The Best Way the Federal Reserve Steals from You

07/07/2011

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These guys are good.  Really good.

They know how to steal, and when they do it, they call it something so innocuously confusing, you don't even realize what's actually going on.

I mean, when the Federal Reserve steals your money, they practically have you thanking them for doing it.  I'm serious.

Before I explain to you the most creative and insidious manner in which the Fed steals your money and repurposes it, allow me to back up for a second:  How much did you learn about the Fed in school?  Do you even remember it being mentioned more than once or twice?  Did you even come close to being told how it operates, how it accomplishes its obtusely stated objectives?  Have you ever wondered why you were taught next to nothing about it?

I'm almost 100% sure of the way you'd answer those questions.  You see, not teaching us anything about this institution has helped maintain the disguise placed on its operations.  A great example of this is "quantitative easing," which is a fancy way of saying "creating more money that never existed before."  It's important we pay attention to the language being used here, and not view it as semantics.  We can inadvertently come to believe something that's not true, simply by being told that something over and over again.  The key is to go behind the language and truly understand what it’s referencing.

So when we take time to explore what the Fed is actually doing on a day-to-day basis, we discover the theft that is taking place right before our eyes.  And so I come to the subject of today's post: recently, I've been reading more about another one of the Fed's operations, something called a "central bank liquidity swap," or CBLS as I'll abbreviate it here.

Sounds great, doesn't it?  Sounds official, like something that central banks need to do, right?  I mean, on the surface, nothing suspicious here...

Let's look at what a CBLS really is.  First I'll use an analogy, then describe the operation in actuality.

The Analogy:

Let's say there are two people, person A and person B, and each holds something of value.  Person A holds object X, and person B holds object Y.  Object X is actually owned by someone else (call them person C), who's left it in A's possession to look after.  Thus, person A has no emotional attachment to the object, just a stated intention to look after it.

On the other hand, person A looks favorably upon person B, at least for this moment in time, and wishes to convey favor upon B for whatever reason.  Even knowing that object Y is less valuable than object X, and knowing Y may very well depreciate in value while X appreciates in value, the two objects are exchanged for each other nonetheless.  Now person A holds object Y and person B holds object X, creating an imbalanced exchange in favor of person B.

The terms of the exchange allow person B to do whatever he pleases with X; however, person A must hold onto object Y for a stated period of time.  This is all well and good -- until one day, person B comes to A and states that object X has been lost, and he does not have anything left to exchange in return to make up for the loss.  However, he tells A that he enjoyed using object X while it lasted.  Thus, things shake out as follows:

Person A is happy, because he had no attachment to object X, and was able to fill person B's need at the time.
Person B is happy because he had the opportunity to attain and use something of higher value than what he started with, and once lost, had no emotional attachment to it anyway.
Person C should be pissed...but has no clue that Object X is gone.  In fact, person A has convinced C that all is well, nothing's changed, and Object X is in good hands.

(Person A is the Fed.  Person B is another central bank.  Person C represents you and I.)

In Actuality:

The Fed maintains what are called swap lines with many other central banks, allowing it to execute CBLS's whenever it needs to.  Many of these swap lines were emplaced in 2007, shortly before the 2008 financial crisis went into full bloom.

A swap line works like this (I'll use the euro as the example currency here):

Assume the Fed is executing a CBLS on August 1.  On that day, the European Central Bank (ECB) sells euros to the Fed at the prevailing USD-EUR exchange rate, after which the Fed deposits the appropriate amount of dollars into the ECB’s account at the Federal Reserve Bank of New York.  Commensurately, the ECB deposits the appropriate amount of euros into the Fed's account with the ECB.  In essence, the two central banks have swapped currencies.

The Fed cannot do anything with the euros it receives; it simply holds them until a certain maturity date, say September 1.  On the other hand, the ECB is allowed to use the dollars it received however it sees fit: loan them to European member banks, or possibly to EU governments whose finances aren't in very good order (i.e., Greece).  On September 1, the Fed receives dollars at the same exchange rate that prevailed on August 1 (not the exchange rate of the date the funds are returned), and conversely, the ECB receives euros.  In addition, the ECB pays a market-based interest payment to the Fed.

See anything wrong with this picture?

1) The Fed is accepting a currency it can't do anything with, so the asset is effectively frozen.  Meanwhile, the other central bank (the ECB in my example) is able to freely invest, loan and otherwise utilize the dollars it receives.

2) What if the dollar strengthens during the wait period of the swap?  The Fed would not benefit from that strengthening since the original exchange rate is in play, not the exchange rate on the date of funds returned.  You might say to that, "well can't the opposite happen, and the dollar weakens during the wait period, which would benefit us in the exchange?"  To that I'd say yes, but...the problem is the Fed is taking the risk of lost appreciation on the dollar, but they are not consulting with any elected official (and certainly not with you and I) as to whether our funds should be risked in this fashion.

3) What if the other central bank can't return the dollars to complete the exchange?  To continue my example from above, what if the ECB loans the money to an EU country such as Greece; Greece uses the money to shore up its balance sheet, but then falters and fails to repay the ECB loan; Greece's default roils the markets and EU banking sector, creating another financial crisis a la 2008; subsequently, the EU defaults on the currency exchange with the Fed.  Effectively then, taxpayer money was siphoned off to Europe, with no return of those funds at the end of the swap agreement.  While such a scenario is unlikely due to the apparent robustness of the ECB/EU, I would not say it's impossible (look at the 2008 crisis for a fractal representation of what is possible), and of course not all swap agreements are made with central banks as viable as the ECB.

I guess if I had to boil this down even further, I'd say that the Fed can take our money, give it to another country, never get it back, and then never tell us about it.

It's called a "central bank liquidity swap."  Sounds harmless enough to me...
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RIP, Benoit Mandelbrot (1924-2010)

10/22/2010

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Benoit Mandelbrot, widely considered the father of fractal geometry, passed away last week after suffering from pancreatic cancer.  I became aware of this fact only after seeing Nassim Taleb's home page, which posted a memoriam to Mandelbrot for the last several days or so (he took the page down as of this evening).

Followers of Taleb as well as this blog may recall that Mandelbrot's work on fractals inspired Taleb's "gray swan" conjecture.  In a very basic sense, fractals provide us with a model for conceiving of what might be possible when attempting to identify black swan events and their potential impacts.  As Taleb points out, we can never safely predict black swans, but using fractals aids us in attempting to forecast potential events and their associated magnitudes (thus turning black swans into gray swans).  All in all, if you’re considering implementing black swan protection protocols, you could enhance your understanding of such protocols greatly by becoming familiar with Mandelbrot and the concept of fractals.  

You can also read my thoughts on fractals here and here.
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The Markets, Economic Data, and My Black Swan Approach

08/19/2010

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Today we received news on two fronts that further indicate the economic recovery is in question.  

1) Initial jobless claims rose once again, this time by 12,000, bringing the total number to the half million mark.  (To clarify, “initial jobless claims” measures the number of individuals applying for unemployment benefits for the first time.) 

2) Manufacturing activity in the mid-Atlantic region fell into negative territory, from +5.1 the prior reading to -7.7 this time around.  (The Philadelphia Federal Reserve bank, one of the 12 regional Fed banks, gauges this index.)  Economists had actually forecast a positive number for this report, so the negative reading was that much more jarring. 

Many are interpreting the jobless claims number as a sign that businesses are not only hesitant to hire workers, but some are even continuing to trim payrolls in anticipation of economic difficulty down the road.  The problem here extends beyond the fact that there are many unfortunate individuals out of work – the jobless numbers even affect those who have jobs, because the number is seen by employed people as a reason to be cautious with their spending and to thus save more.  As savings increase, consumption declines, impacting a large portion of our economy, 70% of which is based on consumer spending.  This spending decline impacts businesses, thus causing them to cut costs (i.e., trim payrolls).  So you can see the detrimental cycle that is set in motion in this kind of environment. 

With respect to the manufacturing number, the decline was viewed as a loss of momentum from earlier positive readings, and suggests that re-stocking of inventories was the primary cause of the better numbers.  Now that that re-stocking is largely complete, those kinds of sales have dwindled while the merchandise has remained on store shelves and not been translated into retail profits. 

If you’ve been following this issue closely, you know that the first few months of the year saw a degree of acknowledgment by the government that a recovery was underway and that stimulus programs had helped contribute to it.  I believe it was unwise for the administration to take credit for that, not only because it wasn’t a large enough data set to draw such conclusions, but because from a political standpoint they must now acknowledge just the opposite – that there is no recovery and in fact the situation appears to be worsening – or risk sounding completely dissonant on this subject. 

Interestingly however, the markets have not been reacting too unfavorably to these kinds of data points over the last several weeks.  Recall that, after some serious volatility in May and early June, we’ve witnessed relative calm and even rising indexes since then, up until the last week or so.  One thing to keep in mind is that the stock market is a leading indicator.  What this means is that the markets have usually digested any sort of current events that could be viewed as impacting economic activity, and are actually a reflection of what investors and traders anticipate to be coming down the road.  It’s for this reason that anyone looking closely at the economic data (and hence the economic outlook going forward) would be left scratching their heads at the upward surge in the markets in July and August. 

At this point I think it would be helpful to illuminate what I’ve been doing both in reaction to the economic data and to be proactive to what I think is still to come.  As you may have read already on my Portfolio page, I do employ black swan protection protocols rather consistently month to month.  What this means is, each month I purchase the following months’ put options on the SPY (the underlying investment symbol for the S&P500 stock index).  These put options, which reflect a bearish outlook on the underlying investment, are bought “out of the money,” meaning the anticipated price (or strike price) that I’m purchasing is below the actual price of SPY as it stands today.  So for example, SPY closed around 107 today, and my September puts have a strike price of 100.  If the SPY were to make a sharp move downward below 100 before September 18 (the day my options expire), I would profit handsomely.  If the puts expire out of the money I’ll lose my entire initial investment sum. 

I’ve been in the process of watching my Aug 105/100/95 puts become worthless from day to day, going back to when I purchased them in early July.  I’ve lost 99% of the value of these options because I held them until expiration (that being tomorrow, August 20).  I did this because, in my mind, a true black swan protection protocol leaves at least a portion of the options in place until expiration in case of a dramatic plunge in the markets.  This belief is derived from the fractal concept Nassim Taleb has often discussed (and which I blogged about on August 4); you use fractals to envision what might be possible, not just what’s happened before. 

Another key here is that I only spend the money I can afford to lose on these options and not a dollar more.  That way I can sleep peacefully even as the options become worthless, knowing that I’m always protected against the catastrophic event month-to-month while not exposing my overall capital position too markedly. 

I bought my SPY Sep 100 puts earlier this month, and I’ll begin looking at October puts around the week following Labor Day.  The worst case scenario in my mind is missing a dramatic market downturn by not having the right put options in place ahead of time.  So given that, I’ll often pull the trigger on a purchase slightly earlier than expected if I get the sense that things might be destabilizing in the markets.  (As I type this, I hear Bloomberg reporting in the background that Asian markets fell in their Friday trading sessions, reinforcing my comfort at having my Sep puts in place.  The Asian markets are probably not experiencing much confidence that the US recovery is sustainable, thus threatening their robust export business to the US.) 

Please continue to check back in, not only with the blog, but my Portfolio page as well.  I always keep that section up to date even if I don’t post an entry to the blog.
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Black Swans and Fractals

08/04/2010

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If you haven’t done so already, I strongly recommend purchasing and reading Nassim Taleb’s 2007 bestseller, “The Black Swan: The Impact of the Highly Improbable” (re-released this year in paperback with new material).  (I say purchase it because you will undoubtedly want to reference his ideas many times over.)  I wrote at some length about Taleb and his black swan concept in my previous blog, and you’ll find a portion of that entry pasted at the end of this article.  (The entry in question was originally posted February 1 of this year.)  Therefore, I don’t want to spend too much time summing up his ideas again here, so if you need a primer I recommend first skipping to the archived blog post further down the page.

On May 6, many of you will recall that there was a “flash crash” in the markets – the Dow Jones index nosedived almost 1,000 points in the span of approximately 15-20 minutes, only to recover a huge portion of those losses before the trading day was over.  About a week later, Bloomberg interviewed Taleb, ostensibly to confront him in regards to a Wall Street Journal hypothesis that it was his black swan investing approach, implemented by a fund he advises (Universa), that caused the crash.  You see, on May 6 Universa purchased millions of dollars worth of put options against the major indexes, betting on a collapse in the market within a few months of the purchase date.  No doubt flattered at the notion that his ideas move markets so drastically, Taleb responded to the interviewer with one of my favorite quotes of his (which my Twitter followers will recognize): “When a bridge collapses, do you blame the last vehicle that drove over it?”

Taleb was making a subtle point we should all take heed of: the market is unstable to begin with, and he simply recognized this fact and acted upon it.  Therefore, while there are many dimensions to the flash crash that are worthy of analysis, this article focuses on applying one of the concepts Taleb introduced in his book regarding the way we should view markets: that is, by applying fractal geometry (fractals).  A quick check in Wikipedia shows the definition of fractals to be “a rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole, a property called self-similarity.”  Think of a snowflake – each “branch” on the flake has its own branches, and those branches have their own branches, and so on.  If you were to snap off one of the branches, it would appear (roughly) to resemble the larger flake from which it came.

When Taleb discussed this topic in “The Black Swan,” he was essentially offering a method for reducing the uncertainty that may lie in a potential black swan event.  A black swan event is difficult or impossible to predict, until afterward when it is viewed as something that should have been knowable (9/11 is an oft-cited example of this).  So Taleb explains that by using fractals, we can reduce black swans to gray swans so to speak, by making the impossible at least appear possible, even if we cannot predict it with complete certitude.  Let’s look at a retrospective example followed by a more recent example:

Prior to October 1987, the stock market had crashed on several occasions throughout the preceding decades (here I define “crash” as a greater than 10% drop in the market over the course of very few [and perhaps one] trading session).  So traders and investors knew the market could fall a great deal over a short timeframe, because there was evidence of it happening previously.  However, if you had said to them “the market is going to plummet 22.6% in one trading day,” they would have scoffed at the notion.  Such a thing had never happened before.  Of course, on October 19, 1987, it did happen.  This black swan event caught nearly everyone by surprise (Taleb was an exception; he made a lot of money off of it by betting it was indeed possible).  However, viewed fractally, one could have argued that if 22% drops were possible over a given timeframe x, then x might be capable of equaling one trading day.

Let’s come back to the present.  On May 6, 2010, the Dow Jones fell nearly 10% in a matter of minutes.  Not weeks.  Not days.  Not one day.  But minutes.  Now, it’s true that it recovered significantly from that low point before the trading day ended.  But we mustn’t allow that fact to cloud the basic truism that the market could plunge by so much, with a rapidity never seen before.  Again, this leads us to the fractal concept: if the market could plunge 10% in one day, why can’t it plunge 10% in one minute?  Could it plunge 22% in one minute?  Or perhaps more?  On May 5 had you suggested such a thing, you’d be looked at as crazy; on May 7, realistic.

The bottom line here is, as investors we should consider the power of applying fractals to our hedging strategies, by stepping outside convention and imagining what the possibilities might be based on the evidence at hand.  This will undoubtedly remove many of the limits we often self-impose on what’s “possible” in the markets, and allow more creative hedging approaches to flourish.

As promised, below I’ve posted the first half of my February 1 article on black swans.  It will provide you with a good summary of the various aspects of the black swan conjecture, as Taleb argues it.  (In a future article I'll post the second half, which addresses use of black swan protection protocols within an investment portfolio.)  Of course, there’s no substitute for reading the book, but this should give you a general working knowledge.
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Title: Black Swan Protection Protocol: An Approach for Weathering the Storm
February 1, 2010

In my August 12, 2009 post, I indicated that there was a separate approach I was undertaking for shielding the money I had no desire to lose – I referred to this approach as “black swan protection protocol.” The genesis of this term lies in the writings of Nassim Nicholas Taleb, and specifically, his 2007 best seller The Black Swan: The Impact of the Highly Improbable. Let me state clearly that this blog post does not suffice for conveying the importance and material significance of Taleb’s conjecture. Nonetheless, I was sufficiently motivated by his insights to fashion a rough outline here of how I plan to follow his advice and why.

If you read my July 15 post regarding Taleb’s ideas, the following may sound a bit redundant, but it’s worth exploring before moving into the details of the actual investment approach. The term “black swan” refers to the discovery in the 17th century of the first non-white swans, invalidating centuries of assumption that all swans were white. Thus, when Taleb speaks of black swan events, he is referring to an event which has the following attributes:

1) the event is completely unexpected

2) it is highly impactful

3) it is retrospectively distorted; that is, afterward it is rationalized as if it was or could have been expected

One of the central themes of the book focuses on the following: the concept of two different realms of existence for humans: Mediocristan and Extremistan. An illustration works best for explaining these concepts.

Take 1,000 individuals randomly from society, tabulating their weight and averaging it out. Then take the 1,001st individual, who is the heaviest individual in the world (say roughly 1,000 pounds for the sake of argument). The average weight for these 1,001 individuals will not have changed substantially with the addition of the 1,001st’s weight to the total. This is Mediocristan.

Now take 1,000 individuals randomly from society and tabulate their net worth, then average it out. Take the 1,001st individual, who happens to be the richest individual in the world: Bill Gates, approximate net worth of $80 billion. What will happen to the average net worth? Rise dramatically, obviously. In other words, the addition of just one individual’s net worth changes the entire complexion of the situation instantaneously. This is Extremistan.

Here’s the basic point: human beings do not intrinsically recognize the kind of world we live in; we think we are living in Mediocristan, when we are actually living in Extremistan. In this sense, we underestimate the impact and importance of unforeseen, significant scale events. Evidence that we are living in Extremistan abounds: see 9/11, the 2008 financial collapse, the 1987 market crash, and so on and so forth. Whether it is due to human nature or evolutionary programming (or lack thereof), the simple fact is we do not effectively recognize the role and impact of randomness and black swan style events in our lives. 

Taleb does an excellent job of exploring why this is the case in some depth, with one of the prime reasons being what he calls the “Platonic fold.” Essentially, this is the differential between what we know and what we think we know. When we act on what we think we know, rather than grasping the notion that we are treading into territory that we cannot possibly predict or explain adequately, we invite disaster or at the very least, a severe under-appreciation for the consequences or implications of a particular event. 

Another key concept Taleb discusses is what he calls the “confirmation bias.” This refers to the fact that, because we do not see an event occur over a period of time, we assume it is not possible (if we can even imagine its possibility to begin with). Taleb uses this great analogy: a turkey is fed and well-cared for by its owner throughout the year, and the turkey comes to believe the owner has its best interest at heart; then, in late November, the turkey is slaughtered by the owner for Thanksgiving. The turkey experienced a confirmation bias, in that every day it was well-treated, it confirmed the notion that the owner had the turkey’s interest at heart. Obviously, this misconception is suddenly clarified, with tragic consequences for the turkey.

The real question becomes, what can we do about these conditions? As Taleb offers in his book, we can only attempt to build a more robust system that is less susceptible to the devastating effects of negative black swans. His prime example of this from a finance perspective resides in the notion that our banking system is severely over-leveraged and, by carrying the amount of debt that we currently have, as well as speculating in complex derivative financial products, simply begging for some catastrophic perturbation to occur to the system. 

But the added problem here is that the banking and overall financial system has become increasingly interconnected in a global sense, thus vastly increasing the complexity of the system itself. A problem at one node, or bank, within the system, can quickly propagate throughout the entire system, causing distress to the system and turbulence in the financial markets. This kind of complexity must be countered with a more robust approach to the kinds of financial products and rule sets that are employed by the institutions themselves. In other words, the less complexity, the less the impact of the failure of a banking or financial institution on the overall system.

Again, I implore readers of this blog to read the book in order to gain a full appreciation of why Taleb’s conjecture is so critical to the health of one’s financial portfolio. There is simply no substitute for his insights.
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