Einhorn on gold, sovereign risk, and more

October 19, 2009

Two years ago, when he spoke at the Value Investing Congress, David Einhorn said Lehman was in deep trouble. Turned out it was a good call. Today he gave another keynote at the conference in which he argued the policies of the administration have put us on a very dangerous path, one which has encouraged him to buy physical gold as insurance against sovereign default(s).

Here’s a pdf of the speech. A few highlights below.

On Bernanke and Geithner:

Presently, Ben Bernanke and Tim Geithner have become the quintessential short-term decision makers. They explicitly “do whatever it takes” to “solve one problem at a time” and deal with the unintended consequences later. It is too soon for history to evaluate their work, because there hasn’t been time for the unintended consequences of the “do whatever it takes” decision-making to materialize.

On too big to fail and the true lesson of Lehman:

The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to make sure that  no institution is too big or inter-connected to fail. The test ought to be that no institution should ever be of individual importance such that if we were faced with its demise the government would be forced to intervene. The real solution is to break up anything that fails that test.

The lesson of Lehman should not be that the government should have prevented its failure. The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie, Freddie, Bear Stearns, Citigroup and a couple dozen others.

The administration talks tough about TBTF, but has made very clear they aren’t willing to make policy choices to do anything to proactively break them up. It was very telling when, in a keynote at the Economist’s Buttonwood Gathering, Larry Summers said too-big-to-fail means too-big-not-to-be-regulated. The correct thing to have said, the correct policy that needs to be worked out so that we avoid a re-run of last year’s crisis is “too big to fail is too big to exist.” But don’t take my word for it, take Alan Greenspan’s.

On CDS (bold mine):

I think that trying to make safer CDS is like trying to make safer asbestos. How many real businesses have to fail before policy makers decide to simply ban them?

On arguments that the lesson of 1937-8 is not to withdraw stimulus too soon:

An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.

Channeling Stephen “There-is-no-exit” Roach:

As we sit here today, the Federal Reserve is propping up the bond market, buying long-dated assets with printed money. It cannot turn around and sell what it has just bought.

There is a basic rule of liquidity. It isn’t the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because of both the size of the position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up….

….The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.

On his gold thesis:

I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked….

….When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.

He’s also buying long-dated options on interest rates using derivatives:

Along these same lines, we have bought long-dated options on much higher U.S. and Japanese interest rates. The options in Japan are particularly cheap because the historical volatility is so low. I prefer options to simply shorting government bonds, because there remains a possibility of a further government bond rally in response to the economy rolling over again. With options, I can clearly limit how much I am willing to lose, while creating a lot of leverage to a possible rate spiral.

There’s much more in the speech.


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[…] Einhorn on gold, sovereign default, and more […]

Posted by Monday Reading | The Big Picture | Report as abusive

David Ranson of Wainwright Economics has been concerned about US government insolvency for some time, and given his understanding of fiat money, the problem is even worse than David Einhorn suggests. This, since to Ranson, the Fed hasn’t any power to influence inflation (Wainwright’s inflation forecasts are based on the price of gold, not the quantity of money), and even the growth of cash in circulation is not closely correlated with inflation except in the very long run.

To his WSJ op-ed, “Money Meltdown,” where Ranson publicly noted his expectation of government insolvency, a reader queried, how can the entity that churns out money become insolvent? Additionally, in so far as the financial monetary system being in crisis, was it cyclical or systemic?

Government can “churn out currency” only in response to the demand for money balances that result from inflation. Bernanke’s “helicopter effect” is wrong. There is no mechanism for creating money for which the private economy has no need. However, there is a mechanism for discounting the market value of the money that already exists.

Only part of the government’s liabilities has been issued through a market mechanism, i.e., bonds. Those debts are easily and legally repudiated by allowing the currency to depreciate. But the major part of the government’s debts is promises to make payments to large populations of beneficiaries, under a formula that protects the payments from inflation by tying them to the CPI. Those government liabilities would remain even if the value of the regular debt was depreciated to nothing. And finally, current conditions of inflation and government solvency are systemic, and not merely cyclical.

Luis de Agustin

Posted by Luis de Agustin | Report as abusive

A sovereign currency issuer will never default – unless it wants to. Default would be a deliberate political act not a financial necessity. As long as these “debts” are denominated in the currency of issue they can always be paid. Those future payments of principal and interest do not need to be “financed” in the same way firms or households have to finance their debts. I have creditors, my business has creditors – the federal government does not have “creditors” in any meaningful sense – especially not in the sense Einhorn means.

Posted by Sensei | Report as abusive

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The worry about the trillion dollar deficit is unrealistic. Those numbers exist only in computers. There will be no need to pay anything back to anyone any more than thinking of paying back your parents for your childhood expenses.

Posted by dick cohen | Report as abusive

Social comments and analytics for this post…

This post was mentioned on Reddit by dariusfunk: Finkle is Einhorn….

Posted by uberVU – social comments | Report as abusive

I remember when Einhorn was making his calls on Lehman back in 2007 – most folks laughed and the media mostly ignored him. Now, in history behind us folks are paying more attention – and again, he’s wise and forward-looking – his calls on inflation and gold are on the target, he’s just right. On the fiscal discipline and ‘short-term’ness of Bernanke and Geithner I could not agree more – it’s just a matter of time when we’ll either default or simply capitulate. Just my 2c. Cheers.

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I don’t disagree with Einhorn, but let’s not forget that he made a big bet on Guaranty Financial and lost basically all of it.

I would amend the statement about sovereign defaults from “sensei” to cover only sovereign issuers who issue debt in their own currency. There’s a reason why countries like argentina have to issue debt denominated in USD.

However, I’d also argue that intentional debasing (to borrow the term as if it were linked to a metal) of a currency is effectively defaulting on an obligation, even though the debt is technically being repaid.

Posted by Andrew | Report as abusive

I agree with Einhorn on doing away with credit default swaps. The world survived until a decade or two ago without them. If a bank is afraid to make a loan to a company without hedging the risk with CDS, don’t make the loan. If a supplier is afraid to sell goods to a customer without hedging with CDS, don’t sell them the goods. The marketplace will discipline companies that are not creditworthy without a CDS market.

It should be clear by now after the AIG debacle that credit default swaps create enormous systemic risks that no regulator or regulators can control.

Unfortunately, CDS are a large source of profits for the major investment banks and the U.S. government is captured by the banksters so there’s virtually no chance CDS will be banned.

Posted by DP | Report as abusive

Reply to Dick Cohen – 20 Oct 3:32AM

What? So the USA doesn’t EVER have to pay back the money we borrowed from US citizens or foreigners who bought our debt!!! YIPEE, let’s go “sell” some more “safe investment – grade securities” that we will never have to payback!

Unless you mean you assume we will always be able to borrow more money to pay back the old debt (Ponzinomics). Or do you mean we will always “just print” more money to payoff the old debt, and flood the world with $’s?

Well now that I think about it some more, we have been doing the last two things for 30 years! Look how good that’s going for us — checked the USDX, or Gold/Oil lately???

Do you work for the Fed by any chance? They seem to believe this utter nonsense.

Posted by Attitude_Check | Report as abusive

[…] notes from the Value Investing Congress.  (footnoted, Rolfe Winkler, market folly, Deal […]

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A simple portfolio of Einhorn’s top 10 holdings, updtated quarterly and rebalanced when the information is public, would have beaten the market by 13% a year since 2000.

source: www.alphaclone.com

Posted by Gerry | Report as abusive

[…] 21, 2009 by greenbackd Rolfe Winkler of Reuters blog Contingent Capital has a great summary of David Einhorn’s talk to the Value Investing Congress. Despite what we say in the title, Einhorn is hardly fickle (we just couldn’t resist). If […]

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[…] Winkler has a speech from David Einhorn Einhorn on gold, sovereign default, and more. Here is the pfd of the speech. I don’t agree with everything he says, but he is […]

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[…] Conference. The entire text(.pdf) is available at Reuters and Rolfe Winkler had some additional comments […]

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It is extremely easy to speak from hindsight, I can also say that E=MC2 is actually simply to derive!

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