Sunday, June 24, 2012

Objects in the Mirror May Be Closer Than They Appear

While I was not a huge fan of the movie Jurassic Park, there's no doubt that one of the best pieces of cinematographic humor is the fleeting shot of the rearview mirror during a near death escape from a rogue Tyrannosaurus Rex.  With his yawning terrifying dentifrice taking up the whole of the mirror, the camera focuses on the words: "Caution: Objects In The Mirror May Be Closer Than They Appear."  While I'm applying a bit of Moore's Law to an analogy, allow me to remind you of the observation of Charles Mackay's timeless commentary on John Law's shenanigans in 1720:

"The regent, who knew nothing whatever of the philosophy of finance, thought that a system which had produced such good effects could never be carried to excess. If five hundred millions of paper had been of such advantage, five hundred millions additional would be of still greater advantage. This was the grand error of the regent, and which Law did not attempt to dispel. The extraordinary avidity of the people kept up the delusion; and the higher the price of Indian and Mississippi stock, the more billets de banque were issued to keep pace with it. The edifice thus reared might not unaptly be compared to the gorgeous palace erected by Potemkin, that princely barbarian of Russia, to surprise and please his imperial mistress: huge blocks of ice were piled one upon another; ionic pillars, of chastest workmanship, in ice, formed a noble portico; and a dome, of the same material, shone in the sun, which had just strength enough to gild, but not to melt it. It glittered afar, like a palace of crystals and diamonds; but there came one warm breeze from the south, and the stately building dissolved away, till none were able even to gather up the fragments. So with Law and his paper system. No sooner did the breath of popular mistrust blow steadily upon it, than it fell to ruins, and none could raise it up again." 

- From Memoirs of Extraordinary Popular Delusions and the Madness of Crowds (1852)

Now our T-Rex in J-Park spanned a bit greater an epochal reach showing up in the mirror of an SUV but his toothy menace should give us considerable pause as we look at the financial news coming from the U.S. and Europe.  Like the ill-fated impulse to see if you could reintroduce giant paleontological behemoths into a theme park, manipulation of things we don't fully understand, regardless of the novelty of the rationale for it, usually ends with something as elegant as the digestive track of a raging lizard.  I have frequently reminded Inverted Alchemists that our obsession with reductionist statistical models - an impulse borne of the celebrated "scientific method" - is central to our societal undoing.  Nothing could be more germane to the moment than the announcement that leading rating agencies have downgraded many of the world's largest banks.

To fully understand the contempt with which I hold this news, we may recall the forbearers of our economic 'innovations' that date back to the very regent co-conspirators of the infamous John Law.  To support the popular delusions of fiat economies (both then and now), it is imperative for an alleged group of observers to provide 'empirical support' for the risk-free nature of the sovereign.  This concept, which should have long found its way into the Museum of Unnatural History, is as alive and well today as the virtual T-Rex was in the park.  To see how little things have changed in 300 years, I commend to your reading at least the first section of Mackay's Memoirs.  However, it's important to note that rating agencies - operating under the SEC and government's modern NSRSO oligopoly blessing - are, at their core, marketing agencies.  Their 'risk assessment' neither correlates to, nor is derived from, verifiable, reproducible data.  That said, they never were supposed to do so.  From the life insurance mandate for long-duration investments leading up to the 1913 creation of what is our current Federal Reserve system to the present, when the economy gets tough, rating agencies must manufacture 'investment grade' rationale for people (and, more importantly, their fiduciary intermediaries) to invest. 

Whimsically, Moody's, S&P, and Fitch - the arbiters of independent risk rating - actually had a rather ironic proclivity to see their risk ratings actually correlate to the world's 60 largest banks' need for government bailouts in 2008!  The better you scored in risk, the more unsound you were.  However, given my aversion to ALL correlative logic for the fallacies upon which it is built, I only offer the preceding observation to kick sand in the face of the proverbial laggard.  The point is that the 15 bank downgrade of this past week actually had very little - if anything - to do with the banks.  Rather it had to do with a recursive error built into the rating process itself - an error that was wired in from day one and is setting us all up for a big, toothy shock.

Now, for a moment I'm going to pick on Moody's - not because of a greater contempt but, to their credit - for their published Bank Financial Strength Ratings (or BFSRs) which go further in describing their process than either S&P or Fitch have the courage to disclose.  I love their dog-ate-my-homework / get-out-of-jail-free disclaimer that stated in 2007, "barring systemic stress and provided that there is reasonable client confidence…" prior to describing how they navigated the markets into the rocks of the sirens!  In other words, "If we actually did measure what the public actually thinks we do, we'd be extinct but, since we don't, business is booming."  According to Moody's, their inputs include: 1) Franchise Value; 2) Regulatory Positioning; 3) Regulatory Environment; 4) Operating Environment; and, 5) Financial Fundamentals.   They go on to state their explicit bias stating that financial fundamentals contribute to 50% of the risk score in "developed markets" and only 30% of the risk score in "emerging markets".  After all, a financial stability rating should have a minority of quantitative inputs coming from financial data, right?!

So, what we've got are a group of soothsayers publishing their contempt for actual risk modeling with impunity who are desperately trying to put lipstick on pigs.  Why?  Well, a huge number of investors, by law or by charter, must buy investment grade assets.  In other words, we require an inventory of good investments be manufactured whether they're good or not!  Pension, life insurance and other insurance companies, banks, etc. are all required to buy fixed income products which are deemed 'safe' so that their public fiduciary obligations can be met.  Now, we've got a T-Rex sized problem which we're trying to cover up with a fig leaf.  Government debt - once the stuff of "risk-free" capital designations - is seeing public confidence collapse like the hanging brick in Hitchhiker's Guide to the Galaxy (if you don't get it, look it up).   Investors the world over have been willing to buy as much corporate and municipal debt as they can get their hands on and the inventory is not what the demand requires.  The European summer and the U.S. Fall (and I do mean over the cliff) all suggest that government debt is going to continue smelling like a Greek fishing village on a hot afternoon with no breeze.  To stay in business, rating agencies who only exist at the pleasure of their sovereign authorizers, have to preemptively make government debt appear more desirable relative to other investment products.  Lest you think this is my commentary, make sure you read all rating agency disclaimers which explicitly state that they're ratings of relative risk - not quantitative risk.  However, this short-term fix is a long-term madness.  By undermining the investment quality of the financial sector, the financial sector, in the short term will be forced by regulatory capital mandates to become bigger consumers of (you guessed it) government debt.  And they'll have to buy it up at the same time that the government debt becomes lower quality which, as you can readily discern, will degrade financial institutions even more.

What's the point?  Well, to keep my streak going, what I'm stating is that the bank downgrade was not about bank risk but rather an impending down-grade in government confidence.  It's the opening act of a comic tragedy that will end with most of the actors with knives in their backs or hemlock in their goblets.  It wasn’t an accident that the bank rating cuts punctuated a week when several governments were debating a unified European debt issuance.  After all, what better a time to have the few productive economies of the EU prop up the majority who are illiquid?  By forcing fixed income buyers and reserve managers into a debt demand for which there is no quality supply, suddenly what is economically suicidal appears to have momentary expediency.  And, as with John Law in the run up to 1720 no one dare question that, in the end, the sovereign knows best.

By this point we're both frustrated.  Many of you faithfully read my blog and share with me your critique that I don't deliver messages in a clear and concise (accessible) manner.  This is not for lack of trying.  When I see the T-Rex in the rearview mirror, I'm not prone to sugar coat the fact that we're about to experience the prey side of the food-chain.  However, in a world where we have Twitter-fed economic literacy, the transparency of the problem hides the treasonous acts in plain sight with virtually no one taking note.  So I'm going to attempt to deliver a punchline that is accessible.

This week's move by the rating agencies was no more about bank risk than the events of 2008 were about real-estate.  You're being fed propaganda and it tastes of carrion.  It was about creating an illusion to cover an up-coming junk debt fabrication and subsequent sale by governments.  If you have any life insurance or long-duration investments (like a pension) you'll be having your money used to fuel the Madness of Crowds.  By downgrading banks, they simultaneously:

a.         Decreased the appetite for investors to support bank equity;
b.         Increased the demand by banks to buy government-issued debt;
c.         Created the illusion that government debt was 'better' than other options (the same phenomenon that has propped up the U.S. Treasuries for the past several months as a relatively safe alternative to Europe because we're deferring addressing our problems until the election which thankfully happens in November);
d.         Failed to measure quantitative risk; and,
e.         Failed to restore credibility in themselves or their models.

What this means to you is that, far from being over, we're about to see a deepening collapse of the heralded 'recovery'.  Going into the next few months, public sentiment is going to be encouraged to falter and, We the People, are going to be invited into the despair that primes the pump for another irrationally unjustified paternalistic intervention. 

So, what can you do?  Well, for starters - DON'T DESPAIR.  These events are the inevitable and timely fruit of a tree planted in an aspirational Eden called Bretton Woods.  If you listen to the snakes and eat from the fruit of the tree…, well, I think you know how that story played out.  This is a time to build productive, essential enterprises at scale.  While intervention-minded policy makers will scamper about trying to tell you to live in fear, explicitly live in a manner that seeks to build value within your communities of proximity and diversity.  Rely on your ability to steward the resources you influence - your abilities to build the context for value and its exchange.  Rather than looking to remote 'solution providers', realize that the 'problems' are not essentially real.  They are but the illusions projected from a master delusion and the less you respond to them, the less power they'll wield.  In short - Live Fully and realize that this past week, we just passed another signpost of the end of a system that did not work for most of the world.  That's good.  Rather than fearing what's looming in the rearview mirror, its time that we look down the road ahead of us and start driving with our eyes on the road through the wind shield.  Between here and there, we'll have a few bug splats and some pterodactyl poop but, that's why we've got wiper blades!

P.S.  I cannot let today pass without calling your attention to the elections in Papua New Guinea today, the elections in Mongolia this week, and the recent statements by President Evo Morales in Bolivia.  These contemporaneous stories all are a referendum on whether the world is going to allow the holders of modern legalized piracy - the colonial equivalent of Letters of Marque - to continue to use colonial business models to take billions from countries while leaving people in financial and social poverty.  Glencore, the latest company to appeal to the tired, pathetic whining about "fairness" - like Rio Tinto in Mongolia and countless others - need to know, that together with artifacts of inhumanity like slavery, racism, and colonialism, they need to exterminate their tactics of entitlement and lead by engaging in true resource development partnerships.  In PNG, Mongolia, Bolivia and scores of other countries, there's enough to go around.  Failure to lead with ethical governance will lead to tired reprisals.  If you want a different outcome, initiate more conscious leadership!  While Rio Tinto seeks to white-wash its reputation by sponsoring human-rights events around the Olympics, I trust that all readers take these democratic events seriously and increase the scrutiny on those operators who have profited far too long at the expense of millions suffering in their shadows.


  1. Agreed,we have to make sure that the switch into the new world is not a cover for a continuation of the delusion. I have a few ideas...

  2. Objective achieved! Clear, concise and accessible observations with essential advice the whole population needs to hear. Now I know what to do...


Thank you for your comment. I look forward to considering this in the expanding dialogue. Dave