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James Rickards in Welling@Weeden

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   VOLUME 12
     ISSUE 4
                      listeningin
 FEBRUARY 26, 2010


  INSIDE
                      Threat Finance
                      Capital Markets Risk Complex And Supercritical, Says James Rickards
 Listening In         James G. Rickards is a                                                            doesn’t mince words,
Need For Market       modern Renaissance                                                                you are right. Read on.
                      man of sorts, a lawyer                                                            KMW
 Reforms, Scale       by training and and old
 Limits Urgent        hand in capital mar-                                                               Your recent FT piece
      PA G E 1        kets. With 35 years on                                                             about Wall Street
                      Wall Street, he has been                                                           having a “Piñata
 Guest Perspectives   an internationalist all                                                            Party” at Greece’s
Steven Reynolds       of his career, but now                                                             expense caught my
  Buyer Beware        sees globalization as                                                              eye, but then I did a
   Risk Waiting       one of the key destabi-                                                            little research and
                      lizing forces threaten-                                                            discovered you’d be
     To Spring        ing the financial mar-                                                             fun to talk to about
  Richard Koo         kets. In part, that’s                                                              everything from
 Take Japan’s Cue     because he’s also made                                                             derivatives to the
   Paul Kasriel       himself into an expert                                                             nature of risk. But
Hey Big Spender?      in risk analysis and                                                               first things first.
 Real Issue Isn’t     econophysics, which                                                                What exactly does
    Deficit, But      the former general                                                                 your firm do? Omnis
  Future Oulays       counsel of Long Term                                                               Inc. doesn’t just
 Michael Belkin       Capital Management lec-                                                            sound a mite
Frontier Markets?     tures on at                                                                        Orwellian, it’s based
                      Northwestern’s Kellogg                                                             in McLean, VA, and
    John Kosar
                      School, among other                                                                its website boasts of
 Inflation & Fed      places. Applying lessons from the realm of               roots in the intelligence community. Just
                      physics to the morass in the capital markets, Jim        what is its “practice in threat finance and
Chart Sightings       says the Street has been deluding itself about the       market intelligence” that you and a part-
                                                                                                                                   well

Dave Rosenberg:       nature of financial risk for a generation or two,        ner head? A cynic might suggest the first
Lacking Confidence    creating a far riskier, and more unstable, market        part of that description is redundant and
Albert Edwards:       in its scramble for short-term profits. There’s no       the second, an oxymoron —
  Japan’s Real        mystery about the lessons of our mushrooming             But I’m sure you know what Oscar Wilde said
Growth Problem        experiences with “fat tail” crashes, in Jim’s view.      about cynics. We have a number of specialties in
 Alan Newman:         The crime is that instead of making the obvious          our firm, but the broadest way to think about
Fund Cash Levels      fixes, the government and the Street combined to         what I do personally is to think about two usual-
                      “double down” after LTCM — and are still doing           ly separate worlds. Take the world of geopolitics
Acute Observations    nothing constructive. If you get the idea that Jim,      and defense and national security and diploma-
 Comic Skews          now senior managing director for market intelli-         cy on the one hand, and then take the world of
                      gence at Omnis, Inc., a scientific consulting firm,      capital markets, commodities, stocks, bonds,
 ALL ON WEBSITE


RESEARCH
                                                          welling@weeden FEBRUARY 25, 2010 PAGE 1
DISCLOSURES PAGE                                               R EPRINTED W ITH P ERMISSION
                                    derivatives, etc., on the other. It’s really the            structure. But just very recently they have
                                    intersection of those two worlds that we are con-           turned that around and now they’re extending
                                    cerned with. In what ways does political insta-             duration. Well, once you are able to get that
 Authorized Reprint                 bility or political risk affect markets? Then, con-         information, then you can think about what it
                                    versely, what can we learn from markets that                says about Chinese intentions and Chinese poli-
                                    would help in the geopolitical sphere? So threat            cy. Likewise, if countries are thinking of getting
 Kathryn M. Welling
                                    finance and market intelligence are basically               out of dollars and getting into euros or gold or
 Editor and Publisher
  welling@weedenco.com              about looking at capital markets and taking                 commodities, you can see those activities as
                                    information out of the capital markets to help              well. The acquisitions made by sovereign
  Published exclusively             policy makers and deci-                                                               wealth funds can tell us
      for clients of
                                    sion makers in the area                                                               something about the
   Weeden & Co. LP
                                    of national defense,                                                                  intentions of nation

    Lance Lonergan
                                    security and intelli-
                                    gence.
                                                                   “As general counsel                                    states. My view is that
                                                                                                                          these things are not
Co-President, Global Sales
   (800) 843-9333 or
                                    Are you saying
                                                                  of LTCM, I negotiated                                   just market transac-
                                                                                                                          tions, they take place
     (203) 861-7670
 lance@weedenco.com                 geopolitical threats             the bailout which                                    in markets, but they
                                    are somehow linked                                                                    reveal something about
      Thomas Orr
Managing Director, Research         to stock fluctuations             averted an even                                     strategic intentions
     (800) 843-9333                 or punts on pork bel-                                                                 and policies of other
 tom_orr@weedenco.com
                                    lies?                             greater disaster                                    countries — which is
                                    You are being way too                                                                 helpful to the United
     Noreen Cadigan
 Institutional Research Sales       literal. Basically, we          at that point. What                                   States. So that’s one
        (203) 861-7644
  ncadigan@weedenco.com             think of the capital
                                    markets as a very rich
                                                                      strikes me now,                                     way that the two worlds
                                                                                                                          we watch come togeth-
      Jean M. Galvin
Business Manager/Webmaster
                                    source of actual infor-
                                    mation, assuming you
                                                                   looking back, is how                                   er.
       (203) 861-9814
 jean_galvin@weedenco.com           know how to read it,          nothing was changed;                                    There are others?
                                    how to drill down and                                                                 The other way is that if
     Subscriptions:
                                    to segregate informa-             no lessons were                                     you’re in the market, if
        Pat Quill                   tion. And there are a                                                                 you’re a dealer, a mar-
     (203) 861-9317                 lot of techniques that        applied. Even though                                    ket maker, an invest-
  pquill@weedenco.com
                                    can be used there to do                                                               ment bank, a trader, a
    Deirdre Sheehan
     (203) 861-7636                 that. The basic idea is             the lessons                                       hedge fund, etc., obvi-
 dsheehan@weedenco.com              that nobody transacts
                                    in a vacuum. If you’re
                                                                       were obvious,                                      ously, you should care
                                                                                                                          enormously about
     Published biweekly
    on Friday mornings,
                                    buying anything or
                                    you’re selling anything,
                                                                         in 1998.”                                        prospects for war
                                                                                                                          between Iran and
    by welling@weeden,
    a research division of          there has to be a coun-                                                               Israel, or about what’s
      Weeden & Co. LP.
      145 Mason Street              terparty at a minimum.                                                                going on with Chavez
   Greenwich, CT 06830.             And there may be a market, though not always.               and Venezuela; how does China feel about
 Telephone: (203 ) 861-9814
     Fax: (203) 618-1752            Sometimes these are over-the-counter markets,               Iran?; what is Russia’s interest in the Middle
                                    but even when you see activity in the over-the-             East? Those are things that have huge impacts
Copyright Warning and Notice: It    counter markets, often the dealer or one of the             on commodities prices as well as other prices —
         is a violation of          market makers is hedging in some traded mar-                and we can interpret those as well, for investors.
federal copyright law to repro-
duce all or part of this publica-   kets. The point being, when countries and orga-             The problem generally is that you have a lot of
       tion or its contents         nizations are transacting, they leave footprints;           brilliant people and a lot of experts on both
 by any means. The Copyright
      Act imposes liability         they leave ripples; they leave signals. If you can          sides of the fence, but not too many people who
of up to $150,000 per issue for     interpret those signals correctly, you can draw a           can really stand on top of the fence and see the
       such infringement.
  welling@weeden does not           lot of inferences about their actions, and that’s           big picture.
      license or authorize          very helpful to policy makers.
 redistribution in any form by
     clients or anyone else.                                                                    And that’s what you’ve been trying to do
However, clients may print one      For instance?                                               for about three years now?
   personal copy and limited
reprint/republication permis-       A very clear cut example that a lot of people fol-          No, I have worked in the capital markets for 35
  sion may be made available        low are Chinese activities in the U.S. govern-              years, but in terms of taking this particular
     upon specific request.
Copyright 2010, K.M. Welling.       ment securities market. We saw this throughout              approach which I have just described as looking
       All rights reserved.         2009. They were shortening up their maturities              at the intersection of capital markets and


                                                           welling@weeden FEBRUARY 25, 2010 PAGE 2
                                                                R EPRINTED W ITH P ERMISSION
geopolitics, I have
been doing that since
2002.

Your company only
dates back to 2004,
doesn’t it?
Well, I was doing some
work on this before I
joined Omnis, which
was launched in 2004.
Our Threat Finance
and Market
Intelligence division is
just one of Omnis’
three divisions.
Another is Research
and Development and
the third is Training
and Education. But our
Financial Threat and
Market Intelligence
unit didn’t really start
operations until early
2007, so it’s only a few
years old. In that
sense, you’re right.
                                                       State Department had embassies in, at the time.
                                                       If I remember correctly, in the late 1970s, the
But being a new kid hasn’t prevented you
                                                       State Department was in about 95 countries
from picking up some blue chip clients —
                                                       and Citibank was in 98 countries.
Correct. Many of our clients are various gov-
ernment directorates. Obviously, we don’t dis-
                                                       Even in those simpler times, Walter
close the clients’ names unless we get permis-
                                                       Wriston’s big global push ended up creat-
sion. But among the ones we are allowed to
                                                       ing all sorts of Latin American debt prob-
mention are the Office of the Secretary of
                                                       lems for Citi, as I recall.
Defense, there’s the Department of the Navy,
                                                       There was certainly a learning curve. At any rate,
the Director of National Intelligence, and some
                                                       after 9-11 there was a lot of outreach by national
other components of the national security com-
                                                       security professionals, looking for various
munity. Then, on the private side, we have
                                                       experts in different fields, whether it was cyber
hedge funds, family offices, investment banks
                                                       security, critical infrastructure, counter-terror-
and high net worth individuals among our
                                                       ism, or in my case, capital markets, and basically
clients.
                                                       utilizing a lot of private sector resources to
                                                       address national security issues. That was the
The usual suspects.
                                                       time that I became more involved and we have
Yes.
                                                       taken it from a little, let’s say, volunteer effort,
                                                       after 9-11 into a full blown business, all essential-
Okay. But you’re a lawyer. What does a
                                                       ly growing out of risk analysis.
lawyer — even one whose bio says he was
the principal negotiator of the LTCM
                                                       Wall Street’s attempts to analyze and man-
bailout — know about the capital markets
                                                       age risk were a key part of what went wrong
and geopolitics?
                                                       and led to the credit bust. That was an obvi-
Actually, it feels like I’ve been in the area forev-
                                                       ous lesson we failed to learn from LTCM.
er. Going back, even prior to law school, I got a
                                                       That’s right. Western capital markets came to
masters degree in international economics.
                                                       the brink of collapse in 1998, when hedge fund
Then, I worked at Citibank when I started my
                                                       Long Term Capital Management, with a trillion
career — and one of the reasons I went there was
                                                       dollar web of counterparty risk at all the major
that they had offices in more countries than the


                                                   welling@weeden FEBRUARY 25, 2010 PAGE 3
                                                        R EPRINTED W ITH P ERMISSION
banks and brokers of the time, failed. Then Fed            2009] on the subject of risk management and
Chairman Alan Greenspan and Robert Rubin,                  the problems of the models Wall Street has been
who at that juncture was Treasury Secretary,               using, and I gave testimony about the risks of
called it the worst financial crisis in 50 years.          financial modeling last September, before the
While the amounts involved and the duration of             House Science Committee’s subcommittee on
that crisis pale next to what we’ve been going             investigations.
through since 2007, it certainly didn’t feel
minor at the time.                                         I missed those, somehow, amid all the babble.
                                                           Well, most of the problems with VaR are fairly
You can say that again.                                    well known at this point. We are certainly not
I know, I was there. As general counsel of                 the first ones to point them out.
LTCM, I negotiated the bailout which averted
an even greater disaster at that point. What               Little things, like being based on faulty
strikes me now, looking back, is how nothing               assumptions — such as the Efficient Market
was changed; no lessons were applied. Even                 Hypothesis, the random walk and that the
though the lessons were obvious, in 1998.                  bell curve applies to markets, you mean?
LTCM used fatally flawed VaR risk models.                  Exactly. VaR would be a fine methodology but
LTCM used too much leverage. LTCM transact-                for the fact that all three of those assumptions
ed in unregulated over-the-counter derivatives             are wrong. Markets are not efficient; no amount
instead of exchange-traded derivatives. So risk            of theory tweaking will make them so. Future
models needed to be changed, or abandoned.                 prices are not independent of the past; not a
Leverage had to be slashed. Derivatives had to             random walk. Risk is not normally distributed.
be traded on exchanges or cleared through                  As the saying goes, “Besides that, Mrs. Lincoln,
clearinghouses. Regulatory oversight needed to             how was the play?” But what we’re trying to do
be ramped up.                                              is go beyond that — not just point out the flaws
                                                           in things like value at risk, which again are pret-
But none of that happened.                                 ty well known — but to suggest alternatives.
Even worse, the government did just the oppo-              There are other analytic methods and other
site. Glass-Steagall was repealed in 1999, so              techniques that actually do give you an ability to
that banks could become hedge funds. The                   understand risk in much better ways, but most
Commodities Futures Modernization Act of                   people who have criticized VaR really haven’t
2000 permitted the creation of more unregulat-             taken the next step and proposed alternatives.
ed derivatives. The Basle II Accords and                   So one of the common defenses you hear from
changes in SEC regulations in 2004 permitted               people continuing to use VaR is something like,
more leverage. The U.S., in effect, stared near-           “Yes, we know it has flaws, but we have to keep
catastrophe in the eye, with LTCM, and decided             using it until something better comes along.”
to double-down.                                            Now, I don’t necessarily agree with that. It’s
                                                           like continuing to drive a car with no gas in the
The government didn’t exactly decide to                    tank just because you can’t find a gas station.
that on its own, out of the blue. Wall                     You’re not going to get very far.
Street spent a lot of money lobbying to
make it happen.                                            A more timely analogy might be a Toyota
Certainly the power of the lobbyists and special           without accelerator repairs —
interests can’t be discounted. Greenspan                   Maybe. The thing is, we actually do have alter-
deserves a lot of the “credit” for pushing his             native methods for modeling financial risk—
belief that the markets could self-regulate. In
fairness, he wasn’t alone in that belief. But I            Are they any better, or just different?
don’t think any of this could have happened in             Better. They are built around a different mathe-
the aftermath of the 1998 crisis, without the              matical construct, which is very well-known,
comfort provided by Wall Street’s quantitative             called a “power curve” or a “power law.”
risk models, most notably, VaR, which cast a               Basically, it’s a different kind of degree distribu-
hypnotic spell, as not-well-understood science             tion. Any degree distribution is simply a plot-
often does, and assured bankers, investors and             ting of the frequency of an event relative to the
regulators that all was well, even as the ashes of         severity of the event. The mistaken belief that
LTCM still smoldered around them. Just about               market risk is “normally distributed” is actually
a year ago, I had a long piece published in the            another corollary to the EMH, which expects
Risk Management Association Journal [March,                future price movements to be random and so


                      welling@weeden FEBRUARY 25, 2010 PAGE 4
                           R EPRINTED W ITH P ERMISSION
says that their degree distribution will also be      natural and man-made systems, from power
random, like a coin toss or roll of the dice. This    outages to earthquakes. And power curve analy-
random or “normal” degree distribution is             sis isn’t even new. Economist Vilfredo Pareto
most frequently represented as a bell curve in        observed in 1906 that wealth distributions in
which the large majority of outcomes are              every society conform to a power curve; in
bunched in region of low severity, with progres-      effect, there’s one Bill Gates for every 100 mil-
sively fewer outcomes shown in the high severi-       lion average Americans. Benoit Mandelbrot pio-
ty region. Because the curve tails off steeply,       neered the empirical analysis in the 1960s that
highly extreme events are so rare as to be almost     showed market prices move in power curve pat-
impossible. In other words, on a bell curve, the      terns.
vast majority of events happen in a fairly narrow
band of two or three standard deviations from a       But bell curve or power curve, doesn’t that
normal activity and are equally distributed on        matter mostly to academics?
both sides, and so when you get to extreme            That’s just it. The difference is not merely acad-
events, which should be defined as five or six or     emic. Gaussian, or bell curve, distributions and
more standard deviations, those are so rare as        power law distributions describe two entirely
to be practically if not literally impossible.        different phenomena: Bell curve distributions
Therefore, people assuming a normal distribu-         in this context describe continuous phenomena
tion of risk in the markets tend to discount the      and power laws describe discontinuous but regu-
probability of extreme events happening.              lar phenomena. Which one applies has enormous
                                                      implications when what you’re trying to model is
Despite evidence they happen with disturb-            financial risk. Power laws accurately describe a
ing frequency, resulting in enormous losses.          class of phenomena known as nonlinear dynami-
Exactly. Experience tells us that extreme events      cal systems that exhibit scale invariance —
do happen all the time, and in fact the normal dis-
tribution of market risk has been known to be         Could you state that in plain English?
false at least since the early 1960s, when pub-       In other words, orderly patterns are repeated at
lished studies of time series of prices showed        all scales. What is often taken for randomness at
them not distributed in the shape of a bell curve     a given scale actually produces order (albeit
but in the shape of a power curve — studies that      chaotic, or unpredictably deterministic) across
have been replicated many times since.                scales. Earthquakes, as I mentioned, are an
                                                      example of such systems in nature. Consider
Can you explain what difference that                  the Richter scale’s inverse proportionality of
makes to someone who isn’t a quant?                   the severity and frequency of earthquakes, with
A power curve, one of the most common degree          minor events being common and events rated
distributions in nature, which accurately             seven or higher being quite rare. That’s a power
describes many phenomena, has fewer low               law distribution.
impact events than the bell curve but has far
more high impact events. When graphed on a            Well then how have several generations of
double logarithmic scale, the power law               academics and financial practioners managed
describing financial market risk is a straight        to get it so wrong, swearing allegiance to the
line sloping downward from left to right. A           notions of efficient markets and bell curve
power curve says that events of any size can          risks for more than 50 years?
happen and that extreme events happen more            Now you’re getting into realms of philosophy
frequently than the bell curve suggests. This         and cognitive neuroscience, or at least behav-
corresponds to the market behavior we have            ioral economics. I’ll just point out that the his-
seen in such extreme events as the crash of           tory of science is filled with false paradigms that
1987, LTCM’s collapse, the dot.com bubble’s           gained followers to the detriment of better sci-
bursting in 2000, the housing collapse in 2007        ence. People really did believe the sun revolved
— you get the idea. Statistically, these events       around the earth for 2,000 years and mathe-
should happen once every 1,000 years or so in a       maticians had the equations to prove it. The
bell curve distribution — but are expected much       sociologist, Robert K. Merton, called this the
more frequently in a power curve distribution.        Matthew Effect from a New Testament verse
In short, a power curve describes market reali-       that says, “For to those who have, more will be
ty, while a bell curve does not. What’s more,         given...” In effect, once an intellectual concept
power curves are well-understood by scientists        attracts a critical mass of supporters, it
because they apply to extreme events in many          becomes entrenched, while other concepts are


                                                  welling@weeden FEBRUARY 25, 2010 PAGE 5
                                                       R EPRINTED W ITH P ERMISSION
crowded out of the marketplace of ideas.                    Naturally enough —
                                                            All too true. But short-sighted. Suppose geolo-
Still, Wall Street, perhaps more than any                   gists abandoned the Richter Scale, a classic
other economic ecosystem, prizes what                       power curve, as useless, just because it has low
works. What generates profits. And there                    predictive power? We know that 8.0 earth-
was loads of evidence, you point out, that                  quakes are possible and we build cities accord-
the bell curve failed at critical junctures.                ingly, even if we cannot know when the big one
You do have to wonder. I don’t know whether it              will strike. Likewise, we can use power curve
was denial or inertia or because people got so              analysis to make our financial system more
wedded to the elegance of the mathematics                   robust even if we cannot predict financial earth-
they’d done that they hated to leave all that               quakes. And one of its lessons is that as you
work behind. After all, the Black-Scholes                   increase the scale of the system, the risk of a
options formula is based on bell curve-type                 mega-earthquake goes up exponentially. If you
price movements. The entire derivatives market              increase the value of derivatives by a factor of
is based on variations of Black-Scholes. So what            10, you may be increasing risk by a factor of
people were doing when presented with the evi-              10,000 without even knowing it. Unfortunately,
dence was saying, “Yes, there are flaws in effi-            this is not something that Wall Street or
cient markets, there are flaws in developmental             Washington currently comprehend. That’s why I
distribution, but we’re going to use it anyway              urged in my Congressional testimony and have
and try to fix the flaws.” In other words, Wall             said repeatedly in numerous other forums that we
Street decided that the wrong map is better                 should abandon the bell curve once and for all
than no map at all — as long as the math is ele-            and accelerate empirical research into the proper
gant. And that led to calling extreme events a              risk metrics of event distributions. The bottom
sort of special case, a “fat tail,” which just              line is that the power curve is a degree distribu-
meant they were happening more frequently                   tion that works. It’s ubiquitous in nature, we
than a bell curve would indicate. So they would             see it in everything from solar-flares to forest
model risk to show a normal distribution most               fires to internet backbone failures, to power
of the time, but fat tail events some of the time,          grid failures to the time series of prices in capi-
and then create a new curve that was faded a lit-           tal and commodities markets. Even if the power
tle bit to include these fat tails. Then the Street         curve’s predictive value is low, there is value in
employed a lot of rocket scientists to stress-test          knowing the limits of our knowledge.
for fat tail events based on historical occur-              Understanding the way risk metastasizes with
rences, such as the ‘87 crash. I call that pinning          scale might be lesson enough. It would offer a
a fat tail on the bell curve and the problem with           proper dose of humility to those trying to super-
it —                                                        size banks and regulators. And once you accept
                                                            the idea of financial risk following the power law
Is that it made investors into donkeys—                     distribution, you can start to draw very different
Yes, exactly. But another reason the Street was             conclusions about how capital markets actually
loath to throw out the whole notion of normally             operate. And that’s what we have done. We
distributed risk, and tried to salvage it instead           have embraced that model, we have done addi-
by putting a fat tail on it, is that the alternative,       tional research, we have published papers. And
a power curve, just didn’t look that palatable to           this has given us actually a very good ability to
most practioners and so comparatively little                understand markets and stay ahead of the
work has been done in applying power curves to              curve.
financial markets.
                                                            How ironic is it that all of Wall Street’s
Why is that, considering the vast                           “rocket science” innovations of the last
resources Wall Street pours into every                      20-30 years — which had so much to do
conceivable way of getting an edge?                         with, if not exactly causing the mess we’re
Don’t get me wrong, some excellent research                 in, exacerbating it by dramatically
has been done in the realm of power curves and              increasing its scale and complexity — were
the capital markets. The thing is, power curves             based on such deeply flawed theories?
don’t have a lot of predictive value. Since most            Yes. I’ve always thought the problem was that,
financial researchers approach the field precisely          although Wall Street was very active in hiring a
to gain a trading edge, once they discover power            lot of Ph.D.s — astrophysicists, applied mathe-
curves aren’t much use there, they move on.                 maticians and others with very good quantita-
                                                            tive theoretical skills, it didn’t let them use


                       welling@weeden FEBRUARY 25, 2010 PAGE 6
                            R EPRINTED W ITH P ERMISSION
their heads. What happened was that their Wall        when it’s sitting harmlessly on your desk, and
Street managers said, “Look, here’s how the           the super-critical state, which is when it turns
financial world works and we want you to model        into a nuclear weapon.
it and code it and develop it and write these
equations and programs.” And so they did. But         And supercriticality has relevance in
Wall Street — and all of us — would have been         finance, too, you’re suggesting?
much better off, had they gone to those rocket        Yes, applied to capital markets, the same thing
scientists and asked, “How does the world actu-       is true. In markets, you have numerous hetero-
ally work?” In other words, instead of telling        geneous, autonomous, interdependent agents,
them what to do, they should have listened.           each of whom has a critical threshold with
Because the idea of power law distributions, in       regard to preference for dollars, euros, gold,
particular, comes from physics. It’s the physi-       stocks, bonds, etc. Are those agents and those
cists who have identified the distribution and        critical threshold preferences arrayed in a sta-
done the empirical work on it in a lot of fields.     ble sub-critical or in an unstable super-critical
So Wall Street risk managers would have been          state? It’s through that kind of thought process
better off listening to the physicists instead of     that we take the physics concepts, apply them
telling them what to do.                              to capital markets, and get a better understand-
                                                      ing of risk.
If they could understand them. I noticed in
your Omnis bio that you’ve delivered papers           But it’s not the sort of model that you can
on something you call “econophysics.”                 feed lots of data into and expect it to tell
Yes. Econophysics is basically understanding          you what the markets are going to do?
the economy using tools derived from physics.         Well no, because you’ll never have that much
So it’s exactly what we’re talking about. The         data. And even if you did, the power needed to
field of nonlinear dynamical systems — which          crunch it would exceed all the computing power
encompasses those described by a power curve          in the world. Let me give you another example.
— has recently been enriched by the concept of        Let’s say you have a movie theater and five peo-
self-organized criticality.                           ple suddenly jump out of their seats and run out
                                                      of the theater. Well, what is everyone else going
Go easy on me, please. The only physics               to do? A few Nervous Nellies might run out too,
course I took in college was something                but most are likely to decide those five are wacky
called “Physics for Poets.”                           and sit back to enjoy the movie. But if 50 people
The idea is that actions propagate throughout         ran out, or 100, or 200, there’d come a time when
systems in a critical chain reaction. In the criti-   they’d start a stampede. So the difference
cal state, the probability that an action will        between acting as an autonomous individual and
propagate is roughly balanced by the probability      as part of a herd, that point where behavior
that the original action will dissipate. In the       changes, is called the critical threshold.
subcritical state, the probability of extensive
effects from the initial action is low. But in the    So it’s what Malcolm Gladwell calls “the
supercritical state, a single minor action can        tipping point.”
lead to a catastrophic collapse. A concrete           Correct, tipping point is the popular jargon.
example may help explain this. Let’s just say         But my point is that different people in the the-
you have a 40-pound cube of uranium sitting in        ater have different tipping points. So let’s say
front of you. It would actually be relatively         that five people run out of a theater but the next
harmless. You’d have to eat it for it to make you     lowest tipping point among the audience is 10.
sick. But if you took the same 40 pounds of ura-      In that world, if five people run out, nothing
nium and shaved part of it into a ball about the      else happens. That’s an example where an ini-
size of a softball and made the rest of it into a     tial act dies out.
rod about the size of a baseball bat and then put     But then let’s assume instead that when those
them into a tube and fired them together at           first five run out, there are 10 other people in
high speed and at the right angle, you would          the audience with a tipping point of five and a
create a nuclear explosion. My point is that          hundred people with a tipping point of 12 and
there is more to understanding those dynamics         then 300 people with a tipping point of 50. If
than just having a quantity of uranium. How it        that’s your system, just the five people run out
is shaped, how it interacts, how is it fired, also    will start a chain reaction as tipping points are
go into determining the difference between            hit that will empty the theater. So the second
what’s called the sub-critical state, which is        example shows how embedded preferences may


                                                 welling@weeden FEBRUARY 25, 2010 PAGE 7
                                                      R EPRINTED W ITH P ERMISSION
be potentially super-critical in terms of all the           alization. The Italian bourse used to be com-
interactions. Now, instead of a couple of hun-              pletely isolated from every other stock market.
dred people in a theater, imagine several hun-              It was a local stock market, run in Milan, domi-
dred million people around the world buying                 nated by local firms and didn’t have much inter-
and selling stocks, bonds, commodities, deriva-             action with other exchanges. That’s no longer
tives all day long. They all have different prefer-         true, of course, because of globalization and the
ences. You would never be able to get that data.            consolidation of exchanges. We’re to the point
And even if you could, the interactions and the             that the New York Stock Exchange and
permutations could be so great they could                   Euronext are one big exchange. Finally, adapt-
never be modeled precisely. So one of the                   ability is just a function of— if I’m not locked
things you learn from complexity theory like                into one country or one system, I can change
this is a lot of humility. There are some things            my behavior based on what I see everyone else
you can’t know because the computational com-               is doing. What I’m saying is that objectively —
plexity of the problem exceeds our ability to               not just theoretically but objectively – all those
compute it.                                                 things have been dialed up in the markets.
                                                            What that tells you is that the system is more
Sure. It’s a meteorologist’s standard excuse.               vulnerable and more risky than it ever has been.
But that doesn’t mean this new paradigm that                Meanwhile, it is operating on a larger scale than
sees the financial system as a self-organized,              it ever has —
scale-invariant, nonlinear dynamical system in a
critical state is worthless. What it means is that          And you’re suggesting this is a case where
you can understand it theoretically and you can             bigger isn’t better?
look for metrics, indications, and warnings that            Yes. While extreme events occur with much
are valuable tools, even if you can’t model it right        greater than normal frequency in nonlinear
down to the last individual actor. You can, for             critical state systems, these events are never-
instance, analyze the markets in terms of the four          theless limited by the scale of the system itself.
operative aspects of a complex network.                     So if the financial system is a self-organized
                                                            critical system, as both empirical evidence and
Which are?                                                  deductive logic strongly suggest, the single
One is diversity, because your preferences are              most important question from a risk manage-
going to be different than mine and we’ll both              ment perspective is: What is the scale of the sys-
differ from the next guy. There also is connect-            tem? Simply put, the larger the scale of the sys-
edness, which is that people have ways of seeing            tem, the greater the potential collapse with
what other people are doing and understanding               macroeconomic and other real world effects.
what other people are doing. Then there’s
interdependence — what I do affects what you                So much for the conventional wisdom that
do. It’s not just that we’re connected and a see-           greater participation and diversification
ing each other, but also that my preferences are            would take risk out of the system —
going to depend on yours, etc. Finally, there’s             Right, the result of all this interconnectedness
adaptability. I may change my behavior based                has been we have scaled up the system. So now
on what I see. So one thing we can do is dial up            when it fails, it fails catastrophically on a much
or dial down those four operative aspects and               greater scale than we have ever seen before.
draw inferences about how risky or critical the             There’s no normalized scale similar to the
system actually is.                                         Richter Scale for measuring the size of markets
                                                            or the size of disruptive events within them. But
And that tells you?                                         a few statistical estimates from the McKinsey
Well, what have we seen in the markets for the              Global Institute make my point: The ratio of
last 20 years, really? More diversity, with the             world financial assets to world GDP grew from
Chinese and Indians — and I’m not talking                   100% in 1980 to 200% in 1993 to 316% in 2005.
about ethnic or national diversity alone. I’m               Over the same period, the absolute level of global
talking about the diversity of preferences and              financial assets increased from $12 trillion to
opinions, partly as a result of globalization. We           $140 trillion. The drivers of this exponential
have more connectedness, because of the inter-              increase in scale are globalization, derivative
net, email, and the exchanges and price ser-                products, and leverage. Globalization, we’ve
vices, and all the telecommunications facilities            talked about. Derivatives have grown even faster
that come into being. We also have more inter-              than the underlying financial assets, owing to
dependence, which is another function of glob-              improved technology in their structuring, pric-


                       welling@weeden FEBRUARY 25, 2010 PAGE 8
                            R EPRINTED W ITH P ERMISSION
ing, and trading — and to the fact that the size of    Well, the good news is that once we understand
the derivatives market is not limited by the physi-    the structure and vulnerability of the financial
cal supply of any stock or commodity. It can theo-     system in this way, some solutions and policy rec-
retically achieve any size, since the underlying       ommendations become obvious.
instrument is notional rather than actual. Thus,
the total notional value of all swaps increased        Do tell.
from $106 trillion to $531 trillion between 2002       They fall into three categories: limiting scale, con-
and 2006. The notional value of equity deriva-         trolling cascades and securing informational
tives increased from $2.5 trillion to $11.9 trillion   advantage. A simple example demonstrates the
over the same period while the notional value of       importance of limiting scale: If the U.S. power grid
credit default swaps increased from $2.2 trillion      east of the Mississippi River were at no point con-
to $54.6 trillion.                                     nected to the power grid west of the Mississippi, a
                                                       nationwide power failure would be an extremely
Those numbers are actually incomprehen-                low probability event. Either the “east system” or
sible. And leverage is the third key                   the “west system” could fail catastrophically in a
enabler?                                               cascading manner. But both systems could not fail
It absolutely supports the massive scaling of          simultaneously except for entirely independent
financial markets; margin debt of U.S. brokerage       reasons because there would be no nodes in com-
firms more than doubled from $134.6 billion to         mon to facilitate propagation across systems. In a
$293.2 billion from 2002 to 2007, while the            financial context, what this tells me is that govern-
amount of total assets per dollar of equity at major   ments should consider preventing mergers that
U.S. brokerage firms increased from approxi-           lead to globalized stock and bond exchanges and
mately $20 to $26 in the same period. In addi-         universal banks.
tion, leveraged investors invest in other entities
which use leverage to make still further invest-       You’d roll back the clock on globalization?
ments. This type of layered leverage is impossible     Yes. But I wouldn’t state it as a pejorative. The first
to unwind in a panic. What I am driving at is that     order efficiencies of such mergers are far out-
it’s indisputable that the markets are larger and      weighed by the risks of large-scale failure, especial-
more complex than ever. What this means, in a          ly if those risks are not properly understood and
dynamically complex critical system, is that the       taken into account. Maybe another example will
size of the maximum potential catastrophe is           drive home the relationship between the scale of a
exponentially greater than ever. What’s more,          system and the extent of the greatest catastrophes
because systems described by a power curve, like       possible in that system, which makes limiting scale
the capital markets, allow events of all sizes and     so crucial. Let’s say I have a ship, with a hold of a
because such events can occur at any time — espe-      certain capacity. If I punch a hole in it, it fills
cially when the system is supercritical — I con-       with water and sinks. But now imagine the same
clude that progressively greater financial cata-       vessel but with the addition of two watertight
strophes, like we’ve been experiencing recently,       bulkheads, so its hold is now divided into three
should be expected frequently.                         watertight sections. If I punch the same hole in
                                                       the ship, the same size hole, the same place,
And you have no doubt about it?                        this time only one compartment fills up with
It’s inescapable. The worst outcomes in a dynami-      water and the vessel doesn’t sink; it floats.
cally complex critical state system are not limited    So what is the impact of removing the bulk-
by historical experience. They’re only limited by      heads? Well, I increase the area at risk by a fac-
the scale of the system itself. The financial crisis   tor of three. But I increase the risk infinitely
which began in July 2007 has lasted longer,            because I go from a vessel that doesn’t sink to a
caused greater losses and been more widespread         vessel that’s guaranteed to sink. So I have
both geographically and sectorally than most ana-      tripled the size of my system but I have expo-
lysts predicted or can explain precisely because       nentially increased my risk.
the vastly greater scale of the financial system can   Now, apply the same thing to capital markets.
produce an exponentially greater catastrophe           When we integrate exchanges, erase borders,
than has ever occurred before. This is why the         come up with global players and global posi-
past is not a guide and why the current crisis may     tions and global strategies on a massive scale,
be expected to produce results as severe as the        we have increased the interconnectedness in a
Great Depression of 1929-1941.                         way that’s going to lead to greater and greater
                                                       catastrophes, which is exactly what we’re see-
You’re just full of good cheer.                        ing. Because people are very good at estimating


                                                   welling@weeden FEBRUARY 25, 2010 PAGE 9
                                                        R EPRINTED W ITH P ERMISSION
the first order efficiencies, but they seem to be           temporarily.
blind to the second order costs.                            A clearinghouse would also provide informa-
                                                            tional transparency that would allow regulators
You’re saying the game has changed into a                   to facilitate the failure of financial institutions
3-D chess match and we’re still playing                     without producing contagion and systemic risk.
checkers?                                                   Such “creative destruction” is another neces-
Exactly. Which points to the next thing we have             sary step on the road to financial recovery.
to do, which is control cascades. Let me use
another example to explain what I am getting                The banks hate the clearinghouse propos-
at. Suppose your town is full of stop signs that            al, for obvious reasons. But they insist it
slow you down on your drive to work every                   won’t work because so many derivatives
morning, but that in the middle of the night                are bespoke contracts.
someone steals all of them. The next morning,               The technical objections to clearinghouse
you’d be driving to work thinking, “Hey, this is            implementation based on the non-uniformity of
great. I’m going faster; this is highly efficient.”         contracts can be overcome easily through con-
All would be wonderful — until somebody goes                sensual contractual modification with price
through an intersection, hits a school bus, and             adjustments upon joining the clearinghouse —
kills a bunch of kids. That’s where the second              enforced by the understanding that those who
order costs come in, and you see that the effi-             refuse to join will be outside the safety net. Only
ciencies of removing the stop signs are out-                by eliminating zombie institutions and creating
weighed by the costs of accidents. Which is why             breathing room for healthy institutions with
we have stop signs. Applied to financial mar-               sound balance sheets can the financial sector
kets, everyone focuses on the efficiencies of               hope to attract sufficient private capital to
larger scale markets. But they ignore the costs             replace government capital and thus re-start
of the car crashes happening with more and                  the credit creation process needed to produce
more frequency.                                             sound economic growth.

So you’re arguing for increased regulation?                 Are there other regulatory changes you
Yes, to control cascades of failure, which is, in           advocate?
part, a matter of circuit breakers and pre-                 I certainly would favor the Volcker Rule and I
rehearsed crisis management so that nascent                 would favor bringing back something like
collapses do not spin into full systemic catastro-          Glass-Steagall. And I’d favor imposing stricter
phes before regulators have the opportunity to              capital ratios on banks and brokers. I’m not
prevent the spread. The combination of diffuse              alone. If you saw last Tuesday’s New York Times
credit and layered leverage means it is not feasi-          there was a story headlined, “Elders of Wall
ble to assemble all of the affected parties in a            Street Favor More Regulation, in which Louis
single room to discuss solutions like in the old            Uchitelle interviewed people like John Reed,
days.                                                       Paul Volcker, William Donaldson, George
                                                            Soros, Nicholas Brady and Jack Bogle, all of
What sort of circuit breakers are you talk-                 whom said that restoring some version of Glass-
ing about?                                                  Steagall would be a good thing.
A significant one, which has been discussed for
over a decade but which has still not been fully            Personally, I’d go further. Too big to fail is too
implemented, is a clearinghouse for all over-               big to exist. They should be broken up. They
the-counter derivatives. Experience with clear-             are manifestly too big to be managed well.
inghouses and netting systems such as the                   That’s right. People in Wall Street, their lobby-
Government Securities Clearing Corporation                  ists and patrons in Congress, try to say that
shows that gross risk can be reduced 90% or                 Volcker Rule won’t work. That’s nonsense. We
more when converted to net risk through the                 had the Volcker Rule from 1934 to 1999. It
intermediation of a clearinghouse. Bearing in               worked fine for 65 years. And I remember how
mind that a decrease in scale produces an expo-             things were in the late 1990s in Wall Street,
nential decrease in risk in a nonlinear system,             around 1998, ’99 and 2000, when Sandy Weill
the kind of risk reduction that arises in a clear-          and John Reed and Phil Gramm were pushing
inghouse could be the single most important                 for the repeal of Glass-Steagall. There was more
step in the direction of stabilizing the financial          than a bit of arrogance in the air. There was an
system today; much more powerful than bail                  attitude that somehow the people in the 1930s
outs which do not reduce risk but merely bury it            must have been dopes; didn’t know what they


                      welling@weeden FEBRUARY 25, 2010 PAGE 10
                            R EPRINTED W ITH P ERMISSION
were doing. Or that they overreacted, so the law      Commission emerging.
was inefficient and a thing of the past. Well,        Well, that’s a very good point. We do have this
what people forget is that in the 1930s they had      Financial Crisis Inquiry Commission, the
lived through something very similar to what          FCIC. Phil Angelides is the Chairman of it and
we’re living through now. They had had a boom         you have Keith Hennessey, Brooksley Born and
in the ’20s. They had a severe market crash in        seven other individuals on it. They’re doing the
1929. Then they had the Great Depression,             best they can, but I don’t know if they’re really
which lasted until 1939, but the most acute           going to be as tough as the Pecora Commission
phase of that was in 1930, 1931, and 1932.            was; whether they’re really willing to hold peo-
So by the time you got to 1933 and ’34, when          ple accountable — including the Congress.
Glass-Steagall and the Securities Acts were
passed, people had been traumatized. Those            There’s plenty of blame to go around. But
laws were their solutions to what they had just       as entertaining as public floggings can be,
lived through. How could we be so casual about        isn’t it more important to put the right
discarding them?                                      fixes into the system?
                                                      I agree there’s a lot of blame to go around.
Good question —                                       You’re certainly right about that. But the prob-
But sure enough, we repealed the law and then         lem analytically is that if you say that everyone’s
went through 10 years that kind of looked like        responsible it’s like saying no one’s responsible.
the 1920s, and then we crashed in a way that          It’s like oh, Wall Street was greedy and short-
looks like the Great Depression. We have              sighted and partly corrupt, and there was too
repeated all the same mistakes — and the basic        much cronyism in Fannie Mae and Freddie Mac
causes of our troubles were the same, too.            and not enough accountability, and the
                                                      Congress was too busy pleasing constituents
Too much credit, you mean?                            and promoting housing finance—
Yes. What happened in the 1920s that was so
horrible? Well, banks originated loans — mostly       Not to mention that Congress was bought
in the form of corporate bonds and sovereign          and paid for.
credits back then — which they then packaged          It was all bought and paid for and the rating
up and sold to their customers. They didn’t           agencies were asleep. That’s all true. But then
care if the loans were any good, because they         what do we do, just throw up our hands? Are we
crammed them down their customers’ throats.           unwilling to untangle that mess?
Because of that abuse, in 1934, the Congress
said “Look, you can be a commercial bank and          How do you suggest going about it?
you can take deposits and make loans. Or, you         Let’s liquidate Fannie Mae and Freddie Mac
can be a securities underwriter, and that’s fine.     once and for all and get back to a private hous-
You cannot be both.”                                  ing market. Let’s allow other rating agencies to
But in 1999, we repealed Glass-Steagall; let          come in and compete with S&P and Moody’s
everybody into everyone else’s business, which,       and let’s eliminate the conflict of interest inher-
by the way, is exactly like removing the water-       ent in the issuers of securities paying fees for
tight bulkheads in my boat analogy. So what           ratings. Let’s break up the big banks and let
happened? They originated a bunch of garbage          them choose whether they want to be commer-
loans and they crammed them down the cus-             cial banks or investment banks, but not both,
tomers’ throats — except this time the customers      etc. Those are all hard choices, but we have
are worldwide. European banks and pension             good reasons to believe that they will work. Yet
funds and U.S. pension funds and hedge funds.         I don’t see any of those solutions being serious-
There’s the exact same conflict of interest and the   ly pursued. Sometimes lip service is paid to the
exact same behavior with the exact same result,       need to do something, but no one is doing any-
except that it all collapsed on a larger scale with   thing.
even worse consequences.
So who are the dopes here? The Congress of the        Don’t forget doing something to break the
1930s or the Congress of 1999? I would say that       stranglehold of special interests on mem-
we once again failed to learn the lessons of the      bers of Congress.
past, now have repeated the mistakes and are          Right. But what concerns me most right now is
again having to suffer through the consequences.      that nothing has changed. If anything, there is
                                                      greater concentration in Wall Street and the
With no obvious successors to the Pecora              only thing that is different is that the Fed has


                                                 welling@weeden FEBRUARY 25, 2010 PAGE 11
                                                       R EPRINTED W ITH P ERMISSION
printed so much money and the Treasury has                  dropped through the floor. It’s kind of a scary
spent so much money that they have papered                  thing when you print this much money and
over the problem temporarily. They also helped              can’t get inflation. So one answer is just to keep
paper things over by changing the accounting                printing, and we’ll get inflation eventually. But
rules. But the toxic assets are still there. The            my view is that the market is dynamically unsta-
market has not cleared. Prices have not hit bot-            ble. Going back to my example with the urani-
tom. Balance sheets are not cleaned up, and                 um, there will come a time when you flip from
lending has not begun. There is no demand for               a subcritical state in which everyone just
private credit and the consumer is flat on his              accepts the dollars to a tipping point where peo-
back. So while we may have temporarily halted               ple are repulsed by the dollar and get out of it as
the slide, we haven’t done anything to solve our            fast as they can and into gold or some other
problems, which means it’s just a matter of time            store of value. That’s why I’d say the better
before one of two things happen: Either the                 alternative would be for the markets to clear at
slide resumes and we finally get to the market              the bottom we never had last year and for the
bottom that we never hit in 2009, or they keep              toxic assets to be written off. We should just let
printing money to paper it over, eventually                 things crash and deflate to the point where all
destroying the dollar and undermining the                   this capital that has been misallocated has been
entire economy. Those are the choices, but                  destroyed.
everyone is just kicking the can down the road
right now.                                                  And another Great Depression wouldn’t
                                                            take down the system?
That’s pretty blunt.                                        The markets have to clear. Right now, nobody is
Well, I think it’s true. I mean, what the Fed               selling anything much. AIG is holding onto
wants is the one thing they’re not going to get:            $500 billion of credit derivatives. Citibank and
Mild inflation. They’re desperately trying to get           JP Morgan and everyone else are holding on.
some inflation going because they’re scared to              Bank of America is holding onto the mortgage
death of deflation. All of their quantitative eas-          portfolios and private equity funds are holding
ing and special programs with the Treasury and              on to their stocks, and other funds are holding
the fiscal stimulus are designed to weaken the              on to the commercial real estate. Nobody’s sell-
dollar. They’re basically trying to scare the mar-          ing anything. People are holding on to their
kets into spending money. But right now, all                homes. Markets are still essentially frozen,
Americans want to do, naturally, is save money,             which means that now it’s a waiting game
de-lever, pay down debt. All very sensible things           between the Fed’s efforts to stimulate inflation,
to do on an individual basis. But when you do               which could get things going again, and the jug-
that, in a world where consumption is 70% of                gernaut of deflation, which is still there, though
GDP, your GDP is going to collapse. That is                 it has been papered over. As I said before, that’s
reflected in the velocity of money. The whole               not price stability; that’s a very unstable ten-
notion that you can dial up nominal GDP by                  sion. It’s like an arm-wrestling contest between
increasing the money supply rests on another                evenly matched opponents. When it starts,
false assumption, which is that velocity is fairly          nothing seems to happen for a long time. Yet
constant. Now, from 1950 to 1980, it actually               enormous stress is building up. Eventually, one
was fairly constant.                                        opponent collapses and the other guy wins, so
                                                            don’t mistake no action for nothing going on.
But no one who has lived through the last                   So what I see, when I look at PPI and CPI,
couple of years can still believe velocity is               which are pretty close to zero, isn’t price stabili-
a constant.                                                 ty. What I see is something like 5% to 7% defla-
Well, they can’t say it with a straight face today          tion being countered by something like 5% to
but, it was true for 30 years;. The problem is              7% inflation. They’re netting out to about zero
that the whole monetarist project ignores veloc-            but, in fact, we have an enormous force for
ity and assumes that you can control everything             deflation, which we see in residential and com-
through the money supply, including nominal                 mercial real estate, and we have enormous force
GDP. The theory is if you dial up the money                 for inflation, which we see in places like the
supply to get nominal GDP up to 4% or 5%,                   Chinese stock market, gold, and other asset
when real GDP is capped at around 3%, you’re                bubbles. I don’t know which way it’s going to
going to get two or three points of inflation.              tip, but I know that when it tips, it’s going to go
And right now, the Fed would like that. But                 to one extreme or the other very quickly. And
they’re not succeeding because velocity has                 we might even get both; we might get a bout of


                      welling@weeden FEBRUARY 25, 2010 PAGE 12
                            R EPRINTED W ITH P ERMISSION
hyperinflation followed by deflation; that’s             other) bonds and pushing out the spread between
what happened in Weimar Germany.                         them and the benchmark. That brings step two,
                                                         which is to call for more margin from the pension
Let’s turn to Greece’s woes. Your FT piece               funds, because the price has moved in favor of the
basically said the country was being set upon            buyer. That margin money gets put into the hedge
by the Street like a piñata at a kid’s party.            funds, which enjoy the cash and paper profits -- and
And implied that credit default swaps make it            20% performance fees — particularly if this hap-
all too easy to game the markets—                        pens around year end. This dynamic of pushing
There are certainly people who disagree, but I           out spreads and calling in margin is the same one
wouldn’t say I’ve gotten hate mail. There are            that took down LTCM in 1998 and AIG in 2008 —
people who say that it’s Greece’s fault; don’t           and is happening again, in Greece.
blame the dealers for something Greece did
wrong; CDS prices are reflective of underlying           Resulting in another bailout?
realities,etc. In fact, that’s what I would call the     Eventually, and then the money flow will be
conventional wisdom on this. But the idea that           reversed. But in the meantime, pension funds earn
CDS dealers just sit there and wait for the              premium, banks earn spreads, hedge funds earn
phone to ring — that someone calls up and says,          fees and everyone’s a winner - except the poor
“Hey, I’m really interested in buying one of             investors in the hedge funds, who pay fat fees on
those credit default swaps, can you make me a            fleeting performance, and the unfortunate inhabi-
market? — is beyond naive.                               tants of the piñata. But all this has very little to do
                                                         with Greece’s fiscal fix. It’s really not much more
Credit default swaps belong to that cate-                than a floating craps game in an alley off Wall
gory of Wall Street product that is sold,                Street.
not bought?
Exactly. And what I wrote is that when you look          But a very lucrative one for the banks.
behind CDS prices, you don’t find an objective           True, but it looks like Goldman is probably fac-
measure of public finances in Greece (which are          ing some materially severe reaction from gov-
a mess, no doubt). What you find instead is              ernment officials in Europe — Germany and
something very different. What happens is that           France in particular. They’re very likely to be
the dealers very aggressively call both sides of         sued by investors because they were lead man-
the trade; they call the pension funds, who are          ager in a number of Greek bond issues at a time
the strong hands who can afford to sell the              when Greece’s off-balance-sheet swap financ-
“insurance” and then sit and wait, and they call         ing, also arranged by Goldman Sachs, was never
the hedge funds, who are the fast money look-            disclosed to prospective investors in the bonds.
ing for a quick pop — and they tell them com-            How on earth are you the lead manager of a
pletely different stories. And of course the firm        bond issue and not tell the buyers that you
in the middle, Goldman Sachs or another large            secretly arranged $1 billion of off-balance-sheet
bank, books a fat spread for its exertions. I            debt for the borrower? That seems like an
mean, we think we know why people might                  open-and-shut case of securities fraud.
want to buy the credit insurance because
Greece is in bad shape. But who on earth would           I’m sure they had legal opinions saying it
want to sell the insurance? You’d have to believe        was perfectly legal.
it was tremendously mispriced. You would have            Well, yes, but that depends on what they had
to believe that the premium is very rich relative        told the lawyers. If you give lawyers a set of
to the risk. In other words, you have to believe         facts, you’ll get a certain opinion. Did the
that the dealers are telling the long-only               lawyers know all the facts? I don’t know. But I
accounts and the institutions, the pension               do know that a lawyer’s opinion is only as good
funds, that this is very good return for them.           as the facts presented to the lawyer. Everyone is
“Don’t worry, in effect, the fix is in. Europe will      entitled to his day in court so I wouldn’t want to
ride to the rescue and Greece will not default,”         prejudge the case. But on the surface, at least,
and that the institutions basically buy that story.      these are very serious issues that probably will
Otherwise, why would they sell credit insurance          take years to play out, between European gov-
on Greece?                                               ernment actions and private lawsuits.

Where does the piñata come in?                           You’ve also written about a major concep-
Once the counterparties have their positions, the        tual flaw in credit default swaps — that
banks start pounding thinly traded Greek (or any         they allow someone without an insurable


                                                    welling@weeden FEBRUARY 25, 2010 PAGE 13
                                                          R EPRINTED W ITH P ERMISSION
interest to buy insurance, creating a per-                                                                                                                                                         Weeden & Co. LP’s
verse wish for the failure of companies or                                                                                                                                                         Research Disclosures
countries by those holding CDS.                                                                                                                                                                    In keeping with Weeden & Co. LP’s
I think there are two solutions. One would be to                                                                                                                                                   reputation for absolute integrity in its
                                                                                                                                                                                                   dealings with its institutional clients,
require an insurable interest so that if I’m buy-                                                                                                                                                  w@w believes that its own reputation
ing insurance, I need to have some interest in                                                                                                                                                     for independence and integrity are
the underlying risk being protected against, and                                                                                                                                                   essential to its mission. Our readers
                                                                                                                                                                                                   must be able to assume that we have
if I’m selling insurance, I should be regulated                                                                                                                                                    no hidden agendas; that our facts are
like an insurance company, or at least have ade-                                                                                                                                                   thoroughly researched and fairly pre-
quate reserves.                                                                                                                                                                                    sented and that when published our
                                                                                                                                                                                                   analyses reflect our best judgments,
The other solution for more liquid markets is                                                                                                                                                      not vested pocketbook interests of
transparency. Put the trading of CDS and other                                                                                                                                                     our sources, colleagues or ourselves.
derivatives on exchanges, have price reporting,                                                                                                                                                    Neither Weeden & Co. LP nor w@w
                                                                                                                                                                                                   engage in investment banking; w@w’s
show bids and offers, have a large number of                                                                                                                                                       mission is strictly research.
dealers, etc. Now, I don’t think you should need                                                                                                                                                   This material is based on data from
insurable interest to sell 10-year note futures on                                                                                                                                                 sources we consider to be accurate
the Chicago futures exchanges. I’m fine with                                                                                                                                                       and reliable, but it is not guaranteed
                                                                                                                                                                                                   as to accuracy and does not purport
that market, because those are very liquid, very                                                                                                                                                   to be complete. Opinions and projec-
well-regulated, very transparent, very safe mar-                                                                                                                                                   tions found in this report reflect
kets. But the thinner the market, the greater                                                                                                                                                      either our opinion (or that of the
                                                                                                                                                                                                   named analyst interviewed) as of the
the need for insurable interest. It’s as simple as                                                                                                                                                 report date and are subject to change
that. And one final thing, please don’t mistake                                                                                                                                                    without notice. When an unaffiliated
CDS prices for valid indicators of a company or                                                                                                                                                    interviewee’s opinions and projec-
                                                                                                                                                                                                   tions are reported, Weeden & Co. is
government’s credit standing. If you look at the                                                                                                                                                   relying on the accuracy and com-
notional value of outstanding CDS relative to                                                                                                                                                      pleteness of that individual/firm’s
the underlying bond markets, you find most are                                                                                                                                                     own research disclosures and
                                                                                                                                                                                                   assumes no liability for same, beyond
terrifically thin. There are a very small number                                                                                                                                                   reprinting them in an adjacent box.
of dealers, two or three large international                                                                                                                                                       This report is neither intended nor
banks, not that many transactions, and it’s very                                                                                                                                                   should it be construed as an offer to
                                                                                                                                                                                                   sell or solicitation or basis for any
easy for dealers to put marks where they want                                                                                                                                                      contract, for the purchase of any
them, causing collateral to move back and                                                                                                                                                          security or financial product. Nor has
forth, and causing profits and losses to arise on                                                                                                                                                  any determination been made that
                                                                                                                                                                                                   any particular security is suitable for
the books of particular institutions without                                                                                                                                                       any client. Nothing contained herein
much linkage to the underlying market.                                                                                                                                                             is intended to be, nor should it be
Indeed, if you look at what I would call objective                                                                                                                                                 considered, investment advice. This
                                                                                                                                                                                                   report does not provide sufficient
metrics of fiscal responsibility, Greece’s debt-                                                                                                                                                   information upon which to base an
to-GDP ratio is about half of Japan’s. Their                                                                                                                                                       investment decision. You are advised
deficit-to-GDP ratio is not that different from                                                                                                                                                    to consult with your broker or other
                                                                                                                                                                                                   financial advisors or professionals as
the United States. So why are the U.S. and                                                                                                                                                         appropriate to verify pricing and
Japan the benchmarks and Greece is the prob-                                                                                                                                                       other information. Weeden & Co. LP ,
lem child? Granted, there are other factors;                                                                                                                                                       its affiliates, directors, officers and
                                                                                                                                                                                                   associates do not assume any liabili-
there were other things going in Greece. And                                                                                                                                                       ty for losses that may result from the
I’m not exonerating them from their own fiscal                                                                                                                                                     reliance by any person upon any such
irresponsibility, but to suggest that the CDS                                                                                                                                                      information or opinions. Past perfor-
                                                                                                                                                                                                   mance of securities or any financial
markets are trustworthy, reliable indicators of                                                                                                                                                    instruments is not indicative of future
fiscal distress, in Greece or anywhere, is non-                                                                                                                                                    performance. From time to time, this
sense.                                                                                                                                                                                             firm, its affiliates, and/or its individ-
                                                                                                                                                                                                   ual officers and/or members of their
                                                                                                                                                                                                   families may have a position in the
Well said. Thanks, Jim.                                                                                                                                                                            subject securities which may be con-
                                                                                                                                                                                                   sistent with or contrary to the rec-
                                                                                                                                                                                                   ommendations contained herein; and
                                                                                                                                                                                                   may make purchases and/or sales of
                                                                                                                                                                                                   those securities in the open market
                                                                                                                                                                                                   or otherwise. Weeden & Co. LP makes
W@W Interviewee Research Disclosure: James G. Rickards is Senior Managing Director for Market Intelligence at Omnis, Inc. and co-head of the firm’s practice in Threat Finance & Market
Intelligence. He is also a member of the Board of Directors. This interview was initiated by Welling@Weeden and contains the current opinions of the interviewee but not necessarily those of
                                                                                                                                                                                                   a market in numerous securities.
Omnis, Inc. Such opinions are subject to change without notice. This interview and all information and opinions discussed herein is being distributed for informational purposes only and should   Weeden & Co. LP is a member of
not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources              FINRA, Nasdaq, and SIPC.
believed to be reliable, but is not guaranteed. In addition, forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted
as investment advice, or as an offer or solicitation for the purchase or sale of any financial instrument. No part of this interview may be reproduced in any form, or referred to in any other
publication, without express written permission of Welling@Weeden. Past performance is no guarantee of future results.




                                                                                          welling@weeden FEBRUARY 25, 2010 PAGE 14
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