What Is Stress Testing?

It is a big week for America's 20 largest banks, as the Obama administration begins a process of stress testing these beleaguered financial institutions. Ever since Treasury Secretary Tim Geithner's uninspiring performance on February 10, the markets have been scrambling to determine what the new financial rescue plan might look like. Even preliminary estimates suggest that Citigroup, Bank of America, Wells Fargo, JP Morgan Chase, Goldman Sachs, and Morgan Stanley all might need additional support from the government.

Much has been written about the murky details of Mr Geithner's public-private investment fund. Indeed, few analysts are convinced that the administration has announced little more than a plan to make a plan. More alarming, however, is the swirling doubt over the imminent stress tests, which appear to be one of the few concrete measures in TARP II. The government has said that these balance sheet evaluations will run a series of "what if" models that will simulate a bank's performance under increasingly adverse conditions (rising unemployment, falling home prices). Still, many are wondering: how will these stress tests work?

In general, stress testing models the valuation of capital under situations that are costly and rare. These test often simulate shocks at a greater intensity than historical data would otherwise suggest and simulate shocks that have never previously occurred. Under Mr Geithner's logic, such an exercise would help Treasury learn which banks are equipped to weather the financial storm, and which are insolvent. The results of the stress tests will not be made public (the institutions that fail could face nightmarish bank runs), the administration hopes to determine where its capital injections are best spent.

Here is the problem: for all intents and purposes, there will be no real stress tests. First, the sheer cost of true stress testing is prohibitive. The process involves an accounting process that would dwarf the post-Enron clean-up, and there is not remotely enough manpower or resources. What is more, a true stress test would almost assuredly require an increase in capital requirements for banks (precisely the opposite of what Mr Geithner wants).

Second, it is unlikely that any of the bank regulators dispatched to perform these stress tests are qualified to analyze today's byzantine financial instruments. The national crash-course in credit derivatives and structured products does not even begin to understand the toxic assets that have torpedoed our economy. A true stress test would measure the cascading consequences on liquidity and contagion of, say, credit default swaps; however, regulators familiar with traditional banking activities are (understandably) clueless on how to price these securities in the current market.

Third, there are reasons to suspect that there is real accounting fraud in the financial services industry. In the age of Bernie Madoff and Allen Stanford, it is somewhat surprising that more attention has not been paid to this scenario. Is it so inconceivable that the $100 billion hole in Lehman's balance sheet was criminal? Real stress tests will have to compare accounting numbers with the underlying documentation (original loan files). Often times, however, these documents are missing as subprime loan originators went bankrupt and simply discarded the files. In the nightmare scenario, crooked accounting practices will further obfuscate the stress tests.

At this point, most observers agree that any viable economic recovery plan requires clarity and commitment. The Bush administration was pilloried for its on-again-off-again responses to the financial crisis. In an effort to chart a new course, Mr Geithner had hoped to lay out a convincing bank rescue plan when he spoke two weeks ago. Unfortunately, the underlying specifics of his message are, at best, underwhelming and, at worst, entirely absent. It is time for new solutions for the banking system, the type Americans are culturally predisposed to abhor. Pre-privatization, anyone?

Mexico: The Border War

In Thursday's speech honoring the army's founding, Mexican President Felipe Calderón defended his decision to pursue military solutions to the country's violent drug war. Brutal clashes between armed drug smugglers accounted for more than 6,000 deaths in Mexico last year, and the 2009 pace is unabated. In response, Mr Calderón has sent more than 45,000 troops to battle Mexican cartels and patrol the most dangerous regions of the country.

The levels of violence in Mexico are staggering. The painful realities of narco-trafficking have long afflicted Mexican society, however, starting last year, there has been a remarkable escalation in the drug war. In September, a grenade attack in Michoacán State killed eight civilians and wounded some 100 more. Last month, another grenade killed a child as armed attackers gunned down two adults in Durango. On February 17, a major firefight broke out in Reynosa between Mexican authorities and armed members of a drug cartel. According to reports, government officials recovered RPG rounds and mortar rounds.

There is no doubt that the lethality of cartel attacks has increased dramatically since 2007. In addition to the heavy weapons used in the Reynosa standoff, smugglers are now using fragmentation grenades and assault rifles to assert their control in Mexico. Escalating violence and the impotence of the central government demonstrate that there is an active war in the country. More specifically, there are three wars.

First, rival drug cartels are fighting one another. While the picture of violence is increasingly dynamic, Mexican cartels are battling over regional supply routes into the US. In Baja California, the Sinaloa cartel is fighting the formerly-dominant Tijuana cartel. The Sinaloa cartel is also fighting a horrific battle against the Gulf cartel for the western Texas supply routes, and there is a multi-cartel struggle for the central Juárez-El Paso route. Control over these major Interstate corridors into the American drug market is an essential part of the billion-dollar narcotics industry.

Second, there is a war between the Mexican government and the cartels. Mr Calderón's two-year offensive against drug traffickers has been widely ineffective, and the resulting violence has put Mexican civilians in the crossfire. Brazen attacks against government officials and local police have convinced many observers that the situation is spiraling out of control. Earlier this month, Mexican drug gangs took over police radio frequencies, issuing death threats (some of which they then carried out) to uncoöperative authorities. In January, a Pentagon report concluded that Mexico was at risk of becoming a "failed state," and could face a full-scale collapse of civil government. Local officials rejected such analysis, but it is clear that Mr Calderón's war on drugs is backsliding.

Third, the alarming rise in civilian kidnappings in Mexico signals a war among the population. To be sure, cartels are often involved in abducting, torturing, and killing high level government officials or rival drug traffickers. But kidnappings appear to happen all across the country (not only in narco-zones) and are perpetrated by a range of actors. Some criminal gangs have developed complex strategies to abduct high-net-worth targets and command million-dollar ransom payments. Other more rudimentary criminals, target ordinary Mexicans in a short-term effort to drain their ATM accounts or extract modest ransom fees. This form of "express kidnapping" has a paralyzing effect on the Mexican population. Similar to terrorism, this war does not target institutional actors, but courses through the daily lives of average citizens.

One year ago today, then-Senator Barack Obama promised to repair the US relationship with Mexico. He made direct reference to the problem of drug cartels, but his solutions were broad and unspecific. Such politicking is to be expected from a candidate, but it will be interesting to see how Mr Obama's policies develop as president. Clearly, the new administration's focus is on the American economy. Nevertheless, the US-Mexico trade relationship is valued at more than $300 billion (the third largest of America's economic partnerships) and will be important to any sort of recovery.

Make no mistake, the violence in Mexico is as much an economic threat as it is a security challenge. Unfortunately, the level of corruption in Mexico (a function of the cartels' infiltration of government offices) means that the country cannot solve its drug problem alone. Indeed, the Mexican drug war is likely to be in an important part of the UN Commission on Narcotic Drugs next month. In reality, though, it will be an American problem before anyone else's outside Mexico. There is a war on the US border, and Mr Obama will have to help craft a solution.

Flower Power: Gaza's Valentine's Day Reprieve

For florists, chocolatiers, and restaurant owners, Valentine's Day is a green holiday. Behind the red hearts and resplendent bouquets are millions of dollars in sales. Even with a slumping economy, retailers are hoping that lovestruck couples will still open their pocketbooks to please their significant others.

The holiday is playing out in international politics as well. In an apparent goodwill gesture, the Israeli government confirmed this week that it would ease its blockade of the Gaza strip to allow Valentine's Day exports. Israel will allow some 25,000 flowers to be exported from the Palestinian territory to Europe, the first crack in a blockade that began in more than a year ago. Since Hamas took control of the Gaza strip in June 2007, Isreal has prevented the coastal region from participating in global trade. The blockade is widely seen as one of the main reasons for Palestinian smuggling tunnels that were the subject of Israeli airstrikes in Gaza. The flower export agreement marks the first time in a year that Palestinian goods will be able to enter the world market.

According to most analysts, however, the current reprieve is simply cosmetic. Mohammed Khalil, head of the Gaza flower growers' association, noted that the territory used to export 40 million flowers each year. By comparison, a mere 25,000 flowers are economically insignificant. What is more, many of the commercial flowers in Gaza have been destroyed (literally fed to animals) because they could not reach European markets. While Palestinians do not celebrate Valentine's Day, local producers had previously benefited from Western demand for flowers and heart-shaped chocolates.

Cut flowers and strawberries were some of the Gaza Strip's main exports before the blockade began, bringing a valuable source of income to the 1.5 million inhabitants of the coastal territory. Israel announced that the Valentine's Day measure did not indicate a shift in their overall trade policity toward Gaza. In short, the blockade will continue and border crossings will remain closed during the current political impasse.

Israel's election results are now official, but it remains unclear as to who will form a ruling coalition. Kadima's Tzipi Livni received the most seats in Tuesday's vote with 28 seats. But a hawkish bloc headed by Benjamin Netanyahu's Likud party, and including the new number three party, Avigdor Lieberman's Yisrael Beitenu, controls 65 seats of the 120-member Knesset, giving Mr Netanyahu the edge in coalition building. Israeli President Shimon Peres must now decide which leader can most effectively pull the country's factions together.

The decision will undoubtedly have an impact on the volatile Arab-Israeli peace process. At this point, it seems unlikely that the two sides are exchanging any Valentine's Day gifts.

The Munich Security Conference and Future US Diplomacy

The 45th Munich Security Conference proved to be one of the more exciting gatherings of top- and supreme-level politicians in the event's recent history. In contrast to the melancholy tone of the economic summit in Davos, about 300 security officials from across the globe came to Germany this past weekend with high hopes for diplomacy.

The event marked the first real opportunity for the new administration in Washington to outline its foreign policy objectives. Accordingly, President Barack Obama sent his VP Joe Biden to address the conference in a highly anticipated speech on Saturday. Mr Biden's introduction was welcomed with great applause and effusive handshakes, a clear sign that much of the world has been waiting to see fresh faces in the White House.

Pleasantries are one thing, policies are quite another. Mr Biden's opening remarks were certainly more conciliatory than similar statements under Bush administration officials, as he spoke of an American "renewal project" with old friends and recent adversaries. With respect to specific security challenges facing the US, however, the Vice President reaffirmed many of the hard-line positions that have heretofore vexed the international community. Speaking about relations with Russia, Mr Biden stated that, "The United States will not -- will not recognize Abkhazia and South Ossetia as independent states. We will not recognize any nation having a sphere of influence."

Before the speech, White House aides said that Mr Biden would announce the administration's willingness to reconsider a planned missile-defense system in Eastern Europe. Under the Bush administration, the US was slated to install weapons in Poland and a radar station in the Czech Republic that could intercept a nuclear attack from Iran and North Korea. For the Kremlin, however, these measures were thought to encroach upon Russia's near-abroad. In the week before the Munich conference, it seemed that Mr Obama, who is determined to restore relations with Moscow, would not push for the defense shield. Once Kyrgyzstan announced it would likely close its American military base (a move Russia is thought to have orchestrated), Mr Biden's speech was changed. He notably added a line saying the US "will continue to develop missile defense to counter the growing Iranian capability."

Even with this lingering standoff, Russian deputy premier Sergei Ivanov said that Mr Biden's speech was "very positive." His own remarks at the conference signaled the potential for greater communication and coöperation between Washington and Moscow. What is more, there are still politically viable ways for the US to back out of the missile defense shield without looking weak. With a $10 billion per year price tag, the system could (and certainly should) be scrapped for economic reasons.

Nevertheless, the Russian exchange demonstrates that many of the Bush-era frustrations cannot be solved with rehotic alone. As his Vice President explained, Mr Obama will ask European leaders for greater commitments to NATO forces in Afghanistan, which special envoy Richard Holbrooke recently described as "a long, difficult struggle." In addition, the Obama administration is likely to put pressure on the EU to support infrastructure development and democracy promotion across the border in Pakistan. For leaders with financial strains and war-weary electorates, American requests are no more agreeable than they were under George Bush.

Still, Mr Obama's rehabilitative efforts must count for something. The president's commitment to multilateralism lends credibility to his diplomatic efforts. The Bush administration made significant nominal changes to foreign policy during its second term, but few foreign leaders took them seriously. See the Iranian example. On Saturday, Mr Biden offered Tehran a familiar choice: "Continue down the current course and there will be continued pressure and isolation; abandon the illicit nuclear program and your support for terrorism, and there will be meaningful incentives." This policy doesn't sound much different than 6 months or 2 years ago. But British Foreign Secretary said that there is a genuine commitment among the new American administration to put direct talks with the Iranian regime on the table.

The next major foreign policy stage for the US is Secretary of State Hillary Clinton's trip to Asia, where she will visit capitals in Beijing, Seoul, Tokyo, and Jakarta. The fact that her first trip is not to Europe or the Middle East simply demonstrates how many issues US diplomatic efforts must address.

Why Aren't Banks Lending

This figure from the Wall Street Journal shows the changes in bank lending for 10 of the 13 largest beneficiaries of the government's Troubled Asset Relief Program (TARP). The overall drop in loan volume has many politicians and taxpayers wondering what happened to the more-than $200 billion dollars spent in the first tranche of the bailout package.

There are a few basic reasons for the general tightening of credit. First, banks are still concerned about the deteriorating economic climate that could imperil even more of their assets. If these institutions face further write-downs (reducing the book value of their positions on their balance sheets) they will need TARP money simply to offset these losses. This process of "augmenting capital" is a way for banks to protect themselves against an uncertain future.

Second, banks used some of this cash to buy US treasuries and, in some cases, rival institutions. In effect, critics argue, the government provided cash for balance sheet "window dressing" (adding government bonds to the portfolio) and a slew of mergers and acquisitions (for which there was no financing on the open market). Bankers claim that these investments reflect their efforts to minimize risk exposure. As layoffs continue, lenders are worried about delinquent debt. Still, such behavior has fueled public skepticism about the Wall Street's motives.

There is, however, another reason that banks have pulled back on lending. Recent financial innovations have changed the way in which banks conduct business. Rather than simply accepting deposits and making loans, banks have increasingly embraced securitization. When banks securitize loans, they bundle up assets in their portfolio and sell them to investors, removing them from their own balance sheet. Until the collapse of mortgage backed securities, this strategy was an innovative was to minimize risk and still generate profits.

Here's where the banks got into trouble. The tranching of collateralized debt obligations (CDOs) allows investors to take different levels of exposure to default. More senior tranches are less risky, but have the lowest returns in the portfolio. The most junior tranche (known as the equity tranche) assumes the most risk, however, this class of CDOs can generate 15-20% returns. When banks securitized loans, they often sold off more senior tranches, but held the equity tranch so as to reap the benefits. During the housing boom, this strategy proved extremely lucrative.

Now these synthetic CDOs are squeezing banks at both ends. As housing prices fall and defaults increase, the tranches which banks are holding are the first to lose value. In addition, there are very few investors who want to buy bundled securities from banks, thus undercutting an important revenue stream for banks. In modern finance, banks don't lend to make interest, they lend to securitize. As a result, bailout packages that increase bank's capital reserves will not necessarily increase their loan volume.

It is misleading to say that banks have completely stopped lending. On the one hand, there are data that show otherwise. But more accurately, bank lending is a market-driven enterprise, where rates are determined by supply and demand. As banks become more fearful of defaulting loans, the rate at which they are willing to lend money rises (often prohibitively). Under these circumstances, even credit-worthy companies are facing a higher cost of borrowing.

Forcing the banks to lend will be a difficult, if not fruitless, task for lawmakers. As Congress calls for prudence and responsibility in the financial world, these institutions may argue that fewer loans are precicely in order. One thing is for certain, there has been no easy way to loosen the credit market.

Looking to Iran for Afghan Supply Routes

Early Tuesday morning, militants in Pakistan bombed a major supply route in the Khyber Pass, about 25 miles northwest of Peshawar. Roughly three-quarters of the supplies destined for NATO troops in Afghanistan are transported through this mountainous region, and the attack highlighted the need for alternative support routes. Pakistani officials said the destroyed bridge would take some time to repair, but a NATO spokesman said there was no risk of a supply shortage.

Most of the food, equipment, and fuel that is needed in Afghanistan first arrives at the Pakistani port in Karachi. These supplies are then transported to the Khyber Pass, where they are trucked through perilous terrain into the Afghan border town of Torkham. Over the past several months, insurgents have launched multiple attacks against the Khyber Pass supply route, hoping to disrupt the US-led mission against the Taliban. The region is part of Pakistan's Federally Administered Tribal Areas, known for heavy weapons and Taliban sympathizers.

As an immediate reprieve, NATO supplies will likely pass through a more southern crossing in Baluchistan, which connects the Pakistani town of Chaman with Kandahar in Afghanistan. Still there is mounting concern among NATO commanders that these routes are insufficient for supplying the mission in Afghanistan. President Barack Obama has signaled his desire to send three additional brigades to Afghanistan (some 10,000-12,000 troops) by mid-summer, and boost forces by another 30,000 in the next 12-18 months. Such an increase in the force level would demand massive logistical support, which the existing supply routes cannot sustain.

The US military is undoubtedly aware of these constraints. Last month, the chief of US Central Command, General David Patraeus, said that agreements had been reached with Russia and Central Asian states to secure new supply lines (though he provided few details). Other than neighboring Pakistan, the following countries share a border with Afghanistan: Turkmenistan, Uzbekistan, Tajikistan, China, and Iran. Regional ports include Georgian docks on the Black Sea or Turkmen docks on the Caspian Sea.

It would be difficult to imagine a list of countries and way-stations with greater diplomatic complications. All of these states are wary of the great political chess match between Russia and the West, and connections to NATO could upset the Kremlin. Few analysts suggest that Russia wants to disrupt the Afghan mission, but Moscow could extract major concessions from the Americans (regional influence) and Europeans (natural gas prices) alike. As a result, this week has seen a dramatic turn in US relations with another regional power: Iran.

On Monday, NATO's top military commander, US General John Craddock, said that alliance members were free to negotiate with Tehran. Not surprisingly, this announcement marks a considerable break from the preëxisting strategy in Afghanistan. In years past, American officials claimed Taliban insurgents were using Iranian weapons, however, the tone has dramatically changed since Mr Obama took office. While it is unlikely the US will use Iran's transport routes any time soon, NATO members with good Iranian relations could benefit from the alternative supply lines. Most analysts expect Germany, France, and Italy to use the Char Bahar port in southeastern Iran.

Route security is an important factor in promoting Afghan stability in the short term. Indeed, many of the additional NATO troops will be used to protect truck convoys, police major highways, and improve transportation throughout the country. These measures are essential in building the necessary infrastructure on which Western forces are hoping to build a viable state. Still, there are many political challenges to come. Any successful strategy in Afghanistan will have to incentivize rival factions to participate in some sort of power-sharing agreement.

In all likelihood, such diplomacy will require the inclusion of the Taliban or Taliban elements (as with Sunni insurgents in Iraq). During this delicate process, the Obama administration's negotiating skills will certainly be tested. Fortunately, the recent announcement on Iran shows a deft understanding of the realities in Central Asia.

At Lehman, What Bankruptcy?

This graph from Calculated Risk shows the deteriorating unemployment picture in the US. According to the year-over-year statistic, 2.6 million fewer Americans were working in December 2008 than December 2007. Still, many analysts predict these numbers will get worse before they get better. And yet...

In a remarkable story, the Wall Street Journal is reporting today that Lehman Brothers is actually hiring. The disgraced financial services firm has already recruited back more than 200 former employees, and is looking to add to its staff. On September 15, Lehman filed for Chapter 11 bankruptcy protection citing a bank debt of $613 billion, a bond debt of $155 billion, and net assets of only $639 billion. The event sent shock waves through the financial system, triggering the settlement of some $400 billion in Credit Default Swaps (CDS) and destabilizing the broader economy in the US and throughout the world.

As with the epicenter of any disaster, this collapse left plenty of debris. Indeed, Lehman's financial ruin will require a significant clean up effort. According to reports, Lehman still has 1,400 private investments valued at $12.3 billion and some 500,000 derivative contracts with 4,000 different trading partners worth about $24 billion. These obligations must be unwound in an orderly and timely fashion, if the firm is to dissolve within its stated goal of 18-24 months.

And so, Lehman is awash with resumes. The WSJ claims that many out-of-work Wall Street professionals are looking for any opportunity with a steady paycheck. Those who lost jobs at Citi, Bank of America, or other competitors, are now looking to join (albeit temporarily) the firm that accelerated the financial crisis. With so many derivatives and real-estate contracts still unsettled, it will take some time before Lehman can sell off all its remaining assets. In an embattled industry, it is a perverse form of job security.

Alvarez & Marshal, the New York restructuring firm that also worked with Arthur Anderson after the Enron collapse, is directing Lehman's clean-up. In an effort to raise cash, A&M have helped the firm sell its impressive contemporary artwork collection (reportedly for some $30 million) and part of its corporate jet fleet (more planes and a Sikorsky helicopter are still up for sale). Lehman also sold its glitzy 38-story office building in Midtown Manhattan as part of its desperation deal with Barclays. Lehman now has about $7 billion dollars, but needs to pay off $150 billion to its creditors. There is still a long road ahead.

The good news is that A&M has decided to manage some of Lehman's holdings rather than sell them into a depressed market. This move should provide some structure for the upcoming months of financial disentanglement and be more profitable than any sort of mark-t0-market scheme in the current environment. The bad news is that Lehman has a psychological effect on investors. The sooner the debris is cleared away, the sooner banks will begin their normal operations. Until Lehman's positions are settled and the entire bankruptcy experience has run its course, credit will remain tight and risk appetite will stay low. After all, no one wants to get caught in another CDS/bond trap.

For now, Lehman's hiring process will flummox (if not enrage) anyone living through this financial storm. But there is reason to believe that once these same jobs are lost, it will actually spell good news for the economy.

Bank Liabilities Overwhelm GDP

This figure comes by way of FT Alphaville, and charts the ratio of outstanding bank liabilities to national GDP for Eurozone and G10 countries.

These measures are important because they are an integral part of the bail out process. Governments hoping to backstop their bank's debt must have a national income that can offset balance sheet losses. Once these liability levels start rocketing above the 100% level (outstanding debts exceeding GDP) individual banks become too big to save.

With the economic glitterati in Davos, let's take a look a Switzerland. According to FT, UBS has a balance sheet of $2 trillion and Credit Suisse has about another $1 trillion. While not fully all of these assets are distressed (credit worthy borrowers are still repaying loans), this $3 trillion exposure is some 10 times the Swiss economy.

There has been plenty of deserved blame leveled against the US, and this chart is surely of little comfort to bankers in America. Still, take note of that much smaller block on the right.

Davos Reveals Big Currency Challenges

On Wednesday, Russian Prime Minister Vladimir Putin stood before a smarting crowd in Davos, Switzerland and warned against the reliability of the US dollar (USD) as a reserve currency. Russian officials, and Mr Putin in particular, aren't always the most reliable economic soothsayers. Still, these comments were reflective of a general unease at this week's World Economic Forum.

Indeed, it seems everyone would like to figure out what is happening in foreign exchange markets. This past year saw an epic collapse for the pound sterling (GBP), mounting concerns about the viability of the euro, the staggering free fall of the Russian ruble, and the sharp appreciation of the Japanese yen (now at a 14 year high). In the United States, new Treasury Secretary Tim Geithner even challenged the dollar's exchange rate with the Chinese yuan, formerly a political taboo.

Such renewed focus on currencies is not surprising. With central banks the world over trying to breathe life into the domestic economies, monetary policy is having major forex implications. For managed and free-float currencies alike, the global crisis is giving economic ministers fits. Efforts to stimulate the economy often include interest rate cuts, which in turn make a currency less attractive for investors to hold and risk inflation. On the other hand, cheaper currencies lead to more competitive exports, a critical component of many developing economies.

Such cross-currents are weighing heavy in many foreign capitals. In Moscow, central bankers try to keep the ruble within some reasonable band of a weighted dollar-euro basket. Last week, however, the Russian currency depreciated about 1.4% every day, which dramatically widened this trading band. The weakening oil price and fears about the fundamentals of Russia's economy have only exacerbated the selling pressure. Over the last three weeks, central bankers have had to sell nearly $30 billion in foreign currency reserves to help prop up the ruble.

The situation is perhaps even worse in China. According to most reports, the country's GDP growth slowed to 6.8% in the fourth quarter of 2008. China needs to grow at around 8% to keep up with demographic realities and avoid social unrest. Even so, some analysts are concerned that the Chinese figure is overly optimistic. Some 60,000 factories have closed in China, and in November of last year, China's growth in electricity production was 8% below the 2007 level. Such figures seem to suggest a much more dire picture for the Chinese economy. Exports are falling rapidly, and there is no way for domestic demand to compensate for such a contraction.

In the US, hurtling jobless numbers and shrinking durable goods orders threaten the dollar. Still, the greenback has been the beneficiary of a continued flight to quality. Curiously, the dollar's rally has not had the predictable effect on gold prices, which are rising. In most cases, investors buy gold as a hedge against USD devaluation or inflation. The dollar is strengthening significantly against both the euro and the pound, and there is little concern of inflation in the short term (at one point TIPS were pricing in deflation). Consequently, it seems this dollar-gold relationship has broken down.

What does all this mean for forex markets? No doubt there are choppy waters ahead, and exchange rate volatility is likely to increase. News, to say nothing of rumor, about monetary policy developments will cause great swings in investor confidence. With all this turbulence, gold may find itself in another record ascent. In a potentially prescient move, the hedge fund Osmium Capital Management will allow its clients to denominate their holdings in gold.

On Thursday, Zimbabwe effectively abandoned its currency, as citizens may now use foreign-denominated notes alongside the Zimbabwean dollar. And so begins the dramatic process of an entire world trying to figure out the meaning of money.

Obama Needs Madiba Magic

Nelson Mandela, the former President of South Africa and one of the world's most respected statesman, led an international reception for Barack Obama on Wednesday, calling the first black US president "a new voice of hope." While some 2 million people packed the frigid National Mall in Washington, DC to hear Mr Obama's voice live, his audience truly spanned the globe. After eight years of an administration which often ran roughshod over the international community, many outside the US were expecting a more conciliatory tone from Mr Obama.

Great expectations were met with grand vision. In his inaugural address, Mr Obama offered a thinly-veiled repudiation of George W Bush's tenure, promising a new commitment to diplomatic relations with friends and foes alike. On his first day in office, Mr Obama suspended military trials at the Guantanamo Bay naval base, and by Wednesday the president had signed an executive order closing the infamous detention camp and the nefarious web of "black site" CIA interrogation facilities across the globe.

In his letter to the American president, Mr Mandela wrote that the inauguration was "something truly historic not only in the political annals of the United States of America, but of the world." While much of Europe, Latin America, and Africa rejoiced, foreign correspondents were trying to gauge the more nuanced reactions in Asia and the Middle East. Indeed, many analysts have commented on the ambivalent reception of Mr Obama's remarks in the Muslim world (some hailing his comments on a withdrawal from Iraq, others lamenting his avoidance of the Israeli-Palestinian conflict).

In North Korea, the highly repressive state media made no mention of the inauguration in Washington, instead choosing to report on presidential proceedings in Equatorial Guinea. Similarly, China Central Television (CCTV) censored parts of Mr Obama's speech. After the president said, "Recall that previous generations faced down fascism and communism," the interpreter's voice was dropped and the picture cut away from the Capitol to an in-studio news anchor. China's online translations of Mr Obama's speech were also edited to remove any references to "communism."

The simple reality is that Mr Obama's overwhelming support comes from non-crisis regions. To be sure, the new president will need European help in fixing the global financial crisis and in strengthening NATO forces in Afghanistan. But in the regions where Mr Obama faces major foreign policy challenges (Iraq, Iran, Gaza, Pakistan, China, and North Korea) his rhetorical skills will have be matched by practical policies.

Mr Mandela proved incredibly adept at finding diplomatic solutions to his most difficult problems. To this day, South Africa's peaceful transition from minority to majority rule is held as an example of leadership for all nations. By all accounts, however, the crises facing Mr Obama are more complicated and more consequential. Let's hope his "new voice" can work the same Madiba magic.

Pay To Play With Manchester United

The troubled insurance giant, American Insurance Group (AIG), has raised plenty of red flags in recent months. Starting in May 2010, however, the company's name will no longer be emblazoned on the world's most popular red jersey. Reports today confirmed that AIG will end their four-year sponsorship deal with English Premier League heavyweights Manchester United.

In the world's richest endorsement, AIG paid 19 million pounds ($26.6m) each season to have the company's logo worn by human billboards like Christiano Ronaldo and Wayne Rooney. With a fan-base that spans the globe, and is particularly prevalent in countries like China and Indonesia, the Man U sponsorship is a lucrative deal that provides massive exposure. Only two other companies have been displayed on the Red Devils jersey, as both Sharp Electronics (1982-2000) and Vodafone (2000-2006) had multi-million dollar contracts with the club.

Back in September, the perils of an accelerating credit crisis caused AIG to reconsider their jersey sponsorship. While AIG executives announced they would be able to honor their existing commitment to the club, it became clear that any further deal was unlikely. As a major holder of mortgage backed securities and credit derivatives, AIG's liquidity crisis triggered alarming write-downs that ultimately required a $100 billion bailout package from the US federal government. After an embarrassingly expensive executive retreat in October, AIG is now desperately trying to cut unnecessary spending.

Man United are not the first club to lose a sponsorship deal as a result of the global financial crisis. Also in September, West Ham United had to drop its contract with XL Holidays, a low-cost airline and tour operator. That three-year deal was worth about $10.5 million, but had to be terminated after the company was placed in administration. Another Premier League club, West Bromwich Albion, struggled to find a replacement sponsor when Deutsche Telekom's T-Mobile dropped its contract.

Many analysts have observed that the financial strains in global capital markets are beginning to manifest themselves in the sporting world. The NBA cut down its number of preseason games in Europe, Formula One racing (the world's most expensive sport) is facing a slew of cost-cutting measures, and many companies will not be buying the exorbitant Super Bowl advertising slots.

Given the club's global prestige, Man U are almost sure to come out of the economic recession unscathed. Indeed, certain marketing experts believe that the club will have little trouble breaking the 20-million-pound mark for their next jersey deal. United officials have already sent sample kits as a sales pitch to a number of potential corporate sponsors. Some reports have pointed towards Sahara India Pariwar, a business conglomerate, which already has several domestic sports sponsorships. Looking for a partner is Asia reflects the interest of many major English clubs to gain popularity in the region.

On the pitch, United are again tops in league play and are among the favorites to defend their Champions League title in Europe. To the disappointment of lesser clubs across the world, AIG's financial troubles will have little effect on the fleet-footed superstars at Old Trafford.

Oil Price: More Than Just Another Number

Quick, what is the price of oil? For a number that is so frequently quoted by market analysts and casual observers alike, the market price for a barrel of petroleum is actually rather confusing. Not only is this value constantly changing, but the question is woefully unspecified. The price is highly dependent on the type of oil, as determined by its specific gravity, sulfur content, and location. As a result, the price of Saudi light sweet crude (which requires less refining) is higher than Venezuela's heavy sour quality.

To complicate matters, most oil is not traded on exchanges, but through over-the-counter contracts in which two parties settle on a price for future oil delivery. In general, however, the oil price references one of the major benchmarks like WTI Light Crude, ICE Brent Crude, or the OPEC basket. For the most part, these benchmarks trade within a close range of one another allowing industry analysts to create a composite "world oil price."

More recently, however, a yawning WTI-Brent spread has begun to alarm traders. Under normal economic circumstances, the higher-grade WTI trades at a premium of $1-$2 per barrel over Brent. But last week, WTI was priced at a record $11.73 discount against the North Sea-based Brent benchmark. According to financial reporters, this price reversal is a logistical artifact, and does not reflect true market realities.

The problem can be traced to Oklahoma of all places. West Texas Intermediate (WTI) is shipped to Cushing, OK where US suppliers store the oil until the delivery contracts are settled. JBC Energy reported that inventory stocks in land-locked Cushing were at 27 million barrels, almost triple their number back in November. Two forces are causing inventories to rise. First, demand is slumping and thus suppliers are drawing less oil from the Cushing facility. Second, there is currently a "super cantango" in the WTI oil market. This phenomenon results when the spot contract (immediate delivery) is much cheaper than the future contract. Oil traders are hereby encouraged to buy discounted WTI, store it in Cushing, and then take the profits on a futures contract.

The Financial Times is reporting that the current WTI-Brent price dislocation could spell trouble for one of the world's most popular benchmarks. If WTI is dominated by technical variables like inventory stock, its ability to reflect broader market conditions is diluted. By definition, this distortion threatens the viability of WTI as an indicator of oil fundamentals.

While there is considerable difficulty in finding suitable benchmarks for the oil price, there is a growing consensus around the cause of its rise and fall: hedge funds. In early 2008, sensing an economic slowdown, hedge funds moved trillions of dollars out of equities and stashed their money in energy Exchange Traded Funds (ETFs). These ETFs are basically tax-efficient, tradeable mutual funds whose profitability was based on hydrocarbons. With global oil demand rising (estimates were based development in China and India), hedge fund managers saw these energy ETFs as a rare safe haven in a bleak trading year.

In just a few months, however, an economic slowdown became a full-blown credit crisis. To cover losses in the stock market, hedge funds were forced to raise cash and begin a painful deleveraging process. As they liquidated their positions in energy ETFs, hedge funds sent the oil price into a fantastic downward spiral. It is important to note that as oil lost three-quarters of its value, demand was trimmed less than 10%. Clearly the petro-bubble was exacerbated by market speculation.

Now, with the oil price lower than the cost of production, there is a dearth of new investment for exploration, extraction, and refining capabilities. Once inventories are sold off, it could be difficult for oil suppliers to meet future demand, even with a global recession. What is more, many analysts suggest that oil is vastly oversold, with Goldman Sachs predicting a rapid price reflation in late 2009.

Just this week, there are reports that several banks have purchased supertankers that will store cheap oil until the price advances again. According to Bloomberg reports, Morgan Stanley is paying $68,000 per day for its tanker. At that rate, you can bet their analysts have thought long and hard about our opening question.

Major Headwinds for the €uro

The euro celebrates its tenth anniversary this January, but there has been little to celebrate for this putative reserve currency. Used by 16 of 27 member states in the European Union, the euro is coming under intense pressure on foreign exchange markets as the global economic crisis hurtles on.

Europe's single currency has historically been a safe haven during financial storms, as its member economies were thought to provide a diverse bulwark against economic hardship. Purchasers of the euro were, in theory, spreading their risk across Germany, France, Spain, and other big EU markets. What is more, economic coherence and the coördination of monetary policy were billed as the pillars of supply-side reforms spurring growth and productivity.

That was then. There are now real concerns that the eurozone could split up, or that one of its member states could suffer a sovereign debt default. Traditionally, the spread on government bonds between countries using the single currency are paper-thin. Over the last ten years, the interest rate on, say, Belgian bonds has not been much greater than the safest German government bonds (called bunds). Low bond spreads have been one of the major attractions of using the euro, especially for new EU members looking to finance their domestic spending.

Some analysts, however, claim that the bond spread convergence is misleading, as there is no legal way for one eurozone country to backstop the debt of another. While they may use the same currency, Germany's economic vitality cannot prevent Slovenia from defaulting. As a result, sovereign debt should be analyzed individually, not part of an EU blend.

This revaluation is precisely what now threatens the single currency. The extra yield on Greek government bonds over German bunds has risen dramatically during the financial crisis (not to mention the weeks of social turmoil in Athens). On Friday, Standard & Poor's put Greece's credit ratings on notice for a potential downgrade, sending both CDS contracts and bond spreads on Greek debt to historic levels.

Similarly, both Spain and Ireland have had their credit ratings cut by S&P in recent days. As a result, these countries will have to pay investors a higher interest rate to finance government spending for economic recovery. With European governments scheduled to sell a record €41 billion in Treasuries this week, bond spreads will be on the mind of central banks throughout the EU.

Most analysts are worried about countries at Europe's periphery that might be tempted to opt out of the euro in an effort to pursue self-interested monetary policy. One of the major criticisms of the single currency is that its rising strength (before the financial collapse) eroded the appeal of European exports and put pressure on domestic spending. To complicate matters, many EU governments have policies that automatically link wage increases to inflation. As a result, Italy and Greece are facing acute strains on their federal budgets, with no way to devalue their currency and boost trade.

In a more striking omen, the likelihood that any country currently using the euro will drop the single currency in the coming year is now at 30%, according to the Intrade prediction market. What once may have seemed an unthinkable development is now a significant concern for policy makers across Europe. To be sure, any country that decides to opt out of the euro would face major economic hardship. Investor confidence would plummet, and local citizens would rush to transfer their euro holdings to more stable accounts outside the country. These costs should outweigh any problems with the euro, but there is no way to predict the domestic political pressures that many European leaders might feel in 2009.

If the EU can successfully navigate this next year and prove its mettle in the face of a financial calamity, then it will likely reassure investors that the euro is a bonafide reserve currency. If, however, one of its member states decides to leave the eurozone, it will likely spell the end for the euro as a major fixture on the forex market. Happy 10th, euro, and good luck in the year ahead.

Kenyan Coalition Stress: Potential Omen

The governing coalition in Kenya is facing new strains after President Mwai Kibaki approved a controversial media law last week. The measure establishes a new communications commission that will regulate broadcasting content and impose tougher jail sentences for press offenses. International observers and local activists had bitterly opposed the law, staging demonstrations and protests in December.

For Mr Kibaki, the measure is designed to balance the media's freedom with its responsibility to "account [for] the overriding interest and safety of Kenyans." Many within the country, however, fear that the communications law will return Kenya to authoritarian government. Indeed, Kenya's vast array of media outlets is now subject to office raids and electronic wiretapping.

Kenya's Prime Minister, Raila Odinga, has openly opposed the bill saying that the expanded federal powers would be "oppressive to the democratic gains achieved" in Kenya. Messrs Odinga and Kibaki fought a tense election battle last spring, in which political violence claimed some 1,500 lives and displaced 300,000 Kenyans. A UN-brokered agreement brought Mr Odinga's Orange Democratic Movement (ODM) and Mr Kibaki's Party of National Unity (PNU) together into a power-sharing deal, but it has proved an uneasy alliance.

Not surprisingly, many analysts are concerned that a dispute over the communications law will send Kenya backsliding into political turmoil. Many officials with the ODM have complained that major decisions (such as diplomatic appointments) are being made without their consent. While the relationship between Messrs Odinga and Kibaki still appears cordial, mounting tensions will make it difficult for these leaders to hold their country together.

These are important times for Kenyan politics. Across the continent, Ghana has (for now) peacefully settled a December presidential election that produced razor-thin margins. The challenger, John Atta Mills, defeated the ruling-party candidate, a feat which Mr Odinga called a "rare example of democracy at work in Africa." Farther south, Africa is host to one of the world's most horrific heads of state, Robert Mugabe, who plans to unilaterally form his own government next month. Mr Mugabe appears to be doing everything in his power to drive a final stake through his earlier power-sharing agreements with Morgan Tsvangirai.

In recent weeks, Abdullahi Yusuf Ahmed resigned from his post as president of Somalia. While the flagrant anarchy in the Horn of Africa rendered this announcement largely ceremonial, Kenya should be concerned about the political forces in its northeastern neighbor. Should the coalition in Nairobi falter, there would be cascading fallout for democratic movements throughout the region. Even in South Africa, the recent democratic lodestar of the continent, there are populist tensions heading into 2009 election. Indeed, much depends on the ability of Messrs Odinga and Kibaki to manage Kenya's fragile coalition.

These are all significant challenges for Africa in 2009, and this review ignores the larger structural problems affecting Sudan, the Democratic Republic of Congo, and the Niger Delta. Certainly all of these political hot spots do not hinge on the Kenyan governing coalition, but leaders in Nairobi must make every effort to start the year off right.