The Capitalist Muse

Dateline, Pakistan
January 11, 2012

The Heir to the Caliphate, Mullah O.

In a remote mountain cave in the Hindu Kush, somewhere within Pakistan’s western border regions, an important meeting is convened. The convener is none other than the famous Mullah O, a Taliban imam formerly from Afghanistan and now the de facto spiritual leader of the Islamic Caliphate movement, living in Pakistan.

Mullah O. sits on a large silk Kashmiri prayer rug reclining slightly on a cushion in the center of the cave. He is blind and his unblinking, blank eyes seem hard and determined, filled with a fundamentalist, messianic resolve. He is after all a chosen warrior of God, a Jihadi in the true sense of the word, who will restore the Kingdom of God on earth, a Utopia promised in the Holy book. He calls the meeting to order. Four of his top commanders flank him, two on each side. These are:

• Ayman al-Zawahiri, the head of Al Qaeda,
• Hakeemullah Mehsud, the leader of the movement of the Taliban in Pakistan and a close ally of al Qaeda,
• General Ashfaq Kayani, Head of the Pakistani Army, a most secret double agent and a member of the Al Qaeda/Taliban network and Mullah O’s  inner cabinet,
• Jalalabad Haqqani, the head of the Haqqani terror group.

Other commanders of the many affiliated terror cells sit in a group in front with their Kalishnikovs in their laps.

Mullah O: (invokes) Bismillah ir-Rahman ir-Rahim … By the grace of God may this meeting come to order. This is our annual meeting to discuss the State of the Union, the progress of the Mujahiddin Movement to destroy our Western enemies and their proxy dictators and occupiers of the Holy Lands. Since we met last year we have lost Sheikh Osama bin Laden,  our Founder and most precious Leader – he has become a shahid, a martyr, in  God’s struggle, and is no doubt in heaven with his 72 well-earned virgin houris.

The Mullah chuckles, and mutters under his breath:
Although, he seems to have been getting quite a lusty preview in the porn sites he was glued to in Abbottabad. Note to Self: Must ask Kayani for a fast Internet connection in my safe house.

I now urge the head of Al Qaeda, brother al-Zawahiri to give us a brief account of our progress in the last year and our goals for this year.

Ayman al-Zawahiri: Thank you, beneficent Mullah and God’s Prime Warrior. It is an honor to lead the Al Qaeda movement after so suddenly and treacherously losing brother Osama.

Unfortunately, I must sum up the State of the Jihad in 2011 in one phrase: Not Good.

We lost not only Osama bin Laden, but the head of our Yemeni operations, Anwar al-Awaki, the American born cleric who was an invaluable asset, and seven of his prized, highly-trained commanders in one drone raid alone. The Al Qaeda ranks have lost two hundred of its most zealous and ruthless regional leaders, emirs, funders and weapons experts. Former warlord governors of Balkh, Kandahar, Zabul, Baghlan, Kunduz – dedicated jihadis – all killed by drone strikes. Our key cabinet members, Ministers of:  War, Money Laundering, Drug Running, Propaganda and Misinformation, Human Trafficking – all gone. Regional commanders of the affiliated Pakistani terror cells – the Lashkar e-Toiba, Jaish e-Mohammad, etc. etc. – you know the groups I’m talking about – all quietly killed! We cannot replenish this kind of talent! Our affiliate groups in Kashmir, Indonesia, Chechnia, Somalia etc. have been similarly decimated.

Mullah O: With all our bluster Allah has made us no match for the powerful infidels. No, our only hope was that we could sow terror in their hearts, make them hysterical and get them to overreact. Only they have the ability to hang themselves and our plan is to induce them to do so. How deliciously they bit by taking the bait on Iraq!

Ayman al-Zawahiri: Yes, they did indeed. Our master terrorism trainer in Afghanistan, Ibn al-Shaykh al-Libi, when tortured in Gitmo in 2002, held out superhumanly until he was ready to deliberately feed the interrogators carefully pre-planned misinformation. He told them (after an insanely ineffective waterboarding session) that Iraq was a hotbed of Al Qaeda and that Saddam Hussain had WMD’s which he was planning to share with us.

Although we knew that the overly trigger-happy leadership of the U.S. at the time was prone to bite on this kind of stuff, we had never imagined how successful we were going to be. By the grace of God they ignored their allies, their analysts and their own Intelligence agencies and attacked! They had not the most rudimentary knowledge of our politics and factions and did not realize that Baathist Saddam had kept the islamic zealots out of Iraq. And of course they had no idea that we cannot abide the majority Shia population of Iraq, the unbelievers and apostates who worship a false Caliph.

Mullah O: The results were spectacular. Our most glorious victory! God is Great!

Ayman al-Zawahiri: Yes, esteemed holiness, they were spectacular. It was as if we had perpetrated a thousand 9/11’s! The infidels spent $3 trillion dollars by one account, lost upwards of 4,000 lives not counting the couple of hundred thousand Iraqis and injured countless of their youth. It was delicious. A gift that kept on giving.

Hakeemullah Mehsud: And they took their attention off Afghanistan where they had us on the run. Sheikh Osama was trapped and many of my Taliban warriors were in perilous danger. Even you, Mullah O, were dispossessed and risked being trapped had the Americans continued the hot pursuit in Afghanistan/Pakistan. The attack on Iraq allowed us to escape to Pakistan and find sanctuaries. We must, of course, thank the Pakistani military and the ISI for taking us all into their protection and initiating a brilliant double game with the Americans.

Iraq is now a terrorists’ playground. The Americans have finally left and there is not a shred of stability or a functioning democracy. We have got a foothold and run many recruitment and training camps as anti-Americanism runs rampant and much of the Iraqi elite has fled. Ideal conditions for us. And, of course the removal of Saddam means that Iran can now control the Shiite Iraq. There’s supreme irony in this for the Americans have delivered Iraq to the most hostile country to them in the entire world!

Mullah O: Ok, so we were doing great. The Great Satan was hanging himself with his own rope. What changed?

Ashfaq Kayani: They got a new President, sir. Barack Obama. At first we rejoiced. He seemed naive and idealistic and something in his background suggested a muslim seed. But he proved crafty and quietly ruthless. He created the only kind of warfare that works against terrorism – unsymmetrical, targeted counterattacks to take us out in pinpoint accurate raids, coupled with heightened intelligence, superior technology  and special ops skill. He ratcheted up the drone attacks and called our Pakistani bluff to be allies with him by requiring us to provide him targeting information.

We complied giving them whatever we could get away with – we needed the billions in aid to which my officers had become hopelessly addicted. Still we assiduously protected the core leadership of the Al Qaeda, Taliban and Haqqani networks. I am astounded and incredulous as to how they still got Osama bin Laden – I had personally given him the prime safe house in our military’s possession. We have no answers in the ultimate analysis against smart Special Ops and their technology.

Mullah O: What is our best hope for 2012 and beyond?

Jalalabad Haqqani: We simply have to get them to attack Iran. It will be a doozie if they bite. A country much bigger and more powerful then Iraq – and one where we can’t get access because they are Shia. If we can get the Americans to tear it down we can have another terrorist haven to fight the infidels. And the black eye that it will give the Americans could prove an existentialist blow. Another few trillions that even they cannot afford, a fractured and war-riven middle class, a polarized American electorate, a destabilized middle east and a lot of motivated jihadis – it is a goal we must avidly fight for.

Mullah O: But Obama won’t easily bite, right?

General Ashfaq Kayani: No sir, he won’t. He is being infuriatingly deliberate in how he takes on the Iran threats. Again he chooses to use the very effective and cheap targeted destabilizing techniques. He injects their nuclear systems with computer viruses causing multi-year setbacks, he takes out their intellectual assets and he aids their growing anti-mullah movements from behind the scenes. Even Mehmud Ahmedinijad is frustrated and has begun saber rattling in the Straits of Hormuz to tempt him to start a ground war. That would be great for Mehmud, of course, as it would give him wartime prestige and power – a legitimacy that he lacks.

Mullah O: What can we do?

Ayman al-Zawahiri: The Republicans are our only hope. They are beating the tom-toms and whooping up bloody war cries like a bunch of demented, native American shamans. Michelle Bachmann even called for missile attacks and war strikes right now! May God give her a hundred lives.

Mullah O: But she has already withdrawn from the race. What about Rick Perry, the born again from Texas? He said that he would not only start a war with Iran but reopen a third front for the Americans by going back to Iraq! Maybe God is working His will on the infidels.

Ayman al-Zawahiri: No, I’m afraid Perry is far too dumb even for his ultra-right constituencies. He doesn’t have a chance in the Republican primaries.

Mullah O: Rick Santorum, surely, then. Isn’t he a possibility?

Ayman al-Zawahiri: He does have the fanatic, fundamentalist fervor. Doesn’t believe in science or college, only in the absolute Infallibility of the Word – God’s and his own. He will be happy to induce the Apocalypse – it’s prophesized by their heathen texts. We pray five times a day that he becomes the next president, but alas, the odds are low. The infidels have gone moderate and are liable to pick Mitt Romney.

Mullah O: That’s not as bad as Ron Paul, I guess. He’s a real anti-war freak. What’s with the Republican Party these days?

Ayman al-Zawahiri: Floundering and giving us a scare. Still Mitt Romney won’t be that bad for us. He said he’s very squarely for a big, destructive war with Iran.  We don’t know for sure what’s in his heart. He is rather the chameleon – acts stupid every so often to please his Republican base.

Mullah O: Well let’s hope it isn’t Obama for another four years. Lucky for us that Obama doesn’t follow up his devastating missions on us with strutting, twirling his gun or landing on an aircraft carrier in bomber pilot duds declaring “Mission Accomplished“.

So the majority of Americans are unaware of his victories and buying into the unscrupulous ruddy-necked rhetoric of him being an appeaser.  God is Great!

The meeting goes on in this vein for several hours…

_______________________________________________

January 12, 2012 (the Next Day)

Phone call from Ayman al-Zawahiri to the Mullah, intercepted by western intelligence.

”Holy Leader, I have bad news. On his drive back to Waziristan, brother Hakeemullah Mesud was killed today by a drone strike. Six of his body guards and several Taliban regional chiefs, who were present at yesterday’s conference, also perished. May God rest their soul and give them the promised fulfillment in heaven!“

Amen.

2011 has been a year of uncertainty and turmoil in the global markets. In the latter part of the year we saw wild gyrations in the U. S. stock markets with the Dow Jones Industrial Average (DJIA) having a record number of days with 400 points or more moves. The European and Asian markets were no better. So what was the final scorecard?

Here’s a summary of U. S. market segments as measured by their indices:

Performance of U.S. Markets

The Dow Jones Industrials (or Dow as we’ll call it)  did the best with an annual return of 8.4%, just 2-3% below its historical average of about 11%, since 1940. At its peak for the year the Dow was up 11% (in May) and at its bottom it was down about 7% (in October) for a net see-saw of 18%.

The S & P 500 Index, on the other hand, only gained 2.3% for the year including dividends. And it gyrated a bit more: from a peak of 8.5% to a bottom of -11%. Its volatility as measured by the annual standard deviation was similar to that of the Dow.

The NASDAQ did worse than both the Dow and S&P500. The annual return was negative and the volatility was similar to the Dow and S&P500. This last bit was a surprise as the NASDAQ is usually quite a bit more volatile.

The worst performer, by far, was the Russell 2000, an index of 2000 small companies. It lost 4.5% while the volatility was sky high. At its worst it was down 23%!

Thus the winner in the U. S. was (tada!) the Dow.

How about if we looked at Europe and Asia? Were they better or worse than the U. S.?
Here are the results in U. S. dollar terms:

They all did very poorly indeed, with the U. K. being the best at a return of -7.7%! In addition the risks in these markets were very high as you can see from the standard deviations and the variations from the highs to the lows. The standard deviation for India is artificially low because it is calculated in rupee terms and does not include the additional volatility of the rupee. The rupee fell almost 20% in 2011, while the other currencies were not so volatile. India was a complete disaster and the prospects for 2012 are also quite cloudy.

So the good old United States was the place to be in 2011.

The Global winner in 2011: The Dow.

You could have beaten the Dow, of course by being in gold, or oil (big integrated oil companies only), or  big cap, high dividend stocks (like large utilities), or consumables (like tobacco). Would you have known? Maybe. Best to stay in the Dow for most passive investors. Most professionally managed mutual funds, after fees, as usual, did not beat the Dow. Hedge funds are said to have done very poorly in 2011 also. If you were weighted financials, high tech, health care, airlines, drug companies, even coal or alternate energies you would have been creamed.

In general when the economy is doing poorly, as it is now, and pessimism is rampant and prospects for housing, employment, credit etc are low, the large cap stocks will have an advantage. They can borrow cheaper because they can float their own paper, and they are less likely than their competitors to perish from market forces and inability to set prices. ”Them as has, gits“ goes a popular market idiom (along with “aint no free lunch”). The Dow represents about 40% of the total market cap of the NYSE so even though we are talking about only 30 stocks they are substantial.

For the next year the Dow stocks are predicted to yield 3.01% according to IndexArb, that tracks such matters. That’s icing on the cake in times when the 10-year government bond is yielding less than 2%.

Have a Happy New Year!

How do bad deals, such as subprime lending, become good deals with some financial engineering?

Let’s do a thought experiment, with 3 hypothetical deals.

Deal #1: Here’s the deal: You invest $100 with me. I’ll pay you $110 at the end of a year. Except 15% of the time you’ll lose all your money. Would you do the deal?

Of course not, you say. What a bad deal. And you’d be right. The “expected return” on your money is -5%. Can’t get rich that way.

Deal #2: You invest $100 with me. I’ll pay you $117 at the end of a year. Except 15% of the time you’ll lose all your money. Would you do the deal?

Tougher choice this time. You stand to make an expected 2% return over the long haul, 17% return about 6/7th of the time and -100% about 1/7th of the time. It’s still not a great deal. You are taking too much risk for a small expected return of 2%.

Deal #3: You invest $100 with me. I’ll pay you $150 at the end of a year. Except 15% of the time you’ll lose all your money. Would you do the deal?

Almost all would do this deal. The expected value of your return is 35%. You will make 50% in 6 out of 7 years and lose everything 1/7 th of the time. I still wouldn’t do the deal with the baby’s milk money – don’t want to take a 15% chance that the poor innocent will starve. But with “Risk Capital” the deal would probably be done. Risk Capital is the money the affluent can afford to lose in order to spice up their expected returns.

All pretty straightforward so far. But sometimes a bad deal like Deal #1 is all you got. But with a little sleight of hand you can make it a good deal and maybe you won’t be around when the fan gets besmirched. That’s what financial engineering is. Let’s go back to Deal #1 and do some financial engineering.

Suppose you could borrow $90 interest free and collateral free when doing the deal. Now you borrow the $90 add in your own $10 for a total of $100 with which you do the deal.

At the end of the year, if you get back $110, as you will 85% of the time, you return the $90 to the lender and you end up with $20 – hundred percent return on your $10 investment!

15% of the time the investment loses $100, but the lender loses the $90 (it’s non recourse – he can’t come after your other assets) and you lose your $10. All of a sudden this has become a great deal for you – a 100% return 85% of the time and loss capped at 100% of your investment 15% of the time. You would almost certainly do the deal.

Fine, you say, but what kind of lender would be foolish enough to make that loan?
Answer: The Federal Government, if the risk taker is a bank!

You’re a bank, let’s say Giddybank. You have $1 Trillion in customer deposits, which is really a loan to you from your depositors, hopefully at a rate of interest that lures customers to deposit money with you. Without regulations you can invest this money any way you want. Say only bad deals such as Deal #1 are available. If you take too much risk, such as Deal #1, you can eventually have losses and therefore no money to repay the loans. No repayment of loans would mean no further depositors and ultimately no business. So you would take only prudent risks to survive and thrive. Good capitalism.

But here’s the difference – the Federal Government through the FDIC insures the customer loans. You can take a high risk flier with the money, such as Deal #1, highly leveraged, and if the default doesn’t happen (6 out of 7 times in our example) you make tons of money. High fives and bonuses result and the Government declares that the FDIC insurance is working. But when (15% of the time in our example) the risk kicks in and you  lose, the Federal Government swallows the losses. How highly leveraged can you go? It used to be about 12x, but rules were relaxed in 2002 on and banks were allowed to go upto 35x! Think about that – you can use $97 of the loan (from the depositer) and just $3 of your own money and do $100 of Deal #1. Your $3 will produce a $10 return (minus the interest on the loan) or a whopping 333% return. Oh minus the interest on the deposits – how much is that? Answer – 0%. Yup, 0%. The Fed is willing to loan the banks money at 0% indefinitely, thus forcing down the interest that banks pay to depositers to 0% also. That makes the return on Deal #1  333%!

Heck, the deal doesn’t even have to be that good to be viable. Banks can take on even lesser deals, with say a 6% return in a good year and a 30% failure rate. Such deals (subprime loans, e.g.) would be ridiculous in a normal free market, but with the Government providing the free “loan” a bank would be insane not to do it. Or insanely moral, which is insane in a competitive capitalist setup.

Another way the government allows bad deals to happen is by insuring the deal itself. If Deal #1 is a mortgage loan to a bad bet (15% chance of default in our example) in a rational banking system such a loan would not be made. But because our society wants to encourage home ownership the Federal Government set up Fanny Mae and Freddie Mac, agencies that implicitly insure home loans against default. They were supposed to take on some of the risk of home loans in return for many more people being able to afford homes. And if the default rate was low, the cost to society was low and the gain was home ownership.

But with risk back-stopped by the government the banks saw enormous opportunity to profit by making really terrible loans that met no sane guidelines. Fanny Mae and Freddie Mac were co-opted – a collusion between banks and government, horrors! – and the go-go era of subprime mushroomed. The risk was even further kited by creating derivatives on credit, but that’s another story, not part of this blog. The effective leverage went from 35x to 300x or even more.

Profits in non default times were huge! The financial sector in 2007 accounted for 40% of all corporate profits in the US!! But the money made by insiders was even larger than that, in commissions, bonuses and hedge fund affiliates.

The crash inevitably came. The government gave trillions to the banks to make them whole again. The banks took the money, thank you, and the hi-fives and the bonuses continued. Back to leveraged loans, derivatives and so on, as if nothing had happened. We continue to operate with the government underwriting deals such as Deal #1 which only work with leverage and backstopping of risk.

Luckily for the banks most of America cannot fathom the arcana in which the financial sector couches this fundamental Ponzi model. They rail against the government and regulation and capital requirements and disclosure. Also, they say,  the reason they made so many insanely risky home loans is because the Federal Government made them do so by guaranteeing the loans. Good capitalism takes what it can get. There is no such thing as right or wrong.

The truth is that the banks today have a fundamentally flawed business. They cannot make any money in a free, capitalist, risk-reward based financial system. They have to take imprudent risk with other peoples’ money to make the profits that they are accustomed to. And when the kiting stops, the Ponzi deflates, they need the government to unshatter the shattered economy.

The Dow Jones Industrial Average, Last Two Days

The stock markets fell across the world today. We saw the biggest two-day decline in the S&P 500 since 2008, and the S&P 500 Index itself is at a twelve month low. Europe is teetering and it’s not just Greece anymore, not even the very scary Italy that is befuddling the markets. Doubts are beginning to be cast on powerhouses France and Germany and, of course, the euro is in shambles.

In the U.S. the volatility of our markets is at historic highs – day after day the markets spasm violently like the death throes of some giant leviathan. We are down 7% in the last 4 days, a kind of uncertainty you see in Banana republics. The economy is unable to generate any momentum, unemployment hovers at 20,000,000 people and 46,000,000+ are below the  poverty line.

What’s going on? You will hear a lot of nonsense explanations from pundits – like it was the Fed speech of Wednesday or an unemployment number blip. But you must understand the deep, deep malaise that affects us and that we seem unwilling to address. The most articulate expression of this came from Dylan Ratigan, who has an extraordinary financial commentary and news coverage at 1:00 pm (albeit on MSNBC). Try him if you want some sensible, fact driven analysis of the markets. He beats the pants off of Fox Business News or CNBC.

Here’s a paraphrase of what he says:

Our market volatility, instead of being driven by irrational fear, is in fact exquisitely rational. This is because the stock market knows that the underlying foundation of the financial system is completely bankrupt, shored up by little or no capital, regulatory requirements or transparency. The entire risk in the financial markets comes from a large chunk of it (99% or even more) remaining dark – outside the exchanges and unregulated by capital requirements, or reporting, or grown-up supervision. This segment includes $600 trillion dollars worth of credit default swaps* (see explanation at bottom) and thousands of other complex instruments, derivatives, private hedge funds and high frequency trading mechanisms.

So the stock market cannot adequately assess risk or or do a rational valuation of its assets. The largest chunk of the risk comes from outside its purview – the dark financial sector which is private, complex and corrupt. Thus the extreme volatility we are seeing today.

Yet our government continues to insure the financial system with its full faith and credit, buoying up a corrupt, too-big-to-fail, technically arcane,  private Ponzi scheme by underwriting it and implicitly promising to rescue it when it inevitably fails. Rescuing it at any cost, even to the point of complete financial collapse of our huge economy!

The way we dealt with the multi-trillion dollar banking collapse of 2008 was by printing huge amounts of money, flooding the financial sector with easy trillions courtesy of the tax payer, provide government bond insurance and government direct injections of capital and continuing the decade old harnessing of Uncle Sam to cover up the underlying flaw in the financial system. Instead of resolving it by pushing the complex derivatives markets into regulated exchanges and pushing capital requirements back into the banking system.

None of the underlying problems that led to disaster were resolved.

It was like you have a big fight with your family, find out that your sibling is stealing all your money, and instead of confronting the problem pretending that it’s not happening, giving him even more money and starting to take drugs to not have to think about it!

This has been a festering decade old problem, since 2000, when under President Clinton, a $600 trillion Credit Default Swaps market was invented by Larry Summers and Robert Rubin under the Commodity Futures and Modernization Act (CFMA) which created the highly technical, hugely risky, and dark, derivatives markets – i. e. no exchanges or reporting requirements and no capital requirements for risk. Some of it was a useful tool in hedging risks for legitimate financial activity but a vast, vast majority of it is idle, zero-sum speculation and because we cannot tell which part is useful and which bogus the tax payers continue to pay off for this $600 trillion dollar casino.

In 2009 our current administration tried to attack the problem by passing the so called Dodd Frank Consumer Protection Act – the creation of an oversight body to curb these underlying flaws and dismantle the casino. It was done in a watered down way, leaving much of the reform to be done in the future by the new Agency created for this purpose. Even this watered down action to fix our pathetic financial sector is now being reversed by the Republicans in Congress whose theology does not permit any reform and who are wholly bought puppets of the financial industry.

But this is not a Republican vs Democratic issue at the big picture level (although the Republican solutions are far, far worse). The Democrats have no desire or ability to make changes either. This shows the extreme power of big money to control our political process – although frankly even the big money interests must now be getting nervous at the extreme instability of the financial house of cards that we have in the Western economies.

Who is the boss? We had hoped it would be Barak Obama. But he has proved unequal to the task. Our economy continues to be schizophrenic with the top handful raking in all the benefits, and at the bottom  20% having inadequate or no jobs,  the middle class shrinking and zero-sum financial games replacing sound economic activity. Obama’s speeches on how he will create jobs, although better than the clueless schemes of the Republicans, seem hollow in the big context. They sound like someone trying to bail out the Titanic with a thimble.

Oh well. It’s a beautiful September day in the Bay Area. What am I carping about? It’s my birthday and I am flooded with good wishes and warm friends. Mustn’t complain.

* What is Credit Default Swaps (CDS)? These are contracts that are equivalent to insurance on some underlying debt. So if you are worried that GE might default on a given bond you can buy insurance against it defaulting by purchasing a CDS. If the bond fails you will be paid its full face value. The problem is that CDS are side bets and can be written to insure a bond many, many times over. These swaps today insure, on average, 600 times the bonds’ floats! Thus if a bond fails someone has the obligation to pay 600 times its float value. Suddenly there’s huge leverage risk. So when the Mortgage based bonds failed it caused losses in the trillions potentially wiping out insuring giants such as AIG and forcing the taxpayer to bail them out.