WFC 10-Q: The Diminishing Returns of Quantitative Easing

The 10-Q for Wells Fargo Bank was just released.  Let’s take a look under the hood and see what this report from the country’s largest mortgage lender tells us about the housing market and the business trends affecting the largest banks.

The first thing you’ll notice is that revenue was down small YOY (-2%) and that pre-tax, pre-provision profit was likewise down a similar amount.  Loans were up about the same amount, not typical for banks broadly, but the AFS securities account was up 8% or twice the rate of growth for the loan book.  Despite the happy talk coming from the latest Fed survey on lending conditions, lenders are having an increasingly difficult time finding acceptable assets for the lending book.  While the average loan book grew $30 billion YOY, WFC’s deposits grew $55 billion or 2x.  Keep in mind too that credit cards, non-agency RMBS and leases are the highest yielding asset sub-classes for WFC.

Allowances for loan losses were down 11% YOY as WFC, like the industry as a whole, continued to reserve less for future losses than was charged off in the current period.  To understand how WFC made its earnings number in Q1 2013, ponder the following.  Revenue was down $300 million YOY to $21.3 billion, but WFC put aside $800 million less in provisions in Q1 2013 vs. the same period in 2012.  Non-interest expense was cut by another $600 million, resulting in net income of $5.2 billion in Q1 2013 or $1 billion above the same period last year.  There is no growth here per se.  WFC is a cost reduction story, plain and simple.  

One of the reasons that WFC and the banking industry generally are able to pad earnings with lower provisions for loan losses is because the 0-89 day past due loan category is continuing to fall.  The dirty little secret in the banking industry is that the +90 day and non-accrual categories are not falling (see chart below).  Indeed, it might surprise many bank investors to know that there are some $190 billion in +90 days and non-accrual 1-4 family loans on the books of US banks. This is a pile of lovely distressed assets equal to nearly 8% of the $2.4 trillion in 1-4s held in portfolio by all FDIC insured banks.  Sell Side analysts never look at this data, you understand, because it would detract from the bull case.  But for those of us who know and love the NPL trade, suffice to say that the proverbial ice cube is not melting nearly as fast as regulators and the Big Media like to believe.  

In terms of net interest margin, the bank’s cost of fund from all sources was just 0.38% while the yield on earning assets was 3.86%.  Net interest margin was 3.48%, down half a point YOY from 3.91%.  About half of WFC’s revenue dollar comes from non-interest sources, much higher than most banks, but NIM is a vital part of the overall business. In dollar terms, the Q1 2013 NIM was $10.8 billion vs. $11.1 billion last year.  Again, this illustrates the fact that the Fed’s QE is no longer propping up NIM and in fact is starting to accelerate NIM compression. 

What are the big areas of growth in terms of income?  Well, service charges on deposit accounts were up 12% YOY. Brokerage and advisory fees were also up 12% vs. last year.  And investment banking fees were up 37% to $357 million in Q1 2013.  Trust and investment fees were also up 13% YOY.  Credit card fees were also up 13%.  Most significant, mortgage banking fees were down 3% YOY as markedly higher servicing fees (+25%) were swamped by falling gain on sale.  

Yes, even though the bond market has rallied due to QE and the monetary lunacy in evidence at the Bank of Japan, gain on sale in the mortgage sector is shrinking.  Again, the diminishing returns of QE are very evident in the WFC results.  With prime lending customers available in dwindling numbers and spread tightening in the agency TBA market, is there any surprise that gain on sale for WFC and other mortgage banks is falling?  If you are surprised, please don't admit it.    

With all of the effort in terms of increased fees to boost non-interest income, the net, net for WFC's non-interest income in Q1 2013 was flat, around $10.8 billion.  Such is the large impact of changes in the mortgage sector.  As time goes on and spreads in the TBA market revert to the mean, it is possible that we may see actual declines in non-interest income at WFC and other banks that operate in the agency TBA market.  At one quarter of non-interest income for WFC, gain on sale is the first thing to look for in earnings results.

The key takeaway from the Q1 2013 results for WFC and the industry as a whole is that US banks are not a growth opportunity at the present time.  Mortgage applications may be up, this according to the Mortgage Bankers Association, but precious few 1-4 family mortgage loans are actually being closed and those which are closing are refinancing of existing loans by a 3:1 ratio, according to the MBA.  Get used to it.     

www.rcwhalen.com

We Are Strong: It is Our Institutions That are Crumbling

Jesus Money Lenders

We Are Strong: It is Our Institutions That are Crumbling

By George Mantor

It is the beginning of the end of the way things used to be. Once reliable institutions are being destroyed from within and we cannot save them. Nor should we want to.

The “one big thing”, globalization, new world order…all failing.

Central Banks, Fiat Money and Fractional Reserve Banking…failing.

Political Parties, most governments, The Catholic Church, Universities…all failing.

And, no matter how much money they get from us they cannot reverse the rot of moral decay. Honesty, integrity, transparency, fairness, accountability, and justice are absent at every level.

This is what happens when you live a lie. You even have so called journalists like the Orlando Sentinel’s, Beth Kassab, arguing that justice is far less important than expediency. How’s that supposed to work?

“Right this way to the showers.” That wasn’t justice, but it sure got rid of a lot of Jews in a hurry.

Already, if you live in Florida and they illegally foreclose on your home you have one minute to make your case of the tangled web of fraud and forged documents. One fucking minute? How is that supposed to work?

We are literally making up money to give to big business and backing it with higher taxes on wage earners, the real bearers of the burden of taxes. How is that supposed to work?

The money system failed in 2008, but the American taxpayer provided more than $16 trillion to banks around the world so they could pretend it didn’t happen. But, the underlying problem hasn’t been resolved. It has grown exponentially.

If they had simply let the banks fail and distributed the $16 trillion in equal shares to every American citizen over the age of 18, we would all be safer, saner, wealthier, functional, viable, and sustainable. It is, after all, our fucking money and they can always print more. What am I missing?

I know it sounds crazy, but don’t you think giving it to bankstas is even crazier?

Iceland did a version of my plan, and boy, are they happy. And now they are prosecuting the bankstas. Iceland must have the only leaders left on the planet that have any balls or any brains.

Right now, the Federal Reserve Bank is buying worthless mortgage bonds to the tune of $85 billion per month on the lame notion that allowing banks to add nonexistent money to their books is better than declaring the bonds worthless. Folks, you just cannot make this stuff up.

It is simply a continuing, on-going, bank bailout with no end in sight. It’s called pumping liquidity into the system so that LOANS will get made, business will fire up, hiring would gradually improve as products are manufactured, distribution kicks in next followed by retail, and taxes get paid.

But, we are still creating debt that cannot be paid back because paying it back hurts bank profits. Few people seem to understand exactly how insanely lunatic the very notion is.

If we were given $16 trillion directly to spend, this is what would have happened.

We would have invested the money to our benefit, not necessarily in the best interest of the corporatocrocy and their high speed computer trading. We would have paid off debt, but that hurts the corporatocrocy because the entire money supply is based on debt. Debt is the only purpose of fiat money.

If we had been given the money, we would have donated some, sent kids to college, started businesses, hired people, bought cars and houses, and paid lots of taxes.

Bankstas buy Bugatti’s and Caspian roe and offshore the rest in secret accounts. They got $16 trillion of our money and what did we get? A $16 trillion national debt that will eventually bring us down.

What we are witnessing in Cyprus is the beginning of the real and final collapse. There is nothing left on the planet to borrow against.

Look at it this way. You maxed out your credit card but you still need to pay your bills so you borrow more money. You intend to pay it back but the debt grows while your income shrinks. It looks okay on paper until that day when you cannot borrow any more money.

Fractional reserve banking means that at least ninety percent of paper money doesn’t exist in any physical form, just zeros on account logs.

Not only is your money not in the bank, it doesn’t actually exist, and it isn’t even your money anymore. You become an unsecured creditor. You are loaning your money to bankstas who, when they assuredly lose it in that swamp apply named “derivatives” will say to depositors/unsecured creditors and investors/stock holders, “Tough shit!”

“But my deposits are insured!”

Is that what you believe? Really? The FDIC has said publically that taxpayers will not foot the bill for the next bail out

The FDIC isn’t planning on returning depositors money in the event of bank failure. Last December, the FDIC published a report entitled “Resolving Globally Active, Systemically Important Financial Institutions”.

The report carefully avoids any mention of the word depositor, but instead uses the legal description, “unsecured creditor”.

Paragraph 26: “By leaving behind substantial unsecured liabilities and stockholder equity in the receivership, assets transferred to the bridge holding company will significantly exceed its liabilities, resulting in a well- capitalized holding company.”

Translation: when the bank fails your unsecured debt is wiped out and they use your money to start a new bank without liabilities. And, you think it can’t happen here? This is the plan.

At the same time, it is primarily wage earners who make up the bulk of the unemployed because they are being shoved out of jobs to temporarily increase corporate profits.

Those translate into higher bonuses, although it is worth noting that the insolvent and tax payer supported Bank of America paid its CEO, Brian Moynihan, $6,450,000 to lose $2,238,000,000. The median employee income at B of A is $44,900. That means half of the employees earn even less. And, they are obviously much better at their jobs.

Once you get past the “WTF???” stage, it makes you wonder exactly how much money you’d have to lose to earn, say, $23.1 million?

Who could we ask? Let’s see, hmmm….ponder….ponder.

You know who might be a good person to ask? Jamie Dimon, head of JP Morgan Chase, who actually said something to the affect that he’s richer then everyone else because he knows the secret to losing extraordinarily large sums in a single trade, like the “London Whale” $6 Billion loss.

It leaves you wondering how it is that losing got to be so profitable. Silly me, I spent my whole life trying to succeed. Duh, what a bonehead, eh? Who knew?

Certainly not me. I never really paid any attention. I did my job and tried to put a little money away. I knew nothing of stocks and bonds or their fundamentals.

I know now that I should have sought professional advice, but I didn’t see why it had to be so complicated. Everyone around me said, “Just do what Buffett does.”

“Follow Buffett, he’s an oracle.”

So, that’s what I did. I remember thinking at the time; well what the heck, what do I know? And, I liked his gulf-western style of music. “A White Sport Coat and a Pink Crustacean”, man, it just doesn’t get any better than that.

Unfortunately, it turns out there is a “Warren” Buffett. On the bright side, everyone raves about my Margaritas. Fresh limes and agave nectar are my secrets.

As I have now learned, the real secret to success is losing money. Never mind the money, how do they keep their jobs?

When I was trying to go to college, I needed a full time job at night. I was the “assistant manager” (night clerk) of a 7-11. The till came up five dollars short…on my day-off. It didn’t matter; they fired everyone who worked there.

Isn’t it interesting that a bank could even lose money since the only money they should have would be depositors for safe keeping? But of course, that isn’t what’s going on at all. It’s a myth we can’t seem to shake.

It’s even worse than them gambling with and losing depositors money. At least their losses could be limited to just their depositors money, a finite sum. But, because banks create money out of debt, they were able to do four destructive things simultaneously:

1. Push unsustainable debt loads onto individuals, businesses, governments and institutions,

2. Leverage everything on the planet six times over,

3. Lose hundreds of trillions of dollars that don’t exist, and

4. Force these enormous losses onto tax payers who could never pay them back…ever.

They don’t get fired, they don’t go to jail, and they get paid like rock stars for fucking up the only business that you would think couldn’t possibly get fucked up if it were managed by mollusks.

As of 2011, Corporate CEO's made 340 times what the average worker made.

What makes them worth that kind of money? I watched a handful of episodes of the television program, “Undercover Boss.” Dear lord! Most of them were completely out of touch with the reality of their businesses and could not even function in entry level jobs in their own companies.

In 1980, CEO pay was only 42 times more than the average worker, but they managed to get by.

I believe a university professor should earn a comfortable living. But then, I also believe that an apprentice hod carrier should earn a comfortable living, as should a fireman, or a retail clerk, or a cobbler. They used to.

When you have college football coaches and administrators earning in the millions while professors rarely make 6 figures, things have gotten out of hand.

Collapse is coming. The world economy of the last one hundred years is just an experiment. Oopsie!

Economies are the result of the effectiveness of the distribution of goods and services. Clearly, the experiment, Keynesianism, Central Banking, Fiat Money, globalization, and corporatocrocy has obviously failed. The handful who have benefited have the incentive and power to maintain it.

And, we cannot see it. We are conditioned like the elephant held in place by a thread. We do not see that we can break free from corporatocrocy and fiat money.

We don’t need them and we never did. All we need is a leader. We cannot afford them or the system that brought us to this point, but it doesn’t matter. We couldn’t stop the collapse no matter how docile and indifferent we become. This isn’t going away.

They know that, and what we are witnessing during this period of high unemployment, falling wages, declining services and rising taxes is also a flurry of legislation designed to restrict the activities of individuals while bestowing unlimited power on corporations to steal, pollute, poison, and kill citizens here and abroad.

The reset button has already been pushed and the evidence is there if you look. Some of the first victims are already starting over doing things they never imagined. I know where the green shoots grow, and so I see the collapse coming with more of a whimper, than a bang.

The first part of the collapse will feel like a shipwreck. There will be confusion and bewilderment. The banks will quickly run out of the money that never existed and ATMs will be shut down. A bank “holiday” will be imposed which might last days or weeks as the treasury tries to actually print all of the money that depositors are demanding.

Cyprus isn’t different. It is the “canary in the mine shaft”. Keep no more money in the bank than you need to pay current expenses. Business owners be warned.

Like a shipwreck, the first step is to gather those things that will be useful to sustain your immediate survival. Prepare now, I implore you. A few simple preparations could make a world of difference, and there is no downside. Look to some of the recent natural disasters to gauge the response you can expect…maybe none at all.

For more on what you might need, go to: http://www.zerohedge.com/contributed/2012-07-12/preparing-inevitable

Slowly, things will evolve into a new normal. An economic disaster is no different than a natural disaster in many respects. Rebuilding begins from the ground up. Even without banks and money, people at the local level will network to provide for each other’s needs. Just like we actually do now, but without the overlords and their vigorish.

And, like a shipwreck, the more you know how to do for yourself and others, the more valuable you are. That’s important when food starts to run low.

Those in large cities will face the greatest challenges, particularly regarding food, because most food distribution is controlled by the corporatocrocy. If, like me, you can grow year round, plant something. Like Ron Finley, L. A. s “Gangsta Gardener”, says “Growing your own food is like printing your own money.”

Ron turns L.A.s vacant lots into lush vegetable gardens and fruit orchards. He is an example of a new beginning. South Central LA is a food desert. Big Agra and big pharma have decided that South Central doesn’t need healthy food; it needs dialysis centers and wheel chair lots. They have lots of liquor stores with their Frito’s and their Snickers. And they have lots of fast food with the chemical nuggets and the GMO fillers. Yum!

They feel strongly about forcing people to eat the crap they truck in. When Ron first turned his boulevard into a garden, he was threatened with jail. This happens all over the country. There was former and currently unemployed Oak Park MI City Planner, Kevin Rulkowski, who threatened resident Julie Bass with 93 days in jail for planting vegetables in her front yard.

The city code reads that front yards must be landscaped with plants “suitable” to front yards.

Rulkowski said that he looked up the word “suitable” in Webster’s Dictionary and that its meaning is “common.”

Nobody who covered the story thought to go to Webster’s and vet his statement. But, I did. He is a lying sack of shit. Nowhere, and I mean absolutely nowhere, in any of the definition’s list of synonyms, or examples of usage does there appear the word “suitable.”

Ironically, if you look up the word “common” one of the synonyms for common is the word “garden” as in an ordinary “garden” variety.

However, by definition, the word “suitable” would justify planting vegetables in the front yard if they would grow well there because they were suitable for the location. Many back yards are too shady to grow vegetables and wouldn’t be suitable.

If you think things have gotten out of hand with these failed institutions attempting to force their will on everyone, this is the perfect act of defiance.

Go plant some vegetables somewhere that is “suitable”.

In addition to food, we all need a means to sustain ourselves. That used to mean getting a job. But, jobs suck. They don’t pay anything, they don’t want to give you any benefits, and no matter how loyal you are to the job, the job will never be loyal to you. Besides, there are no jobs.

Large employers are unwilling to pay for the value they receive from their employees so they export jobs, create part-time jobs, and as a result, draw from only the pool of employees who have no other options, either idiots or the very young.

But the rest of us still have to earn our daily bread. We didn’t go away. We struck out on our own.

For ambitious, creative, energetic people, a door of unusual opportunity is opening.

The opportunity to choose an alternative to the go to school, get a job, retire and die model of life.

By necessity, people will find ways to trade their unique value for what they need. Already there is a renaissance of small, local, craft oriented businesses coming to life.

Big brewers sales are down, but local craft brews are exploding.

Chain restaurants are shutting down while food trucks and carts are bringing new tastes made with higher quality food to the community.

Farmers markets are growing both in number and the number of products available. Meanwhile Super-market chains struggle to stay afloat peddling poison to the people.

Swap meets are the new strip malls without the expensive overhead of bricks and mortar. The former manager of the Sun Glasses Store now has his own business without a boss. He knows how to source sunglasses and how to sell them to customers.

Wal-Mart has empty shelves and while big retail folds and strip malls sit vacant, the employees reinvent themselves.

For all of the resources devoted to it, the results of our health care industry couldn’t be worse. Alternative health and wellness practitioners are beginning to emerge as an alternative to slash and medicate health care.

For decades we have been shedding gate keepers and middlemen. Artists can now bring their creations right to the buyer. Justin Bieber created himself on the internet. He didn’t need a record company’s approval. Self-publishing is finally viable.

Now is the time to think about how you would live your life if your real value was appreciated and fairly compensated.

Local is sustainable, global is not.

We will need a new means of exchange to facilitate a return to real value. Once it was stripped from the gold standard, money devolved into a defacto tax.

One of the things that keep us slaves to the system is our lack of understanding of what money really is and its true purpose. It is a control that has been overlaid on private transactions.

A new monetary system is inevitable. In fact, it is the solution to the problem. Money isn’t real and it isn’t backed by anything but promises already ringing hollow.

Future money might be more localized or the means of exchange among peers, occupations, memberships, etc. There could evolve several different forms of money or means of exchange.

Bitcoin is the first foray into the new frontier of virtual currency pegged to some other measure of value. It’s that simple. Even if it is virtual, just like all of the money provided to the banks, but in this case, its value is actually based on some agreement of value among its users.

But then, you would not have CEOs earning hundreds of times what the average worker makes.

Bitcoin may or may not be the money of the future. It could be one of several different approaches to providing value for value, but fiat money has little future in the new economy.

Change is inevitable, cooperation is optional. Now that you can see where we are headed you can plan a better future than the one offered by our crumbling institutions.

As for me, I’ve got some fresh limes, I’m cranking up my Jimmy Buffett, and I have all of my excess wealth stashed in Tequila.

 

www.4closureFraud.org

Qualified Mortgages, Loan Credit Standards and Safe Harbors for Securities Fraud

 

"Default, dear Brutus, is in our stars, not in ourselves……"   

 

Paraphrase from Julius Caesar Cassius (pronounced "Cash Us")  

 

The announcement last week of the new “qualified mortgage” regulations by the Consumer Financial Protection Bureau has generated a largely muted reaction from the industry, banks and non-banks alike.  The smaller specialized lenders and servicers in the world of distressed residential mortgage finance can easily live with the new normative standard. 

Meanwhile, the large banks are exiting the capital intensive portions of the mortgage business stage right under pressure from Basel III and other regulations.  Under B III, mortgage servicing rights above 15% of tangible common equity will require 100% capital weighting.  And yet, when it comes to lending standards and risk, one could argue, that the new QM rule is more permissive than the bad old days of the subprime boom.   And some people do. 

“The Qualified Residential Mortgage rule is meant to discourage "risky" mortgages,” opines our friend and risk manager Nom de Plumber.  “However, if risk is defined as value or cash flow volatility, please note how both real estate and personal incomes are far riskier than their associated mortgages----whose payments are typically static rather than volatile.”   

He continues:  “During this crisis, borrowers generally defaulted not because their mortgage payments skyrocketed unexpectedly, but because their home prices and employment income collapsed.   The best solution for risky home prices and incomes is less mortgage leverage.  Yet, a 43% DTI is the official, post-crash threshold for "safe, affordable" mortgage payments, oddly far above the 30% to 35% DTI underwriting range of pre-bubble days.”  

Once again, notes Nom de Plumber, the regulators are obfuscating.  “The QRM rule is barking up the wrong tree, sidestepping the core, persistent problem of excessive debt to purchase unaffordable homes.”

Ed Pinto at AEI also is critical of the new rule for being too permissive, “CFPB’s new ‘qualified mortgage’ rule: The devil is in the details,”:

“The rule is made pursuant to the Dodd-Frank Act’s provision calling for minimum mortgage standards. It is being touted as making sure “prime” loans will be made responsibly. Yet true to the government’s long history of promoting excessive leverage, it sets no minimum down payment, no minimum standard for credit worthiness, and no maximum debt-to-income ratio. Under its tortured definition of “prime”, a borrower can have no down payment, a credit score of 580, and a debt ratio over 50% as long as they are approved by a government-sanctioned underwriting system.”

Pinto is critical of the fact that the CFPB has grandfathered the FHA and GSEs such as Fannie and Freddie for seven years.  He also echoes the criticism of Nom de Plumber by noting that “the CFPB has codified HUD’s view that the way to distinguish a prime loan from a subprime one is by the interest rate charged, not risk.”

Of course one area where regulators, Congress, the White House and others are entirely silent is securities fraud.  With Attorney General Eric Holder busily destroying what remains of the Department of Justice, there is no agency in the US governance apparatus  to address fraud.  The degree of securities fraud seen in the Subprime boom was so large that it did threaten the US economy in a systemic way, thus leading to the bailout.  But the bailout also hid the bad deeds of a number of prominent officials in Washington and on Wall Street.  Just read the first 100 pages of Sheila Bair’s book, “Bull by the Horns.”

"In a nutshell, the "real" point is shockingly simple,” notes one veteran bank attorney.  “We forgot a basic lesson of banking.  There is no such thing as an ‘off balance sheet liability’ of any financial intermediary on which the financial system depends.”

As the crisis hit, he argues, we faced an inevitable need to "recognize as much as $67 trillion of ‘shadow banking’ unreported ‘off balance sheet’ liabilities.  Like a manufacturer that suddenly discovers that it's only product produces cancer and that the damages exceed its net worth, the banking system was flat broke and on course to destroy all the wealth ever accumulated within a year or so.”  

“Absent the outstanding crisis management of Chm. Bernanke and others,” says the long serving securities counsel, “the ‘unreported’ $67 trillion liability represented a 67% ‘hit’ to the world's $100 trillion of ‘market value’ for equities,” thus explaining the stock market crash of 2008-9.  “If we had not taken steps to prevent deflation and drastically reduce the ‘carry’ cost of all debt, we were a mere 33% away from total worldwide bankruptcy and the inevitable WW III that would have followed,” he argues.

“Sheila Bair got the FDIC to end ‘off  balance sheet liabilities’ of US insured banks on Sept. 27, 2011 (assuming bankers are unwilling to stoop to outright thefts that insiders are obligated to report under 18 USC Sec. 4).  If her position holds up, we should be past this problem and on a path to ultimate recovery in another year or so.”

Maybe, but the battle in Washington over restraints on securities fraud rages on.  From the moment America’s leaders decided to dismantle depression era control of banking (the "level playing field commission" correctly made that a bi-partisan goal in 1969) we began experimenting with "how" and discovering problems that needed solution for the economy to function.  From then on, the power of unanticipated consequences led us to the doom we faced in 2008 and the economic gloom we now suffer.

For example, it soon became clear to the likes of Bill Isaac (GOP) and Paul Volcker (Dem) that de-regulated banks needed capital requirements or the FDIC’s insurance fund would be decimated.  They discovered, however, that one area of finance, funding trade receivables for manufacturing, was both essential and functioning very well without capital backing, because the depression era lenders created a system based on the Scottish reserve model that was self-correcting.  

That observation led Isaac, Volcker and his successor ( Alan Greenspan) to "bless" the notion that a "few very strong banks" should be allowed to do this "risk-free" form of lending in "conduits" that would not be included for capital purposes.  That, of course, soon blossomed into the entire $67 trillion "shadow banking" industry.

When those "shadow" liabilities came due in 2006-8, recognition of the hidden liability (backed by assets which had no discernible value at the time) destroyed the net worth of just about everyone.  As one of the largest hedge fund managers in the world said to me in 2008, “for a few months we were all broke.”

The illusion that conduits would only be used for low risk lending only lasted through for a few years in the 1980s.  The expansion of “off balance sheet liabilities” beyond funding of "risk free" trade receivables a few “trusted banks," along with the emergence of the private RMBS market, forced FASB to consider when receivables were "sold."  In 1982 it decided that the issue was whether the seller "purported" to sell the receivables (reliance on legal "form," ignoring such obvious issues as "recourse" that converts a "sale" into an "equitable mortgage").  

FDIC, thinking that standard was phony, "opted out" of FASB’s rule and relied on "regulatory accounting" to allow only the "big safe bank conduits" and other "safe" off balance sheet deals it "liked."  The S&L crisis proved "regulatory accounting" was a calamity.  FSLIC's blessing of special rules to hide losses led, in the Winstar case, to the US having to cover the phony capital FSLIC created using regulatory accounting.

FASB in the early 1990s studied its "purport to be a sale" test and correctly decided it was phony.  It adopted "legal isolation" (which recognizes that US law converts fraudulent transfers into secured debts--whereby money paid in exchange for assets a bank wants to hide from capital requirements must be repaid when the "seller's" receiver recovers assets fraudulently transferred).  Effective January 1, 1997, FDIC accepted FASB's legal isolation rule, dumping “regulatory accounting” on this issue.

The next "OOPS" soon emerged.  ABS/MBS lawyers for banks had lobbied FASB for a looser "isolation" standard for banks by absurdly telling FASB that "trustees" in Bankruptcy (Article 1 "administrative" officers) have more power than FDIC as a bank "receiver" (appointed with Article III "judicial" power--giving receivers truly awesome authority).  FASB fell for the lie.  As a result, FASB's first "legal isolation" test was believed to be easier on banks than on others. 

In this instance the permissive tendency of Washington in the FASB rule making combined with the bank lawyers’ mistaken reading of receivership law to create an impossible situation.  FASB falsely assumed receivers have less power, but it turned out that FDIC could overturn literally ALL pre-receivership deals.  The banks' lawyers had, in fact, negotiated a standard which allowed for NO financial asset “sales” by banks.  

An accounting profession committee posed that very problem to FASB and FDIC and asked if "no sales" was what FDIC wanted.  That's resulted in FDIC’s adoption of a "safe harbor" rule for bank asset “sales” that ignored fraudulent transfer laws (which convert transfers for the purpose of leaving a selling bank with inadequate capital into secured borrowings).

It is that rule which Sheila Bair dumped in September 2011, in favor of a rule that finally “levels the playing field,” giving banks the exact power of non-banks--an ability to "sell" assets when the transaction is not done as a fraudulent transfer.

Lawyers that built careers writing the fraudulent transfer arrangements by which banks stripped themselves of assets and generated a large part of the $67 trillion “shadow banking” empire that imploded in 2007-8 are understandably “shocked.”  Unless they can find a new loophole, they will be required to opine on fraudulent transfer law in the same manner as has applied to non-bank lawyers since 1997.  Absent conformance with those laws, future transfers designed to retain “tail” risk while reducing the capital needed to protect FDIC against “tail” loss will be accounted for as secured borrowings—eliminating a major cause of the crisis.

Like the “tax shelter” salesmen of the early 1980s (who found their business depleted when Congress decided to stop that trade), lawyers whose business it was to generate the $67 trillion “shadow banking” empire undoubtedly feel deprived of valuable “rights.”  Their problem, however, is shockingly simple.  It is a “fraudulent transfer” to transfer assets with intent to leave the transferor with inadequate capital.   This has been Anglo-American law since at least the 14th Century.  It is the foundation on which free-enterprise capitalism builds the leverage that permits accelerated growth for new value-added concepts. 

All state laws reflect this standard.  Thus every bank “sale” done for the purpose of reducing regulatory capital is, by definition, fraud – a form of bank theft. 

Only government can waive theft, as long as FDIC affirmatively "waived" the right to challenge these frauds, attorneys could not be required to opine that the transactions complied.  When FDIC stopped waiving this type of fraud in September of 2011, "misprision of felonies" (18 USC Sec. 4) mandates that attorneys disclose these matters to authorities.  Conversely, this may also mean that banks can't be prosecuted for transfers before made FDIC changed course in September 2011. 

Will bank lawyers win a debate by saying "since we clearly cannot be caught having to reveal our clients' thefts, the accountants need to change their rules so we don't need to tell them when theft is occurring"?  Stay tuned. 

www.rcwhalen.com

 

2012 Year In Review – Free Markets, Rule of Law, And Other Urban Legends

Submitted by Dave Collum via Peak Prosperity,

Background

I was just trying to figure it all out.

~ Michael Burry, hedge fund manager

Every December, I write a Year in Review that has now found a home at Chris Martenson’s website PeakProsperity.com.1,2,3 What started as a simple summary intended for a couple dozen people morphed over time into a much more detailed account that accrued over 25,000 clicks last year.4 'Year in Review' is a bit of a misnomer in that it is both a collage of what happened, plus a smattering of issues that are on my radar right now. As to why people care what an organic chemist thinks about investing, economics, monetary policy, and societal moods I can only offer a few thoughts.

For starters, in 33 years of investing with a decidedly undiversified portfolio, I had only one year in which my total wealth decreased in nominal dollars. For the 13 years beginning 01/01/00—the 13 toughest investing years of the new millennium!—I have been able to compound my personal wealth at an 11% annualized rate. This holds up well against the pros. I am also fairly good at distilling complexity down to simplicity and seem to be a congenital contrarian. I also have been a devout follower of Austrian business cycle theory—i.e., free market economics—since the late 1990s.4

Each review begins with a highly personalized analysis of my efforts to get through another year of investing followed by a more holistic overview of what is now a 33-year quest for a ramen-soup-free retirement. These details may be instructive for those interested in my approach to investing. The bulk of the review, however, describes thoughts and observations—the year’s events told as a narrative. The links are copious, albeit not comprehensive. Some are flagged with enthusiasm. Everything can be found here.5

I have tried to avoid themes covered amply in my previous reviews. There is no silver bullet, however, against global crises, credit bubbles, and feckless central bankers. Debt permeates all levels of society, demanding comment every year. Precious metals and natural resources are a personal favorite. This year was particularly distorted by the elections; I offer my opinions as to why. Sections on Baptists, Bankers, The Federal Reserve, and Bootleggers describe the players in Jack Bogle’s Battle for the Soul of Capitalism.6 Special attention is given to a financial crime diaspora fueled by globally overreaching monetary policies. Everything distills down to a relentlessly debated question: What is the role of government? I finish light with the year’s book list that shaped my thinking. I acknowledge individuals who have made pondering capitalism a blast through direct exchanges over the years. They brought wisdom; I brought the chips and dip. You already know who you are. And then there are those characters whose behavior is so erratic, sociopathic, criminal, or just plain inexplicable—you guys are central to the plot. I leapfrog Rome and Titanic metaphors and go straight to the Lusitania.

One last caveat: I subscribe to the Aristotelian notion that one can entertain ideas without necessarily endorsing them, often causing me to color way outside the lines. With trillions of dollars circumnavigating the globe daily, nefarious activities are not only possible but near certainties. If you are prone to denounce conspiracy theories and conspiracy theorists to avoid unpleasant thoughts, you should stop reading now. I’m sure there’s another Black Something sale at Walmart. If you are a bull, you should also bail out or buckle up. This is the bear case. I will remain a permabear until some catharsis knocks me off my stance and they find a cure for my market- and politics-induced PTSD.

As this review was being completed, Lauren Lyster and Demetri Kofinas recently uploaded a companion interview on the Year in Review I did with Capital Accounts on RT_America (to be aired on December 21st and posted on Youtube.)7 In this context I offer wisdom from the Master:

If there is ever a medium to display your ignorance, television is it.

~ Jon Stewart

Footnote superscripts appear extensively throughout this review. The actual footnotes and associated hyperlinks can be found here.

Contents

Investing

The elevated prices of financial assets have already eaten the future.

~ John Hussman, CEO of Hussman Funds

With rebalancing achieved only by directing my savings, I have changed almost nothing consequentially in my portfolio year over year. The total portfolio as of 12/15/12 is as follows:

Precious Metals et al.: 52%

Energy: 15%

Cash Equiv (short-term): 30%

Other: 3%

Most asset classes lurched off the starting line in January like Lance Armstrong. My portfolio eventually settled down and spent most of the year snorkeling slightly up or slightly underwater. In a relatively rare instance, an overall return on investment (ROI) of 4% was beat handily by both the S&P 500 (13%) and Berkshire Hathaway (17%), although nearly the entire return of the S&P was p/e expansion.8 A majority of hedge funds struggled to beat the S&P this year as well.9

My precious metals are distributed in approximately three equal portions to the gold-silver holding company Central Fund of Canada (CEF), Fidelity’s precious metal fund (FSAGX), and physical metals (Figure 1). Gains in gold (17%) and silver (8%) were offset by a horrendously lagging performance for the second year in a row by the corresponding precious metal-based equities (-10%). The metal-equity divergence began in January 2011 and continues to baffle the hard-asset crowd (Figure 2). A plot of the ratio of the silver ETF (SLV) versus the world’s largest silver miner, Pan American Silver (PAAS), is striking (Figure 3). In May I emailed a dozen gurus for opinions about arbitraging (swapping) an SLV position for PAAS. Realizing that collectively these folks controlled billions of dollars, I felt I had to move on the idea pronto (my only portfolio change for the year). After a few weeks of an overwhelming sense of superiority, gyrations eventually left the arbitrage at about break-even. I’m guardedly optimistic about the precious-metal equities, but they have been widowmakers for two years.

Figure 1. Precious-metal-based indices (GLD in green, XAU in red, SLV in brown, and XAU in red) versus the S&P 500 (in blue) for 2012.

Figure 2. Relative performance of gold-based equities (XAU in red) vs. gold (GLD in blue).

Figure 3. SLV/PAAS ratio over three years.

A basket of Fidelity-based energy and materials funds afforded 2-16%. They are represented emblematically by the XLE spider (3%) and XNG Amex natural gas index (1%) in Figure 4. I am wildly bullish on natural gas for reasons discussed in detail two years ago.2 Unfortunately, Fidelity’s natural gas fund (FSNGX) foisted upon me by Cornell got crushed in 2009 and subsequent years relative to its peers. Making the right calls is hard enough without that kind of headwind. New management as of 2010 seems to be finally tracking the XNG. I keep adding to an already chunky position. Friends deeply embedded in the energy complex suggest that the fracking glut will take 2-3 years to burn off. (It is also claimed that the derivatives traders are whacking out the price discovery; what else is new?)10 A global shift toward natural gas should reward patience.

Figure 4. Energy-based indices (XLE in red and XNG in green) versus the S&P 500 (in blue) for 2011.

Cash was in a U.S. Treasury-backed money-market bunker returning 0%. I had a $25K money market fund that failed to reach the IRS taxable threshold! I could care less what risky gangplank Bernanke wishes that I walk. Buying ten-year Treasurys returning <2%, with or without your finger quivering over the sell command, is a fool’s game: I’ll take the yield hit. The bond market will eventually become a killing field. Those who are pair trading—long bonds/short brains—will get their organs harvested. This seems like a near certainty.

The most disappointing part of the year was a personal savings equivalent of only 11% of my gross income compared with 29% last year and 20-30% in typical years. Unusual expenses in the form of a year of college education, a serious violin upgrade, and very large landscaping costs don’t excuse the fact that we chose lower savings over lower consumption. This troubles me deeply. Profound austerity is not a cause but an effect, something the Europeans may be just now figuring out.

To understand my lifetime returns, you must understand two unusual premises that have dominated my thoughts and actions. First, you must become wedded to an investment. Did I just say that? Yep. You’ve got to be a true believer to resist being shaken out of good investments or suckered into bad ones. Many say it’s never a bad time to take a profit. Total hooey. Those ten-baggers—the miracles of compounding—will never materialize if you bail after 20%. Just ask the Microsoft investors who exited in 1990 for a handsome profit.

My second premise is that you have to get it right only about once a decade. One of my favorite bloggers and an e-pal, Grant Williams, illustrated how daisy-chaining four secular bull markets—Gold, Nikkei, NASDAQ, and Gold—could have produced a virtual return of 640,000%—a 6400-bagger (Figure 5).11 Admittedly, this kind of luck is only found in Narnia. Statistically, somebody might have done this, although not likely in such a Texas Hold’em all-in fashion.

Figure 5. Sequential investments in secular bull markets starting in 1970.11

My variant of such a sequential trek via imbalanced portfolios changed in decadal rhythms as follows:

1980-88: exclusively bonds (100%)

1988-99: classic 60:40 equities:bonds

1999-2001: cash, precious metals, shorts (minor)

2001-2012: cash, precious metals, energy, tobacco (minor)

My total wealth accumulated through a combination of savings and investment as shown in Figure 6. (I redacted the dollar amounts along the y-axis.) Avoiding 1987 and 2000 equity crashes and capturing the bull market in precious metals proved fortuitous. You can see that 2008 was the only down year. Berkshire has dropped five years since 1991. A 13-year accumulation rate beginning 01/01/00 of 11% annualized compares favorably to an annualized return on the S&P of -0.03% and on Berkshire of 7%.

Figure 6. Total wealth accumulated (ex-housing) versus year of employment. Absolute dollar values have been omitted.

I also monitor overall progress by what I call a salary multiple, which is defined as the total accumulated investable wealth (excluding my house) divided by annual salary (line 22 of the 1099 form excluding capital gains). Over 33 years my salary (actually total income) rose twelve-fold, which I can fairly accurately dissect into a fourfold gain resulting from inflation and a threefold gain (relative to starting salaries of newly minted assistant professors) due to increasing sources of income and merit-based pay raises. My accumulated wealth normalized to the moving benchmark of a rising income is plotted versus time in Figure 7. The fluctuations visible in Figure 7 not apparent in Figure 6 result from income variations.

Figure 7. Total wealth accumulated measured as a multiple of annual salary versus years of investing.

To clarify the origins of a 13-year return of 11% per year I offer Figure 8. By plunging into the precious-metal and energy sector early and avoiding all other forms of investments (S&P in particular), I was able to capture the entire hard-asset bull market. According to Money magazine’s calculator,12 I can spike the ball in the endzone and dance. They are wrong. My ultimate target—a valid target—is to accumulate 20 salary equivalents over the next 12 years (age 70). This will require an inflation-adjusted (real) annual growth of 4-5%. Some of that will come from savings. As you can tell by the Hussman quote and discussions below, however, such gains are not assured.

Figure 8. Plot of Central Fund of Canada (CEF; 1:1 gold:silver by value), XLE, and S&P.

Thinking About Capitalism

When the blind lead the blind get out of the way.

~ First grader

I realize that is what I do—I think about capitalism. It’s not deep stuff; more like taking a weed whacker to a hay field of information. This year, however, there was something askew—something corrupting the information flow. It was the presidential elections. This is a good starting point.

Election Year

No serious person would question the integrity of the Bureau of Labor Statistics. These numbers are put together by career employees.

~ Alan Krueger, White House Council of Economic Advisers

To a news and economic data junkie, presidential elections are profoundly distorting. The news feeds are inundated by election analyses that are mundane at best and nauseating on a bad day. It’s a variant of Gresham’s Law—bad information pushes out good. The pundits are either talking about the elections explicitly or couching potentially credible news stories in the context of the election. Terrorist attacks in Benghazi mutate into Obama’s Big Screw Up. The news feeds are further corrupted by billions of campaign dollars spent to deceive us. Frank Rich, award-winning New York Times journalist, estimates that George Bush had 120 “journalists” on payroll. They get overtime and hazard pay during elections. The shenanigans go deeper.

There have been numerous accusations of voter fraud. From my recollection, it was mostly the left accusing the right (the CEO of Diebold in particular). A window opened when the mischievous computer hackers, Anonymous, did a smash-and-grab on Stratfor’s server, obtaining over 5 million emails. Stratfor provides confidential intelligence services to large corporations and government agencies, including the U.S. Department of Homeland Security, U.S. Marines, and U.S. Defense Intelligence Agency. From 971 emails released to date (by Wikileaks), we find that Democrats stuffed the ballot boxes in Pennsylvania in 2008 that went unchallenged by McCain. Jesse Jackson shook down Obama for a six-digit payoff.13 Emails detailing the Bin Laden capture are worth a peek.

The most insidious election year distortion may be the tainting of economic data feeds that the marketplace relies on. Data coming from career statisticians in the federal government are always suspect. The inflation numbers, for example, are widely believed to be cooked beyond recognition using corrections recommended by the Boskin Commission.14,15 This year, however, the data massaging morphed into an all-out rub ‘n’ tug to ensure a happy ending for the Democrats.

The data from the Bureau of Labor Statistics (BLS) are especially susceptible to corruption. The Birth-Death Model, for example, estimates new jobs being created that nobody can detect.16 Apparently, the absence of data demands that some get fabricated. These embryonic jobs have reached epidemic proportions—hundreds of thousands per month—oftentimes overwhelming the detectable jobs. Curiously, no administration ever fabricates undetectable job losses.

Another trick is a very simple iterative process for reporting statistics: Step 1—Announce inflated economic statistics as good news; Step 2—correct the inflated statistics at some later date to a very deflated number, hope nobody notices, and call it “old news anyway”; Step 3—Report new inflated numbers that are spectacular improvements relative to the recently deflated statistics. Rinse, lather, repeat.17

The fibbing gets serious during an election year. When pre-election unemployment numbers plummeted by 0.4%—a monumental drop—the response was immediate, visceral, and seemingly uncontestable disbelief. David Rosenberg expressed it well:

I don't believe in conspiracy theories, but I don't believe in today's jobs report either.

~ David Rosenberg, Gluskin Sheff and ex-Merrill Lynch

Well, Rosie, apparently you do believe in conspiracy theories. Within minutes of the report Jack Welch, no neophyte to creative bookkeeping, released his now-infamous Tweet:

Unbelievable jobs numbers...these Chicago guys will do anything... can't debate so change numbers.

~ Jack Welch, former CEO of General Electric

It was an election year, however, so the goofy employment numbers morphed into a hot-button issue. Right-wing pundits accused the Obama administration of cooking the books. Left-wing pundits fired back with the shrill accusation, “Conspiracy theorists!” Few remembered that the GOP accused the Democrats of cooking the same numbers back in 2003.18

The whole sordid affair took a strange turn when Zero Hedge noted an odd mathematical relationship between the two carefully measured employment statistics:

Measured employment numbers:

fully employed/partially employed = 873,000/582,000 = 1.5000…

Gosh. What are the odds that those numbers were actually measured? I would say about 2.000…%.19

Counting those who no longer receive unemployment benefits as no longer unemployed, an accounting gimmick that became chronic once the crisis began, by no means was invented by Team Obama. None of this is new. LBJ was rumored to send economic statistics back to the kitchen for more cooking. The U-6 unemployment numbers account for that mechanical engineer who is now a part-time “deposit bottle recycling engineer and firewood procurement officer.” U-6 is a more accurate measure of the employment stress and is staying persistently above 14%.20

Election year pandering may contribute to a very odd stock cycle.21,22 If you break the 20th and 21st century into 27 four-year fragments corresponding to the election cycle—2009-2012 being the most recent—and average the returns, you get what is called the Presidential Election Cycle (Figure 9). What causes this cycle? One cannot exclude the role of friendly central bankers (sado-monetarists) juicing the markets. Mitt Romney, when he promised to fire Bernanke, may have sealed his fate.

Figure 9. Four-year election stock cycle throughout the 20th century.21

Maybe the four-year cycle in Figure 9 is a statistical anomaly and, even if real, we may not have a clue why it occurs. Nevertheless, it suggests that “Sell in May and go away” has a longer wavelength variant: “Buy the midterm and sell the Presidential.” Urban legend or not, 2013 is looking dangerous.

Events

Dan, quit embarrassing yourself.

~ Caroline Baum of Bloomberg Tweeting to a money guru who claimed that Hurricane Sandy will be stimulative

Acts of God—force majeure—tantalize market watchers and sophists alike but seem to have little effect on even the intermediate term: Economies and markets just keep marching forward. Katrina took its toll and irreparably altered lives, but it primarily illustrated government doing a heckuva job. Hurricane Sandy also exacted revenge against the civilized world (and New Jersey). It may portend things to come, should global warming live up to its billing. There is no doubt that corporations will use Sandy as an excuse for anything and everything. Q4 and year-end reports will have more Sandy-derived debris (including kitchen sinks) than dumpsters along the Jersey shore. Sandy also ushered in like clockwork the absurd claims that Frédéric Bastiat was wrong and that smashing windows and destroying infrastructure is good for the economy. Sandy will increase the GDP, but that is not economic gain. Sandy will be a bump in the road for the nation at large.

As I write this paragraph, cremnophobia—fear of cliffs—is sweeping the land. I submit that base-jumping the Fiscal Cliff may be exciting but doubt it will be some proximate trigger that causes cascading failure. The move to substantially greater austerity seems inevitable and likely to be painfully protracted—think Japan. The Fiscal Cliff would be a fumble on our own ten-yard line. It is just one down in a very, very long game. Regardless of outcome, this will be a topic for my 2013 Year in Review.

Broken Markets

A strange game. The only winning move is to not play.

~ The W.O.P.R. computer on “Wargames”

Since Cro-Magnon Man began trading flint, furs, and women, there have been nefarious activities in the marketplace. Painting the tape—moving markets at the end of a quarter to dupe customers—is tolerated. The pop icon Jim Cramer spilled his guts describing how players of even modest means can push prices around.23 I bet Jim would like a do-over on that video. Options expiration week is always exciting, as the options dealers purportedly move the equities to minimize payouts on the heavily leveraged options to maximize pain on the plebeians. Insider trading is a death sentence for a nobody, but is a misdemeanor for the big bankers. When caught, the going rate on the punishment of investment banks is a 3-5% surcharge on the profit from the illicit trade. One can only imagine how much it would cost us in punitive rebates if the criminal behavior caused a loss.

In general, however, blaming markets for your losses is a fool's game. Nonetheless, something has changed. The Federal Reserve—the Fed—has explicitly stated a vested interest in both the magnitude and direction that markets move, abandoning all willingness to let markets determine prices. These guys are playing God, taking full possession of our hopes and dreams. In analogy to global warming, their loose monetary policy jacks up prices with markedly increased volatility and enormous social costs. Kevin Phillips’ 2005 American Theocracy is a brilliant account of the demise of Western empires. He notes that the final death rattle is the financialization of the economy. When moving money becomes the primary economic activity, the end is near. Let’s look at some of the symptoms.

The high frequency traders (HFTs a.k.a. “algos” or cheetah traders) have really upped their game. The title of this section stems from Sal Arnuk’s and Joe Saluzzi’s book Broken Markets, which describes the seedy world of supercomputers skimming enormous profits. It is consensus that HFT’s are profitable for the trading platforms but of little merit otherwise. They gum up the system intentionally to garner advantage and dump millions of fake quotes to be cancelled within milliseconds.24 None of this is legal, but all is tolerated. They are now trading for razor-thin profit margins of as little as $0.00001 skim per share but making it up on volume—dangerously large volume. One Berkshire Hathaway trade—a $120,000 per share stock—is rumored to have netted $10 total (0.8 cents per share).25

The markets are now at great risk. We should not expect that profiteers benefit society. We can demand that they don’t bring the entire system to its knees. I got my ten seconds of fame in an article describing the consequences of the legendary Flash Crash on May 6th, 2010:26

Wall Street is a crime syndicate, and I am not speaking metaphorically... The banking system is oligarchic and the political system has metastasized into state capitalism. The most important market in the world—the market in which lenders and borrowers meet to haggle over the cost of capital—is the most manipulated market in the world.

~ David Collum, WSJ

Flash crashes are now daily occurrences, as thoroughly documented by market research firm Nanex, and are not restricted to any one market. India tanked 15% in a few minutes.27 The precious metals appear to be a favorite playground: “At 1:22 p.m. SLV was forced down by rapid-fire machine-generated quotes—more than 75,000 per second.”28 Berkshire Hathaway—Berkshire Hathaway!—dropped from $120,000 a share to $1 for a few milliseconds.29 Commodity Futures Trading Commission (CFTC) commissioner Bart Chilton says that the “third largest trader by volume at the Chicago Mercantile Exchange (CME) is one of these cheetah traders in Prague."30 (Bart appears to be a supporter of clean markets, though I remain distrustful.) On August 1st, 150 stocks swung wildly. In a heavy dose of irony, the wildest—a 40% swing—was a company called Bunge.31 The monstrous oil market flash crashed when a 50-fold spike in trade volume hit the tape.32 Some fear a flash crash in the unimaginably large U.S. Treasury market.33

Irony reached a fevered pitch when BATS Global Markets (BATS), the third largest trading platform behind NYSE and NASDAQ, listed their own IPO.34 Their primary customers—the cheetah traders—drove the share price from $16 to 1 cent in 900 milliseconds, forcing the cancellation of the IPO. Knight Trading, while beta-testing their own HFT algo, released it to the wild. While the traders snarfed down celebratory mochaccinos, a pesky sign error caused the HFT algo to buy high-sell low for a very long 45 minutes.35 One of the most respected trading firms in the business was shopping itself to potential buyers within 24 hours. The standard excuse for erratic market behavior—Disney-like “fat-fingered traders” hitting the wrong key on a trade—became comical alibis for deep-seated structural flaws in the markets.

We have a huge problem. Don’t take my word for it. Let’s listen to what some of the pros have to say:

All this trading creates nothing, creates no value, in fact, subtracts from value.

~ John Bogle, inventor of the index fund

Essentially, the for-profit exchanges are approving their own rule changes. The lunatics are now running the asylum.

~ Joe Saluzzi, cofounder of Themis Trading

 High-speed trading, if we may get our two cents in, is a dubious activity to label as a technological advance.

~ Alan Abelson, Former Editor of Barrons

Not all IPOs flash-crashed; some simply beat investors like rented mules using more traditional methods. I had an entertaining Twitter exchange with Sal Arnuk, cofounder of Themis Trading and coauthor of Broken Markets, on May 18th just hours before the now-infamous Facebook IPO:

David Collum:

@nanexllc @joesaluzzi @themisSal A Facebook flashcrash to $0.01 would be fun and educational for the whole family.

Sal Arnuk:

@DavidBCollum doubt that....prepping for weeks

The rest is history. Facebook didn’t flash crash, but weeks of prepping were inadequate. Facebook crashed the NASDAQ market for 17 very long seconds, which is a lifetime when measured in algo years.36 The high-profile Facebook IPO—technically a secondary offering—managed to maximize Facebook’s capital by selling shares into the market near its all-time high. Underwriter Morgan Stanley took a beating (possibly billions) defending the opening price of $38 before watching it drop, eventually reaching the teens. Isn’t “defending shares” illegal? While Morgan Stanley was getting hammered, the other underwriters, Goldman Sachs and JP Morgan, were loaning shares into the market for shorting.37 Despite a huge outcry from those hoping for an IPO opening day bounce, I found this all highly entertaining and a good lesson in risk management. Investors hoping for easy money discovered that IPO stands for “it’s probably overpriced.” Facebook also spawned a cottage industry of Mad Libs (Fraudbook, Faceplant, Farcebook…)

A lesser known IPO failure causing a stir was Ruckus (RKUS), dropping 20% on the opening and blaming it on Hurricane Sandy.38 Splunk’s (SPLK) IPO was halted after it hovered at $32 and then plummeted to $17 on a 500-share trade.39 They eventually dropped 30% in an orderly slide. IPOs from the not-so-distant past that continue to inflict pain include post-IPO losses for ZYNGA (-80%), Groupon (-90%), and Pandora (-60%). Investment-grade Beanie Babies and CPDOs sound good by comparison.

The markets are broken. It’s only a matter of time before the vernacular phrases FUBAR and SNAFU will reassert into our language. The Tacoma Narrows Bridge as a metaphor for instability has been around the web for years, but is well worth a peek.40

Precious Metals

They (gold investors) want everybody to be so scared they run to a cave with gold. Caves might be a better investment than gold. At least they’re not producing new caves all the time.

~ Warren Buffett

Those elements here and abroad who are getting rich from the continued American inflation will oppose a return to sound money.

~ Howard Buffett

Let’s stay on the theme of broken markets as a transition into a discussion of precious metals. Bill Murphy and the folks at the Gold Antitrust Action Committee (GATA) obsess over powerful and dark forces. Declassified documents showing overt attempts to restrain the price of gold provide a few smoking guns.41,42,43,44 The Hunt brothers grotesquely misjudged the silver market and willingness of bankers to trigger margin calls and drive them to bankruptcy.45

By the early 2000s even novice market watchers could see that central bank selling into the open market could have price suppression as a motive. Chancellor of the Exchequer Gordon Brown participated in the most famous market timing fiasco by emptying much of Britain’s gold stash below $300 per ounce.46 That got him promoted to Prime Minister.

Then there is the very strange phenomenon of central bank leasing of gold. I surmise that the idea was presented to the populace as a way to make money from the shiny yellow metal that just sits there in vaults. Why not lease it? The gold carry trade commenced, but lease rates are fractions of a percent per annum.47 No profit motive there. Central bank leasing of gold to the large bullion banks—the Too Big to Fail group—at a fraction of a percent interest seems to serve two purposes: (1) provide essentially free capital to the banks, and (2) apply downward pressure on the gold price. Rumor has it they are going to stop publishing the leasing rates.

The game began to falter in 2001 when neither the announcement of British bullion sales nor the actual sales dropped the price, commencing a decade-long run in the metals. That is not to say the central banks have given up. Sudden and repeated margin hikes at the COMEX trapped the levered longs, and affiliated mob-like hits by insiders became commonplace. A rumored huge silver short position by JP Morgan-Chase (JPM) may lurk beneath the London Whale saga. JPM’s commodity guru, Blythe Masters, began denying the silver short as the whale story started to surface, claiming that JPM’s silver positions were simply hedges for their customers.48 Why would silver bulls hedge their investments? Data from the Office of the Comptroller of the Currency brought to light by Rob Kirby eventually showed that JPM has a whopping $18 billion naked short position in silver,49,50 corresponding to 50% of the estimated global above-ground silver supply.51 Is it any wonder that silver gets “monkey hammered” with some regularity by the invisible hand? Naked shorting on such a scale is both illegal and reckless.52 To the extent that JPM is at risk, taxpayers are at risk. CFTC Commissioner Bart Chilton unabashedly claims that big money with outsized short positions are moving the silver market, although he won’t name names yet and hasn’t done squat.53 Let me help you out Bart: Start with JPM.

I am wildly bullish about the metals going forward. Gold and silver’s returns look like a normal year within a secular bull market [editor's note: this section was written by David  prior to this week's smackdown of the precious metals]. Precious metals investors waited with baited breath as a descending triangle starting in mid-2011—a classic chart pattern recognized in technical analysis (TA)—marched to judgement day (Figure 10). Folklore says when the highs and lows converge, the price will resolve boldly to the upside or downside. OK. That sounds really stupid, but that’s state-of-the-art TA. In any event, it seems like gold took the 50% probability route to the upside thanks to an auspicious goose from more quantitative easing (QEIII). But that’s just T&A (chart porn) for the gold bugs.

Figure 10. Descending triangle and “resolution.”

The future is unknowable, yet $85 billion per month of QE IV is most definitely bullish for tangible assets. Central bankers around the World are printing around the clock. Of course, the usual cast of top callers were braying about a top. Notable gold bears included Warren Buffett hammering gold in the Berkshire Hathaway annual report, quickly followed by a show of support from his poker buddy Bill Gates. Buffett wrote an article entitled “Why Stocks Beat Gold and Bonds” and then promptly bought a gold-mining company.54 Charlie Munger again displayed his tin ear with a decidedly anti-Semitic quote about gold (not worthy of repeating, only criticizing). There are credible arguments against gold, some better than others. An optimist might believe that central bankers will begin to behave themselves…but only in the land of unicorns and Skittles rainbows. Some claim it is a crowded trade. Many argue that gold has been a horrible inflation hedge. To this I note that shovels and bulldozers both move dirt but are very different tools. Equities and gold have similarly differentiated roles as inflation hedges.

Secular (multi-year) bull markets are said to attract investors in three specific phases: (1) first arrivals are wing nuts and whack jobs and precede anybody in their right mind, (2) the smart money arrives once the bull offers evidence there is serious money to be made, and (3) retail investors—the rabble—show up in the final phase. Once group (2) sells to group (3) in what is euphemistically called “distribution,” the invisible hand of the market throws a toaster oven in the pool and the bodies start floating to the surface. This year was dominated by smart-money gold supporters with gravitas and serious bucks. Hedge fund managers supporting gold with dire warnings of monetary chaos included luminaries George Soros, John Paulson, David Einhorn, Jim Rogers, Ray Dalio, and Kyle Bass. Einhorn and Dalio both took special care to condemn Buffett’s gold bash.51,52 Bill Gross, head of PIMCO with almost two trillion dollars under management, noted gold “will be higher than it is today and certainly a better investment than a bond or stock, which will probably return only 3% to 4% over the next 5 to 10 years.”53 Bill has caught the fever. Billionaires Hugo Salinas Price and Eric Sprott are avid precious metal investors and devout believers in organized price suppression.

Central banks became net buyers starting in 2009 after years of selling and have been increasingly aggressive (Figure 11).54 (I call central bankers both “smart money” and “feckless”; I’m still working on resolving that paradox.) Chinese and Korean central bankers have explicitly stated gold is the only safe asset.55 Such reports are picking up in intensity. Other events seemed new to 2012. The International Monetary Fund (IMF) has flipped to net buyer.56 South Korea, Paraguay, Turkey, Vietnam, and Russia all increased their gold holdings. Iran swaps oil for gold with China and Turkey.57,58

Figure 11. Central bank gold purchases

What made this year so interesting was the part occurring below the surface. Gold may soon be designated a Tier 1 asset.59 Banks are required to maintain minimum balances of Tier 1 assets to ensure the safety of the system. (They need to work on that.) When the next credit crisis arrives, rather than selling gold to raise Tier 1 assets, banks will be incented to buy gold. It is beginning to act like a currency. The ramifications are multifold.

For the first time, we are beginning to hear discussions of some form of gold standard. It would probably be a variant of the gold-exchange standard of the early 20th century. I would be satisfied if gold was simply allowed to compete for supremacy in the open market. The most important step would be to pass gold legal-tender laws, which are at various stages in a dozen states.60 (This could elicit a states’-rights battle.) Rendering gold’s price change denominated in dollars as a non-taxable event would be the big move. Bernanke tried to take on the push for a gold standard in a series of lectures at George Washington University.61 I found his arguments unpersuasive, exactly what you would expect from a guy who believes that profound monetary injections and inflation are valid monetary tools. The gold standard seems like a distant possibility given the Republicans endorsed the idea in their platform; we know they lied—their lips moved. The counter argument stems from a survey showing 37 prominent economists all opposed a gold standard; 37 economists couldn’t possibly be right.62

One could dismiss discussions of a gold standard if it were not for the second really interesting topic—global gold movements. Let’s be clear, this story is muddled. There are three variants of gold conspiracy theory that may (or may not) lay the foundations:

(1) Thesis 1: Gold exists in the vaults of the Fed and Fort Knox, but we don’t own it anymore. We are told that the gold possession is as simple as a forklift moving a pallet from one wall to the next within the same vaults. Doubts about ownership are exacerbated by the unwillingness of the authorities to independently audit the gold since the 1950s despite calls for it from Congress. This is odd by any standard.63

(2) Thesis 2: The gold in the vaults is of a substandard quality. This idea is way out there but cannot be summarily dismissed. What does low quality actually mean? Supposedly we have delivered sub-standard gold on a number of occasions.64 There were rumors years ago that the gold in the bank of England was reported to be “flaking,” leading one intrepid analyst to declare that it doesn’t matter “provided they don’t try to sell it.”65 Oh, I just wet myself. As a chemist, I can assure you if it flakes it ain’t gold and that analyst-dude is a perma-doofus. Tungsten-impregnated gold surfacing in retail gold markets has fueled speculation that the central banks are hoarding tungsten.66 The conspiracy theorist in me wonders if the occasional fake gold bar would be good for tamping down an incipient gold mania.

(3) Thesis 3: There is no gold.67 The claim that the gold is missing holds a certain logic. If the Fed leased physical gold to the bullion banks and these banks sold it into the open market for beer money, then it’s gone.68 It is very odd that the Fed pools the physical metal and the leased metal on a single line of their self-reported balance sheet (to save space, I guess).69

The status of sovereign gold stashes is unclear. Here’s where it gets really interesting. Sovereign states are starting to repatriate their gold—they want to bring it home. It started in 2011 when our close friend and ally Hugo Chavez requested 100 tons returned to Venezuela, with a correlated spiking of the spot-price of gold and gold backwardation. (Backwardation is a grammatical abomination indicating that short-term demand for a commodity is high and commodity traders flunked English.) Demand began in earnest starting in the Netherlands and spreading to other postage-stamp-size countries Paraguay, Ecuador, Vietnam, Switzerland, and Germany.70,71 Germany? Germany may be growing weary of sharing a fiat currency with the PIIGS—Portugal, Italy, Ireland, Greece, and Spain (vide infra).

It seems like gold is coming out of the closet. My concern is that we will quickly move from fear of deflation to disquieting inflation culminating in uncontrolled inflation. If the dollar goes south fast, do you think investors will seek safe-haven in another fiat currency? Those who headed to Swiss Francs got their heads handed to them this year in an instantaneous 10% debasement.72 There must have been some forex traders doing laps around the drain that morning. I cannot rule out a run on fiat currencies—a collapse of the entire Bretton Woods currency system. Mitigating such tail risks would not be completely irrational. Am I saying that this time it’s different? No. I am saying our fiat currency will join the other fiat currencies as historical footnotes.73 As the insane posters at Zero Hedge like to say about gold, BTFD (buy the dips).

Resources and Energy

I'd put my money on the sun and solar energy. What a source of power! I hope we don't have to wait until oil and coal run out before we tackle that.

~ Thomas Edison (1931)

Eventually the point is reached when all the energy and resources available to a society are required just to maintain its existing level of complexity.

~ Joseph Tainter, author of Collapse of Complex Societies

The resource sector provides me with a potential inflation hedge and represents a bet on a secular change in energy availability, all the while allowing me to pretend to be normal. In previous years I have endorsed Chris Martenson’s Crash Course with unbridled enthusiasm—a must see,74 which emphasized the case for increasingly constrained oil production, and delineated my enthusiasm for natural gas equities.1,2,3 Many of my views have not changed.

Investment giant Jeremy Grantham continues to actively warn of acute resource depletion. He submits that rapidly rising raw material prices are not a bubble but rather a civilization-altering paradigm shift.75 Simply put, we are depleting everything. The CEO of Gulf Oil, in a decidedly ambiguous statement, noted that “oil consumption in the next seven years is not going to grow and could drop off as much as 15%."76

Suggestions of constrained oil supply continue to work their way into the mainstream. Data shows Saudi production has remained remarkably constant. Many doubt they can ramp it or even sustain it. The former vice president of Saudi Aramco warns of unwarranted optimism that price hikes stem from “the reality that the oil sector has been pushed to the limit of its capabilities.”77 There are claims that the Saudis will be net importers by 2030 but from whom?78 David Greely of Goldman Sachs indicated that it is only a matter of time before “OPEC spare capacity become[s] effectively exhausted, requiring higher oil prices to restrain demand.”79

Other Goldmanites suggest that “a disturbing pattern has emerged where each tentative recovery in the world economy sets off an oil price jump that, in turn, aborts the process… Oil has become an increasingly scarce commodity. A tight supply picture means that incremental increases in demand lead to an increase in prices, rather than ramping up production. The price of oil is in effect acting as an automatic stabilizer.”80 A hyperbole-free interview of prominent oil economist James Hamilton sheds light on a world facing tighter supplies.81

A counter-argument to all these gloomy views came in a report via Bloomberg stating that the U.S. will pump “11.1 million barrels of oil a day in 2020 and 10.9 million in 2025.”82 This may be true, but anybody who projects oil production a dozen years from now to three significant figures has credibility issues. That did not stop viral dissemination across the Twittersphere.

Some suggest that natural gas will fuel our economy for hundreds of years. Others say the case is wildly overstated: Bakken wells lose 90% production within five years.83 Still others focus on the environmental catastrophes and legal boondoggles affiliated with fracking. It seems clear that, come hell or high water, we are going to frack, and we are going to witness a secular shift to a natural-gas-dependent economy. It would be great if this works and does so without environmental calamity. I am agnostic on both. The equity valuations are tame, especially given the current razor-thin profit margins that are projected to expand.84 I continue buying the equities betting that powering the globe will be profitable.

Fresh water and, by direct correlation, food face huge supply issues in China, the U.S., and emerging markets around the world. Staying close to home on this one, the Ogallala Aquifer under the Great Plains was reported to be down to one third of its original depth and is projected to “run dry in two to three decades given recent withdrawal rates.”85 Atlanta is in a legal battle with Florida and Alabama over 20% of the flow from Lake Lanier.86 No matter how you cut it, this is foreshadowing trouble ahead. I looked into water-sector investments a decade ago but couldn’t tease out opportunities.

The blogosphere has made the case for highly constrained rare-earth elements crucial to wind turbines and solar cells.87 The bulls note that China controls 95% of the market and suggest that building alternative energy programs based on the rare earths will drive the price to the moon. I had dinner with the CEO of Chemetall, a major dealer in metals and metal catalysts. He assured me that rare earths are not rare, and that China has driven competitors out of the marketplace; higher prices will fix that when needed. I could detect no agenda in his answers.

The Baptists

The lapse of time during which a given event has not happened is…alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.

~ George Eliot in Silas Marner

We were all worried about these issues in 1927, but you can only worry about things for so long.

~ Anonymous

Prior to any financial dislocations there are many who preach of the coming crisis. In 1924, Roger Babson warned of credit excesses that would lead to catastrophe. Charlie Merrill of Merrill Lynch fame sought psychiatric help due to his inexplicable bearish views; as legend goes, he and his psychiatrist emptied their investment accounts and dodged the carnage. The stock futures speculation in the 1920s was so obvious that Congress held hearings to discuss it well before the crash.88 The crash and subsequent multi-decade global devastation arrived to the total shock of many. Town criers could be heard screaming of a coming tech crash in the late ‘90s by those who listened. We had congressional hearings on derivatives speculation wherein Brooksley Born methodically laid out the plotline for the coming storm in unregulated derivative markets.89 I wrote a 2002 email describing the coming subprime crisis and banking collapse.3,90 Prescient? Not really. I was simply parroting ideas scattered over the Internet. The few who played the housing bust with leverage get the limelight; countless thousands saw the housing excesses in the years leading up to 2007.

This year had its share of preachers of unassailable credibility telling us of more trouble to come. Are they farsighted or fooled? I haven’t a real clue. I can say, however, that their advice demands your attention.

Let’s begin with the most prolific of doomers, David Stockman, former Wall Street insider and Reagan budget genius. Stockman was omnipresent, telling anybody who would listen of a coming mayhem in the bond market and accompanying pension crisis, labeling our current economic status as “the end of a disastrous debt super cycle that has gone on for the last thirty or forty years.”91,92,93

David places blame squarely on the Fed by suggesting “if we don't drive the Bernankes and the Dudleys and the Yellens and the rest of these lunatic money-printers out of the the Fed and get it under the control of people who have at least a modicum of sanity, we are just going to bury everybody deeper.” Somewhat paradoxically, he noted, “if the Fed doesn't keep printing, it's game over.”

John Hussman undermines the very foundations of monetary easing in one of the most cogent arguments that I have read.94 He is a deep-value guy whose analyses have refreshingly long-time horizons and whose portfolios have been bludgeoned in the short term.

George Soros rattled Newsweek readers when he suggested the global credit retrenchment is “about as serious and difficult as I’ve experienced in my career…comparable in many ways to the 1930s. We are facing now a general retrenchment in the developed world, which threatens to put us in a decade of more stagnation, or worse. The best-case scenario is a deflationary environment. The worst-case scenario is a collapse of the financial system.”95 He predicts a collapse of social order, suggesting that “it is about saving the world from a downward economic spiral." George is known for talking his book, but what position is he talking up? This is not a trick question...well maybe it is. (Answer: Gold. Lots and lots of gold.)

Bill Gross suggests that "a 30-50 year virtuous cycle of credit expansion which has produced outsized paranormal returns for financial assets—bonds, stocks, real estate and commodities alike—is now delevering because of excessive ‘risk’ and the ‘price’ of money at the zero-bound.”96 He concludes that “we are witnessing the death of abundance and the borning of austerity, for what may be a long, long time." Detractors like to pick on Bill’s DOW 5000 call years ago. With inflation adjustment—accurate inflation adjustment—that decade-old call is approaching spot on.

Jim Rogers predicted that some of the Ivy League institutions would go bankrupt.97 Harvard had a terrible credit seizure in 2007-09 due to their hedge-fund-like endowment, but Jim’s prediction was made in 2012. Jim doesn’t think we are done yet.

Nomura's Bob Janjuah is always good for brutal assessments.98,99 Bob noted that "markets are so rigged by policy makers that I have no meaningful insights to offer.” Bob goes on to note in a later piece that “central bankers are intentionally mispricing the cost of capital, in an attempt to push the private sector to misallocate capital into consumption and into asset purchases at the wrong time and at the wrong price.” He blames Greenspan and Bernanke explicitly for tens of millions of American citizens who are “either homeless and/or on food stamps.” Bob can really turn a phrase. “Financial anarchy” is always good for a few chuckles. Say what you really think, Bob. The world’s central bankers are reserving their own special place in hell.

Ray Dalio, head of Bridgewater Associates—the largest hedge fund in the world—has been bearish for awhile and is becoming quite the gold bug. In January he noted that he was bearish “through 2028.”100 In subsequent presentations, he seemed to change his tune by referring to our global state of affairs as a “beautiful deleveraging ,” which he defines as some sort of optimal inflation/deflation cross-dresser operating through a combination of defaults and debt monetization.101 I guess beauty is in the eyes of the beholder. One prominent market watcher—me—suspected that Ray had an eye on a Romney-cabinet-level appointment. We’ll never know.

Legendary investor Jeremy Grantham with $150 billion under management, Thomas Brightman of Research Affiliates, and Robert Gordon of NBER lit up the blogosphere late in the year with conclusions that global growth would drop to the 1% zone.102,103,104 Their predicted durations—decades or more—were newsworthy. Grantham suggests that demographics and resource depletion will cause us to never regain our previous growth rates. He had previously amplified a notion first presented by Adam Smith in The Wealth of Nations by showing that a sustainable 3% compounded growth rate, rather than the “greatest invention of all time,” is total mathematical nonsense.105 A cubic meter of physical wealth expanding at 3% over the Egyptian dynasty—admittedly a long time—would fill ten solar systems—a large volume.

Billionaire Richard Branson joins Grantham in predicting that capitalism is destroying the planet, focusing in particular on the perpetual growth model that will consume everything. The great story about Richard is that he is rumored to have tried to hit up Obama for some weed in a recent trip to the White House.106 We don’t know if Obama’s “Choomwagon”107 was in the shop.

Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas Texas, was a buzzkill for the fluffers at the Fed, noting that there is “a frightful storm brewing in the form of un-tethered government debt.”108 He says that he chose the phrase "frightful” to “deliberately avoid hyperbole.” Fisher suggests that the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are working so hard right now to correct.

2012 was a big year for taking the bear case to the Halls of Power. Jim Rickards, author of Currency Wars, presented his concerns about currency debasement to Congress.109 James Grant and Robert Wenzel in speeches at the Federal Reserve both hammered the Fed for horrendous monetary policies that are destroying our currency and capitalist system.110,111,112 Jim is a total genius, and he is very attention-worthy.113,114,115

Legendary hedge fund manager and cherished confidant David Einhorn poked at the Fed with his “jelly donut” speech.116 It was Silence of the Lambs at the Buttonwood Conference when he pointed out what they should have known: Artificially low interest rates drive up commodities and reduce income streams to a trickle, forcing consumers to save more and spend less.117 He throws in a little money multiplier logic and—voilà!—stimulus is totally negated.

Einhorn accuses the Fed of “offering some verbal sleight-of-hand worthy of a three-card Monte hustle.” David wonders out loud: “We have just spent 15 years learning that a policy of creating asset bubbles is a bad idea, so it is hard to imagine why the Fed wants to create another one.” I wonder out loud: How much did Fed policy have to degenerate to force the Einhorns of the world to focus on monetary theory rather than investing?

We had several bootleggers-turned-Baptists. The technical term is “tranny.” John Reed confessed his sins while CEO of Citibank, explaining how Citibank and Travelers, with the aid of a very friendly administration, destroyed the Glass-Steagall safeguards that had protected consumers from financial disaster since the ‘30s.118 Sandy Weill, the next CEO of Citigroup, shocked the world by suggesting that big banks “be broken up so that the taxpayer will never be at risk.” What’s gotten into these Citi-boys? Would it be too much to ask for a mea culpa from Robert Rubin? Yes.

William Cohan, former Wall Street investment banker and author of several best sellers including a comprehensive history of Goldman Sachs, pointed out the cracks in the seams—the omerta—at Goldman, flaws in the FINRA arbitration system, the mathematically nonsensical $100 million IRA of Mitt Romney, the SEC’s lack of oversight on nefarious activities at Citigroup, and a striking exposé of Robert Rubin’s deep-seated political power.119,120,121,122

These guys are some of the sharpest knives in the drawer. They view the world through darker lenses than most. Whether they are right or not, you’ve been warned.

The Bankers

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

~ Henry Ford

The most newsworthy story about Goldman Sachs may be that they weren’t in the news that much. Of course, there were a few skirmishes. Disgruntled employee Greg Smith took his best shot at the Goldman Death Star, but both his interview and book proved toothless.123 Smith told us that Goldman employees showed scorn as they ripped the faces off their clients called “Muppets.” Anybody who read Michael Lewis’s Liar’s Poker knows that clients are chum for the brokerages. Goldmanites had to run out the back door without putting their pants on when it was discovered that they were part-owner of a website focusing on the sex-trafficking of underaged girls.124 It also was reported that many Goldman folks were tipping off Rajaratnam, although that story is now passé. Most importantly, however, JPM managed to knock Goldman below the fold.

Problems for JPM began in 2011. As noted in my 2011 summary, MF Global—a reincarnation of the formerly bankrupted and scandal-riddled Refco—had collapsed, segregated funds had been rehypothecated (rehypothecate = used repeatedly; see also, “stolen”), and the money was lost speculating at the track. Remaining funds (including stored gold bars, if they weren’t already rehypothecated) were quickly snarfed up by JPM under the arcane principle of law referred to as “finders keepers, losers weepers.” We finished 2011 knowing that Corzine was a weasel and in a world of trouble and serious money had “vaporized”—not to be confused with “stolen”—to use language from a planted story.125 Vaporized money brings to mind the must-see South Park episode, “And It’s Gone.”126 The authorities were handed a Madoff-quality scandal to finally prove they are the best regulators money can buy. Twitter hound Mark Melin was posting hourly updates on nefarious activities while legal beagle James Koutoulis was gearing up for a big class action suit.

Just as night follows day, 2012 brought us…crickets. Nothing but chirping crickets. The case was dropped. How the hell did this happen? The JPM legal team exploited the chaos and rushed MF Global into bankruptcy. Chris Whalen explains that bankruptcy gave JPM “first dibs” creditor status whereas a fraud charge would have diverted the funds to less worthy folks—the rightful owners.127

To ensure the transition went smoothly, former FBI Director and political hack Louis Freeh was put in charge of overseeing this mess. Freeh promptly asked the bankruptcy court to allow payouts to MF global executives for the long hours spent cleaning up.128 (I'd give them free room, three square meals, and snappy orange jump suits.) Freeh then diverted funds from clients to legal defense funds of MFG execs.129 The other MFG trustee named Giddens—the other MFG trustee?—pressured litigants to release the banks of all liability to receive reimbursement, suggesting that (1) the money didn’t really vaporize, (2) stealing money and then giving it back when caught should not be a crime, and (3) extortion is legal if you are a trustee.130 Within a week it was announced that the Rule of Law had been downgraded to a guideline.

As often used in comedies, we use an epilogue to track the fates of the major players. Jon Corzine bought himself a “Get Out of Jail Free” card by remaining a major fundraiser (a bundler, to be exact) for Team Obama.131 The Department of Justice (DOJ) stood ready to indict Corzine if he missed a payment. Immunity to Corzine’s consigliere would have revealed some serious dirt, but the DOJ declared there was no case and walked.132 Corzine is exiled in the Hamptons sans ankle bracelet on an OJ-esque quest for the lost funds and a new job as a hedge fund manager. Rumors that Corzine’s life insurers put his policy in a risk pool have not been confirmed. Team Obama got a second term in the White House, and nobody in the administration has been indicted for racketeering. The sordid story of MFG has been relegated to case studies in MBA ethics classes. (Evidence aside, they do have such courses.) The main character, Jamie Dimon, landed a leading role in the next scandal and was put on the shortlist for Secretary of the Treasury.

As the replacement regulators and DOJ were playing Pull My Finger, rumors among the blognoscenti surfaced of a big London-based commodity trader who was in trouble.133 The trader was originally referred to as “The Caveman” but soon became “The London Whale.” Mike Mayo, one of the elite banking analysts, downgraded JPM a day or so before the story broke and later attributed the problem to “negative incentives and the revolving door” (corruption from the unholy alliance of banking-government).134 Jamie Dimon initially claimed it was “a tempest in a teapot ,” but then JPM announced burgeoning losses in the billions. Eventually, even CNBC bought a ticket on the London Whale Watching Tour. Those guys are sleuths.

JPM was in very big trouble. (Just kidding; of course they weren’t.) Damage control was swift and effective. JPM liquidated an estimated >$25 billion of assets to both clean up the mess and book enough profits to guarantee that their reported earnings would show that this was not a BFD (big deal).135 The London Whale, aka Bruno Iksil, was labeled a rogue trader, which is a technical term for a “rainmaker turned patsy.” With dripping irony, Bruno’s boss is named Achilles Macris.

Normally, the story would end there, but the Greatest Banker in the Universe—Jamie Dimon—faced a stark choice: Either claim that he screwed the pooch—uniquely so—or admit that the banking system is still hopelessly corrupted. The forthcoming mea culpas were slathered with gobs of sincerity. “We were total idiots. We can’t pour water out of a boot with the directions on the heel.” (paraphrased, of course) Jamie testified to Congress for no apparent reason, getting grilled by Congressman Tim Johnson who, because of a massive stroke in 2006, was not particularly threatening. Spencer Bachus, Chair of the Financial Services Committee, treated Dimon with kid gloves and let him testify not under oath because JPM is his second biggest donor. What’s appalling is that Bachus sold us down the river for a take of $119,000 over the congressman’s career.136 That was money well spent. Supposedly, the entire Financial Services Committee cost a little over $800,000.137 Peter Schweizer’s book, Throw Them All Out (vide infra) documents in lurid detail that congressmen and congresswomen are prostitutes, but cheaper. In an interview in Davos, Dimon was able to put the problems to rest, noting that “most of the bad actors are gone." You betcha.

Of course, other banks wanted a piece of the action. Barclays made a feeble grab for fame by taking the lead in the Libor scandal.138 Libor, the London Interbank Offered Rate, is a compilation of self-reported lending rates that influence interest rates throughout the $500 trillion global credit markets.139 Self reported? Whatever could go wrong? It turns out Barclays was cheesing the numbers. The retribution was swift and severe: Barclays was fined a whopping $200 million,140 which cut into some of their profits on the scam. The British Banking Society, using language right out of Casablanca, said that they were “shocked.”141

Meanwhile, journalists around the globe, scrambling to figure out what Libor meant, spouted scholarly analysis like Milli Vanilli. It soon became evident, however, that all of the banks were fudging their numbers.142 The scandal was promptly downgraded three levels to an embarrassment when 2008-vintage articles by Mark Gilbert and Gillian Tett surfaced that described the rate rigging.143,144 The Fed knew about it in 2008.145 Liborgate could clog the courts for awhile as borrowers lawyer up hoping to identify damages.

The blogosphere thinks Liborgate is “huge.” I find the scandal oddly anticlimactic given that central banks around the globe openly rig rates on a daily basis. James Grant concurs with this minority view. It is galling, however, that the scandal seems to reach the highest levels of the banking cartel—the central banks. For me, it is profoundly disturbing that global capital has been fully sequestered from price discovery.

The British Banking Association was shocked again when Standard Chartered Bank got accused of illegally laundering $350 billion for Iran.146 Rogue New York banking regulator Benjamin Lawsky filed his charges as the Justice Department was on the verge of declaring that Standard Chartered’s trades “complied with the law.”147 Standard Chartered promptly entered settlement talks with everybody. A Deloitte partner involved with the scandal offed himself. For him, the scandal was a big deal.

The hits just kept coming. HSBC got charged with money laundering for terrorists, drug cartels, and organized crime syndicates. It seems that HSBC must have picked up BCCI’s clients after their scandal-induced collapse in the late ‘90s. This ‘affiliation’ with organized crime is silly: Banking is organized crime. Reuters reported that HSBC could be fined over $1.5 billion for money laundering and face criminal charges.148 Of course they could, but they won’t.

US Bancorp got charged $55 million for scamming customers with overdraft fees by illegally maximizing the number of checks put into overdraft.149 In a possible script for the MFG sequel, Cantor Fitzgerald was accused of “undersegregating” funds.150 This is like “kind of pregnant.” The whole thing seems “sort of criminal.”

The more generic thieves and scoundrels returned with an encore when CEO of Peregrine Financial Group (PFG) stole rehypothecated customer funds for several years.151 The CEO of Attain Asset Management (AAM) captured the spirit of the outrage against PFG, noting “This time it’s personal.”152 PFG CEO Wasendorf attempted suicide, presumably hoping to front run the AAM CEO to (paraphrased) “put a cap in his ass.” Jeffries promptly began a Chapter 7 liquidation of PFG positions after a failed margin call. Once again, Chris Whalen explained the nuances.153 Apparently, this time they did it right by sending PFG into receivership to the advantage of the customers; Reuters reported depositors got 30 cents on the dollar.154 I imagine that debt subordination by big money folks somehow played a role.

Whistleblowers took a serious beating this year. FINRA, Wall Street’s self-policing arbitrators, managed to bankrupt a Morgan Stanley broker with a fine of $1.2 million after he accused Morgan Stanley of adding hidden fees to retirement accounts.155 When the case was followed up, nearly half of the 18 hrs of tape, mandated to be saved, “disappeared.” The transcript of an anonymous whistleblower testifying to CFTC was a great read. The CFTC removed it from their website, but a copy was saved.156 A lawsuit by Securities and Exchange Commission (SEC) whistleblower David Weber alleges that the SEC is involved in all sorts of nefarious activities, including specifically tracking potential whistleblowers.157 David Einhorn also presents the SEC as profoundly corrupt in his book, Fooling Some of the People All of the Time.

We found out this year that Deutsche Bank had been accused by three independent whistleblowers of hiding $12 billion in losses to avoid a bailout during the bailouts (if that makes any sense).158 This scandal is a dog’s breakfast: (1) the whistleblowers—one of them a risk officer—got fired within days of the complaint; and (2) the current SEC’s chief enforcement officer was in charge of the legal compliance at Deutsche Bank and was its general council during the cover up.

I have painted the banking industry with an ugly brush. I’m sure most bankers are good, honest people. If so, it’s time you guys start cleaning up your profession. When you find yourself saying, “Somebody should do something,” that somebody is you. If you stay silent, it’s just a Sandusky sequel.

The Federal Reserve

I simply do not understand most of the thinking that goes on here at the Fed, and I do not understand how this thinking can go on when in my view it smacks up against reality…Do you believe in supply and demand or not?...Let’s have one good meal here. Let’s make it a feast. Then I ask you, I plead with you, I beg you all, walk out of here with me, never to come back. It’s the moral and ethical thing to do. Nothing good goes on in this place. Let’s lock the doors and leave the building to the spiders, moths, and four-legged rats.

~ Robert Wenzel, in a speech at the NY Federal Reserve

Well that pretty much captured my sentiments. The Fed gets their pick of the litter coming out of PhD programs. They are a politically (in)dependent group with a dual mandate of supporting the banks and maximizing bank profits. The dozen or so members of the Federal Open Market Committee (FOMC), by virtue of arrogance and hubris, have become intellectually neutered and are now menaces to society. Why listen to an organic chemist—an academic, to boot? Let’s see what the pros have to say.

A first year investment banking associate knows more about credit creation than the entire FOMC combined…. Our colleagues at the Fed have consistently failed to understand the operations of financial markets and how credit operates in our society. This may surprise some of you, but it doesn't surprise me at all.

~ Chris Whalen, Founder of IRA Risk Analytics

I have to say the monetary policies of the U.S. will destroy the world.

~ Marc Faber, Elite Barrons Round Table Member

The little sliver of remaining hope was officially pronounced dead [with QEIII]….we are witnessing the greatest monetary fiasco ever.

~ Doug Noland, Federated Investors

The Chinese aren't loaning to us anymore. The Russians aren't loaning to us anymore. So who's giving us the trillion? And the answer is we're just making it up. The Federal Reserve is just taking it and saying, ‘Here, we're giving it.' It's just made up money, and this does not augur well for our economic future.

~ Mitt Romney, unemployed

When I read direct quotes and commentary about Bernanke's policy of driving up asset prices in general and equity prices in particular, I almost want to cry over the ludicrousness of this position. The Fed is pursuing the same road to ruin as it did between 2003-2007.

~ Albert Edwards, Societe Generale

Bernanke, and his MIT ilk, has made monetary policy into a laboratory for monetary theoreticians.

~ Kevin Warsh, former Federal Reserve governor

It’s the general global landscape where you have an incredible mispricing of risk that’s being delivered at the hands of academics at the central banks of the world.

~ Wellington Denahan-Norris, CEO of Annaly Capital

I am a little—maybe more than a little bit—worried about the future of central banking. We've constantly felt that there would be light at the end of the tunnel, and there'd be an opportunity to normalize but it’s not really happening so far.

~ James Bullard, President of Saint Louis Federal Reserve

Let’s briefly break away from 2012 condemnations and snag a quote from my favorite book on Austrian economics and the Great Depression:

The end result of what was probably the greatest price-stabilization experiment in history proved to be, simply, the greatest and worst depression.

~ Phillips et al. in Banking and the Business Cycle (1937)

Of course, the big news was the third wave of debt monetization referred to as QE IV, QEtc, QEInfinity, or Cash for Clunkers II. The Fed is jamming over $80 billion of high-powered money per month into the economy. Initial promises to monetize aggressively until 2015 have been extended to infinity and beyond. The Fed pretended it was sterilized—the long-term debt purchases were being offset by short-term debt sales. “Operation Twist” (QE II), however, recycles the short-term debt right back into long-term debt. Problem solved.

There is some room for debate as to why they are pushing monetary policy to the edge of the known universe. They tell us that it is to improve the economy and help the little guy by throwing savers under the bus with repressively low interest rates. Last I looked, the savers are the little guys. It has been estimated that if interest income as a percentage of total personal income had remained at its 2008 level, the total would now be an additional $1.5 trillion.159

To achieve their goal of stabilizing the banks—not all the banks, just the really big ones—the Fed has completely dismissed any notion that the debt markets should be allowed to clear, which is Austrian-speak for establishing market-based pricing. James Grant calls it “waging war on the pricing mechanism.” The Fed does this via purchases of 60-80% of all the newly issued federal debt because our foreign creditors have gone on a buyers’ strike.160 Without the Fed’s unprecedented interventions, bond prices would plummet (sponsored by Red Bull, no doubt), affiliated interest rates would spike, bond holders would get crushed, and the federal government would have to borrow at rates that would completely choke our already auto-asphyxiated federal budget. We’re now homing in on why the Fed is monetizing debt. (Note to readers: When you read an article stating some variant of “low rates show everything is rosey,” that person is an idiot.)

The irony here is that the Fed’s zero interest rate policy (ZIRP) is choking the savers, as noted by David Einhorn (vide supra). Similar cases have been made by Chris Whalen and others.161 William R. White, former Head of the Monetary and Economic Department at the Bank for International Settlements (BIS), wrote a must-read paper entitled, Ultra Easy Monetary Policy and the Law of Unintended Consequences.162 The Fed’s policies are Soviet-style stupidity and a short trek to financial perdition. Even worse, Daniel Kahnemann, Nobel Laureate and expert in behavioral psychology, would probably argue that the Fed’s decision making is no more accurate than “monkeys throwing darts.” Milton Friedman indirectly made a similar case against central planners in an interview with macroeconomist Phil Donohue.163

The Bootleggers

Why does the New York Times hate the banks?

~ Jamie Dimon, CEO of JP Morgan

It’s not the New York Times, Mr. Dimon. It really isn’t. It’s the country that hates the banks these days.

~ Joe Nocera, New York Times

I have beaten on the bankers hard and will continue to do so until somebody can say their house is clean. I should, however, let these bootleggers and affiliates—the Baghdad Bobs of Finance—speak for themselves. As you read these quotes, ask yourself: Did they really say that? Really?

Low Fed rates didn’t fuel the housing bubble.

~ Alan Greenspan, former Chair of FOMC

This is the United States of America. That's what I remember. Guess what.... It's a free f***ing country.

~ Jamie Dimon, CEO of JPM

Hanging bankers won’t help…Public anger over the financial crisis is wrong.

~ Tony Blair, former Prime Minister of England

Large numbers of people who have ‘lost’ their house through foreclosure have actually realized a profit because they carried out refinancings earlier that gave them cash in excess of their cost. In these cases, the evicted homeowner was the winner, and the victim was the lender.

~ Warren Buffett, Berkshire Hathaway

The evidence that I’ve seen and that we’ve done within the Fed suggests that monetary policy did not play an important role in raising house prices during the upswing.

~ Ben Bernanke, Chair of FOMC

We economists…have reason to be proud of our analyses over the past five years. We understood where we were heading, because we knew where we had been.

~ Brad DeLong, economist at UC Berkeley

Quantitative easing isn’t being imposed on an unwitting populace by financiers and rentiers; it’s being undertaken, to the extent that it is, over howls of protest from the financial industry.

~ Paul Krugman, Princeton University and Nobel Laureate

The demonization of Wall Street and bankers is very much a function of the press and of Washington, and not much more broadly held.

~ John Thain, former CEO of Merrill Lynch

Wage and price controls distort markets…prices are prices…We’re not going to monetize US debt.

~ Ben Bernanke, FOMC

Thank the people of AIG for having the courage to do what they did.

~ Robert Benmosche, CEO of AIG

To claim that it’s effectively a gift you have to claim that the prices the Fed is paying are artificially high, or equivalently that interest rates are being pushed artificially low. And you do in fact see assertions to that effect all the time. But if you think about it for even a minute, that claim is truly bizarre.

~ Paul Krugman, Princeton

There is a German word, backpfeifengesicht, that reputedly translates to “a face badly in need of a fist.” It seems appropriate for some of these characters, which would generate some serious schadenfreude. For these gentlemen, however, I’ll let pop culture respond:

What you have just said is one of the most insanely idiotic things I have ever heard. At no point in your rambling, incoherent response were you even close to anything that could be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul.

~ The Principal in Billy Madison

Personal Debt

I spent all my money on women and wine, and the rest I wasted.

~ George Best, Irish soccer player

Debt permeates all levels of the global economy. In the U.S., debt is growing much faster than the GDP (Figure 12). A montage of over 50 charts showing all facets of debt is well worth a peek.164 Authorities are convinced that more spending and more debt will be our salvation. Daniel Bell, a Marxist from the turn of the 20th century, took the other side of this bet, suggesting that the consumer would eventually consume themselves. Apparently, I’m a Marxist. In this section I would like to briefly discuss personal debt. (Special aspects of student and mortgage debt are cordoned off into their own sections.)

Figure 12. Accrued debt with annotations showing dollars of debt required per dollar of GDP (source link lost).

The so-called resilient consumer is getting squeezed from every direction. The income of the average family has dropped from $53,000 to $47,000 in only 5 years.165 Deleveraging is evidenced by a dropping debt-to-income ratio in Figure 12, yet two thirds stem from defaulted mortgages.166 The national savings rate has once dropped to zero from historical norms of 10%. Credit card debt is said to be the leading cause of suicide among adult males.167 Trimtabs reports a 40% drop in net median family worth since 2007.168

Should the average family of four earning $47,000 happen to rashly buy everybody iPhones, they just committed 4-5% of their gross income to phone service. I’m not sure even families earning $150,000 should spend that much on phone service. Television and children’s activities used to be largely free; now we pay. Internet, as amazing as it may be, is a necessary expense. Don’t think so? See how your kids do in school without it. Figure 13 shows the ratio of personal consumption versus compensation. That rise stems from a combination of decreased savings and increased debt.

Figure 13. Personal consumption versus compensation.169

In 2010 I discussed an insidious and overlooked contribution to inflation—accelerated depreciation. It is still overlooked by the mainstream so I am going to take one more abbreviated whack at it. For example, in 2009 I broke a 40-year-old blender. The Boskin Commission14 would argue that its replacement is even cheaper than the price tag would indicate because it has more buttons. Government statisticians actually “hedonically” adjust the price down for improved quality. Alas, that really cheap blender died after only two years of dedicated service. Chintzy goods at affordable prices have trapped consumers in a vicious replacement cycle. If Boskin et al. had looked at the per year cost of the blender, they would have corrected for depreciation with a 20-fold price multiplier before comparing the relative prices of old and new. The net domestic product—the gross domestic product with depreciation included—is an antiquated concept that needs resurrection.170 Meanwhile, the consumers are choking on their vomit trying to keep up with depreciation.

Mortgage Debt

There is not a menace in the world today like that of growing public indebtedness and mounting public expenditures.

~ Warren G. Harding, former President of the United States

Harding was considered to be one of the least competent presidents. Could have fooled me. Mortgage debt presents its own unique issues. We are slowly winding down the mortgage bubble that burst in 2007 through a combination of defaults and debt restructurings. To say, however, that a modest uptick in housing activity means that the problem is solved is ridiculous (Figure 14). Is housing recovering? Not really. Maybe sentiment has begun to change but only with the unprecedented force of a central bank behind it.

Figure 14. Home building employment (red) compared with home builder sentiment (blue).

There are still an estimated 11 million homeowners underwater on their mortgages, including more than a million people who have just bought in the past two years.171 Ill-advised efforts to bail them out—foreclosures clear the market—seem to have faltered. Special Inspector General of the TARP Neil Barofsky discovered Geithner never intended to aid homeowners, only to delay foreclosures for a year or two so that they could occur orderly. Writedowns are taxable income,172 which prevents homeowners from accepting them. Distressed real estate purchased by speculators appears to decrease the housing glut. Unfortunately, this shadow inventory still exists if the speculators intend to flip the houses for a quick capital gain. The market won’t clear until demographics and income growth clear it, both of which are going backwards.

There seems to be some resolution of the catastrophe caused by the Mortgage Electronic Registration System (MERS) in which the ownership of millions of houses are being thrown into legal purgatory by foreclosure. Bank of America supposedly offered to take a deed in lieu of foreclosure, presumably to get the deed legally.173 Legally dubious foreclosures are clearing through the legal expedient of turning a blind eye. Efforts in California to use eminent domain to clear out problematic underwater mortgages are so egregious that I have deferred them to the section on Civil Liberties and the Constitution.

Student Debt

Bart: don’t make fun of grad students. They just made a terrible life choice.

~ Marge Simpson

You’re f*cked.

~ Robert Reich, former Secretary of Labor, to Class of 2012

Student loans have soared from $200 billion in 2000 to over $1 trillion today (Figure 15),174 surpassing credit card debt. Some say there is a student loan bubble, but the Bush-era legislation ensuring that student debt cannot be discharged even in bankruptcy suggests there is no bursting mechanism. Nevertheless, something will give, because loan delinquencies are going parabolic.175 The paradoxical effect of the full-recourse loans is that banks are happy to provide almost unlimited funding to a slice of society rich in ill-conceived ideas. This debt is also localized in the most financially vulnerable demographic slice during a severe economic downturn. It ain’t just the kids. An estimated $38 billion in student loans are owed by seniors 60 and older, probably stemming from desperate efforts to retool their careers as well as co-signed loans for children and grandchildren.176

As if the debt burden was not enough, potential employers are checking credit reports. High student debt can render you unemployable.177 Seems unfair. The average medical school graduate has $161,000 in student loans.178 The ultimate irony is that those young doctors on the cusp of achieving the American Dream cannot afford a starter house. Ben Bernanke’s son is said to be $400,000 in the hole.179 Bernanke is indeed the father of a gigantic credit bubble. Financial independence for twenty-somethings—a rite of passage only a few years back—has become increasingly out of reach.

Figure 15. Comparison of student loan growth and other consumer debt growth.180

An entire generation has been set up for debt servitude. We are eating our young. The source of the problem is a complex and nuanced confluence of factors. The chronically profligate boomers, stressed by inflationary pressures and dazed by the equity and real estate downturn, are in no position to help their kids pay for college. The cost of a four-year college education has also soared, while earnings after college have stagnated (Figure 16).181 The number of 26-year-olds living with their parents has jumped almost 46 percent since 2007.182

Figure 16. Plot comparing college costs and earnings in early adulthood.183

What is causing the rapidly escalating college costs? As a professor of 33 years, I can offer a few thoughts and opinions.

            (1) College tuition—the cost of running a small city—may be the single best measure of inflation. The tuition growth squares well with the inflation numbers posted by John Williams of Shadowstats.com.

            (2) Rapidly growing federal and state mandates to universities escalate bureaucratic costs. You know all those extra positions you see in secondary schools that didn’t exist when we were kids? Universities have them too.

            (3) Universities are much more complex, interconnected organizations than they were 30-40 years ago.

            (4) The quest to attract the best possible students and faculty has produced something akin to an arms race among the schools, forcing up the costs of chasing the competition.

            (5) Universities are financial enterprises that can approach $1 billion annual operating costs and are managed largely by academics often lacking the requisite training. The Dean of Arts and Sciences at Cornell is a physicist—a smart guy by any measure. What prepared him to run a $100+ million enterprise?

            (6) Guaranteed payers—banks offering unlimited student loans in this instance—are always inflationary.

I have an aversion to debt jubilees, but I suspect we are heading for a federally sponsored bailout of borrowers and those who traffic in student loans. How do we prevent a repeat of this debt problem? First, a warning: Don’t buy into the increasingly common claims that college is a waste of money. Such blanket statements are counterfactual. One rich dude bribed 100 kids not to go to college.184 Some will be fine but others are going to get hit by the cluster truck. There are, however, many circumstances in which a kid should not go to college.

Students must be good consumers. It’s not just a degree; it’s an education. This means choosing paths wisely and working hard. Not all majors or institutions are created equal; enough said. Debt is a bad idea if it is not self-extinguishing—paid off with the net gain in proceeds from the education. If the kids lack direction or need a break, parents need to let them take time off. You read that right— it's the parents, not the kids, who oppose the change. Save your money until it will be used wisely. For their part, schools need to focus on strengths and, in many cases, specialize. Paul Smith's College, a small college in the Adirondack Mountains, is a great example. They educated my older son. His profound success after an inauspicious secondary education stems from the school’s focus—only four, highly pragmatic, majors. What a great model!

How do we fund college educations going forward? I understand the origin of full-recourse loans but find non-dischargeable debt to be anathema to the American system. We’ve got to curb predatory lending; full recourse loans with interest rates and penalties akin to subprime debt is loan sharking. The libertarian in me says caveat emptor, yet this is a vulnerable demographic lacking fully developed frontal cortexes. The best idea may involve creditors purchasing a percentage of the students’ earnings after graduation for a fixed period (10% for ten years, by example). It’s a form of venture capitalism. I would gladly invest in a tranche of loans to MIT students promising a slice of their earnings—at the right price, of course. For those schools in which the bet is a bad one—the loans are too big, attrition is TOO high, or incomes after graduation are on average too low—the resulting market-determined high interest rates would force change or the institution would fail.

The idea of “no child left behind” would take a beating, but I don’t buy the notion that we need more college-educated adults. We need better-educated adults. Whether this means education in a four-year college or a trade school is highly student dependent. Father Guido Sarducci’s “Five Minute University” has an appeal.185 Another very entertaining parody makes a case for Princeton.186 I would also say beware of law schools. They can be great opportunities but can also be exceedingly expensive holding tanks for college graduates still lacking direction.187

By the way, would somebody—anybody—start teaching courses in personal finance at the high school and collegiate levels? That void is what got us into this mess in the first place.

Municipal and State Debt

This is not a boating accident.

~ Richard Dreyfus in Jaws

The balance sheets of municipalities and states are a total mess. Forbes recently noted 11 states flagged for dangerous finances.188 It’s not just the sand states that are in trouble. Syracuse, NY is considering a debt restructuring due to excessive expenditures and pension promises.194 Reuters reported that outstanding bonds, unfunded pension commitments, and budget gaps exceed $4 trillion for the 50 states.195 That’s approximately $40,000 per taxpayer in the country. Illinois is now $150 billion in the hole, yet the voters defeated legislation designed to stem rising pension costs.189

California’s estimated annual deficit rose from $9 billion to a considerably larger $15 billion in a matter of months. California alone owes over $600 billion, with New York coming in a distant second at $300.1 billion.190 These are self-inflicted wounds. Orange County paid lifeguards annualized salaries of $200K.191 Hermosa Beach meter maids racked up an astonishing $300K annual salaries.192 Stockton, San Bernardino, and Mammoth Lakes all filed for bankruptcy protection this summer.193 San Bernardino City officials sped up the filing to preempt legal action by creditors. Under Chapter 9, all court cases and other legal actions are halted until the bankruptcy case is over.

Rock star banking analyst Meredith Whitney predicted serious financial stresses for municipalities, yet she made the fateful mistake of predicting what and when.196 The Mayans taught us that you never predict both. At year end, the criticisms have been mounting. With that said, Moody’s is looking to downgrade some California municipal bonds. Buffett picked up a pile of municipal bonds at deep discount during the crisis, presumably using inside knowledge of the Fed backstop that he helped design, only to dump a bunch of these bonds this year.197 The muni bond story is just getting started.

Corporate Debt

In aggregate, US balance sheets are in very poor shape.

~ Andrew Smithers, CEO of Smithers and Co.

You may have heard recently that…U.S. companies…are sitting on growing piles of cash they are ready to invest in the economy. There's just one problem: It's a crock.

~ Brett Arends, MarketWatch

Andrew Smithers and Brett Arends are the only two guys I know who claim that corporate balance sheets are not in good shape.198,199 Everybody else raves about the robust corporate balance sheets while focusing on only one side. Corporations are flush with cash and chock full of debt (Figure 17).200 They are hoarding cash, presumably in anticipation of more credit constraints. The DOW 30 has a net debt (debt minus cash) of $500 billion despite fortress balance sheets by a minority including Microsoft, Cisco, and, if you believe them, JPM. Only 7 of the DOW 30 have net positive cash positions. Pensions of large-cap companies are also significantly underfunded (vide infra). It is estimated that major corporations globally will be refinancing $45 trillion of debt over the next couple of years.201 None of this suggests strong balance sheets, only generous credit lines.

Figure 17. Non-financial US corporate debt market (billions of dollars) (source: SIFMA).

Sovereign Debt

There are two ways to conquer and enslave a nation. One is by the sword…the other is by debt.

~ John Adams, former President of the United States

There’s always the Federal Government to bail us out, right? Maybe, but we’re in serious trouble. The U.S. debt doubled in only four years (19% annualized). A recent Treasury report indicates that in less than a year we added $2.1 trillion to the national debt. Although it is tempting to point fingers, a screw-up of this magnitude requires a bipartisan effort. The Federal debt and deficit inspired Egan-Jones to downgrade U.S. debt,202 which then inspired the SEC to investigate them (Egan-Jones, that is).203 The spendthrifts declare that we had a financial malaise to deal with. I wonder if history will look favorably on a Keynesian experiment in which we injected $1 million of government stimulus for each newly created job.204

It is estimated that we are collecting only 60 cents of every dollar spent by the Federal government. This is not the beginning of the end of some debt frenzy. It is the end of the end. Who is buying all this debt? Funny you should ask. The Fed is buying 60-80% of it. How do we afford it? Oddly enough, the Fed controls the interest rate on federal debt. Uncle Sam has an unbelievably cushy line of credit thanks to Fed largesse. The whole Fiscal Cliff debate illustrates that austerity is too inconvenient to deal with right now. We can worry about tightening the belt later. But this secular bond bull market is very long in the tooth. At some point rates will rise just like night follows day. Each 1% rise in rates on $16 trillion dollar debt adds an additional $160 billion to our interest rate payments.

What if we just really suck it up? Seriously. What if we go to the extreme by dropping all discretionary spending? No more military, highways, education, parks, etc. and pay only the interest on the debt and other payments mandated by statute. We still fall short of a balanced budget.205

For those confused about the Clinton-era balanced budget, it was a hoax—we had gobs of off-balance-sheet expenses putting us in the red. The reported deficit is the innocuous part. If one looks at unfunded liabilities—promises made to the populace for which we haven’t a clue where the money will come from even after projected tax revenues are included—we are in huge trouble. Years ago, Kotlikoff, Burns, and Smetters estimated $44 trillion of unfunded liabilities. Kotlikoff is now estimating over $200 trillion—40 Krugmans! (1 Krugman = $5 trillion)206 That comes to an IOU of $2 million dollars per viable taxpayer. So let’s not trivialize this issue by suggesting that this will hurt our grandchildren. As far as I am concerned, they are on their own. This is gonna crush you and me.

Pension Crisis

Demography is like a glacier: It doesn't move fast, but it is very predictable...it's inexorable.

~ Neil Howe, author of The Fourth Turning

We have a massive, multi-dimensional pension problem. Let’s begin with a look at the personal pension plans most commonly associated with 401K plans and related IRAs. Optimistic retirement planners at Fidelity recommend socking away 8x annual income by retirement.207 That’s not enough. More conservative estimates reach as high as 20x or even 25x your annual salary in savings.208 Further problems stem from the bond market, which approximates 40% of all retirement portfolios.209 In the downturn, huge gains in principal mitigated the pain of the equity losses. The best-case scenario going forward is that rates stay low forever, resulting in miniscule cash flows and no loss in principal. The more likely scenario is that interest rates rise and prices drop causing significant losses in principal. There is no slack left. Reaching for yield buying sketchy forms of fixed income is likely to be a road to ruin. Bold assumptions of 7-8% annual returns on pension portfolios will require double digit equity gains. Buffett and anybody else actually paying attention, however, will tell you that dropping rates, not low rates, helps equities.210 Only the legalize-marijuana crowd on CNBC believes rising rates will not hurt equity returns.

Let us look at what is nearly a best-case scenario, a family in the top 5th percentile—the 5 percenter. This family is defined as earning $154,000 and a net worth of $1.2 million,211 which, by coincidence, is about an 8-fold ratio of savings to annual earnings. A couple at the demographic heart of this 5 percenter also is likely to be a late stage boomer on the doorstep of retirement. Way to go, Fidelity! Using assumptions based on standard portfolio theory and grounded in legally mandated IRA withdrawal rates, the 5 percenter should withdraw only 4% to ensure the money lasts—$48,000 per year. This is a problem. I’ve got to imagine that a 5 percenter is going to find a 50th percentile cash flow in retirement austere. The average boomer with a net worth of $180,000 spinning off only $7,000 per year is within an error bar of living on Social Security. 40% of the boomers literally will have only Social Security.

What about all those folks with defined benefit plans? First, defined benefit plans are becoming anachronistic, having been abandoned years ago by companies unwilling to shoulder the risk. Nonetheless, 341 of the 500 large caps in the S&P have retained some semblance of a defined benefit plan.212 It is also estimated, however, that the pension plans in 97% of these companies are underfunded.213 A paper by William R. White out of the Dallas Fed estimated that the 1,500 leading companies in the U.S. have a 30% pension deficit of $689 billion.162 Despite the Pension Protection Act passed in 2006 aimed at protecting workers against companies using pension pools as cookie jars to boost earnings, the crisis in 2007 and affiliated lobbying campaigns convinced law makers that such protections were too inconvenient.

The municipal and state pension problems are acute. The Illinois State Pension Fund is currently 40% underfunded; there is no obvious way out of their hole short of a Federal bailout. Some states are topping off their pension plans by borrowing money from…wait for it…their state pension plans! Read that last sentence again.214 Fully funding the state pensions would cost >$30,000 per taxpayer.

There is no guarantee that the defined benefits plans will survive. Chapter 11 corporate debt restructurings and Chapter 7 liquidations will continue to chip away at this liability. The Chapter 7 liquidation of Hostess and ensuing Twinkie riots—at least I rioted—leaves some wondering what kind of union-management stalemate could drive a company into bankruptcy. The 2,500 workers lost it all. Chapter 9 bankruptcies for restructuring municipal debts and negating pension commitments, unheard of only several years ago, are likely to become well known.

Unimaginable ink has been spilled discussing and analyzing the coming Social Security crisis. It’s an off-balance-sheet Ponzi scheme. Social Security also will be increasingly important as the other support mechanisms fail. With cooked inflation numbers and affiliated inadequate inflation adjusted payouts, it’s easy to imagine seniors getting stiffed.

Roth IRA: A Bad Idea

Cost of living now outweighs benefits.

~ Headline from The Onion

Before leaving the world of pensions I’m gonna pick a fight with Roth IRAs. When the Roth IRA was first announced I had a unique—as in only-guy-on-the-planet unique—visceral response. The original IRA was very farsighted: Savers were allowed to compound wealth unfettered by taxes while the government deferred tax revenues to future generations. By contrast, the Roth IRA pulled tax revenues forward, leaving future generations to take a hike. Imagine the truly awesome demographic problems we would have if the Roth had been introduced in the 60s and the entire baby boom generation became entirely tax exempt. Was this an oversight? I don’t think so. The introduction of the Roth and the substantial revenues from regular-to-Roth rollovers coincided with the Clinton administration’s efforts to balance the on-balance-sheet Federal budget for the first time in decades.

That is my minor gripe. To set up my really big gripe we must first dispel a widely held misconception and a common oversight.

(1) In a regular IRA, the money is taxed at the end, whereas in a Roth IRA taxes are levied up front. If the two are taxed at the same rate—this is a critical provision—the outcome is identical. They are not just similar, it’s an identity. Break out your calculator if you must. There is no differential advantage offered by compounding in the Roth over the regular IRA. Simply put:

Any advantage of the Roth IRA relative to a regular IRA necessarily stems from a lower tax rate while working than in retirement. Period/full stop.

(2) The tax rates of the Roth and regular IRAs are fundamentally different:

Roth IRA: Front-end loaded taxes paid at the marginal tax rate (highest tax bracket).

Regular IRA: Back-end loaded taxes paid at the effective tax rate (integrated over all tax brackets).

The distinction of marginal versus effective tax rate is critical and seems to be lacking from most analyses. One can calculate marginal and effective rates for any income online.215 Let’s return to the top-5-percentile family—the 5 percenter. If they had used a regular IRA, they would be paying a 7% effective tax rate incurred on their $48,000 per year withdrawal in retirement. They paid an approximate 32% marginal tax rate—the tax rate at the top bracket—to shelter a few thousand per year in a Roth IRA. The numbers simply do not work.

It is worse than that. Let us consider the lucky soul family—the extraordinarily rare couple—who actually accrued 25 annual salaries in their retirement account. For this family a 4% annual withdrawal will be equal to an annual salary while working, placing them in the same tax bracket (ignoring unknowable tax law changes). Even so, they paid 32% marginal tax on the Roth to avoid a 22% effective tax rate incurred by the regular IRA. The numbers still don’t work. I do not understand why the Roth is being sold so enthusiastically to the public.

Now ponder all those folks who rolled over a lump sum from a regular to a Roth IRA. They not only paid the marginal tax rate on the rollover but caused the marginal rate to spike to a higher level! It’s hard to imagine that will prove to be a smart move. Congress is considering moving all pension funds to what is effectively Roth IRA rules as part of their Fiscal Cliff negotiations.216 You young guys are about to get hosed.

Europe

The ECB is going to buy bonds of bankrupt banks just so the banks can buy more bonds from bankrupt governments. Meanwhile, just to prop this up the ESM will borrow money from bankrupt governments to buy the very bonds of those bankrupt governments.

~ Kyle Bass, CEO of Hayman Capital

Watching Europe is like reading Waiting for Godot—it is unintelligible. This is unfortunate because these folks may determine my fate. The problems begin with the PIIGS—Portugal, Italy, Ireland, Greece, and Spain—suffering from insolvency. We were assured that the Maastricht Treaty and Haagen Dazs Accord that spawned the Euro explicitly forbade deficits and bailouts.217 Well that was then and this is now. Christine Lagarde, head of the IMF, held a press conference literally flashing a big, black purse suggesting that it needs some serious money, and—Shazam!—a €700 billion bailout was in place before the weekend was over. Soon there were trillion-euro bailouts with fuzzy names such as Long-Term Refinancing Operation (LTRO), European Stabilization Mechanism (ESM), European Financial Stability Facility (EFSM), and Monetary Injection Liquidity Fund (MILF). Spiking interest rates of the PIIGS were driven down to levels that look like AAA-rated debt of Pfizer and General Electric. The European Commission (EC), International Monetary Fund (IMF), and European Central Bank (ECB)—the so-called Troika—are the enforcers. The banks get what the banks want.

A Greek exit—shortened to Grexit by Willem Buiter—would have created a fiscal crisis as well as an acronym crisis—PIIS. We endured an insane discussion about whether or not Greece should suffer austerity.218 Versus what? Rich, prosperous, and productive? The only legitimate employment was hawking gyros to rioters. A photograph of the Greek Ministry of Finance showing total chaos went viral, becoming a metaphor for the nation.219 Nobody got the memo: Austerity is not a choice; it’s a result. Any banker who lends to Greece will be the author of his own (and our) misfortunes. Iran stopped shipping oil to Greece. Just when Greece appeared to be plumbing the bottom, they suffered a locust attack—a real one.220 Greece is the smallest pawn on the chessboard and with little bargaining power. They were asked to sign a bailout agreement with deep-seated sovereignty issues, yet the document was written in a different language with an incomplete translation.221 However, the Greek default could cost the banks trillions, and the Greeks know this.222

The bailouts are coming from Germany because everyone else is on the receiving end. Yet, with an economy 20% the size of the U.S. economy, the Germans are trying to prop up a gaggle of countries that are collectively bigger than the U.S. economy. Europe has $30 trillion unfunded pension liabilities. It’s not going to work. Discussions of why the Americans should bail out Europe—even more than the hundreds of billions of QE II that ended up in European banks—led to a classic Santelli-Liesman love-fest on CNBC.223 The banks get what the banks want.

Soon Spain began to slip into the abyss,224 something I had been waiting for since 2009. [3] Shockingly, Mariano Rajoy, Prime Minister of Spain, declared, “We support a rescue mechanism, the bigger the better."225 It was all part of a shakedown of the EU, and it seemed to work. Money began flowing into Spanish banks. (Bankia actually got a bailout before the bailouts officially began because they couldn’t wait.)226 Spain put a €2500 cap on cash transactions,227 which is emblematic of an end game. Meanwhile, Spain is bidding for the 2020 Olympics. They will be sponsored by Lowenbrau.228

Then came the Italians. Bill Gross noted that "Italian banks are now issuing state guaranteed paper to obtain funds from the European Central Bank (ECB) and then reinvesting the proceeds into Italian bonds, which is QE by any definition and near Ponzi by another." The oldest bank in the world, Banca Monte dei Paschi di Siena founded in 1472, got bailed out. I wonder how many times that has happened in the last 540 years.229 The wheels of justice in Italy were moving forward; they convicted scientists for failing to predict an earthquake.230 The guys who cause earthquakes are still on the lam.

What happened to the assurances of the Maastricht Treaty that no sovereigns would be bailed out? It seems simple enough to me. Politically disconnected sovereign states are strongly shackled together by a common currency and borderless multinational banks. Why would the politicians in the sovereign states agree to self-destructive austerity deals rather than giving them the Icelandic Salute—a default and the finger? That’s easy, too; the banks own the politicians, probably via Cayman Island subsidiaries. (In the olden days, it would have been the Swiss, but their money-laundering ways are at risk.231) One of the many subplots is a mountain of credit default swaps that would break the banks if they were triggered.232 No problem: The banks refuse to declare the credit event. The banks get what the banks want.

The LTRO is particularly insidious because it subordinates existing debt, inducing a bad case of transurphobia (fear of haircuts). The more LTRO money, the less capital remains backing the existing debt.233 Which legal body gets to make this decision? That’s what the Troika is for—democracy not included. These guys are undermining the debt markets in fundamental ways.

The 2012 Nobel Peace Prize was awarded to the European Union,234 rumored to be for “keeping their shit together” and for “displaying an unprecedented willingness to not start another world war.” The great part about this wave of absurd Nobel Peace Prizes is that, in theory, I could get one—a dollar and a dream.

A World Economic Forum (WEF) report says we must double global debt by 2020 (to $210 trillion) to keep the global economy growing.235 If that’s the price, shrinkage is sounding pretty rational. The killer phrase was that “most of the growth will come from the government segment.” That ain’t economic growth.

Let us not forget the troubles in the UK. Goldman announced that they were installing one of their boys (Mark Carney) as head of the Bank of England, prompting David Stockman to ask, “Is there any monetary post in the world not run by Goldman Sachs?”236 UK family debts are up by almost 50% in a year. That is serious slippage. The Bank of England cranked $140 billion into the system in one day—equivalent to 177% of the annual global gold production.237

The Brits et al. are eating a lot of "toast sandwiches," otherwise known as the "austerity sandwich"—two slices of bread wrapping a piece of toast (butter/salt optional).238 Irish taxpayers withheld property taxes in protest to the Troika. This smacks of a “peasant rebellion” claiming taxation without representation. With this history ringing in his ears, Sir Mervyn King, Governor of the Bank of England, noted, “I have deep sympathy with those who are totally unconnected with the origins of the financial crisis who suddenly find that the returns on their savings have reached negligible levels. These are consequences of the painful adjustment prompted by the financial crisis and the need to rebalance our economy.”239 We feel your pain too, Sir Mervyn. Can I offer you a toast sandwich?

The whole mess has been summarized and bulleted by countless bloggers. A few are worth reading.240,241,242 Credit Swiss noted that “Portugal cannot rescue Greece, Spain cannot rescue Portugal, Italy cannot rescue Spain, France cannot rescue Italy, but Germany can rescue France.”243 Of course, in February Baghdad Ben Bernanke noted that "the ECB is well capitalized."

Asia

Asia is, by comparison, a relatively serene place. There was a seemingly ominous event when the Bank of Japan was said to be selling its bonds (JGBs) for the first time in years.244 This smelled like the beginning of a large deleveraging. Recent reports suggest that they are back to monetizing debt in a big way.245 Some bears such as Greg Weldon, Simon Johnson, and Kyle Bass view Japan as ground zero for financial carnage.246,247,248 Japan has spent 20 years losing 80% on the Nikkei—the so-called “lost decade” to those who can’t count—and now the carnage begins in earnest? Losing all of their nuclear reactors also seems ominous; I am guessing they were not using them as backup sources.249 Demographically, their population will continue to age for decades. This is not a pretty picture.

There are others who think China will be the source of fireworks. On the bearish side, you have Jim Chanos placing some serious shorts in position.250 You must take this as a serious omen. The average bloke does not understand the thoroughness of analyses by guys like Chanos and Einhorn. (Chanos, for example, was way ahead of all of Hewlett Packard’s auditors in detecting an $8 billion screwup in their purchase of Autonomy.251) Besides a bloated real estate market and terrible bank balance sheets, China is said to have a huge buildup of finished goods—channel stuffing—which will cause trouble at some point.252 This is consistent with often-cited suggestions that the authorities are terrified of unemployment and accompanying social unrest. On the other side, Stephen Roach and Jim Rogers, both highly respected market watchers, are rather enthusiastic about China. Years ago Rogers predicted strife in China would come to a head, and that would be the time to buy. I am quite confident, however, that I have no prayer of understanding China either now or in retrospect.

The Baltic Dry Index253 is a widely followed indicator of global economic activity (Figure 18). As you can see, the global economy is looking a little green around the gills.254

Figure 18. Baltic Dry Index as an indicator of global economic well being.254

I leave this section with an aside that is too curious to ignore. We were told this year that Japan had unwisely dumped $138 billion into Lehman before the company’s collapse and were promptly reimbursed by the Fed.255 Makes you wonder about those two Japanese businessmen caught crossing the Italian border with $134 billion of Treasury bonds.256 The Treasury denounced them as fake, but the Italians thought they were real. Who could launder them? (Silly question: HSBC would gladly do so for a cut.)

Government Corruption

Geithner heard this information and looked the other way. Geithner and other regulators should be held accountable, they should be fired across the board. If they knew about an ongoing fraud, and they didn't do anything about it, they don't deserve to have their jobs. I hope we see people in handcuffs.

~ Neil Barofsky, Special Inspector General of TARP

What we’re showing here is that cronyism is now permeating our justice system.

~ Peter Schweizer, author of Throw Them All Out

2012 witnessed plenty of government corruption. It is my thesis that corruption within government is getting worse for three reasons: (1) government is a larger percentage of our peacetime GDP than in any other time in history, (2) thanks to the Supreme Court, unlimited funds flooding into election cycles drown out all other interests, and (3) profound financialization of the economy—movement of money for the sake of money—due to unprecedented Fed interventions and deficit Federal spending aggregates criminal elements and elicits criminal behavior. To put it simply, the crime syndicates all had IPOs. Almost without fail the punishments for white-collar crime—really substantial graft—are a small percentage of the booty obtained from the crime. Failures to investigate and prosecute men of wealth and power are emblematic of a kakistocracy—government by the most unprincipled.

Attorney General Eric Holder was up to his ears in dirt. Holder’s law firm defended Corzine against prosecution by Holder’s Department of Justice.257 The law firm won that battle. This was the same Eric Holder who was charged with contempt of Congress for not forking up information about the “Fast and Furious” Mexican arms deals.258 This was the putative sting in which Federal agents sold arms to Mexicans to track the arms but somehow forgot to include tracking devices. Congress also appears to have forgotten to follow up on the contempt charge. I asked Peter Dale Scott, a UC Berkeley octogenarian and multi-decade scholar on the politics of drug cartels, if he knew what the real story was behind Fast and Furious. He assured me that “there is something very wrong with the picture and the official explanation for it.” Oddly, the investigation into the arms deals was terminated by...you guessed it, the Obama Department of Justice.259 That would be Eric Holder.

The authorities continue to cauterize the wounds from the mortgage fiasco by out-of-court settlements with banks, allowing no admission of guilt, no criminal prosecutions, and cash settlements representing small fractions of the profits. (I get in more trouble for leaving the seat up.) We thought the authorities finally levied a severe fine on the banks and brokerages with a sizeable $25 billion settlement for fraudulent foreclosures, only to find that most of the money—all but a few billion dollars—came from the bailout money and even their own write-downs of losses on defaulted mortgages.260 Dean Baker notes that Obama gave bankers immunity from prosecution, and in return, bankers agree to accept government money to cut mortgage principle.261 Everything but the reduction in mortgage principal came to pass.

Although this is not easily prosecuted corruption, the racketeering (RICO) laws seem appropriate. To clarify, I am recommending RICO laws be used on the government officials who participated. Even the document that represented the attorneys generals’ settlements with the banks was shown to be fraudulent.262 The New York Times reported that money intended for homeowners in the fraud settlement, as little as it was, got diverted by the states into general operating funds.263

Walmart got caught bribing Mexican politicians to foster their business interests South of the Border.264 Somebody bribed the Mexicans? Shocking indeed. This does not happen in the U.S. because we have registered lobbyists. Those same lobbyists will ensure that Walmart’s transition to redemption is seamless.

The SEC, to evade a Freedom of Information Act (FOIA) suit, expunged data pertaining to Citigroup as part of their catch-and-release program.265 Citigroup is protected by the Rubin mafia. This is politics Geithner Style. It will be interesting to see where the starting lineup for Team Obama ends up after they finish their first term. The FOIA by Bloomberg showed how the revolving door totally commandeered the Dodd-Frank act to make sure it was banking-friendly.266 The average salary boost on passing through the government-Wall Street revolving door is estimated at 1400%.267 I’m sure that top dogs like Geithner will do considerably better. Don’t let the revolving door hit you guys in the butts.

Another proud moment for the Obama administration’s push for alternative funding energy: Electric car battery maker Ener1, which received more than $100 million in government handouts, has filed for bankruptcy protection.268 I’m beginning to suspect cronyism here! Peter Schweizer’s book Throw Them All Out (vide infra) documented in repulsive detail the shovel-ready cronyism that occurred during the financial crisis.

There were old-school politics going on when Mississippi Governor Haley Barbour left office. On his way out the door he pardoned a number of seedy characters, including eight men convicted of killing their wives or girlfriends.269 The Mississippi Supreme Court upheld the decision. In Mississippi, the Rule of Law is a bad joke, and True Blood is a documentary. We have, however, not plumbed the level of the Thai politicians. A Thai senator shot his secretary with a machine gun in a restaurant and got a $625 fine for it.270 Very Cheney-esque.

If you want some fun, find the Clinton pardons. The original list I saw had over 1,100 and was easily located. The list was laced with drug busts and bank frauds. I can only find partial lists now. Even so, the number who were in prison for drugs or some form of bank fraud is striking.271 This would partially explain how Clinton left office burdened by onerous legal fees and now has an estimated net worth of $80 million.272 That’s a lot of honoraria for rubber chicken dinners. Tony Blair also seems to have laundered serious money into shell companies.273

State Supreme Court judges run for office in 38 states. Jeffrey Toobin warns us that the lobbyists discovered them in the mid-90s and are diverting some of their resources.274 In 1990 candidates for state supreme courts only raised around $3 million…in the races to the high courts, candidates now raise more than $50 million.

The government sold $5 billion worth of AIG stock acquired during the bailouts. AIG bought $2 billion of it, presumably using money from government bailouts. AIG was shockingly profitable owing to $17 billion of tax credits (gifts by the taxpayer).275

Harvard had a publicly embarrassing cheating scandal in which over a hundred kids in one course were accused of plagiarizing. What course would warrant such bad behavior? Introduction to Congress.276 I’m sure the kids will do better in their Introduction to Ethics in their MBA programs.

Recall the must-see Miami Vice episode entitled, “Prodigal Son?”277 Tubbs and Crocket trace the drug money straight to a wrinkly old banker who explains that the drug money ensures payment of South American bank debt. I remember at the it time that made sense, and it seems haunting now. It is rumored that Mr. Burns in the Simpsons was modeled after the Miami Vice banker.

Civil Liberties and the Constitution

There is very grave danger that an announced need for increased security will be seized upon by those anxious to expand its meaning.

~ John F. Kennedy, former President of the United States

There may be a number of people who cannot be prosecuted for past crimes, in some cases because evidence may be tainted, but who nonetheless may pose a threat to the security of the United States.

~ Barack Obama, President of the United States

One of my favorite bloggers, Charles Hugh Smith, cogently summarized instances in which incarceration was used to protect democracy and civil liberties.278 How ironic. Doug Casey provided a haunting account of creeping fascism in Germany in the ‘30s and how it occurs incrementally.279 It is an easy case to make that we are in a battle to preserve civil liberties simply because every year is a battle to preserve civil liberties. Civil liberties are forfeited one at a time. The battle lines are being drawn. You should fight every fight, no matter how big or small.

There is an ongoing battle for ultimate control of the Internet. Legislation includes the Stop Online Piracy Act (SOPA), the Protect IP Act (PIPA), and the Anti-Counterfeiting Trade Agreement (ACTA).280,281 Superficially they are designed to achieve the named goals. The notion is that pirating sites can be blocked if they are interfering with trade. Their reach, however, is far greater. An accusation alone is sufficient to block a web site prior to any clear evidence of guilt.282 Authorities could shut down search engines Yahoo, Google, or Bing suspected of enabling these hooligans. SOPA got shelved after there was, ironically, a massive Internet-derived protest. The digital world has taken our lives by storm. The Internet is as profoundly democratic as Gutenberg’s printing press. Keep it wide-open at all costs. Efforts to control information flow will keep appearing like the proverbial camel nose under the tent. And here comes the next one on cue in 3…2…1…enter the Trans-Pacific Partnership (TPP)!283

The implications of armed drones are staggering. We are not the only country with drones; they are proliferating around the globe. We managed to survive thermonuclear risk for half a century, and yet we find ourselves racing toward a Skynet-like drone war of staggering magnitude. The skies will be littered with drones like aerial minefields. It is terrorism to those on the receiving end, causing blowback to be almost a certainty. Congress passed a law opening U.S. skies to unmanned drones.284 Companies are lining up to launch them—an estimated 30,000 drones within a few years285—forming a nouveau industrial-military complex. As a guy who finds automated speed-monitoring devices irritating and automated ticketing profoundly disturbing, the drones make me crazy. Even if unarmed, is this not Constitutionally prohibited unlawful search? What event will elicit armed variants to protect us from the bad guys? And if all that isn’t spooky enough, the drones are being engineered for autonomous (human-free) response.286

Digital monitoring of “crimes against traffic” frees up police for more hands-on police work. Petty arrests now justify strip searches. The Economist describes increasing predilections toward stop-and-frisk policies within the cities.287 Legal scholar Jonathan Turley estimates that over 700,000 unwarranted stop-and-frisk searches occur each year in NYC alone.288

Jonathan Turley also notes that the Administration claims the right to assassinate a U.S. citizen either here or abroad, and it would seem that we did such a thing.289 Of course, the target deserved it because he undermined America! The FBI has described extremists as those who “may refuse to pay taxes, defy government environmental regulations, and believe the United States went bankrupt by going off the gold standard."290 Y’all should be careful because you never know what is flying 50,000 feet right above your heads. Obama is the only Nobel Peace Prize winner with a kill list. God save the poor soul spotted by drones entering Manhattan with a Big Gulp. Mayor Bloomberg’s war on Big Soda could turn violent.

Sergey Aleynikov was arrested in 2009 for the most egregious of crimes—stealing software from Goldman Sachs. The Goldman Stasi are good at their jobs, getting him into custody within hours. In 2010, he was convicted and sentenced to 8 years in jail for this profitless crime despite the probation office’s recommendation of 2 years.291 The system seemed to correct itself when the United States Court of Appeals threw the case out in 2012, ruling the source code was not a "stolen good.”292 It was a pyrrhic victory for Aleynikov. They arrested him again using a different jurisdiction to avoid double jeopardy.

Joshua Dressler, a criminal law professor at Ohio State University said that “it was highly unlikely that the separate Federal and state prosecutions in the Aleynikov case would violate the Constitution.” I think they just did. At least now Sergey doesn’t have to start his car in fear.

The National Defense Authorization Act (NDAA) was enacted to protect us against terrorists.294 Of course it was. It provided government authority to incarcerate an American citizen indefinitely without access to legal defense or the courts. Protestors challenging the unlawful incarceration were (you got it) arrested.295 In September, a Federal judge ruled it was not even in the same zip code as the Constitution and put a permanent injunction to protect us.296 Here’s the really troubling part: It had been passed by a large majority in Congress and a 91:9 vote in the Senate, and signed by President Obama. When the outcry began in earnest, Obama assured us that his administration would never act recklessly. I beg to differ: Signing the bill was reckless. I’ll take it a step further: Signing the bill was treason. Read your job description, Mr. President. Watch for that part about upholding the Constitution. And by the way, Team Obama is fighting the injunction.297

There is little doubt that municipalities in the sand states would do almost anything to dig themselves out of the mortgage crisis. The brain trust in San Bernardino, with the legal help of one of my colleagues (Professor Robert Hockett) got the idea to use eminent domain to commandeer underwater mortgages—mortgages that exceed the value of the house.298 The idea is to pay “fair value” (red flag!), bundle them up (red flag!), and sell them to private investors (red flags!). There would be no shortage of cronies willing to buy up these bundles. The subplot might be that this is a veiled attempt to clean up the MERS boondoggle that is causing foreclosures to throw the title of houses into a legal vortex. As preposterous as this sounds, it’s probably Constitutional given the eminent domain case in Connecticut that some believe drove Sandra Day O’Conner to retire from the court.299 It may, however, be illegal in California.300

The Citizens United suit gave Super PACS their unlimited political power by allowing them to spend unlimited money on political campaigns provided they follow a few guidelines.301 Journalist and civil servant Jim Hightower referred to the majority justices as "five traitors to the democratic ideal.” It is indeed odd that support for freedom of speech may have profoundly oppressed free speech. A banking Super PAC overtly promoted by American Banker is blood curdling in its goal to defeat any candidate that is not friendly to banks.302 A suit to ban excessive donations in Montana got nuked.303 According to the Supreme Court, money is speech. As a corollary, if you don’t have money, you will lack a voice.

Corporate civil rights seem to be in the news. An Occupy Wall Street (OWS) protestor carried a sign, "We will know corporations are people when Texas executes one." It seems clear that corporate civil liberties without civil responsibilities is a problem. It is not true, however, that this was a recent or rapid change. Organizations began to accrue Constitutional protections beginning with a case of Dartmouth College versus the State of New Hampshire in 1819. Ted Nace’s Gangs of America tracks through the Supreme Court decisions that incrementally granted civil liberties to corporations. Despite the hyperbolic title, it is a balanced, scholarly analysis.

Why are civil liberties eroding? One notion is that tension between the central planners and free market crowd led to a societal compromise in the 1930s. Capitalism was allowed to flourish, but with safeguards to keep communistic ideals in check. With the fall of the Berlin Wall and the Soviet Block, the proletariat (in the U.S., that is) had no alternative system to keep powerful individuals mindful of their needs. Glass Steagall fell in the late 90s, the banking cartels grew, and wealth disparity—financial apartheid—emerged.

Limits of Government

A sinking economy requires stimulus from two agents, the Federal Reserve and the government.

~ Rich Yamarone, Director of Argus Research

During the time of the Soviet Union the role of the state in economy was made absolute, which eventually led to the total non-competitiveness of the economy…I am sure no one would want history to repeat itself.

~ Vladimir Putin, communist

We have witnessed a seemingly endless battle for the Grand Compromise between those supporting central planning versus market forces. 18th century economist Edmund Burke warned of the role of intellectuals trafficking in snark and trumpeted the Law of Unintended Consequences. Burke also recognized the wealth disparity in 18th-century France and accurately predicted the murderous end result. 19th-century economist Alexi de Tocqueville described the genius of America as not the equality of outcome but rather equality in the eyes of the law. 20th-century economist Joseph Schumpeter also viewed intellectuals with disdain and capitalism not as flawed but fragile. Friedrich Hayek, famous for his opposition to John Maynard Keynes, supported the notion of social safety nets, just not so many and not so invasive. I think Hayek’s stroke of insight was recognizing significant analogies with Darwinian evolution to understand that complex systems arise and persist more by trial and error than by explicit human engineering. Hayek’s Fatal Conceit describes the folly of intellectuals thinking they are smart enough to mess with free markets, hoping to obtain only intended consequences. My reading of Keynes is that he was a profound interventionist—a knob twirler—and was also a radical socialist.

The Yamarone quote illustrates that we have degenerated to a society in which even the big money guys—supposedly the bright bulbs—think that government will solve our problems. While watching a Yale panel discussion on the economy, I was struck by the explicit endorsement of government solutions by the panelists.304 Apparently, we are all Keynesians now. I could buy into a variant of the Keynesian model in which government acts as a financially interested party, buying goods and services when they are cheap and pulling back when they are expensive. It would naturally be counter-cyclical. Unfortunately, there is no chance it will ever work that way. Paraphrasing my dad who was paraphrasing Milton Friedman, government does everything inefficiently, so don’t ask them to do more than you must. It’s not about the morality of what government does; it’s about the low quality and horrendous inefficiency.

Hernando De Soto warns that the U.S. is forfeiting a critical feature that distinguishes it from Third World countries—well-defined property rights. The MERS catastrophe that threw the title of millions of properties into question was an 80-car pile-up on a foggy freeway that will be corrected by legal fiat. By contrast, mutation of the banking system into a cartel, while by no means unprecedented, is a serious problem. Now that this gargantuan organism has control, there is no means to wrestle it back. When you can purchase a politician for $100,000, how can we expect real change? The Citizens United case that opened the political process to unlimited capital is profound because attempts to unring that bell are opposed by unlimited capital. The power of the banking trusts has gone beyond the failsafe point. The Fed—the One Ring that controls them all—is the key. It will be a long trek to the Crack of Doom.

Challenges to our civil liberties, overreach of eminent domain, domestic drone surveillance, and attempts by elected officials to knowingly subvert Constitutional rights all attest to the insidious Orwellian creep of government into our lives. It is not obvious to me that we can negotiate our way out of this one. Some problems do not have solutions if you define a solution as a fix with tolerable pain. I suspect that resolution will occur, but it will be something historic. We are in a barrel speeding down the Niagara River toward the Falls. This is not an episode of Batman or McGyver: all palatable solutions have passed. We will experience the Falls up front and personal. Those in power will claim they did their best when, in fact, they were the root cause. Bernanke, one of the reputed world’s experts on the Great Depression, never mentions loose monetary policy in the 1920s as the cause. It is a lie by omission; a profound one at that.

I close with a simple directive: Watch Ron Paul’s farewell speech to Congress.305 You owe it to yourself. He’s the one that got away. To paraphrase Marlon Brando, “He coulda been a contender.” If you’ve had enough of darkness, try this John Cleese seminar on creativity306—it’s brilliant—or this photo montage of history’s most epic photos.307 Soon I will be off like a prom dress, but first I wish to share the books that I read this year, and the all-important acknowledgements.

Books

Every year I summarize books that I read. I am a slow reader so I try to chose them carefully. I’ve overdosed on crisis books for over a decade (beginning with crisis foreshadowing books) but succumbed to the temptation a few more times. I also slipped back into pop psychology mode.

The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years by Lawrence H. White

White describes the debates that took place throughout the 20th century, pitting the free market advocates against the central planners. Although White shows his colors as a free marketeer, he does a beautiful job of letting the reader ponder the debate rather than force-feeding the conclusion. The book might not be wonky enough for the pros, but I found it to be very scholarly—a great book for a wide swath of macroeconomic enthusiasts. This is the stuff economists-in-training seem to miss in modern curricula. I took the plunge prompted by an Econtalk interview of the author.308

Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio by Sal L. Arnuk and Joseph C. Saluzzi

I don’t really know Sal Arnuk but am a big fan of Joe Saluzzi, occasionally swapping barbs about the horrendous price discovery process in modern markets. Joe and Sal describe in detail how high frequency traders are eroding the foundations of the markets—not just equity markets—through their relentless game of high-frequency Whac-A-Mole. Although Sal’s and Joe’s knowledge of the markets and passion for change is uncontestable, their frustration at times overwhelms the prose. I recommend the book, but some enthusiasm for trading may be required to nudge this book into the five-star group.

Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself by Sheila Bair

I wasn’t going to touch this book if it were not for a personal endorsement from Chris Whalen. Bair, Chair of the FDIC (Federal Deposit Insurance Corporation), describes the incredible turf wars and petty battles below the surface of the bailouts. I previously had sensed Sheila was one of the good guys; the book reinforced it. She describes Bernanke as generally well-meaning, Geithner as a relentlessly pro-Citigroup promoter and Rubin pawn (to the point of racketeering), and a host of others who clearly need severe beatings. It is an antidote to the highly lopsided Sorkin treatise, Too Big to Fail. Here is a Bair interview.309

Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street by Neil Barofsky

Neil entered the crisis plotline as the young, feisty special investigator general to oversee the TARP bailout (SIG-TARP). From his presentation, he was green and naïve, unready for the thugs he would be dealing with. By example, he figured out relatively late in the game that the gaping holes in the bailouts used by the banks to siphon trillions from the Fed were left there by design, not by mistake. The big loser is Geithner, who comes across yet again as a despicable human being. I was disappointed not to get more insight into Elizabeth Warren’s role as Chair of the TARP oversight committee. Barofsky has done many interviews; an Econtalk variant is particularly thorough.310

Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon by Gretchen Morgenson and Joshua Rosner

This is an excellent and detailed analysis of the financial crisis, deeply probing the mortgage industry’s role (more than simply explaining the basics found in all of the crisis books.) Some may find this old news that they would like to put behind them. My only caveat is that one should read this book or Nocera and McLean’s All the Devils Are Here, but not both.

The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order by Benn Steil

Benn is a fellow at the Council on Foreign Relations (CFR) with what I would call an Austrian economic slant. The book will be released in March. In it, Steil describes a fascinating battle between Harry Dexter White and John Maynard Keynes before, at, and after the 1944 Bretton Woods Conference in which the future world currency regime was hammered out. We get deeply insider views of the events in a prose and presentation that I found gripping. Keynes’s role as a diplomat, unknown to many, may have been his most important single contribution. Heads up: Steve Hanke of the Cato Institute and Johns Hopkins University also has a book on the Bretton Woods Conference coming.

Throw Them All Out: How Politicians and Their Friends Get Rich Off Insider Stock Tips, Land Deals, and Cronyism That Would Send the Rest of us to Prison by Peter Schweizer

Many may know Schweizer from a 60 Minutes episode that revealed broadly based, scandalous insider trading by Congress that is legal for them. This is the book upon which the 60 Minutes episode was based. Schweizer tells horror story after horror story of graft that would get normal citizens sent to prison. What is appalling is how often they sell the taxpayer out by billions of dollars so that they can make a few hundred thousand dollars. Obama comes out looking particularly bad as the author describes how shovel-ready projects were really about massive kickbacks for campaign donors. It was not, however, a partisan hatchet job.

Thinking About Capitalism by Jerry Z. Muller and Modern Economic Issues by Robert Whaples

These two trimester-length audio books from The Teaching Company focus on basic principles of economics from a decidedly descriptive slant (as mandated by audio).311 It’s easy listening stuff that is appropriate for those trying to become comfortable with foundational principles. I liked them because they provide these principles in particularly clear and cogent prose. Never pay retail; they go on sale at 80% discount many times during the year.

The Clash of Generations: Saving Ourselves, Our Kids, and Our Economy by Laurence J. Kotlikoff and Scott Burns

This is a follow up to Kotlikoff’s The Coming Generational Storm describing the impending problems from off-balance sheet obligations. The authors, in conjunction with Kent Smetters, did the seminal studies on unfunded liabilities—promises that are unfunded even when projected tax revenues are subtracted. The authors now estimate them at over $200 trillion. I found the The Coming Generational Storm more appropriate for my needs. The clash of generations is part warning and part investment book for those who are not familiar with this issue. I think the authors manifest ‘doomsayer’s fatigue’—the need to be optimistic after years of seeing a dismal future. I am, nonetheless, a huge Kotlikoff fan.

Thinking, Fast and Slow by Daniel Kahnemann

Kahnemann is probably the most prominent contributor to behavioral economics, garnering him the Nobel Memorial Prize in Economics. He works with Nassim Taleb and appears to be Taleb’s mentor. Thinking Fast and Slow presents the constant battle between the instinctive thoughts and more decidedly cognitive reasoning, explaining how we make decisions and how they can go astray. It is more thoughtful than Gladwell’s Blink, sometimes demanding deeper thought.

How We Decide by Jonah Lehrer

Lehrer’s book came recommended via an Econtalk interview.312 It is yet another Blink-genre book looking into how humans make decisions. I love these books but this treatise is presented at a much lower level than Kahnemann’s and is remarkably similar to a book entitled Sway by Ori and Rom Brafman. Consumers of pop psychology should probably check out Ed Yong’s interview on Econtalk discussing the underlying flaws in this type of social science.313

The Wisdom of Crowds by James Surowiecki

Surowiecki discusses how collections of people with limited individual insights, if acting truly independently, display collective "wisdom" and how that wisdom is lost when they start acting in a correlated fashion. There are many cute snippets describing the results that, at times, become a little too loosely connected. Aficionados of this genre will find it both fun but partially redundant to other works (Taleb; Kahnemann; Gladwell).

My Stroke of Insight: A Brain Scientist's Personal Journey by Jill Bolte Taylor

Jill, a Harvard neurophysiologist, wakes up one morning and finds herself having a stroke in the highly rational left brain. Her deductive reasoning goes on- and off-line, throttling her back and forth between euphoria and panic. The story describes the stroke and the long recovery in hysterically funny prose from an especially insightful perspective of a neurophysiologist. I found the audio book to be an excellent medium.

Steve Jobs by Walter Isaacson

In case you’ve been living under a rock, this fully sanctioned biography that was in no way edited by Steve or his family is simply the best biography I’ve ever read. You get a bird’s-eye view of the computer revolution from soup to nuts through the detailed stories and words of all of the key players. Steve was a unique personality with a unique ability to translate unimaginable compulsive behavior into profound success rather than total failure. My conclusion: Sell any shares of Apple Computer because it ain’t the same company without Steve.

Secrets: A Memoir of Vietnam and the Pentagon Papers by Daniel Ellsberg

Ellsberg describes the events leading up to, during, and following the release of the Pentagon Papers, the media-driven exposé of nefarious activities by a string of administrations. It is not really about the content of the papers. Presidents who lie to the American populace seem rather pedestrian in this era. It was interesting but only in the four-star category.

Human Prehistory and the First Civilizations by Professor Brian M. Fagan

I have listened to dozens of trimester-length courses provided by The Teaching Company as audio books.314 With only one exception, they have been great. In this course, Fagan does a great job of following the lineage from the origins of humans starting about 8 million years ago through to the ancient (pre-historic) civilizations across all continents. It’s both informative and very easy listening. Reminder: Never pay retail for these books: they go on 80% sale routinely, bringing the price down to about $70.

Bonhoeffer: Pastor, Martyr, Prophet, Spy by Eric Metaxas

Bonhoeffer was a cleric and a spy in Nazi Germany who eventually gets executed for his role in a conspiracy to kill Hitler. (That is not a plot spoiler; the author tells you he died right up front.) The biography describes the church-state battle, which was very new to me. In my opinion, however, there was way too much church and not enough state. Despite over 500 bonkers reviews at Amazon I found it to be boring.

Acknowledgements

OK. This ain’t a book; it’s just a friggin’ blog. I’ve got to take this opportunity, however, to thank some folks who have generously shared their time and insights so as to make thinking about capitalism a special experience. You guys have made a difference. Chris Martenson brings gravitas to the debate on resource depletion and, in conjunction with Adam Taggart, graciously publishes my Reviews and invited me for my favorite interview.315 Rick Sherlund of Goldman Sachs/Nomura and friend of 40 years inadvertently and unknowingly triggered a discontinuity in my perception of markets with the most innocuous of statements. Bloomberg reporters are especially accessible. I have exchanged hundreds of emails with Mark Gilbert, head of Bloomberg’s London Office, Caroline Baum, and many other colleagues. Dave Lewis, a former Louis Bacon protégé and scholar of a higher order I call a friend although we meet up only sporadically. I have had dozens of exchanges with an eclectic mix of characters ranging from Elizabeth Warren on the left and Lew Rockwell on the way right. Within that enormous chasm includes multiple and meaningful exchanges with Stephen Roach (Morgan Stanley), James Howard Kunstler, Art Cutten (Jesse’s Café Americain), Byron King (Agora), John Rubino, Bill Fleckenstein, Benn Steil (CFR), Gerard Minack (Morgan Stanley), Doug Noland (Federated Investors), Richard Daughty, Jack Crooks, Grant Williams, and Jim Rickards. I thank Richard Uhlig, former CEO of Morgan Stanley’s banking subsidiary, for giving a two-hour guest lecture on mortgage-backed securities in my honors chemistry class. (The kids loved it!) Meetings and conversations with economists Larry Kotlikoff and Steve Hanke are enormously appreciated. I have especially cherished numerous exchanges with David Einhorn, a truly unique individual and intellect, culminating in a meeting with David and subsequent breakfast with his parents. (Mom is quite the bear.) I was profoundly honored when David Weidner included me in a WSJ article on the flash crash and Demetri Kofinas and Lauren Lyster invited me to do an amazing interview on Capital Account.7 These experiences are special and wholly orthogonal to my exposure in chemistry. Lastly, Bruce Ganem rekindled my interest in markets, politics, and economics. Our colleagues will never forgive you.

David B. Collum

Betty R. Miller Professor of Chemistry and Chemical Biology

Cornell University

dbc6@cornell.edu

@DavidBCollum

Links

The superscripted links are found here.

 

Full pdf version of this epic review here.

Zombie Dance Party: Same Girls, New Music

 

"As long as the music is playing, you've got to get up and dance. We're still dancing.”

Chuck Prince

CEO, Citigroup

Bloomberg News reports that Bank of America Corp. (BAC), the best performer in the Dow Jones Industrial Average for 2012, has more than doubled since the start of the year “as the company rebuilds capital and investor confidence.”

My friend Meredith Whitney just upgraded BAC to a “Buy,” a call that is a little late given the stock’s performance to date.  But at just 0.5x book value, to be fair to Meredith, you could argue that the bank is still undervalued.  And many people do in fact believe this.  If we accept the basic bull market thesis for BAC being touted by Whitney and others, what is a reasonable valuation for BAC?  

Let’s set some assumptions.  

First, if you believe the bull market thesis for BAC, you must assume that the bank is going to prevail in the massive litigation it faces with respect to legacy mortgage securities.  This is a considerable assumption, but Whitney and the rest of the Sell Side analyst community seem to already have taken this leap of faith.  For the sake of their clients, let’s hope they are right.  

BTW, watch some of the more critical bank analysts ask BAC and other TBTF banks about the adequacy of reserves for civil litigation and put back claims by Uncle Sam in the Q4 earnings calls this January.  

Second and more important even than the litigation is the question of business model. Earlier this week, BAC CEO Brian Moynihan said that he was satisfied with a high single digit market share in the US mortgage sector.   Wells Fargo (WFC) is close to 40%.  BAC at < 10% market share nationally is perhaps a more profound assumption than the question of the BAC mortgage litigation.  BAC was once the dominant player in mortgage lending, both directly and through third part originations (TPO).  To have this bank’s huge balance sheet at such a low level of deployment is bad for the real estate market and for future earnings.  

Thanks to Senator Elizabeth Warren (D-MA) and the ill-considered Dodd Frank legislation, the TPO market has virtually disappeared.  The lending capacity once represented by Countrywide, WaMu and Lehman Brothers is gone.  BAC is still purchasing some production from outside providers, but the volumes are miniscule compared with the pre-2007 period. Thus the question comes: When Street analysts are showing a positive revenue growth rate for BAC and its peers, from where precisely is this revenue going to come?

Because of Dodd-Frank, Basel III and the Robo-signing settlement, the largest US banks are being forced out of the mortgage market.  Earlier this week, I talked about this dynamic on CNBC’s “Fast Money.” Suffice to say that analysts who assume that BAC will double in 2013 may not understand the new drivers – or lack thereof -- of revenue and earnings in all of the TBTF banks.

That said, I think it may be reasonable for BAC and even much maligned Citigroup (C) to double in the next twelve months, but not because of revenue or earnings growth.  If BAC hits street estimates for revenue in 2013 (+3-4%), is this a sufficient driver to justify a double in the stock?  No, but a doubling of the dividend is a good enough reason for cash starved investors.  In a very real sense, the biggest driver for stocks like BAC or C is not internal revenue growth but the zero rate policy of the FOMC.

During 2012, the preferred stocks of names like BAC and C have appreciated more than 15 points in price.  Yields for preferred issuers like the TBTF banks and General Electric (GE) have fallen by almost two points.  Is this because the revenue growth or earnings of these names have been growing?  No, these metrics are flat to down.  The appreciation of these securities has been driven by the FOMC and the Fed’s ridiculous zero rate policy.  ZIRP does not create jobs nor is it helping bank revenue.  

"Reduced expenses for loan losses and rising noninterest income helped lift insured institutions’ earnings to $37.6 billion in third quarter 2012," notes the FDIC in the most recent Quarterly Banking Profile.  "Two out of every three insured institutions (67.8 percent) reported year-over-year NIM declines, as average asset yields declined faster than average funding costs."  The fact that the TBTF banks are relying on fee income and line items like investment banking to hit revenue and earnings targets is very telling.  

So when you see Sell Side analysts like Meredith Whitney being so constructive on the TBTF banks, even with the poor operating performance, investors need to ask themselves a question.  Is the prospective appreciation of BAC and C the result of strong business fundamentals?  Or is the prospective appreciation of these stocks more a case of traumatized investors fleeing to the fantail of the Titanic to avoid the icy cold financial repression of zero interest rates?  Keep in mind that most of the improvement in earnings which seems to impress Whitney and other analysts has come as a result of expense reductions, mostly credit costs.  Efficiency ratios for the large banks are over 60%, of note. 

Even if you believe that BAC is going to escape the most horrific outcome in the mortgage litigation, the valuation target that is reasonable for this bank, C and the other TBTF institutions such as JPMorgan Chase (JPM) and WFC, is probably between 1 and 1.25x book value.  So yes, given that valuation framework, you can justify a doubling of BAC from current levels to say $20-25 per share.  But keep in mind that this stock was trading at $40 back in 2008 and over $50 in 2006 prior to the acquisition of Countrywide.   Are we likely to see BAC go to over 2x book value again?  Well, maybe, but not because of strong earnings or revenue growth rates.  

Should names like BAC or C manage to get above 1.25x book, it will be because of the Fed and ZIRP.  And as and when Fed interest rate policy changes, look out below.  As I noted on CNBC, without the benefit of a strong mortgage origination and securitization business, the TBTF banks are going to become far less volatile and far more boring.  Even the marginally higher capital levels of today, pre-Basel III, will imply lower asset and equity returns.  And this is not a bad thing.   

Yet investors are really not prepared mentally or emotionally for a market where the large banks are not delivering double digit revenue and earnings growth, whether organically or via M&A.  Most institutional investors, keep in mind, have no idea how the TBTF banks actually make money.  So when well-meaning Sell Side analysts predict wondrous stock price appreciation for the Zombie Dance Queens, the proverbial sheep on the Buy Side sing with joy -- and rush into the interest rate trap so lovingly constructed by Chairman Bernanke and the Fed.  Keep in mind that the corollary of ZIRP is massive interest rate and market risk on the books of all banks.  Think trillions of dollars in option adjusted duration risk.

Without the benefit of gain on sale from mortgage origination and securitization, it is difficult to construct a long term bull scenario for any US bank, large or small.  As and when the Fed normalizes interest rates, the business models of the TBTF banks are going to be far less exciting.  Mark-to-market losses on securities will wipe out stated earnings.  New and innovative ways of presenting “pro forma” earnings will appear on the scene.  The TBTF bank CEOs will rightly blame Washington.  

In this future banking market, names like C which currently trade on a 2 beta will have higher dividends, but relatively flat earnings and revenues.  Cost cutting, not growth, will fund these payouts to investors. Occasionally you will see big numbers from these names when the investment bankers have an especially good quarter.  But overall the TBTF banks are evolving into low growth utilities with nice dividends.  This is precisely the way banks used to be before President Bill Clinton’s “Great Leap Forward” in terms of housing and home ownership.   And, again, this is not a bad thing.  

But investors in the TBTF banks need to understand that the business model for this industry has changed.  The business model for banks is going to continue to evolve away from the high-beta, high volatility model of the 2000s to something that looks more like banking in the 1950s.  The action in terms of significant volume growth is in the non-bank sector.  Get used to it.  

www.rcwhalen.com

 

 

Gold: The Solution To The Banking Crisis?

Authored by Eric Sprott and David Baker of Sprott Global Resource Investment,

The Basel Committee on Banking Supervision is an exclusive and somewhat mysterious entity that issues banking guidelines for the world’s largest financial institutions. It is part of the Bank of International Settlements (BIS) and is often referred to as the Central Banks’ central bank. Ever since the financial meltdown four years ago, the Basel Committee has been hard at work devising new international regulatory rules designed to minimize the potential for another large-scale financial meltdown. The Committee’s latest ‘framework’, as they call it, is referred to as “Basel III”, and involves tougher capital rules that will force all banks to more than triple the amount of core capital they hold from 2% to 7% in order to avoid future taxpayer bailouts. It doesn’t sound like much of an increase, and according to the Basel group’s own survey, the 100 largest global banks will only require approximately €370 billion in additional reserves to comply with the new regulations by 2019. Given that the Spanish banks alone are believed to need well over €100 billion today simply to keep their capital ratios in check, it is hard to believe €370 billion will be enough protect the world’s “too-big-to-fail” banks from future crises, but it is indeed a step in the right direction.

Initial implementation of Basel III’s capital rules was expected to come into effect on January 1, 2013, but US banking regulators issued a press release on November 9th stating that they wouldn’t meet the deadline, citing a large volume of letters (ie. complaints) received from bank participants and a “wide range of views expressed during the comment period”. It has also been revealed that smaller US regional banks are loath to adopt the new rules, which they view as overly complicated and potentially devastating to their bottom lines. The Independent Community Bankers of America has even requested a Basel III exemption for all banks with less than $50 billion in assets,“in order to avoid large-scale industry concentration that would curtail credit for consumers and business borrowers, especially in small communities.” The long-term implementation period for all Basel III measures actually extends to 2019, so the delays are not necessarily meaningful news, but they do illustrate the growing rift between the US banking cartel and its European counterpart regarding the Basel III framework. JP Morgan’s CEO Jamie Dimon is on record having referred to Basel III regulations as “un-American” for their favourable treatment of European covered bonds over US mortgage-backed securities. Readers may also remember when Dimon was caught yelling at Mark Carney, Canada’s (soon to be former) Central Bank Governor and head of the Financial Stability Board, during a meeting in Washington to discuss the same topic. More recently, Deutsche Bank’s co-chief executive Juergen Fitschen suggested that the US regulators’ delay was “hurting trans-Atlantic relations” and creating distrust... stating, “when the whole thing is called un-American, I can only say in disbelief, who can still believe in this day and age that there can be purely European or American rules.” Suffice it to say that Basel III implementation has not gone as smoothly as planned.

One of the more relevant aspects of Basel III for our portfolios is its treatment of gold as an asset class. Documents posted by the Bank of International Settlements (which houses the Basel Committee) and the United States FDIC have both referenced gold as a “zero percent risk-weighted item” in their proposed frameworks, which has launched spirited rumours within the gold community that Basel III may define gold as a “Tier 1” asset, along with cash and AAA-government securities. We have discovered in delving further that gold’s treatment in Basel III is far more complicated than the rumours suggest, and is still, for all intents and purposes, very much undecided. Without burdening our readers with the turgid details, it turns out that the reference to gold as a “zero-percent risk-weighted item” only relates to its treatment in specific Basel III regulation related to the liquidity of bank assets vs. its liabilities. (For a more comprehensive explanation of Basel III’s treatment of gold, please see the Appendix). But what the Basel III proposals do confirm is the regulators’ desire for banks to improve their liquidity position by holding a larger amount of “high-quality”, liquid assets in order to improve their overall solvency in the event of another crisis.

Herein lies the problem, however: the Basel III regulators have stubbornly held to the view that AAA-government securities constitute the bulk of those high quality assets, even as the rest of the financial world increasingly realizes they are anything but that. As banks move forward in their Basel III compliance efforts, they will be forced to buy ever-increasing amounts of AAA-rated government bonds to meet post Basel III-compliant liquidity and capital ratios. As we discussed in our August newsletter entitled, “NIRP: The Financial System’s Death Knell”, the problem with all this regulation-induced buying is that it ultimately pushes government bond yields into negative territory - as banks buy more and more of them not because they want to but because they have to in order to meet the new regulations. Although we have no doubt in the ability of governments’ issue more and more debt to satiate that demand, the captive purchases by the world’s largest banks may turn out to be surprisingly high. Add to this the additional demand for bonds from governments themselves through various Quantitative Easing programs… AND the new Dodd Frank rules, which will require more government bonds to be held on top of what’s required under Basel III, and we may soon have a situation where government bond yields are so low that they simply make no sense to hold at all. This is where gold comes into play.

If the Basel Committee decides to grant gold a favourable liquidity profile under its proposed Basel III framework, it will open the door for gold to compete with cash and government bonds on bank balance sheets – and provide banks with an asset that actually has the chance to appreciate. Given that US Treasury bonds pay little to no yield today, if offered the choice between the “liquidity trifecta” of cash, government bonds or gold to meet Basel III liquidity requirements, why wouldn’t a bank choose gold? From a purely ‘opportunity cost’ perspective, it makes much more sense for a bank to improve its balance sheet liquidity profile through the addition of gold than it does by holding more cash or government bonds – if the banks are given the freedom to choose.

The world’s non-Western central banks have already embraced this concept with their foreign exchange reserves, which are vulnerable to erosion from ‘Central Planning’ printing programs. This is why non-Western central banks are on track to buy at least 500 tonnes of net new physical gold this year, adding to the 440 tonnes they collectively purchased in 2011. In the un-regulated world of central banking, gold has already been accepted as the de-facto forex diversifier of choice, so why shouldn’t the regulated commercial banks be taking note and following suit with their balance sheets? Gold is, after all, one of the only assets they can all own simultaneously that will actually benefit from their respective participation through pure price appreciation. If banks all bought gold as the non-Western central banks have, it is likely that they would all profit while simultaneously improving their liquidity ratios. If they all acted in concert, gold could become the salvation of the banking system. (Highly unlikely… but just a thought).

So far there have only been two banking jurisdictions that have openly incorporated gold into their capital structures. The first, which may surprise you, is Turkey. In an unconventional effort to increase the country’s savings rate and propel loan growth, Turkish Central Bank Governor Erdem Basci has enacted new policies to promote gold within the Turkish banking system. He recently raised the proportion of reserves Turkish banks can keep in gold from 25 percent to 30 percent in an effort to attract more bullion into Turkish bank accounts. Turkiye Garanti Bankasi AS, Turkey’s largest lender, now offers gold-backed loans, where “customers can bring jewelry or coins to the bank and take out loans against their value.” The same bank will also soon “enable customers to withdraw their savings in gold, instead of Turkish lira or foreign exchange.” Basci’s policies have produced dramatic results for the Turkish banks, which have attracted US$8.3 billion in new deposits through gold programs over the past 12 months - which they can now extend for credit. Governor Basci has even stated he may make adjusting the banks’ gold ratio his main monetary policy tool.

The other banking jurisdiction is of course that of China, which has long encouraged its citizens to own physical gold. Recent reports indicate that the Shanghai Gold Exchange is planning to launch an interbank gold market in early December that will “pilot with Chinese banks and eventually be open to all.” Xie Duo, general director of the financial market department of the People’s Bank of China has stated that, “[China] should actively create conditions for the gold market to become integrated with the international gold market,” which suggests that the Chinese authorities have plans to capitalize on their growing gold stockpile. It is also interesting to note that China, of all countries, has been adamant that its 16 largest banks will meet the Basel III deadline on January 1, 2013. We can’t help but wonder if there is any connection between that effort and China’s recent increase in physical gold imports. Could China be positioning itself for the day Western banks finally realize they’d prefer gold over Treasuries? Possibly – and by the time banks figure it out, China may have already cornered most of the world’s physical gold supply.

If global banks’ are realistically going to improve their balance sheet diversification and liquidity profiles, gold will have to be part of that process. It is ludicrous to expect the global banking system to regain a sure footing through the increased ownership of government securities. If anything, we are now at a time when banks should do their utmost to diversify away from them, before the biggest “crowded trade” of all time begins to unravel itself. Basel III liquidity rules may be the start of gold’s re-emergence into mainstream commercial banking, although it is still not guaranteed that the US banking cartel will adopt all of the Basel III measures, and they still have years to hammer out the details. If regulators hold firm in applying stricter liquidity rules, however, gold is the only financial asset that can satisfy those liquidity requirements while freeing banks from the constraints of negative-yielding government bonds. And while it strikes us as somewhat ironic that the banking system may be forced to turn to gold out of sheer regulatory necessity, that’s where we see the potential in Basel III. After all – if the banks are ultimately interested in restoring stability and confidence, they could do worse than holding an asset that has gone up by an average of 17% per year for the last 12 years and represented ‘sound money’ throughout history.

Appendix: Gold’s treatment in Basel III

Basel III is a much more complex “framework” than Basel I or II, although we do not claim to be experts on either. It should also be mentioned that Basel II only came into effect in early 2008, and wasn’t even adopted by the US banks on its launch. Post-meltdown, Basel III is the Basel Committee’s attempt to get it right once and for all, and is designed to provide an all-encompassing, international set of banking regulations designed to avoid future bailouts of the “too-big to fail” banks in the event of another financial crisis.

Without going into cumbersome details, under the older Basel framework (Basel I), the lower the “risk weighting” regulators applied to an asset class, the less capital the banks had to set aside in order to hold it. CNBC’s John Carney writes, “The earlier round of capital regulations… government-rated bonds rated BBB were given 50 percent riskweightings. A-rated bonds were given 20 percent risk weightings. Double A and Triple A were given zero risk weightings — meaning banks did not have to set aside any capital at all for the government bonds they held.” Critics of Basel I argued that the risk-weighting system compelled banks to overweight their exposure to assets that had the lowest riskweightings, which created a herd-like move into same assets. This was most evident in their gradual overexposure to European sovereign debt and mortgage-backed securities, which the regulators had erroneously defined as “low-risk” before the meltdown proved them to be otherwise. The banks and governments learned that lesson the hard way.

Basel III (and Basel II) takes the same idea and complicates it further by dividing bank assets into two risk categories (credit and market risk) and risk-weighting them depending on their attributes. Just like Basel I, the higher the “riskweight” applied to an asset class, the more capital the bank is required to hold to offset them.

tier1.gif

It is our understanding that gold’s reference as a “zero percent risk-weighted asset” in the FDIC and BIS literature only applies to gold’s “credit risk” - which makes perfect sense given that gold isn’t anyone’s counterparty and cannot default in any way. Gold still has “market-risk” however, which stems from its price fluctuations, and this results in the bank having to set aside capital in order to hold it. So for banks who hold physical gold on their balance sheet (and we don’t know of any who do, other than the bullion dealers), the gold would not be treated the same as cash or AAA-bonds for the purposes of calculating their Tier 1 ratio. This is where the gold community’s conjecture on gold as a “Tier 1” asset has been misleading. There really isn’t such a thing as a “Tier 1” asset under Basel III. Instead, “Tier 1” is merely the ratio that reflects the capital supporting a bank’s risk-weighted assets.

HOWEVER, Basel III will also be adding an entirely new layer of regulation concerning the relative liquidity of the bank’s assets and liabilities. This will be reflected in two new ratios banks must calculate starting in 2015: the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).

tier1-2.gif

Just as Basel III requires risk-weights for the asset side of a bank’s balance sheet (based on credit risk and market risk), Basel III will also soon require the application of risk-weights to be applied to the LIQUIDITY profile of both the assets and liabilities held by the bank. The idea here is to address the liquidity constraints that arose during the 2008 meltdown, when banks suffered widespread deposit withdrawals just as their access to wholesale funding dried up.

This is where gold’s Basel III treatment becomes more interesting. Under the proposed LIQUIDITY component of Basel III, gold is currently labeled with a 50% liquidity “haircut”, which is the same haircut that is applied to equities and bonds. This implicitly assumes that gold cannot be easily converted into cash in a stressed period, which is exactly the opposite of what we observed during the crisis. It also requires the bank to maintain a much more stable source of funding in order to hold gold as an asset on its balance sheet. Fortunately, there is a strong chance that this liquidity definition for gold may be changed. The World Gold Council has in fact been lobbying the Basel Committee, the Federal Reserve and the FDIC on this issue as far back as 2009, and published a paper arguing that gold should enjoy the same liquidity profile as cash or AAA-government securities when calculating Basel III’s LCR and NSFR ratios. And as it turns out, the liquidity definitions that will guide banks’ LCR and NSFR calculations have not yet been finalized by the Basel Committee. The Basel III comment period that ended on October 22nd resulted in the deadline being pushed back to January 1, 2013, and given the recent delays with the US bank regulators, will likely be postponed even further next year. Of specific interest to us is how the Basel Committee will treat gold from a liquidity-risk perspective, and whether they decide to lower gold’s liquidity “haircut” from 50% to something more reasonable, given gold’s obvious liquidity superiority over that of equities and bonds.

The only hint we’ve heard thus far has come from the World Gold Council itself, which suggested in an April 2012 research paper, and re-iterated on a recent conference call, that gold will be given a 15% liquidity “haircut”, but we have not been able to confirm this with either the Basel Committee or the FDIC. In fact, all inquiries regarding gold’s treatment made to those groups by ourselves, and by other parties that we have spoken with, have been met with silence. We get the sense that the regulators have no interest in stirring the pot by mentioning anything related to gold out of turn. Given our discussion above, we can understand why they may be hesitant to address the issue, and only time will tell if gold gets the proper liquidity treatment it deserves.

Earnings Setup — JPM, WFC, C, BAC

“The benefits of reduced expenses for loan losses outweighed the drag from declining net interest margins, as insured institutions posted a 12th consecutive year-over-year increase in quarterly net income. Banks earned $34.5 billion in the quarter, a $5.9 billion (20.7 percent) increase compared with second quarter 2011.”

 

FDIC Quarterly Banking Profile

Second Quarter 2012

Time once again for US bank earnings, now for Q3 2012.  Just to review, income among financials has been recovering for the past three years, but mostly as a function of declining credit costs.  There is very little organic growth in the banking sector with larger banks such as Wells Fargo (WFC) and US Bancorp (USB) generating positive revenue and earnings by taking share from other institutions.   More than half of all banks in the US are running off in terms of redemptions vs. new lending.   Net interest margin is about 3.3% and shrinking, but is still above 2007 lows near 3%.

Reports that the housing sector is recovering has generated more than a little irrational exuberance among investors regarding financials.  Another thread in the bull narrative for banks coming from select Sell Side firms involves a rebound in investment banking revenue.  This nirvana is right around the corner or so goes the story.  Given the flat economy and the dearth of activity in the equity and M&A markets, it is hard to put clothes on Rosy Scenario, at least for investment banking volumes.  Would that it were so.  

The big question facing the commercial banking sector is regulation, both in terms of higher capital requirements under the proposed Basel III standard and also greatly increased regulation of the housing sector, is revenue.  In terms of the former, more capital and regulatory constraints means less leverage, lower credit growth and employment, thus lower revenue growth.  If you don’t have credit growth, then you don’t have job creation, etc. 

The second factor of new regulation in home lending sector is a biggie. Mortgage origination and sale has been the key driver in bank revenue, especially for WFC and USB, both who boast up revenue estimates in 2012.  If you follow financials and have not read the comment in this week’s Institutional Risk Analyst, “Tail Risk: Kamala Harris Declares War on Lenders, Loan Servicers in CA,” you need to do so. But remember that almost all of the production of WFC, USB and every other bank in the US is ultimately guaranteed by Washington via the FHA. 

http://us1.irabankratings.com/pub/IRAStory.asp?tag=548

Since most of Wall Street investors only ever look at the top 8-10 bank names by assets, there is no point talking about the rest of the industry.  So let’s run down the four larger universal banks with earnings out this week and next.

Wells Fargo (WFC)

With a dividend yield of 2.5% and a beta just over 1, WFC is the darling of the large bank peer group and also the most fully valued at 1.5 x book.  The street has WFC up single digits on revenue and earnings for Q3 2012.  You have to wonder if that is not already priced into the stock.  

The lawsuit filed against WFC with respect to loans guaranteed by the FHA is small beer, IMHO.  The far larger question is how WFC will continue to generate current levels of revenue and earnings in the Basel III, Dodd Frank nightmare world.  Answer: They won’t.  I will be writing more on WFC and non-bank originators separately.  

JPMorgan (JPM)

The House of Morgan is looking a lot less like a fortress in the wake of the London Whale CIO office trading scandal.  As discussed in my previous post, the litigation involving Bear Stearns likely is going to be far more significant to JPM than the civil claim filed against WFC.  Think orders of magnitude difference.  That said, if JPM is forced to repurchase fraudulent securities issued by Bear Stearns that event will certainly be material.  But Bear will not be fatal to the bank.  

One exception to that judgment might be Jamie Dimon himself, who has used up a number of his nine lives over the past decade.  Imagine yourself sitting on the board of JPM and hearing Dimon and his cohorts (who brought you the CIO trading fiasco) repeating the mantra that they will litigate the plaintiffs in the Bear Stearns litigation “into annihilation.”  And recall that JPM has yet to reserve for a settlement of the Bear Stearns litigation.  

Like the board members of Bank of New York Mellon (BK) who reportedly ejected former CEO Robert Kelly for saying similar things about his own legal problems, the JPM directors have to weigh giving Dimon yet another chance to make good vs. a clean break and a settlement.  At the very least, look for JPM’s board to overrule Dimon and push for a settlement of the Bear Stearns litigation.  Given how badly the litigation has been going for JPM in court, it seems time really is money in this particular case.  

In terms of Q3 earnings, the street has JPM down YOY on revenue and bottom line.  Best guess is a “surprise” on the upside, but remember the hurdle is deliberately set low for a reason.  In terms of valuation, JPM at 0.85 x book is arguably a much better value than WFC, but there is a reason for this too.  

The level of risk at JPM is far higher than with WFC.  JPM’s risk factors flow from a far more diverse list of businesses, accented by rogue hedge fund traders and Teflon coated managers.   This makes JPM’s revenue and earnings far more opaque than its immediate bank peers – and more like the investment banks at Goldman Sachs (GS) and Morgan Stanley (MS). 

Citigroup (C)

The queen of the zombie bank dance party continues to be my least favorite name among the top four.  At 0.5x book and sporting a 0.1% dividend yield, C remains more a preferred trading vehicle for hedge funds and prop desks than an investment.  The 2 beta is another hint that C is more about trading than investing, at least in the traditional sense of that term.  That once meant return of principal with a positive return.   C does not fit into that category.   More like a tech stock with financial exposure. 

Until the management and board of C figure out a way to boost cash flow to investors above that of its peers, I see no reason to even think about recommending C to a value investor.  The whole business model proposition of C was and is still today subprime, albeit with less aggressive exposure at default than during the pre-crisis years.  Yet today C is still in a business with a “normal” internal loss rate target that is obviously higher than its peers.  Investors need to be paid for this risk. 

Remember that C has the highest loss rate of the top four banks as well as the least credible business model, so if they management does not pay investors for this risk there is no reason to own the stock.  Finding a CEO with actual operating and management experience in the lending industry would be a plus as well.  But I don’t want to ask for too much.  

Bank of America (BAC)

BAC is right behind C in terms of a preponderance of negative factors.  Under the tenure of Brian Moynihan, BAC has continued to destroy shareholder value in large chucks, losing key people and assets at a frightening and accelerating rate.  

The core competency of BAC managers like Moynihan, lest we forget, is cost cutting, followed by firing capable people to make way for a deliberately minimalist business model.  This is business model of “manage down” that stretches back to Ken Lewis and Hugh McColl and remains the core ethic of BAC today.     

BAC has largely withdrawn from the mortgage market and remains mired in litigation regarding the legacy RMBS of Countrywide and Merrill Lynch.  I continue to look for BAC to eventually sell or spin off Merrill to shareholders, a move that could be a precursor to a voluntary restructuring of the bank holding company.  

Once a restructuring is complete, then BAC would arguably be in a position to rival WFC in terms of valuation -- albeit given new management.  Frankly, you could break up BAC into 4-6 regional banks and probably enhance shareholder value significantly.  

I have always argued that a voluntary Ch 11, restructuring of the litigation and sale of the BAC banks would easily repay all creditors and even a return for equity holders.  If BAC faces rescission with respect to Countrywide claims, the idea of a restructuring will not seem so far out.  Any funds who want to back a hostile takeover and restructuring of BAC, do give me a call.

If BAC and BK fail in their effort to push through a settlement of the Countywide put back litigation, then a restructuring of BAC becomes far more likely.  The same adverse results in court that are making the Bear Stearns litigation a major headache for JPM are haunting BAC, only to a far greater degree.  

Keep in mind also that like JPM, there is as yet no significant reserve set aside by BAC to fund an eventual settlement of the Countrywide litigation.  Eventually, like Jamie Dimon regards Bear Stearns, Brian Moynihan will have to address this reserve issue regarding Countrywide and Merrill. 

Bottom line on financials is that the best risk adjusted returns in the industry are not found in the four banks previously mentioned.  

Top Economists: Iceland Did It Right … And Everyone Else Is Doing It Wrong

Nobel prize winning economist Joe Stiglitz notes:

What Iceland did was right. It would have been wrong to burden future generations with the mistakes of the financial system.

Nobel prize winning economist Paul Krugman writes:

What [Iceland's recovery] demonstrated was the … case for letting creditors of private banks gone wild eat the losses.

Krugman also says:

A funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver.

Krugman is right.  Letting the banks go bust – instead of perpetually bailing them out – is the right way to go.

We’ve previously noted:

Iceland told the banks to pound sand. And Iceland’s economy is doing much better than virtually all of the countries which have let the banks push them around.

Bloomberg reports:

Iceland holds some key lessons for nations trying to survive bailouts after the island’s approach to its rescue led to a “surprisingly” strong recovery, the International Monetary Fund’s mission chief to the country said.

 

Iceland’s commitment to its program, a decision to push losses on to bondholders instead of taxpayers and the safeguarding of a welfare system that shielded the unemployed from penury helped propel the nation from collapse toward recovery, according to the Washington-based fund.

 

***

 

Iceland refused to protect creditors in its banks, which failed in 2008 after their debts bloated to 10 times the size of the economy.

The IMF’s point about bondholders is an important one:  the failure to force a haircut on the bondholders is dooming the U.S. and Europe to economic doldrums.

The IMF notes:

[The] decision not to make taxpayers liable for bank losses was right, economists say.

In other words, as IMF put it:

Key to Iceland’s recovery was [a] program [which] sought to ensure that the restructuring of the banks would not require Icelandic taxpayers to shoulder excessive private sector losses.

Icenews points out:

Experts continue to praise Iceland’s recovery success after the country’s bank bailouts of 2008.

 

Unlike the US and several countries in the eurozone, Iceland allowed its banking system to fail in the global economic downturn and put the burden on the industry’s creditors rather than taxpayers.

 

***

 

The rebound continues to wow officials, including International Monetary Fund chief Christine Lagarde, who recently referred to the Icelandic recovery as “impressive”. And experts continue to reiterate that European officials should look to Iceland for lessons regarding austerity measures and similar issues.

Barry Ritholtz noted last year:

Rather than bailout the banks — Iceland could not have done so even if they wanted to — they guaranteed deposits (the way our FDIC does), and let the normal capitalistic process of failure run its course.

 

They are now much much better for it than the countries like the US and Ireland who did not.

Bloomberg pointed out February 2011:

Unlike other nations, including the U.S. and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion, 11 times gross domestic product.

 

***

 

“Iceland did the right thing … creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. “Ireland’s done all the wrong things, on the other hand. That’s probably the worst model.”

 

Ireland guaranteed all the liabilities of its banks when they ran into trouble and has been injecting capital — 46 billion euros ($64 billion) so far — to prop them up. That brought the country to the brink of ruin, forcing it to accept a rescue package from the European Union in December.

 

***

 

Countries with larger banking systems can follow Iceland’s example, says Adriaan van der Knaap, a managing director at UBS AG.

 

“It wouldn’t upset the financial system,” says Van der Knaap, who has advised Iceland’s bank resolution committees.

 

***

 

Arni Pall Arnason, 44, Iceland’s minister of economic affairs, says the decision to make debt holders share the pain saved the country’s future.

 

“If we’d guaranteed all the banks’ liabilities, we’d be in the same situation as Ireland,” says Arnason, whose Social Democratic Alliance was a junior coalition partner in the Haarde government.

 

***

 

“In the beginning, banks and other financial institutions in Europe were telling us, ‘Never again will we lend to you,’” Einarsdottir says. “Then it was 10 years, then 5. Now they say they might soon be ready to lend again.”

And Iceland’s prosecution of white collar fraud played a big part in its recovery:

[The U.S. and Europe have thwarted white collar fraud investigations ... let alone prosecutions.] On the other hand, Iceland has prosecuted the fraudster bank heads (and here and here) and their former prime minister, and their economy is recovering nicely … because trust is being restored in the financial system.

Happy Anniversary Countrywide! Or is it Back to the Future?

I was reminded that this is the 5-year anniversary of the emergency Fed Discount Rate cut in response to the collapse of Countrywide Financial (CFC) collapse earlier that week.  See the Board of Governors of the Federal Reserve press release below.  Note that CFC was not mentioned in their release. Thanks to the former CFC officer for the heads up.

Release Date: August 17, 2007

For immediate release

“To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.”

“By Wednesday of that August week, CFC was unable to roll commercial paper (CP) necessary to fund its primary mortgage banking operations and was forced to draw $11.5 billion from backup credit lines,” notes the former CFC officer.  “CFC was immediately downgraded by Moody’s from A3 to Baa3, with CP ratings dropped to P-3 from P-2. Viewing the matter as systemic, the Fed arranged an unscheduled meeting on August 17 in which it reduced the discount rate by 50 basis points.  On the following Wednesday, BofA invested $2 billion in CFC as sole buyer of convertible preferred stock. Under the investment agreement, BofA was granted the right of first refusal to match the terms of any third party to purchase CFC, a fait accompli of a the eventual 2008  acquisition of CFC by BofA.”

“Except for a few prescient hedge fund investors, few recognized this as the starting bell for the ensuing global panic of 2008,” he adds. “The Dow went on reach its high of 14,164+ in October,2007.”

Even today, with all that has been written about the collapse of Countrywide, not enough is said about the incredible negligence of the Fed and other regulators when it came to CFC.  Here was the largest mortgage originator in the US, a bank holding company that had just converted into a thrift to maximize regulator arbitrage opportunities, which was funded by Bank of America’s deposits.  But nobody at the Fed knew or cared.

CFC was turning over its $250 billion balance sheet several times a year in terms mortgage originations and most of that funded by BAC and the commercial paper markets.  Yet the folks at the Fed were caught by surprise by the collapse of CFC.  This massive failure by the Fed’s Division of Supervision and Regulation refutes forever any notion that regulators can be effective in a democracy.  CFC CEO Angelo Mozilo, his colleagues in the mortgage banking industry and the Congress successfully intimidated regulators into a state of passivity.

Keep in mind on this count that CFC had been taking material charges since the early part of the year 2007.  Anybody with any common sense looking at the charges CFC took in Q1 and Q2 of 2007 would have had a pretty good idea that the patient was dying due to a lack of new volumes and changing risk preferences by counterparties.  CFC had a whole team of people watching liquidity issues, for example, from the start of 2007.  But again, nobody in the regulatory community said a word about CFC specifically, even though general warnings about the mortgage sector were growing at agencies such as the FDIC.

To be fair, the ratings published by The IRA Bank Monitor had CFC’s lead bank at “A” through the first part of 2007, a confirmation that public company disclosure is next to useless to help investors understand risk.  The bank was considered “well capitalized” by regulators until Q4 2007, when CFC’s lead bank showed a “C” rating with above-average operational stress compared to the industry.  By Q1 of 2008, CFC was a dead “F” in the IRA Bank Monitor with a public data CAMELS rating of “5,” the worst score on the regulatory scale.

Mozilo has admitted in depositions from the massive litigation against CFC that he was aware of the operational risks involved.  CFC had won top market share in the market for conforming and non-conforming loans by being more aggressive and also better prepared operationally than competitors.  But that also meant that the totality of CFC production included a toxic portion of bad credits.  Large banks with double digit shares are subsets of the total market and thus cannot achieve any significant diversification of risk.  So today when we look at Wells Fargo at more than 40% national market share in residential originations, does this represent a red flag?  Ya think?

Another former CFC risk officer says that the “starting bell” of the meltdown was 6 weeks earlier.  “When S&P and Moody's had emergency calls to say their models were CRAP.  That is when the run started.  Three weeks after that, CFC earnings call said that credit deterioration was really bad, for everyone.”

Five years later, the real legacy of the failure of CFC, Bear, Stearns & Co and Lehman Brothers has been a vast reduction in competition in the mortgage sector.  “Banks don’t make loans, that is the problem.  BAC is made up of 39 different banks.  Each time they acquired an institution, they lost at least half of the loan officers.”

The good news is that the non-bank mortgage sector is regenerating, green shoots if you will.  The new players in non-bank mortgage finance are not well known to the Street, but you will hear about them soon enough.  As commercial banks withdraw from many of the more capital intensive portions of the mortgage equation, new non-bank underwriters will fill the void.  But building up the scale and resources needed to originate loans in the brave new world of national mortgage regulation will take time.

So ask not why Chris is isn’t working on bank M&A deals, but ask instead what I am working on.  That would be non-bank mortgage finance.  Think CFC before Angelo bought his bank in 2001.  More on this soon.  And do enjoy the rest of summer.

The Weaponization of Economic Theory

This is an excellent article by Michael Hudson. The very end is a powerful commentary on the neoliberal ideology, defined in Wiki as "based on the advocacy of economic liberalizationsfree trade, and open markets. Neoliberalism supports privatization of state-owned enterprisesderegulation of markets, and promotion of the private sector's role in society. In the 1980s, much of neoliberal theory was incorporated into mainstream economics." 

This doctrine has been used to shift power, money and other resources to the members at the very top of our society, with great support from the non-top who have been successfully misled into thinking they are supporting an equitable system. It's not, at the very foundations. If you read nothing else, read the final section in which Michael explains why neoliberalism is a weaponization of economic theory - a "doctrine of power and autocracy combined with deregulation and dismantling of democratic law" - aimed at replacing the government's power to protect the people with an oligarchic power to oppress them. It is not about free markets and free trade, as the terms were traditionally used by economists. It is about central planning by financial centers, and it requires deregulation and a tax structure favoring banking and financial institutions, and their major customers, real estate interests and monopolies. We have that now.

Michael argues that "the result is a doctrine of financial war not only against labor but also against industry and government. Gaining the financial power to indebt economies at increasing speed, the banking and financial sector is siphoning resources away from the real economy. Its business plan is not based on employing labor to expand output, but simply to transfer as much of the existing flow of revenue as possible into its own hands, by capitalizing all such revenue into interest payments, on loans collateralized and pledged to creditors." In his conclusion, Michael compares our state to the economic polarization characterizing ancient Rome before its ruin. ~ Ilene

 

The Weaponization of Economic Theory

Courtesy of 

Europe’s three needs: a debt write-down, a real central bank, and a more efficient tax system 

Brussels Talk, Madariaga College, Governing Globalisation in a World Economy in Transition, June 27, 2012

What can Europe learn from the United States?

First, the United States – like Canada, England and China – have central banks that do what central banks outside of Europe were created to do: finance the budget deficit directly.

I have found that it is hard to explain to continental Europe just how different the English-speaking countries are in this respect. There is a prejudice here that central bank financing of a domestic spending deficit by government is inflationary. This is nonsense, as demonstrated by recent U.S. experience: the largest money creation in American history has gone hand in hand with debt deflation.

It is the commercial banks that have created the Bubble Economy’s inflation, from North America to Europe. They have recklessly lent mortgage credit and other credit far beyond the ability of domestic economies to pay. A real central bank can create credit on its electronic keyboards just as easily as commercial banks can do. But central banks do not create credit for speculative purposes. They do not make junk mortgages based on “liars’ loans” (the liars are the banks, not the borrowers), based on fictitious evaluations by crooked appraisers, and sold fraudulently to investment banks to package and sell to gullible Europeans, pension funds and other customers.

In short, there is no need for the present austerity. If Europe acted like the United States, it could bail out the banks.

But would this be a good thing? My second point is that there are good reasons not to fund a dysfunctional debt overhead, financial and tax system. It is preferable to change these systems.

In the United States, Paul Krugman has urged the Federal Reserve to simply lend banks an amount equal to their bad loans and negative equity (debts in excess of the market price of assets). He urges a “Keynesian” program of spending to re-inflate the economy back to bubble levels. This is the liberal answer: to throw money at the problem, without seeking structural reform.

The Bank for International Settlements (BIS) disagreed last week in its annual report. It said – and I believe that it is right – that monetary policy alone cannot solve an insolvency problem. And that is what Europe has now: not merely illiquidity for government bonds and corporate debt, but insolvency when it comes to the ability to pay.

In such circumstances, the BIS explains, it is necessary to write down the debt to the amount that can be paid – and to undertake structural reforms to prevent the Bubble Economy from recurring.

The Canadian postal workers union has an informal slogan: “A job that’s not worth doing is not worth doing well.” I might apply this to Europe by saying that a badly structured economy is not worth subsidizing or saving. It should be made well.

This entails, for starters, writing down the debt overhead. That is what created the German Economic Miracle of 1948: the Allied Monetary Reform that wiped out debts over and above minimum working balances, and wages debts owed by employers to employees. It was easy to write down debts that were owed to Nazis. It is much harder to do so when the debts are owed to powerful and entrenched institutions – especially to banks.

Take the case of a Greek debt writedown. This would hurt the Greek banks first and foremost, and also more innocent German insurance companies and banks.I have a modest suggestion as to how to handle this. First, let the Greek banks go under. They helped stymie the Greek government’s attempt to stop tax evasion and money laundering. They have been described as co-conspirators and corrupt. Of course their depositors should be made whole by a standardized, public bank insurance scheme. But bank bondholders and stockholders, and even non-insured depositors, are another matter.

As for the German institutions, if a Greek Clean Slate pushes them into insolvency, the German Government should do what the U.S. Federal Deposit Insurance Corp. (FDIC) is empowered to do: take them over, make all the depositors and policy holders whole, and operate these institutions as a public option – either temporarily or permanently.

The alternative is austerity and debt deflation that will leave European markets shrinking, living standards falling, and turn Europe into what U.S. Defense Secretary Rumsfeld has said so often: “Old Europe,” as if it is too late to be saved. Any discussion of the U.S. economy necessarily involves the global context. So it is necessary to discuss not only domestic U.S. developments, but also relations with Europe and the BRICS countries.

The most important dynamic is financial. A continued decline in real estate prices, coupled with local government debts, has led to debt deflation. As personal and corporate income are diverted to pay debt service, spending on new consumption and investment goods is cut back. Sales and employment opportunities are falling off, especially for new entrants into the labor force. Major categories of debt cannot be repaid in Europe and the United States, except by foreclosures transferring property to creditors. Short-term financial aims overshadow the long-term adjustments that ultimately will be needed: debt writedowns in the public and private sectors. The alternative to this “business as usual” scenario is for the U.S. and European economies to look increasingly like the Baltics – austerity aggravating economic shrinkage.

The U.S. Government as well as European governments have taken bad bank debts onto the public balance sheet. This is not a problem for the United States, whose Federal Reserve can simply create the credit to roll over its debt. But for Europe, public debts simply cannot be paid under current central bank constraints. Instead of changing the central bank rules, the European Union is willing to plunge the continent into depression and economic shrinkage.

U.S. Austerity and deeper Negative Equity

The U.S. economy is free of the monetary constraint that Europeans impose on themselves. The Federal Reserve does what central banks are supposed to do: monetize government deficit spending by buying public debt. However, the increase in new government debt creation has not been mainly to finance deficit spending to increase economic activity and employment, to invest in rebuilding the nation’s infrastructure or providing states and cities with the revenue sharing that in the past enabled them to balance their local budgets. Instead, the government has created debt in an attempt to re-inflate real estate markets back toward Bubble Economy levels. The idea was for the economy to “borrow its way out of debt.”

In practice, there was not much hope of success. The banks sent the $800 billion of Federal Reserve’s Quantitative Easing (QE2) in 2012 abroad, mainly to the BRICS economies in the form of interest rate and currency arbitrage. The banks’ idea was to earn their way out of their own negative equity, but not by lending to a real estate market whose prices continue to decline. This is forcing more properties into negative equity – and that leaves the banks themselves in a negative equity position. So there is little new lending for real estate, to consumers, or to business. Markets are being shrunk by debt deflation.

States and cities also face a shrinking tax base, and many are subject to constitutional requirements for balanced budgets. The path of least resistance has been to underfund their pension plans – which have fallen far behind, especially inasmuch as most plans assume an 8% annual rate of return. This rate – assuming a savings doubling time of just nine years – has become even more fictitious today than it was a decade ago. So some localities have taken risks and lost – with their loss being the counterpart to earnings by the largest banks on derivatives.

The bottom line here is that the U.S. economy is not in a position to “borrow its way out of debt.” The outlook thus is for a similar austerity to that of Europe.

Financial fraud has been effectively decriminalized in the United States. In a nutshell, people have lost trust in the banks – and the financial sector itself mistrusts its fellow institutions. So the non-bank money market funding has dried up for business, and individuals are afraid to invest in the stock market.

President Obama retains his progressive rhetoric, but actually is neoliberal. (His Senate mentor was Joe Lieberman who helped him go for the money and choose Rubinomics advisors.) Mitt Romney pretends to be a right-wing extremist, but seems reasonable on economic policy. However, he may feel under pressure to support right-wing Republican lobbyists in the Congressional leadership. Even if he does, there will not be much difference from the Obama administration. The U.S. situation thus is much like that of Britain under Labour party leadership in recent years: centrist or even left-wing rhetoric on social policies, but neoliberal financial policy favoring the banks.

BOTTOM LINE: Neither the U.S. nor European economies can “grow their way out of debt.” Their debt deflation will worsen, and their budget deficits will widen.

The U.S. Political Outlook

As in Europe, there is little alternative from the ostensible left – from the Democratic Party, the labor unions and allied interests. President Obama seems likely to win this November’s presidential elections, and he is a neoliberal – probably more so than the Republican candidate Mitt Romney.

The common backers of the Republican and Democratic Parties – mainly, Wall Street and real estate interests – realize that a Democratic President is in a better position than a Republican to neutralize Congressional or Senate opposition to scaling back and privatizing Social Security and Medicare. Democratic politicians are more likely to counter Republican proposals along these lines than proposals put forth by their party’s own president. The situation is much like Tony Blair out-Thatchering Britain’s Conservatives in trying to privatize British rail and tube infrastructure and promoting the Public-Private Partnership plan. This is essentially the Rubinomics position supported by the Democratic leadership.

Many voters simply will stay home, so Mr. Romney may have a chance to win, based on support in the South and the West – and even perhaps some Midwestern swing states. In either case, the 2013-16 administration looks like it will be a bipartisan neoliberal austerity.

From the U.S. vantage point, Europe is a dead zone. It looks to me like financial and fiscal self-destruction.

There would be some hope for progress if the financial crisis was used to clean up bureaucracy and shift the tax system off the cost of living and doing business to a land tax on economic rent. This would prevent a new real estate bubble from developing, by holding down the “free” site value that could be capitalized into bank loans. This would lower the cost of housing, and also free employment from taxation. And it could go hand in hand with reducing the size of the Greek bureaucracy, for instance.

But I don’t see this happening in Europe. So financial austerity is likely to aggravate the budget deficits rather than help them. European economies are likely to grow “surprisingly” less than forecasts suggest, and news media will report this as “unanticipated slowdown” “to everyone’s surprise” and so forth.

The likely political reaction in Europe is likely to be a nationalistic opposition to relinquishing government power. But this opposition is likely to come more from the right than from the left of the political spectrum. This is what is so striking about today’s political situation both in Europe and the United States: the failure of the left to provide an economic alternative, and of the right to reform the tax system and corruption.

BOTTOM LINE: The U.S. trade balance may improve as consumer budgets are squeezed, limiting imports, and as domestic shale gas cuts import demand. But capital inflows are unlikely to increase. And until interest rates begin to rise, capital outflows will continue (much as was the case in Japan after 1990). The U.S. is thus suffering a “Japan syndrome.”

Increasing global fracture into regional blocks

Instead of international “cooperation,” I see a regional rivalry among blocs polarizing between the U.S.-centered NATO bloc and the BRICS, expanding their influence. Europe looks pretty much left out, as its markets are not growing and it is not a prime investment area. The BRICS countries are likely to start erecting capital controls against easy-credit policies in the United States funding a takeover of their assets.

Financial flows and capital flight are putting upward currency pressure on the BRICS at the expense of the euro and the dollar. If the euro does not decline against the dollar, it is largely because both currencies are equally weak together and share similar problems. Both economies will shrink, leading to more insolvency for real estate and also for government budgets. This Euro-American shrinkage is likely to spur moves in China and other BRICS to rely more on growth of their internal market. China’s wage levels are likely to rise, prompting production to aim more to satisfy domestic consumer demand than foreign export demand.

The main problem for China is that one of the first expenditures of families with rising revenue is to buy autos. The government’s response is to invest more in public transportation, and is likely to impose an environmental tax. More dispersion of urban centers is likely in order to minimize transportation costs – and more infrastructure spending in general.

Capital controls are likely, and also a denomination of foreign trade and investment in BRICS currencies rather than the U.S. dollar or euro. This tendency will accelerate if U.S. and European military policy continues to expand into Asia and other regions. As matters look at present, U.S. military diplomacy will focus more on trying to recover influence in Latin America, including privatization of key infrastructure to buyers (on credit) who will engage in rent extraction, adding to the price level. The result of debt deflation is thus to raise the cost of living and doing business for much of the economy, squeezing labor and commerce alike.

These policies are likely to be characterized as “muddling through.” This means postponing what looks like the inevitable end game: a large write-down of government debt, a shift away from the dollar as global currency (quite possibly with a re-introduction of gold to settle balance-of-payments deficits). Diplomatically, these changes will constrain U.S. military spending, while pressuring Europe to re-orient its geographic focus if it is to resume economic growth and pull itself out of a feedback of debt deflation, unemployment and even emigration.

The neoliberal challenge

The term “neoliberalism” misrepresents and even inverts the classical liberal idea of free markets. It is a weaponization of economic theory, kidnapping the original liberal ethic that sought to defend against special privilege and unearned income. To classical economists, a free market meant one free of unearned income, defined as land rent, natural resource rent, monopoly rent and rent-extracting privilege. But to neoliberals a free market is one free from taxes or regulation of such rentier income, and indeed gives it tax favoritism over wages and profits.

Neoliberalism and neo-conservatism are complementary doctrines of power and autocracy combined with deregulation and dismantling of democratic law. The aim is to replace government power as used to protect the people with an oligarchic power to oppress the people.

Today, the neoliberal aim is to cripple government power, enabling a free-for-all for the financial sector. Protecting civil freedoms are also heavily signposted, but the high price of legal representation is a barrier for most. A doctrine primarily of the financial sector, the aim is to un-tax banks and financial institutions and their major customers: real estate and monopolies.

Neoliberalism is a doctrine of central planning, which is to be shifted from governments to the more highly centralized financial centers. This requires disabling public power to regulate and tax banking and finance. As a transition, ideological deregulators such as Alan Greenspan and Tim Geithner have been appointed to the key regulatory positions in the United States.

The result is a doctrine of financial war not only against labor but also against industry and government. Gaining the financial power to indebt economies at increasing speed, the banking and financial sector is siphoning resources away from the real economy. Its business plan is not based on employing labor to expand output, but simply to transfer as much of the existing flow of revenue as possible into its own hands, by capitalizing all such revenue into interest payments, on loans collateralized and pledged to creditors.

The effect is no more democratic than the Roman democracy, which arranged voting by “centuries” headed by the largest landowners – essentially an acre-per-vote, to make an analogy. In the U.S. case, votes are bought not by land as such, but by dollars – mainly from the financial sector. In the end, to be sure, most dollars come from rent extraction.

The result must be economic polarization, above all between creditors and debtors as in Rome. So the end stage of neoliberalism threatens a Dark Age of poverty/immiseration – most characteristically, one of debt peonage. And just as Rome’s creditor class and its predatory imperial expansion brought down the Roman Empire and reduced it to mere subsistence, so the combination of neoliberalism and neo-conservatism today seeks to globalize itself, spreading austerity even as it brings technological progress to sovereign debtors.

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