Ten Years After Lehman: The Solution Was "More Lehmans"

The day Lehman went bankrupt I realized that something monumental had happened. The faces of the dozens of people waiting patiently for trains from the center to their homes were revealing. Most of them were City workers. Panic.

I remember when Freddie Mac and Fannie Mae - both government entities - were bailed out, because it happened shortly before the Lehman collapse. They were the largest originators of subprime mortgages.

Why were subprime mortgages originated by Freddie and Fannie given maximum rating and credit quality? Because they had the government stamp.

What had happened with Lehman? The CEO, Richard Fuld, had been saying for some time that its situation was impeccable, that solvency and liquidity ratios were strong and the viability of the bank was out of the question. He also repeated something we hear too often nowadays, that the shares were simply under the "attack of speculators". Many of my readers will remember similar excuses in Popular, Monte dei Paschi, Abengoa, Tesla and so many others. This "speculator attack" excuse was used a lot years later during the Eurozone crisis.

Lehman Brothers was not a commercial bank, managing deposits of retail savers, it was an investment bank. Their clients were "competent persons" that is, those that regulators deem with sufficient knowledge of the risk and complexity of the financial products they are offered. It is not possible to contract the services of an investment bank without being a competent person. Lehman was not run by incompetent people. It was managed by people that firmly believed in the system and that analysed risk the way that central banks and governments tell them to. Lehman accumulated high-risk mortgages in its assets because it believed, as so many analysts, commentators and experts said, that these assets had very little risk.

Crises never happen due to accumulation in high-risk assets, but due to the massive accumulation of assets that the entire mainstream deems as "low risk". Houses never fall, the economy is booming, etc.

Lehman was a prime example of mainstream consensus analysis of risk and economic opportunity. When asset prices fall, buy more.

Lehman did not buy low. It bought in the middle of an already building bubble. More importantly, it did not sell high. It kept riding the gravy train.

Lehman acquired five mortgage lenders in 2003 and 2004, including subprime lenders, when house prices were already soaring. Its acquisitions were lauded by many analysts as genius. As the bubble grew, Lehman's real estate division led the capital markets unit profits to soar more than 50% between 2004 and 2006. it was the fastest growing division in the entire business. Valuations reflected that "success" sending the multiples at which brokers valued the Lehman stock at all-time highs.

Janet Yellen said in 2005: 

"In my view, it makes sense to organize one's thinking around three consecutive questions –three hurdles to jump before pulling the monetary policy trigger.

First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large?

Second, is it unlikely that the Fed could mitigate the consequences?

Third, is monetary policy the best tool to use to deflate a house-price bubble?

My answers to these questions in the shortest possible form are, "no," "no," and "no."" 

Her analysis would not be as clear later in her years as Chairman of the Fed, where she saw no signs of bubbles.

Yellen was not as clear on the housing bubble as it looks. She also spoke of "sophisticated financial products that mitigate risk and facilitate access to housing financing" and Bernanke spoke of "a slowdown, but not a fall". In essence, she said what most were saying. "Housing is a relatively small sector of the economy, and its decline should be self-correcting". No, it was not.

Bernanke, on the other hand, saw no bubble and no risk for the economy in 2005.  Even in 2007, he saw no risk for the broader economy as subprime mortgages started to collapse.

Lehman beat consensus numerous times and reported record earnings every year from 2005 to 2007. It was unstoppable, an analyst told me at the time. "They buy cheap and always deliver". "Naysayers are always proven wrong", he said.  In fact Lehman bought in the middle of a bubble and rode it like The Beach Boys sang. "Catch a wave and you'll feel on top of the world".

Until the music stopped.

In 2007, Lehman reported net income of a record $4.2 billion on revenues of $19.3 billion. Unstoppable. However, house prices were already showing signals of weakness and subprime mortgages were already cracking in the market. Enter the experts.

The voice on the street, the words of market experts were almost unanimous. It was a correction, nothing else. We were living a new paradigm.

Even holders of subprime packages refused to lend to shortsellers because they believed the assets were super safe.

We must now remember the heroes, those investors and analysts who warned of those risks and who were accused of being stupid, almost terrorism for showing that the risks were enormous. They should be praised today as well.

Bubbles always look like a new paradigm. Valuations soar and the prudent investors are left speechless, looking like fools because they "missed" the rally. 2007 was exactly that. And the hundreds of experts at Lehman as well as most mainstream repeated over and over again the same mantras. "Just a correction", "value opportunities" and more importantly, when reminded of the tech bubble years earlier "this time is different". Houses are hard assets, technology is a promise. This time is different. it wasn't.

And, like all bubbles, it burst when the patience of even the most prudent analyst was tested.

Here is what we learned from Lehman. Or what we did not learn, considering the bubble of everything we are living:

The share price of a bank is the thin veil of hope between its assets and its liabilities. Risk builds slowly and happens fast. Lehman's assets were falling in value as liabilities rose with margin calls being triggered everywhere. Those uniquely profitable assets that were so scarce they could always be sold higher to many investors found no bid at all.

We constantly hear that there is enormous liquidity in the market waiting to buy a correction and that investors are cautious and would jump at the opportunity created by a market drop. It does not happen. The marginal buyer disappears.

Lehman's solvency and liquidity ratios evaporated in months. The bleeding became a massive hemorrhage.

Lehman also showed the futility of stress tests and traditional risk analysis. The impact of exposure to one asset class cannot be analyzed believing everything else remains equal.

The two most dangerous words in economics are "ceteris paribus". All else remaining equal. Nothing remains equal. It is such nonsense I cannot even believe that we still read thousands of pages of academic research and analysts' reports based on that premise.

Lehman's exposure to subprime was deemed "manageable" by bulls. It was not. The bank prided itself on having reduced debt, increased liquidity and sold assets throughout 2007.

By then it was too late. it did not survive the end of the year.

Lehman was not a cause of the financial crisis. it was a symptom of a more significant disease. A crisis created by excess risk and high debt has been "solved" by adding more debt and incentivising risk.

The timeline is always the same.

• First, deny the risk.

• Then, deem it manageable.

• Afterwards, take measures to "please" markets or rating agencies that are too small and too late.

• Stock collapses.

• Following that, blame speculators.

• Finally, close the shop.

The monetary and financial system learned something else from Lehman. To hide any new case under the massive monetary laughing gas cloud. 

We have seen other cases, but asset prices have continued to soar under the excess of monetary policies. Central banks have injected more than $20 trillion in the economies sending financial assets to all-time highs.

However, Japan, China or Europe have showed how that placebo effect stops working. The ECB and BOJ examples are clear. Massive liquidity stops working as an asset price inflation machine when it becomes part of the liquidity. The Bank of Japan started buying ETFs and in 2018 the market stopped rallying while the Topix fell 7%, the ECB prolonged its quantitative easing program and European stocks still fell 4%. Chinese stocks fell more than 10% despite massive liquidity pumping.

More than $9 trillion in negative-yield bonds can cause much more damage to the economy than all investment banks in 2008 combined.

The world is well prepared to avoid repeating the 2008 crisis. The risk is that we are not prepared for the next one. Because global monetary and fiscal policies are aimed at increasing, not decreasing, risk taking and debt.

Monetary laughing gas has covered all asset classes with a fake blanket of security, disguising risk with ultra-low rates. We have solved a crisis of excess risk, debt and imbalances increasing debt, imbalances and taking more risk for lower returns.

We have learned a few things from Lehman, except that it seems that we want to replicate the same bubble with inflationary policies. The Lehman crisis was solved incentivising more Lehmans.

The next one will probably not be 2008-style crisis, it will likely be a Japanese stagnation solution, as the biggest risk today is in sovereign debt.

When the bubble bursts, governments and central banks will blame speculators and lack of regulation. And fuel the next bubble.

Crescat: The Hamstrung Fed, Gold, & The Bursting Of China's "Mother Of All Credit Bubbles"

Crescat Capital's Q2 letter to investors focuses on three key macro ideas that are complementary plays on the unwinding of currency and financial asset bubbles at a likely peak of a global capital cycle, the most leveraged in history:

1. Shorting US stocks at proven, historic-high valuations relative to underlying fundamentals with abundant catalysts for a near-term bear market leading to a US recession;

2. Shorting the overvalued and weakening Chinese yuan and China contagion playsto express the unwinding of a credit bubble that is unprecedented in scale and already bursting; and

3. Buying precious metals commodities at record deep value compared to the global fiat monetary base and related miners at record cheapness to the underlying fundamentals with an increasing number of important new signals showing rising US and global inflationary pressures and a hamstrung Federal Reserve that is unable to stop them.

These themes represent what we believe are the biggest macro imbalances in the world today.

The Hamstrung Fed

The Fed is raising interest rates late in the economic cycle. The problem is that inflationary pressures have finally reached a critical mass where they have rendered the Fed's monetary policy ineffective. The Fed cannot fight inflation and prevent financial asset bubbles from deflating at the same time.

... Even while pushing to new highs recently, the US stock market is running out of steam. Market internals are weakening across multiple breadth indicators. These indicators are diverging compared to the January prior high in the S&P 500: substantially lower new 52-wk highs, much lower % of stocks above 70 on RSI, and much lower percent of stocks above 200-dma. We strongly believe the US stock market is poised to follow the rest of the world down.

The Fed is hamstrung because, while it has been raising rates, it continues to run a hot monetary policy in the US, one that is still way too loose to fight rising domestic inflationary pressures according to our model as well as the Fed's own Taylor Rule. Rising M2 money velocity is one sign of rising inflationary pressure today that many people have overlooked. For much of the last decade, money velocity has been declining, but it has recently broken out of a long-term downtrend as we show in the chart below.

... Per Crescat's model, the neutral Fed funds rate that would be necessary to control rising inflationary pressures today is 5.5%. The current Fed funds rate, however, is only 2%. Our research is based on the history of a breadth of inflation and labor market indicators and the Fed Funds rate going back to 1971.

When the Fed keeps interest rates too low for too long, it creates financial asset bubbles that it has difficulty extricating itself from. If the Fed were to raise interest rates by 3.5% to get to the neutral rate to prevent rising inflation, it would be catastrophic for today's financial asset bubbles. Doing so would massively invert the yield curve, crash the stock and credit markets, and create a recession. Such is the tradeoff between inflation and financial asset bubble deflation that we face today.

It is clear that aggregate US financial asset valuations are at excessive, all-time highs, by looking at the ratio of financial assets to income as shown below. Today's US equity and credit markets valuations combined are what we call MOAB, the mother of all bubbles:

It doesn't matter whether we have stable low inflation, inflation, or deflation, valuation multiples are simply too high today and will shrink in all cases based on history. The market is simply discounting way too much future growth and is not discounting a recession.

China Credit Currency and Credit Bust

While the mother of all financial asset bubbles is represented by US stocks and credit today, China represents the mother of all credit bubbles based on its massively overvalued currency and banking system.

In June, we showed how Crescat can perform as the China credit bubble just started to burst. Crescat Global Macro Fund was one of the top hedge funds through June YTD thanks to our significant yuan short position and other China credit bust plays. We strongly believe there is so much more to play out, especially with respect to China's currency devaluation.

China has been the fastest growing major GDP economy in the world, contributing over 50% of global GDP growth since the Global Financial Crisis. But the China miracle has all been accomplished by unsustainable debt growth, non-productive capital investment, and a massive hidden non-performing loan problem. China's NPLs are estimated at close to USD 10 trillion according to one respected China credit analyst, Charlene Chu, at Autonomous Research. Our analysis concurs. We published our most in-depth China credit bubble research letter last year and we believe that China is now entering a recession that would occur with or without Donald Trump's trade war which is hastening it.

As shown in the charts below, China's massive and unsustainable banking asset growth represents a substantially bigger banking imbalance than that of the US prior to the Global Financial Crisis and a bigger imbalance than the EU banking bubble prior to the European Sovereign Debt Crisis.

Precious Metals

Gold is cheapest ever in history compared to the global fiat monetary base as we recently showed.

Silver is historically cheap to gold. Miners are historically cheap to their own fundamentals, and even cheaper when one considers depressed gold and silver prices today. Precious metals are the ultimate inflation hedge and haven asset of our two MOABs, China credit bubble and the US financial asset bubble burst. Too many investors fear another deflationary bust if they fear one at all. Asset bubbles will certainly deflate. But real economy deflation is the last war. The Fed has already proven in the last cycle that money printing conclusively can beat deflation. We have shown above the many signs of rising inflation today, from rising money velocity, to de-globalization, to new higher fiscal deficits from tax cuts, to Phillips Curve pressures, to Crescat and Fed models that show the Fed still way too accommodative to stop rising inflation. The Fed is currently rendered ineffective in fighting inflation because any serious effort to do so would risk bursting record financial asset bubbles.

Therefore, if we could own just one asset class to hedge against ultimately rising inflation as record financial asset bubbles are bursting, it's precious metals. Next to the US dollar, gold remains the most ubiquitous central bank reserve asset in the world and global central banks have been net acquirers of it since it bottomed in 2015.

We want to be on the same side of central banks.

The recent weakness in gold combined with record speculative short interest presents a great deep-value buy today for gold.

No, Robots Cannot Replace Us

Automation seems to be a never-ending source of fear-mongering. Judging from the commentary, robots will "replace us" and cause large-scale unemployment. With the entry of artificial intelligence (AI), and robots that make robots, the value of human beings as productive forces in the economy is simply zero. People then become value-less consumers, only "mouths to feed" while production is carried out by machines.

And, the story goes, whoever first comes up with a robot that creates robots, and robots that fix themselves, will outcompete everyone else and soon own all means of production. The destiny of our innovative species is to become fundamentally dependent on that one capital owner, who by controlling all production controls all of us.

Engineering, not Economics

The problem is that this dystopian outlook is fundamentally flawed. And, as usual, it is reasoning based on economic illiteracy. Rather than an economic organism, the market economy is seen through the eyes of an engineer. In other words, it is seemingly economic reasoning based on a fundamental misunderstanding of economy – the view that production is about technology and engineering, about maximizing "output," and not about the economizing of means to attain valued ends.

If we see the economy as a circular flow, then its effectiveness comes down to the task of removing imperfections or "transaction costs" and thereby "get the wheels spinning ever faster." An efficient economy is a matter of engineering, and therefore the role of government planning becomes obvious: meticulously planned institutions and regulations can solve many (if not all) of the problems that emerge when irrational and imperfect individuals make decisions.

Similarly, the market's production process with decentralized decision-making can be improved through the adoption of rational central planning where all available information is used properly. The task is thus to get the right people into power, and then have them calculate the best possible outcome given the means and ends already known.

In other words, we need not know anything about economy per se, but the task is one of engineering: to reduce waste and improve the existing processes. Consequently, robots, which do not need vacation, do not have free will, and do not appreciate leisure time, will replace imperfect human labor. And further: if these robots can fix themselves and even produce new robots, then, surely, we will not need any more workers.

But this completely misunderstands what economy is.

The problem is not producing, but economizing

What was stated above observes the economy primarily in terms of production of goods. This is true empirically, that is in our everyday experience of working in the economy: what we're dealing with in the economy is to produce the right stuff in the right ways.

However, this is not what an economy is actually about, and this is what most commenters on the automation "threat" do not understand. Robots and artificial intelligence can likely figure out solutions to many production problems that we are still wrestling with. And robots are, as has been recognized since at least Adam Smith's magnum opus, generally more effective than human labor. That is, after all, why we have developed and used machinery through the ages. The same goes for robots, automation, and AI.

But the threat is not real for the simple reason that the efficiency of production is not the problem that economy tries to solve. The actual problem is the use of scarce means to produce want satisfaction. Both means and ends are valued subjectively. Robots do not value.

So when robots may be more effective workers and possibly better engineers, they cannot figure out what is valued. That's the task of entrepreneurs, who bet on what consumers will want. Even if all production is carried out by robots, those robots cannot figure out what should be produced using value terms.

It is quite possible that robots and AI can figure out how to best supply calories, oxygen and other objective necessities to sustain human life. But the step from "2,000 calories a day" to "food that people will want to purchase" is not a matter of tweaking an algorithm – it is about understanding people and valuation. Even more to the point, it is about speculating what people will value. This is simply out of reach for any robot or non-human, just like it requires a mass of imaginative, human entrepreneurs – a division of intellectual labor – in the market to collectively figure out how to create value.

The economy is about economizing, and economizing is not about physical resources or means of production. While tools and materials are necessary for production, their use in the economy can be expressed in value terms only – and these means are (and must be) economized as such. This fundamental point about economy is regularly skipped over in the commentary on automation and AI.

The economy is about value

A major advantage of Austrian economics over the mainstream variety is its placement of value first, that the economy is understood and explained in value terms. Mainstream economics has, unfortunately, forgotten about value in its aim to predict and explain production in engineering terms. And, as a result, the debate about automation, robots, and the use of AI focuses on that engineering aspect of the economy: producing. But this is inconsequential to the actual workings of any real or theorized economy, which is about solving the problem of using scarce means toward insatiable ends.

But let us be clear: economizing is not about engineering or the physical world. It is an all too common misperception that means and ends can be expressed in non-value terms. They cannot.

The means that need to be economized are not simply natural resources, buteconomic resources. Oil, for example, is a natural resource that became an economic resource. Finding oil meant financial ruin, if not death, to farmers and cattle ranchers prior to the inventions petroleum and internal combustion engines. Now, however, after those inventions have become known and used, finding oil means getting rich. The natural resource it the same, but the economic resource – the value of it – was born with the inventions. Indeed, oil became useful in engines, because those engines satisfy consumers' wants. The value in oil is not its molecular structure, but how it is being used to satisfy wants.

Misunderstanding economy for an engineering problem, and economics for a natural science, is a fundamental error. A good, sold in a market, is not its physical appearance, but the service it provides consumers in their attempts to satisfy wants. In other words, a good provides use value. And value is always in the eyes of the user. The value of any means derives from its contribution to a valuable economic good.

So far the debate on automation has completely skipped the value dimension. While this makes the problem much easier to solve, whether through the creation of machines or algorithms to solve calculations, it provides a solution that misses the core of the question. The economy, including its physical production, is directed toward the satisfaction of human wants – realized by people acting as consumers.

If robots save us from the toil and trouble of working, that's one thing. It means replacing leisure for labor, which cannot be a bad thing. But robots cannot replace us as valuers and consumers; no automated process can figure out what we will want. They can only carry out the work after the ends have been recognized. Ridding humanity of this burden cannot conceivably be a threat.

Alhambra: China Central Bankers Are Desperate... "Like 2015 Desperate"

Chinese Money Math

What has changed in China? Many if not most in the West haven't yet caught on because they can't conceive of where all this might be heading. One literal change was the appointment of Yi Gang as head of the People's Bank of China. Not only did he replace longtime chief Zhou Xiaochuan, Yi's elevation broke an even lengthier unwritten Communist rule.

Officials with overseas experience aren't given the top spot in key government divisions. The PBOC certainly counts as one of those. Yet, Yi was appointed, and confirmed, anyway despite his lengthy American sojourn.

After graduating from Peking University in 1980, he then moved to St. Paul, Minnesota, obtaining an undergraduate degree from Hamline University. Yi then moved on to the University of Illinois, receiving his PhD in Economics in 1986. While there, he apparently attended a lecture by Milton Friedman. Whatever your thoughts on Friedman, he wouldn't have been a popular choice of Chinese Communists for future Chinese Communists.

If there is a reason any of us including China's government officials should be concerned about Yi Gang, it is the same one he shares with all the rest of the world's central bankers. It is spelled out right in his University of Illinois PhD dissertation. I'll just quote the first few lines of its abstract, more than enough for you to get the picture.

This thesis attempts to use Stein type estimators for statistical model selection purposes. First, a parameter truncation criterion developed in conjunction with the new Stein estimator (Stein, 1981) is used in an orthonormal linear statistical model setting, as a basis for simultaneously selecting the model and estimating the unknown parameters. Using a mean squared error of prediction (MSEP) loss measure, the sampling performance of the extended Stein procedure (ESP) is analyzed for two alternative structures of the parameter space and under normal and non-normal errors.

Yi is, like all the rest of them, a mathematician. He is the prototypical modern Western Economist who knows quite a lot, it turns out, about statistical processing. Yi's thesis is actually pretty impressive, just not on the topic most would think. Orthodox Economics is the very essence of technocratic ideals, fitting like a glove onto the 21st century Chinese hand of statist control. Rather, attempts at control.

How about economics? There isn't much to go on in Yi's case, a lengthy career that tells us nothing about competency in the one area you would think mattered the most. The term Economist has been transformed into something else entirely.

When China was confronted by the "unexpected" fallout from the "rising dollar" in 2015, it was Yi Gang who often represented his country on the world stage. As Deputy Governor of the PBOC, his American training and familiarity with Economics as "one of them" made him an easy appearance at the various gatherings. At the IMF-World Bank summit in Peru, for example, Yi assured the throngs of media and officials flocking to him for any hint of China's direction:

Don't worry, China still has pretty much middle to high growth in the near future.

Oh boy. Whether he actually believed it, or whether he was pitching the government's "nothing to see here" official position, is also a matter for debate. What wasn't was the PBOC's often desperate struggles that year (and those that would follow).

It got so bad that bank reserves were allowed to contract – sharply. Not only that, perhaps the greater monetary sin, the PBOC even let currency growth slow down to almost nothing. I'm not talking about the virtual currency of something like the eurodollar, a credit-driven figment of global banking imagination. Real currency growth in China dwindled. No wonder China's economy fell into a nightmare with Western Economists shocked into thoughts of a "hard landing."

Why would they do this? We will probably never know for sure, but I'd bet almost anything it had quite a lot to do with "an orthonormal linear statistical model setting." The PBOC calculated its other moves would be more than enough margin to offset what it was being forced to withstand in terms of "capital outflows" originating in reversing eurodollar markets.They computed wrong, as usual.

But that wasn't just a one-off event, as the world slowly come to realize. To what I'm sure will be Western media horror, when they find out months or even years from now, Chinese money and currency is once again being squeezed. In terms of currency, growth is for 2018 right back down to almost nothing again. In August 2018, according to the PBOC's latest figures, total currency was 2.6% higher than the same month in 2017.

That's below the average for this year, 2.7%, and less than the 3.2% growth averaged in all of troubled 2015.

In terms of virtual money, like currency bank reserve growth has likewise stopped.Year-over-year, these deposits of other depository corporations were flat in August.

It might then appear that something is very different in 2018. That's not really accurate, though. What was unusual was 2016-17 – RMB reflation. Ever since 2013, things have been going the wrong way in China, as I wrote in March 2014 (above). The PBOC has attempted to address this single deficiency in various ways over the nearly five years since then, including RMB "printing" in 2017.

All that accomplished was to prove there is no "middle to high growth in the near future."Forget the myth of rebalancing, so long as the global system remains stuck without meaningful recovery and growth there is nothing China can do about it. Globally synchronized growth was as fake as 2015 models suggesting monetary contraction would be easily handled by China's economy.

This is a hard conclusion for many in the West (and in China, I suppose) to reach.They've been taught the technocracy from the very beginning. Give technocrats full autonomy, as they have in China, and watch all the good things they will accomplish.

This is why each and every struggle especially on the part of the PBOC is characterized as if it was done on purpose.

That's where we are again in 2018. These eurodollar events, as I call them, aren't picked up in many places, the data on offshore "dollars" incredibly sparse by default. Outside of TIC prepared by the US Treasury Department, the People's Bank of China, ironically, may be the second-best source. Its balance sheet data very clearly identifies these ups and downs over the last eleven years in a way few others can.

But it goes one step further because it has to; for every "dollar" FX asset that doesn't appear as a consequence of these global deflationary squeezes, something has to happen on the liability side as a necessary result. It feeds directly into the domestic China economy in ways the PBOC can't so easily manage – if at all.

They can try, and they are still trying (RRR cuts again).

The powerful central bank doesn't appear all that powerful, rather judging by what's really going on in all facets of China money central bankers in 2018 once again appear to be desperate. Like 2015 desperate. Because of their models, this isn't actually different.

Zhou Xiaochuan was supposed to retire in 2013, but he held on for another half decade because he wanted to see his reforms succeed and put China's economy back on track to being a globally stable power. Back in March, when Yi Gang was appointed as Zhou's replacement, Yi told reporters, "I feel peaceful and solemn now as the mission is holy and glorious."

I wonder if he still feels that way, or if he might understand Zhou's catlike smirk as he finally walked out the door leaving for his successor this intractable monetary mess. No complex math is required to reach that conclusion.