Since the majority of the general public, and all of the Financial Media, seem to be constantly asking in bewilderment as to reason AIG keeps requiring additional bail-outs, I decided to try my hands at a simple answer. AIG has exposure to the highest tranches of credit risk. In other words, AIG has insured the highest quality credit in the world. But it did that with gusto. I reckon AIG has risk exposure roughly equal to $1 billion/basis point of investment grade risk*. In other words, every time investment grade credit risk rises by 0.01% AIG books a mark-to-market loss of $1 billion. Why mark-to-market then? The mark-to-market is required by AIG's counterparties and the rating agencies to properly protect against an AIG default. When an adverse mark-to-market takes place, one has to post additional collateral with counterparties or convince rating agencies of reserve adequacy. The inability to do so, causes a total collapse in credit quality and ultimately insolvency. That is why the bail-outs keep coming.
Two years ago investment grade credit spreads where around 30bps. Today they are over 200bps*. This blow-up in credit spreads has happened without any considerable defaults in the investment grade world. What would happen when default start taking place. How much of a bail-out would AIG then need. Go figure!
* A March 3, 2009 article at CNNMoney.com states that the total AIG bailout so far stands at $163 billion. This almost exactly confirms the analysis presented above.
Showing posts with label economy. Show all posts
Showing posts with label economy. Show all posts
Tuesday, March 3, 2009
Friday, January 30, 2009
Filling the Crater
As Washington tries to navigate its way through the current economic morass, the general public is repeatedly stunned by the enormity of the figures. The number trillion (one followed by 12 zeros) was thought by many to be an imaginary number, merely a couple of years ago. Nowadays, it seems that every government official will be in charge of dispensing a trillion or two.
What happened? And is inflation upon us?
The big-bang noise you just heard was the sound of the credit bubble blowing up. The federal reserve system of America, and its sisters around the globe, have been creating capital out of thin air for over 25 years. Through the less than sober expansion of credit, the global economy looked exceptionally healthy for the most part of a quarter of a century. A mini 'real estate'/'savings & loans' bubble, followed by a massive 'technology company'/'stock market' bubble, followed by a giant credit/'hedge fund'/'real estate' bubble, followed by a commodities bubble gave us the pleasurable externalities of a wildly vibrant economy.
The bubble popped! It was tens of trillions of dollars big. Now we are left with a crater. The governments of the world are trying to shovel as much cash as possible into the crater.
In all likelihood, they won't be able to fill the whole crater. That means that no matter how much money they print, it is just a partial rationing of the credit they have already issued. As a result it has no inflationary impact. All prices should fall, albeit not at the same rate. For instance, gold may fall less than Florida real estate. To support asset prices, the government will have to inject so much cash that bubbles will pop up in some unexpected places.
Whether this effort will succeed or not is uncertain. One thing is certain, however, a bubble in government has already begun!
What happened? And is inflation upon us?
The big-bang noise you just heard was the sound of the credit bubble blowing up. The federal reserve system of America, and its sisters around the globe, have been creating capital out of thin air for over 25 years. Through the less than sober expansion of credit, the global economy looked exceptionally healthy for the most part of a quarter of a century. A mini 'real estate'/'savings & loans' bubble, followed by a massive 'technology company'/'stock market' bubble, followed by a giant credit/'hedge fund'/'real estate' bubble, followed by a commodities bubble gave us the pleasurable externalities of a wildly vibrant economy.
The bubble popped! It was tens of trillions of dollars big. Now we are left with a crater. The governments of the world are trying to shovel as much cash as possible into the crater.
In all likelihood, they won't be able to fill the whole crater. That means that no matter how much money they print, it is just a partial rationing of the credit they have already issued. As a result it has no inflationary impact. All prices should fall, albeit not at the same rate. For instance, gold may fall less than Florida real estate. To support asset prices, the government will have to inject so much cash that bubbles will pop up in some unexpected places.
Whether this effort will succeed or not is uncertain. One thing is certain, however, a bubble in government has already begun!
Saturday, November 1, 2008
We Want Change
When Obama supporters shout 'We Want Change' they seem to be, at least on a subconscious level, actualizing what they feel is already happening about them. They tend to sense the presence of a strong undercurrent of ‘Change’. Change with an upper case 'C' represents a paradigm shift; a global power structure rearrangement. In a recent WSJ opinion piece, titled Obama And The Politics Of Crowds, Fouad Ajami discusses Obama's mastery of crowd politics. He argues that Obama, like all revolutionaries before him, is using the crowds, building up their hope, ultimately to disappoint them.
I spent years of my life studying the behavior of aggregate media. An aggregate medium is a large mass made up of a very large number of particles. Various types of aggregate media share similar dynamics. This is generally true, whether we are talking about a fluid medium, such as a large body of water, or a public medium, such as a large society or a nation. Masses, as such, are usually found in one of two states. The first state (scientifically called the ‘steady state’) is a state with a strong and discernible current or flow. In such a state, the current is too powerful for any one (or a few) human actor (actors) to alter. Thus it is hard for charismatic leaders to truly shine when the medium is in such a state.
The second state is a state of turbulence. The currents may be strong, yet the aggregate overall is directionless. This type of state is inherently unstable. The longer it lasts the more chaotic it gets. Such a state eventually results in the ushering in of a charismatic leader. In addition to being in command of crowd dynamics, this leader has to be well in tune with the most dominant of the prevailing undercurrents. The leader then acts as a crystallizing catalyst who helps the alignment of particulate direction. The charismatic leader ultimately helps the return to a steady state as chaos subsides. Observers tend to attribute the state change to the abilities and extreme skill of the charismatic leader. The truth, however, is that in a large pool of talents there is almost always such a leader. Unstable dynamic systems, almost invariably, ultimately reach a steady state stable configuration. The charismatic leader is more like a skilled surfer. When the right wave arrives there is usually a talented surfer around to ride it.
Socially, economically and demographically the world lives in a state of unclear direction. The currents have been building underneath the surface for a long time (see Greenspan's book The Age of Turbulence). It took the recent economical and financial crisis, however, to bring it all to the surface. Mohamed El-Erian, in his book When Markets Collide, analyzed certain of these currents and their impact on the field of investing.
As an example let us briefly examine one such undercurrent, namely the public view regarding the economic direction of America. It seems, at least on the face of it, that Obama supports a socialistic redistributive economy. McCain, on the other hand, seems to advocate the continuation of a regulation-free laissez-faire capitalist economy. The truth is: this is just a hoax. The country is already undergoing the most socialistic wealth redistribution since its inception. The amount of money randomly distributed by the US government in the last year is mind boggling. The sums of money involved in the current economic bailout by the Treasury Department, combined with the unrestrained liquidity offered by the Fed to curb or mitigate the failure of banks and other financial institutions (Bear Stearns, AIG, Fannie Mae, Freddie Mac, Lehman Brothers, WaMu, Wachovia, …), add up to trillions of dollars. By the time the current financial crisis is over, the government would have randomly injected more than $3 trillion into the system. This is in excess of the total IRS collection for the year 2006 of $2.5 trillion. Stated differently, the current government is effectively doubling the tax burden on every American taxpayer. This is happening without the taxpayer’s awareness, since it is done through money supply inflation. Taxpayers still think we live in a free market; and fear Sweden style socialism. When the citizens expect the government to bail them out, they have already voted for socialism. Even more foreboding, when the citizens act irresponsibly for years, turning their economy into a third order one, a form of socialism is almost a foregone conclusion.
I spent years of my life studying the behavior of aggregate media. An aggregate medium is a large mass made up of a very large number of particles. Various types of aggregate media share similar dynamics. This is generally true, whether we are talking about a fluid medium, such as a large body of water, or a public medium, such as a large society or a nation. Masses, as such, are usually found in one of two states. The first state (scientifically called the ‘steady state’) is a state with a strong and discernible current or flow. In such a state, the current is too powerful for any one (or a few) human actor (actors) to alter. Thus it is hard for charismatic leaders to truly shine when the medium is in such a state.
The second state is a state of turbulence. The currents may be strong, yet the aggregate overall is directionless. This type of state is inherently unstable. The longer it lasts the more chaotic it gets. Such a state eventually results in the ushering in of a charismatic leader. In addition to being in command of crowd dynamics, this leader has to be well in tune with the most dominant of the prevailing undercurrents. The leader then acts as a crystallizing catalyst who helps the alignment of particulate direction. The charismatic leader ultimately helps the return to a steady state as chaos subsides. Observers tend to attribute the state change to the abilities and extreme skill of the charismatic leader. The truth, however, is that in a large pool of talents there is almost always such a leader. Unstable dynamic systems, almost invariably, ultimately reach a steady state stable configuration. The charismatic leader is more like a skilled surfer. When the right wave arrives there is usually a talented surfer around to ride it.
Socially, economically and demographically the world lives in a state of unclear direction. The currents have been building underneath the surface for a long time (see Greenspan's book The Age of Turbulence). It took the recent economical and financial crisis, however, to bring it all to the surface. Mohamed El-Erian, in his book When Markets Collide, analyzed certain of these currents and their impact on the field of investing.
As an example let us briefly examine one such undercurrent, namely the public view regarding the economic direction of America. It seems, at least on the face of it, that Obama supports a socialistic redistributive economy. McCain, on the other hand, seems to advocate the continuation of a regulation-free laissez-faire capitalist economy. The truth is: this is just a hoax. The country is already undergoing the most socialistic wealth redistribution since its inception. The amount of money randomly distributed by the US government in the last year is mind boggling. The sums of money involved in the current economic bailout by the Treasury Department, combined with the unrestrained liquidity offered by the Fed to curb or mitigate the failure of banks and other financial institutions (Bear Stearns, AIG, Fannie Mae, Freddie Mac, Lehman Brothers, WaMu, Wachovia, …), add up to trillions of dollars. By the time the current financial crisis is over, the government would have randomly injected more than $3 trillion into the system. This is in excess of the total IRS collection for the year 2006 of $2.5 trillion. Stated differently, the current government is effectively doubling the tax burden on every American taxpayer. This is happening without the taxpayer’s awareness, since it is done through money supply inflation. Taxpayers still think we live in a free market; and fear Sweden style socialism. When the citizens expect the government to bail them out, they have already voted for socialism. Even more foreboding, when the citizens act irresponsibly for years, turning their economy into a third order one, a form of socialism is almost a foregone conclusion.
Tuesday, October 28, 2008
Third Order Economy
'So the last will be first, and the first last.' (Matthew 20:16)
In his highly insightful book 'When Markets Collide', Mohamed El-Erian attributes current financial woes to the rapidly changing economic realities in today's world. He points to several germane factors such as trade and account deficits, national debt levels and GDP growth. He makes the case that world economy is undergoing a reconfiguration phase. The new players are high productivity (in terms of real goods) nations such as China and India, and natural resource rich nations such as Gulf oil producers and Russia. Highly consuming nations such as the USA and the UK are bound to suffer significant standard of living readjustment until they return to savings and productivity.
Although GDP growth and net account and trade deficits are neat quantitative indicators, they may mask deeper indicators that are more qualitative in nature. Economies are dynamic systems whose basic components are human agents and transactions. As such, they tend to undergo anthropomorphic cycles. To a poor individual, activities pertaining to basic needs such as food, shelter, personal safety and procreation seem to occupy the majority of the individual's attention and most of his resources. These are, therefore, first order priorities. The economic activity of a poor nation focuses primarily on the provision of such first order needs. Agriculture, construction, and textile and garment production tend to represent the majority of economic activity of such economies. As the individual's financial standing improves, he starts to value second order priorities such as health, looks, wealth, and leisure. A nation, whose average citizen is in that category, tends to favor economic activities in medicine, pharmaceuticals, sports, cosmetics, architecture, transportation, banking, and time-saving gadgets. In this phase of the economy's cycle it is most productive and flourishing. It is also the most exportable phase, since the basic needs of the local population have already been fulfilled.
A second order economy is a maturing economy that tends to handsomely rewards its agents. Bank accounts start swelling. Standards of living rise. And a general sense of euphoria prevails. Near the end of this phase, with a lot of time to spare, the individual shifts to third order desires; desires that are neither palpable nor necessarily useful. Rather than participate in sports, in this phase individuals watch sports. Rather than work to increase wealth, individuals spend their time thinking up get-rich-quick schemes. A sense of entitlement and invincibility prevails. A third order economy is an aging economy. It is dominated by entertainment, marketing activities, financial bubbles, luxury products, and frenzied non-productive activities. In a second order economy, lawyers are agents of protection. In a third order economy, they are agents of extortion. In a third order economy, a class of extreme elite citizens is born. Its function is primarily organizational, and its compensation is stratospheric.
A prolonged third order economy is possible given it manages to maintain an outward appearance of health. As long as second order economies do exist, and are willing to deal with a third order economy, such economy can manage to stay in business. At the earliest signs of trouble, however, trust is lost as the 'Emperor's New Clothes' are fully exposed for what they really are.
China, India, Brazil and a host of other developing economies are second order economies. Germany, Japan, Switzerland and a host of other developed economies are borderline second/third order economies that can easily revert to a second order economy. The USA and the UK are full-fledged third order economies. Natural resource rich economies are economies whose nature is different from the nature of their individuals. More precisely, such economies may have individuals who live in a first, second or third order lifestyle, yet the economy itself is a first order economy by virtue of what it produces and exports.
Thus, the current tectonic realignment is more fundamental than can simply be explained away via deficit and debt figures. Tectonic shifts of this size and nature are usually painful to all involved. The final outcome is often hard to predict. One thing is certain, however. As a third order economy crumbles under its unsustainable appetite, it has to revert, depending on the skill set retained by its citizens, to either a first order or a second order economy. For us in the USA, let's hope it is the latter.
In his highly insightful book 'When Markets Collide', Mohamed El-Erian attributes current financial woes to the rapidly changing economic realities in today's world. He points to several germane factors such as trade and account deficits, national debt levels and GDP growth. He makes the case that world economy is undergoing a reconfiguration phase. The new players are high productivity (in terms of real goods) nations such as China and India, and natural resource rich nations such as Gulf oil producers and Russia. Highly consuming nations such as the USA and the UK are bound to suffer significant standard of living readjustment until they return to savings and productivity.
Although GDP growth and net account and trade deficits are neat quantitative indicators, they may mask deeper indicators that are more qualitative in nature. Economies are dynamic systems whose basic components are human agents and transactions. As such, they tend to undergo anthropomorphic cycles. To a poor individual, activities pertaining to basic needs such as food, shelter, personal safety and procreation seem to occupy the majority of the individual's attention and most of his resources. These are, therefore, first order priorities. The economic activity of a poor nation focuses primarily on the provision of such first order needs. Agriculture, construction, and textile and garment production tend to represent the majority of economic activity of such economies. As the individual's financial standing improves, he starts to value second order priorities such as health, looks, wealth, and leisure. A nation, whose average citizen is in that category, tends to favor economic activities in medicine, pharmaceuticals, sports, cosmetics, architecture, transportation, banking, and time-saving gadgets. In this phase of the economy's cycle it is most productive and flourishing. It is also the most exportable phase, since the basic needs of the local population have already been fulfilled.
A second order economy is a maturing economy that tends to handsomely rewards its agents. Bank accounts start swelling. Standards of living rise. And a general sense of euphoria prevails. Near the end of this phase, with a lot of time to spare, the individual shifts to third order desires; desires that are neither palpable nor necessarily useful. Rather than participate in sports, in this phase individuals watch sports. Rather than work to increase wealth, individuals spend their time thinking up get-rich-quick schemes. A sense of entitlement and invincibility prevails. A third order economy is an aging economy. It is dominated by entertainment, marketing activities, financial bubbles, luxury products, and frenzied non-productive activities. In a second order economy, lawyers are agents of protection. In a third order economy, they are agents of extortion. In a third order economy, a class of extreme elite citizens is born. Its function is primarily organizational, and its compensation is stratospheric.
A prolonged third order economy is possible given it manages to maintain an outward appearance of health. As long as second order economies do exist, and are willing to deal with a third order economy, such economy can manage to stay in business. At the earliest signs of trouble, however, trust is lost as the 'Emperor's New Clothes' are fully exposed for what they really are.
China, India, Brazil and a host of other developing economies are second order economies. Germany, Japan, Switzerland and a host of other developed economies are borderline second/third order economies that can easily revert to a second order economy. The USA and the UK are full-fledged third order economies. Natural resource rich economies are economies whose nature is different from the nature of their individuals. More precisely, such economies may have individuals who live in a first, second or third order lifestyle, yet the economy itself is a first order economy by virtue of what it produces and exports.
Thus, the current tectonic realignment is more fundamental than can simply be explained away via deficit and debt figures. Tectonic shifts of this size and nature are usually painful to all involved. The final outcome is often hard to predict. One thing is certain, however. As a third order economy crumbles under its unsustainable appetite, it has to revert, depending on the skill set retained by its citizens, to either a first order or a second order economy. For us in the USA, let's hope it is the latter.
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