How Palin Destroyed the Republican Party

This post might be a bit premature as the official tally has yet to come in. Nevertheless, with a strong 10 point lead over McCain in the latest Gallup poll, I think it is pretty safe to say Obama will likely come out on top. If I am wrong, well this post will clearly be irrelevant. Nevertheless, the past 8 years have put the Republican party in a bit of a bind. Since 1980, the Republican Party has been the party of Ronald Reagan. Following the Watergate scandal, Reagan helped re-legitimize the party, by forging an unholy alliance between Middle American and big business. The Wall St. Republicans were willing to concede social issues to Middle Americans, while the Middle Americans were willing to concede economic issues to the Wall St. Republicans. It must be remembered that as recently as 20 years ago, liberal bastions such as Connecticut and New Jersey were voting Republican in national elections. In many ways, George W. Bush was a natural heir to the party's thrown, with a foot in Connecticut big business and a foot in Texas Born-Again Christianity and Conservatism. In effect, Bush's ascension to power within the Republican ranks was the logical conclusion of Reagan's Unholy Alliance. However, as Bush's presidency floundered between unnecessary wars, growing deficits and more recently, the economic crisis, Bush in many ways tore down the legitimacy of Reagan's ideology, the heart and soul of the Republican Party.

As a result, the Republicans currently find themselves at a crossroads. Despite having the presidency and majorities in the House and Senate as recently as 2004, all of the party insiders from that era seem to have the equivalent of political leprosy. The party's views on foreign policy and economics have been discredited and there seems to be no one ready to step into a leadership position. This was most notable during the primary season, given the lack of quality Republican candidates. Mitt Romney was accused of being a Mormon robot and failed to so well in any of the primaries. Rudy Guliani is well, Rudy Guliani, a New York Paleocon, hated by liberals and Middle Americans alike. Ron Paul was probably the most interesting candidate, although slightly insane, he appealed to Wall St., libertarians and for some reason younger Republicans. At the end of the day McCain, a strong contender in 2000, who had since sold his soul to get elected, was chosen. However, aside from Ron Paul, who will probably always be relegated to the roll of something of a circus freak in national politics, the only contender who seems to have a future on the national stage is Mike Huckabee from Arkansas.

Arguably, Huckabee and Palin are going to be left as the two strongest leaders of the Republican party out of this election, however both pose the greatest threat to the integrity of the Republican party. For years, the Republican Party secured victory after victory by getting poor whites to vote against their interests with big business money. However, in the last election cycle there has been a marked change. Obama secured an enormous fund raising advantage, partially through small donors, but largely through big businesses like Goldman Sachs, turning against the Republicans. It has been documented that Wall St. the historic Republican stronghold is likely to vote for Obama 2 to 1 in this election, even with the relative centrist, pro-free market McCain at the helm. Huckabee and Palin represent a sharp departure from this.

Huckabee and Palin are not Republicans in the broader sense. Rather, they are purely Republicans based on social issues, military and Middle-American nationalism. Despite large support amongst individual voters, Huckabee had a miserable time raising money throughout the primaries, as the wealthier faction of the party turned on his more populist economic principles. Palin on the other hand came off as a joke and an offense to the more educated and centrist factions in the party. While both enjoy large support in the conservative, Born-again Christian base, that is not enough to win outside of the Southern and Plains States. In the end, this direction will only serve to alienate more Centrist voters, especially considering the majority of Americans already have an unfavorable opinion of Palin. At the end of the day, the Bush presidency has discredited the central tenants of the Republican party. As a result, the party has been left without any centrist rising stars from this cycle and threatens stear in a more anlienating direction, thus breaking up Reagan's unholy alliance between Wall St. and Middle America.

To Have and to Have Not

Anyone who's kept up with me over the past few years might have noticed a pretty marked conservative shift in my thinking over the past few years. While in high school and the early part of college, I definitely was leaning pretty strongly in favor of socialism, recently I've begun gravitating more towards libertarianism or neo-liberalism. In Resurrection, Tolstoy makes the observation that people tend to adapt their moral beliefs to justify their profession. A prostitute, he claims, believes that she is performing a most necessary duty for humanity, as men first and foremost need sexual satisfaction. I can't say I've had too many interactions with prostitutes, so I'll just have to trust Tolstoy on this one.

Since getting out of college, I've decided to embark on a career in finance. I chance job offer in Oklahoma got me started down the path, where I found that it's actually a really interesting subject and I am not all that bad at it, despite very little formal training. As a result, finance has become my most recent obsession, taking the place of Russian literature. Naturally, my views on economic policy have shifted a bit as I've learned a bit about it. Living in the remains of "Socialist Paradise" has also made a strong impression on my world view, as every day, I see the legacy of 70 years of socialist rule. In any case, over the past few months, there has been one question that still gnaws at me, probably one of the central questions in defining a person's political outlook: why are some people rich and some people poor?

Before I embarked on my journey to the heart of the financial beast, I generally attributed social inequality to dumb luck. I have met more than my share of rich idiots, who have landed cushy jobs merely through of family connections and massive inheritances to boot. On the other hand, I've met plenty of smart, ambitious people, who for whatever reason will remain poor for the rest of their lives. Take Verkhny Lomov, the Russian village I visited a few weeks back. If you are born in a village with in the middle of nowhere, with no indoor plumbing, limited educational opportunities, odds are you won't be able to rise out of it, no matter how brilliant you are. Even when you think about it, genetic gifts boil down to little more than pure and simple dumb luck. My tag line from that era was, "What separates me from a poor, crippled, Somali orphan? Luck."

However, on the other end of the spectrum, we have to realize that life just isn't fair. One thing that annoys me about American society, as anyone who reads this blog might pick up on, is the tendency for Americans to complain. I mean, really, life in America is not all that hard. It's designed not to be. In the summer of '07, when I was in California, one person who I talked a great deal to was my brother's bitter, 45-year old, unemployed roommate Joe. Joe grew up around Chicago in a working class family. Dropped out of High School and moved out to California on a whim. I guess he worked a bunch of odd jobs and at some point along the way got a GED, except like every other bitter, stupid liberal, he fancied himself to be much smarter and more educated than he really was. All he ever wanted to do was bitch about how the system was fixed. For the first day or two, it was interesting to have a lively debate. It quickly dawned on me, that he spent his life sitting in front of a computer, reading the latest conspiracy theory blog, churning over the same-old, ridiculous ideas. At the end of the day, Joe is 45, unmarried, unemployed, studying at community college and living off student loans. While unquestionably, there may have been some circumstances in his life that made him less likely to succeed in life, he still could've done much more to improve his lot. Really, is it anyone else's fault that he is bitter and miserable or did he just piss away every opportunity he was given?

An Idea that Will Piss Everyone Off, but Just Might Work



As my life has descended into chaos this week, I haven't had much time to update this blog. I hope my dear readers don't mind. I've been meaning to write a big piece in defense of Russia in the financial crisis, but it will probably have to wait til next week. In any case, the markets are up 43% or something this week, so it seems the market has beaten me to the punch.

In any case, the American economy is the really interesting story in the world, right now, of course. As I've been harping upon in a few of my recent posts, the real culprit seems to me to be our current account deficit. We've spent more than we've earned recently. While America is still the world's third largest exporter, behind Germany and China, totaling around $1.15 trillion in 2007, our production is nowhere near enough to make up for our consumption. As I mentioned in a previous piece, the United States' current account deficit stood at $800 billion or 5.8% of GDP over the same period.

The structure of the American economy that has developed over the past few years is largely to blame for our current trade imbalances. In 2007, only 23.2% of the work force was dedicated to agriculture or manufacturing. The remainder was dedicated to management and the service sector, effectively making our consumption more efficient but not helping solve our problems of over-consumption. As I stated in my last piece, unions have been a major part of the problem, as they have driven manufacturing wages up in the country, making production in America uneconomical. Additionally, the United States has undergone a gentrification over the past 40 or so years. Today, many Americans regard blue collar jobs as beneath them and demand extra pay to occupy those positions.

Nevertheless, just south of the border there are hoards of people who are willing to work blue collar jobs for minimal pay, who can't get visas to work in America. If we were to begin employing workers from Latin America under a special visa plan, allowing employers to give them work at below the current minimum wage, we could easily provide a much needed boost to American industry, even providing businesses incentives for moving industries such as textiles and other consumer goods to move back to America. Many will see the plan as inherently racist, but at the end of the day, these people are not American citizens and it is their choice. Besides, race would not be a criteria, merely country of origin and we already employ those restrictions. Ask any Russian how hard it is to get a US visa. Relaxing requirements for these new visas would provide the American economy with much needed, cheap workers in the manufacturing sector, and at the end of the day, it would just legitimize and bring under a legal umbrella a system that already exists.

There is Power in a Union



When Billy Bragg wrote those words in 1986, the US and UK were standing at an economic crossroads. For years, unions had been an important economic force in both nations, protecting workers rights. They had been helpful in the creation of the middle class in both countries, however in the 1980s their power began to wane. Many blamed the conservative Reagan and Thatcher for their administrations, rather than accepting the economic reality. While in the past unions have been an extremely useful defender of their workers, right now they are part of the problem, not part of the solution.

The US manufacturing sector has been an unquestionable loser of globalization. In 1964, manufacturing accounted for 27% of GNP and 24% of the workforce, while in 2004, it accounted for 13.8% and 10.5% respectively. In order to offer competitive prices, many American companies have been forced to shift operations overseas in recent decades. Even though Americans manufacturing sector is the most efficient in the world, it is still unprofitable for most companies to maintain operations in America as a result of high labor costs.

Union factory workers in America are often paid far more than the average American. In 2007, unskilled United Auto Worker members for instance are paid an average hourly wage $27.81 an hour or about $58,000 a year, compared to a per capita income of $46,000. While factory workers in America were once making slave wages, the union members of today are doing OK, however their firms are not. The Big 3 automakers, Ford, General Motors and Chrysler are on the knees right now, posting record losses and holding enormous pension-related liabilities, partially as a result of mismanagement, but also a result of their employment costs. Yet, their unions are unwilling to renegotiate their pension liabilities. As a result an everyone loses situation is developing. The Big 3 will likely be forced into bankruptcy, closing plants, laying off workers and eliminating workers' pensions.

When I was working in Oklahoma, my work involved a project with a tire plant that was closing its doors. The company tried to renegotiate with the union, offering to keep the plant open if they could cut salaries by 30%, however union officials refused out of fear of setting a bad precedent.

Many in the media have been critical of Wall St. banks for sacrificing the greater good in the search of short term profit. I fail to see how the unions are any different. While the unions at one point served a great purpose, they need to accept the fact that their members are now firmly in the middle class, and their stuborness will only cause more manufacturing jobs to leave the country.

Evraz: Short-Term Pain, Long-Term Gain

The collapse of the Russian stock market has been one of the more surprising events of the past year. Russia is probably in one of the strongest positions in the world to withstand the crisis, given it's large current account surplus, relatively low leverage levels across the private sector and continued strong economic growth. While Western nations are currently panicking over the prospect of a recession, Russia is likely to produce just shy of 8% economic growth this year, and economists are predicting 5% economic growth next year. Yet despite all this, the RTS index is down around 80% from it's May highs, currently trading with a PE of about 3.

There have been a number of reason's for RTS's precipitous decline. To put it mildly, Putin hasn't exactly done a great job on the PR front this year. While the war with Georgia is debatable, his comments and actions regarding Mechel were just plain stupid. Nevertheless, the reaction by Western investors was also overstated. While fears of repeat of Yukos are understandable, it is an extremely unlikely scenario for a number of reasons that I won't get into here, for the sake of brevity. Still, Putin's comments merely served to increase investors' perceptions of Russia as a risky nation, right at a time when investors were shunning risk. Additionally, outside of the country's oligarchs, Russia has few long-term, value investors. Western hedge funds, investment banks and investment managers account for the majority of the volume on Russia's stock exchanges, resulting in a lack of long-term investors, who would be willing to put in a floor. Consequently, many foreign investors have simply pulled their money out of fear that other western investors would pull their money, resulting in margin calls and more selling. Finally, falling commodity prices have also put significant downward pressure on the markets.

Still, the RTS is trading at such a discount right now, it seems as if some investors are pricing in the Apocalypse. While losses on the RTS will likely continue over the next month as hedge funds continue to sell off assets to meet investor redemptions, Russian stocks are a screaming buy right now. First echelon companies with strong financials like Gazprom and Lukoil are trading with PEs as low as 2.5 and 1.6, respectively. Another interesting name trading with a PE of 2 is Evraz. The company is in an extremely strong financial position, posting a 50% ROE for the year ending June 30. While steel prices are likely to decline and margins are likely to tighten for steel companies around the world in the coming year, Evraz is largely insulated from any moves in iron ore and coal, as the company is vertically integrated, being it able to meet 93% of its iron ore and 100% of its coal requirements. Although the company is relatively leveraged, with a 56% debt-to-equity ratio, many of these issues are coming to maturity in the distant future. Next March, Evraz will have $300 million in eurobonds maturing, but with a debt/EBITDA of 1.57, it should have no trouble meeting its obligations.

While Evraz got into trouble with the government this summer over selling coal on the international market for less than it did on the domestic market, Evraz's international sales only account for 1% of total coal production. Additionally, given Abramovich's close relationship with Putin, it is unlikely that Putin would take significant action.

While there may still be some pain ahead for Evraz shareholders in the coming weeks, in the long term, this company is ready to come screaming back in the next two years.

It's Time to Get Responsible

I've decided to get a little ambitious with this one. As anyone, if there is anyone, who reads this blog may note, I have been very critical of the way the media has been portraying the current crisis. To be redundant, to say this is a subprime crisis misses the point. This is a debt crisis caused by an unsustainable amount of debt in the economy. Underlying this problem, however, is a massive $800 billion annual current account deficit. That means that every year, the US consumes $800 billion more dollars than it produces. To fund this the US relies on artificially low taxes, essentially a government subsidy, paid for with government debt, and private debt from banks and financial intermediaries. In the course of the past year, this debt load became unsustainable, resulting in the current crisis. However, attacking Wall St., derivatives, the mortgage brokers, etc. completely is purely an act of scapegoating and does not address the real culprits or causes. Collectively as a society Americans are to blame for being irresponsible and buying what they can't pay for.

Over the past two decades, since the end of the Cold War, the US has been guilty of nothing short of hubris. Americans hold the belief that their nation is an indestructible fortress and it should be. And while America is undoubtedly an unparalleled military power in the world, she is currently facing an enormous and silent threat to our way of life, an economic one. If left unchecked the nation's habits will result in a massive decline in world standing and way of life, leaving America a shell of its former self.

As I outlined in a previous post, in the past how in the past 20 years a culture of entitlement has developed in America. Defining the laws of economics and nature, Americans have come to believe that the should never die, suffer or be denied. The United States' GDP stood somewhere around $13.8 trillion in 2007, while our current account deficit was $800 billion. This means that we took out debt to finance roughly 5.8% of all our purchases. That year, the US national deficit ran at $162 Billion, meaning the US government took out that much debt to subsidize taxpayers in 2007. However, the deficit grew by about $500 billion due to interest payments. The remainder of the deficit was financed through the private sector. Quite naturally, a nation cannot just take out debt to the tune of 5.8% of GDP ad infinitum and not expect a crash to occur.

America has had a mixed relationship with globalization. On the one hand, the US citizens have been able to buy foreign-produced goods at far cheaper prices than had they been produced domestically. This increase in trade has in turn created many direct and indirect jobs. As Americans have spent more money on clothing, electronics and other consumer discretionary items produced overseas, jobs have been created in the service sector. On the other hand, as companies try to cut costs and remain competitive, many have been forced to shift production overseas. As a result, the American manufacturing sector has been decimated, leading to our massive current account deficit. Over the past few decades in America there has been a gradual shift away from the manufacturing sector into the services sector, which does not produce any exportable goods. At the same time, if the US were simply to decrease imports, many of these jobs in ther service sector would simply be lost, resulting in decreased GDP and in turn consumption of domestic goods. Ultimately, there are no easy solutions to this problem, as Americans in the manufacturing sector would have to take a signficant pay cut to once again make the sector competitive, and any decrease in domestic trade, even of imported goods, would likewise have a negative effect on the economy. Ultimately, a severe recession seems to be the only way for the US to correct its trade imbalance.

There has been much talk in the media of late about energy independence in the United States. Given that the US imports approximately 5 billion barrels of oil per year, and with oil averaging around $65 a barrel in 2007, this resulted in a about $320 billion contribution to our trade imbalance. Yet over the same period, the US imported approximately $2 trillion in good over the same period, and the US consumed $14.3 trillion over the course of the year. Even if the US had been independent from foreign oil in 2007, the nation would've still consumed about $140 billion more than it produced or about 3.5% of GDP, and would have still imported $480 billion more than it exported. While America's dependency on foreign energy is a problem, and will become a growing problem as energy becomes scarcer and scarcer in the coming century, the United State's dependence on foreign oil alone is not the problem. Foreign oil accounted only for 2.2% of total consumption in the US. Over the past few decades Americans have simply spent too much on cars, houses, televisions, etc. and saved too little.

In particular, the United States has spent too much on defense over the past two decades. In 2007, defense spending totalled $700 billion or 5% of total GDP, not including the war in Iraq, which has cost an estimated $800 billion since it began. Americans are in love with their military and hold it as a great source of pride. However, at the end of the day, much of the nation's military spending is purely useless. Even though the Cold War is over, America continues to purchase defense systems designed to fight a war against a major foe with a strong Air Force. As is, no nation in the world would be able to stand up to America's defense systems from 20 years ago, so why continue to invest in weaponry that will never be needed to fire a shot in anger? For instance, congress has allocated $62 billion for the F-22 fighter program. Even though there is no air force in the world that can stand up to the USAF's aging and "outdated" fleet of F-15s. Additionally, the F-22 would only be useful in a war against a major power like Russia, which would go nuclear in about 30 minutes, or China, which would turn into a very long, protracted and bloody struggle. However, these wars are not likely to come about, as they would certainly be a disaster for every country involved and the world at large. Since the end of the Cold War, the US has found itself in low-intensity conflicts against insurgencies, like the ones in Iraq and Afghanistan, fought primarily by infantry on the ground. There is no need to continue acquiring high tech fighter planes that can shoot anything out of the sky, nuclear submarines, stealth bombers and the latest guided missle cruisers for use against these opponents. While Americans may be proud of the fact that we can strike any country on the face of the earth on their home turf with little impunity, this pride is ultimately hurting America. Every year, the US invests hundreds of billions of dollars in defense systems that offer no long term return at a time, when the government needs to be thinking about fiscal responsibility and growth. Being the world's police man and pursuing interventionist policies has provided no economic benefit for America over the past two decades and never will, especially when considering the $800 billion the US has already shelled out for Iraq. These funds would be better off being directed towards projects that have economic benefit. Ultimately, the US military is there to protect the nation, but right now it is making the country less secure, not more.

While the bubble of private debt is currently bursting in America, resulting in a massive recession, there is still a far more scarier bubble growing right now, partially to help salvage the nation's banking system. In 2008, America's sovereign debt currently stands at around $10 trillion or 70% of GDP, and it continues to grow at an astounding pace. The last time the national debt reached this level was in the aftermath of World War II and the Great Depression, yet we are just coming out of a period of unparralleld prosperity. If left unchecked, it is only a matter of time before investors begin to turn away from the US and the dollar experiences a steep devaluation, creating a crisis of unimaginable proportions. Although it may be painful and politically unpopular, it's time the government stopped subsidizing taxpayers excessive spending habits and began addressing it's own wasteful and inefficient use of funds.

As Americans wake up to the fact that they are not as indestructible as they once thought, some serious questions need to be asked. Rather than pointing fingers and blaming everyone but themselves, it's time Americans took a look in the mirror. America has been living beyond its means for some time and now it's paying the price. However, more than anything else, it's time Americans got responsible.

What the Hell Happened to Oil?

I usually try to stay away from commodities, because it is not exactly my forte. I've never studied the complex economics and statistics required to properly estimate how a shift in supply or demand, one way or another will lead to a specific change in price. When I was working in Oklahoma, predicting grain and energy prices was part of my job, and while my predictions for ethanol have more or less come true, I didn't expect grain prices to jump so much. Then again, neither did the department of agriculture. In short, I know my limits, but against the backdrop of what's going on in the broader market, something looks really fishy about the oil market right now.

Today, oil is trading around $68 a barrel, and it was trading around $66 yesterday. Yet, on Sept. 30, it was trading around $100 a barrel. While this summer's run up in oil prices into the $140s was certainly a bit bubbly, oil's recent crash also seems to be driven by something beyond fundamentals. Oil rose sharply in the first half of this year, primarily on the back of a weak dollar. As the dollar declined, investors dove into commodities in search of a hedge. However, as the dollar began to strengthen this summer, oil dropped precipitously. Additionally, there were concerns that the oncoming recession would result in demand destruction for energy. Of course, supply and demand in the oil markets are pretty tight, resulting in a lot of volatility. Any demand destruction will have a huge negative effect on the price of black gold. Nevertheless, something about all this doesn't sit right with me. Oil seemed to be bottoming somewhere around $100 a barrel, in September of this year, a figure, from what I understand that many economists see as the commodity's intrinsic value. If you look at the first graph, you will notice it had a healthy bounce around $90 around that time, indicating a support level. There seems to be something afoot here aside from fear.

If you look at the three month chart of the Dow Jones (the second one), you will note that recent carnage on the equity markets began around October 1. This is important, because at the end of September, hedge funds were hit with redemption requests and were forced to unload a ton of securities to meet those requests, thus driving down the markets. As a result, a non-secular wave of selling oil has begun in the market as hedge funds were and still are pressured to sell off assets. Like with just about every other securities market in the world, oil has disconnected from the fundamentals and probably will be for at least another month or two. Nevertheless, once some of the fear leaves the market place and investors start feeling somewhat comfortable with the situation, there should be a sharp turn around. Although the contracts for delivery in the coming months will not likely experience much of a rebound, due to the general negative sentiment and fear, contracts maturing later in 2009, in May for instance, will likely end up in the long term once this wave of selling is over. The chinese are still buying cars and America is still amazingly dependent on the stuff.

Moscow's Impending Real Estate Crash

It's been a while since I've written here. I hope my devoted readership doesn't mind all that much. I've gotten side tracked by a few things, like trips to the provinces and a weird and interesting encounter last night that may prove pretty promising, but more about that later. I hope my devoted readership doesn't mind. So since I live in Russia, you would think I would focus more on the motherland, but with the crisis in America and everything, which is just so much more interesting, I mean a once in a century event, my attention has been elsewhere.

In any case, as anyone living in Moscow may know, over the past few years, real estate prices have gotten to ridiculous levels, especially given the average income in the city and the quality of living space. For instance, I live in a pretty crappy 3 room apartment, far from the center and in a not particularly posh region to say the least. Apparently, this apartment would now fetch about $300,000. Doing a quick, back of the envelope calculation, that would mean that a mortgage this apartment would cost $42,000 a year, assuming a 17% interest rate (not too ridiculous in Russia), a 5 year term (again, pretty standard) and 52% down (a whopping $156,000, but once again standard in Russia). The first question I have to ask is how many Muscovites can afford $156,000 up front, especially when you consider that the median income is somewhere around $1200 a month. Secondly, we pay out 33,000 roubles a month, which translates into about $15,000 a year, roughly what the average Muscovite makes. Therefore in Moscow, annual mortgage payments cost roughly 3 times as much to buy as it does to rent, even with 52% down! By comparison in the US monthly mortgage payments generally cost about 1.4 times rent, and it's pretty easy to pay only 30% down for a prime mortgage, as opposed to the 52% required by Russian banks. I am not going to go into subprime here. In any case, Moscow is clearly ripe for a fall.

There have been a number of factors driving up Moscow real estate prices over the past few years. First and foremost, many wealthy Russians, who don't know how to or are just not comfortable investing in stocks, bonds, mutual funds, etc. chose to invest in real estate, because it is a more tangible asset. Nevertheless, this has naturally resorted in quite a bubbly market. Additionally, for anyone, who hasn't been to Moscow, for Russians and the former Soviet Union, more generally, Moscow is something like New York, DC and Los Angeles all combined into one, granted with some of the high culture aspects stripped out and left in Petersburg. As a result, anyone stuck in a village with no work, nothing to do and aspirations to something greater comes to Moscow, driving up the price of real estate. For instance, this weekend, I was out in a small village in the countryside 525 KM from Moscow, where there is absolutely no work and nothing to do. When I asked how people make a living, my friend Dima told me half of his classmates from school had come to Moscow to work construction and make a living.

Although many in Russia initially believed it would be immune to the current crisis in the West when it first appeared last fall, a year later, the RTS index is down about 70% and the country completely cut off from the world debt markets, it's clear that it has certainly taken its tole. Despite the fact that the Russian economy is not anywhere near as leveraged as the American economy, loose banking standards are certainly affecting the banking system here. Additionally, Russian banks are having trouble raising money abroad, resulting in a complete clamp down on long-term lending such as mortgages and commercial loans, as in the West. The first victims of the crisis after the banks will likely be the Moscow real estate developers, reliant on this funding, who have already halted a number of projects. This means that the provincial, Caucasian and Central Asian gasterbeiters (construction workers) will likely soon find themselves out of work and forced to search elsewhere. Typically, these gasterbeiters rent out small, run down apartments in the more run-down sections of town. However, when they are gone, demand will decrease and these apartments will become vacant. Many young residents of Moscow, like yours truly, may opt to sacrifice living standards for a cheaper rent, thus pushing down prices throughout the city.

Despite these headwinds, my friend Andrey assures me that he doesn't think a market crash is imminent, due to a lack of transparency in the Moscow real estate market and the relative unpopularity of mortgages in the country. While the Moscow real estate market lack of transparency in the real estate markets may retard the decline of prices, it will still eventually happen. Also, real estate is not a liquid investment. Even in America, where housing prices peaked over two years ago, they are still declining and showing no sign of stopping. By contrast, the Dow Jones has shed about 20% in this October alone. A drop in Moscow real estate prices won't happen over night, but the bubble still has to burst eventually. Secondly, although mortgages are only a recent invention in Russia, they still were still taken out for a lot of real estate purchases in Moscow over the past few years. The lack of availability of mortgages will certainly put another dent in demand for Moscow real estate.

Finally, Andrey maintains that not all regions are likely to be affected equally. While the regions on the outskirts of the city, home to migrant workers will likely see a drop in prices as a result of their departure, the Center might not. However, the center is generally home to Moscow's wealthier business class, the Muscovites most likely to be licking their wounds from this year's crash. Victims of Russia's stock market crash are far less likely to be making any kind of investments in the coming year as their capital base is depleted and worries about the crisis are in the front of their mind.

Before the financial crisis truly hit Russia, demand for apartments in Moscow had already reached an unsustainable level, given the massive discrepancy between earnings and the price of real estate. The price effectively left Moscow apartments off limits to everyone except for Moscow's rich, who while plentiful still have the majority of their assets tied up in real estate already. The crisis will merely serve as the catalyst for the bursting of the bubble. My main question now is how this is going to affect the Russian economy as a whole. Real estate and construction are huge parts of the Moscow economy. Additionally, wages earned at Moscow construction sites provide a living for many in the impoverished provinces. My only hope is that when the bubble bursts, some wealthy Russians will shift some of their assets into other classes. Russian stocks are an amazing buying opportunity right now. Maybe if there had been some more local money in the stock market, the fall wouldn't have been as severe when the fly-by-night, Western, hedge fund managers pulled their money.

Round 3: Main St.

As I've been saying for a while, despite all the pain over the past few weeks, there is plenty more in store for the S&P 500. Despite the fact that stock's in the US are trading around 40% down from their highs this time last year, the indices are still plenty expensive from a P/E and dividend yield perspective. While financial sector Armageddon seems to have been averted this week, with new bailouts coming from Europe and a redirection of the TARP to provide equity injections, there are still more than enough shoes to drop. It looks like Round 2, severe systematic risk to financials, (Round 1 was housing), is somewhat coming to an end, although we are not completely out of the woods yet, round 3, the real recession is just starting. Next up, as seen by today's retail numbers, is Main St.

For months and months, there has been speculation about how hard the financial crisis was going to hit Main St. By now, it is becoming clear that we are about to enter a savage positive feedback loop that will ravage cyclical businesses. As retail sales continue to drop, companies will be forced to cut staff, putting more pressure on the retail sector. The first companies to get hit will be in consumer discretionary, the bigger expense items the hardest. This isn't news to anyone, but Ford and GM are likely going to be the first casualties of the crisis' transition to Main St. Behind them will be any highly cyclical businesses with a high debt/EBITDA, low margins and a significant portion of debt maturing in the next 18 months or so. I am looking at retailers in the consumer discretionary sector primarily, who are likely to suffer a spate of store closings and write downs. Additionally, any vacation-oriented company will likely get pounded as people opt to stay close to home for their vacations, rather than taking exotic vacations. Computer manufacturers and Airlines may also take a strong hit, as well as their upstream suppliers.

Even though the selling induced by hedge fund redemptions will end in a month or two, the indices are just too expensive right now, and as the economy continues to deteriorate, it will only get worse. Probably the best investment right now is in put options in cyclical businesses, with low margins and high debt/EBITDA.

Nationalization Fever

Today was quite a momentous day on the stock markets throughout the world. The Dow surged 936 points, the largest percentage gain since the 1930s. So is it time to wade back into the waters and go long? NO! This was just a correction and I have a feeling we aren't even close to bottoming out. There were a number of factors contributing to today's rally. For starters, there was the short squeeze factor. A lot of traders probably woke up today and figured it was time to close their short positions and buy back the stocks they had shorted, pushing the market up. Then there is the oversold factor. The market just plunged too much too fast and was due for a bit of a rebound. Thirdly, hedge fund, who need to liquidate to meet investor redemption calls are not going to be selling in this market as it will only increase their pain. As a result, a lot of hedge funds have probably stopped selling and are merely waiting for a pop in the markets to unload more assets. Finally, there was the good news coming out of Europe, coming from the G-7. While at the time, letting Lehman fail to stamp out "moral hazard" may have sounded like a good idea at the time, in reality it was probably one of the biggest blunders of this crisis. Now the EU has been forced to pledge $1.8 Trillion to ensure that there isn't a repeat.

The bankruptcy of Lehman Brothers sent waves of fear crashing through the financial sector unprecedented in modern times. A few times last week, it looked like the entire financial system was about to collapse right in front of us. Nevertheless, the G-7's assurances that there is not going to be a repeat of Lehman Brothers have assuaged these fears. Don't worry, though, we're still in for a nasty recession and there is plenty of pain to come on the markets. In any case, I guess Citi and Morgan Stanley won't end up going bust after all, but as I called it, they are probably going to receive some huge government equity injections. Still, these government bailout plans raise a lot of questions. Firstly, who are they going to bail out? Secondly how are they going to bail them out? With equity injections? With what kind of equity injections? Common? Preferred? Warrants? Finally and most importantly, will the participating governments be granted voting rights in the companies they are bailing out?

As the past few months have certainly proved, investment banking is inherently a very risky business. While risk-taking shareholders of even currently profitable firms like Morgan Stanley and Goldman Sachs have been fleeing en masse over the past few months, due to the riskiness of the assets. How will more conservative national governments feel about being on the hook for a prop trader's losses. Then there are questions about banks' derivatives business. While I personally think the dangers of derivatives are seriously overstated, many misinformed politicians and journalists have been constantly railing on them over the past few weeks. How do you think some of these politicians will feel about supporting a bank's derivatives operations after a bailout? It's no secret that business and government tend to work best when separate. If you want to argue with that, take a look at Russia. Even if the federal governments around the world buy up preferred shares with no voting rights, they are about to pony up a bunch of money. It's quite natural for them to be concerned about losses as they will ultimately be the ones paying for them. There are certainly more than enough politicians out there in the world, who want to curb the "reckless and irresponsible behavior that led us to this crisis." (I am not even going to bother addressing that assumption. While in the long term, this government intervention will likely be far better for the world economy than the alternative, there are still many questions about how this will reshape the banking system of the future.

The Problem with Palin

I've decided to change gears a bit for this post and focus on politics, since it is election season and all. As you may notice, I've shied away from politics, as I generally try to write about things that few other people are writing about. After all, it's nice to be able to inject a fresh idea into a conversation, and what hasn't already been said about the elections? In any case, anyone who has talked to me recently probably realizes that I am not a huge fan of Sarah Palin. I've heard that in elections people base their decision more off their ability to identify with that person than anything else. For high offices, we generally try to chose people who exemplify the best values of our country, however, those values are extremely subjective. Palin was clearly chosen, in a deeply cynical move, to capitalize on this identity factor. The issue with Palin, however, is what she represents and how she is being used as a divisive force in American politics.

Sarah Palin epitomizes many of the ideals that conservative Middle-Americans hold dear. She is militantly pro-life. She places an enormous amount of faith in some fairly wacky offshoots of Christianity. But more than anything else, to Middle-Americans, she is "One of us," a typical Middle-American working mother. Like most of the American base, Palin is not some high fulutin' Ivy-League grad, and like most of the American base, her grasp of the issues is at best tenuous. Palin's ignorance prevents her from being able to make insightful comments on issues of foreign policy or the economy, argueably the two biggest challenges the next American president is going to face. Instead she falls back on cheap, but quaint sound bites. While Obama's nuanced understanding of the problems America is facing is at best unappreciated and at worst resented by the average American, Palin relies on language that every American can understand, employing feel good rhetoric about jobs, the American dream and the evils of terrorists and Wall St. In short, the average American is reassured by Palin's ignorance.

America is currently in a very difficult place in the world. Our entire financial system is on the verge of insolvency, world opinion has turned drastically against us, due to the bullying, unilateral nature of our foreign policy, and our government deficit is expanding, threatening the dollar and the American way of life. These are all very complex problems that require intelligent and pragmatic solutions. Many Americans feel left out of political process, due to the complexity of these issues. It takes years of study to develop an informed opinion about the issues facing their country, and most Americans plain and simply can't be bothered. Understandably, people have jobs, families, friends, which are more important to them than trying to figure out the nuances of America's relations with Saudi Arabia. Also, for a person to be interested in a subject, there often times has to be a degree of relevance, and most people simply can't see how what happens 10,000 miles away is relevant to their daily lives. To many of them, the score of the OU football game is more important in their daily lives, and the explanation that, "The terrorists hate us because of our freedom," suffices. Palin was chosen specifically to appeal to this uninformed and uninterested element of the United States' electorate.

While living in Oklahoma, one of the first things I noticed was a deep-rooted resentment towards intellectualism. As my boss put it, once you get 100 miles away from the coast, people stop caring about foreign policy and all that. Rather, in Middle-American society, there is a greater focus on traditional moral values, like religion and family, and an education merely serves as an agent or moral confusion. Many Middle-Americans view the coastalites as overly intellectual, sacrificing core values and hard work for cushy jobs. There is also a degree of resentment and jealousy inherent in Middle-Americanism, directed towards the educated, elite establishment in New York and Washington. To these people, Palin represents the great white hope. As she has not allowed education to interfere with her core values.

Palin was selected to stand in direct opposition to Obama and Biden. By selecting her, the Republican party has effectively politicized the issue of intellectualism, setting a very dangerous precedent for America. At a time when America needs prudent, pragmatic and intelligent leadership to help undo the damage of the disastrous Bush administration, intelect, the very tool necessary to dig us out of this mess, is under assault. Palin's candidacy is dangerous, because she is purely a divisive force and an instrument of class warfare. At a time when Americans need to work together, she is creating a gulf over issues of class, education, race and religion, all in a cynical play for power. While Sarah Palin may be an idiot, I can't necessarily fault her for that. I do however fault the Republican party for using such an cynical tool to discredit one of the core values necessary for a president.

The Great Derivative Hysteria

Recently, I've been hearing a lot of nonsense in the media regarding the role derivatives played in the current crisis. For instance, in a truly ridiculous piece, Katerina Vanden Heuvel of The Nation suggests that there was some woman working under Greenspan, warning about the dangers of derivatives who was silenced, and her voice could have saved us from the current mess we find ourselves in. In another piece, Bernie Sanders, the socialist senator from Vermont, also seems to suggest derivatives are somehow responsible. The highlight of Sanders' piece is the following quote:

"This bill does not deal at all with how we got into this crisis in the first place and the need to undo the deregulatory fervor which created trillions of dollars in complicated and unregulated financial instruments such as credit default swaps and hedge funds."

Both Sanders and Vanden Heuvel are clearly very bright people, but their ignorant pontificating about finance merely serves to obfuscate the reader as to true nature of the crisis and realistic solutions to it. In reality, derivatives have only played a small role in the crisis to date. AIG is the only company that has gotten into trouble with them, and at that their inability to raise money in the capital markets to pay off claims on their derivatives was what did them in, not the actual derivative contracts themselves. As I have stated countless times over, this crisis was the result of 20 years of reckless monetary policy. Investment banks are over-leveraged. The American consumer is over-leveraged. One sixth of American home owners have negative equity in their homes. Are you trying to tell me that derivatives are responsible for this, or was this just the bursting of an asset bubble? While this is not to say that derivatives should not be subject to greater regulation, the fact of the matter is there are many more important and pressing matters right now than the regulation of derivatives. Focussing so much on derivatives merely draws attention away from more pressing matters.

A lot of people are confused about what derivatives actually are. Collateralized debt obligations (CDOs), while complicated, hard to value structured products, and mortgage backed securities (MBS), while difficult to value, due to the inability to predict the future, are not derivatives. In both cases, you actually own a piece of the underlying mortgage. CDOs are essentially pieces of many different securities, mortgages and other forms of debt, which are chopped up and reassembled in the form of a tradeable security. While extremely complex, due to the amount of structuring, a CDO holder still ultimately owns a portion of the debt. Mortgage backed securities are simply mortgages have been transformed into bonds and are freely traded. Banks and investors are having trouble valuing them, because nobody can accurately predict how much further house prices are going to drop and how this will affect default rates amongst homeowners. In effect, CDOs and MBS are just iterations of traditional publicly traded debt securities, like corporate bond and government bonds. While a lot of companies that have gotten into trouble with CDOs, both Lehman Brothers and Bear Stearns, the two banks that really failed, had almost none on their books.


Derivatives are something different and generally fall into three categories: options, futures and swaps. Options are just an option to buy or sell a security at a certain time. The option is just that, as in you don't have to actually exercise it. They are generally very useful for hedging trades, as if a security drops significantly, an investor holding a put option, an option to sell at a certain price, can sell off the security at above market rates, thus cutting his losses. Futures are simply contracts to buy or sell a certain asset at a certain time in the future. Finally, swaps are the most complicated one, but for the sake of brevity, let's just say they are a string of futures tied together, which can last up to several years in the future. From a lot of what I have been reading, it seems like a lot of authors are referring to credit default swaps (CDS). Credit default swaps are essentially insurance contracts for bonds. An investor agrees to pay a counterparty a certain amount of money over a certain amount of time to insure bonds that they are holding. There are currently about $58 Trillion of credit default swaps outstanding. Credit default swaps are long term contracts between two counterparties, lasting up to several years, however traders rarely hold positions for more than a few months. When a trader wants to exit a CDS position, the trader cannot simply sell the CDS off as they would a stock, bond, option or future. They are on the hook for the whole length of a contract. Therefore, in order to exit a position, a trader generally buys or sells a credit default swap of a corresponding term to net out the trade. As a result, the true net exposure to credit default swaps is only a fraction of that $58 Billion.

Nevertheless, the main concern with CDS right now is that the market is completely unregulated. Anyone can sell credit default swaps, regardless of whether or not they have the financial strength to pay off the contract in the event of a default, thus setting off a domino effect of defaults amongst counterparties. While this is a legitimate fear, I think to some extent it's a bit overstated. For one thing, no investment bank or broker worth their salt would allow significant exposure to some rinky-dink hedge fund, known for making wild bets and lacking the capital base to cover them. Secondly, while a counterparty default would result in losses for the fund or bank that traded with them, I doubt that these losses would be catastrophic in most cases, as hedge funds tend to try and be pretty diversified to avoid such an event wiping them out. We have also already gotten through $400 Billion of Lehman Brothers debt defaulting and several billion dollars of CDOs and MBS defaulting without too huge problems, outside of the monoline insurers and AIG. While there will probably be more losses tied to CDS in the future, I doubt it will result in the financial apocalypse some in the media are making it out to be.

Derivatives seem like an easy target for critics, due to the size of the market and the fact that they are so esoteric. Nevertheless, derivatives did not cause the current mess that we are in. While there is definitely a need for greater regulation in the CDS and other derivative markets, there are more pressing concerns right now, like ensuring the entire global banking system does not become insolvent in the next six months. Making misinformed attacks against the derivatives market is completely counterproductive, as it merely distracts from the true problems at hand. Finally, despite the fact that I am extremely opinionated and quite vocal about my opinions, I have generally found it best to keep my mouth closed when I don't know what I am talking about. I would recommend many of these editorialists do the same.

Wells Fargo's Gamble

Yesterday it was announced that Citigroup is backing out of its plans to acquire Wachovia, ceding the company to Wells Fargo. Nevertheless, Citigroup intends to pursue their $60 Billion lawsuit against Wachovia and in turn Wells Fargo. While the sum Citi is seeking may seem a little ridiculous, this is a case with strong precedents, most notably Penzoil v. Texaco in 1987, and Citi has a good chance of extracting some serious cash from WFC. On top of all that, it turns out Wachovia may be expecting much greater losses on its loan book. Has Wells Fargo's mangement lost its mind?

Citibank is in really rough shape right now. Their balance sheet is downright scary for one. Even with the TARP, Citi is in a boat load of trouble. Any litigation for a sum this large would be a very lengthy process. $60 Billion would certainly shore up Citi's balance sheet. The question is whether Citi can wait that long. If Citi were to file for Chapter 11, Wachovia would be released from any agreements, thus nullifying the lawsuit. The one question remaining is if Citi ends up in conservatorship, will the government decide to pursue the lawsuit?

Can You Say Death Spiral?

This morning (American time), an hour and a half before the markets opened, I sent my sister an email. The European markets had all posted modest gains, and futures on all US indicies were in positive territoy, indicating that traders in Europe thought the US market would finally break it's losing streak today. Nevertheless, in my email, I wrote, "Watch this, everyone thinks the markets are going to go up today, but they are going to end up down again." When I left to go have some dinner with my friend Tanya, the Dow Jones was in modest negative territory. Now that I've come back 3 hours later, I find that the index has plunged almost 700 points and has destroyed the 9,000 point milestone, closing around 8,600. The first time the Dow broke through 8,600 was in some time in the Winter of 1998, over 10 and a half years ago. Today's market reaction confirms something I have suspected for a few days. We are no longer in a normal correction, now we are in a death spiral.

Over the past couple weeks, there have been quite a few positive developments,from the passing of the bailout plan, to the coordinated rate cuts, to the Fed's move to start buying up commercial paper to take the strain off the money markets, which would normally, at the very least, spark a rally on one of those days. However, the Dow and the S&P have experienced significant declines for 8 straight days. After the Fed's October rate cuts, the Dow hit its high of around 14,100, even after the credit crisis had began. These haven't been small 100 point declines either. Every day, since September 30, except for one has marked over a 100 point decline. All told, the Dow has declined over 2,000 points in 8 trading days. While many in the media have been chalking the markets' recent performance up to investor fear, there is clearly something greater at work here, given how oversold the market is. Surely some intrepid investors would see this for the buying opportunity it is and stick their necks' out.

While people often times view the stock market as a reflection of the economy, it is wrong to the markets' recent performance and try to generalize it to the economy as a whole. While America will definitely experience a severe recession and maybe even a depression, current market forces are currently divorced from economic realities as in any death spiral. A death spiral occurs when the market suddenly plunges. Investors, who were investing using significant leverage are then forced to make margin calls, selling off assets to prevent their brokers from siezing their assets. These sales drive asset prices down further, resulting in a positive feed back loop with more sales resulting in more margin calls. While investor fear and uncertainty have certainly played into this death spiral and exacerbated it, they are not necessarily at the root of this. Over the past few years, as hedge funds have proliferated, the amount of leverage in the capital markets has increased dramatically, thus resulting in a greater possibility of a death spiral.

To date, hedge funds, high-risk, investment vehicles, have been perfoming poorly, despite their claim that they can return a profit in any market. The average fund was down about 10%, at the end of 3Q, before this mess started. So when, September 30, the end of the third quarter, rolled around, hedge funds were hit with a wave of redemptions from investors. To meet these redemptions, hedge funds have been forced to sell off assets, depressing the market. Note the latest streak of declines began on September 30. These assets sales have bloomed into a full blown death spiral, as hedge funds attempt to close positions, to preserve their investors positions and are hit with margin call simultaneously. No amount of positive news or investor sentiment can stop this wave. It will just continue to roll, until all the hedge funds are able to meet their investors' redemptions.

An Odd Bet

A couple summers ago, when I was driving cross country, I stopped by for a night to stay with my friend Jarred, who is a medical student at the University of West Virginia. I hadn't seen Jarred since I left for Russia, but in my first two years of college, Jarred was one of the people I always enjoyed the most, due to his cynicsm, sense of adventure and dark sense of humor. Jarred had spent a summer in Africa getting himself into all kinds of trouble, just as I spent a year in Russia. There he acquired a deep interest in infectious diseases. While I met him, Jarred was had just started on a gap year in his medical studies to get a masters in infections diseases at UVW. To no one's suprise after the requisite catching up and a few beers to boot our conversation took a bit of an apocalypic turn. Jarred and I made a bet. I bet Jarred that there would be a nuclear war involving Pakistan, before the next major epidemic of some infectious disease, a la the Spanish influenza epidemic following WWI. Today, I think I am one step closer to winning that bet.

To be completely honest, I don't know very much about Pakistan. I am certainly no scholar of the Indian Subcontinent. I had a Pakistani roommate for about 3 months in Oklahoma and he gave me a bit of a superficial glimpse into Pakistani society. Apparently, Pakistan is only one of two nations on Earth created on the basis of faith, nationality be damned, the other being Israel. As a result, Pakistan is a very ethnically diverse nation, with a number of indigeonous tribes competing for power, as well as the recent immigrants from India proper. War Nerd at the exile provides a brief history of the country here. Then there is the poverty issue. Despite a lot of economic promise, Pakistan remains a pretty poor country. In October 2007, the IMF estimated that the country's per capita income will likely stand at around $2,600 in 2008, 128th in the world, that is assuming all hell doesn't break loose. However, like in all emerging markets, even this meager wealth is not evenly distributed, resulting in a substantial uneducated and impoverished segment of the population and a small, wealthy minority. As a result, despite Pakistan's recent economic growth, there were even rice riots in the streets earlier this year as food prices surged.

As if this alone wasn't a formula for instability, Pakistan also finds itself in a unique position in the world given the geopolitical backdrop in the world surrounding it. There seems to be strong division in Pakistan about which direction to take the country in. On the one hand, you have a pro-Western wealthy minority that has signficantly benefited from the nation's recent economic growth. On the other hand, you have a mass of devout, conservative Muslims who would reject Western values and place greater sympathy in more Islamist circles. Quite naturally, Pakistan has a history of bloody coups and power struggles, like the one that brought Musharraf to power. For years America supported Musharraf, a typical third world dictator, in order to keep the more violently Islamist elements of Pakistani society in check. America's recent adventures into Iraq and Afghanistan have only served to widen the chasm between these two groups. Pakistan's recent elections clearly highlight the division in the country. While at the end of the day Pakistanis elected the pro-Western Zardari it was by no means a bloodless affair and the divisions in Pakistani society still remain. The country is a powder keg just looking for a spark, and this financial crisis just might provide it. Oh, and I forgot to mention the scariest part: THEY HAVE NUCLEAR WEAPONS. Not to mention the fact that they've had three wars with India since independence and the issue of Kashmir is still not resolved.

Despite Iceland's recent headlings in the news, it seems like Pakistan's woes have somehow sneaked by the Western media. Pakistan is neck and neck with Iceland in the race to see which sovereign defaults first, having recently had its ratings slashed by S&P to CCC, only a few levels above default. Living in a country that defaulted on its foreign debt 10 years ago, I realize there is nothing as economically destructive as a default. The currency plunges, wealth people had been accumulating for years is instantly worth nothing, banks don't lend, can't lend and go bankrupt, inflation runs rampant and the general economy goes into a nose-dive. On top of all this, Pakistan's current financial woes are at least partially the result of a knock-on effect, stemming from the US's financial crisis. There could be no better way to discredit the Western-leaning politicians, just as Russia's liberals were completely and utterly discredited by 1998, leaving the most militant Islamist voices as the most trustworthy in the society.

Unfortunately, it seems like the odds have just swung in my favor.

Is Morgan Stanley Next?

If you go to take a look at Marketwatch.com's bond page, the answer to these question seems pretty apparent. Almost all of Morgan Stanley's bonds are yielding in the low to mid-20s. God only knows how they are going to roll over their debt and one what terms, with the market expecting those kind of yields. Furthermore, what could they possibly profitably finance with a 24% yield? Short answer: Nothing. Then there is MS's recent stock performance: down 25% today and 74% for the year, and today's action was with the short-selling ban in place! On top of all this, at least a third of the firm's hedge fund clients have deserted it. The market seems doesn't merely seem to be suggesting what's in store for Morgan Stanley; it's shouting it with a bullhorn. So how did we get here?

Morgan Stanley is one of the most strongest and respected names on Wall St, a descendant of JP Morgan's banking empire. Up until Goldman's Ascension in the 1970s, the firm was Wall St.'s undisputed reigning champion. This strength is the only reason MS is still alive today. Nevertheless, the market's seem to have spoken, independent broker dealers are to be no more. Despite it's vaunted name and it's been able to remain profitable through all of this, Morgan seems to be the next victim in line. There are four things that are ultimately bringing down MS, the same three things that brought down Merrill, Lehman and Bear: leverage, a lack of access to deposits, a mismatch between between asset duration and liability duration and most importantly.

Leverage, while at one point the darling of Wall St., has now become its undoing. During the Greenspan years of easy credit, MS loaded up on debt, like its Wall St. brethren. As of its latest earnings release, Morgan Stanley's assets to tangible equity stood at 30.6x. So, if the firm's assets were to lose around 1/33rd of their value, it's goose would be cooked. On top of that, MS relies heavily on short term debt for funding. Around 14% of the firm's assets were funded through the short-term repo markets. Also, since MS is an investment bank, it has no access to cheap, stable, long-term customer deposits. And finally, and most importantly, no one trusts them. After Lehman collapsed, it came out that they had signifcantly over-valued their commerical MBS portfolio. Who is to say that MS isn't doing the same?

While Morgan Stanley's deal with Mitsubishi Financial and their conversion to a bank holding company seemed to offer a stay of execution, all of this seems to be a bit too little too late.

The Puzzle of Russian Nationalism

In case you haven't noticed, in the past few years, Russia has truely re-emerged on the world stage in the capacity of an energy superpower. While many discounted Russia in the 1990s as a has-been, never to reclaim its crown as a major player in world affairs. However, since Putin has assumed power, the country has undergone an economic renaissance. Moscow currently is one of the wealthies cities in the world, hosting the most billionaires if nothing else. Quite naturally, Russia's resurgence has stroked both the flames of domestic patriotism and Western fears; especially in light of the fact that Russia wants to be accepted on its own terms. Simply put, Russia has always followed its own developmental trajectory. They missed out on the Reformation and the Enlightenment and only caught a whiff of the tail-end of Romanticism. While European Monarchies began adopting constitutions in the 19th Century, Russia only abolished serfdom in 1861 and maintained it's autocratic government up until Revolution was already knocking at its door. Then of course, there was the whole experience with Communism. To a large extent, Russia's faith, whether it be the Orthodox Church or the Communist government, has always isolated it from the rest of Europe. While Russians are racially European, this country is by no means European.

A few weeks ago, I went over to a close friend's apartment to have a few beers. There I met another good friend of his, who worked in a state-run corporation in procurement or something. Now, one of the joys of living in Russia, especially in light of the recent tensions, is getting to listen to a lot of crack-pot, nationalistic, conspiracy theories about America. It seems like a lot of Russians do little else aside from sit at home and mull over their hatred towards America, waiting for the first foreigner to spring on. Unfortunately, a lot of the time, I am that foreigner as my friends are mostly Russian. In any case, within five minutes of striking an acquaintance with this friend, the conversation immediately turned to the Federal Reserve and a barage of standard, run-of-the mill conspiracy theories about it being a cabal, controlled by the Wall St. bankers, etc. Trying to explain monetary policy in English is difficult, but in Russian, it's a nightmare. In any case, the conversation ended up devolving into Russia is a great nation, because Russia has a lot of nuclear weapons, and since Russians have lived in shit for so long, in the event of nuclear war, they will be able to plant potatoes, thus surviving, whereas their pampered American counterparts will all starve to death.

Anyway, over the weekend, I went out for a few beers with the same friend, and the subject of his friend his job came up. Apparently, Russian state-run corporations have a really interesting process for procuring equipment. Rather than going directly to the manufacturers of equipment, goscorporatsi hold tender with a number of middle man firms, who handle the logistics and everything. These companies generally win tender by paying off the employee in charge of the tender and turn around, buying the equipment for significantly less than they sell to their client. Corruption is nothing new in Russia, and this is just one more example in a litany of abuses. Having lived here for 2 years, I've run across quite a few policemen, members of the FSB and other assorted government officials. These government officials are often the first to proclaim their love of the country, and defend it in impassioned speaches. When I naively protested the absurity of the practice, my friend turned around and said, "C'mon man, who really gives a fuck? All I care about is that my family lives well and those around me live well." So much for a love of homeland.

So Wall St. Is to Blame?

As I wrote about in my post the other night, over the past few weeks, as the global financial markets have begun to crumble and the true nature of the crisis we are facing sinks in, the blame game has kicked into high gear. Unsurprisingly there has been an outpouring of politicians, bloggers, journalists and pundits casting blame on "Wall St. greed." This seems particularly absurd to me given the fact that the latest victim of the crisis is Wall St. itself. The independent broker/dealer business model, the cornerstone of Wall St., is dead. Thousands of people working in finance have been lost their jobs and some of America's most renowned institutions have failed. To me blaming Wall St. is akin to blaming the victim for the crime. As I wrote about in the other night's post, the financial sector has fallen victim to the moral hazard of Greenspan's lax monetary policy just as much a the single mother of 3 in Arkansas, who is having her house repossessed, because she was duped by predatory lenders. Had Greenspan been willing to let America endure a recession, the financial innovation that led us to this precipice would likely have been corrected, snuffed out before more serious losses could be incurred.

I can understand the average American's suspicion of Wall St. The name alone connotes so much power and privledge attached to it. When you add in the fact that a measly, 22 year old analyst can make $120,000 a year and a top hedge fund manager can earn in excess of $1 Billion a year, a rural farmer's mistrust is completely understandable. How on earth can they honestly make that much money? Then there are the complex machinations of the stock market, understood in depth by a small minority of Americans. While reading about the debates over the bailout bill, I was struck by the countless errors and inaccuracies made by journalists and politicians, some of the most learned segments of our population. Cheif among them that stand out in my memory was Bernie Sanders, an extremely bright man in his own right, ascertion that we need to regulate complicated financial instruments like credit default swaps and hedge funds. For the sake of brevity I won't explain this one, but suffice it to say, this would be like saying we need to regulate agricultural produce, like jeruselum artichokes and supermarkets, in the wake of an E. Coli outbreak. Anyway, given all of this, it's understandable why most Americans hold a very distrustful view of Wall St. There are trillions of dollars changing hands and no one understands how it is happening.

Nevertheless, I think any conspiracy theories immediately fall apart when you take into a part the size of the Wall St. There are hundreds of thousands if not millions of people working in finance world-wide, representing a broad spectrum of races, religions and political beliefs. One thing people seem to forget is that Wall St. is made up of average people, who, like all of us, are just trying to do their job. Wall St. does not simply consist of a half-dozen cigar-smoking villains out of a Bond movie, but hundreds of thousands of people, who go to work every day and come home to their families at night. I can only imagine the annual meeting of the cabal. Once a year, the overlords of the universe rent out Giant Stadium for a night to discuss how they are going to dominate the world this year and make a fortune on the backs of hardworking Americans. While there is a lot of power concentrated in the hands of a dozen or so institutions world-wide, I think few understand the nature of the business.

Investment banking is the grease that makes the economy function. When a corporation, municipality or even national government needs to raise funds, they rely on investment banks to do so. If a large multinational corporation needed a multibillion dollar loan (or several trillion dollars as in the case with the US government), many traditional commercial banks would be unwilling to lend to them, due to the size of the loan and the risk involved. If a commercial bank were to dedicate a significant portion of their loan portfolio to one individual company, the bank could get wiped out if the company defaulted. As a result any bank would be forced to charge exhobinant interest rates to justify the risk. A cheaper alternative is found in the bond markets. Investment banks effectively hook up companies and governments with the funding they need through equity and bond placements. Since there are more potential investors and thus more competition on the capital markets, investment banks can generally arrange this financing at a cheaper rate, than a company can by going to their local bank. In America, investment banks usually guarantee full placesment of the debt or equity, buying any unsold bonds or shares with their own capital. By selling shares or placing bonds, investment banks facilitate the investments that keep the economy growing and provide jobs, keeping a small cut for themselves. This small cut, however, can be quite large when a transaction is several billion dollars. These bonds and stocks are generally bought by pension funds, insurance companies, mutual funds and more recently hedge funds, helping individuals generate wealth, retire early and ensure that their lives and property are taken care of. In short, investment banking is usually win-win-win for everyone involved. Aside from pure investment banking, Wall St. banks make the majority of their money through investing in these bonds and stocks and providing brokerage services for other investors, facilitating investors and partially supporting the markets for these securities.

In the 1980s, two revolutions swept Wall St., sending it on the path, which eventually culminated in this crisis: the development of proprietary trading and the appointment of Alan Greenspan as the Chairman of the Federal Reserve.

The history of proprietary trading is as old as Wall St. itself. Given the nature of their brokerage operations, investment banks have always been required to have a large number of securities on their books at one time, in order to meet their customers needs. Investment banks also often took a proprietary interest in the securities they were holding, acting as direct investors. During the 1980s, computers first started to deeply penetrate Wall St., allowing traders to analyze securities quicker and in greater depth than they had previously. As a result proprietary trading took off and became a central focus for Wall St. firms. Like traditional commerical banks, investment banks also often loaded up on debt to enhance their returns; except rather than giving comsumer or business loans, investment banks tend to invest in stocks and bonds. Additionally, rather than seeking consumer deposits to fund their activities, investment banks were restricted to placing bonds and other forms of direct loans.

Increasing leverage is the easiest way to increase both a firms profitability and risk. Goldman Sach's shareholders have historically expected Goldman to return around 17% a year, making it expensive for the firm to raise equity to fund its operations. By contrast, Goldman Sach's bonds, depending on their term generally yielded between 5-6.5% historically. Thus firms like Goldman increased their leverage throughout the 80s, 90s and 2000s to increase their return. For instance, in 1996, Morgan Stanley's assets stood at 20.4 times equity. By 2006, this ratio had jumped to 31.8 assets-to-equity. This increase in risk was not the result or reckless behavior, rather it was the result of a cultural shift Wall St. underwent as a result of Alan Greenspan's lax fiscal policy.

A whole generation of investment bankers, now finding themselves in senior positions, grew up under Alan Greenspan and his lax monetary policy. As I mentioned earlier, whenever the economy was teatering on the edge of a recession, Greenspan would pump money into the economy by lowering interest rates. More than anyone else, this policy helped at Wall St., as the investment banks were among the first line of beneficiaries. As the general economy soured, loans and stock prices went with it. To compensate for the potential losses, Wall St. firms were given access to funding at extremely low rates, thus reducing their costs and allowing for them to maintain profitable. Over the course of 20 years, this abnormal economic behaviour began to be taken for granted. As a result, many of these bankers had known nothing buy Greenspan's easy money for their entire careers. Due to Greenspan's policies a massive credit bubble built up under his watch. Just as with any asset bubble, it eventually burst, culminating in the crisis we have today.

In search of returns, in the 1990s and early 2000s, investment banks began to get more directly involved in the US housing market. While traditionally, Americans had relied on savings and loans and other local banks for mortgage financing, many of these were wiped out in the early 1990s Savings and Loan crisis. To fill the void left by the loss of over a thousand of these establishments, Wall St. stepped in, buying debt off of small local banks and mortgage brokerages with limited funding capacity and cutting it up into bonds. At the same time, Greenspan's reckless lowering of interest rates encouraged a massive housing bubble in the United States, just as it encouraged investment banks to leverage themselves. To make matters worse, these investment banks bought many of the mortgage-backed securities that they sold to investors. As a result, as this credit bubble is deflating, it is bringing the investment banks with them, who are posting record losses on their already weak, over-leveraged balance sheets.

Wall St. is not to blame for the current crisis we are in. All the bankers did was over-leverage themselves at Greenspan's encouragement, just like the people who bought houses at the height of the boom. Regulation of the financial industry could not have averted this crisis, rather we needed better regulation of our monetary policy.

Citigroup Drama Continues

As you may have noted in my previous post, I thought, even with the Wachovia deal, Citigroup was in trouble. To make this absolutely clear, Wachovia is not insolvent. There is a good chance they will face solvency issues in the future if the bailout is not passed, but right now they are still in the black. In any case, this morning it was reported that Wells Fargo offered to buy Wachovia for $15.1 Billion, seven times more than Citigroup was offering and without federal assistance. Additionally, as recently as yesterday, Wachovia shares were trading in the $4 range, four times the Citigroup offer. Indiciating that a significant number of Wachovia shareholders were going to oppose the Citigroup bid.

In any case, this begs a lot of questions about the initial Citibank-Wachovia merger. Most importantly, why was the FDIC trying so hard to push this deal through, especially in light of the fact that there may have been better deals out there that did not require government assistance? I previously made the case that Citigroup is pretty weak financially. Above all else, wachovia is a commercial bank, with a strong focus on its retail and small business operations. Despite having asset management and broker-dealer arms, the bank is not much of a player on Wall St. By contrast Citigroup has historically been the big business bank, with very little focus on the retail side. In the past Citigroup has acquired other retail-focused banks with a strong emphasis on small and medium-sized business lending, but has failed to integrate them. Whenever Citi gets its hands on a new bank, Citibank usually ends up diverting their assets to Citi's core Wall St. activity, completely ignoring the retail and small and medium-business lending of their recent acquisition. See the European-American Bank for instance. Additionally, dating back to the Citibank-Travelers merger, Citi has done an awful job integrating mergers. In short, very few synergies would have likely resulted from the Wachovia-Citibank merger. In that sense, the Wachovia-Wells Fargo merger makes much more sense, considering their business lines are so similar. From a strategic standpoint, the Citi-Wachovia merger just doesn't make much sense.

Another question is why was the government willing to providing backing for the Wachovia deal when they had previously let some pretty big players fail. As you may remember, the government refused to provide any backing for potential acquirers of Lehman Brothers, resulting in not only the firms bankruptcy, but also the end of several hedge funds and chaos in the money markets. That seems to me to have caused quite a deal of systemic risk. According to the terms of the Citi-Wachovia deal, Wachovia shareholders would be paid with shares of Citibank stock, with no cash changing hands, thus leaving Citibank's balance sheet in tact. Additionally, the FDIC would assume any losses over $42 Billion, possibily stemming from Wachovia's adjustable rate mortgage book. Citibank would have also gotten its hands on valuable deposits at a time when credit markets are frozen and banks are having trouble rasing debt. A failure of Citigroup, one of the three US Mega-banks, with $2 Trillion in assets, would have posed a far greater systemic risk than Lehman Brothers' $600 Billion failure or an $800 Billion failure of Wachovia alone. The fact of the matter is the Wachovia-Citi deal had very little to do with Wachovia's survival. The FDIC pushed it through for the sake of Citi's survival, at the expense of Wachovia's shareholders.

One futher question is what took Wells Fargo so long to push this deal through? Why didn't they jump on this deal over the weekend, rather than wait a week to snatch it from Citibank and face possible litigation? Citibank is indeed going to pursue litigation. Warren Buffet is Well Fargo's main shareholder, with around 10% of the company's stock. Recently, Warren Buffet went on a spending spree, buying $5 Billion in preferred shares from Goldman and $3 Billion in preferred shares of GE, with warrants for a corresponding value of common shares. In an interview on MSNBC, Buffet was asked how the bailout plan affected his decision to buy these companies. Buffet responded frankly, admitting that if the bailout plan is not passed, he has done a very dumb thing. The bailout would present Wachovia an opportunity to unload some of their toxic ARMs, perserving the solvency of the company. Seeing that the bailout was about to pass, Buffet may have asked the management of Well Fargo to jump into the fray offering a bid.

Being American Means You Don't Have to Suffer

Recently there has been a lot of finger pointing going around about who is to blame for the crisis. A lot of people point to the Wall St. banks, but this is ridiculous in so many ways. I will address it in another post. Suffice it to say they are the victims of this crisis just as much, if not moreso than anyone. Some say it was the bond rating agencies, who mispriced the risk in order to get deals, or the predatory lenders, who gave mortages to people who couldn't afford them. While no doubt, they both had more than a little to do with this, they are probably more a symptom than the actual problem. Then there are the people who claim it was Greenspan, in a sense they are right. As far as individual people go, the blame resides more with Greenspan than anyone else, but ultimately the blame falls upon the American consumer and American society.

The United States was founded on the principles of the enlightenment. Chief among the aims of the enlightenment was to eliminate suffering through the use of reason. The Enlightenment grew out of the backdrop of 18th Century Europe, a continent that had been savaged by religious wars between Protestants and Catholics since the start of the 30 years war in 1618. America was founded as a reaction to the brutality and intolerance found in Europe during the 18th Century. A land of democracy, where all would be equal. This has worked pretty well to this date. Sure there have been hiccups along the way, Civil Wars, Great Depressions and such, but the ingenuity and the individualism that this system fostered gave birth to a great country. Around the 1980s, however, Americans view of what it meant to be an American became perverted.

American society up until that point was one, which demanded prudence and self sacrifice, but with the coming-of-age of the self-indulgent baby boomer generation, America shifted from being a society where the merit of a man was judged by his moral integrity and steadfast character, to one where the merit of a man was based upon his possessions. Perhaps more importantly, though, the baby boomers had grown up in a period of unprecdented stability. Despite the Vietnam War and the Oil Shock of the late 1970s, Baby Boomers never suffered the World Wars, Civil Wars or massive depressions of their predecessors. Additionally, they were born in the late-1940s and 50s, the birth of the era of convenience.

The Cultural Wars of the 1980s added a degree of moral ambiguity to American society, which had never before been present before. As a result, many Americans abandoned the pursuit of the "moral path" and searched for affirmation in more material things. As the society of consumption developed and won out over traditional American values, competition between neighbors was fostered over who had the newest gizmo, the nicest house, the biggest TV. The warped perception was born that a nice car and a big house were a birthright of every American. In short, being American began to mean never having to suffer. If a person failed to meet up to this standard, they had somehow failed their patriotic duty. Convenience became the other order of the day. Rather saving and striving for goals, Americans demanded all their wishes fulfilled right now.

To fund this new life style, banks began making credit cards more readily available. "If I can't pay for it now, I'll pay for it tomorrow," became the battle cry. While credit cards when used with discretion are certainly an extremely valuable financial innovation, in the hands of an undisciplined holder, they can spell financial death. As a result, Americans began comitting financial suicide for the dream of the new house and that nice, shiny Mercedes. However, rather than trying to check these practices, from 1987 onward the Federal Reserve would merely encouraged irresponsible spending, ultimately sending us down the road to the financial disaster that we see today.

In 1987, Alan Greenspan became Chairman of the Federal Reserve, succeding the Paul Volker, one of the greatest and most pragmatic central bankers in the history of the US. Within only 2 months of taking office, Greenspan would face his first crisis on Black Friday, August 11, 1987, when the Dow Jones Industrial Average plunged 22.7% in one day. To try to prevent further deterioration of the economy, Greenspan acted by lowering interest rates and pumping liquidity into the economy, a move that would become his trademark. The Greenspan Put.

Monetary policy is one of the trickiest, least understood, but most vital aspects of economics. The Federal Reserve was designed to serve as a politically neutral moderator of the US economy, ensuring that the economy never grew too quickly, resulting in nasty asset bubbles and inflation, nor suffered a too severe recession. On both these accounts Greenspan failed miserably. The Fed Reserve's chief weapons in their arsenal are control of the nations interest rates and money supply. By lowering interest rates and increasing money supply, the Federal Reserve allows banks access to more money at cheaper rates in times of economic hardship. These banks in turn are able to lend this money out to more consumers (through mortgages, consumer loans and credit cards) and more businesses (through traditional business loans and corporate bonds) at lower rates, resulting in greater consumer spending and more capital expenditure, thus reviving the economy. In times when economic growth and inflation are too high and unsustainable, the Federal Reserve can raise interest rates, thus slowing down the flow of money to banks and cooling down an overheating economy, thus preventing the formation of asset bubbles.

Throughout Greenspan's 17 year tenure, many hailed him as the patron saint of the United States' economy. Whenever the US economy was at risk, Greenspan would slash interest rates and let the money supply faucet roar, providing cheap credit. To salvage the US economy, Greenspan would effectively pump debt into the economy at cheap rates to encourage spending. The cheap credit available, whenever the US economy came into a recession merely encouraged America's addiction to debt. Whenever America would be teatering on the edge of a recession, Greenspan would bring it back from the precipice ensuring a soft landing.

One of the key things Greenspan misunderstood was the usefulness of a recession. Whenever an economy goes through a period of rapid growth, asset bubbles form as resources are misallocated. Additionally, many business practices that are not sustainable in the long term thrive. In a recession, however, many of the indulgences of the previous period of growth come to an end, and the economy is forced to rebuild itself in a more sustainable fashion. During recessions the seeds for the next boom are sewn as people are forced to get creative. Nevertheless, by constantly propping the economy up whenever America was facing a slowdown in growth, Greenspan failed to let economics take its natural course. He failed to let the markets right the wrongs of inefficient businesses and he encourced asset bubbles, most notably the current credit bubble we are seeing today. Rather he loaded the economy with debt to delay the inevitable. Like so many of his time, Greenspan was failed by the illusion that being American meant never having to suffer.

The straw that broke the cammel's back came in 2001 with the deflation of the internet bubble. For the better part of the 90s, computers were hailed as the greatest revolution in human history, and they were certainly revolutionary. Seeking to cash in on this new wonder, many investors wrongfully allocated resources to firms that had at best dubious prospects. Naturally in 2001, the bubble burst and many investors lost money. The United States entered into a fairly minor recession, as the economy corrected the overindulgences. Rather than letting the economy take its natural course, however, Greenspan lowered the Fed Funds rate to 1%, a ridiculously low level and kept it there for a year. Additionally, he encouraged banks and consumers to invest in housing, a quite bullish sector that had been left unscathed by the deflation of the internet bubble. In doing so, Greenspan ensured the growth of the current housing bubble and it's eventual bursting, leaving us with the crisis we have today. To merely call this a housing bubble misses the point here, though. This was a credit bubble. The issues were not with Wall St. Greenspan's easy money led Wall St. banks to load up on debt to ridiculous levels, something they are paying greatly for now. As the credit bubble is deflating it has been taking Wall St. with it. If it hadn't been housing and the over-leveraged financial sector, it could have just as easily been an over leveraged corporate sector. The issue is the amount of debt in the American economy and the fact that Greenspan made it too easy for too long, resulting from the belief that being American means you don't have to suffer.