Tuesday, August 19, 2008

Bernanke's Protégés on Bubblenomics

Three of Bernanke's protégés were recently interviewed by Charlie Rose to discuss the current economic weakness plaguing the United States. You can watch the entire interview by clicking here.

The three economists, Markus Brunnermeier, Wei Xiong and Harrison Hong had slightly differing views but they all agreed that economic weakness will continue in the foreseeable future. Of the three, Harrison Hong was the most bearish and in my opinion, he offered the most insight into the current downturn.

Mr. Harrison states that to understand the current cycle, you have to go back because "somewhere along the way in the last decade or so the Fed lost track of leverage in the system." He cites the reasons for this including financial deregulation in the eighties, financial innovation in the form of subprimes, in the form of collateralized default swaps, as well as the boom in hedge funds, all contributing to increase the leverage in the financial system.

Mr. Harrison states that the Fed is now realizing the scope of the leverage in the system: "Because the rates were so low for so long, what the Fed is realizing now is how much leverage there really was that they couldn't track and how much leverage in the form of financial innovation sat the balance sheets of banks." Importantly, he adds that "going forward, I am a lot more pessimistic because it depends how the housing bubble deflates". Since the housing market is very levered,"when these things go down, it is very hard to keep these things from spiraling down because they are so central to the economy and they take a life of their own."

On why hedge funds came out of this crisis better than the banks, both Mr. Brunnermeier and Mr. Harrison state that hedge funds had better risk management, they are more nimble and they did not originate this toxic debt.

On the controversial subject of bubbles in the commodity markets, Mr. Harrison believes that speculative activity - much of which was coming from huge pension inflows into commodity futures - is behind the last surge in oil prices. Interestingly, an article in Financial Week in early August, discussed how revised data showed that speculators controlled nearly half of NYMEX oil futures in mid July.

I quote the following from that article:

A quiet data revision that has boosted by nearly 25% the number of oil futures contracts U.S. regulators think are held by speculators. And that revelation is raising eyebrows in the energy trading community.

The revision means that speculators controlled 48% of the open interest in NYMEX crude oil futures and options as of July 15—compared with just over 38% under the previous classification.

“That’s huge when you look at the numbers,” said Phil Flynn of Alaron Trading in Chicago.

“It changes the whole way you look at the recent moves in this market.”

The U.S. Commodities Futures Trading Commission announced on July 18 that it was reclassifying some trading positions that it had reported as commercial hedging positions as noncommercial speculative positions.

The data revision converted approximately 327,000 long and 330,000 short NYMEX crude oil futures and options positions into mostly spreading positions held by speculators.

The big shift is all the more surprising, oil traders and analysts said, since the CFTC reclassified only one unidentified oil trader at the same time as the data revision.

The important thing that pension funds need to understand is that they do not invest in a vacuum. Following the tech bubble in early 2000, many pension funds searched for higher yields, diversifying out of traditional stocks and bonds into alternative assets.

But the rush to diversify ended up being a double-edged sword. As most pension funds were diversifying their asset mix away from traditional stocks and bonds, to invest in alternatives like hedge funds, private equity, real estate, commodities, etc., they were largely responsible for bidding up the prices of these assets.

Ironically, in looking to diversify away from traditional assets, pension funds created a bubble in alternative assets, adding to the systemic leverage of the financial system and increasing the risk of a systemic crisis. (This bubble in alternative investments will burst, but I am hoping we get one final bubble in alternative energy stocks.)

So what is the end game? The end game will be debt deflation as banks tighten up credit and consumers pay off debts. How long will it last? If we look at what happened in Japan in the nineties, it could last a decade or longer. And which asset class protects you from the ravages of debt deflation? That's easy: good old nominal government bonds (the number one asset class in Japan in the nineties).

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