Political Karn Evil

Welcome back my friends
To the show that never ends
We're so glad you could attend
Come inside! Come inside!
--Emerson, Lake & Palmer

President Obama's speech yesterday on the importance of extending the payroll tax cuts two more months, while a critical number of House Republicans were holding out to extend the cuts thru 2012, was the height of political carnival. The president trotted out stories of the hardships that people would have to burden without the two month extension. One person he cited, for example, claimed that he would have to forego nights out for pizza with his daughters if the extension were not passed.

Seriously.

Of course, the president did not take the time to explain why two more months of pizaa with the kids was superior to the 12 more months of pizza with the kids that House Republicans were proposing.

The portion of the bill (which passed this am) which received nearly no media attention the extension, once again, of benefits for the unemployed.

Those who slurp this stuff up deserve the despotism being heaped upon us.

Gold, Silver, and the Spectre of Systemic Collapse

Fate, it seems, is not without a sense of irony
--Morpheus (The Matrix)

Interesting take (part 1, part 2) on whether precious metals would really 'work' if we get a systemic collapse. The author is careful to state upfront that he is considering the worst case scenarios in the spectrum of chance.

He concludes those seeking power in a vacuum of collapse will likely demonize holders of gold, blaming them for 'causing' the collapse. Because most people will not have acquired precious metals for protection, the masses will likely jump on board this bandwagon in hopes that they will be able to get something for nothing.

He posits that metals markets will come under strict control with limited ability to convert metal into anything other than new script. Conversion rates may penalize metal holders, forcing them to give back much of the gains realized during the runup.

Silver, in his view, may have more utility than gold as a medium of exchange. It may be subject to less oversight, plus it is practically divisible into smaller units conducive to barter and routine trade. For this purpose, the author highlights the merits of US 90% silver coins minted 1964 or earlier.

The potential superiority of silver in this scenario is consistent with conclusions I've reached with my 'inner circle.' Gold is better viewed as a store of value to be passed along to future generations. Silver has more value as a medium for barter or exchange.

The other thing I found valuable in the author's work is his assertion that a powerful few, likely those with great influence in the current system, will try to reclaim control in the 'new' system. If that is the case, then the prudent question to ask is how will these people seek to preserve their weath across the transition? If there is a reasonable answer to this question, then perhaps individuals should allocate some resources in that direction as well.

I find it unpleasant to dream inside such a scenario. But prudent risk management requires exploring those scenarios far out in the tails of probability--where chances of occurence are small but the consequences of occurence are large.

Patterns of Optimism

So glad we've almost made it
So sad they had to fade it
--Tears for Fears

Back in early November technicians were eyeing the pennant patterns forming in the major indexes, and largely opining that the resolution of that pattern was likely to be higher. As we now know, the bulls were fooled as prices moved lower.

Now, technicians are eyeing a forming inverse head and shoulders pattern with similar optimism.

Will Hoofy's heros bring home the bacon this time? That seems to be the growing consensus.

Personally, I'm not playing it that way. There is far too much macro overhang for my tastes, not to mention overvaluation at the micro level, to merit holding a bunch of long equity risk.

Am currently about 10% net long, but that long exposure is in commodities. It is offset not quite one for one with an index equity short. This hedged position has not proven to be as effective this time around because of recent weak commodity performance relative to stocks.

Currently, however, my MO remains the same. Use price to my advantage to a) add exposure at lower prices and b) unload exposure at higher prices. All the while, I want to maintain sizeable dry power (read: cash and short term fixed income).

position in commodities, SPX

Re-Hypothecation and Precious Metal ETFs

"Unexpected this is. And unfortunate."
--Yoda (Return of the Jedi)

Zerohedge has been suggesting that the re-hypothecation issues faced by MF Global could spill over into precious metal ETFs such as GLD and SLV.

Further, ZH has posited a conspiracy theory that the metal ETFs were created to lure unknowing investors into instruments of paper gold and out of mining shares. Banks and other parties interested in getting control of the tangible gold supply chain could thereby acquire mining shares on the cheap. At some point, investors holding GLD et al will discover that they're holding worthless claims while the banks wind up holding the tangible gold assets.

Quite the Jedi Mind Trick...

While the conspiracy theory doesn't do much for me, the ETF re-hypothecation issue does. ZH builds its case around a lawsuit brought by a unit of HSBC on behalf of a client against the legal trustee of MF Global in charge of settling bankruptcy claims. The client (apparently using MF as his broker) was holding $850,000 in physical bullion at HSBC as collateral for underlying commodity contracts w/ MF. Following the MF bankruptcy, the client instructed HSBC to transfer the bullion to his Brink's account. Before the metal could be shipped, the MF trustee wrote HSBC claiming that the bullion was 'customer property' and not the client's.

In the lawsuit, HSBC is asking the court to rule on who is the rightful owner of the bullion.

If MF Global re-hypothecated physical bullion held in client accounts, then it is possible that the plaintiff no longer has legal custody of the bars.

The ramifications for ETFs like GLD are straightforward. These ETFs have gone to great lengths to demonstrate that the funds are actual in possession of physical metal, including publishing lists of bar serial numbers, positioning video cameras in the vaults that show the gold, and taking commentators on guided tours of the vault gold.

However, as the MF case demonstrates, measures that indicate metal on hand do not equate to ownership. The vault metal could be re-hypothecated or leased to someone else. When a counterparty somewhere in a daisy chain of trades fails to uphold its side of a contract, multiple parties might claim ownership.

Not exactly the situation that an investor wants with a 'safe haven' investment...

It is easy to file this situation under the general category of 'counterparty risk' that an investor takes on when buying any 'paper' form of a physical asset. I must admit, however, to being influenced by the re-hypothecation argument.

If you believe, as I do, that today's market prices are built on mountains of paper claims and leverage, then one has to question the validity of a security claiming to represent a physical asset that has no proof of clean title. As Zerohedge suggests, the metal ETFs can be seen as synthetic collateralized debt obligations (CDOs) that provide the illusion of investing in physical gold.

As such, I'm currently looking at lightening up my positions in GLD and SLV, and perhaps exiting them entirely--particularly if we see a relief rally after the recent carnage.

Am also getting the sense that Central Fund of Canada (CEF), while not perfect, is a more valid expression of physical bullion than either GLD or SLV.

position in GLD, SLV, CEF

Natural Law and The Constitution

"Knights, the gift of freedom is yours by right. But the home we seek is not in some distant land. It's in us, and in our actions on this day! If this be our destiny, then so be it. But let history remember that, as free men, we chose to make it so!"
--Arthur Castus (King Arthur)

What made the Constitution remarkable was that it was the first government design grounded in natural law. Yes, prior governments such as Rome incorporated features of natural law into its design. But the Constitution of the United States was the first (and only) attempt to express natural law as articulated by Locke et al across the scope of government.

However, the expression of natural law in the Constitution is not perfect. Several parts of the Constitution are obviously inconsistent with natural law, suggesting that the Framers either did not fully grasp what natural law was about or that they compromised their ideals. The latter seems more likely given what we know about the process that defined the Constitutional Convention of 1787.

The most glaring deviation from natural law is what today is known as the Three Fifths clause, evident right away in Article 1, Section 2. I want to reflect more on this in a later post, but right now it is worth noting that if there was ever an argument against compromise in political processes, then the Three Fifths clause provides it. The Three Fifths clause treats certain individuals as property and denies them their natural rights. It took the country nearly 100 years to reverse it in writing, and a century more to broadly enforce it.

The Constitution strays from natural law in some other ways. In Article 1, Section 8, the Constitution grants the federal government monopoly power over money. The history of the world suggests that governments will always find a way to devalue money, thereby expropriating property from the citizenry.

The Constitution also empowered Congress to grant monopoly power to people deemed by the government to possess innovative inventions and ideas. While this was done with the stated goal 'to promote the Progress of Science and useful Arts,' distibuting legal monopolies shields individuals from market competition, and opens a market for political favor between those seeking special privilege and government officials who can grant it.

One item in the Constitution originally consistent with natural law but has since been bastardized was the muted taxation power of the federal government (Article 1, Section 9). The original design severely limited the federal government's capacity for direct taxation of individuals. This is wholly consistent with the notion of property rights which forms the basis for natural law. The Sixteenth Amendment changed this, granting the federal government with essentially unlimited power to appropriate personal property via income taxes.

Because government officials largely ignore the Constitution today, the extent to which the Constitution aligns with natural law seems unimportant. But that is precisely the point. Our tenuous condition today can be explained by our divergence from natural law which was well, but not perfectly, articulated by the Constitution.

Until/unless we reverse this course, we are destined to meet the same fate as all nations who came and went before us.

Hyper-Hypothecation

All the old paintings on the tomb
They do the sand dance, don't cha know?
If they move too fast
They're falling down like a domino
--The Bangles

On top of hypothecation and re-hypothecation, there is also hyper-hypothecation. Hyper-hypothecation is basically the re-hypothecation process done multiple times between various trading partners.

HH creates systemic counter-party risk in a leveraged system. If one trading partner in a chain fails to make good on a contract, then the entire system freezes up because there is not enough capital to meet all the margin calls.

Conceivably, prices may be in error if participants fail to understand the counterparty risks that cascade thru a market system. Once those risks are understood, prices are likely to drop...significantly.

This pretty much describes our ponzi-esque condition...

Hypothecation and Re-Hypothecation

"The mother of all evil is speculation. Leveraged debt."
--Gordon Gekko (Wall Street: Money Never Sleeps)

The MF Global meltdown has brought the words 'hypothecation' and 're-hypothecation' to the forefront. Hypothecation is the relatively common situation where a buyer pledges collateral to secure a debt. The borrower retains ownership of the collateral, but in the 'hypothetical' case that the borrower defaults, then the creditor can take possession of the collateral.

In the US, the right of a creditor to take ownership of collateral if the debtor defaults is called a lien.

The lion's share of home mortgages reflect hypothecation. The home 'buyer' pledges the property to be purchased as collateral to secure a mortgage from a lender. Until the house is paid off, the creditor retains the right to take possession of the property if the borrower fails to keep up with mortgage payments.

Re-hypothecation occurs when financial entities pledge collateral that has already been posted by clients to support their own borrowing and trading. If a broker dealer such as MF Global puts up assets held by clients in 'margin accounts' as collateral to, say, speculate in Euro sovereign bonds, then this broker dealer would be engaging in re-hypothecation.

The immediate consequence of re-hypothecation is that it increases systemic leverage. More assets can be borrowed and controlled with less amounts of underlying equity.

As we noted many times on these pages, leverage becomes problematic when price moves against you. The higher the leverage, the smaller the change in price necessary to wipe you out.

Thus, when Euro bonds tanked over the past few months, MF Global was wiped out.

In the case where leverage is built on re-hypothecation, then the question becomes one of property rights. Whose property is lost when MF Global was wiped out? If re-hypothecation is in fact a legal aspect of a contract (e.g., a client of MF Global agrees that a condition of maintaining a 'margin account' at the firm is that holdings can be re-hypothecated for MF's own trading endeavors), then it is the client, not the firm, that is on the hook.

Thus, clients of MF Global may be out billions of dollars...

Rational Choice Theory and Media Effects

Hey, everybody plays the fool sometimes
--Aaron Neville

There is a theoretical argument against media bias having any effect on individual perception. Rational choice theory argues that people adjust for the bias of information streaming from particular outlets. Thus, a moderate who is listening to Rush Limbaugh would process information thru a filter that would strip out bias.

Ironically, rational choice theory suggests that listening to Rush Limbaugh drives moderates to become more liberal when processing information rather than more conservative.

In the opposite direction, assume that the average voter understands that the media, on average, are biased left. In previous missives, we have noted that politically motivated journalists will slant their message to a greater extreme in order to sway the voter. Thus, media messages are biased more extremely to the left.

Rational choice theory posits that, because the average voter recognizes the biased message, then the voter process the information with a conservative filter in order to 'sterilize' the message.

However, advances in research cast doubt on the validity of rational choice theory in the realm of media. It appears that significant 'media effects' are present when consuming information presented by politically motivated media. Stated differently, voters can be systematically fooled into thinking and voting against their natural tastes and values.

More in upcoming missives...

Freedom Watch

"Your victories, and your losses, are shared by more than you know. Stay with us. Stay the course!"
--Col Harry Burwell (The Patriot)

Over the past few yrs, I have undertaken significant personal study to better understand the Constitution, its development, and subsequent events that have diminished its influence in American life. Until recently, mainstream media was a worthless resource in this regard.

Fortunately, Judge Andrew Napolitano has shouldered responsibility for delivering nightly analysis and commentary that can help anyone better understand current events in the context of the Constitution and liberty. Here, the judge recaps some of highlights of 2011 and sets the stage for 2012.

I pray for this guy--that he has the stamina to continue in an environment that is hostile to Constitutional context. It does appear that he possesses indominable spirit that will help him press ahead.

Hopefully that indominable spirit rubs off on others in the upcoming period.

Bass Voice

My world's on fire, how about yours?
That's the way I like it and I'll never get bored
--SmashMouth

A couple of interviews w/ Kyle Bass that I have yet to chew fully thru. Similar themes to recent commentary. The end of ponzi in Japan, EU on fire, dysfunctional US govt. One new dimension was his bullish take on Canada--which is tempered by his bearishness elsewhere which will spill over in a negative way to the Knucks.

Interesting stat: value of bank assets worldwide: $87 trillion. Value of bank assets in Europe: $40 trillion. Euro bank balance sheets are 3x levered as the US.

When asked why ECB won't just print the debt whole, Bass said "Your question should be do they print before or after they default. In my opinion, they have to just print afterward because the number that they're going to have to print is so large that they all know this going in."

Not sure I understand what he's saying here. Perhaps the transcript that I'm reading is out of context, and I'll know more once I watch the actual interview.