Thursday, October 18, 2012 - The Only Day Like it Ever

The Only Day Like it Ever

by Sinclair Noe

DOW – 8 = 13,548

SPX – 3 = 1457
NAS – 31 = 3072
10 YR YLD +.01 = 1.83%
OIL un = 92.09
GOLD – 8.30 = 1742.60
SILV - .38 = 32.92
PLAT – 19.00 = 1651.00

Do you remember where you were 25 years ago? It was a Sunday; 1987. The news of the day was that Nancy Reagan had been hospitalized with cancer; there was a threat of war with Iran and within 24 hours the US was shelling Iranian oil platforms; there were concerns about Germany's currency; the United States, wanting to prop up the dollar and restrict inflation, tightened policy faster than the Europeans. US pressure on Germany to change its monetary policy was one of the factors that unnerved investors.The stock market had a wave of steady selling on Friday and the Dow dropped 108 points. Most people really weren't aware; this was before we all had computers and smart phones and tablets. Maybe you read about the Friday sell-off in the Sunday newspaper. Maybe you thought about selling a little bit of your portfolio, but the truth is that it was already too late.

Halfway around the world, the dollar-backed Hong Kong markets were chopped down 10%. And then the crash spread. European bond markets collapsed, which caused interest-sensitive savings and loans and money center banks to plunge. Monday morning, October 19, 1987 the crash washed across lower Manhattan. In a flash, the Dow crumbled and by the end of Black Monday the Dow had dropped 508 points, wiping out 23% of market value.

The 1987 villain was something called portfolio insurance. It was a product that used stock index futures and options to assure institutional investors that they need not worry if market prices seemed to be unreasonably high. Portfolio insurance would let them get out with minimal damage if markets ever began to fall. They would simply sell ever-increasing numbers of futures contracts, a process known as dynamic hedging. The short position in futures contracts would offset the losses caused by falls in the stocks they owned.

Portfolio insurance did not start the widespread selling of stocks in 1987. But it made sure that the process got out of hand. As computers dictated that more and more futures be sold, the buyers of those futures not only insisted on sharply lower prices but also hedged their positions by selling the underlying stocks. That drove prices down further, and produced more sell orders from the computers. At the time, many people generally understood how portfolio insurance worked, but there was a belief that its very nature would assure that it could not cause panic. Everyone would know the selling was not coming from anyone with inside information, so others would be willing to step in and buy to take advantage of bargains. Or so it was believed.

The crash had been predicted. Congressman Edward Markey had issued repeated warnings, largely unheeded. Paul Tudor Jones predicted the crash, traded accordingly and profited greatly. But almost everybody else got burned. After the crash, the markets managed to rebound sweetly over the next couple of years, but most investors were once bitten, twice shy.

What really caused the Crash of 87? We can speculate but we can't say with certainty.

Twenty five years later, and the US is still on the verge of war with Iran, the European currency situation is still fragile, portfolio insurance has been replaced by derivatives and High Frequency Traders

What we do know is that don't know much.

Dallas Federal Reserve President Richard Fisher recently offered a stunning assessment about our policy-making central bankers down in Washington: "Nobody really knows what will work to get the economy back on course. And nobody-in fact, no central bank anywhere on the planet-has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank-not, at least, the Federal Reserve-has ever been on this cruise before."

Did you ever meet someone who has a gambling problem? Probably, I think we all know someone with strange desire to bet on almost anything: football games, horse races, slot machines, the stock market. The Federal Reserve has placed a big bet that they can buy up $40 billion or so worth of mortgage backed securities each and every month until the housing market recovers, and not just recovers but shows enough strength to lift the labor market on its shoulders.

This means the Fed will monetize nearly 50% of the entire US budget deficit in 2013. That will boost its balance sheet from the current $2.8 trillion to approximately $4 trillion , or 24% of GDP, by the end of next year. With more money available, and at lower rates, that money will then work its way through the economy. Businesses would use the cheap money to expand. The idea is that, flush with cash and with fewer opportunities for higher returns, the banks will boost their lending to businesses and consumers, which is the basic idea of traditional banking. The problem is that traditional banking is pretty much dead; replaced by a casino mentality.

So, far the Fed's QE to Infinity and Beyond hasn't pushed down mortgage rates as much as you might anticipate. QE has pushed down rates on Mortgage Backed Securities but not mortgage rates. The banks are sitting on the proceeds from the MBS purchases, rather than passing the money on to customers in the form of lower interest rates; it has really helped increase the margins for the banks; not much help for the customers. William Dudley, President of the New York Fed recently talked about the problem, that the transmission mechanism is broken. He didn't seem to offer a solution, but the Fed is certainly aware.

The banks are not content to just pick up the wider margins, just as a hard core gambler is never content to walk away from the casino, even after the pit boss tells you the roulette wheel is broken. The banks are now leveraging the MBS market. UBS has just launched a 16-times-leveraged MBS ETN. The ETN stands for Exchange Traded Note, and it's an unsecured, unsubordinated debt security; this specific one is called the ETRACS Monthly Pay 2x Leveraged Mortgage REIT, offers double the return of the Market Vectors Global Mortgage REITs Index – itself an investment vehicle with 8 times leverage to mortgage-backed securities.

The idea appears to be that with the Fed acting as a buyer-of-last-resort that prices will take a smooth upward trajectory and that 16:1 leverage makes sense for retail investors as a bet on a sure thing. Yes, you heard right, in the chase for yield 1.75% MBS pools is just too low, so the gambling junkies on Wall Street lever up 8 times; then the gambling junkies at UBS figure to double down

And it may seem like a sure thing because the Fed is backstopping the MBS market, but if you step away from the crack pipe, a closer examination of QE to Infinity and Beyond reveals some holes in the backstop. The Fed could change the transmission mechanism and buy other assets. Let's say that one year from now, the economy is no better off, the Fed could decide they need a fresh approach; no more MBS purchases instead they'll buy up student loan debt or whatever. Let's say that one year from now the economy has shown a tremendous improvement, housing has come roaring back and the jobs picture is bright and glossy and inflation is rearing its ugly head; the Fed backs out of MBS purchases and tries to clean up their books.

What the Fed hasn't figured out is that the bankers are just gamblers. That's the result of the repeal of Glass-Steagall, which demolished the wall between traditional banking and the risk-taking investment banks; now banks could gamble with FDIC insured deposits backing their bets. Toss in the Commodity Modernization Act of 2000, kind of like portfolio insurance on steroids, and the result was the Crash of 2008. Now the banks are short of cash, but they're still neck-deep in the $650 trillion-dollar derivatives casino. And their gambling addiction requires their absolute attention. And just like the addict, they take their money to the table rather than paying their rent.

Practically speaking, the world of high finance has become more dangerous than ever and traditional banking customers have become all but irrelevant. Why write 16 mortgages when you can write just one and leverage it 16 times? The nation's banks once went out of their way to find reasons to give money out. No longer.

So growth slows to a crawl. This results in balance sheet destruction once productive assets go into decline. Corporations cut costs, delay investments, fire workers. Consumers cut back, tighten belts, deleverage and shun debt, even if it's free. Ultimately, demand craters.

The Federal Reserve is probably trying to prevent a deleveraging depression. Maybe they'll be successful. It's a hard slog without fiscal stimulus, and with the dysfunctional Congress, we know not to count on that. One thing I would like to see is a reinstatement of Glass-Steagall. Either you're an investment bank or a commercial bank - but you can't be both. If you're trading derivatives, you're on your own. If you're lending to consumers and businesses, you get the FDIC insurance and the implicit backing of the federal government. If we could just get the bankers away from the casino, maybe we could get them to do their job; you know, a safe repository, a steady lender, circulating money through the economy.