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THE GLOBAL ECONOMY IS AT THE POINT OF MAXIMUM DANGER
It feels like the summer of 1931.
Among Woody Allen's many classic lines is his summary of the human condition: "More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly." Veteran U.K. financial writer Ambrose Evans-Pritchard characterizes the current financial situation facing the world as approximately that.
It feels like the summer of 1931. The world's two biggest financial institutions have had a heart attack. The global currency system is breaking down. The policy doctrines that got us into this mess are bankrupt. No world leader seems able to discern the problem, let alone forge a solution.
The IMF has abdicated into schizophrenia. It has upgraded its 2008 world forecast from 3.7% to 4.1% growth, while warning of a "chance of a global recession". Plainly, the IMF cannot or will not offer any useful insights. Its "mean-reversion" model misses the entire point of this crisis, which is that central banks have pushed debt to fatal levels by holding interest too low for a generation, and now the chickens have come home to roost. True "mean-reversion" would imply debt deflation on such a scale that would, if abrupt, threaten democracy.
Precisely. It depends on what mean you are reverting to.
The risk is that these same central banks will commit a fresh error, this time overreacting to the oil spike. The European Central Bank has raised rates, warning of a 1970s wage-price spiral. Fixated on the rear-view mirror, it is not looking through the windscreen.
The eurozone is falling into recession before the U.S. itself. Its level of credit stress is worse, if measured by Euribor or the iTraxx bond indexes. Core inflation has fallen over the last year from 1.9% to 1.8%.
The U.S. may soon tip into a second leg of this crisis as the fiscal package runs out and Americans lose jobs in earnest. U.S. bank credit has contracted for three months. Real U.S. wages fell at almost 10% (annualized) over May and June. This is a ferocious squeeze for an economy already in the grip of the property and debt crunch.
No doubt the rescue of Fannie Mae and Freddie Mac -- $5.3 trillion pillars of America's mortgage market -- stinks of moral hazard. The Treasury is to buy shares: the Fed has opened its window yet wider. Risks have been socialized. Any rewards will go to capitalists. Alas, no Scandinavian discipline for Wall Street. When Norway's banks fell below critical capital levels in the early 1990s, the Storting authorized seizure. Shareholders were stiffed.
But Nordic purism in the vast universe of U.S. credit would court fate. The Californian lender IndyMac was indeed seized after depositors panicked on the streets of Encino. The police had to restore order. This was America's Northern Rock moment. IndyMac will deplete 1/10 of the $53 billion reserve of the Federal Deposit Insurance Corporation. The FDIC has some 90 "troubled" lenders on watch. IndyMac was not one of them.
The awful reality is that Washington has its back to the wall. Fed chief Ben Bernanke thought the U.S. could always get out of trouble by monetary stimulus ... and letting the dollar slide. He has learned that the world is a more complicated place.
Oil has queered the pitch. So has America's fatal reliance on foreign debt. The Fannie/Freddie rescue, incidentally, has just lifted the U.S. national debt from German "AAA" levels to Italian "AA-" levels.
China, Russia, petro-powers and other foreign states own $985 billion of U.S. agency debt, besides holdings of U.S. Treasuries. Purchases of Fannie/Freddie debt covered a third of the U.S. current account deficit of $700 billion over the last year. Alex Patelis from Merrill Lynch says America faces the risk of a "financing crisis" within months. Foreigners have a veto over U.S. policy.
Japan did not have this problem during its Lost Decade. As the world's supplier of credit, it could let the yen slide. It also had a savings rate of 15%. Albert Edwards from Société Générale says this has fallen to 3% today. It has cushioned the slump. Americans are under water before they start.
My view is that a dollar crash will be averted as it becomes clearer that contagion has spread worldwide. But we are now at the point of maximum danger. Britain, Japan, and the Antipodes are stalling. Denmark is in recession. Germany contracted in the second quarter. May industrial output fell 6% in Holland and 5.5% in Sweden.
The coalitions in Belgium and Austria have just collapsed. Germany's left-right team is fraying. One German banker told me that the doctrines of "left Nazism" (Otto Strasser's group, purged by Hitler) had captured the rising Die Linke party. The Social Democrats are picking up its themes to protect their flank.
This is the healthy part of Europe. Further south, we are not far away from civic protest. BNP Paribas has just issued a hurricane alert for Spain. Finance minister Pedro Solbes said Spain is facing the "most complex" economic crisis in its history.
Actually, it is very simple. The country was lulled into a trap by giveaway interest rates of 2% under EMU, leading to a current account deficit of 10% of GDP. A manic property bubble was funded by foreigners buying covered bonds and securities. This market has dried up. Monetary policy is now being tightened into the crunch by the ECB, hence the bankruptcy last week of Martinsa-Fadesa (€5.1 billion). With Franco-era labour markets (70% of wages are inflation-linked), the adjustment will occur through closure of the job marts.
China, India, East Europe and emerging Asia have all stolen growth from the future by condoning credit excess. To varying degrees, they are now being forced to pay back their own "inter-temporal overdrafts."
If we are lucky, America will start to stabilize before Asia goes down. Should our leaders mismanage affairs, almost every part of the global system will go down together. Then we are in trouble.
ARE WE ENTERING A FINANCIAL MELTDOWN?
A total collapse of the U.S. financial system, while not inevitable, is a contingency which should now be planned for.
Martin Hutchinson submits that it is possible the entire U.S. banking system could implode, which it did not do in the 1930s despite the failure of approximately one quarter of the U.S. banks then. During the 1920s boom, U.S. banks made loans very conservative by today's standards. A 50% down payment for a house was standard! The failures were mostly caused when the Fed failed to do the one thing it conceivably could productively accomplish: Provide short term liquidity to otherwise solvent banks when a panic led to a run on bank deposits.
Hutchinson spells out a plan for the winding down of Fannie Mae and Freddie Mac as major players in the U.S. mortgage market, which he views as essential to the long-run health of the financial system. The plan makes perfect sense, both from theoretical and quasi-realpolitik perspectives, but we know it has virtually no chance of being implemented -- at least in any rational and methodical manner. Events and the market may well effect the same result in a more tumultuous manner.
The financial crisis in the United States and worldwide entered a new phase this week, as Fannie Mae and Freddie Mac, the two huge U.S. home loan institutions, began what appears to be a similar "death spiral" to what which claimed Bear Stearns four months ago. Fannie and Freddie are unique institutions, and will almost certainly be bailed out by the long-suffering taxpayer. However for the first time the specter has been raised of a general financial meltdown, such as the U.S. managed to avoid in 1933 but Sweden succumbed to in 1991.
Sweden's financial meltdown of 1991 involved the government guaranteeing the obligations of the entire Swedish banking system, and recapitalizing the major banks, with the sole major exception of Svenska Handelsbanken. The total cost of the rescue to Swedish taxpayers was around $10 billion, equivalent to about $1 trillion in the context of today's U.S. economy. The causes of the crisis would be familiar to most Americans today: Misuse of off-balance sheet securitization vehicles to invest excessively in real estate and mortgage lending.
It is thus not impossible for the entire U.S. banking system to implode. It did not happen in 1933 (though about a quarter of U.S. banks failed) because U.S. banks in the 1920s had been relatively conservative in their lending, with many banks requiring a 50% down payment for home mortgage loans, for example. Stock margin lending got way out of control in 1928-29, but relatively few banks were involved significantly in that. The main problem in 1932-33 was quite simply liquidity. The Fed failed to supply adequate reserves to the banking system, so crises of confidence in individual banks led to panic withdrawals of deposits that caused the banks themselves to fail.
This time around, the problem is the opposite. Whereas the Fed had been appropriately cautious in the late 1920s, so only in the area of stock margin lending did the banking system get out of control, this time around the Fed has been hopelessly profligate in monetary creation for over a decade. The initial result of this profligacy, the tech bubble of 1999-2000, caused only modest problems in the banking system through telecom losses. The more recent profligacy and the housing bubble it caused have had much more serious consequences, mirroring those in Sweden leading up to 1991. The additional loosening since September has distorted the financial system further, producing a commodity price bubble that itself seems likely to have substantial further adverse consequences.
Fannie and Freddie are probably toast, and about time too. Fed Chairman Ben Bernanke's statement Friday [July 11] that they can discount paper with the Fed may prolong the inevitable, but also increases its likely huge cost to taxpayers. There can be no economic justification for the government guaranteeing the great majority of the nation's home mortgages, and the spurious "government sponsored enterprise" structure of Fannie and Freddie merely hid the likely consequences of their default. Their senior employees have been paid like Wall Street for performing a function that was economically entirely unnecessary, and they have survived for more than 50 years simply through their ability to offer lucrative consulting contracts to ex-Congressmen and other politically well-connected people.
It is thus necessary that any "rescue" for Fannie and Freddie be a euthanasia not a lifeline. They have extracted their rents from the market for too long, and have encouraged the growth of a securitized mortgage market that has proved entirely unsound because of its perverse incentives. Simply providing them with $100 billion or so of extra capital at taxpayer expense, probably structured as some economically unjustified form of subordinated debt so that the shareholders are left undiluted and allowing them to continue operating does not solve the problem, it exacerbates it.
The simplest from of euthanasia for Fannie and Freddie would be a takeover by the Office of Federal Housing Oversight (OFHEO) their regulator, on the grounds that they were no longer able to operate independently. ... Following a takeover, Fannie and Freddie would need to continue performing their current functions of guaranteeing home mortgages, as without such guarantees home mortgages are currently impossible to obtain. However, changes must be made to recognize the revised nature of the business. Since the new guarantees would be direct government obligations (OFHEO being an arm of the government) rather than simply implied obligations, the fees for obtaining them should be jerked sharply upwards, perhaps to 1.5% per annum on the outstanding amount of the mortgage. That would allow mortgage finance to remain available at a cost that is still reasonable in current markets (Fannie Mae paper already pays a 0.75% premium over the government for its borrowings) but as markets recovered it would make Fannie/Freddie guaranteed mortgages highly uncompetitive against direct home loans, by far the healthiest way for housing to be financed. Together with the salary reductions outlined below, it would also begin to reimburse the unfortunate taxpayer for the gigantic costs of this non-rescue operation.
Treasury Secretary Hank Paulson has called for "covered bonds" similar to the German pfandbriefe to be used to finance housing. Since pfandbriefe, bonds issued by German banks to finance housing, remain on German bank balance sheets and retain the bank guarantee, allowing the banks only to escape the funding risk of lending for 30 years at a fixed rate, they avoid the moral hazards of the securitization markets, and are thus an attractive alternative. To encourage their use, and to reduce the capital cost to banks of holding mortgages on balance sheet, the Basel 1 bank regulations, currently being phased out, should be retained. They allowed mortgages to carry only a 4% capital charge as against 8% for regular loans. By this and other means, the private banking sector would be encouraged to make sound home loans directly, without the unnecessary Fannie/Freddie guarantees.
The objective would be over a 5-10 year period for Fannie and Freddie to become insignificant participants in the mortgage market, after which they could be closed altogether. Meanwhile, costs in Fannie and Freddie could be cut drastically, particularly on the staffing side. Since Fannie and Freddie staff would now be government employees, they should be paid on the GS payscale, with the CEO, as a GS-15, receiving appropriate remuneration between $115,317 and $149,000, according to his years of service. Even if the CEO was able to argue himself onto the SES pay scale (after all, he has excellent Congressional contacts) he would be limited to about $205,000 in the Washington area.
Naturally many Fannie/Freddie employees would be outraged at this cut in their living standards, and would attempt to find alternative better-paid employment. I venture to suggest that few would succeed in doing so. That way, redundancy payments would be avoided while salary costs were slashed. There would be a devastating effect on the Northern Virginia housing market, where many senior Fannie/Freddie employees have overextended themselves with giant home mortgages for vulgar McMansions, but that problem too is probably survivable. More important, the now disgruntled employees would perform their job poorly, making applying for a Fannie/Freddie guarantee a bureaucratic and uncertain process, similar to negotiating with the IRS. That too should hasten their disappearance from the housing market.
Fannie and Freddie do not represent the entire U.S. finance sector, far from it. Nevertheless their insolvency would further erode confidence in the rest of the sector, very likely leading to a cascade of death spirals among other institutions. After all the best run large non-global U.S. bank, Wachovia, has itself got in trouble by its insanely foolish acquisition of the California mortgage lender Golden West Financial at the peak of the market in 2006, while Bank of America, the largest retail-oriented U.S. bank, voluntarily took on more of the mess by its purchase of the diseased and probably criminal Countrywide Financial as recently as last January. Citigroup is in deep trouble in a number of areas, particularly relating to its over-enthusiasm for the discredited technique of securitization, while JP Morgan Chase CEO Jamie Dimon wrecked his credibility in May by announcing that the financial crisis was "mostly over" -- presumably wishful thinking in the light of his huge holdings of dodgy Bear Stearns paper.
Only Goldman Sachs appears serenely above the fray, but do not forget -- at May 2008 its "Level 3" assets were $78 billion, more than twice its capital. Level 3 assets, you may remember, are those for which there is no market, so can be valued only by the internal mathematical models of the institution concerned. Since this arcane highly-illiquid paper is the most likely to suffer catastrophic erosion of "value" in a downturn, Goldman Sachs, like Jamie Dimon, must be keeping their fingers crossed that somehow this nightmare must end soon.
It must not. From past experience of such follies it probably has at least another year to go. Thus a total collapse of the U.S. financial system, while not inevitable, is a contingency which should now be planned for.
Is this “It” – the Big It many of us have anticipated with growing dread since the U.S. effectively declared bankruptcy in August 1971?
In his July 14 "Pro Libertate Blog" posting, William Grigg wonders whether this current crisis, the beginning of Doug Casey's Greater Depression ... whatever ... is the "Big It" many have been forecasting, like, forever. Whether or not it is, be aware, he warns, that you -- the average citizen/taxpayer -- will not be among "Those Who Matter" who will be taken care of come the crisis. For all the oligarchs and the ruling class care, you can "eat sh*t and die." (Grigg is not known for pulling his punches.)
“If they’re hungry, they can eat grass, or their own dung, for all I care.” ~~ Andrew J. Myrick, a trader affiliated with the notorious mid-19th Century "Indian Ring," responding to complaints from Sioux that they were starving on the meager, worm-ridden rations provided by the Indian agency, August 15, 1862.
Andrew Myrick was a trader working at the Lower Sioux Agency in southwest Minnesota when desperate Chiefs representing the Sioux arrived, pleading for food. Thomas Galbraith, the federal Indian Agent, was not inclined to help.
The Chiefs had no money, and Galbraith had better business to attend to than helping out a bunch of starving Indians. Galbraith's business, and Myrick's too, was to maximize profits realized through the federal Indian management system. This meant padding expense vouchers, arranging kickbacks, distributing spoiled or otherwise unusable rations to Indians, and generally finding ways of milking the federal subsidies to their advantage and that of their allies.
This institutional corruption would eventually become known, under President U.S. Grant, as the "Indian Ring." In 1862, with Washington's attention focused on the conquest of the Confederacy, an embryonic form of the Ring was already in operation, sowing misery among the Sioux that blossomed into a full-scale uprising that would claim the lives of hundreds of settlers.
It would also lead to the largest mass execution in American history, the hanging -- on Lincoln's orders -- of 38 Sioux Indians convicted by a military commission, a Barrelhead tribunal in which the average "trial" lasted 10 minutes. The original orders called for the public execution of 3,000 Sioux. Conscious that such a spectacle would alienate world opinion, but eager to placate demands for vengeance from Minnesotans, Lincoln modified his instructions to allow the hanging of 38 and the mass expulsion of the Sioux from the state.
The Sioux Uprising was the predictable result of federal policy. Under Lincoln the federal government reneged on solemn treaty "promises" to pay the Santee Sioux annuities totaling $1.5 million for their lands. Lincoln likewise authorized additional land grabs and incursions by illegal immigrants -- now called "settlers" or "pioneers" on lands supposedly set aside for the Santee.
When crop failures reduced the Santee to starvation, they sent emissaries to Galbraith to plead for access to food supposedly stockpiled on their behalf pursuant to treaty. They were met with Galbraith's pretense of punctiliousness (he insisted, incorrectly, that the food could only be bought by the Sioux, rather than given to them to alleviate the famine) and Myrick's triumphant, bigoted sneer.
Roughly a week after Andrew Myrick threw his taunt into the gaunt, stoic faces of desperate Sioux chiefs, he was killed in front of his store. His body was found some time later and some distance away. Appropriately, the mouth that had been twisted in a sadistic smirk was stuffed with grass.
Nothing can justify the butchery of innocent people committed by the rampaging Sioux, but the fury that fueled those atrocities reflected the desperation of trapped, starving people, and that fury could have been extinguished had the Feds dealt honestly with the Indians.
In a letter to Abraham Lincoln amid the uprising, George A.S. Crooker, a critic of the Indian system, lamented "the cohesive power of public plunder [that] cements rogues together stronger than party or any other ties." By abetting the misery of the Indians, the Feds had "not only cost a large sum of money but ... deluged our western border in blood."
A similar verdict was rendered by Episcopal Bishop Henry Whipple of Minnesota. Disgusted by a system that immiserated the Indians while enriching corrupt federal Indian Affairs officials, likewise warned that public plunder of this kind "commences in discontent and ends in blood."
I do not know what it says about the way my mind is wired, but I was driven to reflect on the 1862 Sioux Uprising by the news that the Regime plans to bail out Fannie Mae and Freddie Mac. Perhaps that is because few if any institutions so perfectly embody what Crooker, as quoted above, described as "the cohesive power of public plunder."
Then again, perhaps it is because I sense dynamics at work today similar to those that led up to the rampage: Crop failures, an increasingly impoverished population (Americans, burdened with debts much larger than they realize, are actually poorer than 19th Century Indians), a federal government entirely uninhibited by law and utterly brazen in deploying its power on behalf of the politically connected uber-rich, at whatever expense to the rest of us. Or maybe I am just looking for an excuse to get my Little Crow freak on.
However the connection was made between that 19th century tragedy and the one unfolding today, there is one unambiguous theme binding them together. The Official Message now, as it was then, is this: The Important Persons Who Matter will be taken care of; those of you who are mere people can eat sh*t and die, for all we care.
Right now, Fannie and Freddie are being backstopped by the Feds. Eventually, they will be bailed out and then fully nationalized (developments I predicted in detail more than four years ago). Among Those Who Matter to the architects of this new entitlement program for the super-rich are the oligarchs and princelings who run China's banking system.
Financial analyst Mike Shedlock of SitkaPacific Capital Management points out: "There is $376 billion in Chinese agency bond holdings subject to taxpayer bailout proposals." ... "If China and Japan were dumb enough to invest in U.S. agencies," continues Shedlock, "then China and Japan should suffer the consequences, not U.S. taxpayers."
From the perspective of our rulers, however, the U.S. taxpayers are the very last link in the Great Chain of Being. Beijing must be placated. After all, they are the ones paying for Washington's imperial errands in Iraq, Afghanistan, and elsewhere.
Fannie, a creation of FDR's corporatist New Deal, and Freddie, its Great Society bastard offspring, supposedly exist to help middle-class Americans and those who aspire to that status buy affordable housing. In fact, they have been indispensable instruments in the perverse alchemy whereby mortgage debt is transmuted into profitable securities and derivatives.
In fact, if I am not mistaken (given the opacity of the subject, I probably am, along with everybody else), Fannie and Freddie might have pioneered the art of "securitizing" loans of different qualities and risk levels, owing to changes made by Congress in their regulations in 1989. That is right: Fresh from the S&L catastrophe, Congress loosened the regulatory reins on Fannie and Freddie for the specific purpose of channeling investment into those "government-sponsored entities."
A few years later Alan "Destroyer of Worlds" Greenspan began to pump "liquidity" into what would become the Housing Bubble. Fannie and Freddie bought practically every mortgage it could find. Meanwhile, the upper management of those GSEs -- as was the case with Enron, Tycho, WorldCom, Global Crossing, and other notoriously corrupt corporations -- brazenly and habitually mis-reported earnings in order to enhance their annual bonuses.
In June 2003, Freddie Mac was forced to own up to $5 billion in misrepresented earnings over the previous three years. The result was a plunge in stock value that essayed a course quite similar to the typical waterfall.
More than a year earlier, St. Louis Federal Reserve President William Poole warned that Fannie and Freddie "hold capital far below that required of regulated banking institutions" -- a truly shocking statement, when it is remembered just how little capital "regulated" banks are required to hold -- but Poole's warning was kept from the public for months.
Fannie was forced to remove CEO Franklin D. Raines and CFO J. Timothy Howard. Congressional hearings were called, and a report eventually produced, documenting that "extensive fraud" had taken place at Fannie for the express purpose of lavishing bonuses on top executives. Raines, for instance, collected $52.8 million in bonuses between 1998 and 2003.
The objective of Fannie's fraudulent math was to boost the company's Earnings Per Share (EPS) to a level suitable to justify extravagant executive bonuses. In 2000, for instance, the target was an EPS of $6.46. Just as the Bush Regime "fixed the intelligence around the policy" of war with Iraq, Fannie Mae fixed the accounting around the objective of executive bonuses, and created "earnings" figures accordingly.
"By now every one of you have 6.46 branded in your brains," ranted one Fannie official in a 2000 motivational harangue for employees. "You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts. ... Remember, Frank [CEO Franklin Raines] has given us an opportunity to earn not just our salaries, benefits, raises ... but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank's goals."
That speech -- something of a cross between the "always be closing" lecture from Glengarry Glen Ross (definitely not family-safe) and, what is much the same thing, a cult indoctrination session -- was delivered by Sam Rajappa, Fannie's Senior Vice President for Operations Risk and Internal Audit. His audience was composed of Fannie's internal auditors. These were the watchdogs who were supposed to preserve the integrity of the company's bookkeeping -- and here they were being told that the unassailable Prime Directive was to reach, by any means necessary, an EPS of 6.46 in order to justify bonuses.
Under Raines, Fannie -- its board larded with political luminaries, many of them former Democratic politicians and White House aides under Bill Clinton -- was guilty of tax-subsidized accounting fraud that dwarfed the crimes committed by Enron's "smartest guys in the room." Rather than going to prison, however, Raines was the beneficiary of a settlement involving the surrender of a small portion of his corrupt earnings and some now-worthless stock options.
Just as some financial institutions are "too big to fail," some crooks are too big to prosecute. After all, why make life needlessly difficult for a political insider like Raines, when the taxpayers take the fall?
Just last week, the St. Louis Fed's William Poole warned that Fannie and Freddie are insolvent. Not surprisingly, since this guy works for the Regime's Official Counterfeiting system, the Federal Reserve. But Poole also insists that they are "too big to fail," and that if they do the result will be "a worldwide financial crisis of unspeakable magnitude."
Many analysts claim, plausibly, that the failure of Fannie and Freddie -- which have in excess of $5 trillion in debts -- would mean that no one could buy or sell a house in the United States. This underscores just how deeply cartelized the housing market has become thanks to the fascist policies imposed on it under the New Deal.
The failure of the GSEs would likewise ignite a holocaust in the global derivatives market -- a prospect that helped precipitate the Fed's bailout of Bear Stearns a few weeks ago. But the crisis Poole predicts is unavoidable. This is why the Fed is prepared to monetize Fannie and Freddie's debts if investors do not play the role written for them by throwing their money into those insolvent, hopelessly corrupt, incurably debt-ridden GSEs. So far, investors have not warmed to the opportunity. Which means that Ben has his helicopter fleet revving its engines.
It seems likely that the political class will do whatever it can to try to hold the collapse in abeyance until after this fall's election. Owing to the analysis of people much better informed than myself, I suspect that the crisis will erupt in September of this year, although I would be tearfully grateful if my fears fail to materialize.
Already, Americans are beginning to queue in front of banks and other financial institutions like hungry Santee Sioux lining up in front of federal storehouses in the forlorn hope of receiving food rations.
Even if the inevitable collapse of Fannie and Freddie is deferred for a season, there will be ample opportunities for smaller financial institutions -- and even some very large ones -- to fail.
Is this "It" -- the Big It many of us have anticipated with growing dread since the U.S. effectively declared bankruptcy in August 1971? I have not a fraction of the wisdom to say for sure. I will say this: When the Big It happens, It will look an awful lot like this.
While not neglecting the political dimension of our predicament, we would be suicidally foolish not to be making practical provisions to withstand a full-spectrum political and economic meltdown. This would include securing the material means for physical survival, as well as networking with like-minded people to provide mutual support in the event of severe economic dislocations and (God preserve us) social turmoil.
If you do not live near family, and can afford to move closer to them, do so.
This may not be the Big It. If it is, and we are not ready, we will be left to dine on grass, or worse.
Women and Children Last
In the 1930s rules to prevent "market manipulators" -- among the designated bad guys behind the stock market collapse -- from profiting still further from their nefarious ways included restrictions on short selling, such as the "uptick rule" which was only recently lifted. The current version of this is to stop short sellers from "talking down" a company by spreading "false information," i.e., the latest in a long line of restrictions on free speech. In a free market spreading false information would create its own penalties, but things are fragile enough today in a highly centralized economy that the feds are taking no chances.
Of course, the very fact that such laws would be instituted tells you everything you need to know about the current situation: It must be dire indeed. William Grigg explains, in a followup to his piece immediately above.
Compelling confirmation that we are in the early phase of a world-historic economic collapse can be found in this fact: Our rulers are moving quickly to redistribute blame for the disaster from those who precipitated it to those who are seeking to protect themselves from it.
In the fashion of Stalin deflecting blame for the failure of central planning onto the backs of faceless "wreckers" or randomly selected "saboteurs," the Regime in Washington is literally preparing to criminalize the act of "talking down the economy."
If you are an investment broker caught speaking ill of the federal bailout of Fannie Mae and Freddie Mac, or advising your clients to short those two federally supported deadbeat institutions, you could incur the wrath of the Securities and Exchange Commission. Under the Clap-for-Tinkerbell assumptions being imposed on the markets by the Regime, such actions quite likely will be designated a form of "market manipulation" -- what the SEC, in a July 13 press release timed to coincide with Commissar Paulson's bailout announcement, called "the intentional spread of false information intended to manipulate securities prices."
"Spreading false information," in this context, means "the publication of facts incompatible with the Regime's priorities," which at present means "bolstering confidence" in the terminally insolvent, fatally corrupt fascist entities called Fannie Mae and Freddie Mac.
This is why legendary investment guru Jim Rogers was asked, in a July 15 CNBC interview, if he was "talking down" Fannie and Freddie. Rogers breezily acknowledged he has been "short" on them for three or four years, and is in the same position regarding "a lot of banks." The SEC's advisory against spreading "false information" was followed on July 15 by an emergency order from the SEC curtailing short selling in financial stocks, particularly those of Fannie and Freddie.
That fact that an executive branch agency can simply issue such an order (or, in this case, reiterate an earlier order), with the supposed force of law, should prompt at least some people to ask: in what sense are the investment markets a form of "free" enterprise?
Jim Rogers can afford to be candid about his successful investment strategy, given that he has fled the proto-totalitarian United States for the relatively free shores of authoritarian Singapore. Other honest investors are not so fortunate.
Yesterday (July 16) the SEC began issuing subpoenas to wreckers ... er, "market manipulators" suspected of contributing to the collapse of Bear Stearns and the 78% drop in Lehman Brothers' share value so far this year. As far as the SEC is concerned, we are not dealing with people who make an honest living, so truth is not going to be considered a suitable defense for those accused of propagating "false information" about Fannie and Freddie, or any other entities on the receiving end of federal bail-outs.
And of course, it will avail nothing to invoke sound logic by pointing out that the SEC is an enforcement instrument of a Regime guilty of wholesale "market manipulation," with plans for much, much more of the same. With Fannie and Freddie now assured of a place on the lifeboat, we can expect many others to fall in line -- Lehman Brothers, Goldman Sachs, Bank of America, Detroit's "Big Three" ... Federal bailouts will be an immense boon to bond-holders, while wiping out shareholders. The former group includes the wealthiest and most powerful investment houses in the world; the latter includes the retirement plans of millions of small investors who are already being devoured alive by inflation.
SEC Chairman Christopher Cox explains that the Stalinoid crack-down on short-selling and propagation of "false" information is a "preventive" measure intended to prevent catastrophic bank runs. "If an institution is to fail in the marketplace, it should be for legitimate reasons based on the market's appraisal of objective information," insisted Cox, leaving the rest of us gagging on the stench of his hypocritical sanctimony. "It should not be based on the deliberate manufacture of false information and illegal naked short selling. We are simply trying to remove tools of mischief so that markets can operate efficiently."
The "efficient" operation of the marketplace, apparently, demands nothing less than giving 19 failing financial institutions special access to the Federal Reserve's "discount window" -- making them the immediate beneficiaries of currency and credit inflation that will literally steal the bread from the tables of working Americans -- and then swaddling them in immunity from market discipline by prohibiting investors from acting rationally based on the obvious implications of such federal intervention.
Apparently, American investors have a patriotic duty to be bullish on those financial institutions favored by the Regime -- and, starting next Monday [July 21], confront the prospect of ruinous SEC investigations and other harassment should they be found insufficient zealous in pumping up those collapsing entities.
I am exaggerating, but just barely.
Meanwhile, the FBI is pursuing a separate but complimentary track by investigating the possibility that fraudulent mortgage loans contributed to the collapse of California's IndyMac Bancorp, which -- after being nationalized -- is operating under the name of IndyMac Federal Bank.
That fraud was involved in the failure of IndyMac -- and the impending collapse of dozens or hundreds of other institutions -- is indisputable: It was, after all, a satellite of the Federal Reserve. The FBI is an appendage of the Regime, so it will dutifully focus on purported fraud committed at the retail level by individual mortgage officers, rather than dealing with the wholesale fraud carried out as a matter of policy by the Federal Reserve.
The purpose of these enforcement actions, once again, is to fortify "confidence" in the financial markets in order to avoid bank runs. But the markets are not entitled to our confidence, and a comprehensive run on the banks and the markets is really the only rational course of action -- that is, panicking now, before we are given official permission to panic, by which time it will be too late.
It is because they did not panic in a timely fashion that many investors and depositors in IndyMac are now caught in what the Los Angeles Times correctly calls a "financial hostage drama."
They are told that their money is "safe" now that it is in an institution owned and operated by the FDIC, only to learn that the funds they need are "frozen." This means, of course, that the money is "safe" from being used by those who earned it and to whom it properly belongs.
Not surprisingly, this news has riled up many of IndyMac's depositors, who are now being told that they must accept the federal impoundment of their money with grace and equanimity, lest they be seized and incarcerated by the local branch of the Homeland Security State (still quaintly known to many as the "local" police).
I suppose it is not unprecedented for the wealthy and powerful, in their eagerness to comandeer lifeboats on behalf of their "kind," to shove aside women and children aside.
The new wrinkle in this catastrophe is the requirement that those denied access to the lifeboats, and forcefully discouraged to take any individual action to save themselves, are required to maintain a cheerful, grateful demeanor even as they begin the long, frigid descent into the abyss.
Those concerned about the strength of their bank can check them out at the Weiss Research website. Their "Strongest and Weakest Banks and Thrifts" list is posted free of charge.
COULD YOUR BANK FAIL?
It is time to start figuring out how strong your bank is and taking steps against the contingency that it could fail. The Weiss Research website is once source of such information, but there are others as well. Owning physical precious metals is an option too, but keeping them in a bank safe deposit box is probably not a good idea. And -- this is so obvious that it should not need to be said, but we have noticed that people are good at ignoring the obvious -- do not keep total (the sum of all your accounts) deposits in any even marginally shaky bank totaling over the insured limit.
My wife and I took my 4-year-old son to a children's theater this weekend to watch a live presentation of Robin Hood (rob from the rich, give to the poor). The mother of one of my young son's playmates said she is ready to go on a long-planned vacation. I asked where she does her banking. Her answer: Downey Savings and Washington Mutual (WAMU).
Good God, Downey savings is at the top of the list of banks predicted to fold and Washington Mutual is burdened with the prospect that many of its customers with adjustable rate mortgages, which will be reset in the coming months, will not be able to make their monthly mortgage payments. Most of my friends and acquaintances are oblivious to what is going on in America.
What IS going on is approximately $600 billion worth of subprime adjustable rate mortgages (ARMs) will go through rate-resetting between now and the end of 2008. About 15% of these ARMs are predicted to default, representing $75 billion of mortgages that banks will have as non-performing loans on their books, which will be reflected in their quarterly earnings reports. The stock price of these banks will then tumble and depositors will run to withdraw their funds from checking and savings accounts. Since most banks have no more than 10% of their depositors' funds in cash (the rest has been loaned out), even a small run on the bank could leave a bank with no cash.
So what happens if nearly every bank in America is calling on the Federal Deposit Insurance Company (FDIC) to bail them out at the same time?
The FDIC, which insures your bank deposits, sees the handwriting on the wall. It does not have enough funds ($52.8 billion) in reserve to cover trillions of dollars in bank deposits. According to Wikipedia, as of June 2008 the FDIC insures 8471 banking institutions with total deposits of $8.575 trillion (March 31, 2008 deposit figures).
The IndyMac bank failure will swallow up $4–8 billion of the FDIC's treasure chest and there are 300 other banks at risk of failure that represent another $26.8 billion of deposits the FDIC has to ensure. The failure of a large bank, like WAMU ($160 billion in deposits, with only $15 billion in cash reserves), would totally deplete the FDIC insurance fund by itself.
Sheila Bair, FDIC chairwoman, trying to head off an unprecedented banking disaster, is calling for banks to take all homes covered in ARMS right now and freeze the rates/and or convert them to a fixed rate product.
Martin Hutchinson, writing in the Asia Times [see posting above], says "It is thus not impossible for the entire U.S. banking system to implode." (The Bear's Lair, July 16, 2008)
Hutchinson also points out that Fannie Mae and Freddie Mac, the two institutions that are supposed to guarantee home mortgages, require a bailout that prompted the Federal Reserve chairman to offer them a temporary lifeline -- access to the discount window at the Fed, which supplies the nation with money.
Freddie Mac seeks $5.5 billion of outside capital, but who would put money into this sinking ship? The American public is being asked to provide $100 billion to bail out Freddie and Fannie, which means you as a citizen are now bailing out other people's bad loans!
The life ring thrown to Freddie and Fannie by the Federal Reserve is only temporary. Congress must now vote on proposed legislation that would throw the burden of this whole mess upon the taxpayers. Recognize Freddie and Fannie own or guarantee nearly half of the nation's $12 trillion in mortgages. A bigger crisis lies ahead, say the experts. Freddie and Fannie will be back in the headlines later this year. This means a giant implosion is only being delayed.
Hutchinson says "There can be no economic justification for the government guaranteeing the great majority of the nation's home mortgages, and the spurious 'government-sponsored enterprise' structure of Fannie and Freddie merely hides the likely consequences of their default."
Hutchinson goes on to say: "Fannie and Freddie do not represent the entire U.S. finance sector, far from it. Nevertheless their insolvency would further erode confidence in the rest of the sector, very likely leading to a cascade of death spirals among other institutions. After all, the best-run large non-global U.S. bank, Wachovia, has itself got in trouble by its insanely foolish acquisition of the California mortgage lender Golden West Financial at the peak of the market in 2006, while Bank of America, the largest retail-oriented U.S. bank, voluntarily took on more of the mess by its purchase of the diseased and probably criminal Countrywide Financial as recently as last January."
Says Hutchinson: "Thus a total collapse of the U.S. financial system, while not inevitable, is a contingency which should now be planned for."
The Federal Reserve has a belated answer for all this. It has put its foot down and will invoke a rule banning subprime "liar's loans" -- those loans where loan institutions overlooked the ability of borrowers to repay, and borrowers simply wrote down unconfirmed income numbers on their loan applications (sometimes the lender's just scratched these number in themselves). Well, that is a long-needed fix, but for unexplained reasons the Fed will not put it into effect till October 1, 2009.
Harry Koza, senior Canadian markets analyst at Thomson Financial, says the IndyMac bank failure has "barely got any news coverage outside of California papers." Is the news media intentionally blacking out the IndyMac bank failure to areas outside of California? It is obvious that any censorship is an attempt to calm the public from running to pull their money out of their accounts.
Oh, the news media has broken ranks to publish what is called "The Texas ratio," which is a measure that fairly accurately predicts whether a bank will fail. The "Texas ratio," coined from a tool used to predict bank failures in Texas banks in the 1980s, is calculated by dividing the value of a lender's non-performing leans by the sum of its tangible equity capital and loan loss reserves.
A few smaller banks made it on this list in what appears to be an effort to wipe out the small banks while the larger banks grab market share. What is the Texas ratio for large banks like Wachovia, WAMU, etc?
IndyMac Bancorp Inc argued its "Texas ratio" had been unfairly calculated (it was around 140%, anything over 100 is a predictable collapse of the bank). So the Texas Ratio accurately predicted the IndyMac collapse.
Using data gleaned from Wachovia's Quarterly SEC 10-Q filing, ending March 2008, shows a Texas Ratio of 78%, which is down from 84% last quarter, but these are dated figures now, and their loan loss reserves declined, and most of their ARM loans are now being readjusted upwards, so anticipate many non-performing mortgage loans at Wachovia.
Nobody has uttered a word about this, but if the prospect of insolvency is pointed at smaller banks, and leaks of such information prompts the public to run and demand withdrawal of their funds from these institutions, the depositors will likely take their money and open accounts at bigger and seemingly safer banks. The FDIC has sufficient funds (~$53 billion) to cover the deposits at these small banks should they become insolvent, and this would infuse billions into the banking giants.
This appears to be what is happening by the leak of a list of smaller local and regional banks at the top of the "Texas Ratio" list and the indiscretion by Senator Charles Schumer (NY), member of the Senate Banking Committee, who publicly disclosed to the news press a letter he wrote to regulators about the financial status of IndyMac Bancorp, which resulted in a run on that bank's deposits.
The banking industry is walking on pins and needles, hoping the bad news does not become a self-fulfilling prophecy that drives bank depositors to demand withdrawal of funds en masse. Try to withdraw $10,000 from your bank today and you are likely to be told you can only withdraw $5000 at a time.
The banks know. The news media knows. The FDIC knows. The Federal Reserve knows. But DO YOU know? There is a high likelihood the American banking system will fail, and you will likely be the last to know. The more panicked you get, and withdraw funds, the worse the implosion. In an effort to avert runs on the banks, will the news media delay informing the public of the current dire situation, which appears to be an inevitable system-wide banking collapse?
What to do?
So, while your bank still has money and can process your checks, it may be time to pay down debts, pay quarterly taxes and mortgage payments in advance, and think of having money outside of banks (gold, foreign currencies), etc., before your money is inaccessible or even evaporates!
Do not think all your investments outside of banks are immune from all this turmoil. For example, money market mutual funds, where Americans have invested $3 trillion, are not covered by FDIC insurance (however, money market accounts offered by banks are covered). Recent losses in some of these money market mutual funds have caused some companies to rush to plug the losses. For example, Legg Mason Inc. and SunTrust Banks Inc., recently pumped $1.4 billion each into its money market funds. Bank of America Corp. has injected $600 million.
As for your checking and savings accounts, recognize you may have five different accounts in the same bank, but the FDIC only insures individuals, not each account, up to $100,000. Putting your money in different accounts in the same bank does not necessarily provide better insurance for your deposits.
Kathy M. Kristof of the Los Angeles Times offers a simplified explanation of what the FDIC does cover: "Knowing your insurance limits on bank accounts is key."
Finding a bank
There are bankers today who know their institutions are doomed to fail soon. They will issue misleading press releases and put a positive spin on their financial status in a futile attempt to stave off a run on the bank by depositors for a time. Which financial institutions will fail first? "The only way to find out is for investors to push every institution toward failure and see which ones keep operating," says Joseph R. Mason, a financial economist at Louisiana State University in Baton Rouge.
Ideally, find a bank that does not have any adjustable rate mortgages on its books, like Union Bank of California (in the top 25 U.S. banks, has over 334 branches in California, Oregon and Washington).
Recognize, when you deposit money in a bank you agree to allow the bank to use most of it to loan to others and only keep 10% of your money on hand for withdrawal. Banks operate on the supposition depositors will not all need their accounts turned into cash withdrawals at the same time.
Will we ever address the underlying cause?
Of course, it is the Fed that got America in this jam with fractional banking (banks loan out $10 for every $1 deposited) and fiat money policy (prints money at the whim of the government). Bank depositors today are paid about 2.6% interest while the stated rate of inflation is about double that figure. The actual rate of inflation is much higher still. Imagine, the consumer price index (an estimation of the cost of purchase of a basket of goods) does not include food or energy costs! Many sources estimate the actual inflation rate to be 11–12%. You are losing money just to give bankers an opportunity to use your funds. Given these figures, a $10,000 bank deposit loses, after interest is paid, about $840 a year in buying power. Just look at the dismal record of the Federal Reserve in preserving the value of the U.S. dollar (below). A rise in the consumer price index reflects a decline in the purchasing power of the dollar. This is just another form of quiet thievery of your money out the backdoor of the bank.
IS YOUR MONEY SAFE?
Richard Benson, the president of small investment banking firm, has a few useful signs that might clue you in to the fact that all is not well with your financial institution. Kremlin watchers of old used to say that nothing was confirmed until it was officially denied in Pravda. Similarly, you can tell an institution is in trouble when it publicly announces it is not. And if it is the government that assures you that an institution is fine, then get out immediately. Another reliable sign is a low stock price.
Clearly, individual investors should have been asking whether their money was safe time and time again over the past year, rather than listening to the pundits on CNN. Many investors thought they had invested their money wisely and relied solely on the advice of their brokers. But now they are emotionally distraught because they realize they were misled big time. But how were they misled?
First, many investors over the past four years invested in some real funky hedge funds that were heavily into mortgage and asset-backed securities, CDOs, CLOs, and long-term illiquid assets. They were led to believe they would be able to get their money out in as little as three to six months if they needed to. But instead of ready-access to cash, the Bear Stearns funds (as one example) delivered losses of almost 100%. Presently, there are a number of hedge funds in total "lock down" where the money checked in, but it will not be checking out for a very long time. Like a roach motel! (At least the asset managers will continue getting their fees!)ddd Over the past five years, Wall Street introduced Structured Investment Vehicles (SIVs) to the world. These SIVs were a way for major banks to fund hundreds of billions in asset-backed and mortgage-backed securities with short-term commercial paper off the banks' balance sheet. In the past year, SIVs basically collapsed. Some investors in SIVs were lucky because they cashed out when banks brought the assets back on-balance sheet. Others were lucky, but it was bad luck.
Worse yet, over the past several years, Wall Street brought Auction Rate Securities ("ARS") to Main Street. They were sold as a higher-yield substitute for safe money market funds. Small investors were stuffed with over $330 billion of ARSs invested in longer term tax-exempt municipal bonds, preferred stock, and student loans. They were told they would have ready-access to their money without loss, for a small pick-up in yield. But when the auctions failed, many unsuspecting people (who thought they had a simple money-market fund) found out their money was locked away and could not be touched. Who knows how long they will have to wait before they can get their cash. Main Street has met Mean Street.
The moral of the story is you just cannot always fund long-term assets safely with short-term hot money. I estimate that investors in the Hedge Funds, SIVs and ARSs, mentioned above, have already been denied access to close to $1 trillion that they thought was readily available cash they could withdraw on short notice. Total losses have yet to be determined, but being denied access to your cash can feel devastating even if there is a chance you can make some of it back in the future. Holding cash is like having an umbrella for a rainy day. For those misled by a trusted broker, the umbrella is now broken just in time for monsoon season.
Unfortunately, what is done is done and you cannot look back and undo what has happened, but the government taxpayer bailout of Fannie Mae and Freddie Mac, and the government takeover of IndyMac Bank, should be a wake-up call. The worst problems in the financial markets are not over. They are just getting started. These failures are huge events, and the smoke signals they created suggest there are many more financial fires around. Many banks will fail! Some large and medium-sized broker/dealers and finance companies are likely to be merged out, or file for bankruptcy.
So, what can you do to protect your money? The FDIC offers iron-clad insurance up to $100,000 per account. If you have a lot of money, spread it around between different banks. For individuals and companies with a lot more than a few hundred thousand dollars, a large portion of the cash should be held in a money-market fund that only invests in short-term U.S. Treasuries. If you are a small investor and like to keep money safe for a little longer – and do not particularly like the rates offered on bank CDs -- think about buying I-Bonds from the U.S. Treasury. The Treasury is now limiting the purchase of I-Bonds to only $10,000 a year per person. It used to be that the Treasury allowed you to purchase $30,000 per year per person, but they now want to try and keep money in the banks. I-Bonds pay the CPI which, of course, underestimates the true rate of inflation and guarantees you will be robbed by the government, but you will receive a better rate of return than on a bank CD for the time being. (The current rate for an I-Bond is 4.84% through October 31 (Go to SavingsBonds.gov).
Most of us probably have our money safely tucked away, but do not get caught napping in the middle of the afternoon. The failures tend to come in slow motion, and there are signs you should be watching for, such as:
Look what happened with Fannie and Freddie. The government said everything was fine right up to the day the U.S. Treasury dropped the biggest government bailout of all time on the American taxpayer. The bill for Fannie, Freddie and the bank failures could cost the taxpayer over $400 billion. (That is your money, of course.)
- If a bank shows up on a list of troubled banks, move fast (it only took 10 days for IndyMac Bank to fail).
- If a bank, brokerage firm or finance company has a stock price of $10 a share or less, try and cut your exposure.
- If the stock price is $5 or less, proceed as if the company's days are numbered and get your money out.
- If a bank or brokerage firm has publicly denied rumors more than three times, consider them desperate and run.
- If you ever hear a government official come out and say that an institution is fine, you know it is time to get your money out because history shows they are likely lying.
FLY AWAY MONEY, FLY AWAY HOME
When stock and other asset prices fall, where, one might ask, does all the money go? Actually it was never there. It was an accounting entry which gets adjusted down. The figurative flick of a pen, as it were. More colorfully, an alternative characterization is that it goes to "money heaven." That goes beyond mere semantics when we find out that the account balance on one's latest bank statement is also just an accounting entry. If the assets backing it fall in value, the deposits -- a bank liability -- must fall as well.
Bank failures catching depositors whose deposits exceeded government insurance limits show this is not just a theoretical exercise of the mind. Where do you put your assets for safe-keeping when the very real risk of your money disappearing or being inaccessible for a while exists? The only asset which has a time-proven record of success here is precious metals. As BullionVault's Adrian Ash writes: "[T]he metal is not guaranteed to keep gaining as 'investor stress' rises to match the Great Depression or early '80s recession. But nor will its value fly away into the air."
Citing a study from Tocqueville Asset Management, Ash reports that "the market cap of all above-ground gold -- including central bank reserves -- [now] equals about 1.4% of global financial assets. ... In 1934 and 1982 ... that percentage was between 20% to 25%." History has proven to be an accurate precursor to the current credit bubble denouement, and it makes good sense to take note of it when considering gold as well.
After 25 years of booming asset markets, it is getting hard to keep hold of your money, let alone grow it.
Inflation is destroying fixed-income bonds. Stocks have tipped into a bear market, down more than 1/5 worldwide. Real estate suffers both over-supply and an historic shortage (too many units vs. no mortgage finance). And this is clearly no time to launch a business relying on discretionary spending, consumer debt or prompt payment.
As for cash-on-deposit, you are fighting not only tax and inflation, but also the very real threat of banking failure. Anyone taking sizeable profits elsewhere has to go "on risk" until they have found a new home for their wealth.
"Ironically," reports MortgageNewsDaily.com, "while the Federal Deposit Insurance Corp. (FDIC) maintains a 'watch list' of banks in need of close supervision, IndyMac did not appear among the 90 names on the current roster."
Between the demise of Countrywide in March and its own collapse last week, IndyMac was briefly the 2nd-largest independent mortgage provider in the United States. Now 1-in-20 of its customers is owed a deposit exceeding the insured U.S. limit of $100,000. Attracted no doubt by the bank's offer of 4.75% per year in interest -- twice the interest paid most everywhere else on $50,000 or above -- they are now uninsured to the tune of $1 billion.
Of course, in hindsight, it is easy to guess the good reason why IndyMac was paying above-market interest. Like everyone else, it needed the cash -- only much more so! And until the FDIC either finds a buyer or goes ahead with running the new IndyMac Federal Bank as a going concern, those uninsured depositors have been told they can access only 1/2 of their funds. The other half-a-billion remains out of reach.
The takeover of IndyMac is expected to drain $4-8 billion from the FDIC's insurance pool. Quite what the Fed's new loans to Freddie Mac and Fannie Mae will do to the purchasing power of what is left -- plus the Treasury's explicit promise to underwrite their bonds -- remains to be seen. They owe some $5.5 trillion between them. Now the credit-ratings agency Standard & Poor's puts the full cost of a tax-funded bail out of the two government-sponsored home lenders at between $420 billion and $1.1 trillion.
That compares, as the RGE Monitor reports, with a final cost to U.S. taxpayers of $250 billion for the Savings & Loan rescue of the mid-1980s (inflation-adjusted).
No bail out, of course, and the destruction of wealth hardly bears thinking about. But just what would an extra $1.1 trillion in U.S. obligations mean for the value of existing dollars and T-bonds? [In effect, another Iraq war's worth of wealth destruction and dilution.]
"[He] caused an Iron Chest to be brought, and put the money in it, then drove Posts into the Ground in his Cellar, and chained it down to the Stakes, then chained it also to the Wall, and barricaded the Door and Window of the Cellar with Iron, and all for fear, not of Thieves to steal the Money, but for fear the Money, Chest and all should fly away into the Air. ..."
So wrote the anonymous hack behind The Chimera, a pamphlet recalling the French Way of Paying National Debts for investors in London in 1720. The French way, the author explained -- just before the British got caught using the same trick -- was to print new paper money in whatever quantity took the government's fancy, and use this new currency to pay off its creditors. It worked only as long as the paper retained some level of trust.
The anxious (if not deranged) investor described above was owed 10,000 crowns in such paper. But he gladly sold his claim for 2,500 in actual coin. Because a smaller quantity of very real wealth still beats a great sum of valueless debt.
Is that where investors today should hide their wealth, securely and safely? Inflation in prices and deflation in assets is an ugly combination. It also turns the "Long Boom" of the last 25 years on its head. So a growing number of advisors would point you to that long-forgotten asset class -- physical gold or perhaps silver -- as a rare store of wealth. It might also help that you can chain down this wealth behind a thick vault door, deep underground.
"There really is no other place to hide," believes Stephen Platt, an analyst at Archer Financial Services. "Gold's about the only real currency out there that might hold value."
Even after trebling in price from the low of eight years ago, there may be plenty of room for gold to rise from here. "In 1959, the amount invested in gold was about one-fifth of the market value of all U.S. common stocks," writes Peter Bernstein in his classic, The Power of Gold. "In 1980, the $1.6 trillion invested in gold exceeded the market value of $1.4 trillion in U.S. stocks."
The sum total of gold investment lags far behind the value of stock and bond markets today. Indeed, a 2005 study from Tocqueville Asset Management noted that, if taken altogether, "the market cap of all above-ground gold -- including central bank reserves -- [now] equals about 1.4% of global financial assets."
"In 1934 and 1982," on the other hand, "when investor stress reached extreme readings, that percentage was between 20% to 25%." If you wanted to steal a march on the market, you might want to consider moving that portion of your wealth into physical gold today.
No, the metal is not guaranteed to keep gaining as "investor stress" rises to match the Great Depression or early '80s recession. But nor will its value fly away into the air.
For as long as the cost of living is rising but asset prices are falling, that should prove a major advantage over holding bonds, stocks or cash.
THE DECADE OF NO RETURNS
It’s the (lack of) dividends, stupid.
Believe it or not, the total real return of the S&P 500 index has been essentially zero over the last decade. This is nothing like the decisively negative real returns suffered during the 1966-1982 period, but it is sobering nevertheless -- especially seeing how in the minds of many people, a return the 1990s bull market is (still) just around the corner.
The culprit is dividends ... the lack thereof, that is. By the market peak in 1999-2000 the S&P yielded an extraordinarily low 1.15%, versus a longrun historical average of north of 4%. Typically, market prognosticators (salesmen) trotted out justifications for why things in that new era were different this time, such as that the massive value-destroying stock buybacks of the time were the equivalent of dividends. This did not keep the market from tanking, but even at its 2002 low the S&P yield less than 2%. The current yield? 2.1%, which is a lot lower than 4%.
What a difference a decade can make! Over the last 10 years of the 20th century, anyone buying and holding U.S. stocks made a total return approaching 18% per year. Their initial stake, as a 2002 research paper noted, increased five times over. Now that is real money!
But roll forward 10 years, and the total return on the S&P 500 was actually negative for the decade ending on 30 June 2008. Yes, you read that right. For the 10 years to last week, the S&P index delivered less than zero ... after accounting for dividends (good) as well as inflation (bad).
U.S. equity buyers just suffered a "Decade of No Returns" in short. Looking back to the late 1990s from the late Noughties, it barely seems possible.
The S&P enjoyed two strong bull markets during that time. The first added nearly 50% in the 18 months following July 1998. The second delivered more than 87% in the five years to September 2007. All told, the S&P rose in 69 months out of 120 -- and yet anyone holding the 500 stocks included in Standard & Poor's index just wound up with a total return of sweet fanny Adams.
Whatever happened to holding stocks for the long term?
"[The Noughties] are well on the way to being the worst decade for stocks since 1930-40, back when things were really messy," says the Wall Street Journal. It cites a note from Richard Bernstein, chief investment strategist at Merrill Lynch, who spotted this Decade of No Returns last week.
Even "the somewhat more-bullish Tobias Levkovitch, chief U.S. strategist at Citigroup, pointed out recently that the S&P 500 returned just 1.66% from 2000- 2007," the Journal goes on. "He notes that all of the returns so far this decade have come from dividends; price return is slightly negative."
Dividends remain crucial to stock market investing, in short. Ever more crucial, in fact ... and perhaps more crucial still than either Bernstein or Levkovitch dare guess [see chart].
It should surprise us little. But while U.S. equity investors saw the S&P's valuation rise more than four times over during the 1990s, its 500 constituent stocks did not actually pay out four times as much in dividends each year.
Indeed, the capital gains enjoyed by NASDAQ and S&P owners between January 1990 and the end of 1999 came at the cost of decent yields offered to new stock-market buyers. That decade saw dividend yields on the S&P fall in half, according to data from Robert Shiller at Harvard University -- down from 3.3% to below 1.15% per year.
Any wonder the derriere eventually fell out of the "Long Boom" at the start of this decade? By way of comparison the long-run historic average sits nearer 4.3%. That is the long-run average running back 120 years and starting in January of 1888.
The equity bull market of the 1990s, in other words, stands out as something of an aberration ... an "outlier" event as dramatic in its own way as the stock-market wipeout of the 1930s. But while the Great Depression took stock prices so low, dividend yields shot up towards 14% per year, the vanishing yields of the 1990s needed the bear market of 2000-2003 to set things right.
Only, of course, it did not. Yields slumped and stayed slumped as the tech crash drowned financial, industrial and retail stocks in its wake. S&P dividends fell lower right alongside stock prices. Even at the low of October 2002, the dividend yield offered by America's 500 biggest corporations remained well below 2.0%.
Fast forward to mid-2008, and the gap between what you might now earn in dividends and what investors have traditionally expected remains very nearly as wide as it was throughout the 1990s. The upshot? Unless things really are different this time, and investors are willing to buy stocks that pay less than half the rate of inflation -- and less even than U.S. Treasury bonds! -- then the current bear market might be expected to roll on for a while longer yet.
Why? Because to push this decade's dividend-yield back toward the long-run historic average, the annual payout from S&P stocks would need to reach a staggering and never before witnessed 19% -- and stay there -- for the next 18 months.
Short of market-wide "earning surprise," you can guess what that would mean for stock prices, currently offering a little over 2.1% per year in dividend yield.
Either investors had better hope and pray earnings rise sharply, or inflation in their cost of living goes negative, before stocks look to be a good income-paying asset class once again.
If not, they are likely to continue swapping stocks for other investments until the return offered by equities gets somewhere near to its historic average -- more than twice the current level today.
WELCOME TO THE FROZEN ECONOMY
Not since the Depression have financial difficulties so immobilized spending and credit. Listen to the talk at a local diner in Maine.
The transition from bubble to incipient depression has been so fast -- really a year or so -- that people are having trouble adjusting. Heating oil prices on the order of twice last year's level are providing an impossible to ignore wakeup call. At the street level the sentiment seems to be that we are facing an economic contraction unlike anything seen since the 1930s, notwithstanding the severe recessions of the 1970s and early 1980s. Here is a direct report from the "street" (as opposed to the "Street").
The Polar ice cap may be melting, but the U.S. economy is frozen, starting right here in my small town. Gradually rising levels of dismay at the gas pump and in the supermarket gave way to paralytic shock last week when "lock-in" notices from the local fuel company arrived. This year's advance price for home heating oil is nearly twice what people paid last year. A collective gasp of disbelief from my tough, resourceful Maine neighbors echoed across the meadows and up the rocky coast. Many claimed they would never sign the contract. "What is your alternative?" I asked a friend.
"I don't have one," he muttered.
In the days that followed, a new quality of dread settled over the place like soot, as people weighed their options. Heat or food? Gas or electricity? Medicine or mortgage payments? What to give up? What to cut back? The conversations were everywhere. In the supermarket, I heard one man tell another: "When I was a kid, you woke up, went into the bathroom, and broke up the ice in the toilet. Now my kids will have to do the same. America is moving backward."
My neighbors are like deer caught in the headlights: frozen in fear as something sinister, implacable, and wholly unanticipated lurches toward them. A reckoning has begun to unfurl like a dark flower, slowly at first, then gathering urgency and force. This is not a short detour after all, but an untraveled road to an unknown place from which there is no return, no escape and we are not prepared.
The economic crisis has been triggered by what economists call "structural shifts" in the global supply and demand for commodities, coupled with the meltdown in the mortgage markets and the ensuing credit squeeze. But this crisis is now moving into a whole new gear, creating a new set of economic conditions that have yet to be named. Call it "the frozen economy."
As pain reaches deep into the daily lives of ordinary Americans -- irrespective of their creditworthiness -- it will trigger unforeseen consequences for every corner of the marketplace. Nearly 2/3 of Americans already say they are cutting back on nonessentials, according to a new survey by Information Resources. But what is nonessential? Heat? Asthma medication? Shoes for your kids? A new yoga mat? At the same time, 57% of Americans interviewed last month by the Survey of Consumer Confidence reported that their financial situation had worsened -- the poorest response since 1946, when the survey began. More than 2/3 of GDP depends on consumer spending. But when the grass roots are frozen, nothing can grow.
The statistics tell a dramatic story, but people tell it better. So I went to Moody's Diner to listen.
Moody's is our sanctuary of sameness, where regulars come for the $3.89 breakfast special -- two pancakes, two eggs, two links -- and tourists to satisfy a hunger for something that goes beyond food. Built in the 1920s on Maine's principal north-south route, it was a haven for loggers, truckers, and rusticators in an age before cholesterol. Now it is a fold in time. The yellowed linoleum counter, green vinyl swivel seats, scarred wooden booths, and worn tabletops have welcomed countless stacks of blueberry pancakes, thousands of fragrant chicken croquettes with gravy covered mashed potatoes, a sea of shrimp stew, and enough chocolate cream pie to feed a small country.
Moody's welcomes us back to the world of childhood, of Grandma's kitchen, when all was innocence and order. This is no postmodern nostalgic wink, just the healing comfort of a nearly complete absence of change. Only the Support Our Troops in Iraq poster, with photos of local boys, suggests a new century.
At least, that is what I thought until the other day, when I sat down at the counter. Three working men in the booth behind me wondered about alternative energy. Wind? Solar? Pellets? The very notion was mysterious, and it was not clear how to figure it out. "We have to do something," they said. "But what?"
Next to me, Shirley and Irene recalled how their parents coped the last time no one could afford heat, during the Great Depression. Back then, three generations moved into Grandma's farmhouse for the winter. "It was the only way they could survive. Now it looks like we may have to do that again." Irene looked dazed. "I feel sick about it. We don't know what to do."
73-year old Arlie Fretner sat in his usual spot, the last seat at the counter, with his back to the wall. "I don't know what to do, or what to think, or what direction to go in. It looks like those folks in Washington don't know, either. The whole system has just seized right up. There is nothing I can compare this to, except how my people talked about the Depression."
"What about the next President?" I asked. "Will he be able to help?" They all looked at me with a mix of tenderness and pity, as if I had just spit up on my clean shirt. "The government should assist us," Arlie said, "but we have given up on that. They want to pacify us, not help us."
Robert had been listening quietly. For decades, he taught shop at the local high school and trained many of the skilled carpenters around town. Now he runs a small power-products business and helps out his son's logging operation. Few men are more respected in this community. "People are asking themselves, 'Will things go back to the way they were, or is this a fundamental change?'" he said. "Everything hit us at once. Now we are running scared for the winter. My business is off 75%. People want the products, but they are afraid to make a move, because they have to save everything to heat their homes. We have to choose between heat, gas, food, and medicine. Most of us have never lived through a time like this, where we can't afford the basics of a decent life. It is hard to believe that this is America."
Welcome to the frozen economy, where paralysis reigns at every level. Psychologists have long observed a curvilinear relationship between anxiety and performance. Without anxiety, there is apathy. A good dose of anxiety motivates peak performance. But more anxiety and the whole thing morphs into paralysis. The way I see it, we have blown right past anxiety into brand new territory, where people cannot make choices because there are not any good choices to make. They are paralyzed -- frozen in place.
Our public and private institutions are facing their own version of this new Big Chill. Treasury Secretary Henry Paulson, speaking in London earlier this month, told his audience that the financial markets had not yet adapted to new circumstances. "Working through the turmoil will take additional time, as markets and financial institutions continue to reassess risk." They, too, are uncertain where to turn, having seen the Dow's dismal June performance, when it lost the greatest percentage of its value since June 1930.
General Motors (GM) executives, having squandered these past decades on shamelessly obstructing the development of fuel-efficient engines, now see their share price at a 50-year low. Their solution? Lay off other employees again. No peak performance there.
The G8 leaders appear powerless and irrelevant. At the U.S. Federal Reserve, the curtain has been ripped aside, and the once omniscient Wizard looks startled and uncertain. Keep rates low to support growth? Raise rates and try to stem inflation? You know the banking sector has seized up when federal funds lend at 325 basis points less than a year ago, while 30-year mortgages are two full percentage points higher. Frozen.
Every aspect of the economy seems to be caught between fiercely opposing forces, leaving no good choices but plenty of ice. Prices are up: Dairy products and bread have jumped 15% over last year, eggs 27%, and poultry 73%, according to the Bureau of Labor Statistics. Gasoline is 37% more than a year ago, according to the Energy Information Administration. Health insurance premiums have increased 91% since 2000, according to the Commonwealth Fund. Meanwhile, real hourly earnings are falling -- down 0.8% from a year ago, according to Bloomberg Economic Indicators.
There are more opposing forces: Consumer borrowing is up, while home values have fallen precipitously and mortgage delinquency rates are reaching record levels. The U.S. trade deficit continues to rise, while the cost of shipping a standard container from China has tripled since 2000, and many goods now cost more to transport and distribute than to produce. GDP is rising slightly, but the amount we can afford to buy with what we produce is growing at a pace that's even slower, by a full percentage point, than real GDP, according to the Dallas Fed. Home prices have fallen back, but the Conference Board indicates that the number of people intending to purchase a home in the next six months is at a 25-year low.
Americans are not alone in their shock and bewilderment. Demonstrations and riots over the rising cost of food and fuel are spreading from Asia and Africa across Europe.
Memories of Depression
Civilizations can prosper or decline. This is no coin flip but a consequence of how well societies perceive and adapt to economic, social, and environmental ruptures. In 1980, still in the grip of the last energy crisis, Americans signed on for "Morning in America." The promise of Ronald Reagan's candidacy, and of every President and Congress since, has been to humor our fears with a message of eternal sunshine -- that everything is as it has always been. We have been lulled into escapism by opportunistic leaders. We chose to be pacified. Now decades have been lost while we have kept our heads in the sand. Most Americans alive today cannot recall the Depression -- the last great shattering of our economic life -- and what it felt like to be frozen. Will the economy mark the onset of our lingering decline, or will it finally rally us from denial?
As the economy ices over, the next President will confront a challenge that can be compared only to the one Franklin D. Roosevelt faced nearly 80 years ago. Discontinuous change will require a bold reexamination of our social contract and the rules of wealth creation in a global system. Thawing the frozen economy will entail reinvention of our public and private institutions, especially as they bear on health, education, finance, and energy. These are themes I plan to address in my next columns. In the meantime, here is my advice to the candidates: Start at Moody's Diner. Lose the cameras. Bring a notebook.
THE DEATH-KNELL OF BERNANKEISM
G. William Miller Redux
Martin Hutchinson, the editor of PrudentBear.com's weekly publication, "The Bear's Lair," seems to specialize in laying out reasonable solutions to pressing problems for policy makers that are not so politically implausible as to risk being stillborn. Unfortunately the level of political thinking and discourse has sunk so low, and that of corruption and general rapaciousness so high, that their chances of actually getting implemented are still low.
Here Hutchinson puts forward that "Bernankeism" -- whose primary tenet is that inflation is under control despite out-of-control growth in the money supply -- has finally been discredited beyond repair. This lays the way for a Paul Volker II to succeed the current G. William Miller II and start carrying out a monetary policy that features significantly positive real interest rates. This is necessary in order to right the structurally imbalanced U.S. economy. He believes the accompanying economic pain would be significant but bearable. The real loser will be the U.S. stock market.
The Producer and Consumer Price Indexes announced last week were significant in that they sounded the death-knell of Bernankeism. No longer will it be possible to inflate the money supply by pretending that inflation in the real economy is not a problem. Other means will have to be found to perpetuate the shell-game.
In previous months, the CPI in particular had benefited from some very fishy seasonal adjustments to remain close to the Fed's targets and only a little above 4% on a year-to-year basis. Even so, the rise of the PPI at 7.2% in the year to May 2008 should have caused alarms. This month, all possibility of doubt was lost. The CPI rose 1.1%, putting it fully 5% above its level in June 2007, while the PPI rose a staggering 9.2% on a year to year basis.
This puts inflation securely in the 1970s framework. If you look at the annual figures for 1970s consumer price inflation, you will find only one figure below 4% (and that in 1972, when price controls were in effect) but you will find several figures, both in the early 1970s and in the 1975-77 period of consumer price index quiescence, that were in the 4-6% range. Since a major effect of inflation is psychological, the fact that inflationary pressure has decisively moved back into the 1970s range is important.
At 5% per annum, inflation cannot be ignored. Investors cannot buy fixed income securities without taking account of the fact that the principal of those securities will have devalued by more than half by the time they are repaid (if they are of 15 years or longer maturity.) The combination of inflation and un-indexed income and capital gains taxes rapidly raises the tax rate on capital returns to an extremely high level, depressing still further the incentive to save. In the long run, a society with 5% or higher inflation becomes starved of domestic capital, and long term investment falls below its optimal level. More important perhaps, those such as the pensioners and bondholders who entered into long term arrangements believing in the soundness of money have effectively been swindled by borrowers -- particularly, in most cases, by the government.
My great-aunt retired in 1948 with her savings primarily in 3 1/2% British War Loan. By the time she died in the 1970s she was completely indigent, since the real value of both her capital and income had declined by about 85% as had even the money value of her bonds, which were irredeemable. She was a lifelong Tory voter, and had been a great fan of Stanley Baldwin, so doubtless the postwar Labour government considered her "lower than vermin." Its economic policies certainly had the effect of treating her as such. ...
Since the inflation statistics have changed their nature, monetary policy will also have to change. Whatever brave words Fed Chairman Ben Bernanke puts on it, he will not at this stage be able to switch to "fighting inflation" wholeheartedly. Genuinely fighting inflation would require real interest rates, even in the short term of at least 3-4% -- not maybe as high as the 20% short term rate -- roughly 9% in real terms -- that Paul Volcker imposed on the U.S. economy, but nevertheless well above the neutral long term interest rate, which is well above 2%, probably above 2 1/2%. That would imply a Federal Funds rate in the 9-10% range, well above the 8% that would have been sufficient to fight inflation had Bernanke adopted it in 2006-07. Long-term rates would also have to rise to at least the neutral rate, or around 8% per annum on 10-year Treasury bonds.
As Bernanke would no doubt tell you scornfully, a Federal Funds rate of 9-10% and a long term bond rate of 8% would devastate the U.S. economy, in particular causing further carnage in the housing market. Very well, if Bernanke's monetary policies (and Greenspan's before him) have led the U.S. to a position in which fighting inflation would devastate the economy, then rates must be raised in a two stage process. In the first stage, the gradual raising of the Federal Funds rate from 2% to maybe 4% over the next year, inflation will not be fought, and will consequently continue to rise to perhaps the 7-8% range.
Should he adopt this policy of modest rises in interest rates, Bernanke will no doubt claim to be fighting inflation, but he will be doing no such thing, since real interest rates will remain securely negative. However, even though inflation in general will continue to rise, it will no longer be in an out-of-control spiral and oil and commodity prices in particular will probably "come off the boil" somewhat (though gold, which has not shared in the sharp commodity price appreciation of the past year, may still soar towards $1,500.)
While interest rates remain in the 2-4% range, house prices will continue declining, but the inflation and the ongoing modest strength (if growth around zero can be called strength) of the U.S. economy will pull wages up towards house prices. The dollar will remain weak, since U.S. interest rates will remain well below international rates, but that will have a beneficial effect in rebuilding U.S. export industries and moving the U.S. current account towards balance. Weakness in housing and in retail sales will thus be counterbalanced by strength in the export sector. By late 2009, with house prices down around 30-35% nationwide (and by 55-60% in overbuilt parts of California, Nevada, Florida and the North East) the ratio of house prices to incomes will no longer be unfavorable, and signs will appear of a recovery in the housing market.
At that point, we will reach another decision node. Should Bernanke be reappointed for a second four year term in January 2010, in spite of his manifest failure to control inflation, he will doubtless keep interest rates at their low prevailing levels, which will cause inflation to begin trending upwards more sharply, passing 10% annually in early 2010, at which point real short term rates will be minus 6%. The result will be crisis, which it is unlikely Bernanke will prove capable of solving.
The alternative path will occur if President McCain or President Obama do not reappoint Bernanke, preferably asking him to leave office several months early, and instead appoint a Fed Chairman with a proper commitment to fighting inflation, along the lines of Paul Volcker -- although Volcker himself will be 83 in 2010, presumably too old to want to resume his old stressful and relatively un-lucrative job. In this contest, it is gratifying that Volcker is already advising Obama, suggesting that his relatively mild criticisms of current monetary policy will be taken to heart.
With housing stabilized, and the probability of a financial sector meltdown reduced, the new Fed Chairman -- let us call him Volcker II -- will be able to take a strong line against resurgent inflation. The Federal Funds rate will be increased immediately to at least 12%, which will cause a bond market debacle as long term Treasury rates readjust themselves to their new equilibrium level around 10%. Housing will go into a renewed funk, but with prices and incomes relatively in balance it should be a shallow one in terms of house prices, doubtless causing further bankruptcies among homebuilders, but not mass defaults among home mortgages, the fixed-rate among which will now have interest rates far below the new market level.
The U.S. economy will enter a sharp recession, somewhat exacerbated by a recovery of the dollar from the excessively low levels it will have reached during the easy-money period of 2008-09. However by the end of the slowdown, with the further decline in retail sales that it will cause, the U.S. savings rate will have been rebuilt to a modestly positive level and the current account will be close to balance. As inflation begins to decline and monetary policy to ease, economic growth will resume, probably in time to help the 2012 reelection campaign of President McCain or President Obama.
By 2012, when economic recovery becomes generally apparent and interest rates begin to ease, the United States will have suffered five years of economic growth close to zero (and hence negative when adjusted for population growth) with the construction and financial sectors declining sharply in importance, and export sectors generally increasing. Real consumption per capita in 2012 will be well below that in 2007, although much of that decline will be suffered by the top 1% of income earners who benefited so fabulously from the cheap-money bubble. Prices will have risen by about a third over the five years, and there will still be more work to do in 2012-15 before inflationary psychology has been wrung out of the economy -- real interest rates will remain high for some years. However, the recession will have been nowhere near as deep as the Great Depression, nor will it have been as prolonged as the Japanese stagnation of 1990-2003.
The real sufferer in the 2008-12 decline will be stock prices. Judged by its level of 4,000 in February 1995, the Dow Jones Industrial Index should today be standing at a level of 7,800 (when you increase it in line with nominal GDP) compared to its actual level of 11,400. That would suggest a moderate decline of a further 30% from the Index's current level, a total decline of about 45% from its 2007 high. However, that fails to take account of the market's position in February 1995. At that point it was at an all-time high, almost 50% above what had seemed the unsustainable peak of 1987.
If we measure the Index instead by the increase in nominal GDP from its value at the beginning of the great bull market, of 777 in August 1982, it should bottom out around 3,400 today or about 4,500 in 2012 allowing for inflation between now and then. That is probably a more reasonable estimate for the low. Conditions in 2012 will be those of tight money following a lengthy recession, very similar to those of 1982 but not to those of 1995, which were much sunnier. Hence a decline not of 45% but of 70% in the Dow index is on the cards, with correspondingly severe devastation in baby-boomers' retirement portfolios (only part of which will be in stocks, but the rest will mostly be in debt, affected like my great-aunt's savings by both rising interest rates and inflation.)
If THAT doesn’t get the bastards saving like squirrels, nothing will!
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