Years, Not Months

When it comes to economic and financial matters, few people like hearing about bad news. Those who spend more than a certain amount of time highlighting risks or discussing problems are generally accused of being fear-mongerers, ridiculed as permabears, or dismissed as doom-and-gloomers.

But there are exceptions. Individuals who have achieved widespread recognition as mainstream experts are often given a lot of slack if they suddenly shift into the bearish camp. One example is Satyajit Das, a derivatives wunderkind with an impressive Wall Street pedigree. In "Knowing the Known Unknowns of a Possible Market Disaster" Toronto's Globe and Mail details an outlook from Mr. Das that is anything but upbeat.

Satyajit Das is not the sort of person you want to meet after a really bad day in the markets. The renowned derivatives expert has such a gloomy outlook on the state of the world's financial system that you might have to be kept away from sharp objects after he leaves the room.

“I think this crisis has a long way to run,” the globetrotting Mr. Das said yesterday from London. “It is an extra-innings baseball game and the national anthem still hasn't finished playing. So we really don't know what the worst is.”

Unlike some permabears who see a dark lining to every silver cloud and who have waited vainly for years for what they are convinced will be the mother of all market crashes, Mr. Das backs up his concerns with an impressive track record as a banker, trader, corporate treasurer and risk consultant.

No one is better at explaining the opaque world of what he calls “supersized” leverage stemming from the slicing and dicing of risk and the vast expansion of credit derivatives, which now total $516-trillion (U.S.), accounting for an amazing 75 per cent of the world's liquidity.

His technical reference work on the subject runs four volumes and more than 4,200 pages.

Mr. Das warns that we are in the midst of a tectonic shift of the sort that occurs only two or three times a century and that all signposts point to extreme caution ahead.

“What I'm saying is we now have a shift in the market which is significant in terms of its long-term impact. I just don't think the future is going to be anything like the past.”

Last year, when his latest, most accessible book, Traders Guns & Money, hit the shelves, he gave a series of speeches on the coming credit crash. “People decided that either I had lost my marbles finally or I'd been smoking something awful,” he laughed.

Then the subprime market crumbled and people began taking notice of this risk assessor's convictions that the credit bubble was never sustainable.

“A diet of cheap and excessive debt has created a bloated financial system,” he wrote in a new report commissioned by Jory Capital, a small Winnipeg investment firm that has scored something of a coup by signing him on as an adviser. The firm has even persuaded him to trek to Winnipeg in February to expound on his views.

In a normal world, a bank keeps $1 of real capital on its balance sheet to support $12.50 worth of loans it has underwritten. That's conservative banking. But today, the credit markets use $1 in real capital to support $30 worth of loans through all sorts of exotic structures.

The resolution of the current credit crisis will take years, not months, and will require “regulatory will and an imposition of market disciplines on errant investors and banks,” he writes. “Crash diets rarely work.”

It's a story replete with villains and victims, including the investment banks that created and pedalled incredibly complex, poorly understood credit instruments for enormous profit; the central banks that have been their enablers; and the institutional investors that snapped up the stuff in their quest for ever higher yields at seemingly minimal risk.

His report is largely a recap of long-held views of the global risk posed by massive leverage, reinforced by recent market developments, financial sector writedowns and central bank interventions to prop up ailing institutions.

But it comes out at a time when many investors, egged on by cheerleaders in the analytical community, are looking at financial stocks and some classes of debt as veritable bargains, because they have been so beaten up.

Mr. Das is noted for leavening the gloom with humour. In the report, he echoes a now famous description of the Iraq mess by then U.S. defence secretary Donald Rumsfeld. When it comes to the state of the financial system, he says, the “known known” is that there are losses stemming from subprime mortgages and anything related to them.

The “known unknown is that everybody knows that they do not know the full extent of the problem.” And the “unknown unknown” is that other problems yet to be identified could be lurking out there.

A market crash might be the sexy Hollywood-style sudden ending that people are waiting for. But not Mr. Das. He forecasts a grindingly slow unravelling of the sort that occurred in the 1970s, when inflation effectively halved portfolio values over a period of five to seven years.

If he's right, investors need to adjust for higher inflation, which means focusing on real assets. This helps explain why commodities remain strong and why blue-chip equities have held up remarkably well.

This is the time to look for companies with real cash flows and good businesses that will be sustainable, Mr. Das said.

“Owning debt of a bank or sovereign debt like U.S. Treasuries – in other words, assets with fixed returns – may not be very bright.”

While I agree with Mr. Das in many respects, I'm not so sure about his views on inflation -- at least in the short run -- or his apparent faith in blue chip equities. History suggests an unraveling credit bubble is deflationary and it spurs relentless liquidation pressures.

Either way, the road ahead is likely to be long, dark, and very bumpy.

Comments

[Eric]

Maybe it is the physicist in me, but I tend to think of inflationary pressures as fluid. In past credit unravelings, perhaps the effect was deflationary because there was some place, e.g. China and India, that could absorb inflation? Now, there are global inflationary pressures that might act as a counter to these historically deflationary pressures. If the physical law were "credit bubble unraveling = deflation", then the correct monetary policy would be obvious, wouldn't it? Perhaps I'm wrong, but I'm still not convinced that even looser monetary policy is the way out (if there is a way out).

I'm kind of with Das on this one. Financial markets taking a big hit on the chin might not be enough to turn away inflationary inertia.

[Sackerson]

A very useful post, Michael. As ever, we're stuck trying to work out what the effects are likely to be, but the watchword is caution. Since I can't decide in the inflation/deflation choice, I'd have thought a sensible approach would be (a) pay off debts, (b) build up cash and (c) invest the rest in "things", e.g. oil, gold, land. Does that seem naively simple?

[David Tolhurst]

Inflation is caused by government spending more money than it raises through taxation and honest borrowing times velosity. The velosity is no longer there. The bursting of this credit bubble is going to wipe out billions of misplaced debt resulting in deflation as in the 1930's.

[David P Tolhurst]

Inflation is caused by governments spending more money than they raise through taxation and honsest borrowering times velosity. There is now no velosity due to the unsustainable debt in the world with more money being wiped out than is being printed. Depression and deflation follow. The only safe place for individuals to be in is short term government bonds. Cash is king.