Sunday, April 27, 2008

Minsky Meltdown

I first read "The Plankton Theory Meets Minsky" by Paul McCulley last year after the credit problems we are dealing with now had already begun. It is required reading for anybody that wants to understand how the current situation evolved and be better prepared to recognize future bubbles before they burst.

Minsky, who passed away in 1996, was the father of the Financial Instability Hypothesis, providing a framework for distinguishing between stabilizing and
destabilizing capitalist debt structures. He first articulated the Hypothesis in 1974, and summarized it beautifully in his own hand in 1992:

“Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to ‘roll over’ their liabilities – issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.

It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values.”

GMO 1Q08 Quarterly Letter

I highly recommend the 1Q08 letter from Jeremy Grantham of GMO LLC. As put by Barry Ritholz at The Big Picture, "The 1Q 2008 letter looks at asset bubbles and puts the role of the Fed under the leadership of Greenspan and Bernanke under the microscope, with a wistful nod to Paul Volcker:"

You can find the letter here. Below are a few of my favorite passages:

"Paul Volcker inherited about as big a mess as we have today. He worked out what he had to do and did it with unusual lack of concern about what Congress thought of the necessary pain involved and the number of enemies he might make. He paid the price for forthright behavior by being replaced, despite a record for correct and tough behavior that makes for the most invidious comparison today."

"This has indeed not been our finest hour in the U.S. Times are bad enough, in fact, to make us mourn the American leadership skills of WWII and the generosity and foresight of the Marshall Plan. We can all wonder at the incredible vision, drive, organizational skill, and willingness to sacrifice resources that were required by the Manhattan Project and compare it to the rudderless or even deliberate avoidance of leadership of the greatest issues today: climate change and energy security. We can only wonder what a Manhattan Project aimed at alternative energy might have accomplished by now, had it been started 15 years ago. What we have had in lieu of vision, leadership, and backbone is a series of easy paths taken."

"The idea that occasional economic setbacks might benefit the system in the long run was one of the early ideas to disappear. Yet if you prop up weak sisters who would otherwise fail and in failing present their more efficient competitors with extra growth, you must surely weaken the system. Desperation pricing from weak firms who simply should not exist can weaken the profitability of a whole industry, as it has for the airlines. The average efficiency of most industries is reduced with at least
some effects on our global competitiveness. With a slightly lower average return on equity, the ability to reinvest drops so that, in this world of moral hazard where recessions are few and mild, GDP growth is a little less than it might have been."

"The defense of bailouts is that the alternative is ugly. But surely the penalties for excessive risk taking, issuing flaky paper, passing it on – often in its entirety – to others, and not even understanding the consequences of the low grade paper that you yourself issue should be ugly. “Yes, of course, we would like to punish the excessive risk takers” goes the line, but we can’t do it without hurting the innocent economy. But we will never know what can be absorbed if the penalties are always removed by a bailout. In more traditional times, say, from 1945 to 1985, the economy could absorb substantial punishment from recessions and still grow faster than it has done in the last 10 years. So in a crisis à la Bear Stearns we now transfer pain from risk takers to innocent tax payers. Worse, even the routine treatment for the bubble breaking disease does the same. By raising the slope of the yield curve, the Fed deliberately benefits its bankers and hedge funds that borrow short and invest long and punishes pensioners and others who are trying to make a safe but still reasonable return at the short end."

"The real incompetence here goes back over 20 years: the refusal to deal with investment bubbles as they form, combined with willingness, even eagerness, to rush to the rescue as they break. It’s almost as if neither Greenspan nor Bernanke allows himself to see the bubbles. Greenspan was always conflicted and contradictory about whether bubbles could even exist or not. Bernanke, in contrast, has more of the typical academic’s certainty that the established belief in market efficiency is correct and therefore investment bubbles must be merely the product of investors’ overheated imaginations. It would be convenient to have such an important role as Fed Chairman filled by someone who actually deals with the real world, messy or not, that is given to inconvenient bursts of euphoria and riddled by considerations of career and business risk, which modify behavior far away from economic efficiency."

Thursday, April 24, 2008

Pennsylvania exit polls

I was going through the PA exit polls and thought a few breakdowns were quite interesting.

Age: Obama easily beat Clinton in the 18-39 age group while Clinton was much stronger among 40+. The major difference was the 40+ age group accounted for 78% of total voters.

Religion: Catholics voted for Cinton over Obama 70% to 30%. Those who identified there religion as none went for Obama 62% to 38%

In previous contests the major divides other than race were education and income. In PA Clinton had a 55 to 45 edge among voters making above and below $50,000. Clinton led among college educated voters 51% to 49% and 58% to 42% among voters without a college education.


I don't think the following quote from Dana Milbank's Washington Post column needs much commentary.

"I don't care too much for Obama," Maria Norgren, the daughter and granddaughter
of steelworkers, said in the parking lot of the Giant Eagle shopping center here, near the Obama rally.

"I don't even think he's American," added her husband, Edward, who lost his job when the steel mills closed and now mans the counter at the Puff Discount Tobacco and Lottery shop next to the Giant Eagle.

"His father's from Nigeria, right?" asked Maria, wearing a Pittsburgh Steelers T-shirt.

Tuesday, April 22, 2008

End of Euphoria

The enthusiasm surrounding the historic choices for the Democratic nominee is fading quickly. I love following politics and even I am sick and tired of following the developments of the Democratic primary campaign. A few comments on where we are.

It is not unsurprising the way Clinton is campaigning and I don't have a huge problem with her tactics as after all, this is politics. If she believes her current campaign strategy is the best way to secure the nomination then so be it. It is up to voters and news media to filter out the BS and not get hysterical over ever little comment.

Obama's campaign seems to play the victim too much and has made some minor gaffes that have been turned into the semblance of major gaffes by the media and the Clinton and McCain campaigns.

My big problem is the complete absence of sensible discussion about true issues since the time leading up to Texas and Ohio. I do not include NAFTA as sensible discussion. The issue of trade is credible but the far left liberal talking points both Democratic candidates parodied are not credible. Trade in general is the problem and China most specifically. The trade deficit with Mexico was $74 billion in 2007 with ~40% coming from oil and gas compared to a trade deficit with China of $250 billion with almost nothing coming from oil and gas. Overly dramatizing the negative aspects of NAFTA diverts us from intelligently discussing the bigger structural problems we face. The 6 week gap bewteen OH and PA was the perfect time to delve into the specifics of each candidates platform and ask tough questions. Instead, the media parodied the drivel coming from both campaigns.


I've been thinking about starting a blog for a while but had problems coming up with a good name that wasn't already taken. Inspired by the ineptitude of last week's presidential debate hosted by ABC and the NY Times excellent piece "Behind TV Analysts, Pentagon’s Hidden Hand" my new blog is officially off the ground. I hope to engage readers on issues of politics, business, and anything else that comes to mind.