Where to turn, for financial security?

Richard Bookstaber (whom we've met before, here) looks at asset allocation and makes a point he's made before: in a crisis, everyone wants out, and the relative merits of different assets are ignored in the dash for cash. Provided cash (at bank) hasn't itself become risky - and after last year, that's not a given. Even outside the bank, there's inflation, devaluation and also, potentially, the fate of the Confederate dollar.

Leo Kolivakis comments, "I happen to believe that diversification is still important, but loses its power as huge inflows are going into all sorts of public and alternative asset classes."

That's the problem: we no longer know where to turn. As Kunstler comments, "the most perplexing part is that there hardly seems any safe place to preserve one's savings."

How about the smart, nimble operators? Investment guru Marc Faber spends his time looking at liquidity flows, trying to predict the next sudden tide and get in beforehand - not a game for the type of clients I have usually advised. And even he appears to be readying himself for the worst, "a total disaster, with a collapse of our capitalistic system as we know it today."

Recently, I seem to have been reading more commentators tending to the view that we are heading for that Mises "crack-up boom" - outlined here nine years ago, for example. And worse:

"And 'mid this tumult Kubla heard from far
Ancestral voices prophesying war!"

The great pleasure gardens of China's Emperor took some 40 years to build, in the first half of the eighteenth century. Vast, complex and exquisite, they were testimony to the wealth and power of the Middle Kingdom, only to be methodically destroyed in an act of punitive vandalism by the French and English in 1860. Premier Zhou Enlai decreed that the ruins should remain unaltered, a monumental lesson for the Chinese about the Western powers.

Of all the curses on humankind, long and vengeful memory may be the worst.

Danger of systemic breakdown

Doug Noland looks at the world of financial speculation, which has used loads of borrowed money to boost returns, and worries that as liquidity dries up, the market will become inefficient. This is, I think, one of the things about which Richard Bookstaber has warned. Perhaps the gunslinger day traders should assure themselves of the robustness of their counterparties when playing with futures and options.

Little boxes

In India, where many people cannot read, you sign for the State pension by thumbprint. This seemed like a secure system, until a man was caught with a tobacco-tin full of thumbs.

It would have made no difference had it been a tin of cloned credit cards. You don't need to know what's in the box, or how it works; you need to know what it does, and who it's for.

Once you start thinking along these lines, things get so much clearer. For example, you don't have to be a "quant" like Richard Bookstaber, to know that derivatives are about risk. More precisely, they're for increasing risk.

Supposedly, a derivative reduces risk; but if you look at its use, it's a box that tells lenders and gamblers how far they can go. Seeing the fortunes that can be made in high finance, there is the strongest temptation to push the boundary.

My old primary school had a lovely little garden behind it, where we played at morning break. One game was "What's the time, Mister Wolf?". You went up to the "wolf" and asked him the time; he'd say nine o' clock; to the next child he'd say ten o'clock and so on, until he'd suddenly shout "Dinner time!" and chase you. Obviously, the game was not about telling the time.

So it is with financial risk models that service the need to maximise profits: always another trembling step forward. There's only one way to find out when you've gone too far.

But what if you could ask the time, and know that someone else would end up being chased? I think that explains the subprime packages currently causing so much trouble.

The bit I don't understand is why banks started buying garbage like this from each other. Maybe it's a case of the left hand not knowing what the right hand is doing, since these organisations are so big. Or maybe it's that everyone has their own personal box.

Then there's credit default swaps, and other attempts to herd together for collective security. They don't work if the reduction in fear leads to an increase in risk-taking. United we fall: no point in tying your dinghy to the Titanic's anchor-chain.

In fact, I think this opens up a much wider field of discussion, about efficiency versus survivability. In business, economics and politics we might eventually find ourselves talking about dispersion, diversity and disconnection.

Jim Puplava's interview with Richard Bookstaber

Richard Bookstaber's interview on Financial Sense (21 July - audio file) was interesting. He discussed the derivatives market (which is the subject of his book, "A demon of our own design"), in which he has been intimately involved. It's a long interview and I'll just pick out one or two points.

Derivatives are financial bets. Portfolio managers use them as a kind of insurance, which then means that they can safely (they think!) increase their exposure to equities.

But derivatives are complex, and can have unexpected effects. For example, in October 1987 there was a sizeable drop in the stockmarket, and as the prices went down, automated trading programs noted the crossing of pre-set thresholds and this triggered more selling, which took the market below other programmed thresholds, and so on.

Also, to work properly, the derivatives market needs to be "liquid and efficient". Well, when the major turmoil was happening as just described, people held off buying back in - the scale had scared them. So they weren't doing what the system expected them to do, and this change in behaviour meant that there was less support at certain price levels than the system assumed.

Another way in which the system became inefficient at greatest need, was that certain classes of asset behaved in an untypical fashion. For example, normally bonds move together, and in the opposite direction to equities; but in 1987, when it looked like major disaster, poorer-quality bonds fell as though they were equities (because of fear of their defaulting), whereas Treasury bonds (backed by the government) rose.

I have heard that in times of stress, people make unusual mistakes, such as confusing left and right, and it seems that the derivatives market has similar potential in extreme situations. You can't tell how people will react under great pressure.

Then there's "black swan" events that haven't been factored-in, but can still happen, such as Russia's decision to default on its loans, which very nearly did for Long Term Credit Management and much more besides.

On top of that, there's the question of leverage, i.e. borrowing that greatly increases the risk and returns of an investment. The current debacle re mortgages packaged as interest-yielding investments stems from the fact that not only are the packages leveraged by a factor of 10 or 20 to 1, but the hedge funds that bought them might themselves be leveraged by a factor of 5, so magnifying the basic risk of sub-prime lending by a multiple of 50 or 100. So when things go wrong, they really go wrong. As we now see.

There is also the question of inadequate information about derivatives. The method of accounting was originally developed to track rolling stock for railways, not for super-fast, computer-based trading. The data available may not be what you need to assess the situation properly, and will almost certainly be out of date in the moment-to-moment market changes. Bookstaber thinks we need to use modern technologies to get the right data out of the system fast enough to make sensible decisions.

And in assessing risk, people's memories are too short. Fund managers may be too young to remember really bad times like 1989-91, so run the risk of complacency.

Speaking of age, there's a demographic risk, too: the baby-boomers are coming to the point where they'll want money out for retirement, and maybe the market hasn't fully realised this change in the financial climate. It could be a "slow burn" crisis like the one that hit Japan, lasting maybe 15 or 20 years.

Now, many of these periods of turbulence probably don't impact on the individual investor, says Bookstaber; the private investor should buy and hold, not panic.

However, a systemic risk that could have really serious consequences is the possibility of a major failure in the mortgage and credit markets, which could then roll on to the banking sector.
Yet again, we're back to the banks, credit and the money supply. How ever did we come to think of bankers as responsible people!

Anyhow, listen to the audio file and see if I've represented it fairly. And buy the book if you think it's relevant to your line of work or investment.

Further concern re derivatives

The Contrarian Investor's Journal continues its series on crash preparation. Part 1 showed how you could lose your shirt on shorts; now part 2 sounds a warning on derivatives - like Peter Schiff, Michael Panzner and Richard Bookstaber.

Panzner reviews Bookstaber on derivatives

Michael Panzner's view on the dangers of derivatives is confirmed in a new book by Richard Bookstaber, a senior insider in that world. "A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation " is available from Amazon here, where you will also find a review and further information about the author.

Panzner's Financial Armageddon site reviews it (under 18 May) here, quoting and commenting on a previous Wall Street Journal piece. He calls the whole system "Ponzi finance" and Bookstaber himself is calling for a reduction in the complexity of these financial instruments. See also my review of Panzner's Financial Armageddon, which considers these and other risks to America's economy.