Op/Ed: The People's Republic of Wall Street
Patriotism is supporting your country all the time, and your government when it deserves it.
- Mark Twain
(ANNAPOLIS - December 14, 2008) - I can’t help but wonder what Mark Twain would have written about the recent string of government led bailouts. After all, he once opined that one should be careful about reading health books; you may die of a misprint. We’ve been led to believe that this great nation would prosper indefinitely on the basic tenets of capitalism, a meritorious set of principles grounded in the inalienable philosophy that risk should always be in direct proportion to expected return, that we are paid according to what the free markets are willing to bear and the most efficient and most productive amongst us shall reap the rewards of hard work and innovation. Well, it would seem that this very idea of a free market society is dead, and I’m told it committed suicide.
On Friday October 3rd the House of Representatives passed a $700 billion bailout package to solve a crisis that originated from the unwarranted expansion of credit. Mortgages, car loans and credit cards were offered to unqualified borrowers. These debts were then packaged together and used as collateral for bonds, which represented 38 percent of the bond market . Wall Street firms were deregulated to the extent that they could legally value these bonds themselves, using in-house arbitrary estimates, and subsequently leveraged these same assets by as much as 40 to 1 . Wall Street firms then created credit default swaps, which are essentially bets that a bond would or would not default, valued these bets at $62 trillion and placed them on off-shore balance sheets , because apparently earning $6 for every $1,000 of each mortgage backed security they manufactured didn’t generate enough profit for banking institutions. In essence, they transformed the credit markets into an unparalleled house of cards. Once the housing market collapsed, these “troubled assets” became illiquid and were frozen on the balance sheets of banks, who then were either unwilling or unable to lend money and created a credit crisis that threatened the viability of the entire global financial system. In response, Treasury Secretary Henry Paulson initiated his fifth or sixth attempt, depending on whom you ask, to stabilize the markets by giving banks $250 billion in return for preferred stock . Moreover, the government will ensure all interbank lending, guarantee money market funds, increase FDIC insurance to $250,000 and buy “hard to value” assets from the balance sheets of troubled banks. The purpose of these efforts is to free up credit by flooding the economy with money and unclogging the arteries of the financial markets. Unfortunately, these measures may prove fruitless. For starters, they do not address the underlying problem, the fact that many homeowners cannot pay their mortgage. Furthermore, many banks own complicated and depreciated assets with an undetermined value. How will this injection of capital improve transparency and influence banks to lend to each other again? It now seems that we are flirting with a liquidity trap, a condition that plagued Japan in the 1990’s, whereby interest rates are at or close to zero, reducing the central bank’s ability to stimulate the economy by lowering rates in the future. Instead, money is injected directly into banks, which then hoard the cash for obvious reasons. Sure enough, Secretary Paulson has had to beg banks to actually lend the $250 billion of hard earned taxpayer money in an effort to unfreeze the credit markets . Wall Street orchestrated an unprecedented scam, used the aftermath to blackmail the United States treasury and our congressional leaders lacked the intestinal fortitude to adequately address the crisis. With all due respect to our two party political system, we’re playing kickball with one leg.
The wind always blows before the storm hits
- Percy Johnson, paternal grandfather
Despite the slate of bad news we already know, this may be the tip of the iceberg. Alt-A loans are mortgages offered to borrowers who choose not to document their income, but have good credit. The foreclosure rate for Alt-A loans has quadrupled over the last year and 16 percent of these loans issued since 2006 are 60 days past due or delinquent . If $855 billion in subprime loans were a problem, what happens when $1 trillion in Alt-A loans show signs of stress ? Over the next few years, $300 billion of option ARMs and $820 billion of Interest Only loans will reset – these mortgages represent 15 percent of securitized loans . And now that the national debt clock in New York City has literally run of digits to illustrate the federal government’s current debt of $10.2 trillion , which entities will the government bailout next? In 20 years, social security, Medicare and Medicaid will consume 15 percent of the nation’s economy. In 50 years, it will consume 20 percent . Medicare obligations alone have grown so large that if you sold every home, every farm, every factory, and every business in America and invested the money in something that returned as much as long-term bonds, there would not be enough to pay for the foreseeable Medicare expenditures of this nation in the 21st century . The Pension Benefit Guarantee Corporation is a federal corporation that insures pension plans in the event that an employer is deemed unfit to fulfill its pension obligations. If the PBGC were subject to generally accepted accounting principles (GAAP), it would be considered insolvent , and that’s before it doubled its exposure to stocks in May 2008 . And with 65 percent of S&P 500 company pension plans underfunded , I have a sneaky suspicion that the PBGC will be the recipient of a bailout to be named later. Where is all this money coming from? The only reason the value of the dollar has held its value is because the European markets are in worse shape than our own. Britain plans to provide eight of the U.K.'s largest banks with up to 50 billion pounds, or $88 billion , to help unclog the nation's frozen credit markets, Iceland’s currency has already collapsed and Spain will spend five percent of its GDP to buy troubled assets from banks to give them more funds to lend . This has become a global crisis and the United States is the self-appointed ringleader. Once foreign investors and sovereign wealth funds of OPEC countries, who finance 75 percent of the United States budget deficit , grow impatient with currencies that aren’t backed by anything of value, such as gold, or for that matter, a stable economy, they might very well invest their resources elsewhere. Should that happen, the world would experience a global currency crisis, accompanied by hyper-inflation, high unemployment and political unrest. Americans drank the spiked punch, passed out and woke up to a bankrupt country. I should be alarmed, but instead I’m embarrassed.
Of course, nobody was more humiliated than the French, who built the Maginot Line, an impenetrable wall along the borders of Italy and Germany, supported by heavy artillery and 15 percent of the French army. Its purpose was to defend France from outside aggression, most notably Germany during World War II. I don’t doubt that the French felt safe and secure behind this intimidating obstacle, but in the spring of 1940 an undeterred Adolf Hitler invaded Belgium, went around the wall and conquered Paris by June of that same year. It’s only human nature to seek shelter in times of turbulence, but there are occasions when even the tried and true methods may not be available. CDs are insured by the FDIC for up to $250,000, but the FDIC insures $4.5 trillion in U.S. deposits with only $45 billion in reserves, and that’s before the $8.9 billion cost for the failure of IndyMac is taken into account . Moreover, while 117 banks are on the watch list for failure, it’s possible that 700 of the roughly 8,500 banks that are FDIC insured are in trouble , leading to speculation that the FDIC itself may soon need a bailout . Many investors will turn to money market investments, which are nothing more than pools of short term debts, often collateralized by the very same assets the government agreed to purchase from the balance sheets of banks to prevent their demise. If these so-called cash equivalents are so safe, why did the government feel the need to temporarily guarantee $3.4 trillion of money market investments? And when that didn’t settle the matter, the Federal Reserve launched a new facility to fund purchases of certificates of deposit and commercial paper from money market investments in yet another step to provide liquidity to strained financial markets . More importantly, risk is always in proportion to expected return. Imagine if you lent somebody money on the condition that your funds are returned the next year. Given the short period of time your money is at risk, you would not require significant compensation in the way of an interest rate. Should you lend money to someone who would return these funds in 30 years, considering all that could go wrong between now and 2038, it stands to reason that the interest rate would be higher. Oddly enough, many money market investments and CDs are offering investors the same interest rate as one would receive from a 30 year treasury bond. How can an investor have access to his/her money on a daily basis, or even one year, and still receive the same rate of return as another who must wait until 2038, unless the short-term investments are taking significantly more risk? I understand these instruments may feel safe, but in this environment, they are anything but a guarantee.
Don’t play what’s there; play what is not there
- Miles Davis, Jazz musician
The fall of the Roman Empire has many origins, but it is an indisputable fact that Nero and other emperors debased the currency by reducing its content of precious metals to supply a demand for more coins. Once luxurious emperors like Commodus depleted the imperial coffers, the empire had almost no money left after his assassination. I still endorse the basic premise of asset allocation, that a wide mix of asset classes who move in different directions, given the same economic conditions, mitigate risk over extended periods of time. I also believe that gold is the only incorruptible form of money whose price has been openly manipulated. The gold reserves for the United States have not been fully or independently audited for half a century . Former Federal Reserve chairman Alan Greenspan testified before congress on July 24, 1998 that “central banks stand ready to lease gold in increasing quantities should the price rise”. Barrick Gold Corp admitted in District Court in New Orleans on February 28, 2003 that it assisted central banks in shorting the gold market. I wish this were the talk of conspiracy theorists, but a decade ago 14 European central banks decided to reduce their gold holdings in an orderly fashion. They actually signed a pact to sell no more than an agreed sum between them each year . Accordingly, the United States, the Bank for International Settlements and the International Monetary Fund agreed to adhere to the pact informally. In May 1999, the Bank of England sold ½ of their gold reserves and in May 2008 , the IMF followed suit and sold 400 tonnes of gold into the open market .
Why would central banks deliberately keep the price of gold down? Because they used the fractional reserve system to print money and dilute the major currencies of the world, effectively making them worthless. Had the price of gold dramatically increased to account for the diluted currency values, the markets would have recognized the real rate of inflation, which in turn would have impacted growth and called attention to the unsustainable levels of debt. It took all of human history to build the $7 trillion world economy of 1950; today economic growth grows by that amount each decade. At the current rates of growth, the economy will double in 14 years . We’ve become addicted to short-term growth and gadgets, going from nowhere to no place, and by all accounts these conditions cannot continue unabated. The global financial markets manufactured arbitrarily valued securities, leveraged them to the hilt and hoped the Ponzi scheme would last forever. Spendthrift Americans, who in years past called on others to be responsible for their actions, now find themselves pointing the finger at Wall Street and Washington for their own financial struggles, as if the gangster element of the investment banking community forced them at gunpoint to live beyond their means. Worst of all, the governments of developed nations spent money they didn’t have on social programs, foreign policy initiatives and pet projects by borrowing money from emerging market countries, flooding the economy with an already diluted currency and masking the impact by suppressing the price of gold. Ask yourself, what did we get in return for all of this reckless spending – manufacturing jobs to stimulate the economy, new technologies that we can export to other countries, a thriving alternative energy industry to incent the workforce to become better educated, some means of generating revenue and paying back our debt? Nope, we got overbuilt Florida condominiums and flat screen TVs. It’s a good thing that wealth never disappears, it just shifts, which creates opportunity. Should the broader financial markets continue to deteriorate, causing investors to lose confidence in nations who are deep in debt, they might very well take their losses, reduce their exposure to paper money and look elsewhere to preserve their wealth. Somewhere like gold.
If being born to good parents is a matter of luck, I’m convinced I won the lottery. My mother and father taught me that while we do not live in a perfect republic, so long as I worked hard and maintained a responsible existence, there is no other country I’d rather live. Investors with good judgment will survive these uncertainties; the world is not coming to an end. Having said all of that, I never in my lifetime thought the United States would be so utterly mismanaged. If we learned nothing else, we are being governed by pedantic self-serving attorneys and incompetent third generation millionaires masquerading as the common man. While our politicians sold patriotism on television commercials, they pawned the American flag to foreign investors star by star, stripe by stripe. But here we are, facing the biggest financial crisis the world has seen in 70 years. Every so often there comes a time when individuals must disregard the urge to do what’s considered reasonable by the unreasoned and act in their own best interest. History is replete with occasions when those who consume unsubstantiated pleas to continue antiquated strategies suffer unimaginable consequences - apathy ain’t cheap. Despite the reassurance offered by decades of positive long-term returns in the equity markets, occasionally their behavior can be violent, even hostile, and investors must adapt solutions that take their own sweet time to materialize, which in this case may be the ownership of tangible assets. How many times have we been told to buy, hold and forget, to embrace history lessons detailing the last five or six bear markets – to do absolutely nothing? If I jumped out of the top floor of an 80 story building, I might very well think I’m flying for the first 79 floors. One thing is becoming apparent: this is not a fire drill. What once was considered safe may now be risky. Those assets deemed volatile could become a safe haven during times of tribulation. Countless experts anointed as ingenious have been disproven. Many pundits we thought to be radical are now the authors of increasingly credible ideas. How bad can things get - the Japanese market is worth 1/3 of its value from 19 years ago and the U.S. stock market did not recover from the crash of 1929 until 1954 . The intent of the government led bailout was to prevent a potential market meltdown, but at what cost? The gains of Wall Street were privatized, but the losses have been socialized. As the government adds to its already mounting debt, the consumers may ultimately face higher taxes, rising inflation and increasing costs to borrow money. So in a sense, Mark Twain may have had a point – misprints can be fatal.
JP Morgan Asset Management
A mortgage Fable; Wall Street Journal; 9/22/08
Credit Default Swaps: Weapons of Mass Speculation; Barron’s; 5/12/08
Street Set to Fill Hole in Mortgage Market; Wall Street Journal; 9/8/08
Bank Stocks Surge as Government Pumps in $250 billion; CNBC.com; 10/14/08
Paulson Lacks the Leverage to Make Banks Put Cash to Work, Bloomberg.com; 10/15/08
Alt-A Mortgages Next Risk for Housing Market as Defaults Surge; Bloomberg.com; 9/12/08
Alt-A Mortgages Next Risk for Housing Market as Defaults Surge; Bloomberg.com; 9/12/08
ARM Resets: Tsunami Ahead; CNBC.com; 9/4/08
U.S. Debt Overpowers National Debt Clock; CNN.com; 10/9/08
Government Accountability Office, U.S. Financial Condition and Fiscal Future Briefing; Jan. 2008
Note to the Treasury Secretary: It’s Time to Raise Taxes; New York Times; 6/25/06
Center on Federal Financial Institutions
Gambling for Salvation; Why the PBGC Should Just Say No; Kellog School of Management; 3/3/08
JP Morgan Asset Management
British Government Announces Plan to Help Banks; Washington Post; 10/8/08
Icelanders Sink Under Foreign-Currency Loans as Krona Plunges; Bloomberg; 10/14/08
After Years of Heavy Borrowiung, Spain is Poised for a Slump; Wall Street Journal; 10/9/08
CNN.com; “One Man’s Campaign Against Debt; March 30, 2007
FDIC Proposes Doubling Fees to Boost Insurance Fund, Bloomberg.com; 10/7/08
Yes, That’s $2 Trillion of Debt Related Losses; Barron’s; 8/2/08
FDIC May Need a $150 Billion Bailout as Local Bank Failures Mount; Bloomberg; 9/25/08
Fed Launching New Effort to Help Out Money Funds; CNBC.com; 10/21/08
Gold Anti-Trust Actions Committee, Inc.
Gold May Regain Luster for World’s Central Banks; Wall Street Journal; 9/22/08
Treasury Offloads Gold Reserves; BBC; 5/7/99
Gold Falls as U.S. Pledges Support for Some IMF Bullion Sales; Bloomberg; 2/25/08
“Hot, Flat and Crowded”; Thomas Friedman
Save the Fat Cats; New York Times; 10/2/08
Lessons From the 1929 Stock Market Crash; BBC; 10/9/08