The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Jim Chanos, founder of Kynikos Associates Ltd. hedge fund, talks about China’s economy, debt and real estate market, and investing in the country. He talks with Carol Massar on Bloomberg Television’s “Street Smart.”

Sept. 20 (Bloomberg)

*MOODY’S DOWNGRADES BANK OF AMERICA CORP; BANK OF AMERICA N.A.

charts via Bianco Research, LLC.
September 14, 2011

An NYU Poly Department of Finance and Risk Engineering professor has a forthcoming paper in Algorithmic Finance that claims that “Markets are efficient if and only if P = NP.”

Why is this important? Most economists think markets are at least weakly efficient (I disagree).

Computer scientists think that P != NP — that current prices fully reflect all information available in past prices.

This paper claims they both cannot be correct; one must be incorrect. The author’s proof is that they both cannot be correct at the same time, and therefore one must be wrong.

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Abstract:

I prove that if markets are efficient, meaning current prices fully reflect all information available in past prices, then P = NP, meaning every computational problem whose solution can be verified in polynomial time can also be solved in polynomial time. I also prove the converse by showing how we can “program” the market to solve NP-complete problems. Since P probably does not equal NP, markets are probably not efficient. Specifically, markets become increasingly inefficient as the time series lengthens or becomes more frequent. An illustration by way of partitioning the excess returns to momentum strategies based on data availability confirms this prediction.

Some midweek reads :

• Commercial Space Starts to Wobble (WSJ) see also Joyless Holiday Retail Forecast (WSJ)
• Bullion Vaults Run Out of Space on Gold Rally (Bloomberg) see also Lloyd’s of London Pulls Deposits From European Banks as Confidence Withers (Bloomberg)
• New Reserve Currency? Debate About The Yuan (The Economist)
• Caroline Baum: Bernanke to Preempt Accusations of Do-Nothing Fed: (Bloomberg) see also Bank of England Policy Makers See Greater Stimulus as Increasingly Likely (Bloomberg)
• SEC Pushes Plan for HFT Audit System (WSJ)
• New Buffett Manager Gets Higher Taxes and Less Pay, by Choice (Deal Book)
• IBM pitches overclocked Xeons to Wall Street (The Register)
• Turner Says Murdoch ‘Going to Have to Step Down’ From News Corp. (Bloomberg)
• Here comes iPhone5 October 4 (Ars Technica)
• Google Is Going Face to Facebook (WSJ) see also Rick Santorum’s Absurd Crusade Against Google (TPM)

What are you reading?

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Why do Banking Regulators bother to Conduct Faux Stress Tests?
William K. Black

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One of the many proofs that banking regulators do not believe that financial markets are even remotely efficient is their continued use of faux stress tests to reassure markets. But why do markets need reassurance? If markets do need reassurance that banks can survive stressful conditions, why are they reassured by government-designed stress tests designed to be non-stressful?

Stress tests were first mandated for Fannie and Freddie by statute. Fannie and Freddie’s managers referred to them as “nuclear winter” scenarios – impossibly unlikely and stark disasters. The managers used the ability of Fannie and Freddie to pass the stress tests as proof that the institutions were safe and so well capitalized that they could survive even a lengthy depression. In reality, Fannie and Freddie had exceptionally low capital levels. Fannie and Freddie met their capital requirements under a newly toughened version of the statutory stress test weeks before they collapsed and were revealed to be massively insolvent.

AIG passed its stress test immediately before it failed. The three big Icelandic banks passed their stress tests shortly before they were revealed to be massively insolvent. Lehman passed its stress tests. The stress tests ignored the actual primary causes of losses and failures – extreme losses on fraudulent liar’s loans and CDOs.

For my sins, I read every one of FRBNY President Geithner’s speeches discussing regulation. Geithner is a one-trick pony. His answer, to everything, was stress tests. He claimed that the largest banks had developed advanced, proprietary stress tests that provided ever increasing assurance that they were safe and well-capitalized. The crisis revealed that the models and the safety were illusory.

Geithner and Bernanke ignored the lesson of the crisis and created stress tests that were as fictional as the industry’s failed stress tests. The U.S. stress tests, designed by Fed economists (and that is frightening given their role in causing the crisis) were largely conducted by the largest banks. To everyone’s surprise, they found that the banks were overwhelmingly sound and well-capitalized. The stress tests, however, largely excluded the banks’ losses on liar’s loans and CDOs.

The EU’s stress tests have excluded the banks’ exposure to sovereign debt risk despite the rise of sovereign risk so severe that it could render a number of banks insolvent. German Prime Minister Merkel’s coalition has just lost its sixth regional election (out of the seven most recent elections). Germany’s economic “success” is mixed. It has reduced unemployment, but its middle and working classes have seen flat or even declining incomes. This economic record is one of the reasons why Merkel’s coalition has been losing elections. Merkel’s most acute political problem, however, is that the purported bailout of the periphery is profoundly unpopular in Germany.

The obvious question is why Merkel (eventually) supports the bailouts. The answer is that German banks are the largest single beneficiaries of the bailouts – and much of Europe subsidizes the bailout of German banks by the EU. The German government claims that German banks are sound, but their actions constant betray these claims. The Germans have insisted that any increase in capital requirements in Basel III be phased-in slowly over roughly a decade. The sole reason for the German position is the fear that several large German banks are so insolvent that they would not be able to meet the Basel III requirements. The German banks’ imprudent loans caused great harm in the periphery. (“German Banks Gone Wild!”) Their inadequate capital poses a severe danger to Europe and the U.S. The German regulators have insisted that their banks’ exposure to sovereign risk be excluded from the stress tests. (The European stress tests mirror the U.S. stress tests in largely excluding losses from fraudulent loans.) The Germans have, after allowing the periphery to twist slowly in the wind for months, ultimately favored bailouts of the periphery because they fear that allowing a sovereign default would make obvious the German banks’ large losses and reignite the financial crisis.

Which brings me back to my original question – why are so many banking regulators insisting on conducting faux stress test when everyone knows they are rigged? One need not believe in the efficient markets hypothesis to believe that anyone sentient in the markets must know that the stress tests are shams. The public doesn’t believe, and doesn’t need to believe, that the largest banks (the systemically dangerous institutions (SDIs)) are financially sound. The public believes that the government will bail out the SDIs and protect their depositors from losses. So please join me in urging an end to the farcically faux stress tests.


Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

As we await another FOMC statement, let’s do a quick 10 yr retrospective of Fed policy. The fed funds rate went from 6.5% to 1% early last decade focused on cleaning up the stock market bubble and an easy money induced credit bubble ensued that sent debt levels as a % of GDP to record highs. A bust followed as rates went up to 5.25%. To clean up the aftermath of easy money, the Fed embarked on another phase of easy money, this time on a level far above that ever seen before. We stand now today with an unemployment rate of 9.1% and a record high CPI index with the recent rates of change of 3.8% y/o/y and a core rate of 2%. Instead of calling a time out for an analysis of the track record vs their Congressional mandate of price stability and maximum employment, we’ll get today another bout of Fed induced easy money policy. Hold the applause, please. Not to be outdone, the minutes from the last BoE meeting reveal that they are ready to enlarge their asset purchase program because “there had been significant downside news on activity over the month…which had pointed to a synchronized slowing in global growth.” The pound is at an 8 month low in response. I digress. With the avg 30 yr mortgage rate at just 4.29%, purchase apps still fell to a 7 month low. Refi’s rose just 2.2%. The Shanghai index rose by 2.7% after China’s leading and coincident economic indicator rose to recent highs. In Europe, the Greek government today will discuss internally the demands of the EU/IMF fully expressed over the past week to them. French banks are trading poorly again with BNP in particular matching the lowest level since Mar ’09.

By now, I am pretty much bored silly with the nonstop Fed watching, commentary, will they/wont they chatter about today’s FOMC announcement. So much ink has been spilled over the subject, that much of this is well trod ground.

Rather than repeat the usual blah blah blah, I thought I might raise a few points that might otherwise be overlooked:

1. Zero: With Fed rates pressing at the zero boundary, there is only so much ANY central bank can do to help the economy.

2. Not the usual cyclical recession: The Credit Crisis creates a specific recession recovery cycle. It is markedly different than a regular recession, and characterized by consumer de-leveraging. Hence, low rates are ineffectual to stimulating growth.

3. Fiscal vs Monetary: Problems with unemployment and weak growth will eventually be repaired via the elapsing of time. The alternative is concerted, targeted, intelligent stimulative action from Congress and the White House, unlikely to occur due to ideological rigidity, partisan posturing, and lack of economic intelligence in DC.

4. Wealth Effect: Is widely misinterpreted by economists, including those at the Fed. (It is more correlation than causation). Hence, the Fed’s focus on asset prices such as equities is utterly misguided, and doomed to disappointment (as we have already seen).

5. Liquidity vs Solvency: Central banks can provide a gusher of liquidity to prevent the financial system from seizing. They cannot make insolvent banks whole; they cannot turn debtor nations into creditors; they cannot spin dross into gold.

6. Bailouts: Do not resolve the underlying problems, they merely paper them over. Hence, the 2008 rescue plan, now 3 years old, is fading, once again revealing the underlying problem with a finance sector that still has too much debt, too little capital.

7. FOMC Transparency = Central Bank Failure. The Fed’s moves to be more transparent is an admission that their prior policies have failed to gain the traction they hoped. Interest Rates are totally transparent, the time period they will stay where they are has been unequivocally stated. More jawboning is not a solution.

I am curious to see if Ben Bernanke has any more rabbits to pull out of his hat. If he fails to produce another QE2 like miracle, the odds of a 2012-13 recession will tick higher.

Here’s a great chart just released by the International Monetary Fund.   Note that almost half — 47 percent –  of the US$14.7 trillion U.S. federal government debt is held by the Federal Reserve and the government itself, such as the Social Security trust fund. Add to that the 22 percent foreign official holdings (mainly central banks)  and almost 70 percent of the debt of the U.S. government is held by non-market/non-profit oriented investors.   Stunning!

It’s also interesting to hear Europeans quote the $14.7 trillion (apx. 100% of GDP) figure while U.S. officials like to refer to marketable or debt held by the public, which totals US$10.1 trillion (apx. 75% of GDP).   We’ll be back to you with more on this issue.

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click on the chart to enlarge