The Crunch

by Bill Bonner
by Bill Bonner

DIGG THIS

Poor Bernie Ebbers. His number's up. The man drove up to the Oakdale Correctional Complex in Louisiana yesterday. He got out of his Mercedes and joined the former governor of the state, Edwin Edwards, in the federal pen. Hizonner faces 10 years in the hoosegow for extorting money out of riverboat casinos. Ebbers got 25 for his role in a telecom scandal. Accountants working under his direction took some whole numbers out of the operational columns, they say, and slipped them into the capital budget.

Both men did naughty things, we don't deny it. But putting poor Bernie behind bars for a quarter of a century for some financial hanky-panky seems excessive. When it comes to numbers, after all...anyone can make a mistake. The things are downright slippery.

Just look at poor Brian Hunter. He would tell you. The man was making $75 to $100 million per year, as an ace energy trader. He was so good that even the savviest players in the industry wanted in on his game. Both Morgan Stanley and Goldman Sachs had invested money with Hunter's employer, Amaranth Advisors, the $9 billion hedge fund that blew up last week.

What went wrong? Hedge funds are supposed to be good at numbers, after all. They hire people with advanced degrees in mathematics simply to make sure they've calculated the odds correctly and offset their risks with their expectations in a logical manner.

"Somebody was not monitoring this correctly," said one pro, referring to the extraordinary bet that Hunter placed on gas prices, a bet so large that at one time, he held about 10% of the global market in natural gas futures.

As far as we can tell, these are the numbers in a nutshell: Hunter was long. And investors were short as much as $6 billion.

"It appears we have had a major malfunction," might have been another way to put it. But that famous understatement has already been taken. That was on January 28, 1986...with 50 million TV viewers watching. It was the day the spacecraft Challenger exploded into smithereens.

Nobel prize-winning physicist Richard Feynman described the NASA catastrophe as an institutional failure. The scientists and engineers at NASA, he charged, has been upstaged by bureaucrats who had been allowed to "pervert standards."

But in the financial world, standards are perverted so easily they must have a twisted gene to start with. [See the letter from a dear reader, below, about slipping standards during the Roman era credit collapse. "Rigor at the outset," says Tacitus, speaking broadly about financial affairs, "becoming negligence at the end."]

That's why we can't help but feel sorry for Brian Hunter. Like Ebbers, he came from nothing to make a fortune. He went to college in Alberta, where he was a star at mathematics, of course, specializing in financial models. But the poor 32-year-old had barely gotten used to being extraordinarily rich and extraordinarily talented, when a very ordinary little slip-up with numbers derailed his extraordinary career.

We are reminded of the now legendary Nick Leeson whose rags-to-riches rise also came apart over some mundane, barely noticed figures...figures of eight, in his case.

Leeson, the working class son of a plasterer, who failed his final math exam, made such an impression at Britain's prestigious Barings Bank that he was quickly promoted to the trading floor and then given a new operation in futures markets on the Singapore Monetary Exchange (SIMEX) where he began pulling in millions for Barings by gambling on the movement of the Japanese stock market (Nikkei Index). The whiz kid seemed to have it altogether. By the end of 1993, he had made more than £10m for Barings – nearly 10 percent of its total profit that year.

What Barings didn't know was that Leeson, by now both Chief Trader and also in charge of settling accounts in the office (jobs that were usually done by different people), was hiding his mistakes in an account, numbered 88888, for which the company was liable. By December 1994, the numbers in 88888 had piled up...to over half a billion. A desperate Leeson then placed his most desperate bet – that the Nikkei would not fall below 19,000 points. It would have been a reasonable assumption under ordinary circumstances. But then came one of those fat tail events that give bell curves their shape – on January 17, 1995, a 7.2 earthquake hit Kobe in Japan and the Nikkei crashed by 7% in a week.

Leeson's gambling spiraled out of control as he piled on more and more debt hoping to push the index back the other way. Most of the $1.3 billion he eventually lost for Barings came from trying to cover up what had happened.

On the verge of turning 28, the whiz kid could take it no more. Leaving a scribbled apology, he fled with his wife to Borneo and then to Frankfurt, where he was caught.

The numbers then looked pretty bad: The futures market was in shock, a 233 year-old bank to the Queen was bust; more than a thousand bank employees were out of jobs; and investors were wiped out.

And all for a string of single digits. Ordinary insignificant set of numerals – 88888.

• "And now, as promised, more on America's growing balance of payments problem. For the first time in 90 years, the United States is paying more to foreign creditors than it gets in payments from its overseas investments. The difference grew to $2.5 billion in the second quarter of 2006. This, according to the Wall Street Journal, was the equivalent of a quarterly debt payment of about $22 for each American household, "a turnaround from the $31 in net investment income per household it received a year earlier."

Still peanuts. But going in the wrong direction fast.

"Our net international obligations are coming home to roost," says Catherine Mann, a senior fellow at the Institute for International Economics.

"Since the end of 2001, when the current economic expansion began, the nation's consumption, investment and other outlays have exceeded income by a cumulative $2.9 trillion – the largest gap on record. That current-account deficit contributes directly to the nation's total foreign debt, the value of all the U.S. stocks, bonds, real estate, businesses and other assets owned by non-U.S. residents. As of the end of 2005, total U.S. foreign debt stood at $13.6 trillion – or about $119,000 per household. Net foreign debt, which excluded the $11.1 trillion value of U.S.-owned foreign assets, was $2.5 trillion.

"Foreigners' willingness to lend at low rates has also encouraged Americans and their government to borrow and spend. By buying U.S. Treasuries, foreign investors put up more than four-fifths of the $1.3 trillion the federal government has borrowed since 2001 to help pay for tax breaks, the new Medicare prescription-drug benefit and wars in Afghanistan and Iraq. Over the same period, foreigners put more than $700 billion into various types of U.S. mortgage-backed securities, providing the money for millions of Americans to buy new homes – or extract cash from their existing homes to spend on goods such as washing machines and Hummers."

• And finally, a dear reader writes:

"I believe I have found a Roman parallel to the housing bubble for you. In the course of my thesis research I came across this passage in Tacitus' Annales relating to a 'credit crunch' in 33AD:

'The Senate passed a measure requiring two-thirds of loaned money to be reinvested in Italian real estate to prevent the collapse of land prices resulting from the sale of assets to repay loans. Tiberius himself later offered 100m sesterces on loan for three years to ease the credit crunch.

From Tacitus: "Meanwhile a powerful host of accusers fell with sudden fury on the class which systematically increased its wealth by usury in defiance of a law passed by Caesar the Dictator defining the terms of lending money and of holding estates in Italy, a law long obsolete because the public good is sacrificed to private interest. The curse of usury was indeed of old standing in Rome and a most frequent cause of sedition and discord, and it was therefore repressed even in the early days of a less corrupt morality. First, the Twelve Tables prohibited any one from exacting more than 10 per cent, when, previously, the rate had depended on the caprice of the wealthy. Subsequently, by a bill brought in by the tribunes, interest was reduced to half that amount, and finally compound interest was wholly forbidden. A check too was put by several enactments of the people on evasions which, though continually put down, still, through strange artifices, reappeared. On this occasion, however, Gracchus, the praetor, to whose jurisdiction the inquiry had fallen, felt himself compelled by the number of persons endangered to refer the matter to the Senate. In their dismay the senators, not one of whom was free from similar guilt, threw themselves on the emperor's indulgence. He yielded, and a year and six months were granted, within which every one was to settle his private accounts conformably to the requirements of the law.

"Hence followed a scarcity of money, a great shock being given to all credit, the current coin too, in consequence of the conviction of so many persons and the sale of their property, being locked up in the imperial treasury or the public exchequer. To meet this, the Senate had directed that every creditor should have two-thirds his capital secured on estates in Italy. Creditors however were suing for payment in full, and it was not respectable for persons when sued to break faith. So, at first, there were clamorous meetings and importunate entreaties; then noisy applications to the praetor's court. And the very device intended as a remedy, the sale and purchase of estates, proved the contrary, as the usurers had hoarded up all their money for buying land. The facilities for selling were followed by a fall of prices, and the deeper a man was in debt, the more reluctantly did he part with his property, and many were utterly ruined. The destruction of private wealth precipitated the fall of rank and reputation, till at last the emperor interposed his aid by distributing throughout the banks a hundred million sesterces, and allowing freedom to borrow without interest for three years, provided the borrower gave security to the State in land to double the amount. Credit was thus restored, and gradually private lenders were found. The purchase too of estates was not carried out according to the letter of the Senate's decree, rigour at the outset, as usual with such matters, becoming negligence in the end.'"

September 29, 2006

Bill Bonner [send him mail] is the author, with Addison Wiggin, of Financial Reckoning Day: Surviving the Soft Depression of The 21^st Century and Empire of Debt: The Rise Of An Epic Financial Crisis.

Copyright © 2006 Bill Bonner

Bill Bonner Archives