S&P Above 38.2% Fibonacci Retracement, Eyeing 50% at 1,121

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Technical update: From October 2007 highs 1,576.09 to March 2009 lows 666.79, with the S&P currently trading at 1,053 it is above the 38.2% retracement level 1,014 and is eyeing the 50% retracement level at 1,121.44. Meaning the S&P is eyeing the level to recoup 50% of it's losses from the October 2007 high. It is riding the steep uptrend and there's a downtrend that hits just above the 50% level. Watching for a blow out top sooner or later.

S&P 500 (Courtesy of Stockcharts.com)

US Dollar 3-Month Libor Cheaper Than Yen, Franc (Chart), 0.295%

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Remember when banks were frozen and 3M Libor spiked to 4.75% on October 9, 2008? Remember it was a big relief when Overnight Libor declined 51% to 2.469% the next day? Now USD 3M Libor is at 0.29%! Perhaps Bernanke deserves some "props" for unfreezing credit lines for working capital. When looking at 3 Month Libor today across popular carry currencies, the USD is now cheaper than the Japanese Yen and Swiss Franc to fund higher yielding assets. Will funds continue to pile onto this trade and devalue the USD or will a catalyst widen yields and unwind the carry trade?

Other articles:
Dollar Near Weakest This Year on Record-Low Borrowing Costs (9/15/09)
Dollar Diminishing Makes U.S. Favorite for High-Yield (9/14/09)
Lord Lamont: Dollar As Carry Currency Is Risky Phenomenon (blog post today)

For Libor charts go to Bloomberg.com: US Dollar 3M Libor, Yen 3M Libor, Franc 3M Libor.

Rick Santelli and Liesman Argue On Lehman's Anniversary

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Hell yeah Rick!

Previous clips:

Rick Santelli and Traders Rally for Capitalism at the Chicago Board of Trade (CBOT)


Liesman vs. Santelli Regarding "Dumb Things"!

Lord Lamont: Dollar As Carry Currency Is Risky Phenomenon (CNBC)

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Former British Chancellor Lord Lamont was on CNBC with Jim Rogers this morning. Jim is still banking on a currency crisis or terrible inflation and mentioned the risk of protectionism and dealing with Central Europe's horrible loans.

Lord Lamont said we've seen the end of fear and output falling but the road ahead will not be a strong recovery because there is still debt deflation in the system and banks will be cautious to lend. At the end Lamont said the US Dollar becoming a carry currency is a risky phenomenon. By the way, Germany just issued $4 Billion in Dollar Denominated bonds.

Nassim Taleb Speaks Before Congress on Value-at-Risk Model Defects

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Nassim Taleb (Fooled by Randomness speaks before congress on the defects of modeling complex systems.

Bank of China's Zhu Min Bloomberg Interview (9/10/09)

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I couldn't embed the full interview, the full video is here.

Quick points from the interview:
  • Plenty of infrastructure projects in China to soak up liquidity
  • Risk of asset bubbles forming due to ample liquidity
  • Money needs to go to real projects
  • Wall Street feels like the crisis never happened (over-myopic)
  • Financial crisis stabilized from a cliff drop
  • At the end he said: The real economic crisis is just starting

Wall Street Is ‘Myopic,’ Bank of China’s Zhu Says (Bloomberg)
Bank of China’s Zhu Sees ‘Bubbles’ in Asset Markets (Bloomberg)
China’s New Lending Quickens, Money Supply Rises by Record (Bloomberg)

More analysis by Andy Xie (Former Economist at Morgan Stanley):
Andy Xie: Shanghai Index Fairly Valued At 2,000, Could See Bounce (Video)

FXI Put Protection, Andy Xie On China's Bubble

Puts Active On XLF and Regional Banks For Next Week

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Yesterday was an interesting day in XLF. Fred Ruffy of WhatsTrading.com saw that 108,000 traded on the September $14 Call at $0.15. Fred mentioned this on Twitter along with a 50k ratio put spread on $WFC. Open interest increased today over 100k so the trade wasn't closing out an existing seller, was it a new seller?? The trade could be hedging a potential head and shoulders top which could eventually test the $13.88 neck line. If it was bought-to-open, the $1.62 million (108k*100*.15) used to buy these contracts have 5 business days to exercise below $13.85 or sell out on a volatility spike. It is currently trading at $14.54.

Check Out Nanosolar's Panel Assembly Factory (Video)

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Is solar the next big thing?

Nanosolar Completes Panel Factory, Commences Serial Production (
An Overview of Nanosolar’s Cell Technology Platform (White Paper, 9/09)

ht beanieville

Hecla Mining Breaks Out, Calls Up On Silver Production, Cost Outlook

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Hecla Mining ($HL) spiked 11% today on it's revised silver production and cash cost outlook. They also mention the Lucky Friday Mine. Hecla is riding the silver train at the moment (more below).

Hecla Updates Guidance Increasing Silver Production and Lowering Cash Costs Per Ounce

COEUR D’ALENE, Idaho--(BUSINESS WIRE)--Sep. 9, 2009-- Hecla Mining Company (NYSE:HL) is pleased to announce improved operating performance, increased exploration spending and an update on the development plans for the Lucky Friday mine.

Hecla’s operations continue to show marked improvement as a result of previously implemented plans which focused on lowering cash costs through cost-cutting and optimization programs. Increased production volumes, improved grade control measures and greater availability of hydroelectric power at the Green Creek mine have led to lower operating costs in 2009 compared with 2008. Prices for by-product base metals have also rebounded sharply since early June which helps to reduce operating costs at both the Greens Creek and Lucky Friday mines.

As a result of these programs and improved business conditions, Hecla is revising anticipated full year 2009 silver production to 10.5 to 11 million ounces from 10 to 11 million ounces. The estimate of cash cost per ounce of silver has been reduced by a third to less than $3.00 per ounce of silver from the previously announced estimate of $4.50 per ounce.

Hecla Mining Company President and Chief Executive Officer Phillips S. Baker, Jr., said, “If prices for metals remain at their current levels we should generate substantially more operating cash flow this year than anytime in Hecla’s hundred year history. Second quarter cash flow was $20 million and, importantly, compares favorably with our competitors who produced more silver but at higher operating costs thereby providing less operating margin.”

Baker continued, “Our people have done an excellent job of managing the operations. At Greens Creek we lowered operating costs by increasing throughput while the ore grade at the Lucky Friday mine has improved approximately 10% as a result of grade control measures. In addition, we have also benefited from higher by-product metal prices. I am excited that we have announced a second reduction in our cost guidance and I am confident that we should have full-year cash costs below $3.00 per ounce. These are important achievements and I believe that the location of our mines in the U.S., Hecla’s leverage to a rising silver price and the cash flow generation that we are seeing today makes Hecla an attractive investment.”


As part of Hecla’s commitment to grow its production and reserves in its four district-controlling land packages, Hecla has expanded planned exploration expenditures almost 40% to $9.5 million for the year with $7 million being spent in the second half of 2009.

Surface drilling is already underway on the Northeast Contact target at the Greens Creek mine, on the Vindicator property east of the Lucky Friday mine and on the Bulldog vein which is part of the San Juan joint venture in Colorado where Hecla owns a 70% interest. The remaining 30% of the joint venture is held by Emerald Mining and Leasing, LLC and Golden 8 Mining, LLC. Surface drilling should commence at the San Sebastian property in Mexico in the fourth quarter. By early October, nine drill rigs are expected to test our projects in Alaska, Colorado, Idaho and Mexico.


Preliminary work on studies underway at the Lucky Friday mine in Idaho indicates that mine-life can be materially extended under several alternatives. The studies are examining deep development options to mine beyond 2015 under different capital and development schedules. The lower capital alternative could extend mine-life at Lucky Friday by four years for an estimated investment of less than $10 million. The capital required would be deployed to increase the cooling capacity of the ventilation system and for mine development using existing infrastructure.

A second scenario, requiring a greater capital investment is currently the subject of a feasibility study that will detail long-term infrastructure development of the mine that could extend mine-life by several decades. The feasibility study started earlier in the year... Continued

Hecla's Home Page can be accessed on the Internet at www.hecla-mining.com.

Source: Hecla Mining Company

DV is revisiting a Hecla post from May 20. Hecla is up with silver due to inflation expectations and a weak dollar¹. There is still business risk involved with this company, they recently deferred preferred dividend payments to conserve cash and to not violate a bank credit agreement. Earlier this year they had to amend credit agreements and raise equity to pay down debt. Since April look at the HL vs. SLV, UUP (Silver ETF, US Dollar ETF) chart.

HL/UUP/SLV (Courtesy of Stockcharts.com)

Back in May Dvol thought the size open in Hecla's back-month calls was interesting. If you revisit the post on May 20 there were 67,000 January 2010 calls open at the $2.50 strike for a $1.05 and 19,000 calls open at the $5.00 strike for $0.36. Fast forward to today, with spikes and corrections along the way, Silver and Hecla both broke out and Hecla's stock is up 31%, the January 2010 $2.50 call is up 71% and the $5.00 call is up 39% (the $5.00 call could have been sold in a spread not sure). Also different time frames tell a different story, HL spiked at the end of May but corrected in the 2s in June/July. It closed at $4.20 today and if silver tanks here, watch out!

Hecla Mining Stock (HL)

Hecla Mining January Calls (Courtesy of Yahoo Finance)

No recommendation going forward. These small caps are high risk. DV occasionally tries to find valuation and/or turnaround plays in small to mid cap stocks. Here are previous posts on Thinkorswim Group before the TD Ameritrade buyout, Skyworks Solutions 1, 2 in February, Arbinet Corp in April and Hecla in May.

Pros and Cons of High Frequency Trading (Larry Tabb of Tabb Group)

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Interesting video from Datacenterknowledge.com. Larry Tabb also spoke at the Money:Tech Conference in early 2008 before HFT was even an issue. Adam Sussman of TABB was also interviewed recently on Tech Ticker. I remember hearing Sussman talk about dark pools in early '08 at a P&I conference....

Full Obama Health Care Speech Video/Text (9/9/2009)

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Text of President Barack Obama's address to Congress on health care reform Wednesday, as prepared for delivery and provided by the White House.


Madame Speaker, Vice President Biden, members of Congress, and the American people: When I spoke here last winter, this nation was facing the worst economic crisis since the Great Depression. We were losing an average of 700,000 jobs per month. Credit was frozen. And our financial system was on the verge of collapse.

As any American who is still looking for work or a way to pay their bills will tell you, we are by no means out of the woods. A full and vibrant recovery is many months away. And I will not let up until those Americans who seek jobs can find them; until those businesses that seek capital and credit can thrive; until all responsible homeowners can stay in their homes. That is our ultimate goal. But thanks to the bold and decisive action we have taken since January, I can stand here with confidence and say that we have pulled this economy back from the brink.

I want to thank the members of this body for your efforts and your support in these last several months, and especially those who have taken the difficult votes that have put us on a path to recovery. I also want to thank the American people for their patience and resolve during this trying time for our nation.

But we did not come here just to clean up crises. We came to build a future. So tonight, I return to speak to all of you about an issue that is central to that future -- and that is the issue of health care.

I am not the first president to take up this cause, but I am determined to be the last. It has now been nearly a century since Theodore Roosevelt first called for health care reform. And ever since, nearly every president and Congress, whether Democrat or Republican, has attempted to meet this challenge in some way. A bill for comprehensive health reform was first introduced by John Dingell Sr. in 1943. Sixty-five years later, his son continues to introduce that same bill at the beginning of each session.

Our collective failure to meet this challenge -- year after year, decade after decade -- has led us to a breaking point. Everyone understands the extraordinary hardships that are placed on the uninsured, who live every day just one accident or illness away from bankruptcy. These are not primarily people on welfare. These are middle-class Americans. Some can't get insurance on the job. Others are self-employed, and can't afford it, since buying insurance on your own costs you three times as much as the coverage you get from your employer. Many other Americans who are willing and able to pay are still denied insurance due to previous illnesses or conditions that insurance companies decide are too risky or expensive to cover.

We are the only advanced democracy on Earth -- the only wealthy nation -- that allows such hardships for millions of its people. There are now more than 30 million American citizens who cannot get coverage. In just a two year period, one in every three Americans goes without health care coverage at some point. And every day, 14,000 Americans lose their coverage. In other words, it can happen to anyone.

But the problem that plagues the health care system is not just a problem of the uninsured. Those who do have insurance have never had less security and stability than they do today. More and more Americans worry that if you move, lose your job, or change your job, you'll lose your health insurance too. More and more Americans pay their premiums, only to discover that their insurance company has dropped their coverage when they get sick, or won't pay the full cost of care. It happens every day.

One man from Illinois lost his coverage in the middle of chemotherapy because his insurer found that he hadn't reported gallstones that he didn't even know about. They delayed his treatment, and he died because of it. Another woman from Texas was about to get a double mastectomy when her insurance company canceled her policy because she forgot to declare a case of acne. By the time she had her insurance reinstated, her breast cancer more than doubled in size. That is heartbreaking, it is wrong, and no one should be treated that way in the United States of America.

Then there's the problem of rising costs. We spend one-and-a-half times more per person on health care than any other country, but we aren't any healthier for it. This is one of the reasons that insurance premiums have gone up three times faster than wages. It's why so many employers -- especially small businesses -- are forcing their employees to pay more for insurance, or are dropping their coverage entirely. It's why so many aspiring entrepreneurs cannot afford to open a business in the first place, and why American businesses that compete internationally -- like our automakers -- are at a huge disadvantage. And it's why those of us with health insurance are also paying a hidden and growing tax for those without it -- about $1000 per year that pays for somebody else's emergency room and charitable care.

Finally, our health care system is placing an unsustainable burden on taxpayers. When health care costs grow at the rate they have, it puts greater pressure on programs like Medicare and Medicaid. If we do nothing to slow these skyrocketing costs, we will eventually be spending more on Medicare and Medicaid than every other government program combined. Put simply, our health care problem is our deficit problem. Nothing else even comes close.


Mary Bartels of BofA/Merrill Sees 15-20% Downside in S&P 500 (Video, Chart)

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It is time for TARP banks to take their TARP profits!?

Mary Ann Bartels, head technical analyst at Bank America Securities/Merrill Lynch, said the S&P may correct 15-20%. She's watching 5 "trip wires" to catalyze a market correction. 3 out of the 5 trip wires went negative. She sees this current rally as a "breadth thrust" like '75 and '82 when the market rallied over 60% and had a 14% correction. Since there is no uptick rule today she sees more volatility on the downside. The correction would be part of a "base building" process. She's also bullish on commodities and sees a possible head and shoulders bottom in gold. If it breaks out of the reverse H&S pattern $1,300 is in the cards. Watch the full BloombergTV
video interview.

  1. China market correction
  2. Buy volume deteriorating, higher volume on sell offs; Negative breadth
  3. Investor Intelligence Survey: Pessimism at 2007 lows
  1. Percent of NYSE stocks above 200 day moving average at 91%, highest in 5 years
  2. Tech outperformance
What this correction would look like..

U.S. Stocks at Risk for 20 Percent Decline: Technical Analysis (Bloomberg Article).

DV agrees with Mary and sees a correction once this "breadth thrust" loses it's supply of Pez

Bullish Set Up For US Dollar? 24K UUP December 23 Calls Trading

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The Dollar is getting BEAT DOWN with the market rally. There is interesting volume today in the UUP December $23 Call (24,010 traded today w/3,299 open). 22,791 UUP December $24 calls are also open killing all open interest in the puts. Not sure if those were shorts or what. There are also 31,578 March 2010 calls open at the $26 strike killing all put interest as well. Just something to know about if this thing bases out and/or the market "trips".

UUP December Option Chain (Courtesy of Yahoo Finance)
UUP March Option Chain (Courtesy of Yahoo Finance)
UUP 3 Year Chart, clear downtrend

50 Cent on Power Lunch (CNBC Video) and First Song Ever Made

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Rapper 50 Cent talks about the rap industry, his new book "The 50th Law" (co-authored by Robert Greene), $100 million he made on the Vitamin Water buy out and the recession. He has an estimated net worth of $150 million!

Santelli vs. Pento on Gold, Charts: CRB, Gold, Dollar, 30Y Treasury

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On September 3, Michael Pento of Delta Global Advisors and Rick Santelli argued about the price of gold going forward on CNBC. Gold broke out recently and is now fighting the $1,000 resistance level.

Pento: Gold will hit $1200 by the end of the year, mentions ISM prices paid component surge, China PMI, real interest rates plummeting, commodities in CRB index rising which is 40% CPI.

: Next big move in gold will be a sell off, sees recent gold move as a technical break out, short covering, 3 day charts on dollar, gold and bonds tell a different story, dollar did nothing.

There are definitely input cost pressures globally which I'll touch on next but Rick Santelli makes an interesting point about intermarket relationships. I provided a performance comparison between Gold, the CRB Index (commodities), US Dollar and the 30 Year Treasury Bond from August 13th. Over that time period CRB lost 6.63%, US Dollar lost 0.31%, 30 Year Treasuries gained 1.82% and Gold gained 4.14%. Interesting.... *Updated chart, didn't include gold performance.

George Soros Theory of Reflexivity MIT Speech 1994

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Via Ritholtz

Delivered April 26, 1994 to the MIT Department of Economics World Economy
Laboratory Conference Washington, D.C.

When Rudi Dornbusch invited me to speak at this conference, he gave me a totally free hand in deciding what I wanted to talk about. Well, I want to discuss a subject which fascinates me but doesn’t seem to interest others very much. That is my theory of reflexivity which has guided me both in making money and in giving money away, but has received very little serious consideration from anybody else. It is really a very curious situation. I am taken very seriously; indeed, a bit too seriously. But the theory that I take seriously and, in fact, rely on in my decision-making process is pretty completely ignored. I have written a book about it which was first published in 1987 under the title The Alchemy of Finance; but it received practically no critical examination. It has been out of print for the last several years but demand has been building up as a result of my increased visibility, not to say notoriety, and now the book is being re issued. I think this is a good time to get the theory seriously considered.

I was invited to testify before Congress last week and this is how I started my testimony. I quote: “I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy.” I did not have time to expound my theory before Congress, so I am taking advantage of my captive audience to do so now. My apologies for inflicting a very theoretical discussion on you.

The theory holds, in the most general terms, that the way philosophy and natural science have taught us to look at the world is basically inappropriate when we are considering events which have thinking participants. Both philosophy and natural science have gone to great lengths to separate events from the observations which relate to them. Events are facts and observations are true or false, depending on whether or not they correspond to the facts.

This way of looking at things can be very productive. The achievements of natural science are truly awesome, and the separation between fact and statement provides a very reliable criterion of truth. So I am in no way critical of this approach. The separation between fact and statement was probably a greater advance in the field of thinking than the invention of the wheel in the field of transportation.

But exactly because the approach has been so successful, it has been carried too far. Applied to events which have thinking participants, it provides a distorted picture of reality. The key feature of these events is that the participants’ thinking affects the situation to which it refers. Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences.

Classical economics was modeled on Newtonian physics. It sought to establish the equilibrium position and it used differential equations to do so. To make this intellectual feat possible, economic theory assumed perfect knowledge on the part of the participants. Perfect knowledge meant that the participants’ thinking corresponded to the facts and therefore it could be ignored. Unfortunately, reality never quite conformed to the theory. Up to a point, the discrepancies could be dismissed by saying that the equilibrium situation represented the final outcome and the divergence from equilibrium represented temporary noise. But, eventually, the assumption of perfect knowledge became untenable and it was replaced by a methodological device which was invented by my professor at the London School of Economics, Lionel Robbins, who asserted that the task of economics is to study the relationship between supply and demand; therefore it must take supply and demand as given. This methodological device has managed to protect equilibrium theory from the onslaught of reality down to the present day.

I don't know too much about the prevailing theory about financial markets but, from what little I know, it continues to maintain the approach established by classical economics. This means that financial markets are envisaged as playing an essentially passive role; they discount the future and they do so with remarkable accuracy. There is some kind of magic involved and that is, of course, the magic of the marketplace where all the participants, taken together, are endowed with an intelligence far superior to that which could be attained by any particular individual. I think this interpretation of the way financial markets operate is severely distorted. That is why I have not bothered to familiarize myself with efficient market theory and modern portfolio theory, and that is why I take such a jaundiced view of derivative instruments which are based on what I consider a fundamentally flawed principle. Another reason is that I am rather poor in mathematics.

It may seem strange that a patently false theory should gain such widespread acceptance, except for one consideration; that is, that all our theories about social events are distorted in some way or another. And that is the starting point of my theory, the theory of reflexivity, which holds that our thinking is inherently biased. Thinking participants cannot act on the basis of knowledge. Knowledge presupposes facts which occur independently of the statements which refer to them; but being a participant implies that one’s decisions influence the outcome. Therefore, the situation participants have to deal with does not consist of facts independently given but facts which will be shaped by the decision of the participants. There is an active relationship between thinking and reality, as well as the passive one which is the only one recognized by natural science and, by way of a false analogy, also by economic theory.

I call the passive relationship the “cognitive function” and the active relationship the “participating function,” and the interaction between the two functions I call “reflexivity.” Reflexivity is, in effect, a two-way feedback mechanism in which reality helps shape the participants’ thinking and the participants’ thinking helps shape reality in an unending process in which thinking and reality may come to approach each other but can never become identical. Knowledge implies a correspondence between statements and facts, thoughts and reality, which is not possible in this situation. The key element is the lack of correspondence, the inherent divergence, between the participants’ views and the actual state of affairs. It is this divergence, which I have called the “participant’s bias,” which provides the clue to understanding the course of events. That, in very general terms, is the gist of my theory of reflexivity.

The theory has far-reaching implications. It draws a sharp distinction between natural science and social science, and it introduces an element of indeterminacy into social events which is missing in the events studied by natural science. It interprets social events as a never-ending historical process and not as an equilibrium situation. The process cannot be explained and predicted with the help of universally valid laws, in the manner of natural science, because of the element of indeterminacy introduced by the participants’ bias. The implications are so far-reaching that I can’t even begin to enumerate them. They range from the inherent instability of financial markets to the concept of an open society which is based on the recognition that nobody has access to the ultimate truth. The theory gives rise to a new morality as well as a new epistemology. As you probably know, I am the founder—and the funder—of the Open Society Foundation. That is why I feel justified in claiming that the theory of reflexivity has guided me both in making and in spending money.

But is it possible to come up with a valid new theory about the relationship between thinking and reality? It seems highly unlikely. The subject has been so thoroughly explored that probably everything that can be said has been said. In my defense, I did not produce the theory in a vacuum. The logical indeterminacy of self-referring statements was first discussed by Epimenides, the Cretan philosopher, who said, “Cretans always lie,” and the paradox of the liar was the basis of Bertrand Russell's theory of classes. But I am claiming more than a logical indeterminacy. Reflexivity is a two-way feedback mechanism, which is responsible for a causal indeterminacy as well as a logical one. The causal indeterminacy resembles Heisenberg’s uncertainty principle, but there is a major difference: Heisenberg’s theory deals with observations, whereas reflexivity deals with the role of thinking in generating observable phenomena.

I am thrilled by the possibility that I may have reached a profound new insight, but I am also scared because such claims are usually made by insane people and there are many more insane people in the world than there are people who have reached a profound new insight. I wonder whether my insight has an objective validity or only a subjective significance.

That is why I am so eager to submit my ideas to a critical examination and that is why I find the present situation, where I am taken so seriously but my theory is not, so frustrating. As I have said before, the theory of reflexivity has received practically no serious consideration. It is treated as the self-indulgence of a man who made a lot of money in the stock market. It is generally summed up by saying that markets are influenced by psychological factors, and that is pretty trite. But that is not what the theory says. It says that, in certain cases, the participants’ bias can change the fundamentals which are supposed to determine market prices.

I ask myself, why did I fail to communicate this point? The answer I come up with is that I tried to say too much, too soon. I tried to propound a general theory of reflexivity at a time when reflexivity as a phenomenon is not even recognized. In retrospect, I think I should have started more modestly; I should have tried to prove the existence of reflexivity as a phenomenon before I tried to revise our view of the world based on that phenomenon. It can be done relatively easily, and the financial markets provide an excellent laboratory in which to do it. And that is what I should like to do here today.

What I need to do is to demonstrate that there are instances where the participants’ bias is capable of affecting not only market prices but also the so-called fundamentals that market prices are supposed to reflect. I have collected and analyzed such instances in The Alchemy of Finance, so all I need to do here is simply to enumerate them. In the case of stocks, I have analyzed two particular instances which demonstrate my case perfectly; one is the conglomerate boom and bust of the late 1960s, and the other is the boom and bust of real estate investment trusts in the early 70s. I cite may other instances, such as the leveraged buyout boom of the 1980s and the boom/bust sequences engendered by foreign investors. But these cases are less clear cut.

The common thread in the two instances I have mentioned is so-called equity leveraging; that is to say, companies can use inflated expectations to issue new stock at inflated prices, and the resulting increase in earnings per share can go a long way to validate the inflated expectations. But equity leveraging is only one of many possible mechanisms for transmitting the participants’ bias to the underlying fundamentals. Consider, for instance, the boom in international lending which occurred in the 1970s and led to the bust of 1982. In the boom, banks relied on so-called debt ratios, which they considered as objective measurements of the ability of the borrowing countries to service their debt, and it turned out that these debt ratios were themselves influenced by the lending activity of the banks.

In all these cases, the participants’ bias involved an actual fallacy: in the case of the conglomerate and mortgage trust booms, the growth in earnings per share was treated as if it were independent of equity leveraging; and in the case of the international lending boom, the debt ratio was treated as if it were independent of the lending activities of the banks. But there are other cases where no such fallacy is involved. For instance, in a freely-fluctuating currency market, a change in exchange rates has the capacity to affect the so-called fundamentals which are supposed to determine exchange rates, such as the rate of inflation in the countries concerned; so that any divergence from a theoretical equilibrium has the capacity to validate itself. This self-validating capacity encourages trend-following speculation, and trend-following speculation generates divergences from whatever may be considered the theoretical equilibrium. The circular reasoning is complete. The outcome is that freely fluctuating currency markets tend to produce excessive fluctuations and trend-following speculation tends to be justified.

I believe that these examples are sufficient to demonstrate that reflexivity is real; it is not merely a different way of looking at events; it is a different way in which events unfold. It doesn't occur in every case but, when it does, it changes the character of the situation. Instead of a tendency towards some kind of theoretical equilibrium, the participants’ views and the actual state of affairs enter into a process of dynamic disequilibrium which may be mutually self-reinforcing at first, moving both thinking and reality in a certain direction, but is bound to become unsustainable in the long run and engender a move in the opposite direction. The net result is that neither the participants’ views nor the actual state of affairs returns to the condition from which it started. Once the phenomenon of reflexivity has been isolated and recognized, it can be seen to be at work in a wide variety of situations. I studied one such situation in The Alchemy of Finance which was particularly relevant at the time the book was written. I called it “Reagan’s Imperial Circle.” It consisted of financing a massive armaments program with money borrowed from abroad, particularly from Japan. I showed that the process was initially self-reinforcing but it was bound to become unsustainable. A similar situation has arisen recently with the reunification of Germany, which eventually led to the breakdown of the European Exchange Rate Mechanism. The ERM operated in near- equilibrium conditions for about a decade before the reunification of Germany created a dynamic disequilibrium.

What renders reflexivity significant is that it occurs only intermittently. If it were present in all situations all the time, it would merely constitute a different way of looking at events and not a different way for events to evolve. That is the point I failed to make sufficiently clear in my book. I presented my theory of reflexivity as a general theory in which the absence of reflexivity appears as a special case. I was, of course, trying to imitate Keynes, who proposed his general theory of employment in which full employment was a special case. But Keynes proposed his theory when unemployment was a well-established fact, whereas I proposed the theory of reflexivity before the phenomenon has been recognized. In doing so, I both overstated and understated my case. I overstated it by arguing that the methods and criteria of the natural sciences are totally inapplicable to the study of social phenomena. I called social science a false metaphor. That is an exaggeration because there are many normal, everyday, repetitive situations which can be explained and predicted by universally valid laws whose validity can be tested by scientific method. And even historical, reflexive processes have certain repetitive aspects which lend themselves to statistical generalizations. For instance, the trade cycle follows a certain repetitive pattern, although each instance may have some unique features and there is a lot more to be gained from understanding the unique features than the repetitive pattern.

I have also understated my case by presenting reflexivity as a different way of looking at the structure of social events rather than a different way in which events unfold when reflexivity comes into play. I made the point that, in natural science, one set of facts follows another irrespective of what anybody thinks; whereas in the events studied by social science, there is a two-way interaction between perception and facts. I also drew a distinction between humdrum, everyday events in which the element of indeterminacy introduced by the reflexive connection can be treated as mere noise, and historical events where the reflexive interaction brings about an irreversible change both in the participants' views and the actual state of affairs. All this is very profound and very significant, but the really interesting undertaking is to study the difference between humdrum and historical events and to gain a better understanding of historical processes.

I have done a lot of work in that direction since I wrote The Alchemy of Finance, not so much in the financial markets as in the historical arena. I have come to distinguish between normal conditions and far-from equilibrium conditions. In normal conditions, there is a tendency for the participants’ views and the actual state of affairs to converge or, at least, there are mechanisms at work to prevent them from drifting too far apart. I call these conditions “normal,” because that is what our intellectual traditions—including philosophy and scientific method —have prepared us for. I contrast them with far-from- equilibrium conditions, where the participants’ views are far removed from the actual state of affairs and there is no tendency for the two of them to come together. I have always found the far-from-equilibrium conditions much more fascinating, and I have studied them both in theory and in practice.

There are two very different kinds of far-from-equilibrium conditions: one is associated with the absence of change, and the other with revolutionary change. These two opposite poles act as “strange attractors”—an expression with which has become familiar since chaos theory has come into vogue.

So we can observe three very different conditions in history: the “normal,” in which the participants’ views and the actual state of affairs tend to converge; and two far-from- equilibrium conditions, one of apparent changelessness, in which thinking and reality are very far apart and show no tendency to converge, and one of revolutionary change in which the actual situation is so novel and unexpected and changing so rapidly that the participants’ views cannot keep up with it.

Interestingly, the rise and fall of the Soviet system presents both extremes. During Stalin’s time, reality and dogma were very far apart, but both of them were very rigid and showed no tendency to come together. Indeed, the divergence increased with the passage of time. When the system finally collapsed, people could not cope with the pace of change and events spun out of control. That is what we have witnessed recently.

But the two extremes can also be observed in totally unrelated contexts. Take, for instance, the banking industry in the United States. After the breakdown of the banking system in the Great Depression, it became closely regulated and very rigid; but when the restrictions were relaxed, the industry swung to the other extreme and entered a period of revolutionary change. I can locate the transition point with great precision: it was on that evening in 1973 when the management of First National City Bank held an unprecedented meeting for securities analysts in order to promote the stock as a growth stock. The pattern in the rise and fall of the Soviet system closely parallels the pattern in the fall and rise of the American banking system.

These three conditions are perhaps better explained by using an analogy. The analogy is with water, which also can be found in nature in three conditions: as a liquid, a solid or a gas. The three historical conditions I am trying to describe are as far apart as water, ice and steam. In the case of H2O, we can define exactly the three conditions; it has to do with temperature. Can we establish a similar demarcation line among the three conditions of historical change? I believe we can, and it has to do with the values that guide people in their actions. But I am not yet ready to give a firm answer. That is the problem that I am currently working on. But I feel rather exposed in dealing with such an esoteric issue. I need to know whether what I have said so far makes any sense; that is why I have imposed on you by giving you this rather heavy theoretical lecture, and I would welcome your comments either here or on another occasion.

--George Soros.

Intermarket Update On Gold, US Dollar, Aussie Dollar, S&P Charts (GLD, UUP, FXA, SPY)

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First, here is an updated chart on the S&P ETF ($SPY). It is up trough to peak more than 56% from the March lows with a 9.5% correction along the way. It now has to prove there is still strength to keep this above trend. RSI is just above the important 50 level but has trended lower since late July. You can also see an interesting volume spike on that big sell off day and MACD sitting on its uptrend. Is there another head and shoulders forming, we'll see next week.

I presented below charts of the US Dollar and USD/S&P relationship. They've been moving inversely for some time now. The USD is trading just below the 7 month downtrend and needs a short covering jolt to violate the trend line. The S&P and USD are in this together, unless the trend suddenly flips over. Finally, gold broke out of that
symmetrical triangle recently and is now testing the psychological $1,000 level. It could be hedging inflation, hedging a Dollar and/or market sell off, a terrorist attack or it was just technical in nature (Reuters).

I wanted to point out the relationship between Gold, the US Dollar, S&P and Australian Dollar ($XAD) in early 2008 and now. In early 2008 the S&P started selling off, gold hit 1,000, oil hit $147 and the US Dollar made new lows. Eventually the inflation trade overshot and the financial crisis flipped the commodity inflation trade upside down. You can see that commodity currencies, oil and gold sold off while the Dollar spiked during the Lehman bankruptcy, bank freeze and carry trade unwind. There were times when the USD and Gold rallied together which was interesting look at the yellow boxes below. Of course we all know what happened, Central Banks around the world injected trillions into the global economy which eventually found its way into commodities, commodity currencies, the stock market and now input costs (next post). So the attempt to reflate the economy worked, for the first receivers at least.

Fast forward to today, the S&P is in a steep uptrend, USD in a downtrend, gold is testing 1,000 resistance and AUDUSD broke out above resistance today. So what is gold telling us. Is inflation coming? Stagflation? Market sell off? Something bad about to happen? Or was it just a technical head-fake (Santelli). I wish I f'in knew. But follow the charts aka the money and stay hedged to protect from Elliot.

GLD Breaks Out, December $100 Call Up 49% (Charts: GLD, Comex Gold Futures)

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DV posted many times about the inflection point in GLD, the SPDR Gold Trust ETF (1, 2). It finally broke out of a symmetrical triangle. The October and December Comex Gold futures "pierced" through resistance. Not sure of the exact catalyst, could have been the FOMC Minutes, manufacturing growth in China with inflationary pressures or a safe haven bid. More on China's data.
"Improved demand conditions boosted companies’ pricing power in July, highlighted by the first rise in prices charged in just under a year. Anecdotal evidence suggested that firms had raised their output charges in response to higher input costs. According to the latest data, input price inflation was registered for the first time since September last year. Strong growth of input prices was in contrast to the considerable declines registered around the turn of the year. Survey responses suggested that more expensive raw materials had placed upward pressure on firms’ cost burdens. (CLSA China Manufacturing PMI, CLSA.com)

I provided the GLD chart plus the October and December Comex Gold future. Volume in GLD hit levels not seen since March and volume spiked in the December futures.

Bill Gross September Outlook: On The "Course" To a New Normal

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Here are key highlights from Bill Gross's September 2009 Investment Outlook titled On the “Course” to a New Normal . The full report can be viewed publicly at Pimco.com.

"The investment implications of this New Normal evolution cannot easily be modeled econometrically, quantitatively, or statistically. The applicable word in New Normal is, of course, “new.” The successful investor during this transition will be one with common sense and importantly the powers of intuition, observation, and the willingness to accept uncertain outcomes. As of now, PIMCO observes that the highest probabilities favor the following strategic conclusions:
  1. Global policy rates will remain low for extended periods of time.
  2. The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally.
  3. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.
  4. Asia and Asian-connected economies (Australia, Brazil) will dominate future global growth.
  5. The dollar is vulnerable on a long-term basis."

FOMC Mintues Released From August 11-12, Fed Balance Sheet To Expand

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Selected text from the FOMC Minutes release. GLD, SLV and TLT broke out today.
"Participants' Views on Current Conditions and the Economic Outlook

In their discussion of the economic situation and outlook, meeting participants agreed that the incoming data and anecdotal evidence had strengthened their confidence that the downturn in economic activity was ending and that growth was likely to resume in the second half of the year. Many noted that their baseline projections for the second half of 2009 and for subsequent years had not changed appreciably since the Committee met in June but that they now saw smaller downside risks. Consumer spending appeared to be in the process of leveling out, and activity in a number of local housing markets had stabilized or even increased somewhat. Reports from business contacts supported the view that firms were making progress in bringing inventories into better alignment with their reduced sales and that production was stabilizing in many sectors--albeit at low levels--and beginning to rise in some. Nonetheless, most participants saw the economy as likely to recover only slowly during the second half of this year, and all saw it as still vulnerable to adverse shocks. Conditions in the labor market remained poor, and business contacts generally indicated that firms would be quite cautious in hiring when demand for their products picks up. Moreover, declines in employment and weakness in growth of labor compensation meant that income growth was sluggish. Also, households likely would continue to face unusually tight credit conditions. These factors, along with past declines in wealth that had been only partly offset by recent increases in equity prices, would weigh on consumer spending. The data and business contacts indicated very substantial excess capacity in many sectors; this excess capacity, along with the tight credit conditions facing many firms, likely would mean further weakness in business fixed investment for a time. Even so, less-aggressive inventory cutting and continuing monetary and fiscal policy stimulus could be expected to support growth in production during the second half of 2009 and into 2010. In addition, the outlook for foreign economies had improved somewhat, auguring well for U.S. exports. Participants expected the pace of recovery to pick up in 2010, but they expressed a range of views, and considerable uncertainty, about the likely strength of the upturn--particularly about the pace of projected gains in consumer spending and the extent to which credit conditions would normalize.

Traders Start September Dumping Risk (SPY, QQQQ, UUP, VIX, FXA, AUDJPY, JJC - GLD)

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The markets sold off hard today. Traders started off September dumping risk and the reflation trade. Our markets could follow Shanghai lower if they are supposed to be the global growth story. Funds have been hedging risk for some time now. DV has been watching the Volatility Sonar report and saw that people were scooping up protection in the 30s, Hedging a Market Pullback Using The VIX (Aug 11)
October VIX Future Trading at Big Premium To Cash, VXX (Aug 26).

In the beginning of June the Baltic Dry Index slowed down, then the Shanghai Index, then slowly everything else it seems (Aug chart comparison). It is interesting that GLD caught a bid while UUP and other commodity currencies sold off today (FXA, AUD/USD, AUD/JPY). AUD/JPY sold off after hitting the 50% retracement level. The currencies and commodity ETFs I plotted are at big inflection points, either at trend support (FXA, JJC, UUP and AUD pairs) or at a symmetrical triangle point (GLD). FXI, the China ETF, broke below trend support and traders have been hedging with puts (1, 2).

AUD/USD is interesting. The 20wma on the AUD/USD has been moving higher and could support the pair (on dips) to cross the 100wma eventually. AUD/USD broke above both moving averages and the 20wma is currently at .80. Australia's GDP grew 0.6%, more than expected, and they left the overnight cash rate unchanged so traders are speculating a rate hike in October or November . The CS AUD Price Move For next 12M:CS1YRBA index using the Overnight Index Swap Curve is pricing in a 183 basis point hike over the next year.

CS1YRBA (Bloomberg.com)

SPY (S&P 500 ETF) 2 Year Chart

Bearish Put Spread On IYR Real Estate ETF, SRS Call Activity (Charts n' Chains)

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While looking through a bunch of chains I found interesting option activity in the real estate ETFs, IYR (Dow Jones Real Estate Index) and it's shady counterpart SRS (2x Inverse DJ Real Estate Index). First off the market sold off hard today and if we continue to see weakness I'm sure IYR will follow SPY, we will see though.

I saw that IYR had activity in October and November on the $38 and $33 Put strike. 31,000 contracts traded on both the October 38-33 puts and around 25,000 traded on the November 38-33 strike. It was a bearish put spread to protect from an underlying disaster (Andrew Wilkinson of I-brokers mentioned the October trade). Was November just a hedge on that spread or another trade.. Not scoping out ticks.

LeFrak, Bair: Commercial Real Estate Loan Losses On Small Banks (2010)

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Will community and regional banks continue to get hit by commercial real estate loan losses? Sheila Bair and LeFrak share their thoughts.


Andy Xie: Shanghai Index Fairly Valued At 2,000, Could See Bounce (Video)

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Andy Xie, writer at Caijing and former economist at the IMF and Morgan Stanley Asia, has been warning about the Shanghai Index since early August and it lost 22% since then. It broke below the 50 day moving average and could eventually test the 200 day moving average at 2,479. During the Bloomberg interview Xie said there could be a September bounce but said the Shanghai index was still expensive at 3x book and 30x earnings and was fairly valued at 2,000 or less. It sounds like the Chinese asset markets got over-reflated by Government stimulus. He sees a potential slowdown in the 4th quarter and explained that it will take time for China to change their economic model (from export driven). In this Reuters article in April 2007 Andy Xie predicted the global recession.

Moody's Downgrades Detroit $781M GO Debt Further Into Junk

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Detroit, Michigan (The City of Boom)

This is DV's annual review of Detroit. Read Distressed Detroit on July 12, 2008 where I looked at the city's 2006 CAFR. On August 21, 2009 Moody's PFG (U.S Public Finance Group) downgraded $781 million General Obligation debt further into junk ($491 million GO unlimited Debt to Ba3 from Ba2 and $290 million GO limited debt to B1 from Ba3). Go here for the ratings scale. These June 30, 2007 numbers are prehistoric! On June 30, 2007 things were just getting started; the credit crisis, global recession, GM and Chrysler bankruptcies, 28.9% Detroit unemployment rate, -25% YoY housing prices (Detroit/Las Vegas were the only cities that saw housing price declines in July) and a corrupt local Government. It is all catching up now.
"Charles Beckham, Bing's chief administrative officer, said the city is operating with a $60-million to $80-million cash shortage -- one that could implode come October -- on top of the $275-million to $300-million overall deficit." (Freep, Aug 25)

Review of City of Detroit 2007 CAFR (PDF or ci.detroit.mi.us)
  • General Fund Rev-Exp with transfers $15 million (slide 4)
  • Total Government Funds Rev-Exp w/ transfers -$16 million (5)
  • Total Government Fund Balance Down 65% ($456M to $157M) from 2003 (6)
  • Using RANs and TANs for short term cash flow needs ($129.3 Million) (3)
  • Net Cash & Investments $153M - Short Loan Payables $129M = Net Cash $23.7M (Moody's) (2,3)
  • Net Cash: '01 = 38M, '02 = 59M, '03 = 121.6M, '04 = 101M, '05 = 59.4M, '06 = 30.3M
  • Total General Fund Deficit -91M, improved 14% from -107M (still a deficit since '05) (1)
  • From General Fund $70M transferred to Transportation, $67M to Debt Service Fund
  • Swap agreement amended but termination would owe $400M to counterparties (p.22)
  • Principal property tax payers in 2007: Chrysler, Detroit Edison, GM, MGM Grand, American Axle

(1) General Fund Reserved and Unreserved Balance Trend

(2) General Fund Assets FY 2007

(3) General Fund Liabilities FY 2007
(4) General Fund Rev-Ex FY 2007

(5) Total Governmental Fund Balance Trend (Rev-Ex)

(6) Total Gov Fund Balance: Transfers In/Out, Ending Balance Trend

Plus they have a population/infrastructure ratio that is under 1. Dave Bing talks about Detroit's shrinkage. (CrainsDetroit video)

StockTwits Rings Closing Bell at NASDAQ! (Video)

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StockTwits 4 Life!

RenTec's James Simons Stony Brook Interview Video, Other Interview Links

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Mathematician James Simons, head of hedge fund Renaissance Technologies, made $2.5 billion last year making him the highest paid hedge fund manager of 2008. Below is a 60 minute Stony Brook video interview with James Simons and physicist C. N. Yang on March 28, 2008. Simons testified before congress along with hedge fund managers Paulson, Griffin, Falcone and Soros in late 2008 during the credit crisis.

More articles on James Simons:

Simon's Doesn't Say: Meet The Man Whose 1990s Returns Are Better Than George Soros (Financial World 1996 PDF)

The Secret World of Jim Simons (Institutional Investor, Nov 2000)

Interview with James Simons: The billionaire hedge fund manager discusses the impact of mathematics on his former life in academia and his new one in finance. (Seed Magazine 2006)

Btw, Zero Hedge has interesting posts about RenTec, Renaissance

SPY Is Defying Gravity For Now (Aug S&P ETF 3 Year Chart)

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From escaping a black hole to defying gravity pretty much sums up the past year in the SPY. Looking a few weeks back the 20 week moving average crossed above the 50 week moving average which was a bullish sign. Look how the 20 crossed below the 50 in the beginning of 2008. At some point the S&P will price in all of the stimulus steroids, positive (less negative) economic data and bottom line improvement and reach a new orbit (trading channel). Even in bull markets there are <10% corrections just like the June '09 correction (previous posts with charts: June 2, June 16). Unless of course there is a currency crisis (Jim Rogers: Dow could go to 20-30,000 during currency crisis).

Technicals: SPY broke above the 38.2% Fibonacci retracement level and is right around the pre-Lehman break down in 2008. It might want to fill that gap. If SPY gets another steroid injection with year end fundamental support, the 50% retracement level 109 is not out of the question and eventually the 61.8% retracement / 3 year downtrend resistance level around 120. Looking at a previous post about the 1929-30 bear market rally the Dow rallied hard and retraced 50% of its losses before selling off (not saying that is a definite comparable). Get ready for September folks.

SPY (Courtesy of Stockcharts.com)

Distressed Volatility Clears 11,000 Page Views In August!

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Distressed Volatility cleared 11,000 page views in August. Without transparent data, the Internet, Google and Twitter followers this blog would not exist.

GLD Call Options Active at Dec, March $100 Strike

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I noticed 21,594 December GLD Calls traded at the $100 strike today with 12,363 open. According to this Reuters article there was also a large $100 - $120 call spread on GLD expiring in March 2010. GLD is at a critical inflection point on the chart and I'm sure option players are positioning for a move. It is taking a while for the actual breakout/breakdown to occur... Look at the 2 yr chart you can see the inflection point on the long term pennant or short term symmetrical triangle whatever you are looking at. If these players are betting on a breakout, Robert Prechter (video) is taking the other side of the trade. Whatever happens there will be big price movement on judgment day. Currency issues, inflation and geopolitical events could affect gold going forward.

GLD 2 Year Chart

Watch GLD stream

GLD DEC Option Chain (Courtesy of Yahoo Finance)
GLD MAR '010 Option Chain (Courtesy of Yahoo Finance)

Posts on SPDR GLD:

John Paulson Keeps GLD Investment, Watching Symmetrical Triangle (August 13)
GLD Trade Setting Up Here + UUP, AUDJPY Pre FOMC (August 12)
Paulson Buys GLD, GDX (May 20)

FDIC 2nd Quarter Results (Sheila Bair Presentation Video, Slides)

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Sheila Bair spoke at the FDIC Quarterly Banking Profile Press Conference on August 27, 2009. The full 60 minute video with Q&A can be found at events.vcall.com (takes you to the exact video). FDIC senior staff members make presentations after Bair. I provided her speech and slides below.

FDIC 2nd Quarter Results (Video Link)

Source: FDIC.gov Press Releases

Statement by FDIC Chairman Sheila Bair at the Quarterly Banking Profile Press Conference
August 27, 2009

Good morning everybody, and welcome to our briefing on industry results for the second quarter.

We've all seen the good news that has come out on the economy in the past few weeks. While challenges remain, evidence is building that the American economy is starting to grow again. But no matter how challenging the environment ... the FDIC has ample resources to continue protecting insured depositors as we have for the last 75 years. No insured depositor has ever lost a penny of insured deposits ... and no one ever will.

One of the themes of today's quarterly profile is that banking industry performance is -- as always -- a lagging indicator. The banking industry, too, can look forward to better times ahead. But, for now, the difficult and necessary process of recognizing loan losses and cleaning up balance sheets continues to be reflected in the industry's bottom line.

Insured institutions posted a $3.7 billion net loss in the second quarter. As this first chart shows, they earned $424 million in net operating income. But one-time losses and other items totaling $4.1 billion pulled the overall results into negative territory.


Positive net operating income was achieved even after a special assessment of about five and a half billion dollars to bolster the Deposit Insurance Fund.

Higher provisions push earnings lower

As this next chart shows, deteriorating loan quality is having the greatest impact on industry earnings, as insured institutions continue to set aside reserves to cover loan losses.


Of all the major earnings components, the amount that insured institutions added to their reserves for loan losses was, by far, the largest drag on industry earnings compared to a year ago. As you can see, loss provisions were $16.5 billion higher than a year ago. In all, banks and thrifts set aside $67 billion to cover bad loans in the second quarter.

Other factors that weighed on earnings included expenses stemming from write-downs of asset-backed commercial paper, which increased extraordinary losses ... and higher deposit insurance premiums. (Absent these premiums, non-interest expense would have declined, reflecting banks' efforts to cut costs.)

The upward trend in loan-loss provisions dates back to the second half of 2006. But while the early losses were related to residential loans and complex mortgage-related assets ... where the crisis really began ... we're now seeing problems with more conventional types of retail and commercial loans that have been hit hard by the recession.

This chart shows how loss provisions have grown as a share of the industry's net revenues.


In the second quarter, loss provisions were 10 times what they were three years ago. The obvious reason for this is the ongoing need to bolster reserves in the face of rising levels of troubled loans. These credit problems will outlast the recession by at least a couple of quarters.

Problem loans still increasing

This chart shows the amount of loans that have been written off each quarter (that's the blue segment) ... as well as the quarterly change in the amount of non-current loans remaining on banks' balance sheets (that's the red segment).


The chart shows that both charge-offs and non-current loan levels are still rising. The continued growth in these categories lifted the net charge-off rate and the non-current loan rate to historic highs in the second quarter. And as you can see from this next chart, the gap has also been growing between the level of non-current loans (that's the green line) ... and the industry's reserves (that's the blue line).

This widening gap is driving the high loss provisions. And it's the reason that we expect provisions to remain at elevated levels for some time.


Areas of improvement

Not all of the news in the second quarter was bad. While total non-current loans and net charge-offs continued to rise, the increase was smaller than in the first quarter. Also, non-current home equity and junior lien mortgages declined for the first time in six quarters. And the volume of loans that were 30 to 89 days past due, fell across all major loan categories.

Are these signs of a turning point in asset quality? This may turn out to be the case. But we're going to need another quarter or two to confirm a trend.

Another positive during the quarter was an improvement in net interest margins for community banks as well as for larger institutions. This is good news for community banks, since three-fourths of their revenues come from net interest income.


In many important respects, financial markets are returning to normal. Combined with the positive economic news in recent weeks, we're hopeful that this will lead to a moderation in credit problems in coming quarters. But, as our report shows, cleaning up balance sheets is a painful process that takes time. This process is absolutely necessary in order to restore the industry's profitability, and to strengthen its capacity to lend to businesses and consumers.

Problem list grows

As banks and thrifts continue cleaning up their balance sheets, more are coming onto our problem list. The number rose during the quarter to 416. This chart shows the trend since the Problem List hit an historic low in 2006, when bank profits were at record highs. Although the number continues to increase, it's still well below the levels seen during the last crisis.


As you know, the number of failures is also up. There have been 81 so far this year. We expect the numbers of problem banks and failures will remain elevated, even as the economy begins to recover. (Problem banks and bank failures also tend to be lagging economic indicators.)

DIF update

Now let me turn to how failures are affecting the Deposit Insurance Fund, or the DIF. First: failures cost money. And the costs are charged to the DIF. But one thing that you should know is that the DIF balance has already been adjusted downward for the cost of failures that are expected to occur over the next year. Just as banks set aside reserves for loan losses, we set aside reserves for anticipated bank failures.

Our total reserves -- consisting of both the DIF balance and a contingent loss reserve -- are available to absorb losses. The DIF balance reflects the net worth of the insurance fund. It's also a guide for setting deposit insurance premiums for our industry-funded system. So when a bank fails, to the extent that we have already reserved for a failure, the loss comes out of the contingent loss reserve. For example, when Colonial Bank failed two weeks ago ... there was no reduction in the fund because the estimated loss had already been reserved for.

We review the adequacy of the contingent loss reserve every quarter, and make adjustments as warranted. As illustrated in this chart, we have been shifting large sums to the contingent loss reserve as our failure projections have grown. The total reserves are now over $42 billion.


FDIC resources run deep

Our total reserves should be distinguished from the cash resources at our disposal to protect depositors. As this last chart shows ... our sources of liquidity to protect depositors in future failures include not only the $22 billion of cash and Treasury securities held by the DIF as of June 30, but also the ability to borrow up to $500 billion from the Treasury. To sum up, a decline in the fund balance does NOT diminish our ability to protect insured depositors.



The FDIC was created specifically for times such as these. Our resources are strong. Your insured deposits are safe. And again, no insured depositor has ever lost a penny of insured deposits ... and no one ever will. Thank you very much.