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I have been somewhat reluctant to do this, but tonight’s post stems from a file on nonlinear dynamics on my computer that I developed between 1999 and 2003 for the most part.? Not so humbly, I called it “The Rules.”?? This is the first in a series of what will likely be long set of irregular posts about what I call “The Rules.”? Please understand that I don’t want to make grandiose claims here.? After all, as I once said to Cramer (yes, that one): “The rules work 70% of the time, the rules don’t work 25% of the time, and the opposite of the rules works 5% of the time.”

My best recent example of the rules not working was when the formulas of the quants were blowing up in August 2007.? There were too many quants following the same strategy, and they had overbid the stocks that their models loved, and oversold the ones that they hated.? For a while, the quant models were poison.? Every investment strategy has a limited carrying capacity, and those that exceed the strategy’s capacity are prone for a comeuppance.

Here is today’s rule: There is no net hedging in the market.? At the end of the day, the world is 100% net long with itself.? Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

There are many people, particularly dumb politicians, who think that derivatives are magic.? To them, derivatives create something out of nothing, and that something is strong enough to smash innocent companies/governments that have been behaving themselves, but have somehow found themselves caught in the crossfire.

First, if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.? You have the upper hand.? But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.? Even without derivatives, that is a tough place to be.

With derivatives, for every winner, there is a loser.? It is a zero-sum game.? Yes, as crises arise there are always those that look for a way to make money off of the crisis.? And there are some parties willing to risk that the crisis will not be so bad, at a price.? Derivatives don’t exist in a vacuum.? Same thing for shorting — there is a party that wins, and a party that loses.? So long as a hard locate is enforced, it is only a side bet that does not affect the company whose securities are being played with.

When there are troubles, it is because a company or government has overstretched its limits.? You can’t cheat an honest man (or country).? You can take advantage of countries and companies that have overreached on their balance sheets and cash flow statements.

Cash on the Sidelines, Market is Oversold/Overbought, Money is Moving into or out of…

Every bit of cash on the sidelines is matched by a short term debt obligation somewhere.? Now, that’s not totally neutral, as we learned in the money markets crises in the summers of 2007 and 2008.? If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.? It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.? CIT did die.? Mexico in 1994.? When you can’t roll over your short term debts, it gets really ugly, and fast.? Think of the way we messed up housing finance in the mid-2000s; one of the chief signs that we were in a bubble was that so much of it was being financed on floating rates, or contingent floating rates with short refinance dates.? Initially, that gave people a lot more buying power, at a price of higher unaffordable rates later.? “The phrase, “You can always refinance,” is a lie.? There is never a guarantee that financing will be available on terms that you will like.

This is also a good reason to go for debt that fully amortizes (i.e., when you get to the end of the loan, the payments haven’t risen, and the loan pays off in full).? I’ve never been crazy about the way commercial mortgage loans don’t fully amortize.? I know why it happened this way.? A) in the late ’80s and early ’90s, insurance companies were issuing GICs by the truckload, and needed higher yielding debt with a 5-year maturity.? Voila, 5-year mortgage loans with a balloon payment.? For the real estate developers, the loans were cheaper, but they had to trust that they could refinance — an assumption sorely tested in the early ’90s.? After the death of many S&Ls, a few insurers and developers, and the embarrassment of a more, borrowers and lenders became a little more circumspect.

But the loss of the S&Ls left a void in the market.? The Resolution Trust Company created some of the first Commercial Mortgage Backed Securities [CMBS], that Wall Street then imitated, filling in the void left by the S&Ls.? But to make the securitizations more bond-like, for easy sale the loans were 10-year maturities with a balloon payment at the end.? That way the deals would closer at the end of ten years.? Maybe some of the junk-grade certificates would be stuck at the end with a some ugly loans to work out, but surely the investment grade certificates would all pay off on time.

And that is a big assumption that we are going to be testing for the next five years.? Will developers be able to refinance or not?

This has gotten long, and have more to say, but I’m going to a wedding of a friend, and must cut this off.? Let me close by saying there is a corollary to the rule above, and it is this:

Long-dated assets should be financed by non-putable long-dated liabilities or equity.? Don’t cheat and finance shorter than the life of the assets involved.? There is never an assurance that you will be able to get financing on terms that you will like later.