Overburdened Linchpins And The Rest Of 2012

          It's odd that so many people in the financial community seem already to have lost track of what really happened in 2008. The reason perhaps is that the year has by now been politicized and over-analyzed to where most of us are tired of the commentary and are no longer paying attention. Yet 2008 is still with us in a very immediate way, as is 2001, 1998, 1994 and all the other points of sharp market inflection that have occurred within the career-spans contemporary players. Financial historians will want to look back still further to at least the 1913 founding the American Federal Reserve system, a development that would over time give rise to the dollar-based international monetary system. The institution that was supposed put an end to financial panics, as they were called in those days, instead helped lay the groundwork for systemic instability, a more contemporary term-of-art for roughly the same thing unfolding through high-speed modern markets.

         I want to focus on 2012 and not torture history any more than necessary. Past chains of events, however, always suggest clues to the future and are thus usually worth the time to consider. Several common factors have percolated through past crises, but the one that stands out to my mind above all others is the existence of linchpin events. These are small developments that seem minimally significant upon first appearance, but that spin out of control and, through obscure interconnections, trigger improbably large events.

          Looking back to a couple of years prior to 2008, for example, mortgage analysts will remember that the default rates for subprime mortgages began creeping upward and were soon outside the "worst case" boundaries established by the investment bankers who were structuring mortgage securities. Insiders began taking note, but few people on Wall Street or in Washington were overly concerned, because the problem appeared to be manageable. It was only manageable, of course, until it wasn't, when projected financial losses began to extend beyond the relatively small sub-prime mortgage sector. Then suddenly awareness dawned about how leveraged the entire financial system had become. The succeeding chain of events needs no recounting here, but the end result after a couple of years was the virtual nationalization of supposedly indomitable banks in the U.S. and Europe, political realignments on both continents, and the dawn of what journalists later dubbed the "Great Recession".

         For the past three years the search for new linchpin events has been a favorite dinner-party sport among retired financial types, and a survivalist challenge for people still on the front lines. Now in May of 2012 a couple of developments have appeared that to my mind suggest themselves as serious candidates.

         First is the latest devolution of the situation in Greece. This crisis, of course, has been with us for the past three years. Hardly a slow news day has gone by without pundits attributing either small market upticks to new optimism that a Greek resolution is in the works, or else downticks to erosion of optimism that had supposedly been there the day before. As with a slow-moving cancer, Greece has found its way to the periphery of consciousness for most of us, but will not to go away. The news now is that new elections will be necessary due to the evaporation of whatever frail national consensus there had been to go on collaborating with the northern Europeans. We should remember that what we're dealing with here is not a normal country, however pretty its Aegean islands may be. Greece faced a communist insurgency in the years following WWII, suffered a fascist coup d'etat in 1967, and was living under military dictatorship as late as the 1970's. Political turbulence is not street theater for these people but serious business. The thought of elections in the current climate, with extremist parties gaining strength again, is unsettling.

         I'm no sovereign expert, but it doesn't take a weatherman to know which way the wind blows here. The Greeks and the Germans can no longer tolerate one another, and at the very least it seems we can expect that Greece will exit the eurozone. At that point a couple of ugly genies will be out of the bottle. First, the ties that bind the eurozone together will no longer appear sacrosanct to other member states who might be quietly considering the same option. Secondly, once they have their own currency back, we can expect the Greeks quickly to exercise their new prerogative to debase it. That, after all, is the point of monetary sovereignty for a failed nation. To a continent, and a world, overburdened with debt, little Greece will have demonstrated how easily fiat money can lighten the load. The re-appearance of hyperinflation in Europe, even in a small country, will reverberate loudly.

         The second potential linchpin event currently in the news is the J.P Morgan situation. In a matter of a few days, there has already been too much commentary about this from people with little information about it, and I'll try not to add to the noise here. However, the sudden announcement that even Jamie Dimon's bank doesn't know how to execute a hedge is devastating news for market participants who had been hoping that adults were back in the room and that our modern capital markets were regaining their equilibrium. As Dimon knows, he will now be compelled to hand over his sword to the politicians who, in a presidential election year, are more eager than ever to demonstrate their zeal in punishing Wall Street.

        And for anyone who takes comfort in the prospect of increased regulation, I can only point to the dog's breakfast that still sits largely uneaten on the table in the form of the 2010 Dodd Frank legislation. Paradoxically both over-engineered and unfinished, this body of law arms regulators with powers that are as vague as they are powerful. Implementation will now proceed with a renewed directionless vigor. Regulators will find themselves operating in waters that are dark and over their heads, but they will nonetheless feel compelled to act boldly. None of this bodes well for financial stability.

         For investors, the main lesson of 2008 was that in the midst of systemic instability, a decade's worth of hard-earned gains can be wiped out in a matter of weeks. In my view, the conditions are now in place for another collapse of equal magnitude, perhaps without the sovereign willpower this time to engineer another quick recovery. Investors, however, have no clear safe havens. Gold, the classic panacea for dangerous times, lost money in 2008 and, after big gains during the recovery, is losing money again now. Inflation and low interest rates are eating away at cash and bonds. Short strategies can be disastrous if the timing is wrong, and obvious trends rarely follow obvious timetables. Problems could easily come to a head by the end of this year, but could still drag on, depending mainly on political variables.


  1. No one can rationally dispute your view of the uncertainty of the present economic situation. Anything could happen. The relevant question is, how likely? Here I disagree with your gloom about Greece. As I argue in my earlier essay, even if Greece leaves the market, I think the damage will be limited to Greece. The contagion case is no more persuasive than the old dominos case for Vietnam. As to Dodd-Frank, it is flawed largely because of the compromises necessary to gain blue dog Democratic votes--that is, a degree of conservative acquiescence. The hope, I think, is that regulators outside the immediate political hothouse could make it work better. I don't know what will happen there, but Chase's loss has certainly improved the prospects for a good outcome.

  2. Keith - re your remarks on DF, it's the illusion of every political faction that giving it a free hand is the best way to solve any problem. The fallacy of such thinking is the argument for democracy.


  3. Mark, Check out the fine article by Sally Krawcheck in the current Harv Bus Rev. It's summarized, a little, in today's Nocera column in the NY Times. Good/great ideas, although I don't know who will implement them.

  4. I've always liked Sally Krawcheck, and unsurprisingly coming from her, these are all constructive suggestions. However, they probably don't do much more than chip around the edges of the problem banks have in figuring out how to balance long-range risks and returns.