We Have Reached a Potential Inflection Point

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We have once again reached a potential inflection point for the markets. While the debate rages about the possible solution to the European banking problem, the truth is that the actual need for a solution simply underscores the economic realities we face. None of these banking problems would exist had a true, self-sustaining global recovery been present. The entire administration of global fiscal and monetary responses has been geared toward bridging the divide between contraction and growth, as if the latter was a given.

A typical economic recovery is characterized first and foremost by the expansion of risk taking. The willingness and the ability of a broadening proportion of investors, households and businesses to take on additional risks is where a true recovery begins. In the systemic reset that a contraction represents, the equalization between prices and values (often overshot) gets the process started.

In 2011, however, prices are not being allowed to reset. Systemic risk is being priced by central bank interventions, not considerations of risk/reward from private investors. That monetary bridge to a cyclical recovery involves "managing" the public perception of risk through prices. Allowing even a fleeting thought that the current economic condition is not cyclical would invalidate every artificially low risk price in existence, so the psychology of "deflation" is both feared and persecuted.

For all the massive interventions into nearly every market around the globe, there are still sizable problems with investor perceptions of a growing dichotomy between true values and market prices. The exact path of intervention was designed around the idea that investors and consumers were too busy or unsophisticated to notice that prices were not true representations of value. Or at the very least, that current interventions into the realm of price discovery could credibly create expectations for future conditions where the current perceptions of values would seem inappropriate.

The heart of the European bank crisis is this distinction. Credit investors, including the banking institutions embroiled within it, simply do not "buy" the central bank-inspired prices that are supposed to represent true value of questionable obligors (such as the PIIGS countries). The ECB in particular has been busy propping up the prices of bonds for these troubled countries in an attempt to quell doubts about them. Yet for every round of price manipulation, doubts and uncertainties multiply and amplify.

As markets attempt to redefine the systemic price of risk, central banks are trying to counteract it by manipulating that natural price discovery. But the real cost to such intervention is that doubts about prices then grow beyond simply the asset class in question. If prices are so far from true value in one market, investors naturally question prices across all asset classes, especially given the extraordinary measures central banks have employed in the past few years. Do stock prices accurately reflect the crosscurrent of economic conditions and idiosyncratic characteristics, or are they held aloft by artificially low interest rate comparisons and the subsequent lack of a sufficient discounting factor? Or the obvious absence of suitable investment alternatives (to turn Mr. Krugman's gold thesis on its head)?

The role of interest rates in the economy is not simply to advertise the cost of credit at different maturities. In many ways interest rates are supposed to signal the price of systemic risk, enforcing scarcity upon the financial world. Yet we all know explicitly that interest rates throughout the world today signal nothing of the sort. Instead of displaying true risk pricing, they simply signal what central banks want investors to believe where risk should be priced.

Does a 4.1%, 30-year fixed mortgage in the U.S. represent the true price of the riskiness of holding such an instrument for an expected duration of seven and half years? Given the still elevated delinquency and default rates, that historically low cost is a massive mismatch to the historically high risk of originating a mortgage (GSE's don't really care, of course, so it is little wonder that 80-90% of mortgages in the U.S. since 2009 are originated by them).

But the simple interest rate schematic is not enough to even define risk anymore. The idea of a simple risk/reward tradeoff encapsulated in that 4% yield has been bastardized by the now-primary considerations of available funding and regulatory leverage. A 4.1% rate falls short in information content in order to make any sort of determination of this modern notion of risk: Is that mortgage part of a securitized pool? Is the pool rated AAA? Is there enough repo demand for MBS collateral to obtain the cheapest funding? How much will it cost to accomplish all this credit enhancement and hedging?

Today's financial system is not just a case of simple fractional reserve lending; it is fractional lending to the n th degree. Individual institutions are not just multiplying base money to some safe multiple in the form of loans, resulting in a simple maturity mismatch between assets and liabilities (the basic weakness expressed in traditional bank runs). Rather, firms within the financial system today are leveraging themselves into the maximum amplification of equity capital without ever having to clearly define or even adequately understand that maximum. This is such a profound change that it cannot be understated.

Banks peg their limitations not on the Basel rules per se, but on how they can reasonably (for lack of a better term) take on as much risk as possible and still deem it all to be something far less risky than it is (to align with the letter of the Basel rules). By being given these keys to the risk castle, institutions have put themselves in the position where if they do not have "sufficient" methods of offloading risk through hedging, they would be technically and operationally insolvent. Not to them, mind you, since they are fully convinced by their own mathematical constructions that they can fully and easily manage it all.

It is one thing to be a bank experiencing a run because the public worries about the quality of your assets and your ability to repay liabilities. It is something far worse for you to be insolvent simply because the mathematical formulation of risk through price discovery has changed today. In that case you were always technically bankrupt, you just had the veil of complexity to hide it while you stayed in business far longer than you should have. In other words, a bank can load up on Greek and Italian bonds and appear solvent simply because the true risk of owning those bonds is offset by the more ephemeral calculus of hedging (as it is calculated right at this moment anyway, deltas are not static). Does it really matter for anything other than appearances if your large PIIGS exposure is hedged by counterparties that have identical or larger PIIGS exposure?

The math says that there is no difference, and that is the problem. The math said the same thing of credit default swaps, their prices and the "containment" of subprime credit structures. Instead of focusing on the interaction of credit and how it is created, amplified and ultimately hedged or especially collateralized, authorities and policymakers have chosen to deal with "problems" of pricing or liquidity. If the price of risk can be manipulated, so the thinking goes, then the problems of irregular pricing as it relates to papering over the far greater problems of insolvency should be easily displaced.

The collapse of AIG is a perfect example. The "irregular" pricing of default swaps it had written and offset (netted) led to margin calls and collateral posting that AIG was not expecting - its calculations of its own riskiness did not match the real world's perceptions, or at least how those perceptions of riskiness changed in real time. As such, AIG was not financially able to manage all these changing translations of risk calculations. For all the fancy math and complex accounting, AIG was actually insolvent the day its hedges stopped performing according to their models. The traditional notion of solvency never really applied here, all that mattered was the (in)ability of the firm to manage "risk" in the short run.

On the surface, this seems like a risk pricing or liquidity problem (or simply rollover risk) where central bank interventions into the pricing of hedging and systemic risk might have forestalled the collapse entirely. But that line of thinking again misses the real point.

The true risk was not that it calculated the math incorrectly, or even that math in general is wholly incapable of defining something truly dynamic, it was that AIG ever allowed itself to be in such a position in the first place. AIG created a business that was so rigid in terms of tolerance that once its narrow margin of safety was violated the entire company was bankrupt.

The problem was that it determined its own margin of safety, largely accomplishing that because the price of risk was set by something artificial (though its mathematical origins gave it the veneer of science and acceptability). Because of this artificial system, the company never even knew it was in mortal danger, blinded by its own belief that risk had been, and would continue to be, accurately priced by the past data series. And in that respect, the central banks were similarly behind the curve since they use the same math and models, meaning that they will never be able to actively control prices and conditions enough to offset changing perceptions that occur outside of those mathematical tolerances.

Banks, including central banks, view risk as a number that defines operations. Real risk is the hubris such thinking engenders. The outsourcing of common sense into models is where the financial system ran aground.

Bank managers may feel safe leveraging themselves to the moon, or taking on trillions in derivatives because they are supposedly netted, but the rest of the world pauses over the same actions. While it is easy to dismiss this lack of sophistication in the rest of us, the very fact such sophistication needs to exist simply defines it as risky in the first place. If something requires a heavy element of complexity and a questionable need for mathematical certainty, it is without qualification inherently and intrinsically risky. All the hedging and the rest is just window dressing.

As long as the system remains fractional in nature, many humans recognize the desire of the bank side of the ledger to maximize that fraction, something that will never change. That is a massive risk that cannot be priced away since it is intrinsic not only to the system but to human psychology. Many humans also recognize that the fractional system itself will be pro-active in its measures to redefine or manage the appearance of risk so that said fraction never appears to be so extreme.

What will really assure the wider marketplace is a healthy application of the brutal market discipline that monetary scarcity would enforce. Further, a system that is castrated from its ability to define its own margin of safety would mean that banks and financial firms would have to focus their resources on the actual function of intermediation. Instead of spending so much time and energy calculating the "appropriate" hedges for risky credits or assets, a bank might better spend its time validating the more important economic question of whether such a credit or asset obligor is even worthwhile in the first place.

In this economic sense, the management and price of risk has shifted away from considerations of scarce rationing to considerations of blindly taking on risk and then managing it all through random walk statistics (another flaw). The broadening productivity of money and credit that actual intermediation accomplishes within a regime of scarce money performs the vital role of selecting successful and sustainable long-term growth projects. The mathematical ability to fool oneself into believing that hedging can appropriately offload nearly all the risk of lending to anybody and everybody is economically self-destructive (and financially foolish).

Mathematical expressions of risk and safety have proven inadequate to the task of limiting the base desires of financial firms to grow without limits, and the parallel economic process of being able to fund every bad idea in existence. In fact, the current concept of math-driven risk has given the banking system an intentionally clear path (embodied in all three version of the Basel rules) to unfettered expansion in the first place, with central banks as willing accomplices soaking up the political "benefits" of monetarism and bubblenomics. This is as definable, if unquantifiable, a systemic risk as any model could express.

The only real ironclad law of economics is that humans will always go too far if they are able - and every interest rate regime on the planet needs to reflect that. Base or systemic interest rates should not be derived from central bank calculations of its own perceptions, they should be based on who has ultimate control over money and credit production.

Since the system is unable to restrain itself, the issue of restraint has to be moved outside. Whether that means a modified gold standard, a gold price rule, or some other mechanism for tangible suppression of credit production should be the only debate taking place right now. There should be no debate on the idea of a tangible and exogenous (from the perspective of the banking system) anchor to the concept and price of risk. An exogenous credit limitation does not often (it is not perfect) allow such a massive and growing disconnect between prices and true values.

The answer to a broken system of manipulated markets is not to manipulate and break them further. Given the lack of functioning financial system and the more distinct and apparent lack of real economic results, the status quo should no longer be acceptable to the vast majority - it is not too hard to connect the dots between monetarism's artificial and uncontrolled notions of risk and the lack of sustainable rewards (both financial and economic).

What central banks are ultimately trying to accomplish is to preserve the system's ability to set its own rules; the first rule of which is the systemic price of risk. The economic nomenclature of monetarism is intentional in its attempt to cloak the success of the status quo as vital to the success of the economic whole. We see this in the expression that banks must not be allowed to fail because the whole economy would follow. In reality, true capitalism disfavors the reckless waste of resources embodied in the modern banking system's lack of focus on true intermediation. Capitalism also features self-correction, meaning bad ideas lead to extinction.

Capitalist intermediation is supposed to be a system that matches money with opportunities to create productive endeavors that are both sustainable in the long run and enhance the beneficial properties of labor specialization. This kind of capital focus ensures broad participation in the successes of the system. It also imposes limitations on the usefulness of speculation and the unbridled financial economy. The current iteration of the banking system is unrecognizable from this viewpoint, including the manipulated prices of money and risk.

Monetarism, as it is represented today by the wholesale-funded investment banking system and its central bank aggregators, has little to do with matching money to productive potential. Is there any use for synthetic mortgage structures in the real economy? Or long-dated interest swaptions? These are supposedly tools to help the process of price discovery, but they are really inventions for transferring money from one perception to another without any benefit or even contact to the real world.

The imbalance of speculation (the system always needs some speculation but we passed any ideal "equilibrium" during the Great Inflation, then grew dangerously imbalanced during the Great "Moderation") is a direct product of artificial control over risk pricing. The long-term aspect of beneficial intermediation is drowned in the tide of the short-term sclerotic schematic of quick billions - is it any wonder that the system cannot maintain any semblance of stability?

More than anything, investors, households and businesses are seeking that stability, even if that means accepting no return on savings (what additional evidence is needed to show that monetarism is scandalously upside down). That best describes the current and sad psychology of risk and its price. To fix this broken system requires a credible commitment to stability. Unfortunately all we will ever get from policymakers is more intentional instability as long as the option of preserving the system largely unchanged is thought to be a viable one.

This means that the all-out, desperate maintenance of the artificial disconnect between the price of risk and perceptions of value will be the only "solution" proposed (including any current and future iteration of the dubious EFSF). No one needs mathematical models to accurately predict that policymakers will always be surprised by this perpetual state of crisis and the growing discontent with its consequences.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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