Cezary Salad

Open up any paper today and you’re sure to read something along the lines of “the government’s leverage over US banks is weakening” because so many of them are exiting the Troubled Asset Relief Program (aka the bailout fund). With Citi and Wells Fargo announcing within hours of each other that they will be paying back their bailout packages, the banking sector as a whole will have paid back $161 billion of the $245 billion it received from the bailout fund, according to the Wall Street Journal.

To be sure, there is no denying that by repaying their bailout funds the banks are freeing themselves from the kind of scrutiny and tight control over pay and perks that comes with being a taxpayer-supported entity.

But let’s not kid ourselves: the US never really had much - if any - leverage over the banks it bailed out. I realized as much last week when I went to hear William Dudley, President of the Federal Reserve Bank of New York and a key behind-the-scenes player for bailout of insurer AIG, speak at my university (video available on the Columbia World Leaders Forum website).

Think back to September 2008. When Fed Chairman Ben Bernanke and former Treasury Secretary Hank Paulson went to Capitol Hill to ask Congress for the bailout funds, their rationale was simple: the very existence of the US financial system is at stake. As Dudley put it:

“The choice that faced us was financial Armageddon or saving the financial system. It was a choice between two bads and we picked what we thought was the less bad. But it wasn’t a great outcome - we agree with that.”

The reason it wasn’t a great outcome, of course, is that there was seemingly no way to separate saving the financial system from saving the financiers who nearly felled it. As a recent inspector general report uncovered, the US Treasury made its initial $85 billion loan to AIG last year knowing full well that substantial chunks would be used to make payments to the bankers it dealt with - i.e. Société Générale, Goldman Sachs, Merrill Lynch, Banc of America, among others.

Providing the loan was necessary to avoid the aforementioned Armageddon. But it also resulted in the so-called “backdoor bailout” of these banks, as they got their money and they got it at 100 cents on the dollar. So now that many of them are doing better and have either awarded or are about to award billions of dollars in taxpayer-funded bonuses, “wasn’t a great outcome” is putting it lightly.

Dudley acknowledged as much; he said multiple times that this was unfair, adding “if there were some way that we had the tools to save the financial system and not save the bankers, that would have been a better way to go. But we didn’t have that choice.”

New York Times columnist Paul Krugman thinks they did. In a scathing November 19 editorial, he accused the Fed of treating the financial industry with “kid gloves” because Dudley and his team did not exact concessions from the bankers who got AIG’s - rather, the taxpayers’ - money.

Krugman’s “kid gloves” comment was on my mind when I asked Dudley why he couldn’t wrestle even the slightest concession from, say, Goldman Sachs. After all, the investment bank held a call with business reporters in early March to say, in essence, that it had hedged its bets well enough that it did not need the $13 billion it received from AIG. Dudley was curt in his answer:

“If you’re preventing a bankruptcy, you’re supporting all the counterparties. You cannot pick and choose. And so whether Goldman Sachs was well hedged or not was immaterial.”

In other words, at the point when you say, “we’re going to avoid a bankruptcy,” you lose your leverage. The normal rules of the financial system apply and everyone gets paid what they’re owed, as opposed to a bankruptcy situation, where the senior creditors would have gotten their money first and counterparties like Goldman would likely have ended up empty-handed.

“To put it starkly, power in a negotiation comes either from being able to issue a credible threat or from coercion,” Dudley said in his prepared remarks. He freely admitted that the Fed clearly had neither tool at its disposal.

And so the financial system was saved - as were the bankers.

Lesson learned? Well, if the US gave $85 billion to an insurance company that then went on to post a world record $61.6 billion quarterly loss and reward the executives responsible for the loss with bonuses, that doesn’t say much about our ability to attach strings to bailout funds to limit these not-so-great-outcomes. Indeed, as with AIG, so with the other TARP recipients, who took when they needed and haven’t much changed their behavior.

And why should they? To paraphrase Dudley, power in negotiation comes from leverage. And the only leverage the US has these days is $12 trillion in national debt.

It’s rare to pick up the paper on the way to lunch with someone and find a story that prepares you precisely for the conversation you’re about to have. But that’s what happened to me a few days ago when I read the New York Times on the way to a lunchtime meeting with Ed Grebeck.

Grebeck specializes in a subject of great interest to me – structured finance– and we were meeting to discuss how, more than two years after the outbreak of the financial crisis, not much, if anything, had been done on the regulatory front to make sure that the mistakes of the past don’t happen again.

The Times’ Friday business columnist, Floyd Norris, just happened to have a piece in the paper (yes, I still subscribe to print) that day on MBIA’s lawsuit against Merrill Lynch. The fallen investment bank was a big client of MBIA during the go-go days before the mortgage bubble bust, when it paid the financial insurer to take the hit if any of its mortgage-backed securitisations should ever go sour (so-called credit default swap contracts).

MBIA wrote $5.7 billion worth of these for Merrill at extremely low fees of .08% annually, according to their complaint – all based on assurances from Merrill and credit ratings from Moody’s and S&P that the securities it was insuring were indeed the “highly conservative super-senior,” “above AAA credit quality” debt instruments they thought they were. No credit analysis whatsoever by MBIA of the securities’ underlying assets. In other words, as Norris indicates, it’s another “I didn’t do my homework” lawsuit that’s bound to become a chapter in someone’s book on how the whole financial meltdown started in the first place.

Grebeck got a chuckle out of the story since it wasn’t anything new to him. It was two years ago this month that he, hedge fund managers Bill Ackman and James Chanos and Yale Law School’s Jonathan Macey held panel during which they warned that financial guarantors like MBIA were increasingly dependent on credit rating agencies for their AAA franchises and weren’t doing enough of the homework themselves to make sure guarantees they were making would have the payout rates they expected.

The result was one giant, systemic fallacy of equivocation, where one term with two different meanings is used in a single argument. The argument was: these are AAA-rated securities, so they must be safe. How safe? Well, they wouldn’t be rated AAA if they weren’t as safe as other banks or corporate that earn the same rating, so they must be of the same credit quality – even though they weren’t. As Grebeck points out, in corporate credit there is recourse to secondary sources of capital, such as the value of buildings and capital stock, which can be monetised in case a company becomes insolvent. In structured credit, all you’ve got are the incoming cashflows from the underlying assets: once the cashflows dry up, you’re left with nothing else.

So why equivocate? Part of it was undoubtedly because the regulators let the financiers do it. Take a look at the pre-credit crisis version of the Basel II accord, an international treaty which governs, among other things, how much capital banks must keep on their books against certain types of credit risks. Sure, there’s a special section in Basel on so-called “synthetic” AAA-rated securities resulting from structured finance and how their capital charges should be calculated differently from corporate securities. But not differently enough: “the capital treatment of a securitisation exposure,” Basel said, “must be determined on the basis of its economic substance rather than its legal form.” As the MBIA lawsuit demonstrates, economic substance was hardly considered. So no wonder that banks were able to give their synthetic AAA claims the same risk weighing (20%) as allowed for corporate under Basel.

On the face of it, of course, they should have known better. Even without relying on Merrill, MBIA probably knew that ratings have a way of being off – just by their very nature. As Dimitris Chorafas explains in Economic Capital Allocation With Basel II, the step-ladder AAA, AA, A etc. gradations of credit rating agencies are hardly black-and-white distinctions. Instead, they come in what Chorafas calls “fuzzy sets” where a company rated AAA has a high possibility of being of that grade, but also a low possibility of being AA+, or one notch below, and so on. So even if MBIA took Merrill’s word as gospel, they sure didn’t allocate enough capital to the lower-probability outcomes. Result: under-priced services and over-exposure to risk.

But enough with the causes; what of the solutions? The sad truth is that they’ve been slow to come. It’s just this past July that the Bank of International Settlements, which oversees Basel, took steps to strengthen its so-called “three pillars” of governance. Chief among them are proposals to strengthen capital requirements for securitisations – i.e. end the fallacy of equivocation that allowed all the above-detailed financial arbitrage in the first place.

Will it work? Only time will tell. But for now, I’m tempted to side with Grebeck when he says that credit risk is about behavior – not models. It’s about time bankers were required to draw a hard line between the two.

For anyone interested in emerging markets, the mot juste all of last year was the d-word: “decoupling”. In a nutshell, it’s the theory that emerging economies have gained enough critical mass to chart their own path to growth and prosperity independently of the developed economies in Europe and North America. In other words, a recession here shouldn’t automatically translate to a recession there.

In 2008, the concept became so controversial among economists that one could even catch the venerable Economist weighing-in on both sides of the debate (“Decoupling is not a myth” – March 6, 2008 print edition; “So much for decoupling” – 18 September, 2008 print edition).

This week, Newsweek’s international editor, Fareed Zakaria joined the fray. Zakaria, an astute observer of foreign affairs, argued in his June 8 Newsweek column (“Boom Times Are Back - Just not here in the United States”) that the global economy is increasingly going to become a tale of two worlds. In one camp, there will be the booming, hard-charging emerging economies like China, Indonesia, India and Brazil and in the other the lagging bastions of wealth and power like the US, Europe and Japan (unless, of course, the latter undertake drastic reforms to alter this inevitable fate).

For regular followers of Zakaria, this, of course, is nothing new; his bestseller, The Post American World, is an exposition on this very same paradigm. And he made the same point last year in an article for his previous employer, Foreign Affairs magazine.

But one paragraph caught my attention since, without naming the controversial d-word, Zakaria seemed to use it as a way to justify the tale of two worlds:

Over the past six months, much conventional wisdom about the economy has been discredited. The old experts who spoke with confidence about unending global growth—the boomsters—have been debunked. But the new pundits of pessimism—the doomsters—have demonstrated a similar hubris, ignoring any evidence that might complicate their story. Six months ago, stock markets around the world swooned in unison as the American financial system seemed on the verge of collapse. This led many to conclude that the emerging economies of Asia and Latin America had been growing only because of their exports to America and Europe; that they obviously had no independent strengths of their own and would in all likelihood collapse faster and more furiously than the sophisticated economies of the West. After all, these were Third World countries.

Not exactly. Zakaria’s got the big picture right – there is indeed a growing rift between these two worlds – but he oversimplifies the details of how this fits in vis-à-vis decoupling.

First, one ought to take a longer reference point than the last six months. After the credit markets exploded in August 2007, emerging markets were one of the first places investors went with their displaced capital. So then, like now, as markets peaked here in the US and in Europe, they continued to hum along in places like Brazil, Russia and China.

Then, of course, came the big crash in January 2008, when markets tumbled all around the world and the Federal Reserve made its emergency 75 basis point cut to stem a similar panic here in the US before markets opened on Tuesday, January 22, 2008. It’s that episode, much more than the post-Lehman collapse roller-coaster, that’s ground zero for any debunking. We saw then these “new pundits of pessimism” argue that the emerging economies would follow the US into recession and the “old experts” appeared debunked. Now, thanks to the recent bull market, it seems the opposite is true.

This, of course, sits well with Zakaria’s tale of two worlds. He cites China’s Shanghai index (up 45 percent this year), India’s Sensex (44 percent), Brazil’s Bovespa (38 percent) and Indonesia’s index (up 32 percent) as evidence of this debunking.

But it is more helpful instead to look at peaks and troughs. US markets (as measured by the S&P 500 Index), peaked in October 2007 and bottomed in March 2009. Stocks are a leading indicator, so this means that investors thought the US would enter recession around 1Q 08 and re-emerge sometime this year.

China’s Shanghai index likewise peaked in October 2007, but it troughed earlier – November 2007. India’s Sensex peaked in January 2008 and troughed in March 2009. Brazil’s Bovespa fared better, peaking in May 2008 and troughed in October 2008 (see chart below – interactive version is available here. Indexes are rebased to August 2007 and presented on a logarithmic scale; I left Indonesia out since I don’t know which index Zakaria was referring to in Jakarta).

What’s remarkable about this portrait is that all of these economies seem to have followed the US into recessionary bear markets, peaking after the S&P and recovering before or as it recovered. This begs the question: did these and other emerging countries begin to recover because of their own, innate strength or because investors saw recovery on the horizon in the US and other developing markets?

I certainly don’t claim to have an answer to this question and, as Zakaria wisely points out, stock markets don’t tell the whole story. But it just goes to show that this whole debate is a lot deeper and more complicated than he makes it out to be in his column.

In the long run, though, he certainly has a point: China, Brazil, Indonesia and other emerging economies are certainly in a better fiscal shape than the US and Europe right now and are poised to grab a larger share of the world’s wealth and power in the coming decades.

But how they get there and who follows who is far less clear than the black-and-white tale of two worlds.

I posted a new paper under the philosophy section of my blog in response to George Soros’s new book - The New Paradigm for Financial Markets: the Credit Crisis of 2008 and What it Means. I reproduce it below as a blog post.

Reflecting on Reflexivity

In 1962, a (now famous) philosopher of science named Thomas Kuhn drew much attention for his controversial claim that, when scientific theories of the world change, the world itself changes, too.

Since 1987, financier and philanthropist (and self-admitted amateur philosopher) George Soros has been making a similar claim, but with a focus not on the natural sciences that Kuhn spoke of but instead the social sciences – specifically, economics.

Soros’s dictum – the theory of reflexivity – asks that we set apart sciences which have thinking and non-thinking participants and those which have only thinking participants. A chemist studying a molecule can make independently valid statements about the molecule that may qualify as knowledge. An economist studying the behavior of crowds to make judgments about supply and demand can do no such thing: his theories, in the Kuhnian sense, will impact the world of his participants and thus put knowledge out of reach.

If Soros’ theory is true, it cuts a wide swath. It implies at once a need for a new ethics, a new epistemology and – of course – the need to tear up our classical economics textbooks.

Yet, as Soros confesses in his latest treatise on the subject - The New Paradigm for Financial Markets: the Credit Crisis of 2008 and What it Means – published a year ago in response to the financial crisis, philosophers, economists and financiers alike have failed to give his theory serious consideration.

Naturally, this begs the question: why? Is Soros wrong or is the establishment wrong?

When was an undergrad at Penn, I never thought there would be much synergy from being a philosophy major and a business student. Here, I found my challenge.

What follows is a critique of Soros’s philosophy that I hope can shed some light on where his theory of reflexivity excels and where it falters.

My main claim is very simple: Soros commits the same mistake as Kuhn did in his magnum opus The Structure of Scientific Revolutions: he carries a good idea to an unjustifiable conclusion.

Just as one can read Kuhn and be convinced by his account of how new scientific theories become prevailing paradigms, one can ready Soros and be convinced about his account of how markets influence and are influenced by our attempts to understand them. But when he concludes from this that market participants “cannot base their decisions on knowledge,” Soros makes the same mistake as Kuhn did when he said that our scientific theories change the physical world: he carries his theory a step too far.

Part I of this post outlines Soros’s theory in greater detail to make sure that anyone who has not read it can be on equal footing. Part II outlines my criticism of his theory. Part III, in good faith, contains some advice for how he can strengthen his theory.

Part I: Soros’s theory explained

First, some background: Soros’s theory of reflexivity is based on another theory – the correspondence theory of truth – without which his whole paradigm could not work.

In its simplest form, correspondence holds that a proposition is true when it corresponds to reality, and false when it does not (cocktail party tidbit for you: this is what philosophers term “altheic realism” – the notion that truth hinges not on us, but on the world in which we live).

Soros argues that correspondence works well in the world of natural science but breaks down when applied to social science:

I contend that social events have a different structure from natural phenomena. In natural phenomena there is a causal chain that links one set of facts directly with the next. In human affairs the course of events is more complicated. Not only are facts involved but also the participants’ views and the interplay between them enter into the causal chain (New Paradigm, pg. 7 – emphasis added).

Another way to view this is in mathematical terms: a function is uniquely determined (and therefore true) if it has one independent variable which determines the value of the dependent variable. In natural science, there is just one variable – the natural world – but in social science, there are two variables: our understanding of social phenomena and the impact that our actions have on them.

Soros terms the first variable the “cognitive function” and the second variable the “manipulative function”. In other words, we seek to understand social phenomena but, as a result of being participants in them, we can simultaneously change, or manipulate them. And as we manipulate them, our understanding of them changes. As our understanding changes, so does our interaction with them. So changes in one function are reflected in the other, and vice versa. Soros calls this “reflexivity” and hence the name of the theory

“Reflexive situations are characterized by a lack of correspondence between the participants and the state of affairs,” Soros writes (emphasis his). Participants are always manipulating the state of affairs, so as soon as they make a statement about it that purports to be true, their actions can render the statement false.

Soros provides the following example to make this distinction clear:

Consider a statement about the objective aspect: “It is raining.” That is either true or false; it is not reflexive. But take a statement like: “Your are my enemy.” That may be true or false, depending on how you react to it. That is reflexive (New Paradigm, pg. 28).

Reflexivity is best studied and demonstrated in the financial markets, Soros argues, because market developments are not independently given by natural phenomena but instead are driven by human expectations. Classical economics, he argues, ignores this insight:

Demand and supply curves are presented in textbooks as though they were grounded in empirical evidence. But there is scant evidence for independently given demand and supply curves. Anyone who trades in markets where prices are continuously changing knows that participants are very much influenced by market developments. Rising pries attract buyers and vice versa. How could self-reinforcing trends [bubbles] persist if supply and demand curves were independent of market prices? (New Paradigm, pg. 55).

Our expectations (cognitive function) are reflected in the market when we buy or sell (manipulative function), which in turn impacts our expectations (cognitive function), and so on, ad infinitum. One reinforces the other. This, Soros argues, is how market bubbles are born.

More importantly, he argues that reflexivity “introduces an element of contingency or uncertainty into the course of events, and it prevents the participants’ views from qualifying as knowledge” (New Paradigm, pg. 4). In other words, market decision markers cannot base their decisions on knowledge.

Part II: A critique of reflexivity

Given this background, there are two possible readings of Soros’s philosophy.

One, I would argue, is uncharitable and the other is charitable (in philosophy, these terms typically mean taking the philosopher’s argument at its most extreme meaning versus giving it the benefit of the doubt).

Let’s start with the uncharitable interpretation:

In social situations, reflexivity produces uncertainty and thus prevents our views from qualifying as knowledge. Social science can therefore only succeed in producing opinion, whereas natural science can succeed in producing facts about the world.

This implies that we cannot make any claim to knowledge from observing our behavior and creating Newtonian rules such as the law of supply and demand. And so much, if not all, of economics, sociology, psychology and other social sciences are futile exercises.

Carry this line of thought further and soon you end up being the caveman in Plato’s Allegory of the Cave, mistaking shadows on a wall for a true account of the world. As with the allegory, where concealed persons chatting and carrying various objects before a fire result in the false impression that they are the real world, studying social situations inevitably results in a false view of the world in this Sorosian paradigm.

But is that what Soros is really advocating? I think not; one very easy way to disprove this reading is just to assume that it is correct. If Soros’s observations about the human position are true and reflexivity obtains, then social science can indeed produce some sort of knowledge. After all, what is The New Paradigm for Financial Markets if not a work of social science?

The real question is therefore not the black-and-white, “can we as participants in the social world order come to gain knowledge about it?” but rather, “how perfect is that knowledge?”

Ponder that question vis-à-vis his philosophy, and a much more charitable interpretation results:

In social situations, reflexivity produces uncertainty and thus prevents us from having perfect knowledge. Social science, like natural science, can therefore help us better understand the world, but it cannot reveal the ultimate truth about the world we inhabit.

To his credit, I think Soros believes as much. In later parts of The New Paradigm, he seems to soften his stance, arguing that “people are participants, not just observers, and the knowledge they can acquire is not sufficient to guide them in their actions. They cannot base their decision on knowledge alone” (New Paradigm, pg. 26, emphasis mine).

To make up for this shortcoming, Soros argues that we use various techniques – generalizations, similes, metaphors, habits, rituals – to organize information and make decisions. In doing so, though, various biases, emotions and other non-factual elements can enter our reasoning.

Now think back to Soros’s discussion of financial markets and what results is a pretty convincing case against the efficient market hypothesis.

This hypothesis (which Soros loathes) is predicated on the notion of perfect information: stock prices always reflect all relevant information and therefore trade at their fair value.

But apply the notion of reflexivity to the markets and it soon becomes clear that markets don’t always price in everything they should or exclude everything they shouldn’t price in. Like a river that collects sediment along the way toward its mouth, market biases, emotions, rumors and fictions get swept in with actual facts about a stock, all of which impact participants’ views (cognitive function) and impact the market (manipulative function) when they buy/sell.

Market information is thus not perfect (like the dirty river, it is filled with impurities), markets are not efficient, and they certainly do not tend toward equilibrium; rather, they tend toward whatever prevailing biases preoccupy investors any given point (ex. housing prices will continue to rise) until the bubble pops and the market corrects itself.

Viewed this way, I think Soros’s ideas are far more serious than many economists realize. Reflexivity is not an argument against the very viability of economics (in which case it would be understandable why social scientists would want to thumb their noses at him), but rather a call to arms to better understand the fallibility of our existing paradigms, like the efficient markets hypothesis.

It seems, though, that philosophers, economists and social scientists alike have turned a deaf ear to him for the past 20 years, perhaps opting for the uncharitable interpretation argument of his work and dismissing it accordingly.

So with Kuhn. People originally interpreted his book as a crazy argument that we can change the world with our thoughts: Copernicus comes along and all of a sudden the planets realign around the Sun?  Surely not. Eventually, a more charitable reading of his work gained consensus and his account of how scientific revolutions occur is now a key consideration in any class on the philosophy of science.

Will the same thing happen to Soros? Only time will tell; but in the meanwhile, he can certainly do some things to make his theory more tenable.

Part III: Some advice

Here are some questions that I believe Soros should answer to strengthen his theory of reflexivity (with the important caveat that I’m not an expert; undergraduate degrees in philosophy and economics only – no fancy stuff).

Questions of interest to philosophers:

1. Does reflexivity solely rely on the correspondence theory of truth, or could it co-exist with another theory of truth, such as coherence or identity
2. Reflexivity implies that the Cartesian view of the world (separation of body and mind) is wrong, so what is the proper place of the mind in a reflexive world?
3. What are the boundaries of reflexivity? The theory in its current form implies that all social situations are reflexive. But what’s a social situation and what is not? (Philosophers are notorious for thought experiments; sooner or later, someone will throw a remote control robot into this discussion).

Questions of interest to economists:

1. One of the assumptions of the efficient market hypothesis is that no one market participant is big enough to influence the market on his/her own. Does reflexivity accept the same assumption? (Another way to phrase the question: does someone like Warren Buffet – who can say “the economy has fallen off a cliff” and slice 80 points off the Dow - have more “reflexive” power than some guy with an internet connection and a blog?)
2. Are some markets more reflexive than others? If so, what distinguishes a reflexive market from a non-reflexive market – is it the number of participants, the type of security, or what? For example: I can bet on fed fund futures all I want, but at the end of the day, unless I break into an FOMC meeting and force the Fed Governors to raise or lower the fed funds rate, my bets can do little to move the target. But if I own a large stake in a company, become bearish and start selling, my outlook can influence the market much more. So where do we draw the line?
3. If markets are indeed reflexive, does that mean that we are doomed to forever go through bubbles and busts and super-bubbles and super-busts, or does reflexivity allow us to forge a cure for this?

One last piece of advice for Soros: pick a discipline, because philosophers and social scientists often don’t see eye to eye. I learned the hard way: I once had to spend a whole summer re-writing a thesis because one of my philosophy professors thought the paper I handed in belonged more in the realm of political science than philosophy.

So as long as reflexivity is rooted in both disciplines, chances are that some philosophers and economists will inevitably choose to ignore it because it’s out of their realm.

Good luck, George.

Way down in New York’s financial district, tucked away inconspicuously on the southern end of Wall Street, there’s a little gem of a museum - the Museum of American Finance - filled with all kinds of goodies from 200+ years of booms and busts on, well, Wall Street.

With $8 admisson and a new exhibit about the credit crisis that just opened up this week, it is well worth a Saturday afternoon visit - followed up with a beer at Ulysses down the street.  

The museum’s been around since 1987 but it is only in the last two years that it’s held its current spot on Wall Street - an old Bank of New York branch converted into a giant exhibition hall.

Below are some of my highlights - enjoy.

Obscure monies

My favorite exhibit was the museum’s collection of obscure coins and notes spanning the pre-colonial era to the latest money coming out of the US mint.

We used to have a lot of higher-denomination notes in circulation but Nixon apparently axed them in 1969 in an effort to fight organized crime. McKinley graces the $500 bill and Grover Cleveland landed himself a sweet spot on the $1,000 bill.

You can still use them as legal tender but if you come across one, might as well sell to a collector: they sell for multiples of their face value these days.

I had no idea that these people sat on dollar bills:

$5,000 bill - James Madison

$10,000 bill - Salmon Chase (the banker who puts the “Chase” in JPMorgan Chase)

$100,000 bill - Woodrow Wilson (the president who created the Federal Reserve)

The Wilson note was only used in circulation among Federal Reserve Banks. It makes you wonder, though: if we’re so into putting obscure presidents on our higher-denomination bills, why isn’t there a Millard Fillmore note? It’s about time he got a seat on US currency.

The museum also has a fascinating selection of Depression-era currencies created by localities suffering cash shortages. My favorite was the hand-writtten 50 cent scrip (upper left hand corner in picture above) from Albany County, Wyoming.

Stock and bond certificates

They also have on display some famous stock and bond certificates that have been issued in the US, going back to an IOU signed by George Washington. My favorite, though, was this stock certificate for the Erie Railway, company:

The Erie was the focus of the legendary showdown between industrial tycoons Cornelius Vanderbilt and Jay Gould. Gould spurned Vanderbilt’s takeover of the Erie by issuing watered-down stock that was worth more than the value of the company - which, apparently, was legal back in those days.

This one’s signed by “the Devil of Wall Street” himself:

Also on display: some pretty interesting municipal bonds, like this one issued by New York for bridge repairs:

How Wall Street got its start

One of the coolest things I learned was how Wall Street - specifically, the New York Stock Exchange (below) got its start.

Apparently, back in the early days of the Republic brokers used to trade stocks in the open on Wall Street and would gather under specific lamp posts along the street to deal in specific securities. People would stand on roofs to make announcements and give signals, so it must have been a pretty hectic scene.

In 1792, a group of 28 brokers got tired of this system and organized a brokerage club that served as the beginning of what is today the NYSE.

Old equipment

The museum also has a lot of technological relics from the old days of Wall Street, including an early form of a calculator that belonged to the comptroller of Lehman Brothers - now itself a Wall Street relic. Below are some of my favorites:

A 1981 Quotron - one of the first computer systems used for trading stocks:

And, of course, the first stock tickers. They were invented in 1867 - this one vintage 1875:

Together, the stock ticker and the telegraph revolutionized the speed at which stocks could be traded. The two inventions put the New York Stock Exchange - and with it, American Capitalism - on growth steroids for decades.

Vintage newspapers

As a journalist, I was particularly drawn to the collection of famous editions of newspapers from panics and crises over the ages. To be fair, American printing presses have probably created their own collection of these future museum pieces just within the last 18 months, but it is interesting to look back to see how thoe events were covered.

An edition of the Daily News from 25 October, 1929 read: “Billions lost in Wall St. Debacle”. Much more interesting than the headline, though, is the advice given by the paper’s “Trader” columnist.

Four days before Black Tuesday - when the Dow Jones Industrial Average dropped 12% and officially heralded the beginning of the Great Depression-  his advice read as follows (emphasis added):

If half the suicides which were reported to “TRADER” yesterday had proved true, Wall Street would be a deserted village this morning.

Happily, however, they all turned out to be baseless rumors, although it was amazing how many stories were in circulation as to operators who jumped out of windows at 120 Broadway. The Equitable building certainly got a lot of free advertising, although it wasn’t the kind usually welcomed.

The market today is in the position of a convalescent who has just successfully passed a crisis in an illness which bid fair to be fatal.

Improvement is indicated, with the practical certainty of eventual recovery, but there will be relapses.

“TRADER” therefore advises against speculative purchases, although he expects prices will be materially higher today. If you have money to buy stocks outright, go in and do so, because current prices are bargains which probably will never be sustainable again as long as the United States continues its present prosperity.

Some parallels are clearly visible to today - especially in light of the recent debate sparked by Jon Stewart’s spoof of stock picker Jim Cramer and CNBC coverage of the credit crisis. People routinely call the bottom prematurely, so the only way to know for sure that stocks have hit a bottom is to read about it in a history book - not by reading “Trader” or watching Fast Money on CNBC. However, the sin isn’t calling a bottom too early or voicing an opinion. Stewart had a bone to pick with CNBC - as I’m sure the Stewarts of his day did with “Trader” - because there was so little humility in the way the opinion was being voiced and advertised. At the end of the day, “buy stocks” four days before Black Tuesday and “buy Bear Stearns” a couple of weeks before it collapses are calls that should be heeded as  just another piece of food for thought in deciding where the market might go; slogans like “In Cramer we Trust”, as if he were the god of stock-picking, go against that very important caveat.

It is also useful to point out that Stewart’s criticism of Cramer pales in comparison with what John Kenneth Galbraith had to say about “Trader” in his account of the 1929 crash:

. . . by 1929, numerous journalists were sternly resisting the more subtle blandishments and flattery to which they have been thought susceptible. Instead they were demanding cold cash for news favorable to the market. A financial columnist of the Daily News, who signed himself “The Trader,” received some $19,000 in 1929 and early 1930 from a free-lance operator named John J. Levenson. “The Trader” repeatedly spoke well of stocks in which Mr. Levenson was interested. 

Some progress was made, though. Fast-forward 58 years, and press coverage of the next big stock market debacle was much different:

Another noteworthy decaying newspaper was a copy of the very first edition of the Wall Street Journal: July 8, 1989: 

It is amazing how similar it looked in design until the recent face lift post-Newscorp acquisition.

The Journal’s first lead-left article? A laundry list of price movements: 

The second article from the top - ”The Market To-Day” - references a “bear party” that depressed American stocks. One of the videos at the museum explains that the terms “bull market” and “bear market”, used to describe down markets and up markets, respectively, originated from the way those two animals attack. A bear will claw down its prey, whereas a bull will strike up at its prey.

Strange but true or true but strange?

Credit Crisis

On March 25 the Museum of American Finance unveiled a new exhibit on the financial crisis: a giant timeline that organizes all the key events of the last two years into regulatory, financial, foreign policy and other buckets. It is accompanied by a brief video that sheds some analysis on the crisis’s causes and effects. 

It does a good job of objectively laying out what happened when and organizing it in a logical manner. But it doesn’t yet gel together the events into a cohesive narrative that lets you walk away with clear take-aways on what exactly is going on. I don’t think it is the museum’s fault though: perhaps it is just too early yet for us to completely understand all the dimensions of this crisis and how it will play out.

They should, however, update this exhibit - a chart of the DJIA over the years that has not yet taken the huge dive indicated on the crisis exhibit: 

This one could also use an update: a Bank of America family tree, conspicuously missing Merrill Lynch:

Other exhibits still reference Lehman Brothers as a bond trading powerhouse, etc. I’m sure these will all get corrected over time - after all, these days, if they were to wipe out defunct Wall Street names from their exhibits they might not have time for anything else.

These nips and tucks aside, if you’re ever free on a Saturday afternoon and looking for a good time, I nerdily suggest the MoAF. 

On Tuesday night the Penn Club of New York held its 10th annual Hedge Fund Panel, sponsored by the Club’s Hedge Fund Intra Club, during which six hedge fund managers shared their views on everything from where they see distressed investment opportunities to whether speculation is driving up oil prices (emphatic no). I attended the panel to benefit from their perspective and thought I would share some of the take-aways so that others may benefit as well.

The panelists included Arif Joshi, portfolio manager at Halbis Capital Management (the asset management arm of HSBC), Jed Hart, senior managing director of Centerbridge, John Khoury, portfolio manager at Wesley Capital, Aaron Cowen, managing director for Karsch Capital Management, Jerry Cudzil, managing director at DAC funds, and Leslee Cowen, managing director of the Drawbridge Special Opportunities Fund at Fortress Investment Group.

Obviously, with the economy in a downturn, opportunities to invest in distressed assets were a big focus of the discussion. Asked where they see the opportunities in their respective asset classes, the panelists seemed in agreement that the best (or worst, depending on how you look at it) is yet to come since corporate distress is at the lagging - not the leading end - of defaults. However, the panelists noted that this cycle is different from anything we’ve seen before in several respects. For one, Mr. Hart - who helps manage a credit opportunities fund at Centerbridge - mentioned that “it’s just much bigger” since there’s been about $2 trillion of high yield debt securitized in the last few years. So if corporate default rates, which he said are still incredibly low, start to tick-up to a rate even half the default rate of last credit downturn in 2002 (about 12-15%), there will be “plenty of dollars of default securities to look at and invest in,” with consumer cyclicals leading the charge.

Ms Cowen, whose group within the Drawbridge fund focuses on distressed debt and special situations investing, seconded those thoughts but added that this cycle is also unusual in that defaults are being led by the mortgage markets, not corporate defaults - as was the case with the last cycle. One reason for this, of course, is the downturn in the mortgage markets following the subprime meltdown. But Ms Cowen added that corporations have “a lot of extra cushion” this time around since many of them refinanced their debt in 2005-2007, before the fallout from the credit crunch materialized, and thus have some leeway in terms of liquidity and covenants on their debt. So give it another quarter or two before we start to see some real activity in corporate defaults.

(Meanwhile, of course, the smart money is already well-positioned to take advantage of this trend: earlier this year, the Blackstone Group paid $930 million for GSO Capital Partners - a fund that is now raising money to invest in distressed opportunities).

Taxes were another hot topic during the panel since it looks increasingly likely that Congress will pass the carried interest tax this year, which would tax carried interest - the share of a fund’s profits that goes to the partners - at the rate of ordinary income instead of capital gains. This would effectively mean that that hedge funds and private equity partnerships would have to go from paying 15% to 40% of their profits in tax. The panelists seemed resigned to this development. “It was good while it lasted. If it’s going to end, it’s going to end,” Mr. Hart, commented, adding that he sees this as part of a normalization of tax codes taking place in the U.S. since “there’s no reason why a doctor should be taxed more heavily than an investment analyst.” However, Mr. Hart mentioned that he doesn’t foresee hedge funds shifting operations abroad in response to this - which makes sense since MPs in Great Britain are also spoiling to tax carried interest at a higher rate.

Besides tax strategy, though, operational efficiency and cheaper labor provide additional incentives to shift operations abroad - notably to places like India. Asked whether hedge funds would follow investment banks in taking advantage of this trend, the panelists shared mixed opinions. Mr. Khoury of Wesley Capital, whose hedge fund focuses on real estate securities, noted that “hedge funds get paid for research at the end of the day” and that includes going out to meet management and look at assets. “I just can’t see what part of our investment process you could take outside of the office or outside of the team and outsource it in a way that adds value to it,” he concluded. However, Mr. Cudzil noted that his hedge fund does employ a service that gives it access to six analysts based in India who help it with routine analytical work that has to be done on a daily basis, such as dollar price tests, earnings tests and updating models for annual reports. “We have found it helpful,” he said. So it outsourcing may be less relevant for funds that invest in something tangible like real estate and more important for funds that analyze less tangible investments, like structured credit.

Two other areas that panelists were asked to comment on - the SEC’s restrictions on short selling and the impact of speculation on commodity prices - yielded unsurprising responses. The panelists viewed short selling as a healthy function of the capital markets. One of them opined that short sellers provide a service to investors who might otherwise be buying shares of companies at the wrong price and that restricting short-selling is un-American and akin to socialist restrictions on a free society. And when asked - by me, given my interest in this topic - to comment on whether speculators are driving commodity prices higher, Mr. Cudzil seemed to speak for the panel when said that he believed that global commodity markets are too big to manipulate. “Short-term manipulation in the markets driven by speculators will quickly be corrected,” he said, and supply and demand fundamentals will ultimately drive the markets.

Other trends the panel touched on would also not surprise those who follow the hedge fund world: the big funds will likely keep getting bigger, emerging markets provide some compelling valuations (esp. places like sub-Saharan Africa and South America) but also bigger risks, and it’s as important as ever for investors to do their homework and research their manager before they invest.

This is the last of a three-part series of posts reflecting on what’s really driving the price of oil in today’s markets. Last Thursday’s post focused on the role of dollar depreciation. Then, on Saturday I reflected on the tightening outlook for global supply and demand. Today’s post will examine the impact of commodity price speculators.

The third - and definitely the most controversial - long-term trend that has put upward pressure on oil prices is increasing commodity price speculation.

Under most circumstances, financial theory would dictate that the inflow of speculative capital can’t have an outsize effect on a market as large, open and actively traded as oil futures. That’s because such a market is bound to have a large variety of participants - technical traders, physical hedgers, fundamental investors, passive investors, mean reversion traders - all following various objectives and trading strategies that can’t really have a measurable impact on it.

However, this fails to hold true if there’s so many participants all following the same strategy that they do in fact move the market by creating an imbalance between the number of buyers and sellers, resulting in either a spike (via excessive buying) or a crash (via excessive selling).

And, by the looks of it, that’s precisely what’s going on in the oil futures market right now. Over the past five years, an influx of new investors have flooded the commodity markets with speculative capital, much of it following the same strategy - go long and hold - which helped to create a spike in oil prices.

Big money, big market

Let’s start with the numbers. In May, Michael Masters, manager of hedge fund Masters Capital Management, estimated that assets allocated to commodity index trading have risen twenty-fold from $13 billion at the end of 2003 to $260 billion as of March 2008. Fair disclosure: his hedge fund stood to lose a lot of money with rising oil prices, so he had an interest in arguing for greater regulation of the commodity markets. Moral hazards aside, though, in early July, CNNMoney.com reported that the International Energy Agency had came up with nearly identical figures: $15 billion in 2003, growing to $260 billion by 2008.

Where did all this money come from? The inflow of speculative capital was enabled in large part by an innovation in the world of Exchange-Traded Funds (ETFs), which track indexes but can be traded like stocks. Since 2005, when Barclays Global Investors created the first broad-based commodity ETF, commodity ETFs dedicated to tracking the performance of futures commodity indexes like the Dow Jones AIG Commodity Index (DJAIG) or the Goldman Sachs Commodity Index (GSCI) have mushroomed. This empowered investors worldwide to participate in the commodities bull market like they never could before and naturally led to a huge influx of capital - and not just from hedge funds. In late 2006, for example, CalPERS - one of the largest U.S. public pension schemes - announced that it would earmark $500 million for a pilot commodities investment program. And CalPERS definitely wasn’t alone. By 2008, Masters estimated that investors bet nearly $1 billion per day on commodity indexes in the first 52 trading days of the year.

But it is important to view these numbers in context: there are trillions of dollars’ worth of commodities contracts traded every day (New York Times business columnist Joe Nocera puts the figure at $5 trillion). In this light, a couple hundred billion worth of speculators’ capital can only have a material impact if their positions are so concentrated on any one strategy that a large-scale retreat from or a run to that position reverberates through the market.

Crowded investment strategy

To see how this can happen, it’s important to first draw some distinctions. The Commodities Futures Trading Commission (CFTC), the regulatory body tasked with overseeing the commodity futures markets, distinguishes between two types of participants: commercial and non-commerical. Commercial participants are those who have a legitimate commercial reason to hedge their exposure to a given commodity - such as a grain farmer or an oil refinery - whereas non-commercial participants are those who participate in the market purely for financial gain (i.e. speculators). Both, however, act in the same global market and therefore answer to the same oil prices. Furthermore, there are two types of trading strategies of interest in examining non-commercial participants’ impact on the market: long and short. Long positions bet on rising prices and therefore their accumulation tends to put upward pressure on prices; short positions bet on falling prices (by borrowing shares, selling them high, repurchasing when low, returning them to the borrower and pocketing the difference) and therefore their accumulation tends to put downward pressure on rising prices.

Armed with this knowledge, let’s look at the trends. Last year, the same Congressional committee that Masters testified in front of tasked Edward Krapels, manager of the gas and power practice at consultancy Energy Security Analysis, Inc., to answer essentially the same question: what is the effect of index speculators on oil prices? To answer the question, Krapels examined the difference between non-commercial speculators’ long and short positions on West Texas Intermediate (WTI) crude oil from 1986-2007. What he found was that, with some exception, between 1986 and 2002 non-commercial investors were net short on oil. Between 1992 and 2001, they oscillated between net long and net short interest. But between 2002 and 2007 - a period which saw WTI rise from $20 to $100 - the non-commercial investors were usually net long. For the sake of convenience, below I’ve reproduced the charts that Krapels uses to illustrate these trends (sorry for the bad resolution):

If anything, after Krapels’s testimony in December 2007 we can only guess that this trend continued to snowball. The public spotlight on the tight global supply and demand conditions as well as the plunging dollar gave non-commercial commodity investors few reasons to go short - an indication of how inter-connected these three trends really are. And again, the credit crunch stands out as the common element because in its wake, with the debt markets frozen and the equity markets in disarray, commodities indexes stood out as the only relatively safe place for skittish investors to park their vacant capital. The result? More capital chasing futures contracts using predominantly the same strategy: go long and hold.

Material impact on price

Now, keep in mind that futures prices are driven by expectations. As I argued in my last post, worries about fundamental supply and demand are already putting upward pressure on futures. But this effect is exacerbated by specualtors’ increasing net long interest in oil futures contracts because as more index speculators wishing to go long and hold crowd the market, the marginal futures contract becomes more expensive to purchase, which bids their prices even higher.

Here it is crucial to point out that commodity futures contracts expire every month, which forces their holders to either take the physical delivery of the commodity or to sell the contract. In practice, only about 5% of futures contracts ever result in physical delivery, and this figure isn’t any different in today’s market than in years past. So critics argue that non-commercial commodity investors cannot possibly be bidding up the price of oil since they are not removing a single drop of oil from the market (this is a point espoused by New York Times columnist Paul Krugman); they simply use calendar swaps to sell the contract to someone else before it expires and physical delivery is ultimately accepted by a commercial market participant. Thus, were non-commercial interests bidding up the price of oil, we would see huge pile-ups in oil inventories thanks to the likes of Goldman Sachs and JPMorgan, which is not the case.

But this line of reasoning misses the point. It is not the physical delivery of oil today that determines its price. Instead, it is the futures markets that are at the very front and center of how oil is priced since - as I explained in my last post - oil is priced over a futures benchmark.

Mixing water with oil

This distinction helps explain why comparisons to other commodities markets which are not as heavily traded as oil but are nonetheless surging in price - such as the global market for iron ore - are off the mark.

Yes - by all measures, prices for iron ore globally are booming thanks to growing demand from China. And because this is a market in which the only market-making activities are individual contracts between buyers and sellers, there is no room for speculative influences. Ergo: fundamental demand must be driving iron ore prices, not fundamentals.

Fair enough. But to point to this and to say it this is evidence that oil must also therefore be booming purely because of fundamental demand brushes over several crucial differences that don’t make this an apples-to-apples comparison:

• Oil pricing is benchmarked off of futures contracts. Iron ore pricing is based on spot contracts between individual market makers
• Oil has far more sophisticated market mechanisms that allow for greater price discovery (exchange-based trading, swaps, futures). Iron ore doesn’t
• No one market participant is large enough to significantly impact the price of oil. Conversely, the market for iron ore is dominated by big players who have significant control over price; when Brazilian miner Vale announced in February that it would sell iron ore to South Korean and Japanese steelmakers for 65% more than its 2007 prices, that deal effectively set the price benchmark for the whole industry
• The price of oil is growing by leaps and bounds. Iron ore is experiencing a more modest price escalation. Even a 65% year-over-year increase isn’t bad compared with the more-than-doubling of oil over the last year

Clearly, this well-intended comparison mixes water with oil.

Stormy outlook

Considering all of this, it is difficult to argue that speculators aren’t having any impact on the skyrocketing price of oil. Rather, the appropriate questions are: how much of an impact and how big relative to the other two trends. This is difficult to quantify, but estimates such as 50% of today’s oil price being caused by speculation - as offered by Masters during his testimony - don’t pass the smell test and only galvanize those who wish to keep speculators’ hands clean (in which case, rather than focusing their efforts on rebutting Masters’s testimony point-by-point, critics should try to deconstruct the much more balanced analysis offered by Krapels).

At the same time, though, it is important to remember that any price tag that we apply to speculation’s share of a barrel of oil would not be as high as it is without dollar depreciation and concerns about tight supply and demand since the three are very closely interconnected. As Krapels put it, “it would be naïve to expect any sustained causation between trading strategies and prices,” but “there are, nevertheless, several areas where causation should not be dismissed, all of them consistent with normal economic analysis,” among which he names:

1. Perfect storm episodes: there are likely to be periods of time when the condition of the physical energy market and trading strategies of financial market participants are in such good alignment as to produce “herding” and “bubbles” or their opposite, crashes
2. Variations on the market power syndrome: It is possible that the positions of some market participants - index funds as one example - are so large as to constitute witting or unwitting market power. A large-scale infusion or retreat from any of the various positions very large index funds might have price effects

By the looks of it, we are currently experiencing both situations: the mixing of these three trends has indeed created the perfect storm, and the resulting influx of long-and-hold speculators helped to grow it into the hurricane that it is today.

It’s no news that energy and commodity prices have been rising at breakneck speeds; just look at the Dow Jones AIG Commodity Spot Index - which tracks commodity price levels and is up nearly 40% over the last nine months. Instead, the $126/barrel question that’s stirring up controversy and making news is: why?

There seems to be broad agreement among economists as to who the culprits are: rising demand from countries like India and China for food and energy (exacerbated by a weak dollar), weather-related crop shortfalls reducing supply, speculation in the commodity markets and - perhaps most controversially - the use of corn crops for biofuels.

There is broad disagreement, though on which one of these structural/speculative factors is most to blame, and the tug-of war is just beginning. On Friday, the Wall Street Journal reported that 51% of economists in its latest forecasting survey said that demand from China and India was the prime factor in soaring energy pries, and 41% said that demand was the chief contributor to food costs. Perhaps most strikingly, only 11% saw a bubble developing due to speculation.

Now, no one can deny that growing demand for a refrigerator in every Chinese kitchen and a car in every Indian garage isn’t a powerful driving force behind commodity demand for everything from grains to metals to petroleum. However, looking at the timing of this latest explosion in commodity prices, one is tempted to give the speculation thesis a bit more weight in this debate.

Last week, the U.S. Joint Economic Committee on the Economy held a hearing on precisely this issue, with Tom Buis, President of the National Farmers’ Union and U.S. Department of Agriculture Chief Economist Joseph Glauber leading the testimony (watch the C-SPAN video here). About the first hour was good old-fashioned political grand-standing and speechmaking, but the last hour contained a few excerpts worth sharing:

[1:37:23] Rep. Carolyn Maloney (D-NY): According to the New York Times, commodity-exchange traded funds, which was developed barely 4 years ago, have grown nearly seven-fold since 2005, and to what extend are higher food prices being driven by speculation in commodity markets?

[1:37:42] Tom Buis: I appreciate that question because this has been a big concern. [. . . ] It’s something we’ve been hearing in farm country for quite some time is we can’t capture this price as I mentioned before this futures market has which markets have counted on forever has been eliminated and part of the reason is because the speculation into the market price has caused the market to explode. In the case of wheat, they reached contract limits day after day and, well, when you do that, that country elevator or that farmer has to pay a margin call and one country elevator I talked about that had pre-bought wheat for fall delivery had a million bushels and the price of wheat was going up 60 cents a day. Nothing was changing in the fundamentals at that point. There was lot of speculation, export markets coming in, that was costing him 600 thousand dollars per day to meet the margin calls and as a result he hit his credit limits. Hitting those credit limits forced him to cut off buying that grain from the farmer. So we raised these concerns and we were told nothing extraordinary was wrong except they could not explain: cotton. Cotton - we have a huge surplus of cotton, we had a great crop, it’s all over the country, you can’t hardly give it away and cotton prices spiked upon speculation. Now, when they went up, every farmer’s hoping that they would be able to get that price but weren’t able to. There’s explanations that need to be made. I think its similar to some of the other bubbles we’ve seen recently, and it could be the biggest train wreck we ever see.

[A quick primer on margin calls: let's say I own a grain elevator. The way I make money is basically via a broking business: buy grains low, sell high. To enhance my returns, I may buy grains on margin, meaning that I borrow funds to make the purchase. If my margin limit is 50%, then that means that I must keep my equity at least at 50% until I sell the grains and close my position. So if I buy $100 worth of grains and the price goes up, say, 20%, then I get a margin call from my lender asking me to deposit an additional $10 of equity to meet my 50% margin limit (which went from $50 to $60 as a result of the purchase.]

Long story short: if you are grain elevator posting margin and are locked-in for future delivery via a futures contract, then your short-term liquidity dissipates and you don’t have money to purchase additional grains - even if your grain elevator is just sitting there half empty. If this is indeed what’s happening in farm country right now, then this may indeed be a train wreck waiting to happen since it means that speculation in grain commodities is essentially causing a bottleneck in the supply chain: grain elevators are being maxed out, but not by fundamentals like overproduction but by speculation.

So what impact does this have on the commodities markets? To check it out, I took Buis’s example - cotton - and plotted a USDA-published index for U.S. cotton production alongside a middling index for average U.S. cotton prices on a relative scale starting in July 2007 (see below):

By any standard, this does not look like a healthy price vs. production index graph, where you expect the two variables to move in opposite directions. From August through September, and from November through December, cotton prices actually increase at a faster rate than production (to compare this with price vs. production curves I ran for other commodities on Bloomberg, click here).

Sure, it could be because of higher demand, but the timing here makes me think otherwise: money seems to be pouring into the market about the same time that the credit crunch hits - August - and comes back with a vengeance - November. That it could be dislocated money from the credit crunch looking to find a new home - especially in the midst of a Fed easing cycle - is not entirely implausible.

Granted, so far this amounts to nothing stronger than a hop-skip from correlation to conviction. But when you combine it grain elevators being effectively maxed out due to margin calls, a sharper image starts to take shape. As Buis notes in his written testimony (see below), “with stocks and bonds in turmoil as a result of the mortgage crisis, investment firms seized opportunities in the commodity futures markets. Billions of dollars from pension and other investment houses poured into the hot commodity markets. As a result, many commercial entities of farm commodities have faced skyrocketing margin calls on hedge contracts which have for a long-time been a financial risk tool for farmers and grain elevators.”

Granted, Buis lists higher energy costs (to which food prices are very highly leveraged due to transportation), weather-related supply shocks and the weak dollar and export demand as his top three reasons for hot commodities (ethanol - as expected from a farm man - is not the culprit).

But if this disturbing scenario is indeed playing out in farm country right now, then the bubble which economists seem to be hitherto dismissing - while not the main culprit behind hot commodities - could be far uglier, far larger, and far more damaging than we currently acknowledge.

* * * UPDATE: After I wrote this post, a friend alerted me to an article on the the impact of margin calls on grain elevators from the April 2 edition of the Wall Street Journal. Check it out to get a better understanding of how this all works, and what the potential consequences may be.

The good news: by the official measure of a recession as two consecutive quarters of negative GDP growth, we are not in a recession yet. Today the Bureau of Economic Analysis reported advance first-quarter advance real GDP growth of .6% - over the half point mark, beating consensus (check out the news release here).

The bad news: the economy is definitely weakening, and we don’t need to call it a recession in order to feel its effects. Anemic growth of .6% - same as 4Q 2007 - is weak enough that it could turn negative on future revisions since the average revision to real GDP (without regard to sign) from advance release to final is .6%. And regardless of whether it does actually turn negative, we know already that the economy isn’t growing as fast as it used to and we can see and feel its effects on our pocketbooks, unemployment and spending (all of which have taken a beating from economic indicators in the last few months).

What more, real GDP in the first quarter stayed positive largely thanks to real change in private inventories, which added .81% to the GDP figure - not a particularly strong vote of confidence in the economy since unsold inventories indicate weakness in consumer spending. The BEA also cited “positive contributions from personal consumption expenditures (PCE) for services” and “exports of goods and services, and federal government spending that were partly offset by negative contributions from residential fixed investment and PCE for durable goods.” Additionally, “imports, which are a subtraction in the calculation of GDP, increased.”

Thus, while we may have steered clear of the of making the dreaded r-word official, there was really little to celebrate in the GDP report, and today’s FOMC statement accompanying the Fed’s 25 basis point decrease reflected this:

“Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.”

The Fed also gave a very strong hint that it is likely to take a step back and examine the impacts of its policies to date before it moves forward with further rate cuts:

“The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.”

Translation: “we’ve done a lot so far and it should have an impact, so let’s wait and see.”

And so we wait for more good news next time - hopefully without the bad.

Are we in a recession?

Today, the National Bureau of Economic Research (NBER) - the official research group tasked with dating when a recession begins and ends - will get its first hint of whether the U.S. is in a recession. That’s because at 8:30am, the Bureau of Economic Analysis will publish its first-draft figures for chain-weighted U.S. GDP growth for the first quarter of 2008. Given all the speculation that we have heard in the financial press about whether or not the country is about to enter into, or is already in, a recession, this will definitely be the figure to watch, so don’t miss it. What will it look like? To be sure, the actual chain-weighted GDP release over the past few quarters has looked nothing if not volatile (see below).

However, here are some hints of what the market is expecting:

• The consensus estimate for 1Q08 annualized GDP growth published by the IDEA group, a market intelligence provider, is an anemic but above-negative .3%
• As of yesterday afternoon, Bloomberg placed the average of 80 economist estimates at .4%, with a distribution slightly skewed toward higher growth (.5% median, -.8% low, 1.5% max)

Digging a little deeper, 2007 has thus far posted negative growth in three sectors: construction (-12.1%) and finance/insurance (-.3%), which were a related phenomenon due to the subprime bubble, and nondurable goods (-1.1%).

The question is thus whether the strong contraction in the housing market and the financial services sector continued into the first quarter of 2008 without being sufficiently offset by stronger growth in other sectors to prevent the overall economy from dipping into negative growth.

As you can tell from the consensus estimates, most economists don’t seem to think so. We’ll know for sure in the next few hours, so get ready for an exciting day on Wall Street because if the GDP does indeed stay out of the red then this will be a day to remember.