A Greek Exit May Be the Lesser of Two Evils

One of my favorite financial commentators, Professor John Cochrane of Chicago Booth pooh-poohs talk about a Greek exit from the euro, saying essentially that we are used to sovereign defaults and this issue is separate and distinct from a decision by Greece to exit the euro.  He writes,

"Greece no more needs to leave the euro zone than it needs to leave the meter zone and recalibrate all its rulers, or than it needs to leave the UTC+2 zone and reset all its clocks to Athens time. When large companies default, they do not need to leave the dollar zone. When cities and even US states default they do not need to leave the dollar zone. A common currency means that sovereigns default just like large financial companies."

But, unlike the U.S. dollar which gained wide acceptance after the detailed architecture of the United States of America had been put in place and operating, the euro was created as a common currency without a political union in place, so I would argue that John's comment misses an essential political difference. Finance, more often than not, turns on politics, which is logical since markets are themselves social constructs in which the rulers of the nation-state have an intense interest.

Going back to 2011, we wrote, "...a paralyzed Europe has to come to terms with the failure of the notion of their common currency union."  

In 2012, we wrote, "Meanwhile, the economic and social  costs of the adjustment to the weaker EU members will be genuinely painful."

I can't believe that it's taken four years for the financial press to wake up to the realities as opposed to covering EU press conferences. The Greek government played chicken with Germany, and Greece blinked. Cash was found, debt repayments were made, but they were made with prior loaned amounts found laying around, lent by the IMF/ECB. This was a cruel joke, and the charade continues, but at what cost?

Greece is a sovereign state, and it should have the freedom to make its own foolish economic decisions and to run itself into the ground, if there is no domestic political will.  Instead, its economy is chronically mismanaged, but more so than Italy or France?  And, though its electorate expressed revulsion at the euro scenario by bringing in a reform party, the people's will continues not to be carried out because of the eurozone's fiscal and economic reform requirements.  Sooner or later, this lack of political freedom is a genuine cost of belonging to the euro zone.  

The contagion issue is a technical red herring, in my opinion.  Policy pundits have argued about this before, to no real conclusion or benefit.  Greece needs to confront its own economic and social mismanagement and deal with monetary issues through its own elected representative government.  If Greece were to reissue the drachma, try to prohibit capital flight, and the drachma rose to 500 drachma/euro, then a rather painful adjustment process would begin and a new equilibrium found. But this process might be less destructive to the Greek polity than the slow bloodletting under the ECB/IMF/ESM, Whatever path chosen, it would be chosen by the Greek voters, without outside pressures, other than by market price signals. 

Greece would also being doing a favor for the rest of Europe by exposing the economic fraud which is the EU, that shouldn't have allowed most of the periphery to join the eurozone had it enforced its own rules.  

Jamie Dimon on Regulation, Treasuries and the Next Crisis

I'm still penciling through some recent bank financial reports, and I keep coming back to JPMorgan Chase CEO Jamie Dimon's shareholder letter.  Around page thirty on, there are plenty of good nuggets.

He notes that banks today, driven by backward-looking regulation, are part of a banking system "that is stronger than it ever has been."  Yet, the bond market, and particularly the Treasury market, could be the venue for an event-driven crisis in any one of three or four hotspots around the world.

Regulation has made market making in bonds less profitable, and although bond market spreads have come down and stayed low, the market depth has actually declined. The letter says, "..the market depth of 10-year Treasuries (defined as the average size of the best three bids and offers) today is $125 million, down from $500 million in 2007."  This despite the fact that today's Treasury market is $12.5 trillion as opposed to $4.4 trillion in 2007.  Dealer inventories are down 75% from their 2007 levels.  There's no need to run a complex stress test to see that this is not a healthy market for the asset of choice in a global crisis.

For all the talk about a "flash crash" in stocks, the October 15th, 2014 one day move of 40 bp in Treasuries was a much more serious "shot across the bow."  As the CEO's letter points out, this was a move of 7-8 standard deviations!

Bond investors like Blackrock and others have been writing about the need to innovate these markets for some time, but the point is now that the time to formulate a new structure, agree among the market participants, issuers and regulators will be years in this political environment. A crisis could come in the fall, as they often do.

The supply of Treasuries available for sale is relatively small, given the large size of the stock and the burgeoning demand. Total Treasuries outstanding are said to be $13 trillion.  At least $6 trillion are tied up in central bank forex holdings, another $2.5 trillion on the Fed balance sheet, and another $0.5 trillion held by big banks as liquid assets.  Take out this $9 trillion, and about $4 trillion are potentially available to be traded.

The Japanese central bank, for currency and other economic reasons, has published aggressive targets for purchasing Treasuries on top of the $1.238 trillion which they already hold.

In the event of a typical run, driven by the next crisis, global investors will look to U.S. Treasuries as they did in the last crisis, when more than $2 trillion in demand was created by the fire sales of risky assets.

On April 6th, Wall Street Journal correspondent Michael Casey's lead sentence was "The bond market is malfunctioning."  In a full-blown flight from risk, this could be an understatement.

A Final Word on Bill Gross

Well, it is too bad, but as always happens in the world of Wall Street finance, it is all about personalities.  Wait, that describes politics too, but that's another discussion. Some final thoughts.

• As a fixed income investor, a CFA charter holder, Bill Gross has proved his mettle more than any investor as his industry. His industry awards are testament to this, as any unbiased observer would have to admit.  
• The statement in the press release outlining his departure from Pimco was petty and small minded.  Objectively, without the personal investment management and asset attracting talents of Mr. Gross, there would have been no blockbuster, mega-sale to Allianz, which made his allies and detractors very rich.  This should have been acknowledged, and this shows that the CEO doesn't have a generous spirit, no matter what the simple business decision taken. 
• The culture at Pimco involved, according to the press, lots of shouting and berating of subordinates, colleagues and superiors.  Except for the superiors part, anyone who has worked on Wall Street knows that this is part and parcel of the everybody culture. Were Hunter S. Thompson still alive, he might have written "Fear and Loathing on Wall Street." 
• For Bill's part, it's not a good idea to yell at your CEO or your board members: definitely a lack of EI, likely under duress. Inexcusable, unproductive, not worthy of him as a person or as an executive.  
• It is hard to understand the outflows from Total Return given its long-term track record, and it should have been a matter of the institutional sales and marketing teams getting behind this to prevent it. Corporate buyers of investment management services are very sticky, even in the face of bad long term performance.  The pension consultants needed hand holding to head off the outflows.  The stories of yelling at these functions seems understandable.  Was there accountability here?
• I didn't know that the equity funds launch was Mr. Gross' idea, according to the press. This is unsubstantiated and hard to believe, a side issue nevertheless, as he wasn't responsible for managing their ineptitude.  Again, the marketing of these funds was terrible.
• It will be interesting to see what happens to the management of Harbor Bond Fund.
• If all of this inner turmoil was going on for so long, then the board and CEO were not up to their tasks, which was to bring back unity and stability in the locker room.  They failed.
• Working for Jeff Gundlach, who himself left his employer in a huff without anywhere near Bill Gross' track record, was a non-starter.
• Janus may be a non-starter, unless Bill Gross does better with his yoga and re-centers himself. He and I had a short correspondence way back when about yoga and meditation.  I think he disconnected the asanas from the spiritual development piece.  They are inseparable. 
• It's all unfortunate, but in the end, nobody is indispensable.
• Pimco should lose assets, as whoever takes over Total Return or a clone, can't really claim the historical performance record of Bill Gross, according to how I read the II performance reporting standards.  Instead (s)he will have to articulate their own investment strategy and improve transparency, which was always frustrating when reading the Total Return fund's reporting.

Sayonara, Mr. Gross.  Less time in headstands and more perhaps in seiza. Investors start checking your quality bond fund alternatives.  The universe isn't as big as it should be.  

The Market Continues to Ride the Wind

A healthy market, according to the fundamental and technical watchers of yore, climbed a "wall of worry." Right now, our equity markets continue to ignore both poor macroeconomic and corporate developments in ways that resemble the already forgotten 2006 period.

Looking at our own economy, what are some of the facts we've discounted?

• According to Fed presidents, the labor markets remain weak, unhealthy, in flux or whatever euphemism is acceptable to the Yellen regime;
• The housing "recovery" has stalled, weakened, sputtered.
• The Fed won't tie monetary policy to rules, but some Fed Presidents feel that rates may rise sooner rather than later. 
• Our larger, more concentrated banking sector is shelling out billions in shareholder equity to the government without admitting any crime they've committed.  Meanwhile, their fundamental businesses, with some lending growth, are lackluster.
• Trading revenue continues to flounder for the investment banks.
• Top line revenue continues to be hard to come by, and earnings gains continue to be of low quality, especially in the tech sector, where retirement plan commitments are excluded from "normal" earnings.

Let's move to Europe, where strategists have said the better values were from the fourth quarter of 2013.

• From daily press releases, Chancellor Angela Merkel has gone missing, to be seen only at the World Cup in shades suddenly becoming a fan of the Champions.  
• Is anyone still in the Elysee Palace?  
• Britain put on a dismal performance at the World Cup, but the semi-comatose Roy Hodgson declared satisfaction with his efforts. The British economy seems to be like a Morris Minor with vapor lock.  
• The Russian wolf is reconstructing his empire a bit at a time, alternatively threatening and blaming vast Western conspiracies.  Merkel and Hollande have gone from hectoring the EU periphery to becoming like pet poodles to the Russian wolf. 
• No one knows what's going on in the EU banking sector, and Banco Espirito Santo wasn't on anyone's top ten list of troubled banks, but they are shown to have no clothes. 
• What will a cold winter do to Russian gas prices coming through Europe?  

In the rest of the world, there's a mixed bag at best.

• China's hoarding of raw materials seems to be an expensive and inefficient use of their assets.  Growth rates continue to be strangely high and no one seems worried.
• India's elections were won on an anti-corruption platform, but what's really needed now is a pedal to the metal for infrastructure construction to match the pace of construction (much not completed) growth, apartment and condo development, and new corporate parks.  This will be impossible due to the corrupt program of rural subsidies to buy votes.  Economic policy for the past five years under the former Congress regime was an unmitigated disaster.
• Brazil hosted a World Cup, spent $11 billion or so, and gave up their veneer of artistic and technical supremacy in the beautiful game.  The corporate environment is rife with inefficiency and corruption, the state enterprises leading the way.  Interested in issues of inequality?  Take a walk in a favela---with armed guards and an armored car, though.  
• The Middle East has finally begun to be redrawn.  No one knows how it will settle out, and what the costs will be, especially for the U.S. and Israel.  Normally, this should cause some alarm. Not for these heady markets. 

NY Fed's Bill Dudley on Business Investment

Here's an excerpt from a recent speech by New York Fed President William Dudley:

"Business fixed investment and housing are two key areas where activity has been disappointing.  They need to kick in more forcefully for the economy to grow at an above trend rate for a sustained period.
With respect to capital spending, the recent trajectory has been very soft relative to the apparent strong underlying fundamentals.  Corporate cash flows have been strong, profit margins are high, balance sheets are healthy and financing generally appears readily available at low interest rates.  Moreover, the absolute level of capital outlays is low so that the capital stock is expanding only slowly.  Despite these positive fundamentals, real business spending on equipment and software has risen only 3.2 percent over the past four quarters and contracted in the first quarter.   This is a bit of a puzzle to me.  But, I expect it to be resolved by a pickup in capital spending.  Recent trends in durable goods orders and conversations I have had with businesses in my district suggest that such a pickup may finally be occurring."

 Since the earliest days of QE and the long march of this unconventional monetary policy, we have never wavered about two issues, (1) the efficacy of an unknown policy mechanism that transmits this policy to the real economy, and (2) the problem of unwinding the balance sheet, about which fears were expressed by the President of the Minneapolis Fed, who has since recanted and who now sees the light. 

Here too, the NY Fed  President's remarks are instructive:

"Turning first to economic activity, the trajectory of economic growth continues to disappoint.  Since the downturn ended in mid-2009, real GDP growth has averaged only 2.2 percent per year despite a very accommodative monetary policy."

The Shadows Remain in Shadow Banking

"The basic point is that there has been, and remains, a strong public interest in providing a “safety net” –in particular, deposit insurance and the provision of liquidity in emergencies – for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds - taxpayer funds - protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions."

2010 Testimony of Paul Volcker to U.S. Senate Committee on Banking, Housing and Urban Affairs. 

Politicians of all stripes have rushed to have themselves photographed with the wise, grandfatherly oracle who is Paul Volcker.  But, what do we have after all the delay from 2010 until now?  We have a "rule" of over 1,000 pages which is full of contradictions and definitional lacunae.  A prime example would the prohibition against proprietary trading, or investment banks, who make much of their money from making markets, being enjoined from hedging 100 percent of their portfolios.  I didn't make it through much of the 1,000 pages, but after the champagne has been drunk will come the 2014 hangover when regulators wake up to the need for "tweaks."  Enough said here.

But, a seemingly unrelated story got my attention in regard to Paul Volcker's philosophical first principle that appears underlined in his testimony above.  It is the WSJ story about millions of tons of aluminum, copper, nickel and zinc which are hidden in "shadow warehouses." An owner of a shadow warehouse can, according to this story, have a stash of unreported material on one side of a fence from an LME regulated stash of the same material on the other side.  Material on the LME side goes into published statistics which drive market participant behavior and have impacts on prices.  

"It's a real concern for anyone in the industry that metal can be sucked away into a nonreporting location with no expectation or date as to when it's going to be available again," said Nick Madden, senior vice president and chief supply-chain officer with Atlanta-based Novelis Inc., an aluminum-products maker that is among the world's biggest buyers of the metal."

Guess what kind of entities are involved in this unregulated, speculative activity?  "Until 2010, most warehouses were owned by logistics firms like Netherlands-based C. Steinweg Group. But as metal-financing trades became more popular, C. Steinweg was joined by units of Goldman Sachs Group Inc. and J.P. Morgan Chase & Co. as well as commodity traders Glencore Xstrata PLC of the U.K. and Switzerland and Trafigura Beheer BV of the Netherlands."  

Morgan and Goldman?  Here we go again.  

Markets Continue Their Economic Disconnect

It's always nice to look at a daily portfolio update and see the equities portion of a portfolio going up, but I've never found it comforting when I can't put a finger on why.

Unfortunately most of the economic talking heads commentaries are just political propaganda in a poor disguise.  Paul Krugman: enough said.

Jeffries Economic Forecasting group, headed up by Ward McCarthy, has consistently tracked the fundamentally weak numbers from the labor market.  The divergence between payrolls data and the establishment survey has always been a statistical feature for analysts to deal with, but the current divergence is striking.

As JEF notes in their current bulletin, the establishment survey shows that since the recovery's start in the first quarter of 2010 , the private sector has added 6.11 million jobs, with public sector jobs shrinking net by 610 thousand, for a net jobs addition of 5.5 million.  This sounds good, but the household survey is less encouraging.

The bottom line is that 8,786,000 jobs were lost during the horrific financial downturn, and 3,297,000 more jobs have to be added before the economy gets back to where it was pre-crisis, never mind employing new or returning labor force entrants.  Movements in the unemployment rate, as the authors point out, are dominated by changes in the participation rate, which is down to 63.6% versus 66% at the start of the recession.

What about the rising equity markets, you say?  Surely, they are discounting higher expected streams of corporate profits from a stealth, but improving recovery.  Look at the housing sector.

David Rosenberg, the Chief Economic Strategist for Canadian firm Gluskin Sheff has an illuminating current presentation, which could be called "bearish" in this ebullient market.  I found an older version of it, with the same essence, on Business Insider. This particular slide shows the sharp upticks in the U.S. stock market have coincided with the announcements of  QE1, QE2, and Operation Twist.  The search for fundamental economic underpinning goes on.

Meanwhile, the distortions for business decision making caused by the unconventional monetary policy continue apace.  Jeffries notes the "insatiable" investor demand for yield: Mohawk Industries priced a ten year offering at a paltry 30 basis points over Treasuries.  Mohawk is a split-rated (Ba1/BBB-) issuer with a cyclical business exposed to residential construction and remodeling.  But, the "good news" about housing is old news and surely should have been discounted.  Mohawk is not a strong issuer, which is what a 30 basis point spread would seem to suggest, but this is a desperate investor market.

The Jeffries team also notes the weak bidding for Treasuries, apart from the Fed. As they say, "...both the price action and customer flow at the long end are troubling...The long end is effectively being propped up by Fed purchases."  No good fundamentals here either.

Finally, remember those corporate coffers filled with cash to invest in business expansion?  Large chunks went to special dividends and irrational share buybacks.  Today, we're told that the distorted yield curve from the Fed's policies is forcing corporations like Ford to spend $5 billion for this year's contribution to its corporate pension funds.

As we begin the week, let's hope that the markets re-equilibrate.  In so doing, perhaps they can send a signal to Washington--including the Fed--that feel good asset markets are not a drug of choice for a sputtering economy.

The Best of Davos?

The Wall Street Journal had a blog entry called "Davos in Fifteen Minutes," or the Best of Davos.  If this was the "can't miss" material, it must have truly been a snooze fest.  But that ski slope powder, formidable!  I struggled to take away anything of value from the Best of Davos, but here it is.

Charles Dallara, who was leaving the Institute of International Finance after the meeting, joined the Swiss-based Partners Group, an asset manager.  After a tepid tribute to European central bankers, Dallara made a trenchant observation about where we are post all the financial card shuffling by Mario Draghi and others.  He said that the fundamental economic performance of Spain, Italy, Greece and Portugal continues to be unsatisfactory, despite all the press releases declaring victory.

He also laid blame squarely on the shoulders of the sovereign market investors, which include the national central banks, who have been "asleep at the wheel for years."  Since Europe has traditionally relied more on commercial banks for business lending (80 percent), commercial lending continues to be frozen in Europe.

Investors indeed have themselves to blame for drinking the European Kool Aid, but on the other hand, it was rational of them to take advantage of the "implicit subsidy" on sovereign debt provided by the previously unspoken, but inevitable ECB bailout.  Europe is still a ship taking on water, albeit a bit more slowly.

Robert Shiller of Yale and the Cowles Foundation gave a much more muted assessment of the housing market than is filling the front pages of our newspapers.  Professor Shiller is someone I've always enjoyed reading and listening to, including his economic class lectures at Yale. I want to know what he's thinking.

In the short-term, Shiller says the U.S. housing market is moving off the bottom and may be said to be improving.  Longer-term, as an asset class and as an economic driver, the outlook was--and he struggled for a word--"neutral."  The multi-family apartment market, he said, was more robust because of consumer demand and investor demand for their project paper.  The single family market, which reflects the American Dream of home ownership, had a more problematic and segmented outlook, reading between the lines and the look on his face.

Speaking about the stock market, he clearly wasn't enthused, but he noted that the valuations weren't overblown, especially given the paltry returns in fixed income.  Using the Cyclically Adjusted Price Earnings (CAPE) Ratio, he noted that it stands at 22.2x today.  The average for 2006-2013 was 21.7x, and the median was 21.5x.

Professor Shiller characterized the breathless headlines about the housing market being "off to the races," as so much fluff.

I think I'm going to go outside and enjoy some our fine Midwest powder, by shoveling it off my driveway!

Taking It to the Streets: European Style

La Nouvelle Grande Illusion de l'Europe remains in full swing.  (apologies to Jean Renoir)  Columnists are arguing about whether or not the European Stability Mechanism's "decision" to allow direct recapitalization of national banks from ESM funds is retroactive.  Mario Draghi must be talking to himself as he discusses budgetary union among EU members.  Chancellor Merkel has finally been advised to always agree, since it is never clear what she agreed to and on what terms.  She always reserves the right to be overturned by her courts, regulators, or coalition members.  None of this falderol may matter because of what is unfolding in the economy, and worse, in the streets.

Meanwhile, the economic news from the emergency room is not good:

• Ireland, which seemingly took early action on bank resolutions and fiscal austerity, has just seen its 2012 and 2013 GDP growth forecasts downgraded.  Domestic final demand and net exports are weaker than expected.  Significant emigration is taking away business owners, entrepreneurs and technical workers. The property market is in shambles.  Debt/GDP will finish 2012 above 100% and will trend higher in 2013, according to the IMF.
• Spanish and Italian bond yields are rising today, despite the "unlimited firepower" of the ECB bond buying program.
• Spain still doesn't know how much money it will take to recapitalize its banks until the new austerity budget is submitted. 

What's more important than this political and economic foolishness?  Here's a picture:

                                                New York Times

No, this is not a picture of Bane in Gotham City from "The Dark Knight Rises."  It is a real life street picture from Greece, where the riot police are risking injury from rocks and Molotov cocktails.  The Greek government has to start asking itself: what do we, as elected officials, really have to gain by the current Euro status quo, continued dithering, and by the ultimate medicine we'll have to take? 

In Spain, protests have moved beyond displaced workers to scenes of genuine urban hunger and deprivation.  Here's another New York Times photo,

                                                       Sam Aranda for New York Times
Even the patrician Spanish Prime Minister will have to realize that "dumpster diving" among his young constituents may require coming down from his throne to actually do something besides turning up his nose at a bailout.  Even if he were to get the terms of a bailout, he too may have to reconsider what it means for Spanish sovereign governance. 

The most important leading indicators for the euro crisis unfolding may be in financial rates, but better indicators may be from the streets, as captured by the photographers' eyes. 

Grazie Signore Draghi!

Bill McBride of Calculated Risk has the following chart on his blog.  Get out those rose colored glasses from your last Grateful Dead concert, here it is:

Our equity markets are 112.5% above the financial crisis lows.  Investor sentiment, a contrary indicator, is extremely negative, as further evidenced by the continuing outflow from stock mutual funds into bond funds.  Keeping the macro focus paradigm, our markets should be healthy into midweek, when thoughts turn to the next EuroConfab on Thursday. 

What about the "fundamental" side, if that means anything anymore?

This quote is from Reuters,

"In fact, the recent price-to-earnings high was 13.5 in February 2011, just above current levels. If you are of the view that little has changed since then, there is no reason for the ratio to go much higher. That combined with a slowing earnings picture inevitably means lower prices.


"Our view is that the next double digit move in the market is down not up," said Morgan Stanley in a research note.

The analysts, led by equity strategist Adam Parker, believe the S&P 500 will finish the year at 1,214, 15 percent below where it is now."

Slowing earnings and no multiple expansion...hmmm. 

Andrei Shleifer on Transitions From Communism

Professor Greg Mankiw's blog referred to an article by his Harvard economics colleague, Professor Andrei Shleifer, a Russian born, American trained economist.  Shleifer writes about things he learned about economies transitioning from Communism, with the benefit of twenty years of history, which is still a relatively short time period. 

A few of his point struck me as interesting and different from the mainstream American press narrative.  He writes,

"...economists have greatly exaggerated the benefits of incentives by themselves, without changes in people. Economic theory of socialism has put way too much weight on incentives, and way too little on human capital. Winners in the communist system turned out not to be so good in a market economy. Transition to markets is accomplished by new people, not by old people with better incentives. I realised this and wrote about it in the mid-1990s, but the lesson both in firms and in politics in profound: you cannot teach an old dog new tricks, even with incentives."

He concludes optimistically, "...middle-income countries (like Russia and Ukraine) eventually slouch towards democracy, but not nearly in as direct or consistent a way as they move toward capitalism."

Smug About Europe?

Bret Stephens in the Wall Street Journal has a witty, barbed piece about the recent cruise ship sinking as a metaphor for the sinking of a politically mismanaged Europe.  Readers of this blog know that I've been a skeptic on the notion of European political leaders Merkel and Sarkozy being able to rescue the flawed euro concept.  However, my approach has been to look at it through the regular analysis of political economy.   Unlike Stephens, I don't see what's happening as an indictment of the welfare state or of the flawed economic model there.  We seem to be evolving in a similar direction. We have no reason to be smug, given our lack of any political leadership and our failing institutional memories.

Four years into the global meltdown, we haven't reformed our financial system, and the leaders of the system which brought world markets to their knees continue in place with the healthiest compensation among all public company executives. Instead of any meaningful reform, we have the regulatory spaghetti of Dodd-Frank. Our state government finances are a mess, and the issue of their pension liabilities remain unresolved.  We haven't figured out how to regulate derivatives.  Things are so bad in housing that the Federal Reserve is coming up with a white paper on how to fix an economic sector.  No, whatever is happening in Europe was quite predictable, but we have absolutely no reason to cackle.  Our financial markets are doing better mainly because they continue to profit from being a safe haven as participants try to insulate themselves from a European currency meltdown.

It's Not Rocket Science

As the details begin to emerge about a Guinness Book of Records-size Ponzi scheme by Bernie Madoff's "asset management" company, there were two interesting items about investors who passed on giving assets to the Madoff funds. In some cases they hired firms to perform due diligence. So, did these investigative firms send in laptop-toting, analysts with high-powered statistical packages to back test the firm's strategies? Not at all. They asked the very basic, but penetrating questions.

One firm simply looked at the name of the accountants overseeing the financial reporting for Madoff's $50 billion in assets under strategies that involved indexes and options. They actually called and then visited the accountants and discovered a three person firm, one of whose principals was 78 years old and lived in Florida (the office was in New York). You don't need to turn this over to your risk management committee. It makes no sense, smells bad, and it is highly improbable that they could exercise the proper level of auditing oversight and control. The investigative firm recommended that their investor pass. Bravo!

Another item relates to a simple thinking through of the most basic conflict of interest, namely the trustee that held the securities for the asset management business was indistinguishable from Madoff's entire enterprise. So, this investor rightly concluded that it would be extremely difficult, if not impossible, to independently verify the existence of assets, especially cash which had seemed problematical during several reporting periods. Simple, clean, elegant logic. Maintain independence and verifiability. Avoid conflicts. This same market professional wrote a letter to the SEC of his findings and characterized Madoff's investment firm as a Ponzi scheme in 1999.

Academic research has talked about why people sell winners early and hold onto losers for too long. One of the theories can be summarized by the phrase, "Pride and Regret." This phrase can also apply to the due diligence process for buying into alternative type investments. If you have to ask silly questions, like "Who holds the assets, and are they independent from you, the manager?" you probably don't have the native intelligence, didn't go to the right schools, and are otherwise not worthy of the high returns that are being handed out. Nobody wants to feel like they are unworthy, that is basic pride. Similarly, suppose that a friend at a cocktail party points out that she has never heard of your hedge fund accountants. You might start to feel a twinge of regret, not to mention anger at someone raising something that seems obvious after the fact. "Could she be right? Did I make a bad decision?" It's much easier to assuage the regret by feeling that you will surely cash out before anything catastrophic happens. Or, the "SEC and the regulators watch out for this stuff." Other rationalizations abound, but they revolve around "pride and regret."

Emotions still matter in the matters of money and markets.

Restoring Confidence..or Not

Financial markets, and particularly credit markets, rest on a foundation of confidence, the first principle. When banks lend to each other, when strong industrial companies float commercial paper, there is a confident belief that the lenders will be paid back on a timely basis. This belief is fostered by due diligence and analysis of the credit, for sure. However, it really rests on experience, a history of transactions, and on a belief that a market player will play by the rules.

So, in traditionally deep and liquid markets, like the interbank markets and commercial paper, the risk premia applied to the cost-of-funds rate are usually thin. Now, despite all the Treasury and Fed's opening of the checkbook, the markets still remain frozen, albeit with a thin layer of melted water on top.

The confidence to make credit markets work has not been restored. Massive amounts of liquidity have been injected, but the liquidity has become trapped, to borrow a usage from John Maynard Keynes.

Jim Grant's observation is on point: "The bear market is truly a value restoration project. Wall Street will be going on sale--if the government will let it." We need to get on with the "creative destruction" process. First the cleansing, then the renewal. Forty government folks sitting in a building deciding who is going to survive and who will not is no way to get us out of this fundamental crisis. The Federal Government needs to stand down and let the markets work. There are certainly some legal, administrative and regulatory adjustments that need to be made to facilitate this process. But, no more, "Ready, fire, aim."