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Special Halloween Edition


Monkey Mind – The Zen Of The Financial Markets


Out Of House And Home – Washington Plays Both Ends Against The Middle


Funny Money – Why The Bifurcated Dollar Just Might Matter



Trick Or Treat! – Slouching To The Parade In Search Of Bernie Madoff


Zen masters describe a phenomenon called “Monkey Mind” – the human propensity to grab indiscriminately everything that enters our field of perception and ascribe importance to it.  Our central nervous system, a reptilian throwback, is exquisitely tuned to attribute life-or-death importance to anything new.  Monkey Mind doesn’t let things go, but concocts elaborate back-stories for the most meaningless of events.  The process happens in an instant, but its effects can last a lifetime.  Indeed, they are usually transmitted across generations as prejudices, political and social attitudes, and religion.

Monkey Mind learns nothing from experience and demonstrates clearly the difference between Content and Information.  It grabs at everything in a panic and, since it never knows what is really going on, it experiences tremendous hope, and deadly fear.  This makes human beings perfect customers and explains the success of generations of stockbrokers and politicians, as well as the behavior of the stock market.

Writing in the Wall Street Journal (27 October, “Efficient Market Theory And The Crisis”) Wharton Professor Jeremy Siegel leaps to the defense of the Efficient Market Hypothesis – the theory that all available information is, at all times, embedded in all security prices. 

Professor Siegel lists several factors that contributed to the recent implosion in the financial markets: regulators believed the banks were properly assessing credit risk, and making corresponding offsets; credit agencies and banks relied on flawed risk models; and the markets had been lulled into a sense of security because of, among other things, academic studies showing that first mortgages were incredibly safe.  He also mentions the distinction between the partnership model and the public company, or shareholder model of the financial firm and argues that risk levels were different when senior partners had substantial skin in the game. 

Indeed, EMH models should be updated to account for the fact that senior managements of both corporations and financial firms care far less than they used to about shielding their shareholders from risk, now that they do not have to.  Indeed, by promoting Too Big To Fail into a protected class, the current Administration gives the force of law to management neglect of shareholder interests.

Allow us to introduce The Efficient Monkey Hypothesis.

The Hypothesis says: we know that people, left to their own devices, will destroy the system.  This manifests in wars, environmental disasters, genocide, market meltdowns, and a host of other human-created disruptions which cyclically repeat throughout history.  In the financial markets, this has led to tearing down the regulatory protections in order to let the rich get richer.

Now, instead of reinstituting a firm barrier between different functions which properly require different risk approaches, the Obama Administration proposes a Systemic Risk Regulator who will have a secret TBTF list.  Shareholders and customers of a bank will not be entitled to know that their institution is deemed TBTF, which seems to violate SEC disclosure rules – though we don’t much like the SEC’s chances of forcing the hand held by Geithner and Bernanke.

Permit us, once again, to flog our dead horse.  Perhaps we should say, our dead monkey? 

There are risk, audit and compliance professionals in the industry who have had great success at identifying problem areas, creating programs to prevent problems from arising, and convinced management to undertake such programs.  Note that, to succeed as a compliance professional, you really need to do all three. 

The systemic risk oversight function can be handled only by people who know risk when they see it.

Our hypothesis is that there exist Efficient Monkeys – people who, through trial and error, persistence, orneriness, or just plain dumb luck, have come to understand significant bits of the workings of the financial system.  We have flogged this monkey repeatedly, recommending that the only way to pursue the SEC’s program of cleaning up the industry is to set loose teams of people who have caught the bad guys before.  The fact that the SEC can not launch such a program is a clear indication that actually cleaning up the industry is not an agency priority.

Teams of Efficient Monkeys should be deployed throughout the system, headed by a Chief Monkey – someone like Paul Volcker who has proven his ability to grab and hold onto all the bananas that really matter.  If there is to be a Systemic Risk Regulator, it should be staffed by people who have effectively managed risk – not by academics and career politicians.

Our screed of two weeks ago was headlined “Market Crash Anniversary Edition,” since it ran on October 19th.  One reader wrote in that he had seen only one other media mention of the anniversary.  Indeed, we wonder how many readers even got the reference.  In historical terms, 1987 was not that long ago.  But in Monkey Years, it never even happened. 

Those who fail to learn the lessons of history are… no different from anyone else.  Let’s get teams of people who have proven they are not monkeys and put them to work saving this system before it’s too late.

Out Of House And Home

NY Times chief financial correspondent Floyd Norris blogged last week (http://norris.blogs.nytimes.com/ 28 October, “A Tale of Two Markets”) about the squeezing of the middle class homeowner.  At 38%, the spread between average home prices and the median price – the midpoint in the overall price range – is the highest it has ever been.  This means that both cheaper homes and higher-priced ones are now selling better than they have been, but “those between $200,000 and $400,000 are getting the lowest market share in years.”

Norris thinks “the recovering stock market may have provided more courage (and cash) for those in the higher-end market.”

We think this points to a looming reversal of trend and ultimately, a radical redefinition of The American Dream.  Underlying both pricing in residential real estate markets, and the structure of residential mortgages, is the pattern of people selling a home after 5 years.  Non-fixed rate residential mortgages generally come with a rate reset within the 5-7 year window.  We leave it to historians of mortgage finance to determine whether the bankers espied a broad social trend and adjusted their financings accordingly, or created a financing system that would drive turnover, churning home buyers for origination fees and financing resets.  Needless to say, neither homebuilders nor realtors would have any argument with families being all but compelled to buy a new house every five years.

The pattern, the expectation – the Dream – has always been to trade up.  Whether seeking more square footage, in-ground swimming pools, a better school district or improved access to major urban centers, generations of Americans would never have dreamed of trading down.  Until now.

Washington has rammed through initiatives with reckless lack of concern for the effect on the broadest part of their constituencies.  Trillions of dollars in gifts, loans and guarantees have been thrown at the richest people and institutions in America.  The financial bail-out of financial institutions that were recklessly mismanaged has given the stock market a shot in the arm and enabled banks that would be out of business, but for the bailout, to pay out record bonuses.  All at the expense of the Dollar. 

The Dollar is a contract, based on the world’s agreeing to what it is worth.  (See our next item for a Halloween Fright Night scenario on what that might mean.)  Underpinning the contractual value of the Dollar is the credibility of its ultimate backing.  It’s an odd thing that, as our credibility sinks to generational lows worldwide, the cost of things priced in America’s credibility go up.  This implies that the world understands the American political system is totally corrupt and will sell itself in a heartbeat to the highest bidder.  The world has walked away from the Dollar, but not from things priced in dollars – because the financial marketplace is the domain of the Highest Bidder.  As the credibility of the Nation sinks, the credibility of the plutocracy is reaffirmed.

Observers and well-informed cynics of all stripes have long recognized that we live in a bifurcated society.  This latest housing data is another indication that the Middle Class – always courted, generally abused, inevitably disappointed – are being pulled apart, further widening the gap between the Haves and Have-Nots. 

The term Middle Class no longer means what it once did.  Distinctions of education and career choice no longer define, as today’s middle class comprises everyone from plumbers to physicians.  Washington cares not a whit that helping the wealthiest at the expense of the middle – not to speak of the bottom – has a powerful trickle-down effect to stoke class resentment.  As the gap in housing prices widens, taking with it the upside in home ownership that has long been seen as every American’s birthright, resentment will trickle across the middle, until there will no longer be a Middle.  Of such trends is home-grown social unrest made.

In God We Trust – All Others Pay Cash

The Almighty Dollar – how are the mighty fall’n! – leads a double life.  Appropriate to the Halloween season is the description of the Dollar traveling the world in disguise.  The Wall Street Journal (28 October, “Globally, The Greenback Remains King”) describes the dollar’s not-so-secret life outside this country’s borders.  Currently there is something like one trillion dollars physically in circulation world wide, and an estimated 75% of the physical dollars in circulation are outside of the US. 

One thing not mentioned in the Journal piece is the current value of counterfeit dollars in circulation.  We know that it has been substantial in the recent past – in the 1990’s people claimed the Russian Mafia printed better $100 bills than the US Mint.  These bills were put to liberal use paying off stock promotion scams during those years.  Unlike the global black market in legitimate US currency, this high-quality counterfeit currency was smuggled into the US.  We have no way of knowing how much of it continues to circulate domestically. 

It is our understanding that black market money changers generally know which bills not to take.  We suspect the same may not be true of US money-center banks.

US authorities have a history of giving low priority to certain offshore tax havens and their resident banks.  Our government recently went after the Swiss banks in an all-out assault, while certain island nations in warmer climes did not appear on the radar at all.  When the Swiss bank confrontation was in full kerfuffle, we observed that the Swiss held tremendous levels of dollar deposits, but had failed to support those same dollars by using their reserves to buy US Treasurys.  At the same time, other jurisdictions offering a reasonable degree of secrecy (including numbered accounts, the use of nominee names and the outright refusal to disclose to US tax authorities the existence of accounts), were being ignored.

The US appears to be comfortable with a certain amount of black marketeering and money laundering, as long as it goes on in the right place, and as long as the banks hold a sufficient percentage of their reserves in US Treasurys.  Meanwhile, the global stability of the paper dollar rests on a convergence of factors. 

One factor is rigid exchange controls in many countries whose currencies do not travel well.  Countries mentioned in the article include Nigeria, Vietnam and Venezuela, none of which has a currency in current contention to replace the Dollar as the world’s reserve.  Artificial exchange rates, pegs, and other forms of manipulation create arbitrage opportunities between what a government says its currency is worth, and what the world says it is worth.

Currencies are relative prices.  The relationship between the Dollar, the Venezuelan Bolivar and the Euro tells us at any given moment what the world thinks of the liquidity, stability and overall safety of each geopolitical entity.  Exchanging your local currency for dollars on the black market, and paying higher than the official exchange rate, says you think your government is lying.  For the money changer, dollars are worth the premium because they have a liquidity and transferability the local currency lacks.  Black market currency dealings represent unfettered capitalism.  And, as sharp as one needs to be not to get cheated, robbed or killed, it doesn’t take a genius to figure out that, if your government won’t let you buy something the whole rest of the world wants, you can make money selling it.

At one end of the spectrum the street dealers, back-alley money changers swap fistfuls of local currency for tourist dollars.  Tourists spend the local currency in restaurants and hotels, in taxicabs and in the stores where they load up on clothing and trinkets to bring back home.  When they leave, the shopkeepers and hotel owners and taxi drivers head back to the money changers and swap their local currency back into dollars as the only reliable liquid store of wealth. 

At the other end, where dollars move internationally, there are more barriers.  It is an odd disconnect.  In the world of legitimate bank transactions, the amounts of physical dollars held offshore are considered insignificant.  Trillions of dollars move electronically in global banking and financial market transactions, supplemented by the trillions of value recorded at deposit-taking institutions, and on the books of central banks, sovereign wealth funds and other government institutions. 

Street changers and merchants feel the pinch from a declining dollar, and occasionally they tighten their markets, rather than take losses on their holdings.  But the black market cash handlers quoted in the Journal article tend to remain optimistic about their trade.  The consensus appears to be that nothing will replace the dollar any time soon. 

But when it does?  We don’t know when global economic events will force the disconnect between international banking and back-alley money changing to reconnect, but like any other market, it must surely be subject to sudden, unexpected and game-changing disruption. 

Nigeria, highlighted in the Journal, recently embarked on two bold initiatives.  One is the direct sharing of oil revenues with the Niger Delta, where rebel groups have for years disrupted oil production in their efforts to force the government to share oil revenues with the local population.  This proposal is fraught with political problems, including objections from other regions that want an equivalent deal, and the resumption of hostilities if the deal takes too long to put together.

Nigeria also is readying some $10 billion in corporate bond issues (Financial Times, 22 October, “Nigeria Poised For Push Into Corporate Bonds”).  It is a safe bet that, if open warfare resumes in the Delta, the country’s corporate debt will not be as attractive to outside investors.  Rather than become a leader of African economic development, a Nigerian setback would have broad-ranging implications for its neighbors.

US policy makers would do well to consider that upheaval in a shadow economy always leads to unrest.  The global dollar black market supports substantial portions of the world’s population who either trade the dollars themselves, whose livelihood is tied to cash transactions in dollars, or whose life savings have been converted from illiquid local currency into dollar bills.  The people of the United States have taken the bank bailout lying down and have been all too willing to allow the government to rob the poor to pay the rich.  People in other parts of the world may not be so acquiescent.

Jailhouse Rock

I got myself in a terrible situation. It’s a nightmare.

          - Bernie Madoff

In what must have been a quiet week for news, the Financial Times could come up with no more timely and compelling lead story than “Madoff ‘Amazed’ At Escaping 2006 Check,” (31 October/1 November).  Those who have read the SEC Inspector General’s report on the string of failures surrounding the Madoff matter already know the details of this story.  The “news” – as reported by our colleague Michelle Leder in this weekend’s Footnoted posting (“Friday Night Lights”) snuck some six thousand pages of Madoff-related filings into the public record by posting them in the late window – the SEC filing window stays open for 90 mnutes after market close.  We think companies that post their filings at the last minute on a Friday generally don’t want to call too much attention to themselves.  From what we have seen of the Madoff case, this shoe probably fits the SEC.

Among the items filed was a transcript of a jailhouse conversation with the SEC Inspector General in which Madoff said he was “worried every time” the SEC audited his operation, because his scam was “basic stuff”.

Anything else going on with Bernie that we might want to hear about?

Reports filtering out of the Butner Federal Correctional Complex paint an odd picture of Madoff’s new life.  An article posted in the Orthodox Jewish website Vos Iz Neias? (21 October, “Court Documents Reveal Madoff’s New Friends”) describes Madoff’s late-night walks around the exercise yard, and says he spends a fair amount of time socializing with former Mafia Boss Carmine Persico and Jonathan Pollard, imprisoned for passing US intelligence information to Israel.

It is not clear whether the three of them hang out together, or whether Bernie alternates between the other two.

We tried to envision the movie that will one day be made of these chats.  Sort of an End Of Days version of “My Dinner With Andre”. 

Also of note in SEC Inspector General Kotz’s jailhouse interview with Madoff was the mention of one William Ostrow, an SEC examiner whom Madoff called “an obnoxious guy.”  Madoff recounted that “Ostrow wore an SEC jacket with the word ‘enforcement’ emblazoned across the back,” which “caused an uproar” in the office.  Madoff saysOstrow was so confrontational that they almost came to blows.

For those who doubt he could handle himself in a fight, Bernie has shown ‘em what Madoff is Made Of.  The New York Post reports (13 October, “Bernie’s Bruising Battle – Over Stocks!”) Madoff came out the winner in his first prison-yard scrap, touched off by a heated debate over – yep – the stock market.  When Madoff’s 60-something opponent shoved him, the former NASDAQ Chairman tore into him with both hands, flooring him and then towering over his cowed attacker, “red-faced and glaring.”  Madoff, reports the Post, “paid a consultant for a crash course in prison culture and survival tips” before going into the slammer.  Looks like that was money well spent – though we wonder whose money it was.  Perhaps the prison survival instructor will be clawed back. 

Tough though he might be, Bernie may be on his last legs.  Madoff has confided in fellow prisoners that he is suffering from advanced cancer and doesn’t have long to live.  The Post reported (2 September, “Bernie ‘Dying’ In Jail”) that Bernie has become a New Age celebrity in the slammer, being courted by numerous gangs and buddying up with the prison’s gay posse (the Post hastens to assure us “the relationships are purely platonic”).  The facility also houses a Native American group, and Bernie has been a regular participant in their prayer services and purification rituals, which include him sweating bare-chested over burning hot rocks and smoking a peace pipe.

This sounds like just the kind of place the new crop of hedge fund managers will want to hunker down for the next couple of decades.  We hear Raj has already put in dibs on a bunk down the corridor.  Kind of makes us think of summer camp.  Or maybe boarding school.  You know – Lord Of The Flies.

By the way, the New York Times (12 October, “Trick Or Treat: The Madoff Halloween Mask”) reports that Rubie’s Costume Company came out with a Bernie Madoff Halloween mask in time for this week’s holiday.  We watched the Greenwich Village Halloween Parade this year, where we saw several Michael Jacksons, tons of Roman Gladiators.  Superman and Batman were there in profusion, as was Wonder Woman.  We even spotted Waldo.  All these were mixed in among a rain-soaked flood of people dressed in black, their faces made up in death-white and liberally spattered with blood.  It looked like a cross between an Oakland Raiders fan fest and a Fellini film.  But we didn’t see a single Bernie Madoff.

Still, Rubie’s, the creator of the mask, said they sold out their initial run of 15,000 Bernie Madoff masks in the first week they were on the market and were gearing up to produce more.  There’s no denying it – we do love our rogues. 

Slouching Towards Wall Street… Notes for the Week Ending Friday, October 23, 2009 - bernie

Trick or treat!