by many Americans as a humiliating experience, even 20 years after the end of the Cold War.

The problem for Merkel is that she has no control over the decision. She has promised Medvedev she will support the Magna plan, who suggested a major Russian shipping deal in return. Geopolitically, this cannot end well for Merkel, though I think she is probably more worried about the effect on the upcoming elections.

Commodity Exposure vs. Speculation

A new report from Rice University's Baker Institute by Kenneth Madlock and Amy Jaffe argues the Commodities Futures Modernization Act of 2000 is one of the main reason for high oil prices. A 2007 GAO study concluded the CFMA made it easier for financial players to obviate speculative limits and made it more difficult for the CFTC to regulate oil futures markets. The CFMA allowed oil to be used for risk management products that artificially drove demand. The report states that before the CFMA 20% of oil trading was from "noncommercial participants" (speculators) while today 50% of trading is from these participants. The graphs speak for themselves:

As you can see, the price of oil corresponds with the amount of speculators in the market. When oil peaked at $145, the percentage of non-commercial traders in the market was at its highest.

It is astounding how much opposition there has been to the idea that commodity prices are heavily influenced by speculators. It seems common sense that money flooding into a market will inflate prices, especially if the new entrants are net long. Commodity markets are simply fundamentally different than capital markets because they are intended to serve a completely different purpose. Commodity markets are meant to match supply with demand while capital markets are meant to efficiently allocate capital. When NYMEX oil futures trading is 10 times more than daily consumption, a market is no longer matching supply with demand (very few contracts actually end up in delivery). Peak oil, as it is commonly perceived, is a myth. Prince Turk Al-Faisal underscored this recently in an article in Foreign Policy. If peak oil is a reality and oil is a desparately scarce resource, why does Saudi Arabia have 4.5million bpd excess capacity?

I attribute much of the interest in commodities to trends in popular investment theory. The rising popularity of "absolute returns" and the success of funds who invested in alternative assets (great example is the Yale endowment managed by David Swenson) led to the conviction that all portfolios should have at least a 10% exposure to commodities, since this asset class is historically not coorrelated to traditional assets, thereby reducing risk. This wisdom was spread by consultants and has now become a firm staple of retail investing.

One place where this has been evident recently has been natural gas. After the turmoil of last fall, when commodity prices dropped across the board, investors piled back into commodities. Since retail investors can't buy futures, they bought many shares of commodity ETFs, especially USO and UNG, expecting prices to re-inflate. All commodities, that is, except natural gas. Natural gas actually fell and continued falling. Merril Lynch recently forecast it to go as low as $2/mmbtu. So while institutional investors shunned natural gas, retail investors literally could not get enough of UNG. UNG went from a $447m fund to a $4.5bn fund in three months. The fact that the fund is trading at a 19% premium to NAV underscores the retail demand.

There is nothing wrong with investors seeking exposure to un-correlated assets or hedging their risks with commodities, but these markets were clearly not designed for this level of activity. One good change would be position limits. A market that can be as easily manipulated as commodity markets needs many small players to be efficient, and not distorting elements like the UNG and USO.

(Interestingly, every recession since 1973 can be associated with some sort of oil shock: 1973 and the Yom Kippur War, early 80s and 1979 Iran Hostage Crisis, early 90s and Persian Gulf War, 9/11 and the early 2000s recession, and finally the 2008 oil shock and the "Great Recession." Obviously correlation does not imply causation...but why take the chance and leave these markets to undue influence?)

Arbitrage, Margins, and Efficient Markets

Markets clearly overreacted in the months following the Lehman bankruptcy. The same thing holds true for other financial crisis, such as the 1987 crash and Asian/Russian/LTCM crisis. Market overreaction is not limited to dramatic macroevents. If one looks at implied option volatility, it is clear that market participants predictably overreact/underreact to different types of news. This overreaction is one of the cornerstones of behavioral finance.

Behavioral finance is often seen as the antithesis of the efficient market hypothesis (EMH). One of the premises of the field is that markets cannot be efficient considering markets' tendency to overreact. As behavioral finance as a field of study has boomed in the last two decades, so has rejection of the EMH (a poll showed a strong majority of CFAs reject the theory). Much of the hysteria about the EMH comes from the fact that much financial theory is premised on an efficient market. But behavioral finance should not necessarily threaten this theory outright. The value of the behavioral finance perspective is it helps us figure out which markets are inefficient and why that might be.

It is generally accepted that efficient markets are good for investors. In an efficient market, a buyer can be sure his purchase is at fair value. Markets love certainty. Investors cannot trust markets if they are not efficient. (Check out this recent article in the Financial Times.) For that reason, there should be efforts to create structural changes in finance to make markets more efficient. In the last year, derivative regulation is a step in the right direction. The change in fair value accounting was a move in the wrong direction.

But one structural aspect that has not been addressed is the role of arbitrage. Arbitrage is a driver of efficiency in markets. It is an example of the beautiful way in which the invisible hand of mutual self-interest creates a surprisingly fair market. But in times of stress, arbitrage is no longer a source of efficiency, but a source of inefficiency. This inefficiency comes from the wrong premise that arbitrage requires no capital.

Consider the following example. A hedge fund decides to take advantage of a price differential between S&P500 futures on two different exchanges, buying the cheaper futures and selling the overvalued ones. From an economic perspective, he has locked in the spread between the two exchanges since they are fundamentally the same thing. However, if after the trade the differential increase, technically the transaction has a mark-to-market loss. Because the original price differential was miniscule in the first place, the trader probably levered up to get a better return. As markets are behaving irrationally, the differential could grow further, triggering more accounting losses. These losses require posting collateral, which is why arbitrage is not capital-free. As Keynes said, "the market can stay irrational longer than you can stay solvent," meaning eventually collateral calls can lead to default. (Schleifer and Vishny 1997)

LTCM manager John Meriweather described his arbitrage fund's strategy as "picking up nickels all over the world." Many of these nickels need to be picked up. They make the streets of finance more transparent. When the price differential between S&P500 futures on different exchanges increases, traders should be able to increase their positions and lock in more guaranteed profit rather than having to liquidate trades to post margin. When interest rates on treasuries go negative, as they were briefly after Lehman and during the Great Depression, market participants should be able to clear the nickels and bring yields to reality.

Considering most financial crises are exacerbated by an irrational market causing caustic margin calls, it is interesting to look at how policymakers have fought this effect in the past. The best example comes from the Panic of 1907. The Panic of 1907 was very similar in nature to the 2008 Financial Crisis--caused by a lack of trust in financial institutions, bringing stock prices down 50%. The issue in 1907 was liquidity--bank runs were draining money out of the system. J.P. Morgan famously locked the most important bankers in a room to come up with a solution. The solution was to replace clearinghouse deposits (basically mark-to-market margin) with bonds so banks would have enough cash.

What if this model could be adapted to modern day liquidity crises? (Leveraged) arbitrage is similar in nature to fractional reserve banking. In commercial banking, if every consumer demands their deposits at the same time, the bank will be insolvent. Similarly, if all arbitrage trades go wrong at the same time, a firm will not be able to post margin on all of its trades even though they are economically viable. This example illustrates that for arbitrage to be an effective driver of efficient markets, there must be a mechanism in place that guards arbitrageurs against bank runs. One good step would be counter-cyclical margin requirements like those seen in 1907.

Argentine Credit Indicator

A delegation from Argentina is heading to Europe and the US this week to pitch a debt swap that would extent maturities on $2.3bn inflation-linked bonds. It will be interesting to watch how this is received by creditors. In 2005, many investors rejected Argentina's debt restructuring, leading to lawsuits that have limited Argentina's access to debt.

Adam Smith's statement, "When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and compeltely paid," applies especially to Argentina. Argentina has defaulted on its debt 6 times since 1800 (1830, 1890, 1915, 1930s, 1982, 2001). If the market is willing to lend money to Argentina, then that should be a good indicator that credit is flowing at normal levels.

Natural Gas Price Outlook

Natural gas prices dropped to a 7-year low today, as NYMEX Henry Hub futures (for September) fell 17 cents to $2.95, breaking the $3 barrier. Natural gas has taken a drastic turn in decoupling from the price of oil after the financial crisis. Historically, a barrel of crude oil has traded at a 6-10 multiple of the price of one mmbtu of natural gas. However, during the last half-year, the price of oil has re-inflated to $70 while natural gas has languished at $3/mmbtu due to negative fundamentals.

The drop in natural gas seems strange considering the number of rigs drilling for natgas have dropped by 58% since September 2008, according to Baker Hughes. With conventional production dropping, how come the US department of energy expects stockpiles to reach a record 3,800 mmbtus in November? The reason, according to BoA/ML Energy, is unconventional production from shale has become more profitable. Some producers report being able to find costs as low as $1.5/mmbtu, allowing them to lock in substantial margins with January 2010 futures trading at $5.47/mmbtu.


Considering these economics, natural gas is likely to fall further in the short term as inventories continue to swell. But this cannot go on forever. Due to the difficulties of storing natural gas, storage space is very limited. As inventories rise, the price of storage will rise, pressuring the natgas forward curve towards backwardation. Another risk is regulatory action from the CFTC. The CFTC is holding hearings on whether to limit some dealers' positions in natural gas. This could cause temporary selling pressure as funds decrease their positions.

While there are strong reasons for low natgas prices in the short term, there are good reasons to be bullish on natgas in the long term. One of the best reasons is cap-and-trade. Climate change legislation promises to raise the price of coal and oil relative to gas (gas has lower carbon emissions). In terms of electricity generation, the price per MWH for natural gas will converge closer to that of coal, increasing demand for natgas. In terms of transportation, increased use of liquefied natural gas (as the Pickens Plan promotes) instead of oil will obviously raise demand, as will the increased use of electric cars. I would not be surprised to see natgas trading at $6-7 /mmbtu in 2010, though the long-term future of natural gas ultimately depends on the sustainability of the economics of shale production.