Banks Are Causing Deflation

Last year I have predicted that 1% stimulus package enacted by Bush will do nothing for the economy. That prediction has unfortunately proven to be true. Economy now is in a much worse shape. Last quarter GDP contracted at annual rate of 4%. Unemployment has risen sharply. Even in California where I live, home to most vibrant investment, start up and high-tech community, the unemployment is now at 9%.

I have also argued that banking standards had to be lowered not tightened and that interest rate be reduced or caped. In September 2008, I have written that banks should be only bailed out if the interest rates were capped. Opposite has happened. Banks received funding but has not resumed any lending. Mortgage rates stayed the same despite fed rate reduced to virtually zero. Banks are saying that they are helping home owners to work out mortgages but in fact they are sending work out packages that are more onerous than existing mortgage. Many of the home owners are upside down on their mortgage, which means the can't sell, move or refinance. As a result housing crisis is accelerating, more foreclosures, more wealth destroyed and more people are suffering.

Fear of inflation has been replaced with fear of deflation. How is possible you would think with so much of government's injection of money? I suspect that the reason is that the banks are "sitting" on it. By not lending, banks are effectively reducing money supply thus causing deflation.


One way that monetary expansion can occur is to get around the banks - such as direct funding of specific projects, which is the aim of Obama's stimulus package.


So, will the Obama's package which is about 10% of GDP work? In such a deep crisis, I am afraid it may not be enough. In addition to government spending, credit must be made to flow again.

Obama's administration, has authorization to use second have of TARP money. They need to put restrictions on the use of those funds to be directed towards reducing lending rates and reducing lending standards (now even people with excellent FICO scores are refused credit).

The banks that do not sign up to this plan should be allowed to fail.

Trading Resumed and Why I Never Achieve Hypothetical Trading Returns

I secretly resumed trading Best Market Chances and Have Fun as they have again proven resilience. If I had stuck with these two systems all last year despite heart stopping drawdown period my investment of $50,000 could have grown by $70,000. Instead I barely got some gains. I still have not figured how much. When I do, I will sure to publish.

Following are the main factors of such huge discrepancy

1) Fear. Whenever trading system does something you don't expect you think its broke. Statistically there is much higher likelihood that the system is broke then a simple drawdown. So you pull the plug.

2) Technology. Routing trading system through my computer at home was a big mistake. Lots of lost orders due to multiple hardware, software and communications issues. Now I use OpenECry, the broker which receives orders directly from Collective2 web site. No problems yet.

3) Money Management. Using Have Fun I could be trading two or three contracts and still have the same volatility as Best Market Chances. Instead I succumbed to fear and traded one.

4) I did correctly killed two systems before they took me down. More fear!

Another issue that I worried about was slippage. However, at least with these two systems slippage was not a huge factor. So you can pretty much get close to the performance reported by Collective2.

Ok, now that I fixed the technical issue, my conclusion is that fear is the main culprit responsible for missing gains. But it also responsible for avoiding big loss.

So as everyone else this trader is driven by greed and fear!

Therefore, if I new the system would not break, I would be able to make a sizable gain. However, if I blindly trusted the system I would most likely suffer a sizable loss. So my returns are determined in large factor by my ability to distinguish a system that undergoes a sizable drawdown versus complete break down.

Few words about vendor communications. I like to communicate with the vendor and get an idea of his reasoning. However, most vendors would like to believe that their system is sound even in the overwhelming evidence to the contrary. Many will continue trading and sending signals until the system completely blows up. This is wrong, vendor should pull the plug at some point and save his subscribers from catastrophic losses. Instead some vendors keep assuring subscribers to hang on and point to previous record of accomplishment.

Think about this analogy - you are driving in a car and tracking your progress on the map. You can go slower or faster, but you pretty much able to plan how long its going to take you somewhere based on your average speed. This what happens when we consider a trading system: if you selected a system at some point in time it was because a particular system did not blow up yet. You can look at the stats and decide that this is the vehicle for you to take you into the future. You figure, sometimes it will go fast, sometimes slow but on the average it will gain so many $ / month and you will get to your destination.

Let's say there is a detour in the road and you have to backtrack and take a different road. Now the distance to your destination increases. This is similar to your system is going through a drawdown. Hopefully, you will get through the detour and will be back on your way sooner or later. Your system sooner or later will get out of the drawdown. Keep in mind that time to your destination is determined not so much by your average speed before the detour but how big the detour really is. It could delay you by half hour or by 12.

Now consider a tornado in your cars path. It lifts your car and throws it across the two lanes of high way into the ditch and the car is completely totaled. Miraculously you come out of it unscathed! Every, second after that you average speed begins to fall like a rock. A this point using previous statistics simply does not make sense. Same thing goes for a trading system, there could be something about the market that has changed, and the system that worked over some period of time met its demise. It could be a new regulation, it could be a new large trader that entered the market, it could be some other subtle way that markets interact with each other. Staying with it after that point would make as much sense as sitting in a totaled car and waiting for it to get moving again.

Recognizing your situation and making human decision is the main reason why we can not achieve the hypothetical returns shown on Collective2 and other similar web sites.

Finally fewer homes built then needed.

As I have written last March there are approximately 1.2 M new households created each year. Now 4 years after the housing market peaked in 2005 we are seeing new construction fall bellow what is needed. New housing starts are now at 0.6 M which is about 50% of household growth. Keep in mind that it takes awhile for a new start turn into a new completion. And completions still have not fallen as much as starts: the latest figures show 1 M completions. (Still less then household growth).

At this rate it will still take several years to work of the inventory of homes that were built in access of demand but the tide has turned.

Interest rate caps must be a price the banks pay for bailout

I have to admit that I am very impressed by Bush administration finally starting to come up with ideas on how to limit the damage from economic and financial "hurricane" created by housing collapse rather than just looking for someone to blame. Previously I have argued that I thought that to get things moving we need to cap the interest rates charged by mortgage companies. Of course, this would never happen voluntarily because the banks were defaulting even without interest rate caps.

However, now that government is buying "bad" mortgages, they can implement rate caps as condition of bailout. Once interest rates go down and through refinancing mortgages become more affordable it will benefit not just the troubled mortgage holders, it will benefit everyone. It will reduce cost of housing significantly for vast majority of people, making more money available to purchase other goods and services thus stimulating broader parts of the economy and promoting job growth. It will bring new buyers into the housing market increasing demand for homes and reversing price decline. Reduced mortgage payments, reversed housing price declines, and increased employment will finally bring the foreclosures rate down.

I think Paulson and Bernake think that bailout will cause banks to lower interest rates voluntarily. However, if I was putting up this much money, I think I would be entitled to a guaranty that it will actually happens immediately and not at some future point and at bank's discretion.

Best Market Chances - Suspended Again

Suspended 9/22 - dramatic loss of value in short period of time. Lost everything I have made during the year and then some. This happened during high volatility period with Lehman failing, AIG rescued, gold shutting up 18%. DOW moves up and down by more than 3%. Going back to my weather metaphor - this is category 3 hurricane. Doesn't happen too often but when it does - watch out. The reason for suspending trading is purely emotional - lost too much money in the short period of time. In the last 40 days my equity went from $50k to $57k, down to $47k. This wild ride is hard to stomach.

What is common between banking and trading systems and how to fix housing slump

What does banking and trading systems have in common? Actually quite a bit:

First of all bank lending is defined by certain rules and regulations. For example when you submit an application for mortgage bank checks you credit score, your tax return, verify you debt to earnings ratio, verify value of property. (Obviously, I am assuming standard procedures and not what are considered "bad" practices). The procedures are collective wisdom of previous years of banking which were designed to make sure that the bank makes money. In a trading system, there are a number of rules in place which designer of the system thought would generate positive return for the system. These rules are often tested on historical data and then by real live trading.

As we have already observed, even systems that have worked well in the past can blow up. Something may have changed in the way the markets or commodities work and the system that worked well in the past no longer works. Same thing goes for banking. I believe the single most important error in banking rules was that price of real estate will go up. Therefore all these other rules that were in place may have been relatively less important as the more important assumption of rising prices. As soon as prices began falling, buyers stop buying, fearing future declines. Since most home sales are made with leverage of 5 to 1 or higher, even small decline in value of real estate creates a huge decline in invested capital. The opposite is true also: small increase in price results in large investment return.

So it seems our banking system has blew up just like any other trading system. Even a huge spread between Feds rate and what banks are now charging for mortgages which normally would result in windfall profits for the banks are not motivating banks to help resolve the situation.

In order to solve their own problems banks must be aggressive in reversing housing price declines and get customers back into their own doors. They must reduce the mortgage rates by no more than 2% over Feds rate. They must unilaterally and across the board reduce existing mortgages by !-2% so that foreclosures stop or drastically reduced. It is time to recognize that the previous system the banks have devised to make money is simply not working when the prices are falling!

Bernanke is right on

I have always thought of the recent housing bubble, which precipitated financial slump which precipitated commodities bubble is really a natural disaster such as hurricane. With a lot of very powerful economic forces getting out of control and pumeling everything in its path. In dollar terms this economic hurricane is orders of magnitude larger than physical hurricane such as Katherina. I am very happy to hear that our chief economist also uses a weather metaphor in his assessment.

"Although we have seen improved functioning in some markets, the financial storm that reached gale force some weeks before our last meeting (in Jackson Hole in August 2007) has not yet subsided, and its effects on the broader economy are becoming apparent in the form of softening economic activity and rising unemployment," Mr. Bernanke said.

I think Bernake is right on. Keep on top of it Ben!