Why the Federal Reserve may not be able to predict the next fiscal crisis that is already underway...

According to Alan Greenspan:

"'The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model's structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics,' wrote Greenspan."

Which is the problem with all state-of-the-art statistical models: they are based on historical data, using past trends to create "bounding values" for some future prediction. Even if these bounding values are tweaked by a given amount, they still do not provide sufficient protection against a extremely rare "black swan" event; which may never have occurred in the past.

An clear and concise illustration can be provided by the current mortgage-based crisis. The analytical models used by both the mortgage industry and the ratings agencies were flawed. They failed because they were based on the wrong data.

The rare "black swan" event was far beyond influencing the historical data.

The first "black swan" event was the relaxation of sound banking principles in order to fill Wall Street's burgeoning need to create mortgage-backed securities. Ignoring prudent banking practice saw the creation of SIVA (stated income, verified assets), SISA (state income, stated assets), NIVA (no income, verified assets), NISA (no income, stated assets) and finally NINA (no income, no assets) underwriting requirements. These so-called "liar" loans were an invention not anticipated or incorporated into the analytic datasets.

Where the historical records saw a 2-3% historical default rate,  the smart money thought that they could withstand a 10-12% default rate and still make money. What they did not see was the "black swan" liar loans where default rates rose from 25% to 50% and beyond.

Added to this data insufficiency, we saw the financial organizations allowing borrowers to use the proceeds of HELOC (Home Equity Line of Credit) to pay their monthly mortgage payments which delayed the reporting of troubling circumstances. Further delay in reporting the numbers occurred due to the continual refinancing of "failing loans." Thus making the dataset not only incomplete, but not full descriptive of the ongoing situation.

And the most damaging of all "black swan" events occurred outside of the mortgage arena itself -- the regulatory acceptance of imprudent levels of leverage which allowed someone with $5 million in capital to be at risk for $100 million or more loans.

Thus the "quantifiable" risk was not even in the mortgage system, it was in the unquantified relaxation of sound banking standards and the imprudent use of leverage. Leverage which allowed a wholesale mortgage originator with a $5-million net worth to borrow over $100 million to purchase  even more mortgages for their "production" pipelines.

When the "big boys" (e.g. Merrill Lynch, Countrywide, Fannie Mae, Freddie Mac, etc) began to realize what was happening and stopped purchasing and securitizing these "liar" loans, the warehouse-line originators were stuck with unsold mortgages in their pipelines and multiple millions in money owed to their warehouse line lenders. Thus leading to defaults on payments to warehouse lenders and the ultimate bankruptcy of at least 100+ firms.

Here and now...

Just as the Federal Reserve forced the domestic and international money managers to search for higher returns in mortgage-based investment products when the FOMC (Federal Open Market Committee ) kept the rates artificially low (1%), we are now seeing the same pattern being repeated. As this is being written, the Federal Reserve Target Rate is being supported at 2% and the money managers have turned away from mortgages towards commodities to provide a return on their investment.

Even though the global pool of money has doubled past most rational predications, the number of safe and sound investments that have an acceptable rate of return has not doubled.   

Unless the government restores Treasuries to yield an acceptable return, the search will continue thus driving up prices as too much money chases too few goods -- which is the classic definition of inflation.

So what is the "black swan" effect that might affect the next commodities bubble.

I sincerely believe that the "black swan" event will involve the widespread use of "exchange traded funds" which allows ordinary people to speculate in commodities without going through the traditional problems of opening and maintaining a traditional commodities account... or even understanding the fundamentals of commodity transactions. 

According to Wikipedia ...

"An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. An ETF holds assets such as stocks, bonds, or futures."

"Institutional investors can redeem large blocks of shares of the ETF (known as "creation units") for a "basket" of the underlying assets or, alternately, exchange the underlying assets for creation units. This creation and redemption of shares enables institutions to engage in arbitrage and causes the value of the ETF to approximate the net asset value of the underlying assets."

"Commodity ETFs invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries. Commodity ETFs generally are index funds, but track non-securities indexes. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934.  They may, however, be subject to regulation by the Commodity Futures Trading Commission."

Actively managed ETFs are quite recent and have been offered only since 25 March 2008 in the United States. The actively managed ETFs approved to date are fully transparent, publishing their current securities portfolios on their web sites daily.

Another example of government regulators abrogating their oversight activities and permitting the Wall Street freebooters to create havoc in the marketplace...

However, the SEC has indicated that it is willing to consider allowing actively managed ETFs that are not fully transparent in the future.

The very same SEC which has not attempted to regulate hedge funds which operate as unmonitored investment banks or curb rampant market speculation by controlling margin levels and preventing massive amounts of fund capital from artificially forcing a company's value lower (by buying put options and then selling common stock) and then profiting from its artificially induced price drop.

"The fully transparent nature of existing ETFs means that an actively managed ETF is at risk from arbitrage activities by market participants who might choose to front-run its trades. The initial actively traded equity ETFs have addressed this problem by trading only weekly or monthly. Actively traded debt ETFs, which are less susceptible to front-running, trade their holdings more frequently."

Less transparency equals more opportunity for unsanctionable market manipulation.

This much of the future is predictable...

Our current government is said to be following a "laissez-faire" model which could be roughly construed as the   "idea of leaving people alone to interact freely without government interference." Others attribute this lack of regulatory activity to a lack of moral underpinning or the sheer incompetence of those who are acting out of the hyper-partisan need for political power. Where seeking campaign contributions to support your regime is a 24/7 activity with little time, effort or consideration on "doing the right thing."

Wall Street has always been somewhat apolitical in search of profits and power. However, we are increasingly seeing power-motivated interests buying political influence so that they can continue to milk the public purse.

In a similar vein, I believe that the current promotion of global climate change may be one of these initiatives which would allow the various levels of government to increase their power over the lives of its constituent citizens while simultaneously increasing their revenue base. All to benefit the special interests.

What can YOU do?

Become more aware of the toxic political solution surrounding your local, state and federal government. Demand that your elected officials uphold their sworn duties. Demand that any politician or special interest that has squandered or misspent the public's money be sanctioned by the loss of further government business.

Do not jump into an investment frenzy which may be created in the near future as people react to the "upside" of an expanding commodities bubble.

Consider exactly how much of the world's real wealth -- the product of labor by its citizenry -- has been dissipated into major sinkholes and how many corporate or Wall Street operatives have banked millions in the process of fleecing the public.

The thought that a regional manager of a mortgage originator was making between $75,000 and $125,000 per month with senior executives earning much, much more should be one of the signs that something is wrong with our monetary policy -- where the risk/reward ratio is completely inverted.

Continue to question those who promote a monetary policy that makes a mockery of personal savings -- eroded by inflation to the point where your purchasing power is rapidly eroded.

We now see the mortgage crisis coming full circle as the Federal Reserve accepts  toxic loans as collateral for good funds. Unfortunately, the Federal Reserve will pass the costs of their misadventure onto the American public... and another bubble will form -- to be burst, once again, by a "black swan" event.

-- steve

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