-->Fat Tails

The Daily Reckoning

Paris, France

Wednesday, 8 October 2003

---------------------

*** Dollar plunges... a cause for tears? Still waiting for
the 'recovery' to express itself...

*** Debt. Debt. Debt. Debt = wealth... huh?

*** Thank God for the Carrier Corporation! The weight-
lifter ascends to office... and more...

---------------------

Yesterday brought good news to those who would like to see
the country ruined.

First, stocks continued to rise on Wall Street.

Second, it was reported that consumers continued to scrape
their way towards insolvency throughout the summer.
Borrowings increased by $8.2 billion in August, with
consumer credit rising at a 10.25% rate.

Third, the NY Times reports that the"Dollar weakens
again," adding the cheerful instant analysis:"No U.S.
tears shed."

This last remark may need qualification. When the dollar
goes down, Americans have less purchasing power. Since so
much of what they buy comes from overseas, a serious drop
in the greenback would cause prices to rise and reduce
standards of living. Another way to look at it is that a
fall in the dollar reduces the value of everything made in
America and every asset calibrated in U.S. currency. Even a
10% decrease would be the equivalent of reducing the value
of U.S. output by more than a trillion dollars, for
example.

This may not be cause for tears, but an alert investor
might at least get a little misty-eyed. Likewise, the
California homeowner might be a little disappointed to
realize that the 'equity' he borrowed out of his house
disappeared in the currency markets... while he still has to
pay off the loan or lose his house.

Of course, those of us who live overseas and pay our bills
in Europe feel the greenback's slippage more immediately
and take it more personally. We are annoyed by it every
time we order a glass of beer or tuck into a canard à
l'orange. There is no point in complaining about it, but we
can't but wonder how long it will take for other Americans
to realize that a falling dollar makes them poorer, too.

But no tears were shed yesterday, according to the NY
Times. People imagine that the dollar will do a graceful
dive... and thereby put the world economy back in balance.
Then, they believe, the recovery can fully express itself
and the real boom can begin.

The people who think this are the same people who are not
only delighted that consumers keep digging deeper holes for
themselves... they egg them on! And they are the same people
who think that stocks can go up forever... or at least until
after the next election.

Elsewhere in yesterday's news, it was reported that the
Carrier Corporation, which brought affordable air
conditioning to millions of Americans, announced that it
was ceasing all U.S. manufacturing. Henceforth, all new
Carrier machines will be imported from overseas. Twelve
hundred employees are now sweating out a new job search.

A lower dollar is supposed to help companies like Carrier.
Maybe it will. And surely a decline in the dollar is
necessary... and inevitable. But it won't come
without tears.

More news from Addison, below...

-------------

Addison Wiggin at the Daily Reckoning HQ in Paris...

- Well, at least they appear to be keeping track, even if
they're not at all concerned. The Fed, that is. It was a
Fed report, released yesterday, which informed us that
Americans had piled on $8.2 billion dollars in credit in
August. The annualized figure is $1.95 trillion and change.

- Okay, let's do the math. According to the World Fact
Book, the GDP of the entire U.S. economy is just over $10
trillion - that's $37,600 for every man, woman and scamp in
the country - making it"the largest and most
technologically powerful economy in the world."

- What really goes on in the"largest and most
technologically powerful economy in the world"? Well, a
whole lot of borrowing for consumption, apparently. Apart
from the fact that 80% of that U.S. GDP is derived from
'services,' on an annualized basis, in the month of August,
the Almighty American consumer borrowed nearly 20% of the
world's largest economy's GDP.

- What's more, as we reported in these pages last week, the
average household carries an outstanding credit card debt
load in excess of $8,000. Reaching for the calculator once
again, we see that the average household is funding nearly
20% of the per-capita GDP with consumer credit.

- As if that's not interesting enough... we scan down the
World Fact Book page a little to look at the revenues for
the U.S. government in 2002: $1.94 trillion! If consumers
continued to rack up debt at the rate they did in August
for an entire year - they would borrow more money than all
the tax receipts of the federal government combined. (The
government, of course, spent more than $2.02 trillion in
2002, but what else would you expect from those clowns?)

-"How long can this all go on?" We ask with the droning
repetition of a floor sander. Of course, the reply, for
some, must of necessity be:"as long as possible."

- The Fed themselves might utter just such a response.
According to the Mogambo Guru, who makes a habit of
tracking these things, last week,"the Fed jumped into the
money-mobile, turned on the ignition, put the Fed into high
gear and roared back into the market. Greenspan goosed
total credit by $9.5 billion... a new record. Foreign
central banks decided they would be happy to soak up the
debt of an almost-bankrupt nation of fat deadbeats, and
took up another $10 billion... also a new record."

- Debt. Consumer debt. Treasury debt. Corporate debt. All
is debt. Debt. Debt. Debt. Debt. Debt. Who will pay for all
the debt? And with what quality of currency? One begins to
see the wisdom of the Fed's"War on Deflation"; deflation
makes debt more costly to repay. Inflation, on the other
hand, is a debtor's best friend. If you happen to be a
saver... tough luck, pal.

- Mr. Market, for his part, who makes a habit of ignoring
these things, jumped... the Dow climbed 59 points to
9,654... the Nasdaq leaped 14 to 1,907... and the S&P
slithered nearly 5 points up to 1,039. But who cares?
According to one study, the stock market is but a boil on
the peau of American families' balance sheets.

- Providian Financial Corp., a company that specializes in
debt, bad debt, and worse debt, released findings yesterday
showing that during the boom from 1995 to 2001, the net
wealth of the typical middle-class household rose 23% from
$60,000 to $74,000. But"while stock holdings grew,"
summarizes the AP,"stocks still represent a minor portion
of net wealth" for the typical middle-class family. What
really seems to comprise their wealth is debt... and
consumption.

- One of the more inane explanations we've read recently
explaining the rally in the stock markets and the so-called
'recovery' (jobless as it may have been) came by way of an
editorial in TheStreet.com, written by a writer on whose
behalf we would be ashamed if we were to mention his name,
so we won't. His theory was that"wealth" - at least, as
it's understood in the context of the late degenerate
capitalist model - can be quantified and expressed by a
family's power to consume.

- Under such a scenario, debt = wealth. Again, let's do the
math. If we were to carry $8,000 in credit card debt... we
would be able to add $8,000 dollars to our personal net
worth. The nation, by August standards, would likewise be
able to add an additional $1.95 trillion to the national
GDP. This is the kind of thinking that leads to headlines
lauding economic recovery and the rebirth of the bull
market boom.

- We here at the Daily Reckoning HQ are left with only one
question: Where do these people come from?

- Some 50% of the 1,000 people who responded to the
Providian survey said they were"worried" or"very worried"
about their family's finances. To their credit, the
conclusion of the Providian Financial report was that in
order to avert feelings of worriedness, Americans need to
save more... (Duh... )

-------------

Bill Bonner, reposing in Nicaragua...

*** Thank God for the Carrier Corporation. Your editor
spent much of yesterday hiking over the green hills,
sweating. Had it not been for air conditioning, some of the
most beautiful areas of the planet would be scarcely
habitable.

*** Well, now it is official. The weight-lifter has been
elected governor of the Base Metal State. He takes his
place at the head of the world's fifth-largest economy. At
least, it is now.

The Austrian's name can now be added to a distinguished
list of America's greatest politicians. It is sad to see a
good man gone bad like that.

---------------------

The Daily Reckoning PRESENTS: Bonner on the day that genius
failed; an inspiration for the second chapter of Financial
Reckoning Day.

This essay was originally broadcast on 4 March 2002.


FAT TAILS
by Bill Bonner

"I should have stayed away from the stump."

- Elizabeth Bonner

The figure in the distance was no native Nicaraguan. He was
too pale. Too tall. And he was running towards us. People
do not run in the tropics.

It was my son Jules. But Jules does not run often, either.
Was something wrong?

"Dad," Jules reported when he reached us,"Mom's had an
accident at the stable."

In a second, there were three of us running along the
beach.

People who ride horses suffer accidents all the time. Among
the regular riders we know, few have not worn a cast or a
neck brace on occasion. Riders are regularly kicked,
thrown, knocked off or rolled upon. Riding competitions and
foxhunts usually have a few people with gimpy legs or
crutches in attendance.

Insurance companies can calculate the odds and set rates
according to their risks. A man, raising himself into the
saddle, might know that his chances of breaking his neck
are 1 in 13,000 or that the odds of breaking a leg are 1 in
1,300. But the statistical precision is an illusion. On the
day a man is going to break his neck on horseback, the odds
are 100% against him.

Elizabeth is a good rider, I thought to myself as I ran
along the beach, but so was Christopher Reeve.

Our stay in Nicaragua was blemished by only one scary
event. I bring it up only to raise the subject of
risk... and to leave you in suspense.

On September 23, 1998, William J. McDonough, president of
the N.Y. Federal Reserve Bank, brought together the heads
of America's biggest banks - along with representatives of
several large foreign banks. It was an unusual thing to do.
In fact, it had never been done before. But the Fed feared
the collapse of Long Term Capital Management might expose
the banks to a level of 'systemic risk' that had never been
seen before.

"Long Term knew it had to reduce its positions, but it
couldn't - not with the market under stress. Despite the
ballyhooed growth in derivatives, there was no liquidity in
credit markets. There never is when everyone wants out at
the same time...

"Thus," continues Roger Lowenstein's account of the fall of
Long Term Capital Management in 1998,"in September, 1998,
traders were becoming acutely aware of risk. Spreads
between 'safe' Treasury bonds and less safe corporate or
foreign bonds were spreading. In the crowded theater of
bond trading, in particular, all the players seemed to come
to the same conclusion at the same time. Rushing for the
exits... they posed a danger not only to themselves, but to
the entire world financial system."

We refer to Lowenstein's book,"When Genius Failed," today
because your editor just read it... and because he believes
that genius never fails just once.

The geniuses at Long Term Capital Management managed to
turn its silk purse into a sow's ear in just 4 years. The
losses to LTCM's trading partners might have been even
bigger. But the geniuses at the Fed and central bankers
worldwide rushed to do what central bankers generally rush
to do - provide more credit. The generous helping of new
credit provided by the Fed following the triple disasters
of the late '90s - the Asian currency crisis, the Russian
bond collapse, and the fall of LTCM - was bound to produce
some failure of its own.

"It was bizarre," said one trader, as LTCM was losing
billions."Day after day we had massive losses, and they
didn't stop."

Lowenstein explains what happens at the end of a boom:
"When losses mount, leveraged investors such as Long Term
are forced to sell, lest their losses overwhelm them. When
a firm has to sell in a market without buyers, prices run
to the extremes beyond the bell curve. To take just one
example, yields on News Corporation bonds, which had
recently been trading at 110 points over Treasury's,
bizarrely soared to 180 over, even though the company's
prospects had not changed one iota. In the long run, such a
spread might seem absurd. But long-term thinking is a
luxury not always available to the highly leveraged; they
may not survive that long."

Lowenstein is describing what statisticians call a"fat
tail." A bell curve ought to be perfect - as perfect as the
Nobel Prize winners thought the market itself was. In fact,
the market is not perfect in a mathematical sense or
logical sense. It is only perfect in a moral sense; it
gives people what they deserve.

At the extremes, prices no longer follow a logical pattern.
Investors become irrationally exuberant when prices reach
their peaks at one end of the curve... and desperately
fearful at the other end. Very few stocks, for example,
should ever be extremely expensive or extremely cheap.
Normally, very few are either. But at the dark ends of the
bell curve, fear and greed haunt the markets - and send
prices running in unpredictable ways. Investors buy stocks
at ludicrous prices at the top... and sell them at equally
ludicrous prices at the bottom. The tails - on both sides
of the bell curve - are fattened by absurdities.

But people are free to believe anything they want. And from
time to time, they almost all come to believe the same
thing. In the mid-'90s, professors were winning Nobel
Prizes for showing how markets were perfect and how risk-
reward ratios could be quantified as though an investment
were a throw of the dice or an actuarial table.

When you throw the dice, the odds of any given outcome can
be calculated. And they are always the same. Whether you
get snake eyes one time or a hundred times, the odds of
rolling snake eyes the next time are the same. Dice have no
memory.

Investors do have memories, but not much imagination. They
shift the odds constantly, following their most recent
experience. The period 1982-2000, for example, was marked
by such generous stock market returns that investors came
to expect them. Since then, the last two years have been
losing ones. But investors still think stocks will revert
to the mean return of the '82-'02 period - about 18% per
year.

Prices are a function of confidence. When investors are
confident, prices rise. When they are not, prices fall. But
confidence, too, is mean-reverting. It took 18 years of
rising stock prices to bring investor confidence to present
levels. It will take several years to beat it back down to
the long-term mean.

Neither most investors nor most Nobel Prize winners can
imagine it, but the odds that the next 20 years will mimic
the last 20 are vanishingly small. When investors are
spooked, Lowenstein explains,"capital naturally flows from
riskier assets to less risky ones, irrespective of their
underlying value."

In a real pinch, no one wants the riskiest investments.
Long-Term Capital Management had been so sure of its
computer models and so eager to squeeze out every possible
bit of profit that it found itself in possession of the
riskiest bets in the marketplace. But these were not cheap
stocks it held. It could not just hunker down and wait for
the market to return to its senses. Instead, LTCM held
derivative contracts and other investments that neither
paid dividends nor had any intrinsic value. What's more,
thanks to its stellar reputation, it had been able to
purchase its positions on nearly 'no money down' terms. At
one point, for every $100 in exposure, the fund held only
$1 in equity. As little as a 1% move in market prices - in
the wrong direction - would wipe it out.

In the autumn of 1998, the market was moving in the wrong
direction every day. A fat tail had been reached in credit
markets - where all the traders seemed to want to get out
of the very same positions at the very same time. The
professors didn't know what to make of it. It was"a kind
of volatility they didn't understand," said one of the LTCM
partners.

The company was named"Long Term," but just 4 years after
they opened for business, their backs were up against a
wall of prices they had said would not be likely in more
than a billion years. Their mathematical models, Lowenstein
claims, showed the odds of this kind of market were"so
freakish as to be unlikely to occur even once over the
entire life of the universe and even over numerous
repetitions of the Universe."

"The professors hadn't modeled this," writes Lowenstein.
"They had programmed the market for a cold predictability
that it never had; they had forgotten the predatory
acquisitive, and overwhelmingly protective instincts that
govern real-life traders. They had forgotten the human
factor."

They were right about regression to the mean. Things that
are extremely out-of-whack eventually work their way back
into whack. But then they diverge again and the tails
fatten. Sometimes prices diverge from the mean. Sometimes
they regress towards it. Give yourself enough leverage, and
you can go broke in either direction. The geniuses at LTCM
lost $4.5 billion - much of it their own money. You or I
could probably never have lost anywhere near that much -
even with a computer, we're not that smart.

The banks lost money, too. They would have lost a lot more
had they not come to the aid of LTCM... and the central bank
not come to the aid of everyone by providing more credit.
This new burst of credit was taken up by a new group of
geniuses - such as those at Enron. Compared to Enron, LTCM
was"like a lemonade stand," Frank Partnoy told a
congressional committee. Enron earned more in derivatives
trading in a single year than LTCM did in its entire
existence.

The N.Y. Fed helped save the world from LTCM, but it set
investors up for Enron... which cost them 16 times as much.


Your humble editor,
Bill Bonner

P.S. Elizabeth was already hobbling into the clubhouse,
supported by Manuel, by the time I got there. Her horse had
tripped on a stump and fell over on her. What a relief - to
find her ambulatory, with no bones sticking out in odd
places! She was back on a horse the next day.

P.P.S. Neither the geniuses at LTCM or at Enron are still
geniuses. Both have failed. But the entertainment is not
over. We still have the geniuses at the Fed and far more
'systemic risk.' And plenty of stumps.