"It is commonly argued in America that if the housing bubble were to burst, and falling house prices threatened to choke consumer spending, the Fed would slash interest rates to prop up the economy, as it did after the stockmarket bubble popped in 2001-02. But then inflation was falling. Today, with inflation rising, the Fed would no longer have that option. If the economy hits trouble, investors and homebuyers should not expect to be bailed out again."

"They found that as the number of fine particles less than 2.5 microns in diameter increased, so, too, did the risk of dying: each jump of 10 micrograms per cubic meter corresponded to a 11 to 17 percent increase in the risk of dying from any cause."

"The average concentration of total suspended particulates (TSP) in the city in 1998 was nearly 600 micrograms per cubic meter, according to the World Resources Institute. Local health experts say about 80 percent of Taiyuan’s suspended particles are "respirable" (less than 10 microns in diameter). This would imply the average concentration of lung-damaging PM10 is more than 450 micrograms per cubic meter — nine times the U.S. standard for annual exposure. Add in high levels of SO2 and nitrogen oxides (NOx) and Taiyuan’s composite air pollution index regularly tops the list among China’s 42 major cities."

Leptin promotes inflammation. The hormone provides an interesting link between obesity and pathophysiological processes such as insulin resistance and atherosclerosis, and disorders such as autoimmune and cardiovascular diseases and the metabolic syndrome. Increased serum leptin levels in obesity and metabolic syndrome support the view that these disorders are in fact low-grade systemic inflammatory diseases, characterized by increased concentrations of proinflammatory cytokines like interleukin-6, tumor necrosis factor and leptin. Leptin's proinflammatory role suggests that it may link energy homeostasis to the immune system.

 
Here is yet another chart which should boggle your mind. What we have here is a display of the relationship between foreign buying of U.S. Treasuries (i.e. our Federal Deficit) and the interest rate our government pays buyers of that debt. As you can see, as foreign buyers were increasingly snapping up prodigious quantities of U.S. bonds--to the tune of $400 billion a quarter last year--then interest rates dropped. (Note that this chart reverses the usual format and places higher interest rates at the bottom of the chart.)

Simple addition is all that's needed to draw several sobering conclusions from this chart. First, let's add the $200 billion our nation spends in Iraq every year (if this is for a lousy $20 billion in oil annually, what a crummy deal) to the $200 billion promised for Katrina rebuilding by our President. That's $400 billion. Even before Katrina, the deficit was nearly $400 billion annually, so even if we weren't in Iraq we would still be running a nearly $200 billion deficit just to fund all the tax giveaways, costly (and mostly ineffective) drugs for seniors, and the rest of the money our free-spending leaders lavish on various interest groups (generally wealthy ones).

So let's round it all off to $600 billion in deficit spending. Our wonderful friends, the central banks of Asian nations, have most generously picked up the tab for the last $1.5 trillion or so of our public debt, but they appear to be getting tired of supporting our spendthrift ways, judging by the fact that their quarterly buying has dropped from $400 billion a quarter to a mere $100 billion. Four times $100 billion equals $400 billion, so gosh, it looks like we might have to fund $200 billion ourselves. Oops, the U.S. has a negative savings rate of .6%. Dang, with no savings, it might be hard to buy our own bonds. What a bother.

And who would be stupid enough to lose money by buying a Treasury bond, anyway? Producer Prices rose at a 7% annual rate in August, before Katrina, and we're paying bond holders a miserable 4.25%. Adjusted for inflation, they're actually losing money. Do you reckon we'll have to raise interest rates to something above inflation? In a rational world, the answer is yes.

So why have foreign central banks been so foolishly keen to keep buying our Treasuries? The answer is not easily reached. The usual reason given--Asian central banks recycling their trade surpluses in order to suppress the value of their currencies--turns out not to be supported by data (see this article in The Economist). While those are probably factors, it seems Asian governments may also be holding huge reserves as insurance against another Asian financial crisis of the 1997-98 sort.

One trend is certain: these banks are buying less and less of our debt, even as our political leadership revves up hundreds of billions more in deficit spending. It is difficult to foresee any outcome to this divergence other than rapidly increasing interest rates. And with higher rates, the Great Housing Bubble finally implodes, taking with it the entirely bogus "prosperity" which it spawned. The chickens are in sight, and they appear to be heading home to roost.


September 16, 2005


Is Risk Being Eliminated, or Merely Increased?


A front-page article in the September 12, 2005 Wall Street Journal outlines how mathematical formulas are employed at the highest levels of finance to reduce risk via trading derivatives. The technique is widely used to lower risks in portfolios of stocks, bonds, currencies and commodities as a form of "insurance:" if one part of the portfolio tanks, then the derivative "insurance" (actually a bet in the opposite direction) rises in value, offsetting the loss.

Being financial instruments based on other financial instruments rather than on something with intrinsic value such as a bond or share of stock, derivatives are hard to grasp. Owning a derivative is not the same as owning an actual bond or stock, and as such they can be created out of thin air by financial institutions.

The WSJ article describes how a new algorithm has spurred the rapid growth of bond and mortgage derivatives (see chart). The piece goes on to note that despite the stated goal of lowering risk, the derivatives have the potential to trigger a cascade of financial mayhem should things go wrong.

The person who devised the new formula, David Li, says of it: "It's not the perfect model, but there's not a better one yet." This begs the question: how good is any model?

The answer can be found in a seminal if generally overlooked book by mathematician Benoit Mandelbrot, he of fractal geometry fame, entitled The Misbehavior of Markets. Turning his analytic eye to the stock market, Mandelbrot found an uncanny resemblance between the charts of actual stocks and the semi-chaotic meanderings derived from fractals.

Suspecting that markets may follow a fractal pattern, Mandelbrot examined the "standard model" of portfolio risk management (that is, the one using derivatives as insurance) and found that these standard models did not match the actual behavior of markets.

More specifically, they made no allowance for the rapid, sudden swings up and down which are inherent in fractal geometries and actual market behavior. The odds of a sudden fall-off are tiny in the standard model, yet in real life huge drops occur with startling regularity: the Asian Criss of 1997, the Russian Default crisis of 1998, 9/11/01, and so on.

The takeaway from Mandelbrot is simply this: the standard model of portfolio risk management completely underestimates the risk of sudden, violent downturns in markets.

Interestingly, the WSJ article highlights a "close call" of just the type unanticipated by the standard model. A downgrade of GM bonds last year nearly triggered a meltdown in the bond derivative market, as the model ties all sorts of bond risks together in a chain of "tranches," or degrees of risk sold to different investors.

In other words, the story of this new model and the near-collapse of the derivatives it has spawned suggests that Mandelbrot is correct: the risks that are built into the "standard model" are far higher than generally recognized, and that periodic eruptions of risk have the potential to take the entire system down.

Note that the derivatives based on just this one slice of the market already exceed $1.5 trillion. The size of the entire derivatives market is estimated at $10 trillion, or about the size of the entire U.S. GDP. The potential losses if such a mountain of derivatives should fall are similarly huge.

We have a friend, obviously a very smart person, who trades currencies in New York for one of the large global banks which collectively trade over $1 trillion in currencies each and every day. I once asked him: What's your dollar limit on currency bets? $10 million? $100 million? He shook his head and smiled slightly. There is no limit, he replied. I might own $10 billion or even $100 billion in a currency for a few minutes or hours.

There aren't many such traders in the world--perhaps only a few hundred--but if you add the other big traders in bond and stock derivatives and options, you get a picture of just how much money changes hands in the world financial markets every day, and how quickly an unanticipated "event" could bring the entire supposedly "risk-free" edifice crashing down.


September 15, 2005


Katrina, Vietnam, Iraq: National Purpose, National Sacrifice

A year ago I penned two short essays-- Is This a Nation at War? and A Nation in Denial--about the surreal state of denial in which Americans happily wallowed. Nothing has changed in the past year, but cracks are beginning to appear in the nation's rickety facade of self-absorption and excess.

Let us start with Katrina, by some accounts the single most destructive natural disaster since the 1906 San Francisco earthquake. (The larger disaster seems to be a very human hubris, but never mind that for the moment.)

Though some $70 billion in Federal aid has already been approved, today's Wall Street Journal estimates the eventual total at $200 billion. Who is going to front this enormous sum? The same people who have fronted the current year's $412 billion Federal deficit, of course--the governments of China, Japan, et. al. via their purchase of U.S. bonds.

Was there a call for national belt-tightening by our President or Congressional leaders, a call for a national surtax to fund this vast rebuilding? Of course not. No sacrifice is necessary, as long as foreigners shower us with billions to spend any way we choose.

Are Americans really so shallow and greedy that they cannot bear any financial sacrifice? I think not; last week in Virginia, local fire department folks passed buckets along the lines of commuters waiting at stop lights, collecting cash donations for the Red Cross. Untold numbers of residents in Houston and other nearby cities have toiled overtime to take care of New Orleans' refugees. The failure, it seems, is not in our citizenry, but in our leaders complete lack of faith in our willingness to sacrifice for the greater good. Clearly, our leaders fear that there is no political will for any sort of sacrifice; their measure of American character is so low and mean that I wonder why no one else feels outraged by their crass depreciation of our willingness to face facts.

The lead article in last week's New Republic, titled American Idle, reveals that America's civil engagement has quickly returned to its pre-9/11 lows. Military enrollments were down even before the Iraq war, civic involvement (which correlates nicely with watching TV--the more you watch, the less you do for your community) has returned to the lows of the late 90s, and the stupidities and mindless excesses of our rabidly consumer culture pile ever higher.

For those too young to remember how our nation slipped into a war in Vietnam without a national debate or act of Congress, let me offer you a brief refresher course. Reckoning there was little political support for a ground war in Asia, President Lyndon Johnson avoided telling the American public what was as stake in Vietnam (propping up a hopelessly corrupt but nominally anti-Communist regime created out of whole cloth after World war II). Rather than face a rejection of his policies, he simply slipped us into war "on the cheap," a little at a time, until there were 540,000 American troops in Vietnam and tens of thousands more in Thailand and at sea.

Now we find ourselves yet again in a war being waged "on the cheap," with no visible sacrifice being asked of the American people, with the exception of the National Guard and our 1.4 million-person Armed Forces. Unlike Vietnam, we have been told this war will last for years, perhaps even a decade, but collectively we have not been asked to sacrifice anything for this great effort. All the sacrifice falls on our professional, volunteer military, who are also asked to "tighten their belts" fiscally so our government can pay absurd sums for largely ineffective medicines for our seniors, who vote, it seems, in their own self-interest rather than that of the nation.

Although I generally avoid religious topics, it is time to look for inspiration to our greatest president, Abraham Lincoln, and his deeply religious assessment of the Civil War. The version of Christianity currently popular in our nation is quick to absolve sins; nothing is demanded except a confession or appeal to Jesus. But Lincoln's understanding of sin and sacrifice is nothing like this easy, facile redemption; consider this quote from Lincoln's Second Inaugural Address:

Fondly do we hope, fervently do we pray, that this mighty scourge of war may speedily pass away. Yet, if God wills that it continue until all the wealth piled by the bondsman's two hundred and fifty years of unrequited toil shall be sunk, and until every drop of blood drawn with the lash shall be paid by another drawn with the sword, as was said three thousand years ago, so still it must be said "the judgments of the Lord are true and righteous altogether."

In the U.S.:
"Saving less for a rainy day is becoming a popular earnings-enhancement strategy at U.S. banks increasingly stretched for profit growth. More than a dozen major banks took a lower loan-loss provision in the second quarter compared with a year earlier, and the industry's loan-loss reserves as a percentage of total loans and leases are at a 19-year low, according to the Federal Deposit Insurance Corp. Besides some banks helping their profits with gains that don't necessarily reflect underlying success in attracting borrowers and depositors, some analysts are worried the banks are setting themselves up for trouble should the economy stumble."

In China:
"Run by an outspoken central-bank veteran, Xie Ping, Huijin has shoveled $60 billion of new capital into China Construction Bank, Bank of China and Industrial & Commercial Bank of China. The funds have enabled the three major state-owned commercial banks to write off bad debt and improve their attractiveness to foreign strategic investors ahead of planned overseas listings. In the process, Huijin has become by far the biggest single owner of Chinese banking assets. Basic facts about Huijin remain unclear. The company doesn't reveal its staff numbers. Its telephone numbers aren't listed.

Ultimately, it pits the agency against the Communist Party's Central Organization Department, which to this day appoints the heads of China's big banks. The Ministry of Finance, which used to own China's big banks, also has been displeased by Huijin's growing influence."

"If the U.S. auto fleet of 220 million vehicles went up to three-quarters of a tank -- or, say, 10 gallons more --it would be an additional 2.2 billion gallons of demand."

'Investors are plunking down serious money on bets that oil prices will top $70 and $80 before the year is out. Those bets could point to higher prices. Adam Seiminski, an analyst at Deutsche Bank in New York, said the options market sees a one-in-three chance of oil prices moving above $75 before December, compared with a one-in-20 chance for the same scenario at the start of the year. "With the likelihood of a strong pickup in demand during the fourth quarter and geopolitical risks and weather events lingering, the chances of a move above $75 continue to be upgraded,' he wrote in a recent note."

"The Policy Analysis Market (PAM) was a proposed futures exchange developed by the United States' Defense Advanced Research Projects Agency and based on an idea first proposed by Net Exchange, a San Diego research firm specializing in the development of online markets.

PAM was to be a "a market in the future of the Middle East", and would have allowed trading of futures contracts based on possible political developments in several Middle Eastern countries. The theory behind such a market is that the monetary value of a futures contract on an event reflects the probability that that event will actually occur, since a market's actors rationally bid a contract either up or down based on reliable information. One of the models for PAM was a political futures market run by the University of Iowa, which has allegedly proven more accurate in predicting the outcomes of U.S. elections than either opinion polls or political pundits. PAM was also inspired by the work of George Mason University economist Robin Hanson."