The Daily Reckoning
London, England
Wednesday, September 27, 2006
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*** Bernie Ebbers' number is up...when it comes to numbers, anyone could
make the same mistake - they are very slippery...
*** Hunter was long - and now investors are short $6 billion...the Panic
of 1837 and other financial disasters...
*** The United States' growing balance of payments problem...33 AD's
credit crunch...and more!
Poor Bernie Ebbers. His number's up. The man drove up to the Oakdale
Correctional Complex in Louisiana yesterday. He got out of his Mercedes
and joined the former governor of the state, Edwin Edwards, in the federal
pen. Hizonner faces 10 years in the hoosegow for extorting money out of
riverboat casinos. Ebbers got 25 for his role in a telecom scandal.
Accountants working under his direction took some whole numbers out of the
operational columns, they say, and slipped them into the capital budget.
Both men did naughty things, we don't deny it. But putting poor Bernie
behind bars for a quarter of a century for some financial hanky-panky
seems excessive. When it comes to numbers, after all...anyone can make a
mistake. The things are downright slippery.
Just look at poor Brian Hunter. He would tell you. The man was making $75
to $100 million per year, as an ace energy trader. He was so good that
even the savviest players in the industry wanted in on his game. Both
Morgan Stanley and Goldman Sachs had invested money with Hunter's
employer, Amaranth Advisors, the $9 billion hedge fund that blew up last
week.
What went wrong? Hedge funds are supposed to be good at numbers, after
all. They hire people with advanced degrees in mathematics simply to make
sure they've calculated the odds correctly and offset their risks with
their expectations in a logical manner.
"Somebody was not monitoring this correctly," said one pro, referring to
the extraordinary bet that Hunter placed on gas prices, a bet so large
that at one time, he held about 10% of the global market in natural gas
futures.
As far as we can tell, these are the numbers in a nutshell: Hunter was
long. And investors were short as much as $6 billion.
"It appears we have had a major malfunction," might have been another way
to put it. But that famous understatement has already been taken. That was
on January 28, 1986...with 50 million TV viewers watching. It was the day
the spacecraft Challenger exploded into smithereens.
Nobel prize-winning physicist Richard Feynman described the NASA
catastrophe as an institutional failure. The scientists and engineers at
NASA, he charged, has been upstaged by bureaucrats who had been allowed to
"pervert standards."
But in the financial world, standards are perverted so easily they must
have a twisted gene to start with. [See the letter from a dear reader,
below, about slipping standards during the Roman era credit collapse.
"Rigor at the outset," says Tacitus, speaking broadly about financial
affairs, "becoming negligence at the end."]
That's why we can't help but feel sorry for Brian Hunter. Like Ebbers, he
came from nothing to make a fortune. He went to college in Alberta, where
he was a star at mathematics, of course, specializing in financial models.
But the poor 32-year-old had barely gotten used to being extraordinarily
rich and extraordinarily talented, when a very ordinary little slip-up
with numbers derailed his extraordinary career.
We are reminded of the now legendary Nick Leeson whose rags-to-riches rise
also came apart over some mundane, barely noticed figures...figures of
eight, in his case.
Leeson, the working class son of a plasterer, who failed his final math
exam, made such an impression at Britain's prestigious Barings Bank that
he was quickly promoted to the trading floor and then given a new
operation in futures markets on the Singapore Monetary Exchange (SIMEX)
where he began pulling in millions for Barings by gambling on the movement
of the Japanese stock market (Nikkei Index). The whiz kid seemed to have
it altogether. By the end of 1993, he had made more than £10m for Barings
- nearly 10 percent of its total profit that year.
What Barings didn't know was that Leeson, by now both Chief Trader and
also in charge of settling accounts in the office (jobs that were usually
done by different people), was hiding his mistakes in an account, numbered
88888, for which the company was liable. By December 1994, the numbers in
88888 had piled up...to over half a billion. A desperate Leeson then
placed his most desperate bet - that the Nikkei would not fall below
19,000 points. It would have been a reasonable assumption under ordinary
circumstances. But then came one of those fat tail events that give bell
curves their shape - on January 17, 1995, a 7.2 earthquake hit Kobe in
Japan and the Nikkei crashed by 7% in a week.
Leeson's gambling spiraled out of control as he piled on more and more
debt hoping to push the index back the other way. Most of the $1.3 billion
he eventually lost for Barings came from trying to cover up what had
happened.
On the verge of turning 28, the whiz kid could take it no more. Leaving a
scribbled apology, he fled with his wife to Borneo and then to Frankfurt,
where he was caught.
The numbers then looked pretty bad: The futures market was in shock, a 233
year-old bank to the Queen was bust; more than a thousand bank employees
were out of jobs; and investors were wiped out.
And all for a string of single digits. Ordinary insignificant set of
numerals - 88888.
And more thoughts...
*** "Time to read up on the Panic of 1837," says our Pittsburgh man, Byron
King. "One of the more cogent observers of the time was Ralph Waldo
Emerson, who was trying to uphold the old standards and protest against
the easy morality of the new age.
"'This invasion of Nature by Trade with its Money, its Credit, its Steam,
its Railroads,' he complained, "threatens to upset the balance of man, and
establish a new universal monarchy more tyrannical than Babylon or Rome.'
"Interesting that Emerson comments on 'Railroads.' His pal Henry Throreau
once said, 'Men do not ride on railroads. The railroads ride on us.'
"Emerson actually welcomed the Panic of 1837, as a wholesome lesson to the
new monarchs of manufacturing: 'I see good in such emphatic and universal
calamity...'
"He saw the Panic of 1837 as the taking-down of the juggernauts of
finance, the destruction of the moneychangers in the Temple, vengeance
against those who traded nothing for something, and who sucked off of the
honest toil of the working people of the world. Emerson was a champion of
old fashioned hard work, the mechanical arts, of raw creation, of molding
useful things from the soil and rock of the earth...
"'The American workman who strikes ten blows with his hammer, whilst the
foreign workman only strikes one, is as really vanquishing that foreigner,
as if the blows were aimed at and told on his person.
"'I look on that man as happy, who, when there is question of success,
looks into his work for a reply, not into the market, not into opinion,
not into patronage. In every variety of human employment, in the
mechanical and in the fine arts, in navigation, in farming, in
legislating, there are among the numbers who do their task perfunctorily,
as we say, or just to pass, and as badly as they dare, - there are the
working men, on whom the burden of the business falls, - those who love
work, and love to see it rightly done, who finish their task for its own
sake; and the state and the world is happy, that has the most of such
finishers. The world will always do justice at last to such finishers: it
cannot otherwise.
"'He who has acquired the ability, may wait securely the occasion of
making it felt and appreciated, and know that it will not loiter. Men talk
as if victory were something fortunate. Work is victory. Wherever work is
done, victory is obtained.'"
[Ed. Note: The history of economics is peppered with stories of panics and
financial disasters - each of them important to our present economic
conditions in their own way. Recently, Byron King reviewed the book,
History of Financial Disasters, 1763-1995. These three volumes review the
origins and consequences of the Western world's most important financial
crises in the past quarter millennium.]
*** "And now, as promised, more on America's growing balance of payments
problem. For the first time in 90 years, the United States is paying more
to foreign creditors than it gets in payments from its overseas
investments. The difference grew to $2.5 billion in the second quarter of
2006. This, according to the Wall Street Journal, was the equivalent of a
quarterly debt payment of about $22 for each American household, "a
turnaround from the $31 in net investment income per household it received
a year earlier."
Still peanuts. But going in the wrong direction fast.
"Our net international obligations are coming home to roost," says
Catherine Mann, a senior fellow at the Institute for International
Economics.
"Since the end of 2001, when the current economic expansion began, the
nation's consumption, investment and other outlays have exceeded income by
a cumulative $2.9 trillion - the largest gap on record. That
current-account deficit contributes directly to the nation's total foreign
debt, the value of all the U.S. stocks, bonds, real estate, businesses and
other assets owned by non-U.S. residents. As of the end of 2005, total
U.S. foreign debt stood at $13.6 trillion - or about $119,000 per
household. Net foreign debt, which excluded the $11.1 trillion value of
U.S.-owned foreign assets, was $2.5 trillion.
"Foreigners' willingness to lend at low rates has also encouraged
Americans and their government to borrow and spend. By buying U.S.
Treasuries, foreign investors put up more than four-fifths of the $1.3
trillion the federal government has borrowed since 2001 to help pay for
tax breaks, the new Medicare prescription-drug benefit and wars in
Afghanistan and Iraq. Over the same period, foreigners put more than $700
billion into various types of U.S. mortgage-backed securities, providing
the money for millions of Americans to buy new homes -- or extract cash
from their existing homes to spend on goods such as washing machines and
Hummers."
*** And finally, a dear reader writes:
"I believe I have found a Roman parallel to the housing bubble for your
Daily Reckonings. In the course of my thesis research I came across this
passage in Tacitus' Annales relating to a 'credit crunch' in 33AD:
'The Senate passed a measure requiring two-thirds of loaned money to be
reinvested in Italian real estate to prevent the collapse of land prices
resulting from the sale of assets to repay loans. Tiberius himself later
offered 100m sesterces on loan for three years to ease the credit crunch.
From Tacitus: "Meanwhile a powerful host of accusers fell with sudden fury
on the class which systematically increased its wealth by usury in
defiance of a law passed by Caesar the Dictator defining the terms of
lending money and of holding estates in Italy, a law long obsolete because
the public good is sacrificed to private interest. The curse of usury was
indeed of old standing in Rome and a most frequent cause of sedition and
discord, and it was therefore repressed even in the early days of a less
corrupt morality. First, the Twelve Tables prohibited any one from
exacting more than 10 per cent, when, previously, the rate had depended on
the caprice of the wealthy. Subsequently, by a bill brought in by the
tribunes, interest was reduced to half that amount, and finally compound
interest was wholly forbidden. A check too was put by several enactments
of the people on evasions which, though continually put down, still,
through strange artifices, reappeared. On this occasion, however,
Gracchus, the praetor, to whose jurisdiction the inquiry had fallen, felt
himself compelled by the number of persons endangered to refer the matter
to the Senate. In their dismay the senators, not one of whom was free from
similar guilt, threw themselves on the emperor's indulgence. He yielded,
and a year and six months were granted, within which every one was to
settle his private accounts conformably to the requirements of the law.
"Hence followed a scarcity of money, a great shock being given to all
credit, the current coin too, in consequence of the conviction of so many
persons and the sale of their property, being locked up in the imperial
treasury or the public exchequer. To meet this, the Senate had directed
that every creditor should have two-thirds his capital secured on estates
in Italy. Creditors however were suing for payment in full, and it was not
respectable for persons when sued to break faith. So, at first, there were
clamorous meetings and importunate entreaties; then noisy applications to
the praetor's court. And the very device intended as a remedy, the sale
and purchase of estates, proved the contrary, as the usurers had hoarded
up all their money for buying land. The facilities for selling were
followed by a fall of prices, and the deeper a man was in debt, the more
reluctantly did he part with his property, and many were utterly ruined.
The destruction of private wealth precipitated the fall of rank and
reputation, till at last the emperor interposed his aid by distributing
throughout the banks a hundred million sesterces, and allowing freedom to
borrow without interest for three years, provided the borrower gave
security to the State in land to double the amount. Credit was thus
restored, and gradually private lenders were found. The purchase too of
estates was not carried out according to the letter of the Senate's
decree, rigour at the outset, as usual with such matters, becoming
negligence in the end.'"