Unintended Consequences
By Mr Practical Nov 05, 2008 9:30 am
One important asset class destroyed to protect the highly leveraged ones.
I've been talking for some time about the socialization of markets: How government intervenes in the market process of allocating resources with public (printed) money. When a large non-economic entity interrupts the marketplace, it only creates imbalances and unintended consequences; that entity is operating with limited information and political motivation.
I spoke to my friend John - he runs one of those evil hedge funds, and he gave me a clear example of this. Over the last year, the normal process of creating credit has broken down. Banks can’t borrow through the repo system, because they ran out of capital. So the Fed has stepped in and has been willing to give banks capital in exchange for risky assets; for a bank, that means bad loans.
The Fed has a potpourri of risky assets they're willing to accept in exchange for capital. Because banks have no capital of their own, they can't decide to extend credit on any asset not on the Fed’s list of acceptable collateral.
This brings us to convertible bonds. Corporations have used convertible bonds to raise money over the last 10 years, to the tune of $1 trillion. It has therefore been one of the most important capital-formation asset classes in the world.
Without getting too complicated, corporations exchange a lower interest rate as a cost of funds for a call option on their stock. The whole thing works because hedge funds have been able to pay a higher price for the convertibles, because they can hedge the risk by selling stock short. This requires just a modicum of leverage - about 2 or 4 times.
The companies are happy, because they can raise money at a good cost of capital. The hedge funds are happy because they can earn a reasonable return for a fair risk. There was liquidity in the system.
Positions in GS, GM, GE, JPM
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Reply
2008-11-05 09:52:37
Intended Consequences
Welcome back Mr. Practical. Nice to hear your "voice" again.
When anyone or anything acts in panic, there will always be unintended consequences. And there is little doubt that the world, not just the USA, has been in a panic the last few months.
Even careful thought before action has it's own set of problems.
When is it time to stop trying to "fix" the system and instead examine if the system is the problem.
If that time comes when the system has collapsed, then the replacement will be just as bad.
Why are we asking the same people involved in making this mess to "fix" this mess? All we will get from them is the same "best" thinking that got us here in the first place.
Why is there unquestioned faith that this capital system is the best system?
It's time to stop and think.
When anyone or anything acts in panic, there will always be unintended consequences. And there is little doubt that the world, not just the USA, has been in a panic the last few months.
Even careful thought before action has it's own set of problems.
When is it time to stop trying to "fix" the system and instead examine if the system is the problem.
If that time comes when the system has collapsed, then the replacement will be just as bad.
Why are we asking the same people involved in making this mess to "fix" this mess? All we will get from them is the same "best" thinking that got us here in the first place.
Why is there unquestioned faith that this capital system is the best system?
It's time to stop and think.
2008-11-05 11:30:55
Wellcome back!!
Its great to hear from you Mr P..I missed your great insight these past few weeks, I hope we continue to get your missives as they where priceless in undrestanding this whole mess!!! best rgds
Raul
Raul
2008-11-05 12:00:51
"the right P/E for a stock might be as low as 5"
I realize that this is unthinkable but what is the correct P/E for a company that not only has no growth but is shrinking?
As for unintended consequences, what happens to a city that has a great fire and uses virtually all of its water to try to put the fire out?
Even if it succeeds it seems to me that it's citizens might end up kind of thirsty.
Brush off an old history book and you will be reminded that sometimes the unthinkable happens.
2008-11-05 13:56:25
Welcome back
"Welcome back my friend to the show that never ends.." ELP from "Brain Salad Surgery"
Can't agree more: "When you pay even 10 times earnings for a stock, it must be because it has growth. If there is no growth, the right P/E for a stock might be as low as 5. "
Next years earnings????
Can't agree more: "When you pay even 10 times earnings for a stock, it must be because it has growth. If there is no growth, the right P/E for a stock might be as low as 5. "
Next years earnings????
2008-11-05 15:02:43
Leverage or NON LEVERAGE IS KEY
Maybe you should realize that there is RISK associated with leverage.
If you do the crime then you need to do the time - jail that is.
The non-regulation of this industry - hedge funds - is just one of the keys to the mess the world faces.
Will it be pleasant??? NO
Is it necessary?? YES
Until KISS returns, I don't really care who or what gets rolled on!
The pendulum swung real hard yesterday and I for one am still very Pis*** at the FINANCIAL GENIUSES who got us here.
There's still money for top talent! To bad. I don't want it.
The financial engineering which caused the middle class to disappear in this country was caused by plain and simple greed with the blessing of congress and bushy!!!
That pendulum has a very sharp blade on it - so be prepared.
Preservation of capital and financial intelligence is the key!
Have a good day and DON'T FORGET TO PAY YOUR TAXES!!
If you do the crime then you need to do the time - jail that is.
The non-regulation of this industry - hedge funds - is just one of the keys to the mess the world faces.
Will it be pleasant??? NO
Is it necessary?? YES
Until KISS returns, I don't really care who or what gets rolled on!
The pendulum swung real hard yesterday and I for one am still very Pis*** at the FINANCIAL GENIUSES who got us here.
There's still money for top talent! To bad. I don't want it.
The financial engineering which caused the middle class to disappear in this country was caused by plain and simple greed with the blessing of congress and bushy!!!
That pendulum has a very sharp blade on it - so be prepared.
Preservation of capital and financial intelligence is the key!
Have a good day and DON'T FORGET TO PAY YOUR TAXES!!
2008-11-05 17:28:12
Consequences
This market has turned into a day-trader-only market. How anyone else expects to make any money when it swings 500 points up one day and 500 down the next on no news is beyond me. Why would anyone invest their own hard earned money, long term, in a market like this? The same talking heads telling people now is the time to buy long term were saying the same thing last May. I wish I'd sold and gone away.
2008-11-05 19:25:41
Joe and the derivatives bookie
Any thoughts on how the remaining derivatives are going to unwind?
If many of them are off the books, how can institutions be expected to lend to one another, or do business?
Say I had a friend, we'll call him Joe. Joe wants to borrow some money to make it through a rough patch. But then I find out Joe owes his bookie an undetermined amount of money, since it all of his dealings with the bookie are on another set of books. I also find out the bookie owes Joe money, as Joe counter-partied his bets (Joe has some sense).
Will I lend Joe the money (I don't know what the bets were, and whether or not they will pay off)?
If many of them are off the books, how can institutions be expected to lend to one another, or do business?
Say I had a friend, we'll call him Joe. Joe wants to borrow some money to make it through a rough patch. But then I find out Joe owes his bookie an undetermined amount of money, since it all of his dealings with the bookie are on another set of books. I also find out the bookie owes Joe money, as Joe counter-partied his bets (Joe has some sense).
Will I lend Joe the money (I don't know what the bets were, and whether or not they will pay off)?
2008-11-05 20:20:48
It ain't no social crisis
Oh, wait...yes it is.
Getting back to practical basics; the P/E needs to be based on the reality of the world which wants or produces according to ability and resources. We have been spoiled by the consumer economy, forgetting that it was created out of whole cloth after WWII by psychological efforts in order to keep things humming along at the rate that the government (collecting taxes) and the corporations (making profits) had become accustomed to.
The cloth of 'created markets' is unraveling with the loss of the delusion of perpetual growth.
Do ya think Obama was picked because he would better represent us to the aliens when Cheney calls them in?
Getting back to practical basics; the P/E needs to be based on the reality of the world which wants or produces according to ability and resources. We have been spoiled by the consumer economy, forgetting that it was created out of whole cloth after WWII by psychological efforts in order to keep things humming along at the rate that the government (collecting taxes) and the corporations (making profits) had become accustomed to.
The cloth of 'created markets' is unraveling with the loss of the delusion of perpetual growth.
Do ya think Obama was picked because he would better represent us to the aliens when Cheney calls them in?
2008-11-06 01:26:47
That John is one
sharp dude. Might ya ask him for us if enough funds are out there to finance these Corporations now and going forward? Will short hedging just replace liquidation?
Thnx Mr P.
Thnx Mr P.
2008-11-06 07:30:12
Consequences
liquidity is being destroyed by 1. deflation 2. government intervention creating pockets of imbalances, protecting some assets, abandoning others. the government is pricing risk now and that has destroyed investors confidence in the market. there are no real stock or credit markets in the u.s. now.
2008-11-06 07:31:52
That John is one
price is key. at these prices in convertible bonds it makes sense to issue only if the company is desperate.
2008-11-06 07:33:30
It ain't no social crisis
and it was especially fueled after 1987 by easy Al.
2008-11-06 07:35:25
Joe and the derivatives bookie
the amount of debt (contingent liabilities) imbedded in derivatives dwarfs other more traditional forms. no one knows where these derivatives are marked. jpm has the largest exposure. aig was second.
2008-11-07 23:30:23
One More Question
I pretty much understand what has happened. I also understand how to invest in an inflationary enviornment and a normal enviornment. But I cannot seem to grasp how to invest for deflation. Stocks go down, gold and commodities go down, bonds are overbought, real estate sinks like a rock. I have no debt, but where do you hide your money until this mess clears up?
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