Brutal carnage!

We've seen a lot of action on the markets in the last few weeks, and I suppose that some of my regular readers are probably wondering, "Hey Dikkii. You've been awfully quiet on this."

And I suppose that I have. The thing is, I'm neither greatly spooked, nor am I greatly interested. I've had more important fish to fry at this point in time, but I have been following at a distance.

So I thought that I'd get my thoughts down on paper and attempt to try to put together some thoughts on the week that we've just had, because it has been a doozy. I'm not about to go the way of the financial media and suggest that the global market slide that we saw represents the death of capitalism, though. This has been some disgraceful irresponsibility coupled with a complete lack of knowledge about what capitalism really is. However it is interesting to note that where chickens have been coming home to roost, this blogger did see some of it coming.

1. The "Death of Capitalism"

This is just plain lazy reporting.

Capitalism is just the interplay between those two non-physical forces, Supply and Demand. Nothing more, and nothing less.

Supply and Demand, in turn represent the twin human emotions of greed and laziness.

Note that I haven't mentioned fear. Fear certainly impacts on Supply and Demand, but it is not an emotion on what they're built. Allow me to demonstrate:

Imagine that you are a buyer of something that we'll call "doo-hickeys". Greed and laziness suggest that you'll be more willing to buy more doo-hickeys when prices are low, rather than when they're high. Or to put it another way, you are susceptible to a good bargain, and you're turned off high prices. This, folks, is how the force of Demand works.

Let's now switch roles, and suggest that you are the manufacturer of the aforementioned doo-hickeys. It's via greed and laziness that you are willing to pump up production when prices are high, rather than when they're low. Essentially, you're paying in doo-hickeys for money, and when you can get more money per doo-hickey, you want to make the most of it. Which really makes Supply a sort of inverse Demand priced in commodities rather than money.

So how does fear impact this?

Essentially, fear attacks in waves. Usually, fear inhabits a small corner of one's mind, and is not sufficient in its own right to interrupt the greed and laziness emotions.

However, every now and then, the amount of fear that is there reaches a critical mass in an individual, and this will override the greed and laziness to the point where they fail to register. This is called panic.

So for a buyer of doo-hickeys who's financially fearful, they're going to not be so keen on buying those doo-hickeys, because the fact that they're parting with actual cash to get those doo-hickeys becomes worrying. They'll be worrying about the re-sale value of those doo-hickeys. They'll be worrying about whether the doo-hickeys are any good. In short, they'll be worrying. Or fearful, if you like.

Fear affects suppliers of those doo-hickeys as well, but in a different way. Remember how I said that Supply is a kind of inverse Demand? Well, imagine that you're seeing less and less dollars per doo-hickey sold. You may eventually start fearing that doo-hickeys will eventually be worth nothing. You might choose to dump your entire stockpile on to the market, as you fear that to delay might result in this stockpile eventually becoming worthless.

And even though prices are falling, you may even choose to ramp up production in the hope that prices fall even further, allowing you to buy some back later on to sell when prices stabilise, allowing you to realise a small profit for them.

You can see, just from these examples, that Supply and Demand morph into almost entirely new animals as a result of the introduction of fear, however at no point do they go away. Fear just causes greed and laziness to take on lesser importance in the whole system.

Fear also seems to throw rational thought out the window.

And so it is with assets as opposed to the commodity that we've called doo-hickeys. Supply and Demand work in almost entirely the exact same way. Except when fear comes along, and then it's panic stations.

Supply and Demand will not go away. They'll just take on a different shape for a while. The same can be said about capitalism - after all, it's really the same thing.

2. Complex financial instruments

A little while back, I bemoaned complex financial instruments, and how they appear to exist only to generate fees for the issuers of them.

Since then, we saw one capital guaranteed product issued by Macquarie Bank hit the wall and announce that under the rules that it operated under, investors would get their money back. In 2013. But no additional returns would be paid.

No returns at all until 2013 is a frightfully long time for your money to be going nowhere.

Elsewhere, outside these complicated little instruments that are designed to prey on investor fear, we have lovely little terms permeating the financial department stores, and catching investing novices and veterans out alike.

Frankly, people should fucking well go to gaol for Collateralised Debt Obligations, because these little bastards were designed to mislead. How the fuckety fuck can one bundle up a bunch of bad loans as an AAA-rated security I'll never know.

In Australia, we had all these capital guaranteed funds out there that were marketed a bit like this:

You could earn as much as 20%* (*based on market performance). What's more, we'll capital guarantee them, so if they haven't performed in ten years, you'll get your money back.

Investors now are pretty much locked into things that will now look only as good as what they paid for them in the first place. Which makes only the capital guarantee worth something - the representations on returns were something that should have never appeared in print to begin with.

Contracts For Difference - oh these are going to be fun. I'll come back to these a little further on, but I suspect that we're going to hear a lot about these in the months to come.

Look. The upshot of all this is this: If you can't get your head around how a particular financial product works, then for heaven's sake stay away from it.

3. Derivatives, Sub-Prime Loans and the US Housing Price Crisis

In March 2007, I made a throwaway comment in answer to a comment left by Einzige at this blog that we were yet to see the effects of the US housing price crisis.

I was not looking into a crystal ball, people. I was reading newspapers and watching TV, and if people were talking about it back then, then we knew that there was a problem.

Fast forward to September 2008 and we know now where this has lead. Sub-prime loans have basically now brought down nearly the entire US financial system thanks to an oversupply of housing and a sudden rise in interest rates. Is Alan Greenspan to blame?

Hardly, at least in the first instance. What is to blame is a banking sector that assumed that property prices never go down.

Property prices, just like shares, derivatives and commodities go down sometimes. Can you believe that?

Warren Buffett made the bold assertion back in 2002 that the sudden explosion in derivatives was playing with fire. Why, oh why, can't anyone see that if Buffett, the closest we have to evidence of minor deities, is critical of something then it must be bad?

I mean really. Did Orange County, California file for bankruptcy for nothing?

Hmm. Contracts For Difference. Why did that thought just pop into my head again?

4. Freddie, Fannie, Lehman and AIG.

This month has seen bailouts on an unprecedented scale.

Companies should not be being bailed out. Companies should not be so big that they need to be bailed out by governments.

If there is near total domination of a market by a particular company, this is bad. Back in the early part of this century, Standard Oil was broken up. It was too big to allow the market to operate effectively.

We haven't learnt anything from that. In financial planning, a lot is made of diversifying your investments in order to spread your risk. And granted, Standard wasn't about to go down, but no one benefits from this degree of market dominance.

Economies should also learn from this. How the hell could the US mortgage sector be dominated (I nearly wrote "denominated") by just two companies? Just like investors, economies need to spread their risk.

In Australia, banking is dominated by four companies. Five if you count St George Bank, but it's about to be consumed by Westpac, so really, it only is just four.

Once again, this lot are bleating about being allowed to merge further. This certainly shouldn't be allowed. "But it allows us to build scale in order to become globally competitive," they say.

"Go out and build scale in the rest of the world," I say, "You'll have to eventually."

A free market might be about letting companies build this kind of dominance over time. "Free market economics" also suggests that companies genuinely want to pay tax voluntarily, rather than being made to do so. I think you know where I'm going with this.

5. Stock borrowing and short selling

It's been argued that eventually, short-selling en masse will cause even respectable firms to be completely frozen out.

I applaud the efforts of some countries this week in banning the practice.

In Australia, naked shorts were banned. Rather than something out of Benny Hill, this now means that you cannot sell shares that you don't have. In other words, you will now have to borrow them or, gasp, buy them first.

I'm not actually sure how much naked shorting was going on. It must have been quite a bit because on Friday, the market reacted as though share prices had had a bomb fuse lit underneath them. In any event, I'm not sure that hedge funds are solely to blame.

Let's talk Contracts For Difference. Or CFDs, if you like.

In the early noughties, these were introduced on to the market as a mechanism for "spread betting" on the market. You could go long or short, and in later versions, you can now trade them on the market, rather then selling them back to an intermediary and you can get paid dividends on CFDs that you own if a dividend gets paid on the underlying security.

How do the intermediaries who underwrite the CFDs do it? Well, one would expect that they dabble in the market themselves.

And if there are suddenly a lot of their clientele shorting BNB, doesn't the underwriting institution have to short BNB as well?

What I'd really like to know is this: How many short positions on close of business Friday hadn't been closed out when the ban on naked shorts went through? And how are brokers, in the short term, anyway, going to police the ban?

Folks, we are going to see more carnage hit the markets in a big, ugly and undignified way. And even though we consider ourselves immune in Australia, we're certainly not.

I plan to be getting in and cleaning up on the mess that's left behind. But I don't mean fixing it.

Disclosure: This blogger owns shares in Macquarie Group Limited.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Total carnage

July and August 2007 is proving to be one serious downer for investors, and this blogger, if he didn't exactly tip it, certainly knew that fall-out was imminent.

So far, in Australia, as we speak, markets are down about 12%, and it looks like it's going to continue for some time. The story is similar around the world.

So what's causing it this time?

When the markets had their last major quiver, back in March, this blogger tipped that it would pass and that things would soon be back to normal again, soon.

The reason for the volatility in March was a slide in the Shanghai Stock Exchange, and, as tipped by this blogger, there was absolutely no reason why this should have been seen to have had the major impact on markets that it did.

This time around, I'm tipping that markets around the world will have more lasting problems, and the impact from these will be a little more heavily felt.

Allow me to demonstrate.

The first thing that should be realised, is that this little bit of mayhem is being caused by problems in the US housing sector created by too much money being lent to people who shouldn't have been allowed to borrow in the first place. In delightful understatement, these are called, 'sub-prime' mortgages.

Lenders in the US were bundling up their loan books and then on-selling them on to the market in securitised packages. This had the double impact of raising further money for lenders to continue their risky activities, and re-locating the credit risk on the money lent to the new owners of the loans in question. The most common arrangement was called a collateralised debt obligation, or CDO.

This is not a new practice. Lenders have been doing this for some time. And not just lenders of 'sub-prime' mortgages.

A lender in Australia, RAMS, recently floated on the Australian Stock Exchange (ASX). RAMS floated at a share price of about AUD $2.50 back in July. RAMS' share price is now around AUD 89c and there is nothing that their management can do about it.

RAMS is not really exposed to 'sub-prime' activity (which is called 'non-conforming' in Australia). However, RAMS needs to be able to on-sell it's current mortgage book, otherwise, it will not be able to continue to lend money out to people.

And if no one is willing to buy RAMS' current crop of mortgages from them, then RAMS is going to have to discount the whole package until they can find a buyer. Hence the fall in RAMS' share price.

RAMS will have trouble selling the current lot of mortgages because the institutions that buy this kind of security from them are now reconsidering if this sort of security is worth the risk. And that is regardless of the quality of RAMS mortgage book - mortgages of any type, hell, fixed interest of any type is now being re-assessed across the board and investors are now expecting higher returns for the risk that they're taking on.

Anyway, RAMS investors really have to ask themselves could they have foreseen this? I don't believe that they could.

But this whole meltdown doesn't just end with the lenders, folks.

The debt securities sold by the lenders have been traditionally bought by fund managers for their mortgage and fixed interest portfolios. Normally, these are considered defensive assets - all other things remaining equal, mortgage and fixed interest funds are recommended as short to medium term investments within a portfolio, and form the defensive part of most Australians' superannuation funds.

But investment in CDOs is crystallising risks far riskier than what would normally be considered prudent.

So mortgage funds and fixed interest funds are going to take a hit. This is bearable. At least I would have thought.

But it turns out that quite a lot of buyers of these investments are a different type of fund manager again.

Hello, hedge funds. Fancy seeing you here?

Hedge funds, in their never-ending quest to satisfy investors seeking lower risks and greater returns for their investment whilst at the same time kicking a shitload of fees in the direction of fund managers have had their snouts in the trough for some time.

This was apparently a no-brainer for your average inscrutable hedge fund manager. Borrow at standard rates and invest in a fixed interest security paying well more than your standard mortgage or fixed interest rate of return. And then do it again. And again.

The end result of this was that some hedge funds, in their search for endless returns were geared several times over mainly as a result of idiotic risk assessments that had these sub-prime mortgages being seen as relatively low-risk, when the reality is substantially different.

So much money was whizzing round the economy and inflating asset prices that when the housing price crunch set in in the US last year, there was going to be problems. Bear Stearns was the first company to feel the heat and have advised that the investors in two of their hedge funds are unlikely to get anything back.

In Australia, we heard problems initially from Basis Capital, a fund manager whose products were actually rated AAA from Standard and Poors. Not long after this, Macquarie Bank have advised that some of their hedge funds are suspending new investment and redemptions, because they are having a hard time valuing their portfolios.

So what for the broader market?

Well a lot of the sell-off that we are seeing has to be driven by hedge fund activity. Hedge funds own other assets and it makes sense that they simply have to liquidate large sections of their portfolios just in order to ensure that their offerings are sufficiently liquid when the investors come a calling.

On top of that, because hedge funds are so opaque in their operation, investors in the broader market simply don't know the level of exposure of other businesses.

One municipal council in Sydney is facing losses of up to AUD 60c in the dollar due to some unwise investment in CDOs directly.

And all this is contributing to an environment where borrowing is going to be so much harder in the months ahead - which stymies investment by you, me and businesses. About the only people who should be rubbing their hands together with glee are going to be the banks - their main lending operations come from quality mortgages, and they don't relay on sourcing cheap funds by way of securitisation to do it.

This is going to be nasty, folks. For me, what makes matters worse is that all my money is currently invested and I don't have any more to plough into what appears to be a corrected market. And for most Australians, superannuation returns will be the worst this year that they have been in quite some time - probably about 7 years.

On the plus side, it does appear that that Australian stock market has fixed up the serious over-valuation that has been identified for some time by financial journalists. It means that some rationality has returned to the table.

But things may actually get worse before they get better. This is not like March, folks.

Disclosure: This blogger owns shares in Macquarie Bank Limited.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.