Futures...

Y’know, it is strange sometimes how things work out. I went away for an extended weekend – I have eight days leave due to me and another 20 at the ened of the month – so SWMBO and I invited some very good friends to come and share a few days along with some good wine, good food and good conversation at the beachside in Opononi. Now the forecast was not promising, with 25 plus knots of nor-easter and rainy bits as well. But we managed, and our friends left well-satisifed as did we. But that is not what I want to talk about.

In one of the papers between Friday and Sunday was a small article that gave a somewhat different paradigm to the “current financial meltdown”. I made a mental note to look it up on the net when we got back to the big smoke. Could I find it? Not even au!!

But I did turn up two other articles, both ex Granny Herald, that have a quite curious connection apart from their appearance in consecutive editions.

The first of the two is by-lined Pamela Hess, a lady I do not recall having read previously. She has flicked out a report from the National Intelligence Council titled "Global Trends 2025: A Transformed World”

Some of our preliminary assessments are highlighted below:
 The whole international system—as constructed following WWII—will be revolutionized. Not only will new players—Brazil, Russia, India and China— have a seat at the international high table, they will bring new stakes and rules of the game.
 The unprecedented transfer of wealth roughly from West to East now under way will continue for the foreseeable future.
 Unprecedented economic growth, coupled with 1.5 billion more people, will put pressure on resources—particularly energy, food, and water—raising the specter of scarcities emerging as demand outstrips supply.
 The potential for conflict will increase owing partly to political turbulence in parts of the greater Middle East.

Hess tempts with others –

It also says the warming earth will extend Russia and Canada's growing season and ease their access to northern oil fields, which will strengthen their economies. But Russia's potential emergence as a world power may be clouded by lagging investment in its energy sector, persistent crime and government corruption, the report says.

Analysts also warn that the same kind of organized crime plaguing Russia could eventually take over the government of an Eastern or Central European country. The report is silent on which one.

It also says countries in Africa and South Asia may find themselves unstable and ungoverned, as state regimes collapse or wither away under security problems and water and food shortages brought about by climate change and a population increase of 1.4 billion.

The potential for conflict will be greater in 2025 than it is now, as the world's population competes for declining and shifting food, water and energy resources.

Despite a more precarious world situation, the report also says al-Qaida's terrorist franchise could decay "sooner than people think". It cites its growing unpopularity in the Muslim world, where it kills most of its victims.

"The prospect that al-Qaida will be among the small number of groups able to transcend the generational timeline is not high, given its harsh ideology, unachievable strategic objectives and inability to become a mass movement," the report states.

The report forecasts a geopolitical rise in non-Arab Muslim states outside of the Middle East, including Turkey and Indonesia, and says Iran could also be a central player in a new world order if it sheds its theocracy.

... suggests the world may complete its move away from its dependence on oil, ...

...that the US dollar, while remaining important, will decline to "first among equals" among other national currencies.

US global power will likely decline, as Americans' concerns about putting resources into solving domestic problems may cause the United States to withdraw some resources from foreign and global problems.

The second contrasts quite nicely. It flows like a gentle stream from the keyboard of Gwynne Dyer – a regular if not subscribed “international correspondant”. He kicks off with –

Barack Obama will inherit the in-box from hell when he becomes President. But an all-points crisis like the present one also creates opportunities for radical change that do not exist in normal times.

As Rahm Emanuel, his newly appointed chief of staff, put it: "Never waste a crisis."

Is Obama clever enough and radical enough to seize those opportunities?

From there he runs into promises to close Guantanamo, GWB’s exective veto on measures that put emission controls in place in California, and how about this for a Dyering gem

The recession will feel like a crisis for only a few more months. People eventually get used to almost anything.

Ah, there is a saying, Gwynne, widely used in a beer advertisement round these parts; “Yeah, right!”

It gets worser though.

The century-long pre-eminence of the US as the economic superpower was bound to decline gradually as the Asian giants industrialised, but the financial collapse risks turning that into a steep and irreversible fall. Even the US dollar could lose its place as the global reserve currency.

To limit the damage, Obama has to play a poor hand very well. He has implicit permission from the financial gurus to run even bigger deficits over the next couple of years than the Bush Administration did.

That will let him do some repair work on the American social fabric as well as just bailing out failing businesses and jobless people. But rebuilding America's reputation abroad will take more than money.

This is getting close to populist and simplistic nonsense. Like so many others, Dyer is promoting the messianic level of Obama’s campaign. It loses sight of the truth; that POTUS is an administrator, a bureaucrat. He is not a dictator, benign or otherwise. For a commentator or mere journalist of his stature to forget that fundamental is unforgiveable.

So, I will have to return to what I can remember of the article I failed to find. It would have appealed immensely to Lucy. It was a thoughtful and practicle analysis of the similarities between personal and national finance, the need for thrift and economy not in times of hardship but at all times. It castigated the profligacy and waste of both money and resources by western society. It promoted, indirectly, the stupidity of the continual pressure to spend and consume in pursuit of the good life. It had its sweet little homilies, that TF might also have enjoyed. For instance the story of Mrs Wheelbarrow and the fridge. Mrs Wheelbarrow needs a new refridgerator. Why? The old one is still working. Well, her neighbours have a brand new one with a brushed stainless steel finish and it looks beautiful. So, Mrs Wheelbarrow deserves one as well.

It was well written and a joy to read, if you were prepared to take on board the hard lessons. It might have fitted in well with the NIC report as a means of the west's survival in the long term.

What a shame it was “lost”. I can’t find it. I can not remember the author. It has gone.

North Korea 2 - United States of America 1

OK, so it was "only" the final of the World Soccer Cup.

OK OK so it was only U17 Women.

...or should that be "girls".

But North Korea did win.

American politics...

...at the worst.

Well, no, that is a bit harsh. But it says little for the nation that holds itself out as the last bastion of Democracy.

From the Herald this morning

since the November 4 election, law enforcement officials have seen more potentially threatening writings, internet postings and other activity directed at Obama than has been seen with any past president-elect, said officials aware of the situation, who spoke on condition of anonymity because the issue of a president's security is so sensitive.

Earlier this week, the Secret Service looked into the case of a sign posted on a tree in Vay, Idaho, with Obama's name and the offer of a "free public hanging". In North Carolina, civil rights officials complained of threatening racist graffiti targeting Obama found in a tunnel near the North Carolina State University campus.

And in a Maine convenience store, an Associated Press reporter saw a sign inviting customers to join a betting pool on when Obama might fall victim to an assassin.

The sign solicited US$1 (NZ$1.79) entries into "The Osama Obama Shotgun Pool," saying the money would go to the person picking the date closest to when Obama was attacked. "Let's hope we have a winner," said the sign, since taken down.

...

One of the most popular white supremacist websites, stormfront.org, got more than 2000 new members the day after the election, compared with 91 new members on election day, according to an AP count.

On Saturday, one Stormfront poster, identified as Dalderian Germanicus, of North Las Vegas, said, "I want the SOB laid out in a box to see how `messiahs' come to rest. God has abandoned us, this country is doomed."

How sad.

Vale Miriam Makeba

One of those singers of traditional music that never has had the international recognition deserved.

Most will remember her for just one song - known colloquially as "The Click Song".

She has been one of the bastions of presenting the Xkosa culture; intimately, accurately and excellently.

The world is a slightly darker place.

What I did yesterday...

Well, first and most important we had our daughter staying with us for part of the weekend. Good to see her. We don't see her all that often these days what with her living in New Plymouth and all. Now she is 7 months hapu she can no longer fly so we will not see her again until after the bub is born in mid January. Mum will be taken down to be the good grandmother for a couple weeks.

The non-event of the weekend was spending 10 minutes to whizz around to the local school to cast my vote in the General Election.

Pansy Wong for the local representative. I have a fair respect for the work she does despite her political affiliation.

Maori Party for the party vote.

Say, WHAT!!!??!!!

My rationale goes as follows -

1. They are probably the most honest of the rat-bags that occupy the Beehive.
2. They have a unique process of consultation with their electorate. I could, if I wished, join in that process by attending at a local marae at the right time; and if I put the effort into becoming more fluent in Maori.

It goes without saying that the Jonkey is now "Our Noble Leader".

Winnie the Pooh is no longer a representative of anything. He lost his electorate by a dozen streets. Ron Mark (one of the few rational beings in the Beehive) was also turfed out. The NZF party polled only 4.3% (the minimum for representation by right is 5%) so no list seats either.

Auntie Helen has announced her retirement as leader of the Labour Party. That was about the only surprise of the night. I thought it would have been before the Party's next conference, rather than on the night.

Krystallnacht - 11/10/1938

Next Monday night - 10 November - is the 70th anniversary of that horrendous night in Germany's history and the start of the Jewish exclusion and Hitler's eventual attempts at extermination of the Jewish race in Euorope.

I shall remember them.

But that is not all.

There millions of others killed since then - in the furtherance of political ideals and the personal lust for power - who should also be remembered;

Cambodia
Rwanda
Congo
Zimbabwe
South Africa
Russia
China
Chile
Argentina
Palestine
Lebanon
Israel
Somalia
Sudan
Mozambique

And let us also remember those who performed these atrocities.

Most importantly, let us all remember that we did little and nothing to prevent or stop them. In some instances we have been guilty of actively assisting those who kill.

Commend the innocent to your Gods.

Deja vue?

Listed at ALD...

With those who yearn for "the old days" and the freedom of open markets is this little piece of history.

Fueled by easy credit, the real-estate market had been rising swiftly for some years. Members of Congress were determined to assure the continuation of that easy credit. Suddenly, the party came to a devastating halt. Defaults multiplied, banks began to fail. Soon the economic troubles spread beyond real estate. Depression stalked the land.

The year was 1836.

The nexus of excess speculation, political mischief, and financial disaster—the same tangle that led to our present economic crisis—has been long and deep. Its nature has changed over the years as Americans have endeavored, with varying success, to learn from the mistakes of the past. But it has always been there, and the commonalities from era to era are stark and stunning. Given the recurrence of these themes over the course of three centuries, there is every reason to believe that similar calamities will beset the system as long as human nature and human action play a role in the workings of markets.

Yes, Al, much of the cause can be sheeted home to "government interference". That as much as anything is my point.

The result was a credit crunch. Interest rates that had been at 7 percent a year rose to 2 and even 3 percent a month. Weaker, overextended banks began to fail. Bankruptcies spread. Even several state governments found they could not roll over their debts, forcing them into default. By April 1837, a month after Jackson left the presidency, the great New York diarist Philip Hone noted that “the immense fortunes which we heard so much about in the days of speculation have melted like the snows before an April sun.”

The longest depression in American history had set in. Recovery would not begin until 1843. In Charles Dickens’s A Christmas Carol, published that same year, Ebenezer Scrooge worries that a note payable to him in three days might be as worthless as “a mere United States security.”

All manner of good quotes -

Many people, especially liberal politicians, have blamed the disaster on the deregulation of the last 30 years. But they do so in order to avoid the blame’s falling where it should—squarely on their own shoulders. For the same politicians now loudly proclaiming that deregulation caused the problem are the ones who fought tooth and nail to prevent increased regulation of Fannie and Freddie—the source of so much political money, their mother’s milk.

and

Herbert Hoover famously remarked that “the trouble with capitalism is capitalists. They’re too greedy.” That is true. But another and equal trouble with capitalism is politicians. Like the rest of us, they are made of all-too-human clay and can be easily blinded to reality by naked self-interest, at a cost we are only now beginning to fathom.

Libertarianism R.I.P.

An interesting little debate between Jacob Weisberg in Slate and
Richard Epstein in Forbes on the “Death of Libertarianism”, HT to my mates at ALD.

Each has their own little hobby-horses which to trot around the stage and play at jousting in the lists.

On the subject of the causes of the “current” collapse of the financial and banking systems, there is as might be expected considerable difference of opinion.

Epstein, predictably, blames government involvement and interference –

Alas, the financial rot started in the underlying home-mortgage market, with the government decision to subsidize home mortgages generally through low interest rates, and compounds the problem by offering special Fannie and Freddie guarantees at the low end of the market.
These foolish decisions prompted market actors to react just as libertarians fear: to profit privately from public foolishness. Savvy lenders looked less to the creditworthiness of their borrowers and more to unwise government guarantees that insulated them from risk. A high-risk loan of $1,000, without that guarantee, could be worth half that sum before the ink was dry. But who cares, if a government agency will pick up the slack?
Similarly, self-interested borrowers eagerly grasped at cheap-money loans, thereby driving up the price of underlying assets. But once these subsidies became too expensive to sustain, the capital markets raised the price of interest, which killed off refinancing for persons living beyond their means.

All of that is quite true, and quite logical. I am not going to argue against it.

Weisberg lays his “cause” like this –

Perhaps the most alarming moment was the failure of a giant, superleveraged hedge fund called Long-Term Capital Management, which threatened the solvency of financial institutions that served as counter-parties to its derivative contracts, much in the manner of Bear Stearns and Lehman Bros. this year. After LTCM's collapse, it became abundantly clear to anyone paying attention to this unfortunately esoteric issue that unregulated credit market derivatives posed risks to the global financial system, and that supervision and limits of some kind were advisable. This was a very scary problem and a very boring one, a hazardous combination.

Those with memories might dredge out the graphic I stole from Herald back in September; the inverted pyramid of the “money supply”. Weisberg I think could well have included that to illustrate his point.

I have to say that my views are no more valid than either of these august gentlemen. I balance that by admitting that in terms of erudition and learning they probably stand a few miles ahead of me.

I think that both these jousters are correct – in the small and very specific parts of the overall train of events that they have presented to support their respective views. That, I submit, is the danger of taking both of these gentlemen at face value and in isolation.

So, when Epstein says

” At this point, securitization, which diversified some risks, accentuated others by spreading the bad paper throughout the entire system. Now the high default rates on mortgages introduced massive uncertainty for valuing these financial instruments, which triggered government mark-to-market re-evaluations--which in turn forced a premature liquidation of assets. And presto, the failure of the Wall Street investment banks mushroomed into a larger financial crisis.”

...he is right on that thin edge of untruth. It is a matter of regulation in most markets – regulation set by the markets themselves and by the participants – that many different contract forms must be regularly, and as regularly as daily, revalued (mark to market) and the difference if negative lodged with the market. That is practice, and not something that “the government” suddenly undertook, and which he implies caused the collapse. Yes, it is likely that mark to market pressures were a major partial cause. But that was likely as a result of traders not being able to obtain the readies to lodge with the market as practice and convention required.

In my view the reality is that there was little that any government could have done to prevent the collapse of the banking and credit systems. So much of the system is based upon the fundamentals of fair dealing, of personal and commercial trust, of open and honest trading that regulation was (and still will be) an impossibility.

For that very same reason, the future control and regulation of the credit supply will continue to be at the hand of commercial practices and market convention rather than by government control.

Despite that midpoint conclusion, and to balance the number of times I quote the two protagonists, I do like Weisberg’s conclusion

The worst thing you can say about libertarians is that they are intellectually immature, frozen in the worldview many of them absorbed from reading Ayn Rand novels in high school. Like other ideologues, libertarians react to the world's failing to conform to their model by asking where the world went wrong. Their heroic view of capitalism makes it difficult for them to accept that markets can be irrational, misunderstand risk, and misallocate resources or that financial systems without vigorous government oversight and the capacity for pragmatic intervention constitute a recipe for disaster.

As I have said before – the perfect system will fail, because humans are involved in its operation.

Forwards, futures, onwards...

I am not going to argue Dave Justus’ remark on whether the trading of futures and other commodity wagering “stabilises markets” or not. He can do that if he wishes.

There is one small part where he is right. There is much where I think he is quite wrong.

The derivative trading and arbitrage processes do have “beneficial” effects between markets. If a price difference for a tradable commodity exists between two markets (NY and London for example) then traders will buy in the cheap market to sell on the higher priced market. That small part of the process is as DJ says.

I must point out that in the whole process of derivative trading, arbitrage and cross trading is just a very small part of the whole process.

Other than that, Dave’s extrapolation and Mises in particular are long on propaganda and short on true analysis.

If one takes the trouble to view commodity markets objectively, and forward/futures trading in particular from the wider POV, a different picture emerges. It is, regretfully, not what the like of Dave, or Al, or Mises want you to hear. Well, not quite as baldly as I state it, though it is hinted at.

I will try to work down through the levels of complexity as simply as I can.

The process of wagering, sorry, forward or future derivatives –

1. For a specified standard commodity,
2. for a standard quantity
3. At a specified future date
4. Deliver and settle for an agreed price.

Now as far as I am concerned, and while Mises does cover the point briefly, and Wikipedia and other sources give emphasis to the “discounting” process, those last two words are the most critical of all.

When that future matures, there will be one winner (either buyer or seller) and one loser. Who wins and loses is not critical to the debate. The important fact, inescapable fact, is that the price on that derivative becomes the cost to the buyer.

Six months out from the Hurricane Season, traders are betting the probabilities of a stormy or not season, and the likelihood of supply interruption. When, six months later a Cat 5 hurricane does start advancing toward the Gulf of Mexico all of the traders factor into their wagers the likely (possible) impact that storm might have on oil supplies. A lot of damage is going to mean higher prices until repairs are made, facilities reopened and production is restored. If the damage does not occur, then someone is going to take a bath. The dickering over probabilities and pricing is the fundamental of forwards and futures trading.

Lying under that comparatively simple strata we start getting into the darker realms of hedging, and short selling.

If a trader is prudent, he will self-insure (carry the potential liability for losses) in part, and will seek to pass on the rest of that risk to other (willing) traders. This hedging process is rather like sticking a large sum on the nose of a horse with one bookie, then going around the corner and placing smaller bets against that horse with other bookies. Yeah it costs a bit, but this is the secret of derivative trading. It is the process of sharing risk across the market, while preserving as much as possible of potential profits on one’s own book.

Hedging is not a difficulty at this level, but short selling can be. That takes us to the next level of this Dantean Inferno.

Short selling is not difficult to understand. The trader sells commodity that he has borrowed from another trader. Not difficult; there is documentation, principal in the form of commodity, interest paid on the value of that principle. The security for the “loan” is paper written by the trader.

Now, consider that a “good” trader is not likely to enter a forward or future contract without having first lined up a few other ducks. The cost of the interest on the hedge, the commissions incurred, the risk factors all have been well set out and considered.

Together, the sum of all of those constitutes the Margin that the trader hopes to gain through his top level wager.

But wait, there’s MORE!!!

Let’s peek into the murk on the next level of this Inferno.

Remember that “short selling” is in effect using someone else’s commodity to secure the hedge or the basic forward contract.

But what to do if the product can not be bought at a price giving a suitable margin, or is simply not being sold at the price you are offering?

Look out for the streakers folks, ‘cos here comes the “naked short selling”.

The trader is now selling “non-existent commodity”. Well it does exist, but not on his books. He just has to get it together before settlement date, or he has to sell his forward contract, or he has to suck his very burnt fingers or combinations of all three.

Of course, if the market price does not exceed the future price of his contract he could do quite well out of his bet / wager / contract, thank you!

There is one winner and one loser in this whole process. If the trader is the loser, he can attempt to recover his losses on one contract with winnings on others. If the buyer is the loser, then his recovery comes from passing the higher price on to the people who buy the commodity from him. Eventually, and this is “trickle-down economics” at its best, the poor little guy at the bottom of the heap pays the price – whatever it might be.

That price does include the original production (well-head if it is oil) cost, plus the producer’s margin, plus the margins for all of the speculators and traders between there and the refinery, plus the refinery’s costs and margin, plus the refined product can be traded in the same way as the crude with all the margins added in there ad nauseum.

What do you buy for your gallon of gas?

The retailer’s margin – in NZ it is said to be about 2c/litre.
Government taxes. In NZ said to be about 45% of the total price.
The transport cost from supply storage to retailer.
The cost of storage.
The cost of transport from refinery to storage.
The refiners costs.
Cost of transport from wellhead to refinery
Production costs at wellhead.
Extraction royalties and duties
Research, prospecting, drilling, and extraction costs

Plus, in the midst of all that, is the profit (or losses) taken by the people who trade little pieces of paper with “O I L” written on them. Mind you, you can buy little pieces of paper with “R W C” on them. You will even find futures contracts based on the value of the DOW at the end of a day’s trading, or to buy and sell a currency.

If you own a piece of paper that says “BRENT LIGHT CRUDE, 1 Barrel” then six months or so ago it could have been worth about USD130. That would be about 65 cents per gallon. That “market price” is quoted on the London Exchange (ICE) and represents the forward price for the “current” block of that commodity. As I understand it, there is a standard monthly maturity for settlement and delivery. Now the market is quoting USD60.29 or 30 cents per gallon.

All of the costs I have listed above are predominantly unchanged. So, where does the difference go?

This is the point that I contend. It is the point that the likes of Mises, the “free-marketers” and the rest would prefer not to talk about.

That difference might end up with reduced profits along that chain. But in my opinion, that possibility is minimal because the long-term loss of profitability leads to only one thing – extinction. If you look at the oil industry that is something that is not likely to happen (to the whole industry, not individual players) any time soon.

But by far the greatest part of that fall in cost content is the direct result of the fall in the volume of forward and futures trading. With the withdrawal of credit, the speculators are unable to back their wagers with your money and mine. The true value of short sale commodity scrip is being critically examined. Trades are being done far more directly from well-head to refinery to wholesaler to retailer.

And that, dear reader, is the basis for my contention that the argument put up by Dave the Justus is counter-intuitive, even just plain wrong!