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BUFFETT’S “TIME BOMB” GOES OFF ON WALL STREET
Berkshire Hathaway bought General Re in 1998. Buffett and Munger decided to exit GenRe's derivatives business in 2003 and set about liquidating its contracts. The 2002 Berkshire annual report, published in the spring of 2003, spelled out their thoughts on derivatives thusly: "We view them as time bombs, both for the parties that deal in them and the economic system. ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
Already chastened by the losses absorbed to date in closing down GenRe's business, the 2005 Berkshire annaul report said about the then incomplete process of unwinding GenRe's contracts: "Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully."
And at the 2008 shareholder's meeting, Buffett said of the by-then-completed process: "Four years ago when we started to liquidate GenRe's portfolio, we had hundreds of millions set aside in reserves. We had auditors who can attest that the accounts were marked to market and I wish I had sold the positions to the auditors back then. We would have been better off by about $400 million or so."
Ignoring both Buffett and Mungers' warning and their experience, the players opened the throttle wide and took dead aim at the "Bridge Out" sign. This article covers a few details, which mirror the sloppiness of the macro-bets.
On Main Street, insurance protects people from the effects of catastrophes. But on Wall Street, specialized insurance known as a credit default swaps are turning a bad situation into a catastrophe.
When historians write about the current crisis, much of the blame will go to the slump in the housing and mortgage markets, which triggered the losses, layoffs and liquidations sweeping the financial industry. But credit default swaps -- complex derivatives originally designed to protect banks from deadbeat borrowers -- are adding to the turmoil.
"This was supposedly a way to hedge risk," says Ellen Brown, the author of the book Web of Debt. "I am sure their predictive models were right as far as the risk of the things they were insuring against. But what they did not factor in was the risk that the sellers of this protection would not pay ... That is what we are seeing now."
Brown is hardly alone in her criticism of the derivatives. Five years ago, billionaire investor Warren Buffett called them a "time bomb" and "financial weapons of mass destruction" and directed the insurance arm of his Berkshire Hathaway Inc to exit the business.
Recent events suggest Buffett was right. The collapse of Bear Stearns. The fire sale of Merrill Lynch. The meltdown at American International Group. In each case, credit default swaps played a role in the fall of these financial giants. ...
Over the last three quarters, AIG suffered $18 billion of losses tied to guarantees it wrote on mortgage-linked derivatives. Its struggles intensified in recent weeks as losses in its own investments led to cuts in its credit ratings. Those cuts triggered clauses in the policies AIG had written that forced it to put up billions of dollars in extra collateral -- billions it did not have and could not raise. ...
When the credit default market began back in the mid-1990s, the transactions were simpler, more transparent affairs. Not all the sellers were insurance companies like AIG -- most were not. But the protection buyer usually knew the protection seller.
As it grew -- according to the industry's trade group, the credit default market grew to $46 trillion by the first half of 2007 from $631 billion in 2000 -- all that changed.
An over-the-counter market grew up and some of the most active players became asset managers, including hedge fund managers, who bought and sold the policies like any other investment. And in those deals, they sold protection as often as they bought it -- although they rarely set aside the reserves they would need if the obligation ever had to be paid.
In one notorious case, a small hedge fund agreed to insure UBS AG, the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million. The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee -- and capitalized it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44%. But in the summer of 2007, as home owners began to default, things got ugly. UBS demanded the hedge fund put up additional collateral. The fund balked. UBS sued.
The dispute is hardly unique. Both Wachovia Corp. and Citigroup Inc. are involved in similar litigation with firms that promised to step up and act like insurers -- but were not actually insurers.
"Insurance companies have armies of actuaries and deep pools of policyholders and the financial wherewithal to pay claims," says Mike Barry, a spokesman at the Insurance Information Institute.
Another problem: As hedge funds and others bought and sold these protection policies, they did not always get prior written consent from the people they were supposed to be insuring. Patrick Parkinson, the deputy director of the Fed's research and statistic arm, calls the practice "sloppy." As a result, some protection buyers had trouble figuring out who was standing behind the insurance they bought. And it put investors into webs of relationships they did not understand.
"This is the derivative nightmare that everyone has been warning about," says Peter Schiff, the president of Euro Pacific Capital at the author of Crash Proof: How to Profit From the Coming Economic Collapse. "They booked all these derivatives assuming bad things would never happen. It was like writing fire insurance, assuming no one is ever going to have a fire, only now they are turning around and watching as the whole town burns down."
GOING FOR BROKE
Uncle Sam plans to spend like there is no tomorrow to cure what ails the credit markets and rev up investors. Will it work?
It may take years, if not decades, to sift through all the wild market action and government intervention skullduggery that went on last week. But we have to start now. The thinking of veteran Barron’s lead commentator and skeptic Alan Abelson is as good a place to begin as any. He is skeptical.
Baby, it's cold out there. So let's toss another billion on the fire.
What does that make it? Well, let's see: $29 billion for Bear Stearns, somewhere between $1 billion and $100 billion each for Fannie and Freddie (a nice narrow range), $85 billion for AIG, a couple of hundred billion to keep stray banks, brokers and their errant kin from asphyxiating themselves by swallowing toxic paper. And then there is the proposed reincarnation of the Resolution Trust Corp., which all by itself may mean shelling out $800 billion, perhaps even as much as $1 trillion.
While we are at it, we might as well include the $400 billion with which the Paulson-Bernanke grand plan envisages endowing the Federal Deposit Insurance Corp. so it can insure money-market funds.
But, please, understand those mind-boggling sums in no way, shape or form are to be construed as designed to aid and abet a bailout. Instead, they are merely the essential ingredients of an "intervention," or, if you prefer, a "rescue" -- just about anything, in other words, that is semantically sweeter than bailout, with its ugly connotation of a sinking ship.
Besides, we have it on the best authority that none of this largess will cost the taxpayer a cent over the long run, which, if nothing else, speaks volumes about what constitutes the best authority these days. The reasoning is simple (or perhaps simple-minded is more accurate), namely that deep-pockets Uncle Sam can sell off the assets of the foundering companies on which he has bestowed that bounty and come out whole.
Surely, they jest. For a heap of those so-called assets might easily be confused with liabilities since even those that can be sold will likely fetch a feeble fraction of what their possessors now claim they are worth.
This is not to say that until the powers-that-be pounded the panic button last week, the billions they had already thrown at the problem as well as taking a big step further and making the wretched companies soaking up those billion de facto vassals of the government were completely in vain. They undeniably had an instant impact. Unfortunately, an instant was about as long as the impact lasted, and it failed miserably to becalm the frantic credit markets or rekindle investor confidence.
The sad truth is that just about every one of Messrs. Paulson and Bernanke's previous brainstorms -- and they seemed to come with increasing frequency as Hank and Ben's agitation mounted -- touched off a brief spasm of exhilaration among investors, only to evaporate in very short order as the credit crisis resolutely morphed into a credit calamity. Or, to change the metaphor, what had been a slow-motion train wreck picked up demonic speed.
That little chart that adorns these gray columns offers an eloquent description of how bad things had gotten until the clouds parted and the sun finally came out as the week wore down. It depicts the yield on 3-month Treasury bills going back to 1930. On last Wednesday, investors were so gripped with fear and desperate for a haven that they poured into the bills even though the yield was nonexistent. In effect, they were willing to pay the government for keeping their money safe. As a glance at the chart shows, that has not happened since the Depression.
Then, everything changed, at least for now. And the soaring rise in the stock market that began Thursday afternoon and extended through the final bell on Friday had Ben and Hank whooping with joy, exchanging high fives and just venting their pleasure with cat-that-swallowed-the-canary smiles, a welcome change from the funereal faces they had donned for the past few months.
While we are in a generous mood, we might as well add Christopher Cox to the cheerful circle of celebrants. The SEC chief has been the target of a steady stream of slings and arrows directed his way by John McCain, which rather than nailing Cox's inadequacies (and they are bountiful) once again demonstrated that McCain and his advisers have not much of a clue how markets work.
Cox, in any case, deserves some of the credit for the smashing rally that boosted the Dow comfortably nearly 800 points in two sessions. For he proudly announced a ban on shorting 799 financial stocks and sparked talk of banning short selling entirely, and that scared the dickens out of the shorts who en masse rushed to cover. The resulting buying burst, we have not a scintilla of doubt, played a significant role in the great market lift-off.
Frankly, it seems to us, Cox, in taking out after the shorts -- whom nobody loves except their immediate families (and we are not even sure about them) -- was more interested in covering his derrière than in protecting investors. As an early-warning sounder, keeping markets reasonably honest and offering a way to hedge against the inevitable mistakes or bad luck that investors are prey to -- short selling serves a valuable function, and messing with it is apt to yield a lot more harm than good.
And we say that fully aware short selling has its quota of bad guys who do wicked things, but also aware that there are rules and regulations aplenty to curb untoward practices, if somebody would only enforce them.
But then, if regulators had not been asleep, banks probably would have had real trouble finding ways to go belly-up, those innovative weapons of mass destruction called derivatives might have been defused long before they blew up, and those speculative bubbles, as in housing, might not have made the Guinness Book of Records for sheer size.
Just think of all the fun we would have missed.
WILL THE GRAND PLAN WORK? Will piling on all those billions on billions atop a budget deficit that is already a cinch to shoot up to over half a trillion next fiscal year allow the badly winded economy to start a sustainable recovery?
Ben, remember, vowed to use helicopters to drop money from the sky, but now he seems to be gearing up to use 747s. Can the Fed run its printing machine full-time to churn out all those billions without a substantial infusion from increasingly pinched taxpayers? And will priming the pump like mad not drive the dollar back into the pits and force interest rates higher?
The plan, in all its extravagance, seems to have been thrown together on the fly, and once Congress gets a whack at it in the waning days before the lawmakers scurry off to the hustings, it may bear only passing resemblance, for better but probably for worse, to Paulson and Bernanke's handiwork.
Obviously, the unknowns greatly outweigh the knowns, which make those and myriad other questions tough or downright impossible to answer.
We are willing to concede that some forceful action was necessary, if only so the Fed can pay penance for its critical part in creating the incredible credit-cum-housing disaster.
As Merrill Lynch's David Rosenberg observes, the fact that the government is suddenly so aggressive in coming to grips with an epic credit collapse is eloquent testimony to how the Fed and the Treasury "have consistently underestimated the severity of that collapse from the get-go."
He reminds us, moreover, that the original Resolution Trust Corp. was strictly about buying bad mortgages. So he wonders whether the new incarnation will also undertake the purchase of Level 3 assets, whose value is extremely problematic and, in any case, more than a little difficult to gauge, and which are a sizable and not particularly desirable presence in many banks' portfolios. And will the new RTC also buy credit-card debt, commercial real estate, leveraged loans "or the other mountains of bad debts out there?"
David cautions that the entire credit collapse to date has "reflected the unwind of the largest bubble of all time -- residential real estate. Meanwhile, a consumer-led recession is taking hold this very quarter for the first time in 17 years, and every consumer recession in the past was followed by a negative credit cycle of its own."
As to the euphoric market reaction, he thinks it is a bit much. In their stampede to buy, investors seem to be ignoring the depressing fact that what prompted such drastic action was the sorry state of the financial system, which is not likely to change overnight no matter how vigorous the government exertion.
After the RTC was set up in 1989, he notes, it took two years for the economy to turn around, three years for housing to recover and a year for the stock market to bottom.
So what's the rush?
MR. MARKET NEVER LOSES
When the shooting stops and the smoke clears, only one man will be left standing. That man will be gold.
In need of a laugh, we turn to Bill Bonner to see what he has to say about recent events. And of course it is at most a slight variant on what he has been saying all along. Bonner might forecast early and often, but the forecast does not change. He has been saying buy gold and sell stocks since the dawn of this millenium. So far so good. But don't stop now. The fun has just begun.
"There is a war going on -- a battle between a natural market correction ... and an artificial attempt to avoid it," says Mr. Bonner. "On the one hand, Mr. Market wants to correct the excesses of the boom/bubble period that began in 1982. On the other, Misters Bernanke and Paulson want to prevent him. Mr. Market takes down asset prices. Mr. Market Manipulators push them back up. ... [T]his war has already caused millions of casualties ... from Wall Street's masters of the universe ... to the little guy with a sub-prime mortgage on his double-wide. But when the shooting stops and the smoke clears -- only one man will be left standing. That man will be gold. Make sure you are standing next to him."
You could skip the article, having heard the conclusion. That would be like not bothering to watch Some Like It Hot except for the last 10 minutes.
"I've never seen anything like it," said Capital & Crisis's Chris Mayer
(This past Friday) The Dow rose more than 400 points. Gold was up $46 at the close of the day. The dollar is falling ... oil is holding steady.
We are hosting a meeting of financial analysts here at our conference center in Normandy. Last night, after dinner, we all gathered around a computer screen -- amazed, aghast and appalled.
"I can't believe it." ... "Incredible." ... "What will they think of next?"
Your Daily Reckoning editor loved it. He did not know what to laugh at first!
From England came word that the financial regulators had banned short selling of financial stocks. What did they think ... that they could keep prices up by decree?
But the Americans did the same thing, only dumber. The SEC issued an emergency edict prohibiting "abusive" short selling. What the heck is that, we wondered?
Maybe it is when you sell a company when the share price has already fallen more than 10% ... Like kicking a man when he is down; it is not very sporting.
The feds announced a program of coordinated intervention ... with $250 billion to be made available to the financial industry to cover its bad debts.
And get this ... CNBC: "Bad Debt Plan May Cost up to a Half a Trillion Dollars."
Where do the feds get that kind of money? Ha ... ha ... ha ...
But we are not the only ones. Russia is new to the ways of late, degenerate capitalism. But it is getting the hang of it fast. It too is manipulating markets with a $20 billion injection "to boost the stock market."
And then, there is this item from Bloomberg: The latest crises "expose the flaws" and "tarnish the image" of the U.S. economy. (See post from last week.)
They are missing the point completely. It is not "flaws" that are being exposed -- it is the whole consumer economic model and the whole generation of jackass economists who created it. They rejected the insights of classical economics. Instead of encouraging saving and capital formation, they thought they could nurture growth by luring consumers to spend more money.
"Tarnish the image?" No, this crisis will eventually destroy the image altogether, not tarnish it.
But let us return to the story as we have been telling it. There is a war going on -- a battle between a natural market correction ... and an artificial attempt to avoid it. On the one hand, Mr. Market wants to correct the excesses of the boom/bubble period that began in 1982. On the other, Misters Bernanke and Paulson want to prevent him. Mr. Market takes down asset prices. Mr. Market Manipulators push them back up.
We know who the ultimate victor will be. Mr. Market never loses. One way or another, real prices must come down. That is just the way it works. Night follows day, whether you like it or not. Stocks, bonds, property, art become expensive ... and then they become cheap. Recently, they have been expensive. Soon, they will be cheap.
As recently as a few months ago, it looked like the feds might be able to hold off a correction. Government-caused inflation was pushing up prices all over the world. Oil hit $147. Gold shot over $1000. Investors were getting rich in Chinese stocks and London property. Consumer price inflation was rising everywhere. Back then, it looked like consumers would be the big casualties of this war. They were facing much higher prices ... with declining incomes.
But then, financial institutions began to take [on water] ... and pretty soon ... the whole battalion of investors, worldwide, were getting beaten back. Stock market investors suffered flesh wounds in the United States; the Dow is down about 17%. In China, investors have practically had their heads blown off; the Shanghai index has lost 67%. Commodity investors got whacked too. Oil is down a third from its high. Yesterday, it closed at $97. Gold lost a quarter of its value, from the high. And investors in many of the safest, surest and smartest companies on earth -- investment banks, mortgage lenders, and other financial institutions -- have been wiped out.
But this week reminds us that the war is not over. The feds still have some ammunition left. The Fed has 200 basis points left to zero; it can cut rates further. The government can intervene directly in markets; it can seize companies; it can lend to anyone at half the rate of inflation; it can send out checks ... In fact, judging on recent evidence, it can do anything. ...
But the one thing it cannot do is create real money. Every intervention costs money. And money is the one thing the feds do not have. Not real money. They only have phony money. And when investors finally realize the difference -- between real money and funny money -- that is when things will get very, very interesting.
So far, only one major asset class has escaped Mr. Market's correction: bonds. U.S. Treasury bonds have gone up (meaning, yields have gone down) as investors sought the safety of what used to be, and should be, the surest credit on earth. But bonds depend on not only on the ability of the issuer to repay, but also the value of the money in which they are calibrated. And if that money starts to sink in value, bonds take a hit.
U.S. Treasury bonds are unique. They depend on the value of the dollar ... which the issuer itself controls. But as the war between Mr. Market and the feds continues, the U.S. Treasury will have a harder and harder time maintaining the value of the dollar. Because wars are costly. The feds will have to stretch the dollar farther and farther in order to meet the expense. Eventually, the elastic dollar will snap ... and bonds investors will have their turn. Bonds will crumple over too.
Dear Reader, this war has already caused millions of casualties ... from Wall Street's masters of the universe ... to the little guy with a sub-prime mortgage on his double-wide. But when the shooting stops and the smoke clears -- only one man will be left standing. That man will be gold. Make sure you are standing next to him.
"Is the United States no longer the global beacon of unfettered, free-market capitalism?" asks the International Herald Tribune.
"We have the irony of a free-market administration doing things that the most liberal Democratic administration would never have imagined itself doing in its wildest dreams," says Ron Chernow, a leading American financial historian.
Where has he been? Where have they all been? They might as well be a spider watching a couple make love; he sees the action but has no idea what is going on.
The Bush Administration has been the most liberal administration since Franklin Roosevelt. It has added more debt, more restrictions, more jackass programs, wars, spending, humbugs and bamboozles than any U.S. government in half a century. The one thing it has not done is raise taxes to increase federal revenues; thank God. But it spent the money anyway!
Not that we are complaining. Far from it. We have enjoyed the show.
Besides, our role here at The Daily Reckoning headquarters is not to gripe and moan ... but merely to try to understand. How is it possible for a "conservative" government to nationalize the insurance business? What comes into the heads of "conservative" leaders that makes them want to spend a half trillion they do not have bailing out investors? Why would any U.S. official with his wits about him want to raise the possibility of war with Russia ... over Georgia? Maybe Atlanta would be worth defending ... and even there we have our doubts. But Tbilisi?
How does it work? How do people come to think such things? We don't know, but we have a theory: People come to think what they must think when they must think it.
In other words, history follows certain patterns. Not predictable. Not exact. But broadly reflecting the inherent blockheadedness of the race ... and generally in line with historical precedents.
America is in a period of imperial decline. Its economy is slipping. It citizens are getting poorer, both absolutely and relative to the rest of the world. The "smart" thing to do would be to hunker down, cut costs, bring troops home, reduce Medicare and Medicaid, raise interest rates, encourage saving and give the country time to get back on its feet economically -- so it could enjoy its relative decline with good grace.
But that is not the way history works. Did Alexander stop at the Hellespont? Did Napoleon stop at the Rhine? Did Hitler stop at the Oder? George Bush I stopped at the border of Iraq. But George W. Bush, under the sway of the neocons, kept going. His mission: to destroy the U.S. empire.
No, of course, he does not know that is his mission. He is an agent of change ... a useful idiot, as Lenin would have said ... a stooge ... willing to do what isn't so smart, but what helps the course of history along to its end.
And now, we have a financial crisis. Does the government respond like Andrew Mellon in the 1920s? "Liquidate labor ... liquidate the banks ... liquidate the farmer ..." said Mellon, willing to let the chips fall where they may. No. That would be smart. Get it over with. Move on. But because the U.S. economy is in a long-term decline, moving on is the last thing people want.
In the '20s, the United States could let chips fall, because it had a growing, dynamic economy. Other chips would rise up quickly. But now it must try to keep the chips from falling ... because it is mature ... aging ... decaying. It wants to hold on ... to keep things together ... to avoid change.
That is why socialism is so attractive to Americans. It offers the illusion of safety and stability.
HOW TO CURE THIS SICK SYSTEM
Forbes magazine publisher and owner, not to mention former U.S. presidential candidate, Steve Forbes, has an easy optimism about the capacity of the economic ship of state to right itself if only a few misguided policies were changed. It is at once comforting while also bringing to mind the dictum that for every complex problem there is a solution that is simple, obvious ... and wrong. Having said that, Forbes has been very persistent, and very right in our opinion, in advocating sound money. He recommends a soft gold standard, setting a dollar price of gold and sticking to it.
That could only be a vast improvement over what we have. The deeper issue Forbes glosses over is whether the U.S. is truly insolvent, or merely going through a liquidity crisis. Another one of his recommendations, not using mark-to-market accounting rules for assets being held to maturity, assumes that the institution at hand is cash flow positive even if it has a short-term funding issue. The two issues may get conflated during periods of maximum tumult. And if a severe economic downturn fails to appear, most debtors may well continue to pay. Indeed marking long-lived illiquid assets to market daily is ludicrous, but, again, the greater question here is one of economic viability rather than accounting.
Not even during the Great Depression did we witness what is now unfolding -- a sizable number of big financial institutions going under. What enabled their taking on so much debt and so many questionable assets was, primarily, the easy-money policy of the Federal Reserve. Chairmen Alan Greenspan and Ben Bernanke created massive amounts of excess liquidity. If the dollar had been kept stable relative to gold, as it was between the end of WWII and the late 1960s, the scale of the bingeing in recent years would have been impossible.
The first prescription for a cure is to formally strengthen the dollar and announce it publicly. A year ago August the price of gold was more than $650 per ounce. In late 2003 it had breached $400. The Fed should declare that its goal for gold is around $500 to $550. That would stabilize the buck -- and stability is essential if animal spirits and risk taking are to revive.
Also of immediate urgency is for regulators to suspend any mark-to-market rules for long-term assets. Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline.
Think of the mark-to-market madness this way: You buy a house for $350,000 and take out a $250,000 30-year fixed-rate mortgage. Your income is more than adequate to make the monthly payments. But under mark-to-market rules the bank could call up and say that if your house had to be sold immediately, it would fetch maybe $200,000 in such a distressed sale. The bank would then tell you that you owe $250,000 on a house worth only $200,000 and to please fork over the $50,000 immediately or else lose the house.
Absurd? Obviously. But that is what, in effect, is happening today. Thus institutions with long-term assets are having to drastically reprice them downward. And so the crisis feeds on itself.
The SEC should immediately reverse its foolish decision to get rid of the so-called uptick rule in short-selling. That would provide a small road bump to the short-selling that is helping to destroy financial institutions.
At the same time the SEC should promulgate an emergency rule (which we thought was already the rule): No naked short-selling. That is, you have to own or borrow shares in a company before you can short it. The rules should make clear that short-sellers must have ample documentation proving they truly possess the shares at the time of the short sale. Otherwise, each violation will result in heavy fines. That would not be a road bump but a wall of Everest-like proportions. Regulators should also be told to instruct banks to keep their solvent customers solvent. The last thing the economy needs right now is for the banking system to seize up.
The federal government should also consider setting up a new Resolution Trust Corp., which was devised during the savings and loan crisis nearly 20 years ago as a dumping ground for bad S&L assets. Today's bad assets could then be liquidated in an orderly way. And, finally, the financial industry should be encouraged to create new exchanges for exotic instruments. This would result in the standardization of these things, which would mean more transparency.
These steps would quickly revive financial markets. Already mortgage rates are coming down. It will not be long before American homeowners start an avalanche of refinancings, which would be an enormous boon to confidence and the economy.
THE END OF AN ERA
The best and the brightest in America’s financial institutions were blind as bats.
"Countries don't go bankrupt," Citibank chairman Walter Wrinston famously intoned in the 1970s. That call ranks up there with IBM's assessment of the total world market for computers, five (in 1943), and Irving Fisher's prediction that stocks had reached a "permanently higher plateau" in 1929. "They are too big to fail," Wrinston probably thought. In mid-August 1982 Mexico threatened to declare de facto bankruptcy and send Citibank and its fellow money center banks into de jure insolvency.
Of course the New York banks were not going to be allowed to actually fold, thereafter to be replaced by more soundly run institutions. The only question was what form the bailout would take. The mechanism actually used led to the great 1980s/‘90s/2000s credit bubble. The Federal Reserve reversed the tight money policy it had been pursuing since Paul Volker's appointment by Jimmy Carter in 1979. Big time. "A rolling loan gathers no loss," and the bankrupt Latin American countries' loans were rolled over by hook or by crook until they could be written off or the debtors recovered their ability to pay.
With the monetary profligacy came a concomitant "guns and butter" redux fiscal extravagance by the federal government and a "to heck with austerity" consumer spending binge. No one dreamed at the time that the world could absord so much U.S. debt -- in particular from households, financial institutions, and the federal government. See, e.g., this report, for details. "Deficits don't matter," was the new rallying cry.
Now, 25 years later, it appears that deficits do matter. Like the man who jumps off the top floor of a skyscraper and calls out "so far, so good" as he passes by each window, the ground is suddenly looming large. And as the skydivers say, "It's not the fall that kills you, it's the sudden stop at the end!" It is the end of an era, as Gary North elaborates here.
This investment era began on Monday, August 16, 1982. On Friday the 13th, Mexico had threatened to nationalize all foreign banks and default on its debt. That weekend, the world's central bankers were meeting. They agreed to start pumping in new money. They negotiated new terms with Mexico. On Friday, the 13th, the Dow Jones Industrial Average bottomed at 777.
The week of September 14, 2008, will go into the textbooks as the end of an era. It marked the end of the investing public's confidence in the Powers That Be.
When the Dow Jones fell 504 points on Monday, September 15, in response to the failed bailout Sunday night of Lehman Brothers Holdings, it was obvious that the public's faith was shaky.
On September 7, Treasury Secretary Henry Paulson, acting on his own authority, nationalized Fannie Mae and Freddie Mac. Nothing like this had ever been done in American financial history. Presidents have done things like this in crisis periods, but never a lame-duck Treasury Secretary.
One week later, Merrill Lynch was bought by Bank of America, Lehman went bankrupt, and Paulson justified this on the basis that he did not want to bail out another company or a pair of companies. It was intended to sound inspirational. Here was a man who had transferred $5 trillion of mortgage liabilities to the Federal government on his own authority the previous Sunday. Yet here he was, valiantly informing the public that enough was enough: There would be no government bailout.
Fast-forward 48 hours. The Federal Reserve released a press release at 10 p.m., eastern daylight time, that it will loan AIG $85 billion in exchange for 80% of the company. This is the biggest bailout in American history. There was no discussion of it in Congress. The next day the Dow Jones Industrial Average fell 449 points.
What reversed the fall was an announcement on Thursday of a $700 billion bailout at taxpayers' expense. If Congress approves of this, there will be more emergency requests. Call this $700 billion a follow-up on Tuesday's $85 billion. This was a world away from Sunday's assurances that there would be no more bailouts.
The people in charge are riding the whirlwind. They have pulled us on board.
What I find amusing in retrospect is that on Monday, the government asked Goldman Sachs and J.P. Morgan to pony up $75 billion to lend to AIG. They ignored the opportunity. What was Paulson thinking of? A loan to a near-bankrupt giant? How? Goldman Sachs shares had been $240 in November 2007. Down they went, month after month. On Wednesday, Goldman Sachs shares fell to $100, then recovered to $115.
This was a follow-up on an equally preposterous scheme on Sunday. Paulson had assembled 10 financial institutions to bail out Lehman. One of the 10 institutions was Merrill Lynch. Before the bailout was nixed by Barclays Bank, Merrill Lynch had gone out of business as a separate institution. Paulson was so out of the loop that he did not realize that not only could Merrill Lynch not come up with $7 billion as its share of the proposed bailout, it would cease to exist as a separate institution before the day was over.
If ever there was a man who is out of the loop it is Treasury Secretary Paulson. Yet he was CEO of Goldman Sachs before he was Treasury Secretary. He saw no signs that Merrill Lynch was about to go belly-up.
To give you some idea if how far removed from reality Paulson has been for months, read his September/October article in Foreign Affairs. This is the most important journal of opinion in the United States and probably in the world. His article is a long discussion of trade with China. There was not a word on the looming collapse of America's banks.
The story of the merger is amazing. I saw the CEO of Bank of America interviewed on Monday. He gave a cheerful assessment of what a great idea it was for Bank of America to buy Merrill Lynch for $50 billion in BofA stock. Understand, this is the man who oversaw the purchase of Countrywide Financial. So, when he gives cheery analyses, I tend to be a bit skeptical.
He went on to say that he got a call from the CEO of Merrill on Friday afternoon. By Saturday, they had discussed the merger in person. On Sunday, the two completed the merger. Neither of them had discussed this with their boards of directors. There was no warning to investors in either company that a merger was required in order to save Merrill from bankruptcy.
On Monday, Standard & Poor's rating service dropped the Bank of America from AA to AA-. At the same time, the stock market rendered its vote of no-confidence. On Friday, Bank of America shares sold at $34. The stock opened at $28 on Monday morning. By Monday's close, it sold for $27. Yet the CEO assured us that this was just a terrific merger that would be beneficial to both organizations.
It was obvious by Monday afternoon that the investing public was not buying any of it. It had just had one weekend surprise too many. It was clear to the public that the people at the top did not have a clue as to what was taking place. They did not know how to solve the problem.
Then, late Tuesday night, the Federal Reserve issued its press release. There was no discussion by Bernanke. There was no discussion by any senior FED official. There was a statement from some unnamed Federal Reserve staffers who assured the public that this was not the nationalization of AIG. Yet it was obviously the nationalization of AIG. It was a nationalization comparable to the nationalization of Freddie Mac and Fannie Mae. That nationalization was called a conservatorship.
The leaders of American finance apparently believe that the secret of saving the financial structure is through word magic. If they re-name what the bailout process is, somehow it will be palatable to the investing public.
Lehman has gone bankrupt. All of its assets, totaling $639 billion, will have to be sold into a market that is in crisis mode. No one knows what market value these assets possess. No one knows what degree of toxic waste is in the asset column of Lehman's balance sheet. We are going to find out very soon.
Masters of the Universe, Emeritus
The public has been trained to believe that the people making the decisions at the top of the American financial system are masters of the universe. These were the best and the brightest. They had invented all of these wonderful new contractual obligations that made billions of dollars of profits for their companies. It was going to go on forever.
Then, like toppling dominoes, the masters of the universe were exposed as bunglers of the universe. They took their severance pay of tens of millions of dollars each, and went off into the oblivion that is reserved for ex-masters of the universe.
These stories kept coming before the public, beginning with the forced sale of Bear Stearns in March. One by one, the organizations that supposedly are at the heart of American financial capitalism have been exposed as barely functional operations that have been run by men who did not have any understanding of the new finance.
All of these leveraged securities had been designed by mathematical geniuses. So had Long-Term Capital Management, which went bust in 1998. The problem is, the heads of these organizations are not mathematicians. They took the word of a bunch of "quants," who had no experience making money, that these incredibly complex contractual arrangements would make above-average profits, year after year, and not expose the issuing organizations to gigantic risk. In other words, they trusted mathematicians and computer geeks with the future of their companies.
Anyone who has dealt with computer geeks knows that some of these people have trouble balancing a checkbook. They are whizzes at constructing arcane codes that nobody understands. It is even worse with the mathematicians. They thought that you can evaluate risk in advance and shield yourself against risk by establishing co-party agreements. AIG wrote $447 billion of these agreements. No one knows how the Federal government will pay off any of them in a market collapse.
Meanwhile, all over the world, these agreements are now coming due. The bankruptcies have forced the contractual parties to come up with the money to pay off the people on the other side of the contracts. The trouble is, there is no mechanism, no court system, no nothing that is able to enforce these contracts. The organizations have become dependent upon them, trusting in their liquidity and their enforceability to protect them against downside moves of the market. Lots of luck to everyone who believes that the person on the other side of the contract is going to have enough money to pay off that contract. Lots of luck in dealing with his lawyers.
The entire system is unraveling. Nobody has a handle on it. Nobody knows how many agreements are out there, or how much money is at risk, or how many bankruptcies we can expect. All that the experts know is that this system has been designed by mathematicians and computer geeks.
The people in charge of sorting out the mess are tenured, salaried economists who work for the Federal Reserve System and the Department of the Treasury. These are the fellows who were not good enough at mathematics to become mathematicians. Yet these are the people who are expected to produce a cure for the developing catastrophe that is threatening the capital markets of the entire world.
Why should anyone have believed that the people in authority knew anything about the system which was being constructed in terms of Alan Greenspan's expansion of the money supply after 1995? Yet they did believe that these people knew what they were talking about. They put faith in these people. Now that faith has been betrayed. The masters of the universe, whether in the private markets that have been subsidized by the fiat money of the Federal Reserve System, or hired by the Federal Reserve System, are now perceived as what they always were: people who did not know what was happening.
The Skeptic Who Sounded a Warning
One man who knew that they did not know what they were doing was Dr. Kurt Richebächer. From the year 2000 until his death in August of 2007, he issued a monthly 12-page analysis of why Greenspan had created the largest asset bubble in history. He warned, month after month, that this system would break. He said that when it breaks, it will bring down capital markets all over the world. He had been a German central banker, and he knew better than to believe that central bankers were in any position to administer the capital markets by injections of fiat money. He died in the month that the first crack in the system began.
If you look at any of the stock market charts, beginning in May 2007 until today, you see an interesting pattern. There was a significant fall in the value of shares in August 2007. Then, very rapidly, the market rebounded. All the indexes went back up. They peaked in October 2007, when the Dow Jones Industrial Average for one day went over 14,000.
On November 5, I posted an article on my website to alert my subscribers that it was time to short the American stock market. I recommended that they short the Standard & Poor's 500. I later updated this to include the Russell 2000 index. It was clear to me that when the Standard & Poor's 500 index fell from 1550 to 1500, the game was over. I was convinced that there was no way that the bull market would go back above 1550. I was convinced that what Richebächer had said was accurate, and what Austrian economic theory says about the business cycle is accurate. I believed the stock market was headed down. I have not changed my view.
The stock market really is past the point of no return. I believed that we were beyond it last November. Nothing has convinced me since that time that we did not pass the point of no return in October of 2007. The stock market is down. All over Asia, stock markets are down by 50% this year. I warned my subscribers this would happen, and I told them not to buy any Asian stocks. The Asian stock market went down faster and more sharply than the American stock market has.
No Port in this Storm
There is no national port in the storm that has now begun to hit us. This storm is like Hurricane Ike. Hurricane Ike was gigantic in terms of its diameter. It was as big as the state of Texas. Like Hurricane Ike, the financial storm we are in is not yet a Category 3 or higher. It is more like a Category 1. It will not stay a Category 1. It is going to go to Category 2 or 3. And, like Ike, it is going to cover a lot of territory.
Experts now say that this is going to be a mild recession. They have said that it will last six months. These are the same people who said there would be no recession. They did not tell you to short the stock market in 2007. These are the people who have been perma-bulls since 1982. They tell you to have a balanced portfolio of stocks and bonds.
The storm is coming. You have been warned that the storm is coming. Those of us who have been critical of Alan Greenspan since 1987, because we knew that he believed he could outsmart the capital markets of the world, were amused to hear him say on Sunday, September 14, that the capital markets are entering into a crisis period that we see once in a century. Thanks, Alan, for you are the engineer who created it.
There comes a time to face reality. The reality is this: the best and the brightest in America's financial institutions were blind as bats. They thought that risk was minimal. They took gigantic risks with the capital of their companies and investors' capital to squeeze out an extra percentage point of return on investments that should never have been made at all. They are matched in blindness by the economists at the Federal Reserve System and the United States Treasury.
We have a lame-duck President, a lame-duck Treasury Secretary, and an academic economist who is running the Federal Reserve System. The best and the brightest in the private sector have been dismissed. They took their tens of millions of dollars and wandered away. Now we are left with tenured government bureaucrats who are in charge of Fannie Mae, Freddie Mac, and the largest insurance company in the United States.
Investors last week began to figure it out. A lot more investors are going to figure it out. They are going to have two years to figure it out. This is if things go well. They may have three years to figure it out.
Whoever is elected President in November is going to preside over the worst financial disaster in American history in the postwar era. Some lucky soul is going to lose this election. You had better batten down the hatches.
THE WALL STREET MODEL: UNINTELLIGENT DESIGN
Wall Street of the past decade never really had a business model as much as it had a business creed: greed is good; leveraged greed is even better.
Pam Martens worked Wall Street for 21 years and now writes on public interest issues, including this piece for CounterPunch. Here she thoroughly eviscerates the whole Wall Street/U.S. government unholy embrace and all its pretentions.
Unindicted coconspirators are: (1) The retail buyers who buy the peddled junk. As Peter Lynch said, the average investor spends more time choosing a refrigerator than a stock. Moreover, it is hardly a secret that Wall Street is a bit of a rigged game, so caveat emptor is the operative principle. In the words of the late, great Ann Landers: For every victim there is a victimizer and someone who allows themselves to be victimized. (2) More damning, the nominally professional institutional investors, who get sucked into the same consensus thinking and deferral to self-anointed experts as their retail counterparts, but with far less excuse. Oh yes, and (3) The Federal Reserve.
Wall Street is collapsing not because of bad mortgage debt or lack of capital or over-leverage. Those are merely symptoms. Wall Street is collapsing because it deserves to collapse. It needs to collapse in order for America to survive. The economist Joseph Schumpeter called it creative destruction, a system where outdated models collapse to make room for new innovation.
Wall Street of the past decade never really had a business model as much as it had a business creed: greed is good; leveraged greed is even better.
The fact that Wall Street is collapsing is a given. How it survived as long as it did under its corrupted model is the question that will be debated in history books for the next generation.
For example, imagine a business model that bases remuneration to brokers on how much money they make for their Wall Street employer and not one dime for how well their customers' portfolios perform. A Wall Street broker receives remuneration that rises from approximately 30 to 50% of the gross commission based on their cumulative trading commissions with zero regard to how well the clients' accounts have done. There is no acknowledged internal mechanism in any of the major Wall Street firms to gauge the overall success of the accounts the broker is managing.
This characterizes any commission-driven compensation scheme. Wall Street, real estate brokers, and the local Best Buy salesman all get compensated that way. Some scruples on the part of the salesman, a health dose of skepticism on the buyer's part, and some supervisory oversight all keep the system in check and value-creating. The accusation is that at the very least Wall Street was deficient in the third attribute.
The industry has been irreconcilably incentivized to corruption just as brokers have been socialized to silence. The reason we are seeing a stampede this week into U.S. Treasury securities is that much of this money belonged there in the first place, not in esoteric mortgage backed securities, junk bonds, commodity funds or annuities backed by AIG. Brokers put their clients "safe money" in these unsuitable investments because their Wall Street employer dangled a seductive financial inducement. A broker receives less than $1,000 in gross commissions ("gross" meaning before their firm takes their 50 to 70% cut) on $100,000 of longer dated Treasuries. Putting that same $100,000 in a junk bond or mortgage-backed security or annuity could generate $3,000 or more. In other words, the financial incentive has created an artificial demand. And, as must inevitably happen, the true state of that demand is just now catching up with the true glut of supply.
What would be the incentive for Wall Street firms to offer higher commissions for some products over others? Because on top of their cut of the brokers commissions, they receive origination and syndication fees for the more esoteric investment products. These firms so despised the low-paying Treasuries that they replaced Treasuries with Freddie Mac and Fannie Mae paper in mutual funds bearing the name "U.S. Government Fund." (This misleading practice and the fact that billions of dollars of public money resided in these misnamed funds has certainly played a role in the government's decision to nationalize Freddie Mac and Fannie Mae.)
Then there is the insane model of bringing flim-flam new businesses to market. If we look at the people who are at the helm of today's collapsing Wall Street, they have shifted in their chairs, but they are mostly the same conflicted individuals who brought America the NASDAQ bust that began in March 2000 and evaporated $7 trillion of American wealth. There is no longer any incentive on Wall Street to bring about initial public offerings of only companies that will stand the test of time and create new jobs and new markets to make America strong and globally competitive. There is only an incentive to collect the underwriting fee and cash out quickly on private equity stakes.
Next is the corrupted model of housing a trading desk for the firm inside the same company that is supposed to issue unbiased research to the public. For example, say that XYZ Brokerage buys a big stake in ABC Company on its proprietary trading desk (the desk that trades for profits for the firm) on Wednesday afternoon. On Thursday afternoon, it could almost guarantee profits for itself by issuing a research report upgrading the stock. Conversely, it could short the stock on Wednesday and issue a negative report to drive down the price on Thursday, also guaranteeing itself a profit. Other than a fictional Chinese Wall, there is absolutely nothing to stop this type of public looting.
Now, ask yourself this. With the multitude of other ways that Wall Street has to make money, why are they allowed to have their own trading desk while simultaneously issuing conflicted research to the public. After the NASDAQ scandals that revealed Wall Street issuing biased research for personal profit, why were proprietary trading desks and public research issuance shut not down at these firms. There are plenty of boutique research firms to fill the void. The only conclusion to be drawn is what Europe is calling "regulatory capture" here in the U.S. That is a phrase similar to what Nancy Pelosi was calling "crony capitalism" on Wednesday, September 17 before she decided to join the crony capitalists at a microphone on Thursday, September 18 to promise bipartisanship on the mother of all bailouts to Wall Street.
Lately a joke has been making the rounds that there are two parties: the stupid party and the evil party. When they get together and pass something that is both stupid and evil it is called "bipartisanship."
This unintelligent design business model would have cracked and imploded long ago but for one saving grace: it came with its own unintelligent design justice system called mandatory arbitration. Gloria Steinem once called mandatory arbitration "McJustice." It is really more like Burger King; Wall Street can have it their way. In a system designed by Wall Street's own attorneys, arbitrators do not have to follow the law, or legal precedent, or write a reasoned decision, or pull arbitrators from a large unbiased pool as is done in jury selection. Industry insiders routinely serve over and over again. Had there been ongoing trials in open, public courtrooms, the magnitude of the leverage, worthless securities, and corrupted business model would have been exposed before it brought America to the financial brink.
That Wall Street and its Washington coterie are stilled embraced in regulatory capture and unintelligent design is most keenly evidenced by the recent merger of Merrill Lynch, the brokerage/investment firm, with Bank of America, the commercial bank and ongoing discussions to merge Morgan Stanley, the brokerage/investment firm with a commercial bank. (Memo to Enemy Combatants Against Taxpayers a/k/a Wall Street/Washington: this new model is the failed model of Citigroup. Why do you hate America?)
Make no mistake that what ever the dollar amount announced next week to funnel into an entity to buy bad debts from banks and Wall Street firms, it will not be enough. It is a Band-Aid on a malignant tumor. That tumor is Credit Default Swaps (CDS) with over $60 trillion now owed through secret contracts in an unregulated market created, financed and owned by the unintelligent design masters, Wall Street firms themselves. (See "How Wall Street Blew Itself Up," CounterPunch, January 21, 2008.)
There is no sincere plan by this administration to help America or Americans. There is only a plan to slow the financial collapse until after the November elections by throwing a politically palatable amount of money at it and a plan to continue to blame it on a housing bust.
If we, the American people, allow this to happen, we are enablers to the unintelligent design model. Before one more penny of our taxes are spent on this ruse, we must demand a seat at the table (I think Ralph Nader should occupy that seat) to discuss breaking up Wall Street, crushing this model, innovating a sensible model that serves the individual investor and deserving businesses, and promises our children a future of more than a banana republic.
BEHIND AMERICAN INTERNATIONAL GROUP’S CRISIS, BLIND EYE TO A WEB OF RISK
New York Times financial columnist Gretchen Morgenson supplies some details on the decline and fall of American International Group.
Of all the casualties of the credit implosion so far, Fannie Mae and Freddie Mac were metaphysically preordained to fail, given their charters and the political pressure on them to press the boundaries of financial sanity until something gave. It was also a lead-pipe cinch that a typical litany of too-aggressive banks would succumb with the arrival of a downturn, the only question being how many and how big a draw on FDIC reserves. The big investment banks should have known better, but one can see how the institutional cultures and incentive systems led to the stretching of their basically mediocre businesses beyond the breaking point. AIG, however, was a legendary success story with an exceptional set of business franchises. It had absolutely no need to enter the credit derivatives business.
In the end a company which prospered by taking intelligent risks catastrophically ventured a risk too far. It is hard to come up with a more disastrous business decision, although Wachovia's purchase of option-ARM mortgage specialist Golden West Financial at the height of the bubble is a contender.
“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.” ~~ Joseph J. Cassano, a former A.I.G. executive, August 2007
Two weeks ago, the nation's most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.
As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America's oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world's largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.
The only Wall Street chief executive participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson's former firm. Mr. Blankfein had particular reason for concern.
Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals' woes, was A.I.G.'s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements. A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman's side, several of these people said.
Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion. Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.
A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.'s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm's own interests.
Yet an exploration of A.I.G.'s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected -- and astonishingly fragile -- financial world that began to implode in recent weeks.
Although America's housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators -- sometimes even beyond the understanding of executives peddling them.
Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.
In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world's most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.
"It is beyond shocking that this small operation could blow up the holding company," said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Connecticut. "They found a quick way to make a fast buck on derivatives based on A.I.G.'s solid credit rating and strong balance sheet. But it all got out of control." ...
NOURIEL ROUBINI: PAULSON PLAN IS A DISGRACE
Nouriel "Black Swan" Roubini says that the Paulson plan uses general public money to bail out speculators who bet wrong, while doing "nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown."
Inquiring minds are interested in Nouriel Roubini's thoughts on the Paulson Plan. ...
The Treasury plan (even in its current version agreed with Congress) is very poorly conceived and does not contain many of the key elements of a sound and efficient and fair rescue plan. Like in my 10 step HOME plan many other economists and commentators (Charles Calomiris, Raghu Rajan, Kotlikoff and Mehrling, Luigi Zingales, Martin Wolf, Barry Ritholtz, Chris Whalen and twenty others whose views have been featured this week in the RGE Monitor group blogs) have presented ideas that would have minimized the cost to the US taxpayer of a resolution of this financial crisis. It is a disgrace that no professional economist was consulted by Congress or invited to present his/her views at the Congressional hearings on the Treasury rescue plan.
Specifically, the Treasury plan does not formally provide senior preferred shares for the government in exchange for the government purchase of the toxic/illiquid assets of the financial institutions; so this rescue plan is a huge and massive bailout of the shareholders and the unsecured creditors of the firms; with $700 billion of taxpayer money the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession.
The Treasury plan is a disgrace: a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the U.S. taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown.
BAILOUT OR NOT, CREDIT WILL BE CRUNCHED
Don’t exhale yet: The credit crunch has only just begun.
The prevailing consensus is coming around to what Bob Prechter and his cohorts at Elliott Wave International predicted years ago would come to pass once the credit fever broke: The consumer is tapped out; leverage is out; savings is in. Among the evidence is that household credit growth is at its lowest level since 1970.
"It is the consumer's turn to go through a restructuring," says Nancy Lazar, vice chairwoman and economist at Manhattan's ISI Group. The implications for various consumer discretionary economic sectors and the overseas economies which have been feeding the U.S. consumer's maw will be somewhere between uncomfortable and devastating. In the longer run there is a whole world of demand to be fufilled. Getting there from here will be the trick. It will involve a world of capital stock restructuring. The misallocations induced by the international credit bubble are too mammoth to be undone quickly.
The government's sweeping financial bailout plan may have cheered Wall Street -- but it will take a lot more to lift spirits on Main Street.
The bailout could go a long way in stemming the freefall of financial asset prices, helping to stabilize banks and Wall Street firms. Unfortunately, that will not be enough to truly stoke lending or ease the economic vise that is squeezing American businesses and consumers.
Bank capital will likely remain scarce, businesses will find it tougher to get financing at the same time demand for their wares fades, and consumers are coming under the twin pressures of rising unemployment and falling wages just as their net worths are declining and their ability to borrow is being crimped.
"The risk is increasing for the state of the economy as we move forward because of the substantial stresses," says A. Marshall Acuff Jr., chairman of the investment committee of Richmond, Virginia-based Cary Street Partners, and formerly U.S. equity strategist at Smith Barney. "There will be slow growth in the world; it won't be the end of the world but it will be slow. There will be no quick fix."
The crumbling of some of the biggest and best known financial institutions in the world in a matter of days is causing jitters throughout American industry. That was clear last week during a conference call arranged by the principals of a $140 billion investment-management firm. One caller, from Boeing, wanted to know how to explain to management what the federal bailout of AIG, once the world's largest insurance company, meant for the giant aerospace company. He was told that Boeing should minimize its own counterparty risk, keep liquidity high and preserve cash flow, especially as the fourth quarter approaches and projections call for record losses at financial institutions.
Another caller, from consulting firm Mercer, wondered about the implications of a long and deep recession. He was told U.S. credit growth could fall as low as 2%, the minimum needed for sustainable economic growth and a level only seen in one decade in the last century: 1930-39.
The current crisis is as much one of confidence as it is of credit. That prompted moves late last week by the U.S. government to restore order, bolster security and alleviate the stresses in the system by announcing a comprehensive plan to safeguard the banking system, instead of waiting to deal with individual cases on the brink of collapse. Meanwhile, the Federal Reserve and major central banks around the world made billions available to ailing commercial financial institutions aiming to free up credit.
All the same, the growth of world economies is slowing sharply. International Strategy and Investment Group in Manhattan is forecasting 1% growth in U.S. GDP through the first quarter of 2010. Germany is on the edge of a severe recession; a wage price spiral is unfolding in Eastern Europe; Asian economies are slowing; and declining commodity prices and deteriorating growth in developed markets are pressuring growth in emerging economies.
Yes, there have been some upbeat signs. The outlook for inflation has improved, the manufacturing sector has picked up, mortgage rates have fallen and energy prices are lower. The problem is, it is not enough.
"This is not the end of the credit crunch -- the credit crunch is just beginning," asserts Larry Jeddeloh, publisher of the Market Intelligence Report and founder and chief investment officer of Minneapolis-based TIS Group, an independent research service. "What we have seen thus far are just the first signs of deleveraging at the banks, the consumer level and among corporations. Savings are in. Consumption based on leverage is going out of favor." And he adds: "If you think Wal-Mart and the Dollar Menu at McDonald's rule the roost now, wait a few years. ... Saving and reducing debt and value shopping are the new trends."
Already, year-over-year growth in nonfinancial credit-market debt collapsed to a 3.5% seasonally adjusted annual rate in the second quarter from 9.1% in the third-quarter of 2007, according to the calculations of economists John Ryding and Conrad DeQuadros, founders of RDQ Economics.
Household credit growth is at its lowest level since 1970 and the rate of growth of household liabilities slowed to 3.9%, the lowest growth rate since the fourth quarter of 1970. Yet, as a share of net worth, household liabilities rose to a record high of 25.9%, according to Ryding and DeQuadros.
"It is the consumer's turn to go through a restructuring," says Nancy Lazar, vice chairwoman and economist at Manhattan's ISI Group. "The lack of credit availability combined with a decline in net worth and cyclical forces are creating the beginnings of a sustained slowdown in the U.S. consumer."
That, in turn, will have severe implications for emerging economies, which have become the world's suppliers of consumer goods.
Lazar expects the consumer savings rate to rise sharply, a development that has not occurred in 17 years and will likely trigger a significant and prolonged slump in consumer spending, which represents 2/3 of the U.S. economy.
Lazar expects the consequences of this to be most severe for retailers -- we are potentially "overretailed" and "internationally oversupplied," she says. And she is most concerned about non-durable, heavily discretionary areas such as travel, entertainment, casinos and luxury goods because durable goods, such as autos and furniture, have already been hit hard.
"We are on the downside of the credit boom," says Jeremy Grantham, co-founder and chairman of Boston-based investment manager GMO with $120 billion under management. "Acquiring leverage for any purpose will be made harder."
For the first time, he points out, a global credit crisis has coincided with asset prices that have been overpriced around the world and that will exacerbate the problem.
"There will be a material slowdown in global growth," he says, and "this is going to echo around for a long time."
Real-estate prices have peaked, energy and commodity prices have peaked, and financial assets have peaked.
One notable exception has been the art market. Indeed, in a 2-day period last week, as some of the world's mightiest financial firms fell by the wayside, Sotheby's held a record-shattering, single-artist auction of 223 works done in the past two years by London's Damien Hirst.
The auction, titled "Beautiful Inside My Head Forever," brought $200.7 million, well above the auction house's high estimate of $177.6 million. While Americans were missing from the bidding, the Russians were out in force as were collectors from the Middle East and Asia.
But, don't be surprised if the auction proves to be the peak in the art market, says Grantham, just as Sam Zell's sale of Equity Office Properties in early 2007 to Blackstone Group marked the top of the real-estate market and Blackstone Group's subsequent initial public offering was the beginning of the end for the private-equity boom.
The Hirst auction, notes Grantham, in retrospect might become known as "the Hirst peak," in which the price paid for the works will, indeed, be beautiful only to Hirst and Sotheby's.
DOES THE U.S. FACE A FULL-SCALE RUN ON ITS CURRENCY?
The creation of the credit bubble was one of the most disgraceful episodes of economic government in western history. But that does not mean the ship is lost.
Ambrose Evans-Pritchard takes a look at the various and sundry dollar-collapse forecasts, and takes a pass ... for now. He thinks the other major currencies are in even worse shape, as hard as that may be to believe. Soon enough this will be gold, he believes, but not until it is clear that every central bank will be cranking up the presses.
This just arrived in my e-mail from Alex Patelis, global strategist at Merrill Lynch.
AS THE U.S. PRINTING PRESS STARTS
* Treasury buying mortgage-related assets: $700 billion
* Potential supplementary stimulus package favoured by Democrats: $100 billion
* Insuring money market funds: $50 billion
* Treasury fortifying the Fed's balance sheet: $100 billion
* Expansion of temporary swap lines with central banks: $180 billion
* Loan to AIG: $85 billion
* Fed purchase of agency discount notes & ABCP: amount not specified
* Fed loans through the Primary Dealer Credit Facility: $20 billion through Sept 17
* Fed's discount window: $33 billion balance
* Treasury purchase of GSE MBS this month: $10 billion
* Potential cost of Fannie/Freddie bailout: $200-$300 billion
* Financing the current account deficit: priceless
SELL THE U.S. DOLLAR
"The fiscal cost to the United States is likely to be enormous. Speculation will intensify on a possible U.S. government paper downgrade. U.S. policy-making and credibility has been put into question. The safety of U.S. assets has been put into question. We remain concerned with the repercussions that this crisis will have on the financial flows into the United States against the context of a still large current account deficit."
Mr. Patelis has come within a whisker of warning that the U.S. now faces a full-scale run on its currency and debt markets. There is certainly a risk that this could happen.
By my tally, the serial bail-outs add $1.6 trillion to total U.S. debt, or 12% of GDP, (at least on paper). This is worse than the Swedish banking collapse in the early 1990s.
An entire generation of American policy-makers -- Clinton, Bush, Rubin, Greenspan, and the Congressional leadership of both parties -- has come perilously close to ruining a great nation. The creation of the credit bubble was one of the most disgraceful episodes of economic government in western history.
Nothing can justify it. There is no parallel to the Spain of Phillip II, who ruined his empire to pursue the religious cause of Counter-Reformation, or to the bankruptcy of the British Empire combating fascism. It occurred because America abandoned all restraint and gave licence to consumer hedonism.
Having said that, I still believe that the U.S. has the cultural vitality to pull itself out of this debacle.
While I endorse Mr. Patelis's indictment, I do not entirely share his conclusions. The debt added is backed by collateral, mostly housing, and is therefore nothing like normal government debt.
Even if it were, the U.S. general government debt (owed to the public, under IMF measures) would rise from 48% to 60% of GDP. Yes, I know the U.S. "national debt" is higher, but that is not the relevant benchmark for worldwide comparisons.
This extra debt is a tax on the future. It is unconscionable, but it is not a catastrophe. It would still leave U.S. debt at French or German levels, and well below those of Japan and Italy -- assuming you believe the official figures.
I do not think it will come to this. The RTC made a profit in the early 1990s as the Savings and Loan crisis slowly abated. Paulson's "TARP" may do likewise. The ABX index used to price subprime debt almost certainly overstates the likely default rate.
Stephen Jen, currency chief at Morgan Stanley, says bank crises are bloody for currencies, but nationalizations of the banking system (which is what we have here, in disguised form) typically mark the bottom.
I do not share the widespread view that the dollar will collapse. This has prompted a volley of hostile comment, as if I was somehow turning traitor to the cause of bears, or had become an optimist overnight.
The reason why it will not collapse -- at least for now -- is that the euro is facing an even deeper and more intractable crisis, Britain is mangled, Sweden frozen, most of Eastern Europe is facing a swing from property boom to bust, Brazil is about to slow dramatically, Japan is in full-recession, and China's banking systems is buckling, as Fitch warned today (September 23).
What I envisage as this credit crisis goes turns into a full-fledged global economic slump is that half the world resorts to currency devaluation in a beggar-thy-neighbor scramble to stave off recession and cling to market share.
This will be very good for gold, though only once the EMU smash-up becomes more evident, perhaps with the onset of street protests in Spain. You will not have to wait very long.
To those GATA loyalists asking me why I never report on their claim that the gold price is manipulated by central banks, I can only say that it would be a full-time job to attempt to verify such assertions. I cannot judge whether China, Japan, Russia, emerging Asia, or the Mid-East petro-powers are colluding in such practices, or ascertain why they would do so. And unless they collude, any unilateral efforts by the U.S. to suppress gold would prove futile -- would it not?
MISDIRECTED CREDIT RUNS UNABATED
A classic case of throwing good “money” after bad. The current direction of bubble-sustaining policymaking goes the wrong direction in almost all aspects.
Doug Noland warns that behind all the bailout proposals lies the fundamental misconception about what will be required to put the U.S. economy on sound footing. The U.S. is not faced with a simple liquidity/"confidence" issue. The true problem is that the whole capital allocation and pricing mechanism has been grossly distorted by years of excess credit growth. Ultimately "an epic restructuring of the U.S. economic system" will be required, with a reemphasis on saving over spending, and production of tradeable goods over services. Any hints of understanding regarding this have thus far failed to emanate from Washington or Wall Street.
When I titled last week's piece "Too Big to Suffer a Loss" I had no real inkling of what the past week would have in store. Actually, I had presumed that the Treasury and Fed would not allow Lehman to fail. Lehman Brothers, after all, was one of the major players in the precarious daisy chain of Wall Street risk intermediation. A failure by any key player in this realm would immediately have this historic credit crisis jumping the firebreak from the rugged terrain of mortgages and "risk assets" into the hallowed land of perceived safe and liquid contemporary "money." The consequences of such a lurid escalation were potentially so catastrophic that I believed Hank Paulson and Ben Bernanke were prepared to use the overwhelming force of fleets of aerial supertankers to ensure our "money" tinderbox was not set ablaze.
It now appears they did not appreciate the ramifications for Lehman going under -- how this would quickly ignite a run on the core of our monetary system. It was not long, however, before the horror of watching the entire system going up in flames prompted a mad scramble to conjure the equivalent of monetary firefighting "Shock and Awe". ...
[T]he administration presented Congress a $700 billion plan to stem the credit and, increasingly, economic crises. Wall Street and the Banking system have been rapidly burning through their entire "capital" buffer, as the risk intermediation community suffers enormous and unending losses. The bursting of the credit bubble is proving catastrophic for many that intermediated the risk between $trillions of risky loan assets funded by the issuance of $trillions of perceived safe and liquid money-like liabilities. For a while, the global sovereign wealth funds, speculators, and some investors were content to step up and lead a recapitalization process. As time passed, however, this was increasingly recognized as a classic case of "throwing good 'money' after bad."
As losses escalated and sources of additional "capital" dried up, focus quickly turned to escalating losses being suffered by some gigantic and highly leveraged players (i.e., Lehman, Merrill, and AIG). At least in the case of Lehman, a run on their money market liabilities (especially "repos") had commenced. Bankruptcy by Lehman -- with the extreme market uncertainty associated with unprecedented losses to bondholders, creditors and counterparties -- immediately froze the credit default swap marketplace. Dislocation in the CDS market was a deathblow for AIG and many hedge funds.
The Lehman Contagion quickly incited panic throughout the money fund complex, to-this-point a bulletproof sector that had, after a year of enormous growth, become an even more vital pillar to the sacred domain of contemporary "money." Exposure to Lehman forced the Primary Reserve Fund, a venerable money market operation, to mark down its portfolio 3%. Primary Reserve saw 60% of its fund (almost $40 billion) redeemed in just two days, as trading in even the lost "liquid" short-term money market instruments seized up. A modern day electronic "run" on contemporary "money" had commenced. The system had reached the brink of collapse.
To stabilize the system at such a point required nothing less than unprecedented measures. The Treasury and Federal Reserve would have to become major "buyers of last resort" -- both the providers of massive marketplace liquidity and the underwriter of massive credit losses. With the monetary system breaking down, the federal government saw no alternative than to fill the void left by the impaired risk intermediators. Or, from a more theoretical perspective, our government would have to guarantee the "moneyness of credit" -- assume the spiraling losses between the trillions of risky system loans and the trillions issued of perceived safe and liquid "money." No systemic federal guarantee, no more "moneyness" -- and an immediate end to the last bastions of credit growth that have been sustaining the U.S. Bubble Economy.
So what is the problem with the government stepping up to guarantee "moneyness"? How can it be inflationary, when credit growth has slowed so dramatically, assets prices have come under such pressure, and confidence in the system has been so shaken? Well, I continue to believe that some overriding issues are today lost in the discussion; lost in all the pontificating; lost in the frenzy of panicked policymaking.
I am not surprised that our policymakers nationalized Fannie and Freddie. It was predictable that the Treasury and Fed were forced into wholesale bailouts and unprecedented liquidity operations. That Washington had to step up and guarantee money fund deposits is not all too surprising. Ditto with the upwards of $1 trillion of Congressional authorizations, with policymakers bumbling through various measures in hopes of stabilizing the system. Over the years, we have been pretty cognizant of the extreme nature of excesses, the extent of system vulnerability, and the expensive bill that would come due with the arrival of the bust. But I want to be especially clear on one thing: I am shocked and incredibly alarmed that all these measures became necessary at such an early stage of financial and economic adjustment. After all, the Dow remains above 11,000 and GDP expanded 3.3% last quarter.
And this gets right to the heart of the matter -- where the analytical rubber meets the road. A massive inflation of government obligations; a major government intrusion into all matters financial and economic; and an unprecedented circumvention of free market forces have been unleashed -- but to what end? I believe it is a grave predicament that such a rampage of radical policymaking has been unleashed in order to maintain inflated asset markets and to sustain a Bubble Economy. Normally, such desperate measures would be employed only after a crash and in the midst of a major economic downturn -- not in efforts specifically to forestall the unwind. Not only will such measures not work, I believe they will only exacerbate today's already extreme global monetary disorder. They will definitely worsen the inevitable financial and economic dislocation.
I have over the past several years repeatedly taken issue with the revisionist view that had the Fed recapitalized the banking system after the 1929 stock market crash the Great Depression would have been avoided. Some have suggested that $4 billion from the Fed back then would have replenished lost banking system capital and stemmed economic collapse. But I believe passionately that this is deeply flawed and dangerous analysis. An injection of a relatively small $4 billion would have mattered little. What might have worked -- albeit only temporarily -- would have been the creation of many tens of billions of new credit required to arrest asset and debt market deflation and refuel the Bubble Economy. Importantly, however, at that point only continuous and massive credit injections would have kept the system from commencing its inevitable lurch into a downward financial and economic spiral.
Importantly, market, asset and economic bubbles are voracious credit gluttons. I would argue that the system today continues to operate at grossly inflated -- bubble -- levels. The upshot of years of credit excess are grossly distorted asset prices, household incomes, corporate cash flows and spending, government receipts and expenditures, system investment and economy-wide spending and, especially, imports. So to generally stabilize today's maladjusted system will, as we are now witnessing, require massive government intervention. Enormous government-supported credit growth will be necessary this year, next year, and the years after that. To be sure, a protracted and historic cycle of misdirected credit runs unabated.
Today's efforts to sustain the Bubble Economy create an untenable situation. Washington is now in the process of spending trillions to bolster a failed financial structure, while focusing support on troubled mortgages, housing, and household spending. Regrettably, this is a classic case of throwing good "money" after bad. Not yet understood by our policymakers, literally trillions of new credit will at some point be necessary to finance an epic restructuring of the U.S. economic system. Our economy will have no choice but to adjust to less household spending, major changes in the pattern of spending (i.e., less "upscale" and services), fewer imports, more exports, and less energy consumption. Moreover, our economy must adjust and adapt to being much less dependent on finance and credit growth -- which will require our "output" to be much more product-based as opposed to "services"-based. We will be forced to trade goods for goods.
The current direction of bubble-sustaining policymaking goes the wrong direction in almost all aspects. At some point, the markets will recognize this bubble predicament, setting the stage for a very problematic crisis of confidence for the dollar and our federal debt markets.
GOLD MARKS TIME, GOLD STOCKS TREND STILL EXTREMELY BEARISH
Those holding unleveraged gold need not concern themselves with the intermediate-term precipitous decline in the metal's price. Those buying or selling gold on margin, or dabbling in mining shares -- which are effectively a leveraged bet on gold's price -- do not have that luxury. If you bought gold "for the long-term" at $1000/ounce using 2-to-1 leverage you got killed unless you had a stop-loss sell order in place.
According to this commentary, from a source we are new to, the sudden surge in gold in the last two weeks does turn the trend positive, if just barely. He finds silver's technicals less compelling, and is recommending that one wait on buying precious metals mining shares for a safer entry point.
We advocate a core holding of gold as a hedge against financial turmoil. It is the one financial asset which is not someone else's liability. Also remembering that just because something is inevitable does not mean it is imminent, and that the market is always right, we like to keep an eye on what the precious metals trackers and soothsayers are saying.
After a sharp move on Monday it seemed that gold bugs just threw in the towel and stepped to the sidelines. The rest of the week was basically a lateral move with a downside bias. Everyone is now waiting for this week to see what the politicians will do.
Gold: Long Term
Two weeks ago I showed the long term point and figure chart dating back to the start of this long bull trend (interspersed with some short downer periods). I thought it was appropriate to update it as the chart is in a very interesting position. Although the bull break had been a very weak one with a projection only to the $930 level, which it almost reached, the subsequent consolidation on the chart suggests that a more major move may be ahead.
A move to the $930 level would be a new break-out and would then project to at least the $1050 level, a new high. That could set in motion all sorts of possibilities that we would have to look at when and if it should come to past. On the other hand a move back to the $825 level could have a serious negative impact.
Looking at the regular chart and indicators the price of gold (presently using the Dec. 2008 contract data) closed on Friday just below its long term moving average and the moving average is still very slightly sloping downward. The long term momentum indicator, however, remains just above its neutral line in the positive zone and above its positive trigger line. The volume indicator is showing very little speculative interest in gold one way or the other and is in more of a lateral trend but below its negative trigger line. All in all, we are still in a neutral rating period.
Gold: Intermediate Term
Despite a sharp move upward on Monday the rest of the week pretty well nullified its effect. By the end of the week we were back where we were a week ago as far as the indicators and ratings are concerned. Gold remains above its moving average line and the line slope remains very, very gently upwards. The momentum indicator remains in its positive zone but only slightly. It is also slightly above its positive trigger line. The volume indicator, as mentioned above, continues to move sideways below its negative trigger line. All this had given us a bullish rating last week and the rating remains the same, at bullish.
There is that problem with the volume indicator. Its weakness does not bode well for a continued advance in the price of gold. If it does not perk up soon then we may expect the price of gold to possibly take a downward direction.
Gold: Short Term
Looking at the short term chart most of the trend and momentum indicators are still positive but if we go a little deeper into the very short term we start to get an uncomfortable feeling. First, the short term. As we see, gold remains above its short term moving average line (15 DMAw) and the line is still sloping upwards. The short term momentum remains in its positive zone but has now dropped below its still positive trigger line. Gold seems to be trapped, at least for now, inside a "box" pattern. All is still in place for a bullish short term rating.
As for the immediate direction of least resistance, well that seems to be edging towards the down side. Gold closed Friday just a hair below its very short term moving average line and the Stochastic Oscillator seems to be running at full speed towards its negative zone and is already below its negative trigger line. For now the immediate direction of least resistance seems to be towards the downside.
Although silver had a pretty good week it still has far to go to meet gold's recent performance. While gold is consolidating above its previous resistance (now a support) line silver is still far below its line. On the silver chart (not shown) this line is at the $16 mark while on the gold chart it is at the $850 mark ... It does look like silver may be developing a bullish reverse head and shoulder pattern but I would be careful with it. I like to see the momentum indicator show a positive divergence at the head but we have no such divergence. That does not mean that a reverse head and shoulder cannot develop, only that the risk is higher of it proving its projection should it develop.
Although there has been a two week rally the price of silver is still below its intermediate term moving average line and the line is still sloping downward. The intermediate term momentum indicator remains in its negative zone but is above its positive trigger line. The volume indicator seems to be going nowhere except sideways despite the two week rally. Seems there is little speculative interest on the up side to this point. Where gold is rated as bullish, silver is rated as intermediate term Bearish.
Precious Metal Stocks
Since late February the average gold and silver stock, as represented by the 160 stocks of the Merv's Gold & Silver 160 Index, has taken a severe tumble, almost the reverse of its sharp advance of late 2005 and early 2006. I guess what goes up must come down. There are many analysts out there who claim this is a very good time to pick up bargains, as they have been claiming throughout the decline. They will be right at some point. I have been cautioning readers for many months now that there will be plenty of profits to be made once the turn around is upon us but the thing is to sit tight, hold on to your capital and wait for the turn to be confirmed. That time has not yet come.
Looking over where these 160 stocks rate (technically) we see that the bias is still on the bearish side. For the short term the ratings stand at 48% BULL and 37% BEAR. On the intermediate term those ratings are 18% BULL and 69% BEAR while on the long term it is 6% BULL and 85% BEAR. So we see that these stocks still have a lot of work to do before they become lower risk investments. The short term is the place to look for a hint of a reversal in the works but also on the short term we have more whip-saw events, but it is a place to watch for advance warnings. ... [T]he short term is very volatile and these stocks have a habit of reversing quickly.
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