Among the illusions which have invested our civilization is an absolute belief that the solutions to our problems must be a more determined application of rationally organized expertise… The reality is that our problems are largely the product of that application.

Voltaire's Bastards: The Dictatorship of Reason in the West 
John Ralston Saul
The Free Press, 1992

We do not know where the next explosion will occur. We do know it is coming. In the global market, the credit default swap (CDS) on the United States has doubled in price since the Fannie-Freddie nationalization (10-yr CDS from 8 basis points to 16). This security trades in euro because dollar pricing makes no sense when measuring credit risk on the primary issuer of dollar denominated debt. Likewise the credit default swap on Germany trades in dollars because the German home currency is the euro. The US is now priced at double the credit risk of Germany. Both are still low compared to other countries. Most importantly, the US trend is clearly negative.

David Kotok
Cumberland Advisors

The IRA is headed to Leen's Lodge in Down East Maine for the annual Shadow Jackson Hole fishing trip sponsored by David Kotok of Cumberland Advisors, whose latest missive we quote above. We hear tell that CNBC will carry the event live on the Friday, August 1 edition of "Squawk Box" between 6-9 AM ET. 

Below are a number of items that have accumulated on the desktop. Call it risk sashimi. We also feature an excerpt from our extended conversation last month in Washington with Timothy Dickinson.

Please Raise Rates

The Fed needs to raise interest rates. The crisis in confidence in global credit markets illustrated by widening CDS spreads for US risk feeds on the defensive posture of the US central bank. A couple of quarter-point increases in rates will have little appreciable impact on an already mushy US economy and might cause the dollar to rally and spreads to come in. And watch oil collapse back toward $100 if the greenback starts a serious rebound. Net, net, modest rate hike looks like a positive.

We are hearing numerous stories of blockage in the credit channel (see below). If the Fed wants to restore confidence, then the central bank should allow the various temporary lending facilities expire, get on with liquidating the Maiden Lane vehicle, and let market interest rates begin to reflect actual inflation.

The current situation, where little or no new credit is flowing to the real economy, is unsustainable, but this snafu arises from the negative real rates in effect due to the Fed's panic mode. Raising rates to positive real levels signals to the markets that the crisis is over. It also better rewards banks and investors for making prudent asset allocation choices.

The likes of Lehman Brothers (NYSE:LEH) and Merrill Lynch (NYSE:MER) cannot survive no matter how much capital they may raise unless their credit spreads tighten. Seeing LEH pay over 7% or plus 360bp to the curve for five-year money this week makes us more than a little nauseous.

If the Fed wants to stabilize confidence and thereby attract money to recapitalize all financials, then gently raise rates 1% over the next year to make holding dollar assets worthwhile again. But even then, the end of the independent dealer model still seems inevitable.

Black Monday and the GSEs

The IRA received the following note last week from a reader named Marie, who describes banks suddenly walking away from loan workouts as a result of worries about Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). Send any comments to our attention and we'll pass them along:

"Hey...I work for a Southeast Michigan nonprofit that works to prevent foreclosures. We work with lawyers, brokers, MSHDA, financial counselors, etc. to do budgets, refinances, and work out deals with lenders. (Mostly it comes down to the last one, lately. It wasn't always so bad, but as you probably know, there's almost no mortgage money left in this state for refinances.)"

"Anyway, I'm doing research on the Freddie/Fannie issue, and I was hoping you might know something that would help us...My organization is calling yesterday "Black Monday", because at 9 a.m. sharp, the phones went crazy with banks calling to tell us that all deals were off. We lost about ten workouts yesterday that, on Friday, we thought were done deals. And let me tell you, calling families to tell them that is not a fun gig."

"Do you have any idea how what happened over the weekend could cause banks to back out en masse from mortgage workouts? Until we know what they're thinking, there's no way we can come up with a solution that might address it and get them to work with us again. (It's one of the paradoxes of our work that banks insist that foreclosures cost them all this money (40K is a number I hear often) and that they'd love to avoid them; yet when you offer a deal where they can keep the mortgage active by sacrificing a few thousand dollars max, they almost always turn you down flat. Unless you have a good lawyer to argue and negotiate with them, it's nearly impossible lately to get even a modest workout.)"

"Something about the Freddie/Fannie situation and/or bailout has got banks thinking that for some reason, they'd rather let everything foreclose, and it's devastating to hardworking families trying to recover from job losses and/or bad mortgages! If you know anything that might help us understand and address this situation, that'd be wonderful."

Capital vs. Relationships

Over the past several weeks, we've spoken to several veteran observers of the financial markets about the state of the markets. The demise of Bear, Stearns and the near-miss with LEH dominate many conversations, in large measure because the shock from these events remains so fresh in our minds.

One credit officer tells The IRA that the difference between Bear, Stearns and the likes of Morgan Stanley (NYSE:MS) or Goldman Sachs (NYSE:GSE) comes down to relationships. "Relationships are what is turning out to matter in the money markets," he tells The IRA. "Bear did not have them. LEH has good relationships to a degree, but not to the same extent as MS or GS. Those relationships mean stability at the moment."

The same observer, who helped us understand the clearing system implications of an accumulation of failed cash equity market trades ("A Normal Correction: February 27 Market Break"),  notes that the larger US an EU dealers are seeing record volumes in many cash equity and debt markets, both in the US and in Asia. For these players, the risk due to underinvestment in back office systems and failures related to the unanticipated growth in cash trading volumes remains significant.

The Tyranny of Reason: Lunch with Timothy Dickinson

Several weeks ago, The IRA had lunch at the Mayflower in Washington with Timothy Dickinson, noted polymath and observer of the American scene. Whether you are researching a book or pondering the world, Dickinson is the man to consult.

He commented on the demise of Bear and related matters as seen from his perch atop Mt. St Alban in N.W. Washington. We started our conversation talking about how the other dealers turned away from Bear, Stearns & Co and ultimately sealed its fate.

The IRA: The boys at Bear were never members of the club, were they?

Dickinson: Well, they'd gone out of their way not to be, which was the interesting thing. They weren't pathetic outsiders who that gang had determined to humiliate. They could have moved in quite comfortably if they'd been prepared to make an adjustment or two. The failure of Long Term Capital, when they sneered at the rest of the Street, was not helpful. I felt a great deal of impatience with the Street's eagerness to save LTCM myself, but it was rescued, like buying the Michelangelo fresco before the building falls down.

The IRA: Go back to what you where saying before about the US financial system being out of balance. Almost sounds like the composer Phillip Glass or IRA CEO Dennis Santiago, who's been remarking in similar a vein on some of the trends he sees in the banking world.

Dickinson: The discovery of equilibrium and, incidentally, the discovery by anthropologists that the most apparently irrational actions in fact work to long term purposes and so on, served to rationalize an awful lot of attitudes and activities. What appears to be the working of the system, its institutions, is simulated to make things look as if they were planned and deliberate, with operating procedures, etc., etc. This appearance of design is meant not just to reassure the investor but to caution the journalist, for example, from daring to suggest that anything is amiss with the system lest they be subject to ridicule...

The IRA: And career death.

Dickinson: Well, twenty or thirty years ago that did not apply. Today if you make one mistake, you have essentially used up your allowance. Twenty one years ago on Black Monday, a number of people made total fools of themselves, led by Galbraith, and suffered not at all. But that would not be the case today. But there is a great deal of subtle intimidation against people who come forward and say there is something wrong with the system.

The IRA: Until you reach the proverbial tipping point.

Dickinson: Yes. You were allowed to say that there was a bubble because the bubble was inconcealable, but the consequences of that bubble, well they were not discussed at all until fairly recently.

The IRA: We discussed this very point with Martin Mayer ("The Vigorish of OTC: Interview with Martin Mayer"),  namely the use of terms like "innovation" and "technology" to clothe previously banned practices with respectability.

Dickinson: Precisely my point.

The IRA: None of the Platonic Guardians we discussed in our interview with Alex Pollock ("Conflicted Agents and Platonic Guardians: Interview with Alex Pollock")  gave us any warning about the implications of the bubble. Christopher Cox at the SEC, for example, is the chief case in point. He is charged with investor protection, after all.

Dickinson: Well, what kind of Republican wants to head an agency like the SEC?

The IRA: Agreed.

Dickinson: But back to the systemic issue, democracy is after all an allowance made by the sheer complexity of things. No one is in charge because no one is genuinely informed enough to be in charge. There is absence of government by default. It is so interesting to look at the Iraq war. Even this self pleased crowd [in the Bush Administration] had to admit that they did not know their stuff about the Middle East…

The IRA: We did not notice any reluctance on the part of the Bush Administration to plunge into a trillion dollar war.

Dickinson: They were certain, but that is a very different thing from being informed. This is a morality play for them, not an unfolding of expertise. And the war in Iraq is meant also to be an example to China and Russia, even as the latter complains about the advance of the EU to their western borders. The Russians know that the real arm wrestle is and will be in Central Asia.

The IRA: Well, the Russians have the EU captive via the gas supply relationship.

Dickinson: The EU either has to make up its mind that it is fundamentally an American client, in which case it can be far uglier with the Russians, which I would not mind at all, or it has to maintain the pretense of independence.

The IRA: And of course they will do the latter…

Dickinson: Ha! No doubt.

The IRA: But speaking of certainty, don't you believe that it is impossible to give our leaders a pass with respect to the mortgage bubble? How can we look at Alan Greenspan, Larry Summers or Bob Rubin and allow them to say that they were surprised by the magnitude of the bubble and the horrible consequences?

Dickinson: Well, partly because these massive egos believe that they had "fine tuned" things and would not take any of the consequences of a break. They thought that their record of qualification would distinguish them and keep them from being blamed. The reality is, in my view, than none of them had the courage to overturn a few apple carts early in the game and thereby forewarn the public before the 18-wheeler overturned.

The IRA: Dr. Anna Schwartz has called for Greenspan to be publicly held to account for his actions.

Dickinson: Ah! I am delighted to know that she is in a position to make such a statement at her age. She has a rare kind of upright, almost rabbinical authority, the view of someone who believes you should be held accountable for your actions.

The IRA: IRA co-founder Christopher Whalen was once scolded by Schwartz, who wagged her finger and said "I see statist tendencies in your writings!" What greater honor than to be scolded by Dr. Schwartz?

Dickinson: So a question for you: How long does it take for the antelope to make its way through the boa constrictor? When does the banking industry bottom?

The IRA: We are telling our clients the first half of 2009. The rate of change in the loss rates in US banks shows no signs of slowing. That is the first sign we look for that the fever is breaking. But figure a year from today.

Dickinson: Ah, that should coincide nicely with the unraveling of the bubble in China. I have in mind something like the Panic of 1907. When China finally let's its bad idea lose upon the rest of the world, then we'll see that we ain't seen nothing yet.

The IRA: For a nation that endured half a century of socialist rectification, the Chinese as a people seem to have an enormous capacity for financial speculation. If they so much as hear the name of a company, literally millions of Chinese will rush out to buy it.

Dickinson: They are a nation of gamblers - really very interesting. And not only will they buy a stock, but they will fake large amounts of the paper and sell that too. No I am really scared. When China has its first land-slip and its second and third judging by the unwillingness of people to learn on present records, the current discomfort will seem minor. Think about how many foolish bubbles there have been in our lifetime. The systems-conglomerate bubble of 1967-1969; the financial markets bubble that came to an end on Black Monday in October 1987; the S&L real estate bubble of the same time period; the high tech dot.com stock bubble in the late 1990s; and now the present difficulties in real estate. At least five bubbles in 41 years.

The IRA: Is this a function of a maturing economy that is losing the ability to produce and create value?

Dickinson: I was rather hoping you would tell me.

The IRA: It is difficult to ignore the rise of speculation as an excuse for productive activity as real industries and jobs are destroyed in the US by the thousands. We talked at length over the years about the difference between extraction and production. When you stop adding value and producing wealth, then perhaps gambling becomes the short-term expedient.

Dickinson: Well, you start reasoning that you are not gambling, you are "taping in" to some imagined pattern of real growth.

The IRA: Or some engineered vision of growth, a vision that is not substantive. It reminds me of the way investors blithely accept that price and value are the same, to paraphrase our friend Sylvain Raynes at Baruch College. He argues that the Chicago School has done enormous damage by successfully propagating that falsity.

Dickinson: What the Chicago School did, again, played up to the notion that there are so many things that prove to be rational in the long term, but they then turned that relationship on its head and said that this means that things are rational in the short term. This is one of the supreme distinctions made. There is always at least one truly terrible idea going around. The Chicago School rightly said that there are more rational responses in a system than we might think at our first God-like glance, but it did not deal with the fact of a large number of irrational responses.

The IRA: You mean the markets are not efficient?

Dickinson: If the Chicago School's view of the world were correct, World War I would have remained a great idea not fully justified. The Chicago School avoided, no, thoughtfully closed their eyes to the more modest insights of the Critical Path movement. You have to do a lot of work to find a way between two highly persuasive but extreme positions like central planning and free markets.

The IRA: Thanks Timothy.

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