From GMO’s Edward Chancellor

The Typical Characteristics of a Stock Market Mania

1. This-time-is-different mentality. Throughout history, successive market manias have been rationalized with the argument that history is no longer a reliable guide to the future. Both the “new era” of the 1920s and “new paradigm” of the 1990s were marked by a “this-time-is-different” mentality. The same mode of thinking is evident again today. U.S. profit margins are currently at peak levels and the profit share of GDP in the United States is more than two standard deviations above its long-term mean (based on data going back to the 1920s). The U.S. profits dataset is the most reliably mean-reverting financial series available, claims Andrew Smithers of Smithers & Co. Most commentary, however, assumes that U.S. profits have reached, in Irving Fisher’s immortal phrase, a “permanently high plateau.” As John Hussman of Hussman Funds comments, “Believing that historical tendencies have evolved into a new paradigm will likely have the same results as playing leapfrog with a unicorn.” Painful.

2. Moral hazard. Speculative bubbles tend to form when market participants believe that financial risk has been underwritten by the authorities. The “Greenspan Put” appeared in the late 1990s after it became clear that the Fed was prepared to support falling markets but wasn’t going to act against the bubble in  technology stocks. Fed policy hasn’t significantly changed since then. Monetary policy in the aftermath of the financial crisis has aimed to put a floor under asset prices, encouraging investors to take on more risk. As a consequence, U.S. household wealth – comprising largely of home equity and stocks – has rebounded to a near-record level of 472% of GDP, nearly 100% above its long-term mean. Whenever a cloud appears over Wall Street, market participants have come to expect more quantitative easing and guarantees of perpetually low interest rates. The personnel may change at the Fed, but the Greenspan Put remains in place.

3. Easy money. Great speculative bubbles have generally been accompanied by periods of low interest rates. Greenspan’s easy money policies in the last decade inflated the U.S. housing bubble, along with numerous other bubbles around the world. Bernanke’s cure for the economy in the wake of the financial crisis has been more of the same. For more than five years, U.S. real interest rates have been maintained at negative levels. An avowed aim of the Fed’s quantitative easing has been to push down long-term interest rates in order to boost both the stock market and home prices. In particular, lowering the long-term discount rate has boosted the valuation of growth stocks.

4. Overblown growth stories. Another common feature of a bubble is the overblown growth story. We witnessed this during the Dotcom bubble, ad nauseam. In the late 1990s we were told that tech stocks were experiencing “S-curve” growth (which posits very rapid growth in the near term); investors were also encouraged to value the “real options” of Internet stocks from future income streams yet to be conceived. Many of today’s high profile growth stocks – operating in fields such as social networking, electric cars, biotechnology, and, of course, the Internet – have been boosted by similar wishful thinking. Just as there were serial railway bubbles over the course of the 19th century, Internet stocks in the age of Dotcom 2.0 appear to be experiencing what my colleague James Montier has termed a “bubble echo.”

5. No valuation anchor. The most speculative markets – from the 17th century Dutch tulip mania onwards – have been marked by the absence of any valuation anchor; when there’s no income to tether the speculator’s imagination, asset prices can become unbounded. Our electronic age has even come up with a digital version of the Semper Augustus tulip. The fact that Bitcoin – the best known among the dozens of competing crypto-currencies – soared by 5,500% during the course of 2013 is testimony to the strength of the recent speculative tempo.

Needless to say, most of the recent stock market darlings – Netflix, Facebook, Tesla, and Twitter – have little or nothing in the way of profits. Internet retailer Amazon.com, whose margins have deteriorated in recent years yet whose stock soared nearly 60% in 2013, is the poster child for a market that is more obsessed with growth than profitability.

6. Conspicuous consumption. Asset price bubbles are associated with quick fortunes, rising inequality, and luxury spending booms. Since the spring of 2009, not only has the Fed engineered a strong rebound in the level of household wealth, but the richest part of the population has enjoyed the greatest share of the gains. Luxury spending has surged globally since the crisis.

The art market provides an excellent barometer of the speculative mood, given art prices depend entirely upon what other people are prepared to pay. A bubble in modern and contemporary art, which was evident before the financial crisis, has returned. Last November, a sculpture by Jeff Koons – Balloon Dog (Orange) – fetched $58 million at auction, a record sum for a work by a living artist. The contemporary collector apparently isn’t fazed by the fact that this dog was one of five “unique” versions or that Koons himself didn’t produce the work by his own hand but had it made in a factory. The same month, a painting by Francis Bacon sold for $142 million, the highest price ever paid for any work at auction.

7. Ponzi finance. Manic markets are often marked by a decline in credit standards. In the last decade, subprime debt inflated the U.S. real estate bubble. The financial crisis may have had many unpleasant after-effects, but it hasn’t diminished the appetite for low quality U.S. credit. In fact, we have recently witnessed the lowest yields for junk bonds in history. The quality of debt issuance has been deteriorating. Last year, nearly two out of three corporate bond issues carried a junk rating. Last year, total issuance of high yield and leveraged loans exceeded $1 trillion. More than half of the 2013 vintage leveraged loans came without the traditional covenants to protect investors. The decline in the quality of credit has attracted the attention of Jeremy Stein, one of the more market-savvy Fed governors. Stein’s boss, Janet Yellen, has also expressed concern about the manic leveraged loan market.

8. Irrational exuberance. Valuation is the truest measure of speculative mood. There are other ways to take the market’s pulse, however. Most conventional measures of market sentiment have become very elevated over the past year. The IPO market in 2013 and into the first quarter of 2014 has become particularly speculative. New IPOs in 2013 rose on average by 20% on their first day’s trading (Twitter rose 74% on the day it came to the market last November). Nearly three-quarters of the IPOs, which were launched in the six months to March, produced no profits. A good portion of these profitless IPOs, in particular those of the biotech variety, hadn’t even got around to generating anything by way of revenue. They are story stocks, pure and simple.

Other sentiment measures have been telling the same story. The trading activity of corporate insiders is a reasonably good indicator of managements’ view on the intrinsic value of their companies. Recently, the ratio of insider sales to purchases has climbed to near record levels. Equity mutual fund flows – another commonly cited sentiment indicator – have also picked up lately, while household cash balances (as a share of total assets) have declined. Margin debt as a share of GDP is close to its peak level. Market volatility has been trending downwards, while the daily correlation of stocks – another useful gauge of the market’s fear level – has also come down.

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And yes: we have all of the above right now, most of which in record amounts. So… buy, buy, buy.

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Original source at: zero hedge - on a long enough timeline, the survival rate for everyone drops to zero | http://www.zerohedge.com/news/2014-05-05/eight-characteristics-stock-market-mania

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Over the weekend, I met with John Titus, Executive Producer of the new documentary film “Bailout: The Dukes of Moral Hazard,” which tells the story of individual Americans affected by the financial bust.  Myself, Yves Smith and other members of the blogerati are featured in the film.

We talked about why the film seems to connect with people at a viseral level.  Our conclusion is that the clarity and hilarity comes from the choice of our late friend John Fox as narrator. 

http://thecomicscomic.com/2012/05/31/r-i-p-john-fox-1957-2012/

The next screening of “Bailout” will be in Philadelphia later this month:

http://usabailout.com/content/screening-philadelphia-june-20-and-june-23

The subject matter of “Bailout” had to pass through the keen, irreverant perspective that John Fox, a veteran television writer and later stand up commedian, brought to all of his work.  When the man who opened for Rodney Dangerfield for eight years tells you about the subprime crisis, it somehow makes sense.

But even though Bailout Director Sean Patrick Fahey vividly presents the impact of the crisis on home owners, there is another part of the story that remains untold, namely the hundreds of billions of dollars in losses borne by investors.  Incredibly, the vast majority of the losses on residential mortgage backed securities (RMBS) and toxic derivatives like collateralized debt obligations (CDO) have been left on the table. 

Consumer and legal advocates, and politicians, focus most of their attention on the impact of the crisis on home owners and communities.  No surprise since this is where the heat is politically.  Likewise for the media, back to the point about John Fox in the role of interlocutor, the most easily understood and conveyed part of the crisis is found in the world of consumer real estate and foreclosures.  Talking about the role of a trustee in an RMBS trust quickly causes the eyes to glaze, but that same complexity and unattractiveness creates vast opportunities for fraud. 

I had an interesting conversation last week with a several consumer advocates who also understand the world of loan servicing in an intimate fashion.  These advocates have been successfully defeating foreclosure petitions in states such as New Jersey because the servicers lack the ability to prove their right to proceed to foreclosure.  That is, the party attempting to foreclose does not have the mortgage note and often cannot even document precisely who is supposed to own the note.

What many consumer advocates and politicians don’t seem to want to understand is that the chaos in the courts with respect to the robo signing mess is a big hint about a whole other area of criminality: securities fraud.  The same systemic inefficiency that makes it difficult for servicers to foreclose on a mortgage with defects in the chain of possesion of the note also enables fraud.  Wall Street firms such as Countrywide, Lehman Brothers and Bear Stearns reportedly double-pledged tens of billions of dollars worth of real and ficticious mortgages. And there has been zero interest from the Obama Administration or state attorneys general in pursuing these claims.

Back in February I wrote a comment for Housing Wire, Eric Schneiderman delves into housing, outlining some of the areas where the NY AG could act to address systemic fraud on Wall Street. 

http://www.housingwire.com/news/eric-schneiderman-delves-housing

But the trouble is that Scheiderman has done nothing.  It seems that the entire system of government in the US has been compromised by the TBTF banks.  From the Federal Reserve Board in Washington to the office of the US Attorney to the various state AGs to the world of Buy Side managers, nobody has any interest in asking difficult questions about the provenance of the collateral underlying a significant — as in double digit percentages of some RMBS and CDOs.

Based upon my discussions with managers and also Sell Side firms involved in the liquidation of asset classes like CDOs, for example, loss rates are running close to 60% on the total $700 billion plus in securities issued.  And something like 2/3rds or more of the principal amount of loss to investors remains on the table, with no claims filed in the courts.  We are talking about tens of billions of dollars in losses, mostly to Buy Side end investors like pension funds, insurers and funds.  Mad now?

The claims here have effectively been abandoned by the supposed managers and advisors.  These orphan claims could be pursued by either public sector or private parties, yet nothing is done.  Why?  Let’s go through the casual chain of complicity and inaction.

First we start with the Fed, OCC, FDIC and other regulators.  From the acquisition of Countrywide Financial by Bank of America, to the acquisition of Bear Stearns and Washington Mutual by JPMorgan, the objective has always been to preserve primary dealers at all cost.  This means the Fed must keep the lid on disclosure of the true asset quality of these TBTF originator/servicr banks, both on balance sheet and in the trillions of dollars in off-balance sheet RMBS securitizations and CDOs sponsored by these banks.  This also means that my friends at the FDIC are sometimes unknowingly on the wrong side of disputes involving the chain of title on collateral.  

Likewise in the case of Lehman Brothers, the bankruptcy process served to obscure the issue with respect to fraud.  As I noted in earlier posts, the trustee in a bankruptcy does not have the power to pursue fraud by third parties.  Only a receiver appointed by a federal district court a la The Stanford Group fraud has this power.  See the evergreen copy of  The IRA Institutional Risk Analyst comment on ZH: “The IRA | It’s All About the Fraud: Madoff, MF Global & Antonin Scalia.

http://www.zerohedge.com/contributed/2012-19-13/ira-its-all-about-fraud-madoff-mf-global-antonin-scalia

Thus when a financial institution files for bankruptcy, unless the creditors understand their right to ask to the appropriate federal district court for the appointment of a receiver, the chances of recoveries and equity fall dramatically.  In a bankruptcy, the officers and directors will almost always walk away scott free — unless a loss to an insured depository allows the FDIC to sue under US banking laws.  FDIC has power to protect the Deposit Insurance Fund (DIF) from loss and, more important, to be advocate for uninsured depositors and other bank creditors as well. 

Note that the payout waterfall in an FDIC insured bank in liquidation is different because the uninsured depositors are next in line after the insured deposits covered by the DIF.  Note too that in the case of a bank failure the FDIC is not merely trustee of the dead bank, but rather receiver with quasi judicial, Article I powers to protect the interests of third party creditors, including depositors, vendors, etc.  FDIC also has expedited access to the federal, Article III courts to compell obedience with its findings as receiver. 

Think of the appointment of an equitable reciever in a bankrtupcy like MF Global as a more general way to apply the same power weilded by FDIC as receiver to all types of fraud.  The unfortunate situation with MF Global illustrates the dilema facing the trustee in that case.  I will write a more detailed post on ZH regarding MF Global to discuss the actions of the trustee. If anybody out there can get me on the phone withe the counsel for the MF Global Bankruptcy Trustee I will put them in touch with my mentors on this issue.

Ask yourself a question:  Just why did BAC have to buy Countrywide?  Was the driver of that transaction merely that BAC was the warehouse lender to Countrywide?  Or was the issue more complex, namely that the target had billions of dollars in ficiticious assets on its balance sheet, bogus securities that were in some cases used as collateral in repurchase transactions.  It can be argued that BAC’s warehouse for Countrywide was the engine for vast fraud.  

Likewise with Lehman Brothers, nobody could buy the firm in its totality because nobody could or would attest to the assets, on or off balance sheet.  There was literally nobody who could or would sign off on representations and warranties needed to sell the company.  And the proverbial bodies were then burried in bankruptcy without the benefit of a receiver, allowing former CEO Dick Fuld and his cohorts to walk away without any criminal sanctions for what seem like obvious, dliberate acts of accounting and securities fraud.

With Bear Stearns and Washington Mutual, JPM CEO Jamie Dimin likewise provided the cover to keep these two rancid situtations under wraps and away from close scrutiny.  Recall when during the last US presidential campaign, Senator John McCain (R-AZ) famously said that we would go through the subprime mess “loan by loan?”  That was the end of John McCain’s presidential run as far as Wall Street was concerned, says one industry insider.

President Obama, by comparison, has been very accommodating to the TBTF banks and their agenda to hide the ball when it comes to systemic securities fraud on Wall Street.  Remember we are talking about loss rates about 50% for production from Bear Stearns, for example, yet none of the responsible parties in the creation of these toxic securities have been indicted. 

Now you will notice there has been no discussion fo the SEC in this tirade.  The SEC has done nothing, squat, buptkus with respect to systemic fraud on Wall Street.  And as we have noted afore this, the Fed and other regulators are complicit in allowing these hideous zombies to merge to avoid resolution and bankruptcy.  The Merrill transaction with BAC, for example, brings along $30 billion in existing litigation due to CDOs.  But this number is still a fraction of the totality of the losses on this asset class.

So if the politicians and supposed officers of the federal and state courts have been bought off when it comes to pursuing criminal and even civil claims related to various flavors of fraud involved with the origination and sale of mortgages, what about the managers, trustees and custodians of RMBS trusts?  Sadly, there are no advocates real or imagine in this group either, except in those rare exceptions where managers have been willing to go to war with some of the biggest firms on Wall Street. 

The simple fact is that the nominee trust of today’s financial markets is a sham.  The trustee appointed by the sponsor of the deal is essentially ministerial in function, with neither the funding nor the mandate to act as an advocate for investor interests. The custodians of these trusts have likewise not historically acted as advocates for investors, although there are some notable exceptions. 

Bank of New York’s DE chancelery court  litigation against BAC behalf of Countrywide bond holders is one rare example.  And the moves by US Bancorp and Deutsche Bank to sue sponsors of deals where they acted as custodian to ingratiate themselves with NY AG Schneiderman is another example.  But of course the two biggest players in the market, BAC and BK, have yet to sue themselves for the deals in which they were involved together.        

Unlike an FDIC bank resolution where the receivership can pursue officers and directors for acts of fraud, in cases such as Maddoff and MF Global, the trustee is hamstrung in pursuing third party claims.  Likewise the investors in an RMBS trust or CDO must organize themselves to pursue claims. They must pay and indemnify the trustee, who then hires counsel and sues the sponsor.  But only in a small minority of deals has a claim been filed.

Aside from the legal and operational issues facing investors who want to sue deal sponsors for fraud, the fact is that managers don’t want to sue because, during discovery, it will be shown that they made bad investmnt choices.  That is a generous description.  Less generous is to say that the manager does to want admit publicly buying a “bag of shells” in terms of diligence on deals. 

Nobody on the Buy Side wants to sue JPM, Goldman Sachs, Morgan Stanley et al for securities fraud on the more problematic deals of the past decade.  Buy Side asset managers who sue the largest Sell Side sponsors become pariah, excluded from the flow of deals and information.  But you have to wonder if the damage these passive managers are doing to investors and the US markets by not zealously pursuing legal claims against the sponsors of RMBS and CDOs is not a worse outcome at the end of the day.

If we take Schneiderman’s statement that nothing is “off the table” in terms of prosecuting acts of fraud, an ideal outcome here, IMHO, would be the following:

1)  NY AG Schneiderman goes into federal court next week and files a motion removing BK as custodian with respect to all RMBS trusts governed by NY law.  Schneiderman should ask the court to appoint a receiver with respect to all of the trusts where BK was custodian and immediately investigate whether fraud and professional malfeasance occurred.

2)  Schneiderman asks the court to appoint a receiver with respect to BAC because of ongoing acts of fraud and the recalcitrance shown to the court. Several federal courts have already found BAC to be engaging in “deliberate delay,” discovery abuse and other acts of bad faith in the various lawsuits now underway.  These acts of contempt of court alone are sufficient reason to apppoint a receiver with respect to BAC.    

3)  And come to think of it, while Schneiderman is in the court house, he can file an emergency motion to intervene in the MF Global bankruptcy and ask the court to appoint James W. Giddens as receiver in that matter.  Schneiderman has standing to bring this motion and could ask the IL AG and US attorney to join him in making the representations to the court.  Then we wipe that grin off Jon Corzine’s face and start to make some real progress on MF Global.  More tomorrow.

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Original source at: zero hedge - on a long enough timeline, the survival rate for everyone drops to zero | http://www.zerohedge.com/contributed/2012-06-10/its-all-about-fraud-silence-buy-side

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