My paper and presentation should be available on my site

Open Capital

early next week, for those interested in such things.

By way of preparation I wrote an article which will be published in two Iranian newspapers on Saturday, I understand, and "Asia Times" have been kind enough to publish it today, despite the fact it directly addresses Iran

A New Dawn for Iran

After the conference I have quite a few meetings already lined up, including ministers, leading parliamentarians, financial services practitioners, and - perhaps the one I most looking forward to, believe it or not, a meeting with clerics in the Holy City of Qom, to discuss the values underpinning financial markets and products.

Interesting times, indeed....

Beyond Peak Credit - a New Dawn for Iran?

I have been working for some seven years, with a background in global financial services at the highest level, to assist Iran in developing a coherent financial system fit for the 21st Century.

Throughout this sometimes painful process I have made clear that the Western "market economy" is fundamentally unsustainable and that its collapse would occur sooner rather than later. Unfortunately, those decision-makers in Iran who received my advice took the mistaken - but conventional - view that the Western "Twin Peaks" financial market model based upon "Debt" (credit created as money by credit institutions) and "Equity" (in Corporations) was both sustainable and even desirable.

But, as I have been saying throughout, both privately and in articles published globally, this model never was sustainable. Exponential economic growth required by the mathematics of compound interest on a money supply based on money as debt must always run up eventually against the finite nature of Earth's resources - particularly carbon-based energy.

The Problem - "Peak Credit"

The dollar-based global financial system is continuing a slow, and irreversible, collapse from the point - I call it "Peak Credit" - in August 2007 when the unsustainable US property price "bubble" finally burst.

The problem is not one of liquidity - ie the absence of money - Central Banks can print as much of that as necessary. The problem is a terminal shortage of capital or Equity in the global banking system - a solvency problem. The US government was previously able to resolve such a problem - as they did in the 1930's - by deploying unused domestic resources.

The US has brought forward, through its catastrophic waste of resources in Iraq, its "Suez Moment". This is the realisation forced upon Britain by the US in 1956 that economic realities require an End to Empire. The US cannot resolve the insolvency of the Dollar-based global financial system without the assistance of their international creditors, and this requires a new global settlement - a "Bretton Woods II".

It is ironic that Iran has been protected from being infected by the "Anglo Disease" by the very sanctions which were aimed at damaging her.

What is the Alternative?

We must recognise the distinction between "Money" and "Money's Worth" and ensure that the financial system reflects this.

Over 70% of Dollars created are in fact based upon the value of land use - and came into existence as loans secured by a legal claim or "mortgage" over land. Most of the rest of the Dollars are based upon the value of carbon-based energy (ie oil) much of which originated in Iran.

Firstly, in relation to energy, I advocate the replacement of the literally worthless (because "deficit-based") Dollar created by the US Federal Reserve Bank with an "asset-based" "Energy Dollar" or "Carbon Dollar" value unit based upon the intrinsic energy value of carbon-based fuels.

This currency would be created by "Unitising" energy as "Units" redeemable against energy within the "PetroTrust" framework I am presenting in Teheran at the important International Oil Refining Conference on 11th/12th October. Such Units would then circulate globally, subject to mutual guarantees, within the framework of an "International Clearing Union" similar to that proposed by the great economist John Maynard Keynes at the first Bretton Woods conference in 1944.

Secondly, in relation to the value of land I propose a new "Co-ownership" framework for direct investment - "Unitisation" - in a new type of "Real Estate Investment Trust" ("REIT"). This would replace the conventional financing of land and buildings through secured "mortgage" lending which invariably gives rise to bubbles in land prices.

Such "Capital Partnerships" between Investor and User of Investment are in fact already emerging in the UK and will be immediately recognised by anyone who is familiar with the revenue and production sharing agreements which have been at the heart of Iranian and Middle Eastern commerce for literally thousands of years.

A National Equity?

The alternative to an unsustainable "Deficit-based" system can only be "Asset-based": new forms of "Equity" -beyond the "Corporation" - to replace unsustainable secured Debt. Existing national accounting - based upon a "National Debt" - is fundamentally flawed but is unquestioned, and until recently, unquestionable.

I believe that Iran could be the first to evolve a "National Equity" to replace much of her - conventional "National Debt".

The means to do so is simply to use new alternatives to the legal form Iranians - like everyone else - regard as a fixed constant - the "Limited Company" or Corporation. Once it is realised that alternatives to the Corporation are not only possible, but are emerging because they actually work better, then everything else will fall into place.

I am pointing out that Iran does not need to sell ownership and control of her natural resources to multinationals when she can simply "Unitise" and "sell forward" part of her production to investors, receiving interest-free finance in return.

A New Dawn

The resources of Iran in terms of energy, whether carbon-based or the energy of her immensely talented and young population, are phenomenal. I believe that it is possible for the Iranian people - with wise leadership, which is not lacking - to harness these energies and to "self organise" within agreed frameworks to meet the global challenges we face.

It goes without saying that Iran cannot address these challenges alone. But I believe that the simple, but radical partnership mechanisms now emerging will not only allow Iran to transcend sterile arguments and competition, but to do so in a way that integrates her eternal values with an optimal economic model which will cure the "Anglo Disease".

Finally, to those in Iran who advocate reform, I have this advice: the last thing Iran needs is to reform itself to achieve a "Western" financial market model which has demonstrably failed. Indeed, Iran is fortunate that circumstances have prevented her from going down this road.

Instead, I believe that Iran should examine - from first principles - how a market economy might operate collaboratively to develop Iran's productive economy, rather than being operated as a casino for the benefit of financiers at the expense of the productive economy.

I look forward to working with my Iranian friends to achieve an economy fit for the 21st Century

And a hat tip to Jerome, whose "Anglo Disease" receives an honourable mention....

Only in Norwegian so far, but the Iceland Prime Minister was just on TV to say that the government is taking control of the banks, but may not have the resources to save them.

He said that it is too risky for Iceland as a nation to bail out the banks, and therefore there is a real possibility that the Icelandic economy will collapse...

Update [2008-10-8 11:46:51 by ChrisCook]:

The Icelandic Central Bank has announced that it has given up supporting the kronur - which was always a bit like resisting tanks with a pea-shooter

The Swedish Central Bank has apparently offered a SK 5 billion loan to prop up Kaupthing's Swedish operation - Kaupthing Bank Sweden AB - where 25,000 Swedes put their money in the last year alone in search of a 5.55% interest rate...

In the UK, Kauthing's UK division, Kaupthing Singer & Friedlander has been put into administration, and the retail deposits of Kaupthing Edge have been shifted to ING

As they say, if something looks too good to be true, then it probably is...

Which sums up Iceland's economy in recent years pretty well...

Credit worries slow OTC oil trading

which illustrates that the credit ripples are spreading....

They said credit worries were also spurring a shift to clear over-the-counter oil trades, such as price swaps, on NYMEX Clearport, which offers clearing for some OTC derivatives.

"It's driving a lot of people toward doing cleared OTC business, we've seen that to quite a degree," said Christopher Bellew, a broker at Bache Commodities Limited.

On the face of it, that has to be a good thing in terms of regulatory risk and transparency to the regulators.

But as I have pointed out elsewhere, I don't think either market participants or regulators appreciate that clearing houses are as much a "single point of failure" as Fannie Mae and Freddie Mac are.

They have in common the fact that they both support a pyramid of price risk supported by a sliver of capital. As I have recently said - again - the risk of "Black Swan" events wiping out that capital is far higher than is generally appreciated

Oil markets: an accident waiting to happen

Moreover, the ongoing move by the Intercontinental Exchange to clear their own business

Ice Clear Europe

(and thereby make more money from what is known in the trade as a "vertical silo" approach) is temporarily on hold

Clearing transition postponed

during the current market turbulence.

No doubt the FSA is asking them very searching questions about their risk management.

But the bottom line is that the pool of capital supporting these transactions after the transition must - as far as I can see - be less than it is when the risk lies in London Clearing House's risk pool of capital which covers several other markets beyond oil.

Another classic case of the profit motive acting to increase systemic risk,

In praise of free markets

and was moved to write the following LTE, which will undoubtedly go the way of most of the rest...

Dear Sir

Further to your leader yesterday, as a former market regulator - I recently gave evidence to  the Treasury Select Committee in relation to oil market regulation -  I naturally advocate a market solution.

But to borrow language from Dr Yunus of Grameen Bank, I advocate a market which operates "Not for Loss", rather than "For Profit".

The UK bit the bullet and chose the "Public" solution of nationalisation : the US twists and turns to find a "Private" or  "For Profit" solution, albeit a genetically modified one.

I propose a "Not for Loss" synthesis in the form of a "Capital Partnership" within the framework of a UK LLP or US LLC.

A Bradford & Bingley Partnership would operate as follows:

Step One: B & B assets are put into the hands of a "Custodian".

Step Two: existing B & B Equity is exchanged for proportional "Units" in B & B gross revenues eg billionths.

Step Three:  the B & B "rump" now stripped of finance capital remains as "human capital"  which receives an agreed proportional allocation of Units as a "Managing Partner",

Step Four: the Treasury introduces Public investment as necessary and in exchange receives Units from the Investor allocation, thereby diluting existing Investors.

Such a "Capital Partnership" is a simple, but radical "hybrid" solution, but transcends the "Principal/Agency" conflict between the interests of owners and management which both the UK and US leave intact in different ways.

The interests of B & B management and B & B investors - whether public or private - are now aligned in a simple, radical, and, believe it or not, Islamically sound, way.

It's not Rocket Science.

Yours faithfully

Chris Cook

The "Glasgow Herald" published today a slight variant of my FT LTE

Introducing a new market solution for banking crisis

Probably too radical for the FT!

The plot thickens: is there to be white collar crime in the White House?

Hagen to breakfast with Bush

Our recycling Norwegian shirt hero Stein Erik Hagen and his wife are to have dinner tonight with President Bush, and breakfast in the White House tomorrow - between bank collapses, no doubt.

The background for Hagen's Washington visit is that Hagen has for years been on the advisory board of the Library of Congress.

Hagen did not wish to comment on the meetings when journalists met him at Oslo airport on  Thursday.

....but it is confidently expected that he will appear in the White House in new shirt collars, and with new soles on his shoes.

Surely the Library of Congress is a cover for something more sinister, since everyone knows Bush doesn't read, and Hagen only reads balance sheets.

Is this in fact a meeting of the Illuminati, or the Bilderberg shirt working group?

The People must be told!

Shirts.

Stein Erik Hagen is - or was - one of Norway's "nouveaux riche" financial engineers.

He is notorious for giving highly public advice to the curent "Red/Green" Government in relation to economic policy, inevitably from a perspective somewhat to the Right of Genghis Khan.

He has been somewhat surprised - a bit like McCain's ignorance as to his private housing stock - that Joe Public (sorry... Ole Nordmand...) did not appreciate the economic sacrifices he recently said he was making.

That's right.

Stein Erik Hagen is surprised about the shirt scandal

about how he sends his shirts (which apparently cost over NOK 2000 or £200.00 each) to London to have new collars fitted, rather than buying new ones.

Don't people know sacrifices have to be made??!!

Nordic and global shirt news - afew

LQD: Central Banks and Unintended Consequences

I had a quick look at the proposition that current Bank of England policy - based upon conventional thinking about money and inflation - is diametrically wrong and can only lead to the outcome they are aiming to prevent.

More evidence is gathering daily that liquidity is draining out of the system despite what appears to be the valiant efforts of the Fed to maintain it.

A case in point is Norway, and a few others, who have been "bailed out" (honestly!... you couldn't make this up...) by the Fed because they have been running out of dollars to settle inter-bank dollar borrowing.

U.S. Fed Agrees to $30 Billion Swap With Four Central Banks

In fact, on one day last week virtually no Norwegian bank could give a price on NOK/$ at all....

Norway's central bank, or Norges Bank, yesterday supplied $5 billion in one-week dollar currency swaps to ease liquidity in financial markets. The bank also swapped $5 billion to ease dollar shortages last week.

The point is that, as Geoffrey Gardiner pointed out in that LQD there is a big difference between "pro inflationary" printing of dollars "unfunded" by T Bills, and "anti deflationary" printing of dollars to replace the catastrophic destruction of dollars by defaults.

If the Fed continues on this course they can only make a bad situation worse. They have forgotten - if they ever learned - the lessons of deflationary times which is, counter to conventional thinking, that the printing presses must roll to replace the money destroyed.

As I understand it, Gardiner is saying that the Banks are unable to create credit because of a shortage of "high-powered" money.

Now, as Thomas Edison said

"But here is the point: If our nation can issue a dollar bond, it can issue a dollar bill. The element that makes the bond good makes the bill good."

That is as true in the age of electronic bills as it was in the age of paper ones. Why should it not be the case that the users of a pool of Treasury credits, which cost nothing to create, actually pay no "inteerst" but instead pay a provision for the use of the Treasury guarantee, and a service charge to the banks who would manage the system?

Gang 8

The banking expert Geoffrey Gardiner has this counter-intuitive advice for the Treasury and Bank of England....

Another ridiculous twist in this farce is that the central banks are lending like fury to raise the 'liquidity' (really assignable government debt) of the banks while stripping the 'liquidity' out again by funding government debts.

The public's 'flight to quality' ensures this, and the result is that US government bonds are higher than since 1940. I was at a lunch with the woman who runs the British National Savings schemes a few weeks ago and she said that the Northern Rock affair had caused her organisation to be overwhelmed with applications for National Savings products.

So the savings of the public are going to the government which is lending them back to the banks at extortionate rates of interest. The Bank of England's profits in the main go straight to the Treasury. One can imagine that some Treasury official, desperate to cover the government deficit might regard this as a good wheeze, but in the long run it must be ruinous to the country.

The 'liquidity crisis' could be solved by a suspension of issues of government bonds and National Savings products. Savers would have to put their money in the banks and central bank loans would be repaid.

Government borrowing would for a while remain unfunded and the government's new borrowing would therefore be reflected in large deposits by banks at the central bank, which in turn would be anxious to lend them out for a better return. They would do so but of course the liquidity level would remain high, and a multiplier effect would take place.

This is the obverse of standard anti-inflationary strategy. What governments are doing is pursuing standard anti-inflationary tactics at a time when the horror of deflation is close at hand. No-one in government remembers what deflation is like; they are too young. Nor do they understand that this is the way to deal with it.

What Gardiner did not say here, but has pointed out before, is that one of the key problems is structural.

Quite recently, the Treasury took over from the Bank of England - after 300 years of relatively trouble-free operation - the department that deals with debt management - the "Debt Management Office".

Since that point the DMO has been run by a Treasury which knows bugger all about the banking system, and even less about managing an economy, due to their use of the literally insane "Washington Consensus" monetary policy framework.

I pointed out here in the context of Northern Rock that far from losing the tax payer money, the tax payer was making £20 million per week from the mad strategy Gardiner refers to here, and said at the time was stripping the system of the true liquidity it needed. (Albeit, some of these profits are now being eroded by defaults).

The Treasury is of course rationalising its greed with the position that to issue new money in this way is "inflationary". They therefore miss the crucial point that the purpose of issuing new money is to prevent deflation, by replacing money destroyed by defaults. It therefore never enters the system at all (remaining "static" through being "tied up" in secured loans) and cannot create inflation.

An Accident Waiting to Happen

ET regulars will know there's been a lively debate here about whether or not the run up in the oil price to $147 per barrel and back down to the low $90's constituted a "bubble" or  "large volatility".

My view is that sooner or later the oil market will go through a speculative bubble/ large volatility and a rush for "crowded exits" will cause a "market meltdown".

In this article, I am only referring to the problem. I hope shortly to get another article published with a proposal for a market solution.

Anyway, here it is ( I retain the copyright).

The title I provided, and which I prefer, is "An Accident Waiting to Happen".

Oil Market Collapse Waiting to happen
After a phenomenal "spike" in oil prices to US$147 per barrel, the price has declined to just over $90. In the US this led to a "spike" to $4 per gallon of gasoline and placed energy prices right at the top of the US political agenda.

Moreover, this political interest rapidly crossed the Atlantic since British trading of US contracts was believed to be instrumental in a speculative oil market price "bubble".

In view of my background in energy markets - I was for several years director of compliance and market supervision at the International Petroleum Exchange (which is now ICE Futures Europe) - I was asked recently by the British parliament's Treasury Select Committee to give evidence to them in relation to regulation of oil markets. Such an inquiry is a new direction for the committee, and following this initial hearing they decided to commence a full-blown Inquiry - in the finest US tradition - in October.

I told the committee - and their subsequent initial questioning that day of British regulators implied that my message was understood - that to follow the US approach to regulation of oil futures markets would be to try and solve today's problems with yesterday's tools.

The New York Mercantile Exchange (NYMEX) West Texas Intermediate (WTI) crude oil market price has become almost entirely irrelevant in the real world of physical and forward oil trading, which largely takes place, believe it or not, in Yahoo chat rooms. While NYMEX members still provide a massive pool of trading capital or "liquidity", the inconvenient truth is that oil market pricing power has moved across the Atlantic to the price of North Sea crude oil.

Brent benchmark
The price of North Sea (Brent) crude oil is now the direct benchmark for over 60% of global crude oil pricing, and, through the mechanism of massive "arbitrage" trading between Brent and WTI, it also constitutes an indirect benchmark for most of the other 40%.

Most people - including virtually all mainstream press reporters - believe that it is the price of futures contracts that is used as a benchmark. In fact, it is the reported "spot" market price of "dated" Brent/BFOE (see below) cargo transactions that constitutes the direct and indirect benchmark for most global oil transactions. The massively traded ICE Futures Europe Brent/BFOE Crude Oil contract is merely a financial bet on these underlying prices, and these financial contracts are settled in cash, not oil.

For many years, the production of the Brent oil field has been in decline, and the production of other North Sea oil fields has therefore been amalgamated with it to ensure a sufficient number of transactions to give a credible benchmark price.

We now see four fields - Brent, Forties, Oseberg and Ekofisk ("BFOE") - together supplying the BFOE "Brent" contract whereby 600,000 barrel "cargoes" of these qualities of oil may be bought and sold forward for eventual physical delivery.

The problem is that even this extended North Sea BFOE production is still only running at less than 70 cargoes per month, which is a total monthly production of little more than 40 million barrels. Even at $150 per barrel that represents a value of only $6 billion, and at current prices less than $4 billion.

Sitting on this base of physical trading is an off-exchange complex of price risk consisting of the simple forward BFOE contracts themselves, a host of derivative contracts, and an increasing number of "structured finance" transactions. It is estimated that in total, some $260 billion was recently invested in oil markets one way and another, and this pool of funds was superimposed as an inverted pyramid of risk on this relatively tiny base of physical crude oil.

Could these transactions have been instrumental in causing an oil market speculative bubble?

The answer is obvious: of course they could, and in all likelihood, they did. Unfortunately, because the transactions directly affecting the BFOE price took place off-exchange, not only does no regulator know, but none is in a position to know. Worse than that, even if regulators did know, there are no agreed market regulatory standards to enforce, and any offenders are for the most part smugly immune from enforcement action in offshore jurisdictions in any case.

Don't shoot the piano player
As I pointed out to the Treasury select committee, to blame national regulators, such as the FSA in Britain and CFTC in the US, for problems of a global marketplace does not help, other than in providing a useful scapegoat. This is because the problem lies both in the global scope of the market and in its conflicted structure, where the interests of trading intermediaries or middlemen are diametrically opposed to those of end-user producers and consumers of oil and oil products.

In the absence of a new approach to market structure we will inevitably see repeats of the recent spike in oil prices as waves of hot money swill in and out of the market. In my opinion, that will inevitably lead, sooner rather than later, to a market meltdown - similar to the literally overnight collapse of the tin market in 1985 from $800 to $400 per tonne.

The conventional wisdom is that the "central counterparty" clearing houses of futures exchanges, which guarantee the performance of transactions, backed by a pool of capital and margin, are a strength of these markets.

In my view, they also constitute a single point of failure, where oil price risk is concentrated in exactly the same way that Fannie Mae and Freddie Mac were massively exposed to house price risk.

I made a presentation a couple of years ago in Lausanne to an audience of high-level security experts at a seminar covering the subject of economic terrorism. This fascinating seminar covered the subject of the susceptibility of global markets and commerce to acts aimed at causing economic destruction, rather than physical destruction and death.

I pointed out that current levels of gearing and risk, and the concentration of risk in single points of failure, together mean that the only difference between "economic terrorists" and proprietary traders such as hedge funds is motive. The former would destroy a market deliberately: the latter by accident.

While the oil market survived the recent storm surge of money, the inevitability of future waves of speculative money sweeping into the market, mean that an oil market meltdown is an accident waiting to happen.

Feds to take over Fannie and Freddie

Of course, this is not technically nationalisation, but to all intents and purposes a Fed "SIV" like Northern Rock's "Granite" vehicle.

The plan, which would place the companies into a conservatorship, was outlined in separate meetings with the chief executives at the office of the companies' new regulator.

The executives were told that, under the plan, they and their boards would be replaced and that shareholders would be virtually wiped out but that the companies would be able to continue functioning with the government generally standing behind their debt, people briefed on the discussions said.

The interesting thing is that it appears that all of the Equity would be wiped out.

Under a conservatorship, the common and preferred shares of Fannie and Freddie would be reduced to little or nothing, and any losses on mortgages they own or guarantee could be paid by taxpayers. Shareholders have already lost billions of dollars as the stocks have plunged more than 80 percent this year.

A conservatorship would operate much like a prepackaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets. It would allow for uninterrupted operation of the companies, crucial players in the diminished mortgage market, where they are now responsible for nearly 70 percent of new loans.

If this is so, it will certainly give a lot of banks a major headache since many are heavily invested in these Preference shares, because they are counted towards their base capital. So they'll be looking for more capital....

Ellen Brown had an interesting take on it here

Take a Load off Fannie

She refers to Roubini's support for nationalisation

". . . [L]et's call a spade a bloody shovel: nationalise Freddie Mac and Fannie May. They should never have been privatised in the first place.

 . . . Increase taxes or cut other public spending to finance the exercise. But stop pretending. Stop lying about the financial viability of institutions designed to hand out subsidies to favoured constituencies."

but suggests that there are alternatives to nationalisation, such as the reprise of the 30's Home Owners Loan Corporation ("HOLC") referred to by Alan Binder in an article in February 2008 in the NYT...

"The HOLC was established in June 1933 to help distressed families avert foreclosures by replacing mortgages that were in or near default with new ones that homeowners could afford. It did so by buying old mortgages from banks . . . and then issuing new loans to homeowners. The HOLC financed itself by borrowing from capital markets and the Treasury.

The scale of the operation was impressive.  Within two years, the HOLC granted over a million new mortgages. (Adjusting only for population growth, the corresponding mortgage figure today would be almost 2.5 million.) Nearly one of every five mortgages in America became owned by the HOLC. Its total lending amounted to $3.5 billion. . . . (The corresponding figure today would be about $750 billion.)

As a public corporation chartered for a public purpose, the HOLC was a patient and even lenient lender. . . . But times were tough in the 1930s, and nearly 20 percent of the HOLC's borrowers defaulted anyway.  So the corporation eventually acquired ownership of about 200,000 houses, nearly all of which were sold by 1944. The HOLC closed its books in 1951, or 15 years after its last 1936 mortgage was paid off, with a small profit. It was a heavy lift, but the incredible HOLC lifted it.

Today's lift would be far lighter. . . . Given current low interest rates, a new HOLC could borrow cheaply and should find it easy to earn a two-percentage-point spread between borrowing and lending rates, for a gross profit of maybe $4 billion to $8 billion a year."

She goes on to point out that it is equally valid for governments - like Pennsylvania in the 18th Century - to create the necessary credit directly.

Why do we need debt anyway?

I recommend a different approach - reinvent "Equity".

Rather than using debt either conventional or unconventional, I recommend a new approach to "Equity" - through the use of partnership and trust frameworks - and a Debt/Equity swap on a grand scale.

All secured borrowers - whether "distressed" or defaulted - would be offered the chance to refinance their secured borrowing by transferring their property to the Custodianship of a Land/Property Pool.

All secured debt would be exchanged for a new class of redeemable Equity in a massive, "pooled" network of "REIT's" with a common "Custodian".

There would be no debt obligation, but a reasonable - index-linked - "rental" would be charged for the use of the Capital invested ie the value of the land and buildings.

Occupier "Co-owners" may acquire equity in their homes simply by acquiring redeemable Units from the Pool at the market price.

I reckon this would bring the cost of financing down to maybe 1 to 2% pa on the "Investment" necessary.

It can be this low, because it is:

(a) a "Real" return - because the rentalflow unitised is index-linked - note that investors are currently accepting a negative real return on "risk-free" Treasuries;

(b) virtually risk free - because it is based on land ownership in the Pool, and the affordability of the rental makes payment more certain.

The outcome would essentially be a  "land-based" money consisting of Units redeemable against land/property rentals.  John Law proposed a not dissimilar "land-backed" (credit secured against land) currency for Scotland in 1705 - here

Money & Trade Consider'd....

I think that the time has come to update that proposal for the 21st Century.

Our hero, Arkady Renko, is a Moscow-based policeman who has come from Russia - post Communism - to Cuba in order to establish whether a decomposed body found floating in Havana Bay is that of an old friend.

A passage in the book, between Renko, and one of the protagonists, O'Brien, stimulated some thought on my part as to the nature of gambling and speculation.

My highlights.

"Do you gamble, Arkady?"

"No"

"Why?"

"I don't have the money to lose".

"Everyone has the money to lose. Poor people gamble all the time. What you mean is, you don't like to lose."

"I suppose so".

"Well, you're unusual, most people need to. If they happen to win, they keep on playing until they do lose. Right now around the world more people are gambling than ever in the history of man."

O'Brien shrugged to show that the phenomenon was beyond him.

"Maybe it's the coming millennium. It's as if people want to shed material things, not in a church but in a casino. People are willing to lose everything as long as they have fun. They can't resist. It's human. The worst snub in the world is a casino where they won't take your money".

I would define "investment" - which is arguably a medium and long term and relatively risk averse activity - as the acquisition of ownership of productive assets.

"Speculation" or "Gambling", on the other hand is relatively short term, and transaction based risk taking, whereby something - it doesn't really matter what - is bought and sold (not necessarily in that order) in the expectation of profit.

Is there an increasing propensity to gamble?

And is it an analogy to a "Death Wish"?

A "Loss Wish", maybe?

Habitat for Humanity Homes

I've followed Habitat for Humanity for a while. Their "direct action" approach to building affordable homes with volunteer assistance certainly has its heart in the right place.

But what interested me in the blog post was this quote...

"We are currently investigating ways for Habitat to acquire foreclosed properties, rehab them and sell them to families. The challenge is that at the moment, it is still more expensive to buy existing homes for rehab than it is to buy dirt and build new, high quality homes."

The statement raises several issues of which three in particular struck me.

Firstly: the difference between the UK property market - where the lack of availability of "Dirt" to build on, and therefore its price, is key - and much of the US property market.

Secondly: the scale of the staggering waste of resources implicit in the wave of US foreclosures and effective abandonment of property.

Thirdly: what the statement implies in relation to realisations by Banks who foreclose, and therefore the true value of their property "assets"....

Will attend:
Ceebs
Colman + Sam + Christopher
Crazy Horse
Cyrille
Fran
Frank Schnittger
Helen
In Wales
Izzy
Jérôme
LEP and estHer
linca
Melanchton
Metatone
Migeru
redstar
sassafras
someone and ???
tzt
whataboutbob and Liliana
ChrisCook and Solveig
dvx

Maybe:
afew
DoDo
siegestate
Sven Triloqvist
the stormy present
metavision
Bernard

It appears that

PassyHome

is the ET Annexe.

Who's booked there?

I thought Greenspan's take in the FT on the oil market deserved comment.

Greenspan says 'good speculation' will cut the top off market peak

The recent fall in the price of oil is primarily the result of investors unwinding speculative positions that helped drive up oil prices earlier this year, Alan Greenspan has told the Financial Times.

The former Federal Reserve chairman said speculation was "importantly responsible" for the rapid move up in oil prices in late 2007 and early 2008.

But he said this was "good speculation" of the kind that ultimately moderates a change in prices, and not "bad speculation" of the bubble-creating kind.

Let's first have a look at "speculation" and "bubbles".

I see speculation as a transaction-based phenomenon, when investors buy and sell (not necessarily in that order) in pursuit of a profit, and risk a loss.  Investment, on the other hand, to me involves the purchase and sale of productive assets.

Speculation involves risk transfer, and I have never had any problem with the role of speculators as "risk taking" liquidity providers eg market-makers.

We must simply be careful not to let these middlemen own and run the markets for their own benefit.

The problem comes when "speculation" is reinforced by "gearing", through the use of deficit finance. This may be through margined futures  contracts; other derivatives, the use of borrowed money to buy the relevant assets, or a combination.

There is qualitatively no difference between the role of a central counterparty operating a "margining" system in futures contracts, and the role of of banks in "fractional reserve" banking.  Our Money - which is credit created by credit institutions and backed by their Capital - essentially is a futures contract.

I digress.

 Mr Greenspan said that while the long-term rise in oil prices was "wholly a physical phenomenon", financial speculation influenced the "timing and profile" of price increases.

I think that this is essentially a truism.

"Financial speculation did play a significant part in the rapid increase in oil prices," Mr Greenspan said. From 2004 onwards financial investors identified a one-time opportunity to profit from the expected increase in the price of oil caused by pressure of mounting demand on constrained supply.

"It was classic stabilising speculation," he said. "It brought forward the price increase that would have otherwise taken place over a much longer period of time, reducing demand sooner and ultimately cutting the top off the intermediate peak price."

I think he has it entirely wrong. I think that the role of a market maker as a liquidity provider could be used as an example of "stabilising" speculation.

But that is not the case here. I think that we have seen a classic case of destabilising speculation in the form of a "bubble" itself generated - as are all "bubbles" - by the phenomenon of "gearing".

In other words, the market price ran up far higher, and far quicker, than it should have, generating profits and losses for speculators, and huge profits for the financial service providers through prime brokerage and proprietary trading based upon privileged information.

But it is no surprise that the person responsible for the "Mother of All Bubbles" - currently deflating and taking the US financial system with it - should have a blind spot about the nature of speculation.

Indeed, IMHO this MegaBubble he fostered will have had the beneficial effect of bringing forward the end of an unsustainable monetary system, in an analogy to the role he claims of "good speculation" in the oil market.

Many experts reject the idea that financial speculation played a significant role in driving up oil prices, arguing that it did not affect the underlying balance of supply and demand for oil.

This is the key issue, and it comes down to discussion of what the oil price actually is and the nature of the sale contracts which are habitually in use.

Mr Greenspan disagrees. He said the data suggested that financial investors from 2004 onwards built up a large net long position in crude oil futures.

The counterparties to their net long positions were owners of oil inventories, who in effect sold forward some of their existing stock of oil.

In order to compensate, the owners of oil inventories stepped up their acquisition of new oil. "This showed up as a significant rise in the stock of usable crude - that is, oil inventories over and above that needed to keep the pipelines, tankers and refineries operating."

Over the past year, he said, owners of inventories continued to bid for oil, but their attempts to replenish their owned stocks were largely thwarted by increases in demand from China and other emerging economies.

Never having been a trader, and not being embedded in the market as I used to be when I was a market regulator, I would be interested in the opinion of other market professionals in relation to Greenspan's analysis.

Mr Greenspan said financial investors began to unwind their net long positions in July to realise capital gains amid indications of slowing global growth, removing the upward pressure on oil.

This reinforced the "demand destruction" caused by high prices sustained for long enough to allow consumers and businesses to change their behaviour.

However, Mr Greenspan said the underlying supply/demand balance suggested "we will not go back to $80 or lower". Once the current economic downturn was over, "oil could go back to $150 or higher" unless oil producers significantly increased their capacity.

But he said: "Future price increases will probably be stretched out over a longer period of time than the increases from mid-2007 to mid-2008."

My take is that speculative money has indeed been instrumental in recent market gyrations, but it is not clear to me - or indeed, to anyone else due to the current global absence of transparency - that it has been the futures markets which have been the primary mechanism, as opposed to massive "off exchange" positions.

Unlike Greenspan, I do not see a smooth increase over time in obeisance to the Gods of market forces. I see greater waves of speculative money washing in and out of the market until there is - and IMHO it is inevitable - a "market meltdown" analogous to the Tin Crisis in 1985.

ie a "market discontinuity" which will wipe out the single points of failure known as Clearing Houses, which are pretty much as undercapitalised for the risks they run as Fannie Mae and Freddie Mac are in the mortgage market.

...and of course the taxpayer will pick up the pieces.

Improving the EU Emissions Trading Scheme

and of course we have this article in the "Guardian" today as a result....

Europe's vital step to make carbon markets work

This extract says it all

The European Central Bank removed governments' ability to set interest rates, and therefore to pursue short term political gains at the cost of inflation. The running of Europe's carbon market should be similarly depoliticised.

A central bank-type institution could provide both the political independence and the institutional credibility to reassure investors that a high carbon price will be sustained.

This institution - an emissions trading authority - would distribute national emissions caps to the member states and monitor emissions reductions.

These caps would be set at the level the authority deemed necessary to meet a long term politically defined target (such as a particular percentage cut in emissions by 2050).

This would be similar to the relationship between central banks and governments, with the bank setting interest rates to meet an inflation target.

I posted a comment in response to Bell's article

The measure of emissions trading as a concept was a comment a few years ago at the annual futures market conference in London

"If you want to keep a donkey healthy you don't regulate what comes out of it: you regulate what goes in".

The point is that the value of carbon in CO2 is intrinsically worthless, so that the only way to give it a value in exchange is through a political act and a suitable bureaucracy.

ie it is simply another "fiat" currency, which is why emissions trading is brought to us by the same people who have brought us the "Credit Crunch".

The solution IMHO is to create "Energy Pools" - which would be funded by levies on carbon-based energy at the point of consumption. eg petrol sales, and gas bills.

The resulting funds would then be directly invested in renewable energy (MegaWatts) and energy savings ("NegaWatts"). The key is the concept that returns on investment may be in energy, rather than conventional money..

In other words, renewable energy projects may be funded simply by selling production forward by creating "Units" in a suitable vehicle which are redeemable in energy. Likewise, energy saving investments/loans made in "Energy Units" would be repaid by the purchase of "Energy Units" in the Pool out of the value of energy savings made.

Ownership of the Redeemable Units in the "Pool" would be distributed equally to all citizens as a "Renewable Energy Dividend" and used either in exchange for renewable energy consumed, or in to repay "energy loan" investments made by the Pool in energy savings.

In this way, those with above average use of carbon based energy would make a net transfer to those with below average use, and the investment made in renewable energy and in energy savings would lead to reductions in consumption of non renewables

ie to "contraction and convergence".

The outcome would essentially be a Unit consisting of the value of energy in carbon - which has a value in exchange - rather than the value of carbon in CO2, which has none.

Why not monetise intrinsically valuable energy, therefore, rather than intrinsically worthless waste gases?

What do I know?

Well, for what it's worth I did give evidence to the Treasury Select Committee re Oil markets a couple of weeks ago, and the future of energy markets is something I have been working on for a while.

It grieves me inexpressibly to see that emissions trading continues to be taken seriously.

Can no-one see that this Emperor has no Clothes?

Giving Away the Farm

on her website in connection with Fannie Mae, Freddie Mac, and foreign investment in the US, but with some interesting thoughts about the use by Governments of their ability to issue interest-free credits.

According to analysts, the bailout of the two mortgage giants is necessary "because America's relations with a host of countries are intricately tied to Fannie and Freddie," and because we need to assure "Americans' future ability to gain access to credit. If foreign companies and governments abandon United States investments, home, auto and credit card loans will be much more difficult to come by."

The same sort of argument was once made by U.S. banks to get Third World countries to pay up on their foreign loans. The U.S., it seems, has finally achieved Third World debtor-nation status.

For the last half century, the push for "free trade" has been all about preserving profitable opportunities for investment, finding ways to "make money" without actually making anything, exploiting the work of others by buying up corporations around the world and drawing profits off the top.

But now the tables have turned. We have gone from being the world's largest creditor to the world's largest debtor. We spent our dollars abroad and now they are coming back to shop for our own real estate and corporate assets. Timmons observes:

    Asian institutions and investors hold some $800 billion in securities issued by Fannie and Freddie, the bulk of that in China and Japan. China held $376 billion and Japan $228 billion as of June 2007 . . . . Russian buyers hold $75 billion. Sovereign wealth funds in the Middle East are also believed to be big investors in Fannie and Freddie debt.

Sovereign wealth funds (investment funds of sovereign nations and their central banks) are now busily buying up U.S. assets, in what Bill Bonner has called "the biggest transfer of wealth in history." Writing in The Daily Reckoning on July 11, he observed:

    [T]he balance sheet of the U.S. Fed shows $2.3 trillion of US treasury debt held in custody for foreign central banks. The harder the Fed fights the [economic] correction . . . the more money and credit it puts out. This monetary inflation causes prices for oil and imports to rise . . . and more money goes into foreign reserves and Sovereign Wealth Funds in the East, to be used to buy more assets in the West. Thanks to America's mad monetary policy, these private assets are being taken into public ownership. Some of America's most important properties are being nationalized . . . but by other nations.

And the result is that

According to a July 21 report by Heather Timmons in The New York Times:

    One out of 10 American mortgages is, in effect, in the hands of institutions and governments outside the United States.

The mechanics of this massive transfer of "wealth" from the US are interesting

The ultimate irony is that these other nations may be buying our federal bonds and mortgage-backed securities with money they simply created on a printing press.

John Succo is a hedge fund manager who writes on the Internet as "Mr. Practical."

He estimates that as much as 90 percent of foreign money used to buy U.S. securities comes from foreign central banks, which print their own local currencies, buy U.S. dollars with them, and then use the dollars to buy U.S. securities.

These nations are doing what Congress itself has declined to do: exercising the sovereign right of governments to print their own money.

Unlike the U.S. Federal Reserve, which is wholly owned by a consortium of private banks, the People's Bank of China (PBoC) is actually owned by the Chinese government.  

When Chinese merchants, awash with U.S. dollars, cash them in for local currency to pay their workers, the PBoC obliges by swapping dollars for government-issued renminbi.  The workers get paid in local currency, and the PBoC gets the dollars for the cost of printing the renminbi.  

The PBoC then uses the dollars to buy either U.S. interest-bearing bonds or Fannie and Freddie securities, which have conveniently opened up U.S. real estate to foreign investment.  

In effect, American citizens are paying a foreign government to turn U.S. debt into money, using currency the foreign government issued by fiat (Latin for "let it be" or "so be it" - money simply ordered into existence by the sovereign).

This leads to the simple, but radical suggestion - a "Great Unthinkable" or, maybe, "Financial Pornography"

Why doesn't the U.S. government just issue its own fiat money?

Well, when that suggestion is raised, the stock answer  is that this would be inflationary wouldn't it?

Whereas to allow Private Banks to create an equivalent amount of credit with a burden of interest attached is not inflationary.....

Clearly, if we allow credit creation willy nilly for the purposes of consumption, then the result would be hyper inflation. So what matters is what credit is created for; how that credit creation is managed, and who by; and what, if anything such credit "costs"....

Note that credit creation for the purpose of creating productive assets is in my view qualitatively different from the credit = time to pay which constitutes the lifeblood of our economy.

But I digress.

That solution may seem radical now, but it could start to look better if Congress has to do what President Roosevelt did in 1933 - declare national bankruptcy and call for a plan of reorganization.

There is simply not enough money in the public till to bail out Bear Stearns, IndyMac, and now the private mortgage giants Fannie Mae and Freddie Mac, as well as pay $500 billion annually to service a gargantuan federal debt, and still have enough money left over to repair our failing infrastructure, develop sustainable energy systems, and generally provide for the Common Wealth.  The cookie jar is empty, and it is empty because private profiteers have been helping themselves to the cookies.

If the Federal Reserve were made a truly "federal" agency, Federal Reserve Notes (dollar bills) could simply be issued by the U.S. government, instead of being borrowed from a private banking system that creates them with accounting entries and charges interest for the privilege.  

(See E. Brown, "Putting the `Federal' Back in the Federal Reserve," www.webofdebt.com/articles, July 26, 2008.)  

Rather than scrambling to find foreign investors to roll over a $10 trillion debt, Congress could just pay off the debt as the bonds came due, using the same sort of money that foreign central banks used to purchase the bonds in the first place - government-issued national currency.  Congress would just be giving them their fiat money back.

As for Fannie and Freddie, they are too big to fail; but they aren't too big to be nationalized. If we the people are paying the bills, we should get the stock. Fannie Mae began in the 1930s as a truly federal agency, funded by a wholly government-owned bank.

The Reconstruction Finance Corporation (RFC) advanced its own federal credit, which was used to fund not only the New Deal but the rapid industrialization that led to victory in World War II.

The result was to make America the world leader in industry and productivity for most of the rest of the century. It may be time to try that experiment again.The RFC had some flaws, but they could be worked out. That is another subject, to be covered in another article.

The bottom line here is that the deed to the farm needs to remain on these shores, and so does the sovereign power to issue money and credit. The existing system of banking and credit creation is teetering on the brink of a collapse brought about by its own internal contradictions and corruption.

The system has long since failed in its primary mission of channeling this country's resources towards investment in a sustainable future. As it stumbles from crisis to crisis, we have neither the time nor the resources to give it yet another chance to do the job. The time has come to clear the boards and begin a new game with new rules.

As I have said elsewhere there is some misunderstanding as to the true economic function of a Bank when operating as a "Credit Intermediary".

Credit costs nothing to create, whoever issues it.

What a Bank actually does is provide an implicit guarantee of Borrowers' credit/ability to pay.

What the "interest" charged by Banks is actually paying for is:

(a) their operating costs;

(b) their defaults;

(c) their profits - if operating "For Profit", as opposed to operating as a "Mutual".

The same costs apply if it is a Treasury or a Central Bank acting as Credit Intermediary, except that whereas system users would pay "Interest" to a Central Bank, they could instead pay "Taxes" to a Treasury.

Of course the interest/tax costs to State sponsored institutions do not include the additional - and inflationary - burden of the Profits accruing to shareholders of private Banks.

In fact what citizens would be paying either Interest or Tax for would be the cost of system operation and the implicit State "Guarantee".

There was an interesting comment the other day from one of the most knowledgeable bankers of his generation, in connection with the injection of £3 billion "taxpayers' money" into the recently nationalised Northern Rock.

The idea is presumably to strengthen the capital base of the Rock, but why should a government owned bank, guaranteed by the government, require any capital base at all?

The answer is of course that it should not....

To sum up, I agree with Ellen Brown that a "new game with new rules" is necessary and that this requires a completely new approach to issue and backing of credits issued by Treasuries.

However, I differ from her in that I advocate the creation of what would essentially be domestic "Land Backed" currencies not dissimilar to

John Law's proposal in 1705

for a land-backed currency for Scotland, but using a new - and dis-intermediated - partnership-based framework or "enterprise model" to do so.

While in Oslo for a couple of weeks tidying up after a property transaction gone wrong, I'm planning  - as an intellectual exercise - to update Law's Proposal for the 21st Century.  

Paulson loses control

This segment

The real economy contracting rapidly
Behind the reassuring statements from Paulson and others that the "worst is over", the reality of the credit collapse since August 2007 is a deepening economic contraction which I have said several times in this space will surpass the Great Depression of the 1929-1938 period.

A good friend who is an unemployed homebuilder in a prosperous part of Arizona just sent me the following list of US department retail store closures. It is worth noting that over 70% of the US gross domestic product is consumer spending and that the entire Federal Reserve strategy of then chairman Alan Greenspan after the March 2000 collapse of the stock market bubble was to bring US interest rates to their lowest levels since the 1930s to stimulate consumer spending on credit (that is, debt) to avoid "recession". Note the scale of the following store closures across America in recent weeks:

# Ann Taylor - 117 stores nationwide.
# Eddie Bauer to close more stores after closing 27 stores in the first quarter.
# Cache, a women's retailer - 20 to 23 stores this year.
# Lane Bryant, Fashion Bug, Catherines -150 stores.
# Talbots, J Jill - Talbots will close all 78 of its kids and men's stores plus 22 that are a mix of Talbots women's and J Jill.
# Gap Inc - 85 stores.
# Foot Locker - 140 stores.
# Wickes Furniture is closing all of its stores after filing for bankruptcy protection.
# Levitz, a furniture retailer - 76 in December.
# Zales, Piercing Pagoda - 82 stores by July 31 followed by another 23.
# Disney Store owner has the right to close 98 stores.
# Home Depot - 15 outlets, affecting 1,300 employees. It is the first time the world's largest home improvement store chain has closed a flagship store.
# CompUSA - company closed.
# Macy's - 9.
# Movie Gallery, a video rental company - to close 400 of 3,500 Movie Gallery and Hollywood Video stores in addition to 520 closed last autumn.
# Pacific Sunwear - 153 Demo stores closing.
# Pep Boys, an auto parts supplier - 33.
# Sprint Nextel - 125, with 4,000 employees affected, following 5,000 layoffs last year.
# J C Penney, Lowe's and Office Depot - scaling back.
# Ethan Allen Interiors - 12 of 300 stores.
# Wilsons the Leather Experts - 158.
# Bombay Company - all 384 of its US-based stores.
# KB Toys - 356 stores as part of its bankruptcy reorganization.
# Dillard's - another six stores this year.

For anyone familiar with American shopping malls and retailing, this represents a staggering part of the daily economic life of the nation, from furniture stores to clothing to video rentals to leather. The process has only begun and neither major party presidential candidate has dared to mention this on-the-ground economic reality because they evidently have no solutions to offer that would not jeopardize their campaign finances.

Obama is tied to not only Pritzker but also to Omaha billionaire Warren Buffett and George Soros. McCain depends on the traditional money contributions of the Republican Party, which demands permanent tax reform for highest-income earners and a pro-bank laissez faire treatment of millions of homeowners facing home foreclosure and asset seizure by banks.

Banks across the country have severely cut back on loans, fearful of bad debts. That has aggravated the consumer collapse documented above. Hundreds of thousands of real estate brokers, small and large bankers, furniture workers and salespeople, and construction workers are unable to find work. Jobs are being cut wholesale and those working are often on reduced hours. Car sales in June plunged by 28% for Ford, 18% for General Motors and even 21% for Toyota, which will mean more layoffs in coming weeks. This will be the next wave of unemployment.

The economic reality is not reflected in official US Commerce Department or Labor Department statistics. There the data is constantly being "revised" to hide the grim reality in an election year.

highlights the gathering storm as the draining of credit=money out of the system starts to impact big-time on the productive "Real World".

I agree with Engdahl that what is coming will be worse than the Great Depression with the caveat that it could be avoided if radical action is taken.

This would involve the evolution/transition of the existing system to:

(a) a Clearing Union architecture similar to that proposed by Keynes at Bretton Woods;

and

(b)a reversal of the polarity of Money from deficit basis to asset basis.

For those who think such a transition is "pie in the sky" I say that it is a logical consequence of the pervasive, organic and unstoppable spread of direct "Peer to Peer" connections - "Napsterisation" or "Bit-Torrentisation" for perfectionists - to the financial sector.

The Price of Everything

is always good value, and yesterday's blog post

We're Economic Agents and we're here to help

is a case in point.

As he points out, there's a new City talking shop...

By all accounts, this is not an April Fool.

Alistair "Northern Rock" Darling and Sir Win "Citigroup's writedowns and credit costs $54.6 billion" Bischoff are chairing a Treasury-sponsored committee, the Financial Services Global Competitiveness Group (FSGCG), to report on the weaknesses jeopardising the City's reputation as a centre for banking, broking and fund management.

Which will no doubt come as news to those who believed that the City still had any reputation for banking, broking and fund management - or at least, one worth talking about other than in an embarrassed whisper.

Price uses his acid wit to great effect.

The first sensible conclusion of the FSGCG ought to be that the gravest threat to the reputation of the Square Mile would be that the incumbent management of most of the UK's banks remain employed.

Quite how the chief executives of the banking industry have been allowed, almost without exception, to squander billions in shareholder value by inappropriate investments and evidently uncontrolled risk-taking is scandalous.

It is doubly scandalous where those chief executives have denied any commercial problems to the extent of hiking their banks' dividends, only to come crawling back to the market in a matter of weeks to tap shareholders for emergency rights issues - some of which haven't even come off.

Buying depressed bank shares is throwing good money after bad, particularly if the chief executives who created the credit crunch are allowed to stay at the helm.

concluding with this gem....

It's a bit like paying the captain of the Titanic a success fee.

He then gets into the nitty gritty.

In a thought-provoking piece of research that gets to the heart of this debate over the City's sustainability ("The Sociology of Markets"), Legg Mason's Michael Mauboussin asks the simple-sounding question whether financial institutions matter to asset pricing.

In traditional economics they don't, which is just one reason why traditional economics is a waste of time. Franklin Allen gave a presidential address to the American Finance Association in 2001 in which he identified a strange dichotomy.

In corporate finance, agency theory - and the role of economic agents - has been extensively explored over a period of 75 years. In asset pricing theory, however, agents are almost completely absent. As in traditional economics, the role of institutions within the financial markets has been "assumed away" to make the equations easier.

As Mauboussin points out,

"Several market observers, including Jack Bogle [founder of the Vanguard Group], Charley Ellis [founder of Greenwich Associates], and David Swensen [Chief Investment Officer of the Yale University Endowment] have been vocal in pointing out that the agents - professional money managers - have incentives to behaviour that is not in the interest of investors."

Mauboussin asks why financial institutions and related agency costs have played so little role in asset pricing theory. One answer, as he reveals, is that for a long time there was no principal-agent problem.

"As recently as 1980, individuals owned almost three-quarters of all stocks. Only recently have principals delegated a majority of assets to agents - financial institutions such as pension funds and mutual funds (sic) - but principals dominated agents as asset pricing theory developed in the 1950s and 1960s.

For instance, in 1950 individuals directly controlled over 90% of corporate equities. Agency theory wasn't in the models because agents weren't in the picture."

As Mauboussin makes clear, agency theory matters because agents control the market. They control the market in absolute monetary terms, but also in marketing, "research" and newsflow: they control the chatter about the marketplace too, although it would be nice to believe that the rise of the blogosphere is helping to restore the balance back toward some semblance of independence.

"And, not surprisingly, agents have very different incentives than principals do. And this game is close to zero sum: the more the agents extract, the lower the returns for the principals."

This sums up the problem inherent in global markets owned and controlled by "agents" / intermediaries.

My thesis is that we currently stand at the zenith of the "centralised but connected" Market 2.0 where market participation is through agents/intermediaries.

I believe that the market is rapidly evolving - at "Internet Speed" - towards a "decentralised but connected" and "Peer to Peer" Market 3.0.

The only thing slowing this evolution, I believe, has been the barrier of legal protocols that together actually constitute a global Market.

I believe that nothing whatever - other than a global Armageddon - can prevent a new generation of partnership-based - and therefore "consensual" - protocols/ frameworks within which value-extracting "agents" evolve (if they are able) into value creating service providers.

This process - which I term "Napsterisation" after the proto - "peer to peer" music site - is IMHO both irreversible and accelerating.

This one views the US approach to bank rescue, through the lens of Bear Stearns

Too Big to Fail

As the credit market subsides in what is a continuing "Credit Crash" from a point of "Peak Credit" last year, we are seeing a continuing fall out among the key banking institutions responsible for the bubble and the Crash.

We have already seen how the UK approached the collapse of the mortgage lender, Northern Rock, and we will now turn to the remarkable “market-based” solution applied in the US to the collapse of Bear Stearns and its acquisition by J P Morgan.

It was in fact J P Morgan themselves who invented credit derivatives – essentially a form of time limited guarantee against a loan default given in return for a payment - and in the years since then these derivatives have become widely used to enable portfolios of loans to be “diced and sliced” in ever more complex ways.

Both Bear Stearns and J P Morgan were investment banks hugely active both in the origination and “securitisation” of loans and also in the creation of “Collateralised Debt Obligations” and structured investments incorporating credit derivatives in varying degrees of complexity.

By early 2008 there was fairly widespread concern in relation to Bear Stearns position, and it appears to have been put about that they were the "first in line" for failure.  Moreover, Bear Stearns, unlike J P Morgan, did not have direct access to Federal Reserve funding via the "discount window" although this access was subsequently extended to other banks - two weeks too late to save Bear Stearns.

There is a widespread perception that J P Morgan stepped in on March 16th 2008 to "rescue" Bear Stearns,. However, some market commentators believe that J P Morgan was as much in need of rescuing as Bear Stearns.

Rob Kirby - a market commentator - had this to say in an April 23 article

"....J.P. Morgan's derivatives book is 2-3 times bigger than Citibank's - and it was derivatives that caused losses of more than 30 billion at Citibank...

...so, it only made common sense that J.P. Morgan had to be a little more than `knee deep' in the same stuff that Citibank was - but how do you tell the market that a bank - any bank - needs to be recapitalized to the tune of 50 - 80 billion?"

Furthermore, in respect of a very large part of the J P Morgan derivatives portfolio - as was the case for most other major Investment Banks - their wholesale market counterparty was Bear Stearns, who were therefore part of that elite club of US banks "too big to fail".

Note here that there is a significant difference between the US approach to Bear Stearns and the UK approach to Northern Rock which - being a retail operator, albeit with wholesale funding - had a market capitalisation a fraction of that of Bear Stearns.

The point is that the failure of Bear Stearns would have adversely affected the banking system: the failure of Northern Rock on the other hand would have adversely affected several million UK voters.

"The Day Market Capitalism Died"
"Remember Friday March 14, 2008," wrote Martin Wolf in the Financial Times; "it was the day the dream of global free-market capitalism died."

There are two aspects to the Bear Stearns transaction: there is the takeover itself, where JP Morgan paid for Bear Stearns shares not with cash but with its own stock, and there is the matter of the price at which it took place - which collapsed from a high of $156 to a low of $2, to bounce back to $10 a week after the deal in response to a wave of shareholder outrage..

The necessary funds to keep Bear Stearns afloat were provided by the Federal Reserve (or "Fed") who lent $25 billion to Bear Stearns and another $30 billion to J P Morgan, a total of $55 billion that all found its way to J P Morgan'.

The Collapse
John Olagues - a leading authority on stock options - maintains that the Bear Stearns collapse was artificially created to allow J P Morgan to be paid $55 billion of taxpayer money to cover its own insolvency and acquire its rival Bear Stearns.

This was allegedly achieved through a combination of a coordinated campaign of market rumour coupled with manipulation of Bear Stearns shares using a form of derivative called a "Put" option. A put is an option to sell a stock at an agreed-upon price, called the strike price or exercise price, at any time up to an agreed-upon date. If the stock's price falls below the strike price, the option becomes profitable.  

By way of example the right to sell Bear Stearns shares at $20.00 each is worth virtually nothing (it is "Out of the Money") if the market price is far above the $20.00 "strike price".   If the market price falls below, then shares may be bought in the market and sold to make a profit.

Olagues wrote

"On March 10, 2008, Bear Stearns stock dropped to $70 a share -- a recent low, but not the first time the stock had reached that level in 2008, having also traded there eight weeks earlier.

On or before March 10, 2008, requests were made to the Options Exchanges to open a new April series of puts with exercise prices of $20 and $22.50 and a new March series with an exercise price of $25. The March series had only eight days left to expiration, meaning the stock would have to drop by an unlikely $45 a share in eight days for the put-buyers to score.

It was a very risky bet, unless the traders knew something the market didn't; and they evidently thought they did, because after the series opened on March 11, 2008, purchases were made of massive volumes of puts controlling millions of shares.

On or before March 13, 2008, another request was made of the Options Exchanges to open additional March and April put series with very low exercise prices, although the March put options would have just five days of trading to expiration. Again the exchanges accommodated the requests and massive amounts of puts were bought."

Olagues then goes on to point out that:

"The fact that the requests were made on March 10 or earlier that those new series be opened and those requests were accommodated together with the subsequent massive open positions in those newly opened series is conclusive proof that there were some who knew about the collapse in advance . . . . This was no case of a sudden development on the 13 or 14th, where things changed dramatically making it such that they needed a bail-out immediately. The collapse was anticipated and prepared for."

Manipulation - and the Curious Incident of the Dog in the Night-Time

As a former Exchange regulator myself, I would be crawling all over these trades, which must have generated substantial profits and losses.  It is not difficult to apply the fraud investigator's Golden Rule - "Follow the Money".

The most interesting thing in the whole saga is that no-one seems to be complaining.

This brings to mind the "Curious Incident of the Dog in the Night-time" - in the Sherlock Holmes story "Silver Blaze"

Gregory (detective): "Is there any other point to which you would wish to draw my attention?"

Holmes: "To the curious incident of the dog in the night-time."

Gregory: "The dog did nothing in the night-time."

Holmes: "That was the curious incident."

Perhaps the reason for the inaction is that the loss in the option market was insignificant by comparison to the benefits generated in another transaction - ie the takeover at very low value which resulted.

Such a "Sprat to Catch a Mackerel"" was precisely what happened on the International Petroleum Exchange in the late 90's when traders were routinely manipulating the daily settlement prices of IPE Brent Crude Oil contracts through abuse of the "Settlement Trade" facility.

The relatively minor losses they made "on exchange" to individual "local" IPE  traders (who called these happy moments "Grab a Grand") were minor compared to the profits they were making "off-exchange" in contracts which used the manipulated settlement prices as a reference.

I "blew the whistle" on this manipulation in 2001 but made the mistake of describing this market abuse as "systematic" (taken, by the Commission appointed to investigate, to mean a few traders doing it most of the time) rather than as "systemic" (most traders doing it some of the time) and I was crucified as a result.

So far no "whistle blower" has emerged in the Bear Stearns case, so perhaps there is a perfectly reasonable explanation for the whole series of transactions.

But one of the interesting aspects that tends to support the thesis that there is something deeply wrong in the whole transaction is the alacrity with which JP Morgan raised their bid price from the original $2.00 to a price of $10.00.

In normal takeover transactions, even a rise to $2.50 would have been fought over tooth and nail: JP Morgan raised their bid by 500%.  To a suspicious mind this indicates that there was a great deal of gravy on this particular plate.

In summary, the Bear Stearns takeover has all the hall marks of being what J K Galbraith memorably called "the Bezzle" - an economic loss where the losers are not aware that they are losing.

It speaks volumes about exactly who are the true beneficiaries of the US financial system.

Did the Bear Stearns takeover in fact also rescue the rescuer?

Islamic Finance News

where a question is asked in relation to Islamic Finance and various commentators in the sector contribute their thoughts. My role seems to be as the "Joker in the Pack" although I understand there is a considerable amount of sympathy with my views.

The latest question was this

The lack of demand for Islamic hedge funds is primarily a Shariah concern.  Some say it is a complex structure which lacks investor attraction, while others believe it has great potential in the Islamic finance industry.

What are your views?

And my response, which should be published in the next edition - I can only recall one occasion in maybe 20 when my comments have been omitted - is as follows.

The principal characteristic of hedge funds is the use of "gearing" or "leverage".  That is to say, hedge funds typically magnify returns - and of course the risks inherent in achieving these returns - by either using derivatives such as futures contracts or by borrowing at interest.

Insofar as hedge funds use leverage, therefore, they cannot be Sharia'h compliant, and the great majority of Islamic investors are intuitively aware of the fact and therefore wary of hedge funds.

The impossibility of Islamically acceptable "leverage" or "gearing" is not just an issue in relation to hedge funds of course.  It is the "elephant in the room" or "Inconvenient Truth" of the entire Islamic Finance industry, where a cadre of experts consistently works to justify the inherently unjustifiable.