How Does Obama Define Success in Syria?

Barack Obama has flinched.  Not once.  Not twice.  But three times in the last year or so.  Each time, he rattled the saber at Syrian President Bashar al-Assad, Assad called Obama's hand, and Obama flinched.  Now, evidently rattled himself by the unexpected rejection of military action by the British Parliament, Obama seems to be looking around for someone to offer a fist bump.  French President Francois Hollande has been supportive, but Obama has called for Congress to pass a resolution endorsing a military response to Assad's use of chemical weapons on Syrian civilians.

The Democrats, who control the Senate, are feeling queasy, but may support a narrowly crafted resolution.  The Republicans, who control the House, are skeptical and may reject the resolution. 

The Administration has offered a variety of negative reasons for striking Assad's forces, arguing that bad or negative consequences will ensue if the U.S. does not strike.  Chemical weapons are horrible and are prohibited by international law.  The United States, and especially the President would lose credibility.  The Iranians would be emboldened in their quest for nuclear weapons.  The North Koreans would be emboldened to pull more septic content.  The Russians would be emboldened in any number of ways. 

Chemical weapons are horrible.  But does the President see himself as a referee, seeking to penalize Assad for face masking?  Is the President's plan to throw down a yellow flag, move Assad back a few yards, and then let the slaughter continue?  Is it okay for Assad to continue his nationwide massacre if he just limits himself to conventional weapons?  Why don't we issue striped uniforms to the U.S. military and give them whistles to blow along with cruise missiles to fire?

As for credibility, Assad is in a fight for his very life.  He couldn't give a rat's left ear what Obama does, because Obama won't put U.S. boots on the ground and hasn't even provided military support to the Syrian rebels that he promised months ago.  Obama doesn't present a significant threat to Assad.  Maybe Assad's forces will refrain from obvious use of chemical weapons for a while and employ more conventional but plenty lethal weaponry to kill many more Syrians.  But nothing Obama is contemplating will make him more credible to anyone who matters.

The Iranians are, if the vaguely sourced information published by the press over the past few years is accurate, hellbent on building nuclear weapons on the fastest possible schedule.  It won't matter a bit what Obama does in Syria.  A U.S. military strike there will only lead the Iranians to more comprehensively disguise their activities.  But it won't dissuade them in the least from halting their nuclear program.

The North Koreans are constrained by the presence of 26,000 U.S. troops stationed along the demilitarized zone in the Korean peninsula.  North Korea can't do anything substantial to South Korea or any other nation without affecting these troops.  As long as those troops are there, what Obama does or doesn't do in Syria isn't significant.

As for Russia, Prime Minister Vladimir Putin is ex-KBG.  If there was an intelligence service that knew how to spot and exploit human weakness, it was the KGB.  Putin surely has Obama figured out--the man isn't bold.  He's not a risk taker.  He wants to be on the winning side no matter who that is or what happens (this is how the U.S. wound up being detested by everyone in Egypt--we tried to be everyone's buddy and ended up no one's buddy).  Obama is like the political equivalent of Microsoft--very successful, but not so likely to continue that success in the future because of an aversion to taking real risks.  Whatever carefully calibrated and narrowly focused military strike Obama now orders isn't going to convince Putin that Obama is anything except a smart, but cautious man trying to stay on his feet in a back alley brawl.  The smartest man in the alley might win the brawl, but the meanest man is the one you have to watch out for.

To persuade Congress and the American people that military action in Syria is justified, President Obama has to present positive reasons.  We need to know how we succeed, how we win.  Waging war for the purpose of stopping bad people from being bad isn't likely to work, unless one is prepared to wage total war and completely conquer the enemy, as America did to Germany and Japan in World War II.  No one has suggested that America conquer Syria.  For the past fifty years, America has dived into military adventures for poorly conceived reasons, and not surprisingly done poorly.  The only clear case for offensive military action--the 2001 invasion of Afghanistan-- was thoroughly botched by the second Bush Administration when it failed to deal definitively with Osama bin Laden after trapping him in late 2001 at Tora Bora.  We're still suffering the consequences of that failure.  If President Obama wants our support for a strike in Syria, he should tell us how we attain victory.  If there is no victory that can be defined or attained, we should hold our fire.

The Hidden Inflation

The Federal Reserve assures us that inflation is modest, and can point to measures of inflation it prefers (the PCE price index) or doesn't prefer (the CPI), both of which tend to be modest--in the 2% range or less.  But if you ask a lot of people out in the real world, they'll tell you inflation is worse than that.  And they are right, once you take account of what inflation really means.

The ultimate problem created by inflation comes up when price increases exceed income increases.  If your real income is falling, your standard of living will drop.  That's cause for concern.  When incomes rise faster than price increases, people complain but then dig into their steaks and lobster. 

Incomes today are, in real terms, falling for a lot of people.  Workers on average earn less, net of price inflation: see http://www.bls.gov/news.release/realer.nr0.htm and  http://money.cnn.com/2013/08/15/news/economy/cpi-inflation-wages/index.html.  Median household incomes have fallen since the beginning of the Great Recession: http://www.cnbc.com/id/100980411.  While the fall in household income may in part be due to higher unemployment, it would also reflect the drop in worker earnings. 

Once you look at earnings and household incomes, you can see that inflation in the broader sense isn't so modest.  Since the Great Recession began in 2009, government statistics show that real average weekly pay for full-time workers has fallen 3.5% from 2009 to the second quarter of 2013.  (See http://data.bls.gov/cgi-bin/surveymost.)  The social discord and turmoil that can come from inflation is rooted in falling real incomes, not nominal price increases.  Despite all the statistical soothing the Fed may offer, many Americans today are hurting from this hidden inflation. 

There is little the Fed can do about falling real incomes.  Its monetary tools and bond purchases have little connection to wage and salary levels.  They may boost household income to the extent they promote greater employment.  However, because they significantly reduce interest income for savers, they may also exacerbate the problem of falling incomes. 

As for Congress and the Administration, they're on August recess right now.  And they won't do much about this problem when they get back.  Fights over a budget for the next federal fiscal year (beginning Oct. 1, 2013) and the looming debt ceiling will provide photo ops and Sunday morning talk show invites for the high and the mighty.  The dreariness of ordinary life is likely to get lost in the shuffle.  Talk at the state level about raising the minimum wage may have some impact.  But falling incomes is as much a problem of the middle class as of lower income persons.  Minimum wage laws won't help the middle class very much. 

The overall structure of American society, with its exceedingly generous corporate compensation practices to tax laws favoring the 1% to the decreasing degree of upward social mobility to the astonishing growth in the cost of college educations and more, is thinning out and pushing down the middle class.  No nation has gone on to its greatest days with increased social stratification and top-heavy distribution of wealth.  But nothing is happening right now to change the trend.  This story won't end well.

Why No Great Rotation?

A popular view among market aficionados is that, with bond prices falling while stocks have been rising, money would shift from bonds to stocks.  Stocks and bonds have historically often moved inversely.  When stocks rose, bonds fell, and vice versa. With bonds falling now, it would seem reasonable to expect investors to rotate their money into stocks.  But there has been no rotation.  Why not?

First, for the past five years, we've had a brave new Fed which has manipulated asset values in ways beyond historical experience.  Since early 2009, central bank easy money has helped to spur a stock rally accompanied by a bond rally.  Both asset classes rose simultaneously, instead of moving inversely.  With their traditional relationship out of whack, it is hardly surprising that they don't cha-cha when they're supposed to.  Investors would be understandably suspicious of stocks in a market that is seemingly dependent on the Fed's methadone program, especially when the Fed is talking about easing out of its role as Dr. Feelgood.

Second, the Great Rotation is an investment strategy for the medium to long term.  Today's stock market is dominated by high-speed, computerized trading, where the holding period for stocks is measured in milliseconds.  The long term human investors that might consider rotating greatly have mostly been supplanted, and many have chosen to invest on autopilot, buying index funds and throwing salt over their left shoulders.

So whither the markets?  That's the $64,000 question, and in truth nobody knows the answer.  With both stocks and bonds having enjoyed years-long bull markets, logic and experience, especially recent very painful experience, tell us that when markets can't keep rising indefinitely, they won't.

Why an SEC Victory Counts More Than an SEC Loss

Since the SEC won a jury verdict against former Goldman Sachs VP Fabrice Tourre last week, the financial press has published semi-snarky commentary about how the SEC has lost more financial crisis cases than it has won.  This game of statistics misses an essential point.  Wall Streeters, corporate executives and directors, and their attorneys are cautious folk.  You might not think so from some of the inexplicably risky things they occasionally do, but on the whole they are more concerned about downside risk than upside potential.  (Even good hedge fund traders look first at how much they can lose before they focus on how much they might make.)

A high profile SEC win, like the Tourre case, makes the risk averse pause and reflect all the more so before taking the plunge.  It's better to settle and hide behind your PR person who repeatedly declines to comment to press inquiries than to be photographed outside a federal courthouse wearing a nice suit and a gloomy expression.  People will remember that expression for a long time.  Tourre didn't have to do a perp walk, but there's nobody--absolutely nobody--on Wall Street, Main Street or anywhere else in the corporate world who wants to wear his suit. 

When the SEC loses in court, the defendants have a day in the sunshine.  But then their cases are largely forgotten.  Major SEC victories are remembered.  The SEC's cases against notorious insider trader Ivan Boesky and junk bond king Michael Milken still receive public mention, even after 25 or so years.  Who remembers the cases the SEC lost in the 1980's?

In the plush conference rooms and offices where corporate lawyers and their clients under SEC investigation discuss the risks of settling versus litigating, you can be sure that the SEC victory in the Tourre case is getting a lot of attention.  The SEC's losses are probably mentioned as well.  But no good attorney wants to be caught making, or even implying, a promise s/he can't keep, and the story of Fabrice Tourre is likely being presented as a cautionary tale.  People with a lot more to lose from an SEC victory than they have to win from an SEC loss may well see the merit of capping their downside risks.

SEC 1, Tourre 0, Goldman 0, Financial Press -1

Today's jury verdict finding Fabrice (the "Fabulous Fab") Tourre liable on six of the seven civil counts against him represents a major victory for the SEC.  That's not simply because of the prominence of the case, which involved the sale of a controversial motgage-backed derivatives investment and is the highest profile SEC enforcement action to come out of the 2008 financial crisis.  It's because the agency's very efficacy has been under attack for the better part of a decade.  Widely viewed as ineffectual, the SEC has re-established its presence as a cop on the beat.  While one victory doesn't win the war, a victory this big will make a lot of corporate and white collar defendants think harder about settling, even if the price involves admitting to making bad choices.

Fabrice Tourre rolled the dice and lost.  Litigation is a gamble, and some bets turn out to be losers.  Perhaps he chose to fight instead of settling up front because he was angry about being a lower level guy who was singled out as a named defendant.  But anger doesn't equate to victory in court.  Above all, what matters is the evidence.  Tourre may have been his own worst enemy, seemingly adding insouciance as too much of a fillip to his e-mails.  Most likely, his attorneys will soon make motions for this and that, and perhaps later file appeals.  But now that the jury has spoken, Tourre faces an uphill battle.

Goldman Sachs wasn't a party to the case.  But it reportedly financed Tourre's defense.  And perhaps it has reasons beyond loyalty to a former employee.  Goldman faces potential liability in private civil lawsuits involving charges similar to those in the SEC case.  If Tourre had won, Goldman might have negotiated more favorable settlements in those cases.  Now that he's lost, GS has shifted closer to the 8-ball.  But that's all just a matter of money, of which GS has a fair pile.  GS isn't going to be kicked out of the securities business, as Tourre might be, because GS already settled with the SEC, thereby capping its regulatory liability.   Now that he's been held liable by a jury, Tourre not only faces SEC sanctions, but perhaps demands for payment from the plaintiffs' attorneys in those private civil lawsuits as well.  Poor Fab.  Not so fabulous any more.

The financial press ends up looking silly.  Not one publication of any prominence, to this writer's knowledge, predicted the SEC's victory.  Many expressed serious doubt about the SEC's case.  The coverage during the trial was frequently skeptical of the SEC's evidence and efforts.  It might be interesting to know why the press coverage was so imbalanced.  Whatever the reason, the press was scooped by the SEC staff, which convinced the jury to announce the real story. 

From the Fed: Short Term Gain, Long Term Pain

As the Fed's ultra low interest rate policies grind on for a fifth year, we can see ever more clearly that there is no such thing as a free lunch, even when it comes to central bank policies.  The benefits of the Fed's low interest rate policies were easy to see at first:  cheap credit, stimulus to housing, a boost to the economy.  The costs didn't seem so great. 

However, by persistently favoring borrowers and heaping mulch on income-seeking investors for five years, the long term costs of the Fed's policies are emerging--and painfully so.  Detroit is in bankruptcy, and other cities teeter on the brink. Corporate defined benefit pension plans are becoming less common than the ivory-billed woodpecker. It's no wonder why.  Pension funds rely on safe long term investments that provide solid returns.  U.S. Treasury notes and bonds used to be crucially important components of pension fund portfolios.  AAA-rated corporates, which would have to pay slightly better than Treasuries, also were favored investments.  But pension plan returns came under stress as the returns on these low-risk investments nosedived.  And pension fund deficiencies, calculated on the basis of long term returns, balloon when returns fall.  Plan sponsors have to increase contributions--sometimes enormously--to keep the plans solvent.  Corporate executives intent on making the big score with their stock options see little upside to signing off on these contributions.  Shrinking cities like Detroit have little ability to make them.  Something has to give, and pensioners seem to be doing a lot of giving these days.  Detroit's problems go well beyond low long term interest rates.  But the city really didn't need the Fed to push it closer to the abyss. 

Neither did a lot of corporate employees whose retirements are less secure after losing their defined benefit pensions or seeing the plans capped.  Most people aren't skilled at managing their finances.  When fewer have defined benefit pensions, more are likely to end up with just Social Security, even if they start retirement with good-sized 401(k) account balances.  When people have fewer or no private resources, cutting benefits from the government becomes political anathema. 

Low interest rates hurt older folks in other ways.  As income from their interest-bearing investments dries up, fear drives them to become serial economizers.  That's a hard habit to break even after rates rise again (assuming they do).  Consumption may be impaired for a long time.  In addition, long term care insurance is getting scarce and expensive.  While poorly conceived estimates by insurers of the cost of care have much to do with that, the inability of insurers to obtain decent, safe returns on investments has added to the problem.  Fewer people are able to afford such policies.  So we have a ticking demographic time bomb, with lots of uninsured elderly likely to need Medicaid in a decade or two or three instead of being able to rely on their own resources.  Low interest rates are beneficial to the federal government's borrowing costs right now, keeping the budget deficit lower.  But positioning a lot of people to need Medicaid in decades to come means we'll have pressure toward an increased deficit in the long term.

 The Fed is taking a page from corporate America:  focus on short term returns at the risk of increasing long term costs.  The great corporate success stories don't follow this plot line.  But there's not much chance the narrative will change.  The Fed's easy money merry-go-round keeps the stock market buoyant.  With mid-term Congressional elections coming up next year, the Obama administration needs to keep the market feeling chipper.  Ultimately, everything in Washington happens for political reasons.  And politics dictates that Janet Yellen, a monetary dove, will be Obama's nominee as the next Chairman of the Fed.

Managing Personal Risk

Modern businesses put a lot of effort into managing risk.  They take risks, because that's how they might make big money.  But they also work to mitigate the downsides of their risks, because employee stock options don't pay off real well if the CEO, or someone or something else, blows up the business.

Individuals need to manage risk as well.  Bankruptcies most often result from unexpected problems, like a medical crisis or job loss.  If you don't deal with the ways that life can fall apart, the chances of your life fallling apart increase. The need to manage personal risk may be one of the most under-appreciated aspects of financial planning. While there's no perfect or complete way to analyze personal risk, here are some things to think about.

Age.  As you grow older, reduce risk.  If anything goes wrong, you will have less time to recover, and less ability to recover as your value in the labor force declines (and it eventually will).  There are variety of ways to reduce risk discussed below.  The important point is that as time passes and you accumulate more gray hair, reduce personal risk.

Occupation.  Your occupation can be a major risk factor.  Some types of work can't be performed by older people.  This would include construction, law enforcement, military service, fire fighting and other jobs that demand physical strength and endurance.  It could also include jobs that don't demand physical strength, but do require certain abilities that deteriorate with age, such as flying, working as an air traffic controller, or performing surgery.   If your job has a relatively limited time span, start building wealth at an early age and persist.  You may be able to have a second career when the first one ends.  But then again, maybe not.  Don't count on what's highly uncertain.  Assume your first occupation is all that you'll ever have and base your financial planning on it.

Employment stability.  If your job security is unstable, build up a large pool of savings to tide you over the rough spots.  A year's worth of living expenses, or more, in an emergency fund would be a good idea.  If you work in a boom-bust industry, like construction or oil and gas drilling, or an unpredictable job, like entertainment, your savings account is your best friend.  If you have to take on debts, or lose a car and/or house, because you didn't prepare for a layoff, your long term financial future may be cloudy.

Health.  Factor into your financial planning your health problems, especially any chronic ones you have.  There is no way to avoid having health problems, especially as you get older.  That's why having health insurance is so important--you will definitely use it.  Also have some savings available for health care expenses not covered by insurance--these expenses are one of the leading reasons for personal bankruptcy filings.  If your health is good, save plenty because you may need to finance a long life span. 

Debts.  Debts are one of the most dangerous risks.  Jobs may not be secure, but debts, once incurred, are a certainty.  If you're poor, but debt free, you won't end up in bankruptcy.  Poverty doesn't lead to bankruptcy; unmanageable debts do.  But debts are also one of the most controllable risks.  Avoid taking on debt unless it's really necessary.  Pay off debts as quickly as possible, especially as you get older.  A mortgage-free house is better than a sleeping pill.  There are some financial planners who will tell you to have a mortgage and invest your cash in stocks.  Well, if stocks maintained a nice, steady upward trend all the time, this might well be a smart move.  But if stocks are sometimes volatile--well, some people do manage to eat dog food.  Avoid debt and you avoid risk.

Moral and voluntary obligations.  Lots of people help their kids pay for college--and then help some more when the kids rebound home after graduating.  Many help their aged parents.  Quite a few help siblings, nieces, nephews, friends and so on when the going gets tough.  If you are likely to accept these obligations, manage your finances to be able to meet them.  Being nice can be a major financial risk factor. 

Riskiness of your assets.  This isn't quite the same as asset allocation.  This is preparing for things to go wrong with your choice of assets.  Don't think your allocation is necessarily right.  Almost no one predicted the financial crisis of 2008 and hundreds of millions of savers worldwide got a big tummy ache as a result.  If you really think that you and your financial planner have it all figured out, contact me about buying a very nice bridge in Brooklyn, and at a bargain price, too.

But back to the first point.  Stress test your investments (see http://blogger.uncleleosden.com/2010/11/stress-test-your-retirement.html).  If you are uncomfortable with the potential losses you could incur, change your allocation.  Of course, no matter what you do, you'll end up with some kind of allocation.  The important thing is to end up with something that you can live with on good days and bad.  

Insurance.  Only Congress is less popular than insurance companies.  But having some insurance coverage is important to mitigating risks.  We've already covered health insurance.  Have homeowners or renter's coverage.  Maintain plenty of liability coverage on your auto policy, and buy an umbrella policy if you have a significant net worth.  Get disability coverage (first check to see what your employer offers, and supplement it if appropriate).  If you have dependents, like minor children, buy life insurance.  Think about long term care coverage if you have significant assets.  Granted, writing a check to an insurance company feels like eating sawdust.  But if life takes a u-turn, it's comforting to be able to forward the bill to an insurance company.

Boost your benefits.  Work as long as possible to build up your Social Security credits and any pension benefits for which you are eligible.  Okay, Congress, the White House, City Hall, the boss, or somebody is always threatening to trim or take away these benefits.  But they will very likely survive in one form or another, and you benefit from maximizing them because they may offer the best shelter available when cold economic winds blow.

Is the Fed Losing Control?

In the past two weeks, we heard from Chairman Hyde and then Chairman Jekyll.  A couple of weeks ago, Ben Bernanke made allusions to gradually winding down the Fed's bond buying program, called quantitative easing.  Up to this point, the market had perceived the current round of QE as infinite, a perception that Fed had encouraged by placing no time limts on the program, and offering only the vaguest of guidance as to when QE might end.

But two weeks ago Chairman Hyde frowned and cleared his throat, and the bond bulls began running.  In their panic, they gored many an investor who had drank the Kool-aid however reluctantly and bought risk assets like long term Treasuries, corporate bonds and junk bonds.

Within days of Chairman Hyde's hint that the punch bowl might be taken away, the ten year Treasury note was yielding over 2.5% (up from 1.6% in May) and 30-year mortgages popped up about 1% to 4.5%.  Stocks quivered, but didn't belly flop like bonds.  Alarmed, various governors of the Fed and presidents of Federal Reserve Banks chimed in and suggested that the punch bowl wouldn't be withdrawn any time soon.  Stocks perked up, but bonds continued to pout and mortgage rates kept rising. This was emphatically not what the Fed wanted, since the Fed is resorting to its old trick of trying to revive the economy by bubbling up the housing market.  Even though this is what got us into trouble in 2007-08 with the mortgage crisis, the Fed evidently has an abiding faith in its old tricks.

With the housing rally now threatened, Chairman Jekyll spoke up this past Wednesday (July 10) and made nice nice.  The little toddler of a recovery would need propping up for a long time, he said, before he'd expect it to walk on its own--a very, very long time.  He also said he was sending the senior Fed staff out for a late night booze run to stoke up the punch bowl.

Stocks did a cheery little conga and stepped up to new heights.  This might produce a bit of a wealth effect to boost the economy.  But it will be hardly a smidgen, if the bond market doldrums continue. Bonds barely budged after Chairman Jekyll's attempted love fest.  The ten-year Treasury dallied briefly with the 2.53% level, but then went back up to 2.59%.  Mortgage rates continue to cloud the skies over the housing market. 

Is the Fed losing control?  This is really two questions.  What message is the Fed trying to send?  The most recent minutes it released indicate sharp divisions within the Open Market Committee, and the truth may be that a highly mixed message would be the most accurate.  Bernanke's initial statements two weeks ago may have been an attempt to be transparent and let the public know what the Committee really thinks.  But the Fed got what it perceived as an over-reaction from the market, and has been trying to cover its tracks ever since.

But did the Fed get an over-reaction, or an accurate reaction?  The sharp sell-off in bonds and rise in mortgage rates may have reflected the erstwhile rationality of betting on a continuing rally in fixed income.  Central banks worldwide have joined together and danced the most accommodative bunny hop in the history of banking.  Anyone who anticipated a reversion to the mean in the money markets has been just about rendered CIA-style. Much of the flash crash in the bond markets may have been hedge funds and other big players unwinding leveraged positions betting on more booze for the punch bowl.  Now that the Open Market Committee may be going wobbly on the idea of giving a drunk yet another pitcher of Martinis, bond pros evidently are becoming wary of the hair of the dog that just bit them.  If so, the Fed may have lost control of the long end of the yield curve.

If the Fed no longer has a clear message to send, and can't maneuver the long end of the yield curve any more, it may lose control of the economic recovery.  But perhaps it never really had that much control.  Maybe things looked good for a while because people wanted to believe, and the Fed provided the only federal economic policy they could believe in.  With Chairman Bernanke now a short timer, courtesy of President Obama, it's unclear what anyone can believe in.  And that won't be good for the market or the economy.

Regulatory Challenges of the Bond Market

The Great 2013 Bond Market Chain Saw Massacre has probably caused trillions of dollars of losses.  On May 1, 2013, the yield on the U.S. Treasury 10-year note went as low as 1.61%.  Since then, it has vaulted as high as 2.72% and most recently closed at 2.63%.  Such a jump in yields is, as kindergartners would put it, ginormous. 

The inverse math of the bond market would dictate that when yields jump this much this fast, the principal value of bonds will fall painfully and nasty losses will be incurred.  While precise numbers aren't readily available, losses in Treasuries may reach a trillion dollars.  And when you add in corporates, munis, junk bonds, and mortgage-backed securities, the losses could be multiple trillions.

The game of musical losses is now in progress.  Through short positions, derivatives contracts and other hedges, the losses are flowing through to wherever they will end up.  The challenge for regulators is to find out, and quickly, where that end will be.  What must be ascertained is whether the losses are spread out and landing in places where they can be absorbed without too much fuss.  Or whether the losses are concentrated somewhere and could have secondary and tertiary rippling effects (i.e., cause a run on one or a few major financial institution(s)).  Well within living memory (2008, to be exact), sharp losses in the mortgage markets triggered tsunamis in the financial markets that washed over Bear Stearns and Lehman Brothers, and threatened to wipe out AIG, Fannie Mae, Freddie Mac and Merrill Lynch.  Bailouts and regulator-encouraged acquisitions barely prevented an abrupt, loud, low-flow flush of the entire financial system.

Regulators should be proactively trying to pin down where the bond market losses will fall.  Complicating their task is the likelihood of speculators who used leverage to make derivatives bets on a fall in interest rates.  Since there is no prohibition on speculating with derivatives, as opposed to hedging, it is possible (and probable) that some players in the financial markets made such a bet.  That wouldn't be intrinsically different from the bet that John Paulson made in mortgages shortly before the mortgage crisis that sweetened his net worth by billions.  It's also not intrinsically different from the gold bets that John Paulson's gold fund has likely made, which reportedly has sustained losses in excess of 60% (ouch).  Any such speculative bets in the bond markets could exacerbate the game of musical losses, and make the regulators' tasks all the more difficult, since many of the speculators might be trading through entities chartered in off-shore locations that might frustrate U.S. government oversight.  But the Feds will have to do their best, because the alternative would be what happened in 2008, when they waited until things blew up and bailouts were just about the only option.

There's more.  The yield curve has been steepening during the last two months.  The short end remains squashed by the Fed's scorched earth policy on short term interest rates.  But the long end, as we noted above, has been rising meteorically.  This steepening makes attractive a type of carry trade.  It's possible to make a lot of money by borrowing short term and investing long term.  

Fed policy makes this carry trade all the more enticing.  The Fed's intent, as far as it can be discerned from the entrails currently visible, is to begin cutting down on bond purchases (i.e., QE) within months, but to keep short term rates at zero until unemployment reaches 6.5%.  Although employment has been rising, the unemployment rate has been static for several months.  While no one really knows when unemployment will reach 6.5%, it's not uncommon to read predictions of mid-2014 or so for that level to be acheived.  If so, the carry trade could be profitable for a while, especially if the Fed's reduction of bond purchases push long term yields even higher. 

To paraphrase P.T. Barnum, or Mark Twain, or somebody, there's a smarty pants who shows up in the financial markets every minute. Some--and perhaps many-- will surely indulge in this carry trade, most likely on a leveraged basis (because leverage boosts profits, assuming the trade works in your favor).  But if the unemployment rate unexpectedly drops quickly to 6.5%, the partakers of this carry trade might wonder if they aren't living in a septic tank. 

Either way, the regulators have to keep an eye out for the possibility of mounting risks from this sort of carry trade.  It could look like easy money to banks, hedge funds, insurance companies and other important players in the financial markets--after all, with the Federal Reserve at least momentarily anchoring their borrowing costs while pushing up their profits, the government is on their side.  But borrowing short to invest long is the E. coli that has poisoned many a would-be financial marvel.  Regulators need to be watchful not only for bond market losses from risks that have already materialized, but also for the growth of more risk from the changing landscape of the market.

Tale of the Magic Dragon

Betrayal.  The Vietnam War was full of betrayals.  And they didn't come from the enemy.   In Tale of the Magic Dragon, men who knew too much were sold out. 

 

Officially, the patrol never happened and nothing was said about the men left behind.  But former Green Beret Frank McTigue, a struggling private investigator, learns the truth when he agrees to protect pretty Lia, who had witnessed the murder of his former commanding officer.  A voice from the past dredges up unfinished business from his tour of duty in Southeast Asia. He can't let it go. Outnumbered and outgunned, he teams up with his Special Forces comrade at arms Odell Franklin.  They end up in a desperate fight where secrets are dear and lives are cheap--and find a glimmer of hope for redemption.

 Rated 5-Stars on Amazon and Barnes & Noble.

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Available on Amazon at https://www.amazon.com/Tale-Magic-Dragon-Leo-Wang-ebook/dp/B00D9I4FRY.

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