MnRT

Oil Prices to Hit $375 by 2025- Exxon Invests $.6 Billion in Biofuels

The dynamics of oil production is no mystery to oil giant Exxon Mobil. Based on their thorough understanding of global oil resources, they announced a significant first investment in biofuel production. To understand why the oil industry stalwart took this action, we turn to mathematics, and specifically a model of future oil production.

Previously we used STELLA modeling to document the flaw in capitalist credit markets, which turned out to be our second most popular article after the discussion of pandemic flu. Today we’ll introduce you to a STELLA model of peak oil in China and related global price and energy implications. For an explanation of STELLA, please refer to the previous post or just Google “STELLA modeling”. The outcome of that modelling is the input to Exxon's alternate fuel investment strategy.

Let’s begin by stating the obvious: Oil is a limited resource that is being consumed rapidly, mostly for energy but also for chemical feedstock. The rate of oil consumption is dependent on the number of people on the planet and the efficiency with which we use oil’s energy content. Because the rate at which oil is naturally produced is insignificant when compared to the rate of consumption, global oil reserves are being depleted. Eventually, the quantity of oil available from conventional oil reserves relative to consumption will cause oil production declines and an increase in the price of oil. The price of oil will then decouple from the consumer supply-demand markets and be determined by large oil trading markets, resulting in large, volatile, and destructive swings in oil prices. These fluctuations will further cripple capital markets unless alternative energy sources are satisfying a significant portion of consumer and industrial demand.

The discussion here is based on the model of Tao and Li (2007, Systems dynamics model of Hubbert Peak for China’s Oil, Energy Policy v. 35, pages 2281-2286). The model presented here as well as the data used come from that paper and are explained and referenced there. I reproduced their STELLA model (see Figure 1) and added a simple price model. You can download the model if you like (it requires the STELLA player program to run), examine the model parameters and equations, and run the model using a model player (to run the model file).

Figure 1- Model of China peak oil re-created from Tao and Li (2007). The key variables include cumulative proven reserves, ultimate reserves, and Hubbert production.

Though the peak oil model is simple, its detractors frequently attack the model as “unproven”: in fact –part of the model works like your bank account balance. You have a certain amount in the account (reserves), you withdraw a certain amount every year (consumption), and you deposit some money (new discoveries). The only uncertainties in the model are the rates of consumption and discovery, and these can be varied within realistic limits to see how sensitive the model is.

Based on this model for China Peak Oil, Tao and Li reasoned that by 2040, China’s crude oil production would have fallen back to the levels of 1990, despite increased demand (see Figure 2). Their sensitivity analysis suggests that the Hubbert Peak for China Oil production will happen between the years 2010 and 2022, and is roughly the inflection point in the cumulative production curve.

Figure 2- Model results showing the time series predicted for cumulative oil production (blue), Hubbert annual production (red), and annual increase in proven reserves (purple). Note the clear Peak in Hubbert oil production which marks the point where production declines begin.

As a general rule sentient beings try to envision natural systems in ways that mimic their own sentience. So while at the Hubbert Peak about half of the world’s oil supply remains in the ground, people imagine this is a great deal of oil and there is no immediate problem. But scale and rates are where the human brain generally fails to correctly match intuition to reality, and mathematics are needed to determine the truth.

The mathematics of Hubbert Peak Oil are so simple and results so dramatic that its implications are difficult to believe or assimilate. But recall, the implications of the mathematics of leverage in the credit markets was hard to believe, until that is all you read about for 2 years.

So what does this all mean for oil prices, energy prices, and civilization? For beginners, take a look at Figure 3, which shows an oil price model that is only coupled to the relative abundance and scarcity of the resource. Because the rate of oil consumption is dependent on the number of people on the planet and the efficiency with which we use oil’s energy content, fluctuations in consumer demand are generally short lived departures from the overall population trend. The model suggests that as the Hubbert Peak approaches, the price of oil will ascend dramatically, and by 2025, oil prices will be about $375/barrel. And then oil prices go through the roof, the stratosphere, and finally into space.

Figure 3- A simple model of oil pricing based on the relative scarcity and abundance of oil. The less oil that remains in the global oil reservoirs, the more expensive the price. You can download the model here.

Clearly, every large industrialized nation of the world, unlike most readers and investors, know this, and are taking dramatic steps to fund and support alternative energy technologies, and to promote conservation (including cap and trade). As the price of oil accelerates, large pools of capital via commodity trading markets will provide feedback to the prices system and decouple the pricing market from true consumption demand. Traders will cause volatile and gut wrenching fluctuations in oil prices. But what needs to be strongly emphasized is the stress this acceleration of oil pricing will put on capital markets. I can only hope that the financial system recovers in time to face its next challenge.

Road Map to Credit Crises and a Blueprint for Change

Let's just dispense with the polemics against economists, economic and financial journalists, and politically motivated mercenary pundit provocateurs and get down to the nuts of bolts of modern capitalism in order to explain how this credit crisis happened and how the Federal government has responded. It is certainly a sufficient indictment of our Economics brain trust that you have to read about how capitalism works in this blog.

Implicit in this discussion is a general blueprint for future changes in the way our capitalist system works. First I present a model (see Figure 1), which shows how and why credit crises happen, and are inevitable under the current structure. Then I'll walk you through how the Federal government has responded so far. Finally I will allude to the needed fix. In this posting I will provide a general overview, and in subsequent posts, try to further elaborate details as needed.

Figure 1. A lumped parameter systems model of capitalism. The bottom section (blue) represents the portion of the system that relates to producing things and increasing value in the system. The upper section (yellow) represents the portion of the system that relates to financial operations for non-productive assets. The gray box shows how these two subsystems intersect. See text for more explanation. The bold red arrow identifies a critical problem in the yellow portion, while the green arrow identifies a working function in the blue portion.

Okay, I apologize if this blog seems pedantic or overly technical to you, but in reality the danger is that I have over simplified this system by grouping factors into a lumped parameter model. The idea is to identify how capital flows, accumulates, and is distributed in a model that accounts for and predicts cyclic asset bubbles and resultant credit crises. I am presenting only the kernel of the system, and clearly can't even include all of the most important factors as separate variables. But if you want to understand what is going on in our economy, then you'll have to wade through this discussion.

First I'll adopt a simple model syntax to explain how capitalism works. The model syntax. which comes from the MIT contribution to System Dynamics, is ubiquitous in the literature for those who are interested. In this syntax I use four symbols: 1) a reservoir (or a state variable) representing money or value, 2) a valve controlled conduit connecting value reservoirs, 3) a functional relation, and 4) the flow of information. This syntax would me to design a logical model of modern capitalism and then run an actual numerical simulation to explore the effects of variables on system behavior. Take a look at Figure 1.

In this figure there are rectangles that represent reservoirs of money or capital. Some of this capital is in the form of industrial equipment (see Economic Capital in Figure), some is in the form of assets such as intellectual property and real estate (see Asset Capital), and a very important and reservoir of capital is in liquid assets that can be used for credit purposes.

The only way capital moves from one reservoir to another is through a valve controlled conduit, where the rate of money movement is directly and explicitly controlled by the valve. The valves look like circles with a handle on top of them and always lie between capital reservoirs.

Functions are shown as circles, and represent financial rules, legal regulations, industry practices, etc, that affect how the valves operate. The thin arrows connecting reservoirs, valves, and functions, represent the flow of information required for the function to work. For example, if you locate the function "Fed Powers" which refers to the rules and powers of the Federal Reserve Bank, you'll see an information flow to the valve "Credit". This means that the credit available is a dependent on what the Fed does (and also the amount of capital in the "Liquid Capital" reservoir). By the way, this functional relationship explains why the Fed can only ease credit when there is sufficient money in the "Liquid Capital" reservoir, and if there isn't, they are powerless to directly promote a credit easing.

Capitalism 101

Capitalism works by creating value in excess of the costs of production, and that excess value can stimulate further growth or be used for further capital accumulation. This value is created in the blue portion of the system where real things get produced. You might say that intellectual property belongs in this section, and while the ideas might be produced in this system, the value of the ideas are held separately as an asset.

We can walk through how the blue subsystem works. Liquid Capital held in banks, commercial banks, investment banks, etc, is available to provide credit to purchase Economic Capital. For example, a solar company needs capital to build a solar wafer facility and needs to borrow the money. That credit is extended based on a risk function, a composite of a business model, cost and availability of credit, and efficiency of invested capital. Some investment don't work out and that poor investment deflates the overall Economic Capital while those investments that are productive and create value serve to create a positive feedback for further investment.

The Banks that are regulated by the Federal Reserve are required to keep reserves on hand in order to payout deposits. Thus the Federal government, through the Federal Reserve and the FDIC basically provide the only "hedge" or insurance on the value of money and the liquidity of the regulated banks.

"The Great Moderation" is basically a testimony to how well this system works, and it does work well as far as it goes. Remarkably, and by purely empirical methods we can determine that modern capitalism produces an apparent average annual value excess as the capitalist system of producing material goods allows for the continued creativity of the human imagination.

Why Does Capitalism Crash?

In a sentence, capitalism crashes because of a system of hedging that promotes asset bubbles and guarantees that bubbles end in a crash. The crashing happens in the upper (yellow) portion of Figure 1. Liquid Capital is used to extend credit for assets, such as real estate. Now what is the rational for extending credit to purchase an asset such as real estate? It doesn't produce anything, there is no business model to evaluate, there is only the market value to provide a method of collateral hedging. This hedging function determines the value of the assets, and is unfortunately also dependent on the value of the assets. Whenever a function effects the value of and asset and is also controlled by that value, we have a problem. Simply stated, when the assets are increasing in value the hedging function promotes inflation of the asset value, which in turn creates a further pool of asset capital that can be securitized to underwrite further loans. But as soon as the cost of hedging becomes astronomically high (commonly due to leverage), the securitization valve is shut, the loans stop, and the asset values fall in an unrestrained feedback loop. Thus the lending institutions are under-capitalized and stop lending, and the hedging mechanisms through hedging institutions fail catastrophically. The mechanical details of that failure are not shown on Figure 1.

Recall that assets that produce things, like equipment, wear out over time and decrease in value as part of a life cycle and are considered part of Economic Capital. However there are dangers to investing in new equipment that comes from the value of associated intellectual property, which is part of Asset Capital. Intellectual property can also be subject to the same sort of boom bust cycle as tangible assets like Tulips or real estate.

Are there other reasons that Capitalism crashes? Yes.

What Has the Fed Done So Far?

We can easily see what the Fed has done by seeing how the Fed fits into the system on Figure 1. The first course of action by the Fed was to pump money into the Liquid Capital reservoir. Next they lowered the target rate, then they pumped more money into to Liquid Capital reservoir. Most recently they have created a new connection between their own "Hedges" valve, and the "Hedge Value" valve in the yellow subsystem, thereby providing "insurance" for the assets of Citigroup and preventing them from draining out of the Liquid Capital reservoir.

How to Fix the System:

The problem now is the "Hedge Function" which causes asset inflation to expand until the hedging is fundamentally mathematically and practically impossible at which point the function then causes immediate asset collapse with associated contraction of liquidity and credit. Fix that and you've made the system much more resilient.

When the Obvious is the Unthinkable: Banking collapse and the nationalization of credit

When the oxygen first got sucked out of the credit markets during the summer of 2007, many analysts tried to estimate how a big a problem this could be. Our estimate, based on short term foreclosure estimates, leveraged asset write downs, and a sane response from (now extinct) investment banks, was about $400-500 billion. Our estimate was heavily weighted by the banks' draw on the Fed's discount window, robust numbers in the U.S. economy, and the existence of bond insurers. When the bond insurers Ambac and MBIA failed to support the capital requirements to guarantee their portfolios, and the Federal government in a moment of incredible stupidity failed to guarantee the guarantors, an accelerated process of write downs and losses began, and now the estimates for potential losses are truly astounding.

We tried to alert investors through posts at the New York Times:

Jan 27, 2008

"There remains a critical systemic need for the survival of a very well capitalized bond insurance industry, without which liquidity will contract to levels that cannot sustain even normal economic activity.
In fact, the bond insurance industry needs to be significantly expanded and strengthened, as it provides the only monetary defense against large global dislocations caused by de facto undersecuritization.
The stage is set for high drama:"
http://mnrtrading.blogspot.com/2008/01/high-noon-at-wal l-street-corral-federal.html

and again on February 23, 2008

"Because no one will know the details of the current credit crisis until a team of dedicated writers and forensic specialists sift through the data, or until Ben Bernanke writes his memoir “The Age of Turbulent Moderation” or Richard Bookstaber publishes “Another Demon of Our Own Design” one can only outline the events and infer their importance.
This episode of financial recklessness occurred on a scale never before in the history of capitalism (although the panic of 1837 might be comparable in impact for the U.S.) and whatever the near-term outcome of negotiations between Ambac and “the banks”, the federal government and the Federal Reserve needs to address how “lending institutions” could leverage more than 10 times the entire national money supply in circulation without any mandated reserves (other than the flimsy models of private rating agencies)."
http://mnrtrading.blogspot.com/2008/01/high-noon-at-wal l-street-corral-federal_6923.html

Let's take a look at the numbers. The U.S. residential mortgage debt alone is about $12-13 trillion and about half of that debt is within the zone of inflated housing prices, or post 2003. About %10 of that latter debt must be considered at some level of risk to non-payment and foreclosure. Thus we have about $1200 billion at risk for non-payment within the next 5 years, and about $6 trillion of mortgage debt at risk for protracted devaluations.

The recent passage of the unprecedented $700 billion "Bailout" package by Congress is presumably designed to address only the smaller of these two risks: the risk from short term non-payment and foreclosure, and assumes that ALL of these risky mortgages can be purchased for about 50 cents on the dollar, or about $650 billion. As staggering as that sum of money is, it is dwarfed by the leveraged risks remaining on outstanding mortgage debt.

Even if the Treasury's aggressive plan works exactly as designed, there remains $6 trillion dollars in mortgage debt that may continue to devalue for many years to come. That devaluing asset puts constant pressure on all financial institutions to raise capital to make up for the asset write down, and maintain capital requirements. A slow 10% decrease in house prices creates another $600 billion capital hole in the financial sector. When you consider that commercial banks hold between 20-40% of mortgage debt, you quickly realize that this crisis is not going to end well.

But it gets worse. Investment banks that used those mortgage backed debt securities to borrow had leverage as high as 30 to 1, meaning that the amplification of the credit shortage is catastrophic to them. That capital shortfall is optimally worsened because there is NO market for these securities anymore, except for Central Banks and National Treasuries. So margin calls wipe out investment banks, Hedge Funds, and anyone caught on the wrong side of the leverage. Investment Bank bankruptcies and Hedge Fund liquidation drives the stock market lower in a dramatic fashion.

The total paper losses to the financial sector over the next five years could reach about $3 trillion or $600 billion each and every year, if you assume that the total potential losses to the sector will be caused only by the decline in U.S. Housing prices to its long term average, and not counting the positive feedback resulting from the collapse of credit and injurious effects to economy. However if leveraged losses are factored in, the total loss could be $30 trillion.

Even assuming only the direct declines in mortgage assets, the effects on the general credit market will be catastrophic. How bad is it really? Worse than the tulip bubble. Just imagine that a bank's asset was written on the value of a tulip, and that tulip's value was $1000. The bank could loan $900 of the value of that asset. Now the tulip is worthless, and the bank has no assets on which to write loans, and it has to raise the shortfall in capital. The shortfall in capital appears to be growing at least $600 billion/year and won't stop at least until housing prices appreciate. Quite possibly, mortgage back securities will never be the same class asset as it represented in the past. The problem is also complicated that in a strongly recessionary spiral, there is no appreciating asset class in which to anchor an investment.

Given this scenario the future credit and economic landscape is completely uncharted. The U.S. has already nationalized a significant part of the credit market, and even before the $700 billion bailout package was passed, held nearly 35% of the national mortgage debt through Fannie Mae and Freddy Mac. With the current bailout, they have assumed another 10% or so, depending on prices, and guaranteed FDIC bank deposits to $250,000 (for a period of time).

Big questions remain: How can an economy survive with no credit market, and how can a society survive with no capital?

The Federal Reserve's Geomagnetic Storm Warning

Research sponsored by the Federal Reserve Bank of Atlanta established a correlation between geomagnetic storms and stock market returns. Based on that study we further infer that because geomagnetic storms run on top of an 11-year solar cycle, we may be heading into a recession that will bottom in 2011-2012.

When the U.S. Geological Survey and NOAA issued a warning that a major geomagnetic storm was to arrive during June 2000, most economists were unaware that this alert could presage the popping of the dot-com bubble. Those non-scientists who follow this phenomenon might have eagerly anticipated the associated intensification of "northern lights" and other aurorae atmospheric fireworks. Engineers however were bracing for potential disruptions in radio communications, satellite transmissions, and computer anomalies. The military was on alert due to the potential disruption of military communications and GPS satellites. However, there is evidence to suggest that geomagnetic storms effect people as well as other animals that use magnetism for navigation (such as birds, whales, etc.). Alas, the economists, traders, and quants, were all completely unaware.

Figures showing the U.S. Geological Survey geomagnetic monitoring stations and fluctuations of the magnetic field on the top, and how solar storm activity interacts with the Earth's magnetic field, on the bottom.

Cesare Robotti, from the Federal Reserve Bank of Atlanta , and Anna Krivelyova (a PhD candidate at the time) from Boston College, studied the effects of geomagnetic storms on the movement of stock prices empirically, given that psychological data support the position that geomagnetic storms affect people's moods. Their report concluded that geomagnetic storms affect people, and those people may be more likely to sell stocks because of their altered mood.

"Unusually high levels of geomagnetic activity have a negative, statistically and economically significant effect on the following week’s stock returns for all US stock market indices. "

The authors summarize their data with a simple bar chart that shows U.S. Stock returns during geomagnetic storms (the red bars) compared to normal non-storm days (blue bars).

Figure showing relative stock returns on geomagnetic storm days versus non-storm days (this is Figure III in the original paper).

You might even see some impact of storms on annual returns by comparing the number of geomagnetic storms each month to monthly returns.

Figure showing the averaged stock market returns monthly from 1926 - 2006. Note that "sell in May and go away" really should be sell in April.

Figure showing the average number of storm days per month.

But we opine that the most significant aspect of geomagnetic storm effect is the underlying solar storm cycle, which is about 11-years long. The nadir of that cycle, ie., the best conditions for the stock market occurred in last February. Beginning with that point in time the solar cycle will rise until a peak late in 2011, during which time, according to solar cycle economic theory, we will be in a recession, mostly because of mood disorders.

If you want to use real-time geomagnetic data to understand the stock market and your own mood, just bookmark this page and check out the alert below, which indicates the level of geomagnetic field activity (from NOAA).

Solar X-rays:
Geomagnetic Field:

Current conditions From n3kl.org

When visiting the NOAA site, be sure to check the K-index, a general measure of geomagnetic storms disturbance, in the horizontal component of earth's magnetic field. It is an integer in the range 0-9 with 1 being calm and 5 or more indicating a geomagnetic storm.

The Fed vs Treasury: Moral vs Immoral hazards

"I would put the GSEs at the top of my list of sources of potentially serious problems. "

from Feb 29, 2008 speech by William Poole
President, Federal Reserve Bank of St. Louis

Today, Freddie Mac and Fannie Mae hit new lows while Treasury Secretary Paulson testified that these GSEs were not in any financial danger and were "adequately capitalized". Paulson's comments raises the concept of "immoral hazard" whereby disseminating potentially false information produces an asymmetry of information designed specifically to counterbalance a negative market reality.

The issue is simple: William Poole of the Federal Reserve stated in February that Freddie Mac and Fannie Mae were in serious trouble. But Paulson has been pushing a distinctly different line.

Paulson and Bernanke: See no hazard, speak no hazard.

The Moral Hazard

William Poole describes the moral hazard using an analogy:

"The concept of moral hazard is most easily explained in the context of insurance. The very existence of insurance may change the behavior of the insured person, who becomes less careful in taking care of insured property than he otherwise would if the property were uninsured. Being less careful with others’ property than your own is not moral behavior and is a hazard to the insurance company."

Another part of the moral hazard is asymmetry of information so that two parties in a transaction do not share the same accuracy of information resulting in higher inherent risks to one party. The Federal Reserve has maintained a stated policy of avoiding the moral hazard that could result from its policies.

The Immoral Hazard

Expanding on Poole's analogy of insurance, if one party knows that a property sits on a fault zone but describes it to other parties as "safe" then we have an immoral hazard. The immoral hazard basically promotes "normal" behavior despite knowledge of higher risks.

William Poole Provides a Blunt Assessment

Poole's speech in February was crystal clear regarding the situation of Fannie Mae and Freddie Mac.

"As I emphasized some time ago, GSE losses will depend on the variance as well as the mean of changes in national home prices. Losses in markets with home prices falling more than the national average will not be offset by gains in markets with price changes above the national average. I do not have a new message here; we have known for a long time that advance preparation and a strong balance sheet are the keys to riding out a financial storm. As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues. I do not have any information on the GSEs that the market does not also have. Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs."

MNRTrading Warns Feb 21, 2008

One week before Poole's comments about Fannie Mae and Freddie Mac, we had already issued a warning that the market was about to break out to new lows.

The comments by Fed President Poole were a confirmation that the cause of the market breakdown would be be further credit deterioration.

Microsoft Retreat Confirms High Risk to Business Model

Microsoft's next big loss- virtualization.

Microsoft withdrew its $33 a share offer to buy Internet portal Yahoo on Saturday raising a number of interesting questions regarding the future of Microsoft's business model. Since Microsoft's earlier and historic retreat from thin-client computing in 2001, the software giant's business advantages has been slowly eroding. Microsoft had developed a technology to offer its software portfolio over the Internet but scrapped the plan which encouraged competition in that arena. Ballmer made a critical error, believing that business and consumers would prefer to own a piece of software rather than pay to use it. Their error was that while it might have been true at the time, it wouldn't always be true.

Enter Google, Salesforce, VMWare, and plethora of smaller companies whose goal is to "head Microsoft off at the pass" by choking off enormous potential future revenues from the Redmond giant before Microsoft can respond. The success of Google is the clearest example of how this process works. Google's business model aimed to tap into revenues of a market that was initially very small, but one that they projected and predicted to be very large. Google moved while Microsoft balked, and the rest is history.

Our earlier commentary indicated that part of the Google strategy was to bleed Microsoft of cash to control some its aggressive tactics, through a brilliant plan of "revenue sapping". That strategy worked and may have played a part in Microsoft's initial withdrawal from the Yahoo deal.

It is also possible that some of Microsoft's cash has evaporated in asset write downs associated with the mortgage and credit crises.

But the risks to Microsoft's business model are rising every day, and as MNRTrading models the various risk scenarios using system dynamics, we see very significant potential risk coming from virtualization technologies that can eventually eliminate the need for a single computer operating system. That development could undermine Microsoft more catastrophically than the inevitable but gradual loss of revenue due to Google Office and Google business services.

Virtualization eliminates Microsoft's trump card, the operating system from which they have created their software empire. Google will continue to successfully "sap" Microsoft revenue streams, and unless Microsoft can develop their own virtualization business plan to accommodate the inevitable transformation the software industry, they will become a marginal player in the future.

Microsoft lacks the leadership to visualize their own future in a marketplace that must evolve. To the contrary, Microsoft has tried to hold back the tide of innovation in order to maintain their own control over the industry. In the long term, evolution always proceeds.

Nuclear Shutdown Signals Solar Industry Breakout: Florida Power & Light Turns off Nuclear Power

Millions of people were without power today (February 26, 2008) as Florida's largest electric utility shut down a nuclear reactor south of Miami today. Associated Press reported that "Authorities did not specify the cause of the shutdown but say there were no safety concerns."

But Florida Power & Light (NYSE:FPL) is in the eye of a hurricane of controversy regarding nuclear power in a world with limited energy options. That controversy centers on the four realistic energy options for electricity production: coal, natural gas, nuclear, and solar. The problems inherent with each of these non-solar options will trigger the next significant expansion in solar demand.

Today's nuclear shutdown and the problems it underscores will serve as a catalyst for solar power.

Recent Problems at Florida Power & Light

On Saturday, Jan. 19, shortly after 11 PM, two circuit breakers opened in the electrical switch yard on the non-nuclear side of the facility immediately sending the power plant off-line.

On January 22, 2008, The Nuclear Regulatory Commission (NRC) staff proposed a $208,000 fine against Florida Power & Light Co., for security violations at the Turkey Point nuclear power plant, according to a NRC press release.

"NRC officials said the agency identified violations of NRC security requirements during an inspection in February and a separate investigation in August, both in 2006. The NRC said that in April 2004, FP&L failed to ensure that two armed responders had operable weapons to meet their job of protecting the plant. Specifically, an FP&L contract security officer willfully removed the firing pins from two weapons, rendering them non-functional."

On January 29, 2008, the Saint Lucie 2 nuclear power unit in Florida was shut to fix a reactor coolant pump. The power plant exited ramped up to full power by February 11, the U.S. Nuclear Regulatory Commission said in a report.

A Long History of Problems with Florida's Nuclear Plants

Problems are no stranger to Florida Power & Light (FPL). Both Turkey Point and St. Lucie make the top 30 list of "significant" nuclear events (Nuclear Regulatory Commission, Nuclear Accidents) and these nuclear plants have been implicated in radioactive releases that contaminated drinking water.

The problems with Florida Power & Light's nuclear power systems have a long history, including their now infamous implication in the "Tooth Fairy Project" in south Florida which concluded:

"The study found the highest levels of radioactivity in samples of drinking water found within 20 miles of the Turkey Point (located south of Miami) and St. Lucie (located north of West Palm Beach) nuclear power plants, while levels of radioactivity were significantly lower in water samples further away from the reactors.
The rise in Sr-90 levels in both drinking water and baby teeth parallels a 32.5% rise in cancer rates in children under 10 in the southeast Florida counties, which are closest to the nuclear power plants. This compares with a average 10.8% rise in national childhood cancer rates from the early 1980s to the late 1990s.
The baby teeth study conclusions are consistent with the recent U.S. Environmental Protection Agency admission that children age 2 and younger are 10 times more susceptible than adults to the cancer causing effects of toxic chemicals and radioactivity. According to the National Cancer Institute's SEER Cancer Statistics Review, from early 1970s to late 1990s, U.S. childhood cancer overall has increased by 26%, brain cancer by 50%, leukemia by 45% and bone cancer by 40%."

Nuclear Power Uncertainties Emphasize Solar Certainties

What do these problems have to do with solar power stocks (LDK, STP, SPWR, CSIQ, YGE)? The stock market does not like uncertainty and nuclear expansion in the U.S. is surrounded by uncertainty.

Financing of coal-fired power plants is also surrounded by uncertainty, as evidenced by the recent "Carbon Prinicples" that might affect lending from the nations leading banks.

Solar power is a clear beneficiary of that uncertainty.

POSTSCRIPT:

27 February 2008: One day after this post, Canadian Solar (NasdaqGM:CSIQ) was up over 7% in mid-day trading. Other stocks mentioned were trading significantly down following a downgrade in analyst ratings. The downgrade came from Bank of America, a leading lender to the coal industry (Arch Coal, Massey Energy, International Coal, and Dynegy's coal power plants). We believe the selling is providing a buy opportunity for investors.

Stock Market Indicators: Market Breakout is Now Imminent

"a very significant move is going to occur .... probably within the next 30 days."

Continued concerns about slowing economic growth, financial instability related to CDOs, and the reversed leverage effect on credit markets has resulted in significant uncertainty in the stock market. Perhaps most tenacious of these problems is the reverse leverage that CDOs now have on the credit markets, and without a simple mechanism to ease credit concerns, there is no end to the market uncertainty.

Leverage is a wonderful thing if you can use it to work for you, but when the fulcrum moves (the value of the underlying assets), you find yourself on the wrong side of the lever. Basically, the Federal Government needs to put "a bottom" under the housing and mortgage market to prevent the threat of further CDO weakness.

Market uncertainty is indirectly reflected by the VIX volatility index. Refer to Volatility in Transition Phase for more discussion about the VIX. The VIX increases in anticipation of a change (either positive of negative) in economic growth rates.

A more direct measure of the impact of uncertainty on equity prices can be determined by looking at the standard deviation of a stock's closing prices calculated monthly. The likelihood for large daily trading ranges happen as this volatility measure increases. The use of the standard deviation, when couched within Chebyshev's theorem, can be used to make very simple and direct statements about how much the price of a stock might vary. For example, we might state that there is a high chance that the price of a stock will vary by at least its standard deviation. If we look at the S & P 500 index as a whole, we note that monthly standard deviations track the VIX in a very general way. In reality, it might be that the VIX tracks the monthly standard deviation, as monthly option expirations are a factor in price volatility.

The greater the monthly derived standard deviation in the SPX index, the greater the apparent mis-match between current market prices the next months' prices. The current value of SPX monthly derived standard deviation indicates that a very significant move is going to occur in the S & P index, probably within the next 30 days. Unfortunately, the direction of that move cannot be forecast.

Figure showing SPX (S & P 500 index) and standard deviation of the index in the lower part of the graph. The graph covers the period 1990 to the present.

Related Posts:

POSTSCRIPT:
26 February 2008: The DOW is up around 600 points since this original post, the S & P is up 50 points. Confirmation is still needed.

27 February 2008: The failure of the rally to confirm suggests the move may be to the downside. Look for testing of January lows again.

Investment Strategies: Decision Making during the Financial Crisis

"...the continued fracturing of the financial system's credit pipelines is very troubling, because they cause critical shortages in the capital needed to maintain normal economic functions, and are costly to fix."

Today the stock market reacted to "a surprise number" from the ISM Services (non-manufacturing) sector indicating that financial services and credit markets in particular are still not functioning normally. To be precise, although bank to banks services are relatively functional, other financial services were clearly reflecting the resurgence of credit problems caused by very large negative leverage from mortgage backed securities. Also to be precise, the ISM Services number was no surprise. The index fell to 41.9, the lowest level since the the two World Trade Center towers were destroyed. The current chapter of this financial crisis began at the end of July 2007 when the twin towers of the financial system, Ambak Financial Group and MBIA, started to collapse on the sixth anniversary of the Sept 11 attacks.

On the positive side, the U.S. Federal Reserve has already reacted to those financial dislocations. On the negative side, uncertainty exists regarding the mechanics and costs of unwinding a large amount of negative leverage on the financial system.

Followers of MNRTrading know that we deal with the uncertainty in a simple and logical way, by pulling money out of equities and taking profits, and keeping cash until the reward/risk ratio is high enough to reinvest. Our Model Portfolio is still almost 50% in cash (not including profits already realized), and until the financial risk abates, there is little incentive to invest, some reasons to trade on day spreads (our version of option trading with daily expirations), but lots of reasons to assess the market landscape. We certainly did not follow the crowd "off the cliff" that the pundits suggested was a "defensive play".

In addition, we adjusted the balance of company market capitalization in the Model Portfolio to increase the fraction invested in Mega-Cap companies. Currently, the Model Portfolio is about 20% invested in stocks with capitalization over $50 billion, namely Intel and Google. Interestingly, both of those investments are now negative, but we expect that portion of the portfolio to be the most resistant to further declines moving forward.

Figure Showing the Market Capitalization distribution of the MNRTrading Model Portfolio. This chart is dynamic and will change as the portfolio changes. Our allocations between cash and stocks can be found here.

We still have conflicting data regarding the stock market performance over the next quarter, including the results of our own analysis.

If you are not following our Model Portfolio, the volatility can hurt if you did not follow our cue to raise cash by taking profits earlier. If the stock market declined by 50% tomorrow, we'd still be up for the year, and that fact provides a margin of comfort that makes it easier to make cool investment decisions. Therefore the 7% decline in our Model Portfolio nominal returns since December, is not very troubling.

However, the continued fracturing of the financial system's credit pipelines is very troubling, because they cause critical shortages in the capital needed to maintain normal economic functions, and are costly to fix.

The French Connection: Ackman, Fimilac, and MBIA

Commentary

Rating Agencies Next in Line for Scrutiny

"Follow the money" and "there is no such thing as coincidence". Those are the mantras of crime investigation and particularly for financial crimes. And what a coincidence it was that the SocGen rogue trader revelations, the Fitch downgrade of bond insurer FGIC, and the announcement that Bill Ackman's estimates of Ambac and MBIA losses where much larger than being reported by those companies, all happened within days of the Federal Reserve's rate cuts which were designed to help the struggling bond insurers. To many observers, it seemed that these developments were negating any Fed cut rally.

The FBI is already involved in gathering information about ratings agency protocols, accusations are being drafted against investment banks, and rumors are rampant. Bill Ackman is no stranger to this: he has been investigated before in relation to his negative bets against bond insurer MBIA.

The U.S. Federal Reserve and New York Insurance Superintendent Eric Dinallo are both committed to shoring the weakness in the financial markets and specifically bond insurers Ambac and MBIA, The players are all heavyweights, and the stakes are high, and crime is suspected everywhere.

The New York Attorney General Office is vigorously pursuing criminal investigations, reported the New York Times:

"Clayton Holdings, a company based in Connecticut that vetted home loans for many investment banks, has agreed to provide important documents and the testimony of its officials to the New York attorney general, Andrew M. Cuomo, in exchange for immunity from civil and criminal prosecution in the state."

The Feds are even more frustrated, and according to the FBI, the number of investigations into possible mortgage fraud tripled between 2003 and last year, rising from 400 to 1,200. The FBI also has launched large investigations into 14 companies directly involved in sub-prime mortgage loans or in the marketing of securities backed by those mortgage loans.

Conflicts of Interest

In the not too distant past, the public discovered that the stock recommendations coming from investment banks and the clients of those investment banks were correlated. If Merrill Lynch had a large client doing banking business with them, there was internal pressure to recommend the stock, even if the analyst did not agree with the recommendation. Clearly there was a conflict of interest and a public outcry. New York's Attorney General, now Governor, Eliot Spitzer, had won large cases prosecuting these conflicts. In 2002, Spitzer reached an unprecedented agreement with Merrill Lynch designed to reform their investment practices and forced them to pay a $100 million penalty. According to the New York Attorney General Office:

"The agreement with Merrill Lynch comes after allegations that the company’s investment advice was tainted by conflicts of interest. A core issue was whether or not analysts were being truthful and fair in their public pronouncements on stocks of companies for which Merrill Lynch did investment banking business.

Merrill Lynch has agreed to enact significant and immediate reforms that will further insulate securities research analysts from undue influence from its investment banking division, and will change the way analysts are compensated."

Now questions are being raised concerning rating agencies, Moody's, Standard and Poor's, and Fitch. Fitch Ratings in particular, a majority-owned subsidiary of Fimalac, S.A., an international business support services group headquartered in Paris, France, may have a similar conflict of interest to the investment banks.

Fitch Ratings, with " operating offices and joint ventures in more than 49 locations and covering entities in more than 90 countries, including insurer financial strength ratings on over 2,000 insurance companies" ended Wednesday's (Jan 30) 200-point Fed cut triggered rally in the Dow Jones Industrials by downgrading the fourth-largest bond insurer Financial Guaranty Insurance (FGIC). The coincidence of the announcement was curious, coming at the peak of the nascent rally.

According to the Fitch web site: "Fitch's credit ratings provide an opinion on the relative ability of an entity to meet financial commitments, such as interest, preferred dividends, repayment of principal, insurance claims or counterparty obligations. Credit ratings are used by investors as indications of the likelihood of receiving their money back in accordance with the terms on which they invested. Fitch's credit ratings cover the global spectrum of corporate, sovereign (including supranational and sub-national), financial, bank, insurance, municipal and other public finance entities and the securities or other obligations they issue, as well as structured finance securities backed by receivables or other financial assets."

But the other side of Fimilac, the owner of Fitch Ratings, is Algorithmics a Toronto-based risk management firm. Algorithmics provides financial institutions with advanced enterprise risk management solutions that help them better measure and manage their financial risk. When you boil these two companies down to their essential services, Fitch Ratings assigns risk and Algorithmics protects against that risk. Obviously those two companies could benefit from information between them, and one must naturally question whether there is any "leakage" of information across the corporate membranes. To some, it might seem that Fimilac is running a protection racket.

And why stop there with questions about "information leaks". What about parties sharing the same legal advisors? Davies Ward Phillips & Vineberg LLP was counsel to US funds managers (Bill Ackman's) Pershing Square Capital Management L.P., Knott Partners Management, LLC and Hawkeye Capital Management, LLC in connection with active shareholder opposition to the take-over of Sears Canada Inc. by Sears Holdings Corp. Davies also acted on behalf of the Ontario Teachers Pension Plan, one of the selling equity holders, in the $175 million acquisition of Algorithmics.

While all of these coincidences prove nothing, one thing is certain. Investigators will have no shortage of theories to investigate.

Samuelson vs Cramer

Editorial Comments:

Cramer got whacked in Newsweek. Robert Samuelson starts "The Market's Echo Chamber" article in Newsweek with a comment about Jim Cramer's tirades on Fed Chief Ben Bernanke. He writes that Cramer's tack on the Fed "is entertaining", but fears that Cramer and the "rise of financial populism" has "fundamentally altered the climate in which the Federal Reserve makes economic policy". He paints Cramer with a broad brush,

"What Cramer and many talking heads offer are selective and sensationalized views that favor short-term conditions and immediate gratification: higher stock prices tomorrow; better trading profits."

Cramer's reaction was 100% Cramer: "I'm sick and tired of taking abuse from people who say I've gotten it wrong". Funny, I think Bernanke is saying the same thing.

Samuelson is trying to say something deep, but never mentions that the market's echo chamber is in part the result of the decline in paid news research, consolidation in media, and the explosion of bloggers. After a painfully manipulative statistical and historical narrative, he follows a circuitous path that finally leads him to give his own opinion:

"Unlike financial populists, the Fed should focus on the economy's performance in the next six years, not the next six months. "

After all is said and done, Samuelson has simply added his voice to the cacophony of advice for the Fed.

My comment (reproduced below) on the Newsweek website points out that truth should not be trampled for the purpose of what Samuelson thinks is a more noble cause.

"On May 16, 2006, Fed Chairman Ben Bernanke gave a speech at the 2006 Financial Markets Conference where he was responding to evidence of a surging crisis in credit markets. He said "The concern arises because, all else being equal, highly leveraged investors are more vulnerable to market shocks."
He then explained that the Fed did not actually know the extent of the crisis,
"Concerns about hedge fund opacity and possible liquidity risk have motivated a range of proposals for regulatory authorities to create and maintain a database of hedge fund positions. Such a database, it is argued, would allow authorities to monitor this possible source of systemic risk and to address the buildup of risk as it occurs...".
That database did not exist. So from a strictly factual point of view, Jim Cramer's statement that "they know nothing" has some basis in fact, within the strict context of the August 2007 liquidity crisis.
Unfortunately, the blame for the lack of reliable public financial reporting should placed at the door of real financial journalists, but you are at least correct that the financial "echo chamber" has made it hard to learn the truth."

So Cramer might have been right regarding earlier Fed rate cuts, but that was the result of "opacity" of risk from hedge funds and investment banks.

That fact is not the point.

The tone of Jim Cramer's ad hominem, nearly violent outbursts regarding Ben Bernanke and the Fed are more incite than insight and contribute to a mob mentality that once unleashed cannot be controlled. Cramer's personal attacks on Bernanke on CNBC's Mad Money are destructive, dangerous, and unsuitable for mass media.

Frankly Jim, its more than a little disingenuous to demonize the Fed for losses in the stock market. Those losses are usually due to failed business plans or casualties of business cycles.

Samuelson seems more concerned that "financial populism" will affect the independence of the Federal Reserve. If there is such a threat, it might come from Washington as easily as from "The Echo Chamber". I am more concerned that Cramer's personal polemics will overwhelm his program's real educational and entertainment value and degrade America's sense of citizenship and civic responsibility.

High Noon at the Wall Street Corral: The Federal Reserve's Three Act Play (Act III)

Because no one will know the details of the current credit crisis until a team of dedicated writers and forensic specialists sift through the data, or until Ben Bernanke writes his memoir "The Age of Turbulent Moderation" or Richard Bookstaber publishes volume 2 of "Another Demon of Our Own Design" we can only outline the events and infer their importance.

Related Reading:

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
by Richard Bookstaber

Read more about this book...

The Age of Turbulence: Adventures in a New World

by Alan Greenspan

Read more about this book...

Act Three: High Noon at the Wall Street Corral

In the process of stabilizing the U.S. economy, investment banks also began to favor and accelerated the use of a new investment vehicle, the Collateral Debt Obligation (CDO), that allowed a blend of investment assets. The blending of mortgage backed securities, including subprime mortgages, empowered banks to create a huge amount of credit.

Capitalism is based on sufficient accumulations of capital to provide credit to new and expanding businesses, and that is how economic growth occurs. However, for about the last 100 years (since 1913 when the Federal Reserve system was established), the U.S. has restricted or at least tried to regulate somewhat, the process of credit issuance by banks. To the point, traditional banks must maintain cash reserves. Of course, only the Federal Government can print money.

Investment banks circumvented the Federal Reserve's primary control over liquidity. Banks used securitized mortgage debt, and leverage on that debt to create a potential credit arsenal equivalent to world's most powerful central banks. Because these derivatives are not subject to the stabilizing effects of cash reserves that banks themselves are required to have, banks broke the rules of the reserve system, although the laws are unfortunately not in place to make these actions illegal.

In theory, they could create a mortgage backed security, and then use that debt obligation to borrow further capital. Metaphorically, they waged war on the Fed, in the sense that they could loosen credit using leverage to their hearts' content, without the Fed having to lower interest rates and without any regulatory restrictions on their activity. It appears that Wall Street continued to do this with at least some knowledge that by 2006 the risks were no longer correctly reflected in the credit ratings of CDOs. Instead of putting the brakes on further expansion of this under-collateralized derivative, they expanded its use. This reckless action, broke the Fed's alliance with Wall Street and set the stage for a financial crisis. The extent of this activity is currently being investigated by the New York Attorney General.

Bookstaber notes that the 1987 financial crisis,

"might have been surmountable if it were not combined with another characteristic that we have built into markets ... Tight coupling. Tight coupling means that the consequences of a process are critically interdependent; they are linked with little room for error or time for recalibration or adjustment."

The Fed was careful in assessing its options. Unlike Alan Greenspan, Bernanke was concerned with The Moral Hazard of direct Fed intervention. On May 16, 2006 Bernanke commented on the surging financial crisis:

"If several funds had similar positions, how would authorities avoid giving a competitive advantage to one fund over another in using the information from the database? Perhaps most important, would counterparties relax their vigilance if they thought the authorities were monitoring and constraining hedge funds' risk-taking? A risk of any prescriptive regulatory regime is that, by creating moral hazard in the marketplace, it leaves the system less rather than more stable. "

We know for example that Bill Gross along with other PIMCO representatives met with "high-ranking Treasury and Fed officials presumably to discuss a near vacuum in liquidity and sinking confidence in the bond markets on August 16. One can safely assume that Treasury and Fed officials were talking to investment banks as well.

The Fed wanted investment banks to create a reserve fund, the so called superfund to save the Structured Investment Vehicle market and thus put up a line of defense to stop the rapid deterioration of these securities. That was a natural reaction from the Fed, sort of a private version of the Federal Reserve itself, the Investment Bank Reserve. It was actually a good idea, and still is in theory, but the investment banks wanted large interest rate cuts up front. Bernanke said no, inflation was too risky.

Video showing Jim Cramer's "They Know Nothing" plea to the Fed

Wall Street investment bankers and the Fed stared at each other. They glared, they yelled. Jim Cramer squealed. The Fed was dogmatic, they took the party line, "just do your jobs better in the future, and mark down your assets". Perhaps the Fed was a bit defensive given the vitriol emanating from Wall Street, or unaccustomed to the New York investment bankers' version of the Maori haka.

Video showing the Maori haka, representing my impression of Investment Bankers' reaction to the Fed's initial refusal to lower interest rates.

The investment banks thought, actually they knew that the Fed could not do this alone, so they were recalcitrant. But there were also political pressures, and Bush doesn't want to be pictured as bailing out those big bad bankers, and politics trumps logic every election year.

The result wasn't pretty, Only a few banks joined the effort, Citigroup (NYSE:C) (perhaps in exchange for a free pass to get large foreign capital infusions), Bank of America (NYSE:BAC) (perhaps in exchange for a no hassle takeover of Countrywide Financial), and JP Morgan Chase (NYSE:JPM) (perhaps in exchange for a free pass to make its bank acquisition).

But most banks did not participate and in the end, the financial defense was never finished. Nobody flinched in that standoff at the Wall Street Corral and everybody lost on that deal. Crash! Bamm! The banks lost big time and were forced to take huge asset write-downs, CEOs left. But the financial system was still not stabilized.

The standoff led to the next and possibly final defense, the bond insurers like Ambak Financial Group (NYSE:ABK) and MBIA (NYSE:MBI). Since the failure of the SIV Superfund, the Fed and Treasury have been watching closely. Federal Reserve Bank of New York President Geithner along with New York State insurance regulators were trying to put the next deal in place. The investment banks again said, "probably not, we think that this might be too big for us", you need to get the ECB on board, and did their haka again.

But this time the Fed had no choice, it was their last lines of defense before hand to hand combat, so they cut interest rates dramatically by 75 basis points, cuts that mirrored the emergency cuts following the 9/11 attacks.

Everyone is speculating whether either side knows something the other doesn't. Do the investment banks believe that the interest rate cuts that the Fed is forced to make to relieve credit and liquidity pressures will actually be sufficient in themselves? Or perhaps, and more likely, do they want the Fed to cut rates up front again, and cut them even more aggressively in order to guarantee that they will be able to get a return on their investment and recoup some of their losses?

It is High Noon at the Wall Street Corral.

POSTSCRIPT:

29 January 2008: Just two days after we posted this story, reports are emerging of sweeping investigations. The Wall Street Journal reported today that Federal investigators have opened criminal investigations related to "accounting fraud, securitization of loans and insider trading, among other areas".

High Noon at the Wall Street Corral: The Federal Reserve's Three Act Play (Act II)

Related Reading:

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
by Richard Bookstaber

Read more about this book...

The Age of Turbulence: Adventures in a New World

by Alan Greenspan

Read more about this book...

Act Two: One Nation Under Funded

The new strategic partnership between Washington and Wall Street began immediately. The mission, create liquidity and lots of it. A series of large, pro-business tax packages sacrificed the viability of important government programs in an attempt to stimulate the economy and reverse the painful loss of jobs that the economy had been hemorrhaging for several years as the dot-com hysteria morphed into post 9/11 realities. The "Moral Hazard" was nationalized and put under "protective custody". In addition, the Federal Reserve's dual mandate kicked in, requiring the Fed to address rising unemployment rates.

Deflation which began before 9/11 accelerated in earnest immediately following the attacks, and would continue to plague the economy throughout most of 2003. By then the Fed had lowered fed funds rate to an historic 1%.

Real estate prices which had already been inflated during the dot-com expansion were starting to find support in the form of low mortgage interest rates. As the Fed continued to lower interest rates, housing naturally inflated upwards to reflect the increased purchasing power of the home buyer. By early 2004 the housing market was boom-booming. More buyers, real estate speculators, and home builders, flush with easy credit jumped in to cash in on "sure thing".

Ten home buyers where outbidding each other for each property, houses were selling in hours or days after being put on the market, it was crazy but true. Brains and decision making were being affected by those neuro-transmitting chemicals stimulated by the heady economic gains.

And it wasn't just the affluent that were getting into the housing market. The Community Reinvestment Act of 1977 and extended in 1995, which mandates that banks provide loans to "under-served populations", was created ensure that banks would serve all portions of the community, rich and not rich, equally. Less qualified home buyers had the option of subprime mortgages. And so a well intentioned law fed unsuspecting home buyers from financially weaker portions of the population into a hurricane of a financial crisis.

The 1995 revisions to the Community Reinvestment Act allowed the securitization of loans containing subprime mortgages. And securitization is the way to go if you are a bank. Recall that the Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by mortgages back in 1968.

There are so many benefits to the originator from securitization that it is exceptional not to go that route. Benefits include: transfer of risks; accelerated profit recognition; lower capital requirements. The risk to the investor is primary in establishing the value of the underlying assets (mortgages) and in the chance that the value of those assets will decline over time.

However with housing prices increasing and delinquencies reaching new lows, the market seemed secure (see Figure below).

Figures showing Housing prices and subprime ARM foreclosures, from Taylor, 2007, Housing and Monetary Policy. The upper graph is what the housing market looked like to banks and other lenders in 2005, with declining subprime ARM delinquencies and increasing housing prices. The lower graph is the includes the rest of the history.

The U.S. economy was growing so fast, and appeared to be so strong, that investment banks had no difficulty selling the securitized mortgages all over the world. Banks were making money hand over fist and the credit expansion created further economic opportunities for large banks. The investment banks were euphoric. Home owners were euphoric. The stock market community was euphoric. Yes, euphoria all around. Although energy prices were not behaving as predicted, and the dollar was weakening despite the economic growth, all was good.

The economic crisis in the wake of 9/11 was over.

Economic theory suggests that the process of securitization distributes risk, so the financial system was protected. The Department of Homeland Security wanted risk to be distributed, so the nation's financial infrastructure was safe. The Federal Reserve's dual mandate had been accomplished. When Alan Greenspan talks, the world listens, but only hears what it wants to.

However by early 2006 it was clear that there was a problem, the only question was, how big was it going to get and what was the best way to deal with potential double whammy in the financial industry caused by a weak housing market coupled to increasing mortgage default rates?

Next Episode, Act Three: High Noon at the Wall Street Corral

High Noon at the Wall Street Corral: The Federal Reserve's Three Act Play (Act I)

Because no one will know the actual details of the current credit crisis until a team of dedicated writers and forensic specialists sift through the data, or until Ben Bernanke writes his memoir "The Age of Turbulent Moderation" or Richard Bookstaber publishes Volume 2 of "Another Demon of Our Own Design" we can only outline the events and infer their importance.

Related Reading:

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
by Richard Bookstaber

Read more about this book...

The Age of Turbulence: Adventures in a New World

by Alan Greenspan

Read more about this book...

Act I: Terrorists Strike Financial Center

Our story begins shortly after the terrorist attacks on New York's World Trade Center on September 11, 2001. This attack was not only aimed at causing maximum casualties and human anguish, it was a premeditated strike on a critical component of the United State's world hegemony: the U.S. financial system.

The attacks in New York City had disrupted communications and when the market reopened on September 17, 2001, the Dow fell 684 points and continued to fall nearly 1400 points by the end of the week. The NYSE was under special guard. The Federal Reserve building in New York was evacuated. Rudy Giuliani was roaming the streets of New York with his posse.

Everyone was on heightened alert, and everyone was in a siege mentality: we were fearful, angry, and determined to repair the damage. One month after 9/11 came the first anthrax case.

The attacks accelerated a deflationary cycle that represented the devaluation and painful write-downs of dot.com era investments gone bad. The attacks revealed vulnerabilities to our financial system.

The Federal Reserve moved swiftly to prevent panic and a run on the banks. Ferguson and then Greenspan responded. In the days immediately after 9/11 the Fed injected $81 billion into the government securities markets, loaned $46 billion from the discount window, and executed a series of currency swaps, with the European Central Bank, the Bank of England, and the Bank of Canada totaling $90 billion. You have to appreciate the magnitude of this gargantuan effort by the Federal Reserve: between $200-$300 billion in lending or agreements to lend in a matter of days and lowering short-term interest rates by 100 basis points over a three week period.

The nation was already in a recession. The stock market was tanking, sinking, in a free fall. Investors could not grasp what was happening, could not accept it. Following the inevitable losses, the write downs, and the endless emotional forecasting came irrational fears about where the bottom might be. The dot.com boom had brought average people into the stock market lured by powerful trading tools and cheap transaction fees and the promise of riches. And now their wealth was evaporating, and they just watched in disbelief.

The Federal government set out to strengthen security, communications, emergency preparedness, and data redundancy in financial institutions. In addition they almost immediately began to plan to rebuild a badly hurt financial sector. They wanted to create a new resiliency in the system, a financial system with super powers.

Of course the President called upon the Federal Reserve to get involved, and in a Presidential order, gave the Fed a new emergency mandate: rebuild the financial system. The exchange might have gone something like this:

"Hi Alan, thanks for coming over, I don't have much time and with all the anthrax scare I don't want outside people in the White House, so here is what I want you to do, fix this sh-t, and do it fast."

"Yes, Mr. President, we know what to do, the Fed is already taking action", but Greenspan was thinking "Mr. President, you focus on building a better America and don't interfere with monetary policies."

When Fed Vice Chairman Roger Ferguson, Jr., addressed the Conference on Bank Structure and Competition in Chicago, the plans were already in full swing:

"Financial services firms in and near the World Trade Center were severely affected by the 9/11 attacks. The industry experienced an unprecedented loss of lives and property, requiring massive, long-term relocations to contingency sites and dedicated efforts to protect and reassure staff. "

Ferguson continued to explain:

"As best practices emerge to address the new paradigm, we may find it appropriate to expand supervisory guidance so as to obtain the appropriate level of overall resilience for the financial system. I expect we will come to some conclusion about the need for additional guidance over the next few months. However, I feel strongly that any such guidance should resist taking an overly prescriptive approach."

However, it appears that one of the important goals of the new and rebuilt financial system was to create a system of distributed risk so that in the case of terrorist attacks, financial centers in the United States would not shoulder the entire risk. In Ferguson's own words:

"I expect that the marketplace will create its own incentives for institutions to invest in business resumption, as customers begin to demand assurances that their financial institutions can indeed continue to provide services if a regional or widespread operational disruption occurs."

And so a plan was developed that would rebuild and strengthen the financial system, return the U.S. to the path of economic growth, innovation, and provide the resources to meet the challenges of security and a potential social crisis caused by an injured national identity. President Bush, The Federal Reserve, and Wall Street partnered up to rebuild what 9/11 broke.

Next Episode, Act Two: One Nation Under Funded

Bernanke vs Wall Street: A Dangerous Game of Brinkmanship

Market Commentary: The sound of silence before the FOMC meeting is loud.

Wall Street wants much lower interest rates. The Federal Reserve wants Wall Street to secure the monoline insurers and maintain financial stability. Wall Street says "we dare you not to cut rates". The Federal Reserve says, "you can't win this game anymore". Wall Street says "we always win in the end". The Fed says, "but today you will lose". Wall Street says "assholes", the Fed says "cretins". The rancor is rather unpleasant and disturbing.

The first battle of the titans between the Federal Reserve (allied with Treasury) and investment banks was over saving the mortgage industry. The Fed wanted investment banks to create a reserve fund, the so called superfund to save the Structured Investment Vehicle market and thus put up a line of defense to stop the rapid deterioration of these securities. That was a natural reaction from the Fed, sort of a private version of the Federal Reserve itself, the Investment Bank Reserve. It was actually a good idea, and still is in theory, but the investment banks wanted large interest rate cuts up front. Bernanke said no, inflation was too risky.

They stared at each other. They glared, they yelled. Jim Cramer squealed. The Fed was dogmatic, they took the party line, "just do your jobs better in the future, and mark down your assets". Perhaps the Fed was a bit defensive given the vitriol emanating from Wall Street, or unaccustomed to the New York investment bankers' version of the Maori haka.

But most banks did not participate and in the end, the financial defense was never built. Nobody flinched and everybody lost on that deal. Crash! Bamm! The banks lost big time and were forced to take huge asset write-downs, CEOs left. But the financial system was still not stabilized.

I do not know how or why the talks broke down, perhaps they should have involved the State Department in the negotiations. But for now, its high suspense. My guess, and it is only a guess, is that the Fed will take no chances, and therefore cut rates again, and try to put together a new deal.

Related Posts:

The Test of "The Great Moderation"

The number of traders lacking confidence in the recent rally increased in the afternoon as markets continue to fall from the open. The VIX volatility index is approaching the extreme level again (30 or greater), after having dropped to more moderate levels in the tail of the past rally.

We have very strong misgivings regarding the dragging on of the Ambac (ABK) crises, which prompts us to remind our readers of the following.

Einstein is widely quoted:

"The splitting of the atom has changed everything except for how we think?"

The interpretation is that the great power of the atom did not change human nature.

Our related quote is:

"The Federal Reserve's (and Bernanke's) notion of "The Great Moderation" has changed everything, except for how investment bankers think."

The interpretation is that the great power of the Federal Reserve did not change the economic system and the human nature of investment bankers.

Related Posts:

Investment Banks Stall for Time over Ambac

The market is relatively flat this morning as large investment banks apparently scurry to adjust their own positions prior to finalizing any Ambac announcement. The amount of cash required to stabilize Ambac is small relative to the further write downs investment banks would incur, and therefore the request for time to reach a resolution seems more like a pause for insider trading than time needed to sort things out.

Expect a great deal of gut wrenching churn in the stock market while investment banks make their adjustments.

The importance of resolving the potential insolvency of bond insurers is critical to the economy and the stock market, because that insured paper is everywhere and tied to debt everywhere, and used for collateral to debt everywhere.

Meanwhile, Reuters reports that Billionaire Wilbur Ross is in serious talks to take over Ambac, noting that he was looking at investments in bond insurers. Reuters also reported talks are "serious and progressing well." Buffet's new bond insurance business also relies on stability and would benefit from an Ambac resolution.

The dangerous "game of chicken" the investment banks are playing is curious to say the least, given that both Treasury Secretary Paulson and New York Fed president Geithner are actively involved.

The complex insurance of other monolines and derivatives may have turned out to be bad business, but right now Ambac and the Federal Reserve are on the same side of the fence, meaning they are trying to provide a shock absorber for the financial system. If Ambac is not stabilized, there is nothing any central bank can do to stem credit dislocations, and therefore betting against Ambac is like betting against the Federal Government (which also would not earn a AAA rating). The faster the Federal Reserve and other regulators hammer out the specific plan for Ambac, the sooner the economy can move past this crisis.

Geithner has requested government data on the investment bank involvement with the current financial debacle, perhaps to strengthen his negotiating position.

The chronicles of Ambac will become a best selling book.

Ambac Financial Group: Sanity Prevails

Just one week ago a huge financial earthquake, whose epicenter was Ambac Financial Group (ABK), rattled the world's financial sector sending the stock market into a panic. In part that panic was caused by the tsunamis of the associated write-downs and perhaps "margin-calls" that an Ambac bankruptcy would have caused.

We suggested on January 17, that the Federal Reserve coax a bailout or risk financial insanity. The first reaction of the Federal Reserve was to provide emergency relief via a 75 basis point cut in the funds rate, in order to take further pressure off of the Ambac portfolio. That decision provided immediate "pressure-valve" relief to what was developing into a world wide run on the banks and stock market. The second action which exactly followed the suggestion we proposed, was reported today, and indicated that the emergency is over.

Today, New York State's insurance regulators and U.S. banks discussed raising new capital for bond insurers, as much as $15 billion, reported Bloomberg, in an effort to stabilize the bond guarantors

Bloomberg also indicated that "Federal Reserve Bank of New York President Timothy Geithner has taken a central role among federal regulators monitoring the financial health of bond insurers since October, according to an official familiar with the matter. "

The impact of the news lead to a rally of financial sector stocks, and a nearly 600-point bottom to top rally in the Dow.

My personal thanks to Tim Geithner for his decisive actions.

Leading and Lagging: Stay ahead of the Market

Remarkably most stock traders are backward looking. That statement surely contradicts how traders look at themselves, and does not even jive with the words coming out of their mouths. But it is still true.

Let's take the example of technical traders. A technician relies an past data for their technical indicators. In the simple case of 20-, 50-, and 200-day moving averages, the technician is comparing smoothed but past data with current market price. From that comparison the technician looks for a trend, and tries to make a forecast (see figure below). So while the technician says he/she is looking at the future, they are actually looking backward.

Figure showing an example of technical analysis found online.

Another example is the fundamentals trader. Most fundamentals traders look at past earnings reports and try to come up with reasonable estimates, sometimes guesses, of future earnings. However a significant number of these fundamentals traders actually use past data to forecast future earnings (see example of Apple Computer (AAPL) below). They are actually looking backward, and that is why when a company misses earnings, the stock price changes so quickly.

Figure showing how earnings outlook change affects stock price. On January 21, Apple (AAPL) forecast a slower growth in the next quarter's earnings which led to a large drop in price even though current earnings were at record levels. Because analysts and traders were using past data to make forecasts, the stock price changed dramatically with the company outlook.

Even consider the macro-economist traders. These traders use a broad family of economic data to categorize overall economic conditions, specifically GDP rates, and then place trades based on how the market has performed under these economic conditions in the past. Yet again, we have a group of traders that are looking backward.

Figure showing Goldman Sachs' "macro-economic" predictions and results so far. The top panel shows the market summary for the day before the Goldman Sachs announcement indicating money moving out of the financial sector and into healthcare. Today the market action was clearly the reverse of what Goldman Sachs had forecast.

Although each of these methods of market analysis are worthwhile and provide valuable market information, stock trading success cannot be guaranteed by any of these methods. Obviously, if any single or combination of methods was able to make accurate predictions, the large dislocations in equity prices would not happen because of higher "market efficiency".

Small investors lose money because they act like traders instead of investors and lag the market. In other words they sell too late and buy too late. The underlying cause for this lag is emotional trading, with a touch of real gambling addiction.

In volatile markets, i.e. VIX above 30, you need to take hold of yourself and shake yourself out of the panic trance that immobilizes you until your actions are too late. Take the opportunity to further educate yourself about how the stock market works, in reality.

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Federal Reserve Yanks Market from the Brink

The Yanks are coming, as the Federal Reserve lowered the funds rate to 3.5% accompanied by aggressive talk of further easing as conditions require. The overnight action "rescued" European markets for the day, and as of mid-day today, also stemmed the panic selling on Wall Street.

Part of the financial rally is due to the potential relief the lower rates offer struggling bond insurers Ambac (ABK) and MBIA (MBI) whose shares rebounded over 40% today. Also notable is the recovery of mortgage companies including Annaly Capital Management (NLY) whose stock price reached a 52 week high. The financial sector as a whole and regional banks in particular all rebounded strongly.

VIX volatility jumped into the extreme field, reaching 37.57 during morning trading, indicating higher levels of uncertainty regarding market performance and direction.

The high volatility created extraordinary opportunities today, which we took advantage of in stock trading. We jumped in and out, and therefore maintained net high cash positions. However, we did reopen a position in RAIT (RAS). You can track our trades online. Just click on Portfolio on the menu located at the top of the page, where you can also examine our overall cash to stock ratio.

Figure showing MNRTrading cash/stock allocation on January 22, 2008. This chart is updated in real time on the Model Portfolio tracker.

The easing of credit today again moved the markets in a direction opposite to that predicted by Goldman Sachs' (GS) official recommendations to the investment community.

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Stock Market Collapse?: Sentiment, Fact, and Actions

Let's face it. When everything that you read in the financial news is negative, a consensus develops. Currently (as of January 16, 2008), the AAII investor poll indicates that the sentiment is overwhelmingly negative, with Bears dominating by more than a 2 to 1 margin (read our advice about Bulls and Bears).

Bullish:	24.26%
Bearish:	54.44%

In the real world, that poll means that there are few independent investors that are buyers in this market, and without buyers, there is no price support.

Eventually, institutional investors, and small investors will return to the market, and the poll will eventually reflect that change in sentiment. A great deal of money is made during the transition from a negative market sentiment to a positive one because during this period many investors are either afraid to sell, or afraid to buy, and that fear creates opportunities for other investors with sound information and analysis to take advantage of strong but transient dis-equilibrium in stock valuations.

During the August 2007 dip in the stock market, we were able to develop a case for a return to normal market conditions, and our Model Portfolio reflected that view. In other words we determined, as best one can, that August was a short lived blip and our actions followed from that conclusion. We were correct in that instance and most of our Model Portfolio returns resulted from those special situations.

The current situation is more problematic. Our recession indicator (the Federal Reserve model) still does not suggest imminent recession, but we also know that conditions were primed and if the indicator begins to ramp, it happens very quickly.

clipped from mnrtrading.blogspot.com

p(R) is a leading indicator that requires at least one spike (sometimes several happen) before the onset of recession. That first spike brings the Fed into action, which is always an effective palliative but never a cure. It is quite possible that this condition (the first spike) was satisfied in April 2007.

There are several independent confirming signs of economic slowdown, but other signs suggesting it might be mostly a housing slowdown. Perhaps more importantly, since the beginning of the 2008 there are few buyers to create a support level for equity prices. Worse, there are have been many sellers trying to exit with some profits.

Our earlier analysis of the VIX suggested that a change in economic growth rate was being indicated, and a weakness in GDP for a quarter or two is almost a certainty. On the other hand GDP, after removing the housing market's negative contributions, might be quite robust, and therefore the link between the stock market and the economy can be more complicated than is reflected in the market indices.

Fortunately, our readers can follow our sentiment readings not only by reading analysis posted here, but also by following the changes in our Model Portfolio. The chart below shows "buys" and "sells" in our Model Portfolio since May 2007 (we were 100% cash in April 2007 when a similar slowdown was indicated). Starting in November, we began taking profits from our trades and raising cash. In January, our cash position has been between 40-50%, as we trimmed back our equity exposure.

Figure showing MNRTrading sentiment based on the number of stocks sold since May 2007. Note: we issued a warning concerning the Chinese stock market in September.

Unlike nearly all other sources of market information, we show our reaction to market developments in real ways, namely buy or sell stocks. The Model Portfolio represents gains or losses that also reflect actions that an investor would have.

Investment education has to follow the actions that real investors can make. The return from the Model Portfolio reflects those buy and sell decisions, not inflated or misleading statistics derived from stock returns that might assume infinite investment resources and perfect buy and sell execution.

The high cash position we raised since November has put us in a doubly advantaged position: 1) we already took some profits and 2) we have cash to buy oversold and undervalued stocks.

To the point, our cash position does not reflect either a negative or a positive long-term outlook, just an acceptance of current market conditions and calm preparation for tomorrow's opportunities.

POSTSCRIPT:

January 22, 2008: The Federal Reserve cut the funds rate by 75 basis points to 3.5% overnight. The Dow opened about 500 points down.

Implications of Ambac Financial Group Freefall

Ambac Financial (ABK) gapped down in early trading, falling about 60%, following a statement from Moody's that it had placed Ambac ratings on review for a possible downgrade. That statement by Moody's virtually guaranteed that Ambac would not be able to raise the short term funds, nearly $1 billion, that it needs through conventional means.

Moody's said that sector-wide pressures would lead to more evaluations. S&P will also need to reevaluate the sector's ratings to factor in continued weakness in the housing market and illiquidity in the derivatives market.

Fortunately for MBIA (MBI), it already raised $1 billion in notes last week with a 14% coupon fixed for five years. However today these notes were trading at below 80 cents on the dollar indicating that Ambac's capital costs could be prohibitive, if not impossible.

The question is whether the Federal Reserve can coax a bailout for Ambac Financial, along the lines of the lifeline extended to Countrywide Financial, or simply avail its discount window to Ambac through a banking intermediary to meet short term needs, or simply watch the debacle from the sidelines.

If Ambac is allowed to fail, which is a distinct possibility even though letting a mortgage insurer fail would be an insane choice, you can expect to see larger ripples in the banking sector, more weakness in MBIA (MBI) and PMI Group (PMI), and further mark-to-market write downs.

POSTSCRIPT:

January 18, 2008: One day after this post, and in a rare agreement in strategy, CNBC's Jim Cramer proposed a plan to bailout Ambac and "Save the Markets", similar to the one proposed here. You can watch his statement below.

Cramer's plan to save the markets

January 21, 2008: As predicted, the world's markets, notably financial sector stocks, have begun their response to the Ambac debacle.

Goldman Sachs and Cramer Defense Recommendations: Schering-Plough Stings Investors

Despite strong recommendations from Goldman Sachs and Jim Cramer's reiterations to buy Schering-Plough (SGP), the health care sector, and pharma in particular, many sector stocks continue to fall below the buy points. As recently as yesterday, January 16, 2008, Cramer was recommending Schering-Plough as a buy: "I think Schering can break out here" Cramer said in an interview.

Schering-Plough fell over 10% today alone, on reports indicating that several of their drugs are not more effective than other alternative drugs.

See Cramer: Drug Stocks That'll Soar posted on TheStreet.com to listen to Cramer's comments.

Also note see our investor warnings:

Goldman Sachs' Defense Strategy Failing

Recession 2008: Does Goldman Sachs say Zig while it Zags?

Nuclear Power and Energy Policy: The Democratic Debate

About one month ago, MNRTrading reiterated concerns about nuclear power prospects in the near term due to the long-standing reality in the political world, and especially within the Democratic Party.

Despite recent "recommendations" by Goldman Sachs and stock market pundits to invest in nuclear power utilities, we spoke against the grain and urged caution. Also refer to our investor alert regarding uranium ore and reprocessing stocks back on June 11, 2007.

On January 15 the Democratic MSNBC debate raised energy issues including nuclear energy.

As we predicted, the question of the Yucca Mountain nuclear waste repository came up in the debate and each candidate either clearly opposed the Yucca Mountain repository or had concerns about it. Listen to the candidates' own words.

We reiterate caution in investing in this sector, especially given the political importance of California and Nevada, and the 99.99% probability that you do not want nuclear waste in your backyard (NIMBY).

VIX: Volatility in the Transition Phase

The VIX moves in phases with the economy, as reflected by the S&P 500 index. As the economy either expands or contracts, the VIX increases. For example, as liquidity flowed into technology during the period 1996-1999 and the economy grew rapidly, volatility as measured by the VIX was as high as it ever has been since. That spike in volatility actually signaled a transition into a period of profound economic growth. However, even during that period of time, if you tried to use the VIX to predict what the market would do the very next day, you would be wrong about half of the time on the average.

However, the VIX does have phases, or more exactly fields, that characterize market uncertainty. Uncertainty is a neutral term, and it simply means that near terms valuations are in question. That could be positive or negative overall.

A true fear index is one that is based only on the clear preponderance of negative news (financial data), sentiment (financial pundits and entertainers), forecasts (economists), and importantly the resultant number of Google searches by investors. Increases in the VIX, in distinction to a true fear index, results from informed investor decisions.

While a true psychological fear index might have a strong inverse correlation with the S&P 500, the daily close of the VIX has no correlation to the daily change in the S&P 500 index. If the VIX is high on any one day, the next day SPY can either be up or down, positive OR negative.

The graph below (you need to click on the graphs to see these details because every day since 1993 is plotted) illustrates these points. The graph plots the daily change in (SPY) on the Y-axis and the daily VIX close on the X-axis, from 1993 until last Friday's closing.

Figure showing the VIX plotted against the daily changes in SPY for every day since 1993. Three generally temporally contiguous volatility fields exist. In July 2007, the market entered the High Volatility field. (raw data courtesy Yahoo Finance). Click the graph below for a larger version showing the data without the fields plotted. Note that the historical performance of (SPY) is shown in the upper right corner.

Clearly, there is NO correlation between daily VIX values and the daily change in the S&P 500 index and you cannot use the VIX to predict the value or direction of the S&P 500 on a daily basis.

There are three generalized volatility fields: Normal (below 20), High Volatility (between 20 and 30), and Extreme Volatility (above 30). As the market and economic consensus develops, the VIX moves from one field to another, but rarely occupies all three fields over a short period of time. The VIX moves to the High Volatility field when bets are being made that a change in the economic growth rate, either acceleration or deceleration, may occur.

As you can see, from 1993 through 1995, the VIX sat in the Normal field. Then from 2005 through June, 2007, the VIX was again in the Normal field. Beginning in July 2007, the VIX moved completely into the High Volatility field, indicating that trades are being made which point to a change in the economic growth rate, either acceleration or deceleration.

Therefore, it is also clear, that as a predictor of market direction, i.e., either indicating a market top or a market bottom, the VIX is not a predictor. The VIX simply indicates that based on the preponderance of bets being placed, a change may occur.

At the end of 2002, many market analysts believed that the spike in the VIX was a near guarantee that the Bear market which began in 2001, had a long way to go before the market turned around. Those fund managers who were heavily short the market took a beating as the market turned positive, with high volatility. It wasn't until 2005 that volatility returned to the Normal field.

From the low in the S&P 500 index in 2002 and all through 2005, there was a core group of Bear pundits (and fund managers) that were saying we were still in a Bear market.

The liquidity crises in the summer of 2007 rattled the market out of its Bull complacency and volatility has jumped to the transition field again. We indicated that our analysis of the S&P 500 performance, using a form of market-spectroscopy, does not reveal any downward process yet. In summary, while the VIX is suggesting a change in the economic growth rate, we do not see the effects of any underlying process which is moving the market significantly.