It’s About Damn Time; Behemoth Banks In Sights

I know most of you are simply glued to the screen waiting for some sign that Bernanke & Co. are about to flood another $10 trillion into global equity markets. And you may get your announcement yet (harbingers of death that you are).

However, there is a great deal of other interesting developments occurring at this meeting which you are perhaps overlooking, although they are right in front of your eyes.

One of the key purposes of this meeting seems to be to discuss the new framework of regulation required of the Fed by the Dodd-Frank bill. Now, in addition to the individual prospects of financial institutions, the Fed is also required to look at the big picture when making regulatory decisions.

In a speech given by Governor Daniel K. Tarullo, some extremely relevant phrases were uttered, in my opinion.

First, with regards to the place of the Fed and cheap money:

“The familiar, “microprudential” approach to regulation focuses on risk within individual firms. The ability to borrow at a risk-free rate conferred by deposit insurance, combined with the limited liability that is standard in corporate structures, presents banks with incentives to take on socially inefficient risks. This well-known moral hazard problem traditionally has been addressed through regulation and supervision directed specifically at protection of the deposit insurance fund. Thus, for example, traditional bank holding company regulation was actually fairly narrowly defined: It sought to protect insured depository institutions from the risks of their uninsured affiliates and to limit use of insured deposits to fund activities in other parts of the holding company. The potential effects of an individual bank’s behavior on the financial system as a whole–much less that of a bank holding company or unregulated financial firm–were generally not addressed in prudential regulatory laws and only unevenly considered in supervisory practice. “

The Fed is aware that letting major banks borrow from them at super cheap rates is creating market inefficiencies and mal-investment which could create more problems down the road. Thus, they may look to avoid letting the window be used again during market problems in the future, opting instead for preeminent “strong hand” policies.

The second, has to do with the economies of scale:

“Well before the financial crisis and my arrival at the Federal Reserve, I had found that the relative dearth of empirical work on the nature of economies of scale and scope in large financial firms hindered the development and execution of optimal regulatory and supervisory policies. Some regulatory features added by the Dodd-Frank Act only increase the importance of more such work to fill out our understanding of the social utility of the largest, most complex financial firms. Ultimately, we want to understand what these scale or scope economies imply for the degree to which large size or functional reach across many types of financial activities is essential for the efficient allocation of capital and liquidity and for the international competitiveness of domestic firms.

Significant economies of scale in terms of production costs have been demonstrated for services related to payment networks. Generally, though, even where intuition suggests economies in some other areas–such as the breadth of securities distribution networks and the ability to provide all forms of financing in significant amounts–evidence for the existence of such economies is limited and mixed. Moreover, even where significant scale is necessary to achieve certain economies, an important question will be what the minimum efficient scale–or, perhaps more realistically, the minimum feasible scale–actually is. It is possible that a firm would need to be quite large and diversified to achieve these economies, but still not as large and diversified as some of today’s firms have become.”

People in the Fed, and not just this governor either, are finally starting to question whether there is any advantage to having gigantic banks. We know that having larger institutions exist lets them work in volume, letting them lower costs for clients and consumers. However, at what point does that ability become a liability? There is very little complete work in the study, as economies of scale, before now, have been assumed to always be advantageous. Obviously, that isn’t always true. The Fed is beginning to question the soundness of this poor logic.

Which leads us to the coup de gras; the single most important statement uttered as of yet is this one:

“While much of the interchange I have in mind will simply add nuance to existing work, we must recognize that some earlier findings about optimal market structure or regulatory policy may not hold once researchers incorporate systemic risk considerations into normative standards about what constitutes an efficient outcome. As specific regulatory proposals or acquisitions are considered, we may well identify tensions between the traditional IO approach to antitrust and regulation, on the one hand, and the goal of maintaining the stability of the financial system, on the other.”

What I have taken this to mean is that the Fed is not complacent with the size of existing financial institutions. If this line of inquiry continues, it would mean, in my mind, that the Fed believes the likes of JPM, GS, C, and friends to be too big.

In the very near future, perhaps as early as next year, we may witness the first forced splitting of a major U.S. banking operation in our lifetimes.

Today is a solid lift, which doesn’t surprise me. I figured people would be too afraid to short stocks, what with Ben Bernanke at the helm. In recent weeks, we’ve also had Fed policy makers who had previously been deriding the inflationary atmosphere recant and state that if the conditions worsened, they would not be opposed to further action.

But today, right now, none of us knows for sure whether or not the Fed will actually intervene. That is important.

Only juveniles talk about the “probability” of outcomes in a situation like this. Listen, I’ve spent an inordinate amount of time thinking about statistics, so let me share a bit of wisdom with you now.

I’m hearing people say something along the lines of, “There’s a 25% chance that the Fed intervenes extensively, a 25% chance the Fed does nothing, and a 50% chance the Fed defers to a later time” or “10% chance Greece doesn’t default, 10% chance they default immediately, 80% chance they stave off bankruptcy until next year.”

These sorts of statements are totally meaningless, because they are not statistical. Guess what? There is a 100% probability that whatever happens is going to happen. Statistically, saying Greece has an 80% chance of default would imply that with X observations of Greece as a creditor, 80% of the time in similar situations, Greece has defaulted.

Since this is such a one off event, there is no suitable sample of data which you could possibly have to tell you that such a statement is true. So the real statistical expectation of a Greek default, or a split of the European Union, or an American Bankruptcy, or an alien invasion, is totally undefinable.

While you could argue that there exists some classical probability of a Greek default, how the fuck are you going to define that? This isn’t like counting faces on a die. And no, don’t say “…well, (humph) the bond market is telling us that there is a (Y) probability of outcome (Z)…”

No jackass, because the bond market is defined by participants, and there is no participant who could possibly have a firm handle on the statistics of these extreme events, the bond and equity markets by extension are just as lost to the true likelihood of the outcomes.

At this point, these statistical discussions are really just elaborate, technical-sounding ways for pseudo-intelligent money managers to throw out wild guesses.

The truth is, unless you have some truly uncanny information regarding the actions and thoughts of every politician, individual, and feline inside of Europe, you have no idea what is about to happen.

This means that the decisions you need to be making right now should not be based on “what the market is telling you” but rather should be founded on the size and scope of the outcomes.

What happens if a major series of European defaults gets under way? What happens if Asia slows down? What if central bankers the world over put the presses on high and start using domestic currencies to wallpaper homeless shelters?

What I’m seeing, when I ask these questions, is that there is a wild domain of solutions. Literally, a single phrase or its omission, over the next 24-36 hours, could result in the market marching 20% higher, or else doing a 180 and slamming 20% lower.

There is nothing to be gained from playing in that kind of field.

You need your back against a wall, and I do as well. So here’s what I’m recommending:

Play all ways, and keep yourself grounded. You can accomplish this by,

1. Holding names that are trading close to book value, and that aren’t overly dependent on earnings. Utilities come to mind; worse economic data will result in mark downs of assets and earnings, but cheap names will still lose the least.

2. Playing both sides of the ball. There’s no reason to bet the market is going up or down. Bet both ways and have an exit strategy when the correct path reveals itself.

3. Keep your fucking eyes open. The last gazelle gets the crocodile.

Take a look at that end of the day action. That is the kind of movement you get for one reason, and one reason only. Shorts are respecting the Fed, by backing down.

I am not one to go intensely long equities at this moment. I have a nice sized buffer because the dollar itself is coming into its glory. This by itself implies that U.S. markets and most commodities are ripe for a selloff; not a tepid selloff either. In terms of commodities, I’m thinking 20-30% is not out of the question. U.S. equities will be more a rush to realistic earnings, as better people like the Fly have discussed before now.

However, you would have to be suffering from some kind of rare brain amoeba, moments from death, to get the reckless stupidity needed to short this market.

Maybe I’m still short oil by a good amount, but that’s because oil still has a good shot to trade down. And I’ve got the adjacent assets needed to cover my back if I’m wrong.

To actually go net short this market would be akin to laying your neck across a Chinese high-speed light rail. Or it would be like actually riding a Chinese high-speed light rail train.

Or be within 100 yards of a Chinese high-speed light rail system…

The point is it’s a needless risk just inviting doom and death upon your person. Obviously, something is just waiting to go wrong. Maybe you get decapitated; maybe the train slams into a barrier comprised of an orphanage and a retirement community; maybe two trains just collide going in opposite directions and the resulting carnage of fused material at 500mph equivalent force send a shard of glass through your trachea.

But with such a host of options, why wait around and find out?

Bernanke is exactly like a Chinese light rail system (zero safety systems, no restrictions) just with less regulation. It’s obvious he is meddling overseas right now; Treasury officials and Fed officials have been running back and forth across the Atlantic for months now.

They are working on something; they didn’t come this far to watch Europe ruin it all.

Does that mean we trade up from here? No, not necessarily. Personally, I still think we trade down some more, which is why I’m still short oil. But that doesn’t mean you should make the jump to putting your health on the line.

Don’t give Bernanke the opportunity to hurt you. Because he will.

My account is definitely lower today, down 1.5% last I looked as my core portfolio falls. CCJ in particular is getting crushed thanks to…well, the fact that it was being crushed before today mostly.

Cameco Corporation is in a type of self-fulfilling prophesy of downward mobility as “magical lines” keep people from jumping into an obviously beaten down and underappreciated business. It will take time, or else a few stalwart men and women with courage to make the call early, in order for that position to reverse higher. However, when it does, there will be no looking back for it.

I was hoping, obviously, that uranium miners would experience the same kind of rebound that oil drillers experienced last summer. Sadly, the current setting of debt crises and credit crunches plus a dosage of stagnant fear are making that outcome implausible. CCJ will not be another APC for me. But with time, it may still be one of the best investments I’ve ever made.

Uranium reactors are non-replaceable in the here and now. CCJ has at least 10 years of the world needing their fuel source, non-negotiable. In reality, CCJ probably has a lifetime of the world needing their fuel source, non-negotiable. I will buy more to make my point, if I have to.

My new short position of TMF is also getting skewered. I believe I stated this was a possibility explicitly, when I clearly declared three times (PPT, Twitter, and my page) that the short was high risk and could easily blow out.

If we get a major credit event in Europe, TMF goes to $100, along with the rest of the treasury positions. That’s why the position was only 2% of my assets. Long term, treasuries are extremely overpriced, and by carefully edging in, 1-2% at a time, I will get a great average price for the coming fall.

If you can find the exposure, shorting the short term maturities is a much more viable strategy than the long term stuff, as the Treasury and Fed are working in tangent to support the long term stuff. However, I found that getting exposure to the short term maturities was more difficult. And, of course, shorting those treasuries with short term maturities outright has dangers of its own.

I am adding to my short at 20% intervals. The next add will be coming closer to $70, as an eyeball estimate.

My only profitable position today is my remaining short stake in UCO. If you recall, last week I cut that in half, as I was not much interested in messing around with the unprecedented cooperation of central banks the world over.

I still feel that’s the right choice. My expectation is that the euro continues to weaken, sending commodities and US equities lower. However, I no longer need to hedge against the end of Western civilization. Having that much short oil exposure was more of a liability than an asset, as a sudden shift in the sand could bury me alive.

My short UCO stake is now closer to a full sized position on my books, whereas before it was the equivalent of two of my other positions.

I think you should have cash; at least 20%, maybe more like 30-40%. But if you got caught leaning long, you can probably wait until tomorrow for the Fed extravagancy to get underway. You have two days for short sellers to panic and permabulls to go full optimist; no need to sell into a selloff.

I’m sitting here, sipping gently on a warm cup of coffee, with liberal amounts of cream, and yearning for a nice everything bagel with plain cream cheese. The morning air was brisk and my drive to work was like floating in a cold spring. The crisp flavors and turnings of Fall are upon us in Michigan. The leaves will begin to fad to auburn soon, and the apple orchards will begin pressing cider.

If you have never visited our orchards to taste a sweet apple straight from the branch, or a glass of rich cider accompanying a fresh baked donut, covered in nuts; my friend! You have not lived.

I’m not going to pretend like I’m a meteorologist, over here. I pale in knowledge of weather, and think longingly for the differential models of Dr. Cane (Veritas) to visit us again.

I do, however, know how to read an almanac. And I do so every year, looking for an idea of the coming weather patterns and if there’s a good trade to be made along the supply line. For instance, in October of 2009 (my God, has it already been two years?) I realized it was going to be an exceptionally cold winter.

Following this train of thought, I engaged in a strategic purchase of a gas distribution company, PNY, which was right in the center of the coldest part of the country, scalping a quick run up in prices.

So this morning, Michigan’s cool breathe stirring my memory, I picked up my almanac and flipped through to the weather predictions page.

What I read suggests that this winter is going to be rather mild. If that is the case, then there won’t be much opportunity for extreme weather events to drive up prices in any part of the country.

I’m turned off to the winter trade this year, based on what I’ve read. If one were the gambling sort, he or she could perhaps bet against natural gas, as a mild winter is sure to see huge buildups of supply along with nasty levels of depreciation for companies who deal in the energy source, as I am told it is quite tricky (and subsequently, expensive) to store.

I will not be joining you, sadly. This is not my cup of tea.

And speaking of tea…that sounds much better than refilling my now depleted cup of coffee. I am going to fetch up a nice pot of Earl Gray, with its sour pitch of aromatic bergamot wafting to my senses. I’m a summer spirit at heart, but I do enjoy that certain mellowness of Fall, for a spell.

Greeting friends, to my office, come in. And witness the latest plans from the 9th floor with your own eyes.

The commodity depreciation monster has been slain; Bernanke burned out its eyes with his mighty blunt, but urinated on it.

However, the Fed’s actions do not necessarily guarantee that commodities are back “in play.” Specifically, he’s just hiding dollars overseas so that Euro banks are free to spend all of their euros in their markets. It’s a silly game, but having some green pieces of cotton in their vaults lets them worry about money less.

We could still see the euro weaken against the dollar from here, which would still result in lower commodity prices.

What has really changed is the prospect for another plunge. It is most unlikely, with the various central banks of the world looking to shore up Europe, that we go back to an across the board sell off. That does not mean we go higher. It just means we don’t go to $0.

It also means that safe haven plays are at extreme risk. If Europe is not going to disintegrate before our eyes, then why hold half your net worth in gold.

Or treasuries…

Which is why today, and with EXTREME CAUTION, I initiated a very small short of TMF, barely 2% of my assets. This is a highly leveraged bull ETF of long term treasury yields.

I would have preferred to short TYD, which is a highly leveraged ETF of shorter term maturity debt (7-10 years), but I could not find any. So, I will keep a lookout for later, while maintaining this small exposure.

In addition to the obvious risk from further fallout from abroad pushing our Treasuries higher, there is a second danger.

The Fed and Treasury have already stated they intend to roll over maturing debt into long term positions. If they do so too aggressively, then even in spite of safe haven investors selling out of treasuries, I could still lose a great deal of this position thanks to the government forcing long term yields lower.

Basically, this is a very dangerous position and I don’t recommend you do anything in size. I am expecting that the Fed would like to see outward maturing debt with higher yields before they buy, so they get bang for their buck. But even if I’m right and this is a turning point in treasuries, as I said, the stuff I’m holding could still track higher, pushing yields lower along with this 2% of my account.

The strategy is simple. If treasuries do reverse lower, I’ll be up small. Depending on where we are then, I’ll add, pass or cover. If treasuries go higher, this position is so small that I can add more or cover for a small loss.

But the position itself, being small, is controlled. No matter what happens, I live. That is very important with this sort of thing.