The Semantics of Central Banking

Lately a lot of financial journalists have been speculating on whether or not the ECB will become the "lender of last resort" to European governments. Some of these journalists even have the gall to quote the central bankers' Bible - Bagehot's "Lombard Street" - as evidence of the historical precedent for such action (for example - here).

Unfortunately these journalists are just plain wrong in their interpretation of what Bagehot's text. When he said that central banks should act as lenders of last resort, he was referring to extending credit to private banks during liquidity squeezes. For the conspiracy theorists out there, I should further clarify that Bagehot advocated lending to solvent banks during liquidity squeezes, charging a punitive interest rate and demanding high-quality collateral.

Thankfully I am not the only one taking these simpletons to task. Mervyn King - the governor of the Bank of England - has also chimed in on the matter (here):

This phrase 'lender of last resort' has been bandied around by people who, it seems to me, have no idea what lender of last resort actually means, to be perfectly honest. It is very clear from its origin that lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent. And it is done against good collateral, and at a penalty rate. That's what lender of last resort means.

Couldn't have said it better myself.

Paulson Takes it on the Chin

John Paulson is probably the most celebrated hedge fund manager in the world. For those of you who have been living under a rock for the past few years, he rose to prominence after one of his funds returned just under 600% in 2007 after taking long positions in CDOs which tracked MBS backed by sub-prime mortgages. This trade has been the inspiration for two books: Gregory Zuckerman's "The Greatest Trade Ever" and Michael Lewis' "The Big Short", and the basis for a record-setting settlement in an SEC case filed against Goldman Sachs.

Although he was not the only one to see through the mess of subprime mortgage securitization, he certainly profited the most handsomely. He followed up this bet with short positions in select financial firms in 2008 and reversed this position in time to catch the epic rally in bank stocks from the March 2009 lows.

Lately however, he has been giving his profits back. His largest fund is down 46% year to date (here), representing approximately $9 billion in losses. In response, Paulson is reportedly scaling back risk, which will make it awfully effectively impossible for him to reclaim his high water. Presumably massive redemption requests are in the mail.

Personally, I have always thought that Paulson was a considerably over-hyped. Before his subprime bet, he was an also-ran in the merger arbitrage space. Yes, he made one fantastic call but if he was a mediocre merger-arb manager, how does one call make him a savant? His bets on a vigorous economic recovery have made it quite clear that he (and his analysts) do not understand what a post credit-bubble economy looks like. The fact that he held somewhere around $1B of Sino-Forest stock speaks volumes to his due diligence practices.

Paulson's investment attributes aside though, he may be suffering from a very common problem in the hedge fund world - size begetting poor performance. FTAlphaville recently posted an article summarizing a comprehensive report of hedge fund returns (here):

Using data from 1980 to 2008, the authors calculated the compound annual return for the average hedge fund to be 13.8%... The dollar-weighted number is a much better proxy for actual profits earned by investors in hedge funds. For the whole period 1980-2008 that number is 6.1% as opposed to the 13.8% headline number.

It is a common refrain that the best returns are earned when a fund is in its infancy, but it is nice to see someone actually run the numbers to confirm it. Combine that fact with the astronomical growth in Paulson & Co's assets under management (and a manager with dubious global macro credentials), and the -50% annualized return becomes much less of a surprise.

I would not be surprised if Paulson & Co shuts up shop sometime in 2012.

Political Paralysis

Mohammed El-Erian recently provided readers with a very sobering wake-up call by comparing America's present political paralysis to that in Japan during their lost decade, and the implications of continued paralysis in Washington (here). El-Erian recalls that

there was a time when America looked down on Japan for the latter’s inability to deal with its economic problems. No more. Like Japan, America is now realizing how difficult a post bubble economy can be. The fear is that it will also find out that that it lacks some of Japan’s attributes needed to cope with long years of economic stagnation.

The attributes he is referring to are a higher level of social cohesion (and the concomitant social safety net), and Japan's net creditor status (ie the sectors of the economy are savers in aggregate). El-Erian figures that these attributes made Japan more capable of dealing with a prolonged period of stagnant economic growth and that as a result urgent action from American policy makers is necessary in order to prevent an adjustment even more painful than that experienced in Japan.

However, El-Erian did not discuss the likelihood of the urgent policy he is calling for being enacted. I consdier the probability of anything substantive being passed before the presidential elections to be effectively nil. The Republicans are convinced that they will win both houses in 2012 and are content to torpedo anything the Democrats table until then. Whether this is on purely ideological grounds (as they proclaim) or a tactic to weaken the economy in the hopes of improving their chances of winning the White House is not entirely clear, but it is of no real consequence. The Democrats for their part are refusing to let the GOP dictate the agenda, and why should they? They have a majority in the Senate and control the White House.

So then what do I expect in 2012? I think the Dems are closer to the mark in terms of economic policy (my views are very much in line with Cullen Roche at the Pragmatic Capitalist - here) than the Republicans, so a Democratic majority in both houses would be my preferred outcome, but I do not consider this particularly likely. A Republican majority in both houses would be a nightmare - too much austerity at precisely the wrong time. Thankfully I consider this quite unlikely as well, as the Tea Party simply scares too many independents (and rightfully so). My base case is for another stalemate in Washington, with split houses and a Democrat in the White House (because the Republicans won't field a candidate with mass appeal). Hopefully at that point, the Republicans will be in more of a compromising mood. I for one am not holding my breath.