Monday Morning Quarterback: Salvation Lies Within

By Todd Harrison  OCT 12, 2008 10:00 PM

To get through this we must go through this.

 


“Let me tell you something my friend. Hope is a dangerous thing. Hope can drive a man insane.”  --Ellis Boyd ‘Red’ Redding, The Shawshank Redemption

Someone once said we should hope for the best but prepare for the worst. In the financial system, hope isn’t a viable investment strategy but risk management will save you from the worst-case scenario.

Over the weekend—yet another abbreviated respite that screeched to a halt when Asia and U.S. equity futures opened on Sunday—the world digested the latest proposed solution to one of—if not the—worst financial crisis in history.

The IMF started the procession by offering what Minyans have long known.

"Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown," said Dominique Strauss-Kahn, IMF managing director.

The brink of systematic meltdown, you ask? Credit has crashed, equities had their worst week ever and the contagion has spread to every conceivable corner of the earth.

As horrific as the last six weeks—no, the last twelve months—have been, it can indeed get worse. If, how and when remain to be seen but as the big picture is made up of many smaller pictures, I’ll share my current trading posture later on in this article.

What is clear is that cumulative imbalances have been building since the turn of the century and we’re in the throes of the “prolonged period of socioeconomic malaise entirely more depressing than a recession” that we warned of in 2006.

Social mood and risk appetites shape financial markets and both seismically shifted when faith in the system and the credibility of our leaders evaporated. The denial-migration-panic continuum is coming full circle and that is perhaps a reason for optimism, if only for a trade.

To get through this, we needed to go through this and we’re going through it now.

Minyanville mapped this script for many years.
As some pundits—many of whom never saw this coming—scream fire in the crowded theater, we’ve shifted our lens to identifying potential solutions, providing insight along the journey and encouraging lucidity and perspective as we digest the necessary, albeit painful, medicine.

One year ago, as the Dow Jones Industrial Average probed all-time highs, we offered the following thoughts:

“The structural imbalances, hidden risks, counter-party collateral exposure and embedded insecurities aren’t one-and-done write-downs. That’s not how the knitting is weaved with $500 trillion dollars of derivatives in play. In fact, one could argue that the inherent learning curve needed to unwind these interdependencies will allow the issues themselves to manifest.

The frightening part of these modern day sequels is that the same greed and reward-chasing behavior that was responsible for the universal acceptance of risk has again been so readily embraced. It is that story itself—the twisted tale of misguided agendas—that is the common thread of these seemingly disparate plots.

Trick or treat, my friends, and be wary of the bad apples. For when we bite into the forbidden fruit, we’re liable to find the pin that pricks collective psychology and leaves us all howling at the moon.”

Where Wolf? There Wolf!

We all know the monsters now. They look like derivatives, they smell like debt and they act like profiting is a privilege rather than a right. Admitting you have a problem is the first step towards recovery and the world has received the wake-up call.

Steps must be taken to stabilize the patient as the progression of debt destruction runs its natural course. Once this happens—make no mistake, it will—there will be profound opportunities for those who persevered the process and prepared in kind.

To be sure, the derivative and credit disease is bigger than the actual patient at this point. That leveraged volcano has been rumbling under the seemingly calm surface for years. Now that it erupted, we’ll need to toss in some maidens to appease the Trading Gods and sacrifice a few for the greater good.

The professors have mused about what we would like to see (as well as the flaws of such an approach).

At the top of the list is the protection of all consumer deposits. If we’re going to rebuild a sustainable foundation of recovery, it must start with credibility in the system and confidence that savers will be rewarded for doing the right thing.

There also needs to be culpability, which should be shouldered by those over-extended on credit, institutions responsible for financial engineering and policy makers complicit by acceptance. Existing equity in most financial institutions could conceivably be wiped out (replaced with taxpayer owned equity or warrants) but the pound of flesh must come from somewhere.

There are several other alternatives, game changers if you will, although none of them are particularly pleasant to discuss. They include dollar debasement (maximum pain for savers), Operation CDS Clean Sweep (wiping out speculators), shifting the rules of mark-to-market accounting, a comprehensive global nationalization process and programs to guarantee interbank lending.

We the people must remain calm as we chew through this process. None of this is something one would wish for but it’s where we are and we must forge ahead. It will take tenacity, resolve and profound patience but if we’re not part of the solution, we’re part of the future problem. Therein lies the greatest risk to this entire dynamic. The Blame Game is good and thick and societal acrimony could potentially shift into social unrest stateside and abroad.

And that's not something anybody wants to see happen. Not for us, not for our children and most certainly not as we attempt to defend the foundational elements of our U.S. Constitution. This is where we'll earn our stripes and earn them we will.

Some Random Thoughts:
 


R.P.

Positions in WFT, RIG, OSX, QLD

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

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