Forecast such things

Paulson, Bernanke and Geithner have horrible forecasting records. Anyone forecasting, leaves himself open for a certain amount of embarrassment. Yet these people persist in pretending that they are capable of managing the economic condition of the country. That is truly scary!
Now we have the latest bit of evidence of  their prowess. Look at this statement (one of many in a detailed report) made by Frederick Mishkin when he was on the Federal Reserve Board: “… they clearly illustrate that Iceland is a well run, advanced Nordic country that has little in common with emerging market countries, a fact important to recognize when we start discussing financial stability in the next section.” Shortly thereafter, Iceland inconveniently and totally collapsed into financial rubble.
Perhaps it isn’t Bernanke; perhaps it is his aides that are so wrong. Actually it is neither. No one can accurately forecast such things. That they are wrong is not surprising; that they have the hubris to pretend to know these things is what is amazing. Frederick Hayek’s Nobel acceptance speech entitled The Pretence of Knowledge has much to say both about the problem and professional hubris. Perhaps this speech should be required reading by all Washington economic and other policy dunderheads.

The current economic crisis

A rosy assessment by Bloomberg. Their assessment of growth is reasonable; the statement that “… government stimulus helped bring an end to the worst recession since the 1930s…” is highly unlikely. It appears to be both an early and foolish call. During normal recessions, it is typical to have an intervening quarter or two of growth and then return to negative numbers.
This is no ordinary recession. There can be no recovery until the private sector (more properly called the productive sector) starts growing again. The public sector (better called the non-productive sector) produces virtually nothing, although it can appear to “cause” growth because of the manner in which GDP is defined. The government has no money of its own. It gets money either by taking it from the productive sector or by printing it. To get money from the productive center, it either coercively takes it in the form of taxes or sells bonds. Either way, the productive center has less funds to use. The government cannot produce growth in this fashion because of the dollar for dollar trade-off. Their spending makes us poorer in the sense that they do not spend the way we would. Simply stated, as a consumer would you rather have $100 bill or have your neighbor spend the $100 for you and show up with gifts or groceries that he assumed you would like?
The third method the government can use to obtain funds is printing money. But this is inflation.

The return to risky behavior is already underway

Hope and Change in the Banking System seems to be “hope” that the system can get through this economic cycle while “change” is non-existent. “Too big to fail” creates incentives for risk-taking that would not occur in a true free market. Taxpayers underwriting risk and backstopping failure ensure that firms will take on more, rather than less, risk.
Legislated rules need to be imposed to contain excessive risk-taking based upon taxpayer guarantees. While a truly free market could handle this better than legislation, there appears to be zero hope for that occurring. Thus, a reinstatement of Glass-Steagall or its equivalent is necessary. Without some type of legislation, we are merely waiting for the next crisis to occur. With it, crises will still occur, but they should be more manageable.
The return to risky behavior is already underway.

You might as well label JP Morgan the new Lehman Brothers because they are operating like an investment bank.  So much for those bailouts helping the average American.  The media really needs to scrutinize how these companies make their earnings.  They are simply using hot and easy money to double down in the Wall Street casino on the taxpayer dime.  No reform has happened since the collapse of Wall Street because these banks own our politicians.

This threat looms ever larger with the passage of time

Julian Robertson, legendary investor, expressed what I believe to be the critical immediate problem facing the US (and the rest of the world). With my emphasis added, he said the following:

I prefer to run scared through here. I think that if the Chinese stop buying our debt, it is virtually the end of the financial world as we know it. The conventional thinking is that they will continue buying. But I don‟t think it’s logical to assume somebody will continue to buy our paper which declines in value. Our dollar is declining in value, and it’s been pretty shocking over the last four or five months. The politicians who are so tough on businessmen and so critical – they and the Federal Reserve caused us to be in this predicament. What really caused me to predict the problems we had in 2007 and 2008 was that we were spending so much and no one was balancing the budget. No family can keep doing that forever, no corporation can keep doing that forever and no nation can continue doing that forever. We did it on all three fronts – and it blew up in our face.

Robertson speaks of what happens if/when the US can no longer depend on the “kindness of strangers” to fund our deficits. If/when our benefactors stop lending us money, both Treasury bonds and the US currency will collapse. As he alludes , bonds and currency are merely symptoms of underlying problems. While many believe that Blanche du Bois (the United States) will be able to bypass what Robertson fears because strangers will continue to support us, I do not. Furthermore, unless and until we remedy the underlying problems (government spending that cannot be supported by taxes, weakness in the private sector, etc.), this threat looms ever larger with the passage of time. At this point, there are no signs of the US even addressing these problems. Government projections (probably highly optimistic) for the remainder of this decade show deficits 2-3 times larger than any prior to last year.
Our kind strangers are not altruists, have their own needs for funds and their own political/national objectives. The frightening part of this entire situation is that we literally have no control over the short-term outcome. We have lost most of our economic clout, are viewed as profligate and probably have lost much of our political clout. We appear to be following the path of Britain when it lost its world leadership. Whether we fall to what arguably approached third-world nation status for Britain before recovering to a much smaller role in the world or not is moot. Our role as economic leader appears to be quickly slipping away. Even so, geopolitically we will remain relevant so long as we are in possession of ICBMs, sort of like Russia today but without the natural resources.

It invites anarchy

This swamp is too big and too far gone to be drained by electing “the other guys.” There are no other guys; they are all the same. I’m not sure what the answer is, but the wise words of Justice Brandies should have served as a warning and ultimately may become prophetic:
“In a government of laws, the existence of the government will be imperiled if it fails to observe the law scrupulously. Our government is the potent, the omnipotent teacher. For good or ill, it teaches the whole people by its example. If government becomes a lawbreaker it breeds contempt for law: it invites every man to become a law unto himself. It invites anarchy.”
Scary times with even more thrills ahead I am afraid.

At least from a monetary perspective

This is a piece that I wrote in response to a request for a guest post over at ZeroHedge. It ran there yesterday garnering some nice attention and a diverse range of comments beneath.
Based on some of those comments, this article represents nothing more than my attempt to find an explanation that matches the data.

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My central thesis to this crisis, developed a few years before it even hit, is that the economic troubles are the symptoms, while the money system itself is the cause. My views on this are expressed in the opening of an article that I initially penned in 2006 but updated in 2008:

Within the next twenty years, the most profound changes in all of economic history will sweep the globe. The economic chaos and turbulence we are now experiencing are merely the opening salvos in what will prove to be a long, disruptive period of adjustment. Our choices now are to either evolve a new economic model that is compatible with limited physical resources, or to risk a catastrophic failure of our monetary system, and with it the basis for civilization as we know it today.
In order to understand why, we must start at the beginning. While it was operating well, our monetary system was a great system, one that fostered incredible technological innovation and advances in standards of living, two characteristics that I fervently wish to continue. But every system has its pros and its cons, and our monetary system has a doozy of a flaw.
It is this: Our monetary system must continually expand, forever.

The article above provides the big-picture backdrop that drives my long-term vision and thinking.  I raise it now so that you’ll understand that I principally view the economic world through a monetary lens.
The hot topic of the day is “Inflation or Deflation?” and the camps are firmly divided into groups of inflationistas and deflationistas.  When asked which camp I am in, I reply “Yes.”  Some would say that puts me in the confusionista camp, but I actually have an explanation for why are living in a world encompassing both.
From a technical perspective, we are absolutely in one of the most powerfully deflationary periods in history, yet, besides housing prices and a few over-produced consumer goods, we find that stocks, bonds, and commodities are all well-bid at the moment.
While we can ascribe some of this to the artificial wall of liquidity (come to think of it, is there any other kind?) currently being thrown into the financial market(s) by the Fed, it leaves hanging the question of why that money is not being completely swallowed into the bottomless black hole that the deflationist camp says lies at the heart of our current financial system.
And they are right; there is a black hole at the center.  If we treat the credit doubling that occurred between 2000 and 2008 (from $26 to $52 trillion) as a normal bubble that will follow the same pattern of decline as numerous historical bubbles, then we might reasonably predict that some $26 trillion of debt will somehow “go away” over the next 6 years.  This is indeed a massive black hole.
Yet everything just keeps perking along.  What gives?
The answer, I believe, requires us to ask a Zen-like question along the lines of, “What is the sound of one hand clapping?”  That question is, “If nobody recognizes a defaulted debt on their balance sheet, does it exist?”
Suppose, for the sake of argument, that there is a world in which banks are allowed by their regulators to pretend their default losses simply do not exist.  And, even more outlandishly, some of these banks are allowed to sell heavily damaged loans to their central bank at nearly their full original price.
What does “deflation” mean in such a world?  Not much, as it turns out.  At least from a monetary perspective, because money is not being destroyed at nearly the rate that would be expected or predicted by the size and rate of the defaults.
This is the world in which we currently live.  Trillions in probable and provable losses quietly exist, out of sight, on the balance sheets of the Federal Reserve and other financial institutions.  If they ever come out of hiding and onto the books, I think the deflationists will be proven correct beyond all doubt.
But let me ask this:  What prevents the authorities from simply storing them out of sight forever?  Or at least long enough to allow the wave of liquidity to work its inevitable magic?  So far, much to my great surprise, they’ve managed to do exactly that, with hardly a squeak from the mainstream press (although the blogsphere is on the job, as usual).  I am now wondering if they cannot keep this up indefinitely.
So from a purely monetary perspective, money can only be “destroyed” if banks and other financial institutions are compelled to recognize the losses and take a hit to capital.  If the loss is not recognized, no money is destroyed.  At least it is not recognized as gone.
Perversely, when a bank sells a ruined loan ‘asset’ to the Federal Reserve, it is a double shot of money to the system – the money initially created upon the issuance of the original loan, which is still out there in circulation, and a second bolus when the Fed creates money out of thin air to buy the failing ‘asset’ from the bank.  One blob of money into the system when the loan is made, another when it is bought by the Fed.  One loan, two blobs of money.  Many have failed to recognize this feature of the Fed’s asset purchase programs.
So from this perspective, we could even argue that by employing the ‘pretend and extend’ strategy, coupled with an aggressive Fed purchase policy, it is possible that more money is being created than destroyed right now.  Which means that from a strictly monetary perspective, I am not yet sold on the idea that money is being destroyed at the rates sometimes implied by the deflationary arguments.
Also, the data is not really in support of that notion either:

Of course, this money needs willing lenders and borrowers, which brings us back to the matter of price deflation.
Out in the real world, where consumers and producers exist, the bursting credit bubble has severely cut off consumers’ access to and desire for new credit, and producers have dialed back excessive capacity and cut their prices in order to attract business and survive.
There is no doubt about this process, but here I would argue that falling prices are currently as much a matter of supply and demand as they are a monetary issue.  In other words, the price deflation that we are currently seeing is not a pure monetary phenomenon.
Which means I think we are in a bizarre hybrid world, where deflation should be the order of the day, but it currently is not, because its impacts are being held in abeyance by the simple expedient of pretending the losses do not exist.
My current outlook calls for productive capacity to continue to fall out in the real world, even as the Fed conjures more money into existence in the make-believe world of ‘high finance.’  (What are they smoking over there?).
Is this not a recipe for eventual inflation?  More money, but fewer goods and services?  History says ‘yes.’
All that said, I would not disagree with the notion that there’s another year or three of grinding along (where stock and bond prices are concerned), possibly down, but maybe not, before the monetary/goods imbalance comes charging out of the chute ready to throw off the unwary and trample them in a blistering round of inflation.
But it could be sooner than that.  Or later.  The point here is that we really don’t know, and because our monetary system operates on faith, it means that we have to be prepared for the fact that a shift could happen at any time.  Nobody can predict when a school of fish will suddenly turn to the left.  Who knows what final trigger will cause a critical minority to suddenly determine that they’d rather hold things other than paper?
For now, while I understand and appreciate the deflationist argument, the only thing that would convert me fully to that camp would be a sudden return to rigorous application of honest accounting.  If you derisively snorted at that last sentence, then we share the same assessment of the likelihood of that happening any time soon.
In order to answer the main question of this article, we regretfully have to turn to Dadaism* to develop an appropriately absurd non-sequitur:
“What is the sound of one hand clapping?   Insanely high stock and bond prices.”

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* Dada was a protest by a group of European artists against World War I, bourgeois society, and the conservativism of traditional thought.  Its followers used absurdities and non-sequiturs to create artworks and performances which defied any intellectual analysis. The founders included the French artist Jean Arp and the writers Hugo Ball and Tristan Tzara.  Francis Picabia and Marcel Duchamp were also key contributors.
The Dada movement evolved into Surrealism in the 1920′s.

The Future of the Dollar

 Here is an outstanding, must-read regarding the dollar and economy. Warning, it is long and more technical than some other articles you have been referred to, but worth investing some time to fully understand. In my opinion, the issues discussed in this article are key to understanding our current situation and the manner in which it resolves.
It is hard to imagine a happy future for the dollar, and I was going to say that before Robert Fisk published his The Demise of the Dollar, in which he describes secret talks among central bankers and finance ministers of various countries on how to move away from trading oil in dollars.

Is Fisk’s report true? I have already been told once today that the story was a bit too “conspiratorial” to be taken seriously. The expected official denial followed quickly.

But top officials of Saudi Arabia and Russia, speaking on the sidelines of International Monetary Fund meetings in Istanbul, denied there were such talks. The two countries are the world’s largest and second-largest oil exporters.
Asked by reporters about the newspaper story, Saudi Arabia’s central bank chief Muhammad al-Jasser said: “Absolutely incorrect.” He repeated the same response when asked whether Saudi Arabia was in such talks.

The pols have chosen to cover up the problem

The disgraceful and unsustainable government sham continues. Rather than face up to problems, the government tries to hide them and create another credit bubble. This extend and pretend strategy cannot work although was easily predicted. Previous posts dealt with what was happening. This one, US Government Has Become Fannie and Freddie, is one example.

Political cowardice and the need to cover-up criminal activity made such predictions easy. Rather than face up, politicians and the Fed are trying to bluff their way through. This approach cannot work because the government is bankrupt and nearly out of options. Trying to add more credit to the system is like changing the title of an old movie and then being surprised when the ending is the same. There is no exit that doesn’t involve pain. Recognizing that and dealing with it involves the least economic pain. Avoiding the problem involves the least, short-term, political pain.
The pols have chosen to cover up the problem, hoping it goes away. In poker terms, markets hold 4 aces and the pols have a busted hand but think they can win the pot by bluffing. No chance! Unfortunately their all-in play will bankrupt the government and the country. The sources of new money to sustain this Ponzi scheme are drying up.
What we are witnessing at this point is a cornered and wounded animal, desperate to survive and willing to do ANYTHING to do so. Accounting gimmickry, cover-ups, lying about how bad the situation really is and other measures to perpetuate the scam are not working. As things become more desperate, more dangerous tactics will follow. This ending will not be pretty and will have historical ramifications that will reverberate for decades.

Former Fannie Chief Credit Officer Says FHA Is $54 Billion Underwater

In keeping with the warnings presented by Kyle Bass warned that the entire housing bubble is now being ported over to the taxpayer’s balance sheet, Edward Pinto, a former chief credit officer for Fannie Mae claims that the Federal Housing Administration will likely require a major taxpayer bailout “in the next 24 to 36 months” as it is likely to incur $56 billion more in losses than it can withstand.
For those that think the NINJA loans are a thing of the past, think again – the Fed is now actively encouraging just those same reckless standards that brought America to the brink:

The FHA program’s volumes have quadrupled since 2006 as private lenders and insurers pulled back amid the U.S. housing slump, Pinto said. The trend has left the agency backing risky loans and exposed to fraud in a “market where prices have yet to stabilize,” he said. The program insures loans with down payments as low as 3.5 percent and has no formal credit-score requirements.

The FHA Commissioner, David Stevens, is keeping to his side of the story, which is that everything is being properly accounted for, and there is no risk in the future of the Administration. Don’t expect this story to change until the next time the handout hat startrs getting tossed around legislators. In the meantime, the deterioration in loan standards keeps accelerating:

About 14.4 percent of FHA loans were delinquent as of June 30 and 2.98 percent were already being foreclosed upon, according to the Mortgage Bankers Association. The combined percentage for all mortgages was a record 13.16 percent, according to data from the Washington-based trade group, which said in releasing the figures the share of FHA loans past due is being suppressed by the large amount new debt.

Insurance policy against both inflation and deflation

Deflation could be the biggest threat to the economy, but gold — usually an inflation hedge — is reaching new highs. That’s because smart investors aren’t playing the inflation trade, they’re buying currency crisis insurance.
With the amount being spent by the public sector, with the huge amounts of leverage still in the system, there’s a palpable fear that America won’t be able to meet its obligations. Relative to GDP, the amount we’re borrowing to finance deficits makes us look irresponsible.
When such economies hit a wall, investors make a run on the currency, typically moving their assets to a stronger currency, like the dollar.
But this time the problem is the dollar, along with other leading paper currencies, all of which are threatened by profligate fiscal and monetary policies. So some investors want out of the system entirely. Gold, as my colleague Neil Collins noted earlier, is a way to do that.
The gold market is small enough that a decision by a handful of money managers to increase their asset allocation from, say, zero to 5 percent can move the market. All the gold ever mined would fit aboard an oil tanker; its total weight of 125,000 tons amounts to a few hours’ output for the U.S. steel industry.
But economists tell us that inflation isn’t a risk now. Are they wrong? No and yes.
The conventional way economists view inflation is to look at things like “output gaps.” When the economy falls below a level of output it previously achieved, it is said to have unemployed resources. If you think of inflation as workers demanding and getting higher wages, which leads to higher prices for the goods and services they produce, then inflation isn’t a threat.
So economists tell us more borrowing and money printing won’t be inflationary as long as people are unemployed.
One problem: Their models ignore the fact that peak output was artificially inflated by a credit binge. Borrowing more to sustain an unsustainable level of spending borders on insanity, yet that’s precisely what such economic models tell us we need to do.
There’s an extra variable these models don’t account for — the Chinese and all major lenders to the United States. They don’t much care if our employment rate is below desirable levels. At a certain point, they may recognize that the United States is acting like a banana republic and choose to stop lending.
When that happens, we might see a “sudden stop” event: Capital inflows to the private and public sector cease as everyone races to get out of dollars.
Eric Sprott, CEO of Sprott Asset Management has $4.5 billion under management, $2 billion of which is invested in physical bullion — silver and gold — stored at banks in Canada. Another large chunk is invested in gold stocks.
He views gold as an insurance policy against both inflation and deflation. Central bank quantitative easing policies mean “we’re printing paper currency like crazy,” so he doubts the long-run value of fiat currencies.
On the flip side, if central banks pull back, you could enter a deflationary spiral, essentially a banking collapse, in which case “your deposits wouldn’t be returned to you. Better to have physical gold in your control.”
Most economists and investors still labor under the illusion that there’s a way out of debt that doesn’t involve a drastic reduction in the paper value of wealth. Smart investors aren’t so sure and want at least a portion of their assets out of the financial system.
A dollar crisis isn’t necessarily coming tomorrow, so there’s no guarantee gold’s price will keep going higher. Still, gold is a decent insurance policy against economic Armageddon.

Institutions and incentive structures

Arguably Macroeconomics is not economics. It deals with aggregates, statistics and mathematical models that purport to explain the behavior of the economy. But economics is not about aggregates, it is about human behavior. The building block for meaningful economics must be the individual, not some aggregate called Consumption or Investment. These aggregates are nothing more than the outcomes of millions of individual decisions. Aggregates do not make decisions, they result from decisions. They are statistical constructs only, often useful to summarize history. To the extent that they have correlation, (the incorrect premise of macroeconomics is that they are causally related), the correlation results from stability at the micro level. Institutions and incentive structures provide the framework that influences individuals. If these are stable, then aggregate outcomes will appear to be stable over time. But there is no causal relationship among aggregates that can be managed as if it were some giant machine.Yet, that is the basis for macroeconomics. If we “input” more Consumption, the “output” of the machine will increase. If we increase Government Spending, it will increase GDP. If we increase the Money Supply then …… Such is the world of macoreconomics. Unfortunately the underlying premise of macroeconomics, causality, is at best correlation. Macro management of an economy is based on a false premise.

An example of how the micro level affects the macro level is apparent in this piece that hit my email. Whether the story is true or not is immaterial. It demonstrates the thought processes of individuals when their incentive structure is changed. This behavior, magnified across all decision-makers (consumers and businessmen), is indicative of how aggregates are affected. Past correlations will not hold as a result. Policy makers in Washington will once again be “surprised.”

The Employee Meeting:
I would like to start by thanking you for attending this meeting, though it’s not like you had much of a choice. After all, attendance was mandatory. I’m also glad many of you accepted my invitation to your family members to be here as well. I have a few remarks to make to all of you, and then we’ll retire to the ballroom for a great lunch and some employee awards.
I felt that this meeting was important enough to close all 12 of our tire and automotive shops today so that you could be here. To reassure you, everybody is being paid for the day — except me. Since our stores are closed we’re making no money. That economic loss is mine to sustain. Carrington Automotive has 157 full time employees and around 30 additional part-timers. All of you are here. I thank you for that.
When you walked into this auditorium you were handed a rather thick 78-page document. Many of you have already taken a peek. You were probably surprised to see that it’s my personal tax return for 2008. Those of you who are adept at reading these tax returns will see that last year my taxable income was $534,000.00. Now I’m sure this seems rather high to many of you. So … let’s talk about this tax return.
Carrington Automotive Enterprises is what we call a Sub-S – a Subchapter S corporation. The name comes from a particular part of our tax code. Sub-S status means that the income from all 12 of our stores is reported on my personal tax return. Businesses that report their income on the owner’s personal tax return are referred to as “small businesses.” So, you see now that this $534,000 is really the total taxable income – the total combined profit from all 12 of our stores. That works out to an average of a bit over $44,000 per store.
Why did I feel it important for you to see my actual 2008 tax return? Well, there’s a lot of rhetoric being thrown around today about taxes, small businesses and rich people. To the people in charge in Washington right now I’m a wealthy American making over a half-million dollars a year. Most Americans would agree: I’m just another rich guy; after all … I had over a half-million in income last year, right? In this room we know that the reality is that I’m a small business owner who runs 12 retail establishments and employs 187 people. Now here’s something that shouldn’t surprise you, but it will: Just under 100 percent … Make that 99.7 percent of all employers in this country are small businesses, just like ours.
Every one of these businesses reports their income on a personal income tax return. You need to understand that small businesses like our s are responsible for about 80 percent of all private sector jobs in this country, and about 70 percent of all jobs that have been created over the past year. You also need to know that when you hear some politician talking about rich people who earn over $200,000 or $500,000 a year, they’re talking about the people who create the jobs.
The people who are now running the show in Washington have been talking for months about raising taxes on wealthy Americans. I already know that in two years my federal income taxes are going to go up by about 4.5 percent. That happens when Obama and the Democrats allow the Bush tax cuts to expire. When my taxes climb by 4.5 percent the Democrats will be on television saying that this really isn’t a tax increase. They’ll explain that the Bush tax cuts have expired .. Nothing more Here at Carrington we’ll know that almost 5% has been taken right off of our bottom line. And that means it will be coming off your bottom line.
Numbers are boring, I know … But let’s talk a bit more about that $534,000. That’s the money that was left last year from company revenues after I paid all of the salaries and expenses of running this business. Now I could have kept every penny of that for myself, but that would have left us with nothing to grow our business, to attract new customers and to hire new employees. You’re aware that we’ve been talking about opening new stores in Virginia Beach and Newport News . To do that I will have to buy or lease property, construct a building and purchase inventory. I also have to hire additional people to work in those stores. These people wouldn’t immediately be earning their pay. So, where do you think the money for all of this comes from? Right out of our profits .. Right out of that $534,000. I need to advertise to bring Customers in, especially in these tough times. Where do you think that money comes from? Oh sure, I can count it as an expense when I file my next income tax return . But for right now that comes from either current revenues or last year’s profits. Revenues right now aren’t all that hot … so do the math. A good effective advertising campaign might cost us more than $300,000.
Is this all starting to come together for you now?
Right now the Democrats are pushing a nationalized health care plan that, depending on who’s doing the talking, will add anywhere from another two percent to an additional 4.6 percent to my taxes. If I add a few more stores, which I would like to do, and if the economy improves, my taxable income … our business income … could go over one million dollars! If that happens the Democrats have yet another tax waiting, another five percent plus! I’ve really lost track of all of the new government programs the Democrats and President Obama are proposing that they claim they will be able to finance with new taxes on what they call “wealthy Americans..”
And while we’re talking about health care, let me explain something else to you. I understand that possibly your biggest complaint with our company is that we don’t provide you with health insurance. That is because as your employer I believe that it is my responsibility to provide you with a safe workplace and a fair wage and to do all that I can to preserve and grow this company that provides us all with income. I no more have a responsibility to provide you with health insurance than I do with life, auto or homeowner’s insurance. As you know, I have periodically invited agents for health insurance companies here to provide you with information on private health insurance plans.
The Democrats are proposing to levy yet another tax against Carrington in the amount of 8 percent of my payroll as a penalty for not providing you with health insurance. You should know that if they do this I will be reducing every person’s salary or hourly wage by that same 8 percent. This will not be done to put any more money in my pocket. It will be done to make sure that I don’t suffer financially from the Democrat’s efforts to place our healthcare under the control of the federal government. It is your health, not mine. It is your healthcare, not mine. These are your expenses, not mine. If you think I’m wrong about all this, I would sure love to hear your reasoning
Try to understand what I’m telling you here. Those people that Obama and the Democrats call “wealthy Americans” are, in very large part, America ‘s small business owners. I’m one of them. You have the evidence, and surely you don’t think that the owner of a bunch of tire stores is anything special. That $534,000 figure on my income tax return puts me squarely in Democrat crosshairs when it comes to tax increases. Let’s be clear about this … crystal clear. Any federal tax increase on me is going to cost you money, not me. Any new taxes on Carrington Automotive will be new taxes that you, or the people I don’t hire to staff the new stores I won’t be building, will be paying. Do you understand what I’m telling you? You’ve heard about things rolling downhill, right? Fine .. then you need to know that taxes, like that other stuff, roll downhill. Now you and I may understand that you are not among those that the Democrats call “wealthy Americans,” but when this “tax the rich” thing comes down you are going to be standing at the bottom of the mud slide, if you get my drift. That’s life in the big city, my friends … where elections have consequences.
You know our economy is very weak right now. I’ve pledged to get us through this without layoffs or cuts in your wages and benefits. It’s too bad the politicians can’t get us through this without attacking our profits. To insure our survival I have to take a substantial portion of that $534,000 and set it aside for unexpected expenses and a worsening economy. Trouble is, the government is eyeing that money too … and they have the guns. If they want it, they can take it.
I don’t want to make this too long. There’s a great lunch waiting for us all. But you need to understand what’s happening here. I’ve worked hard for 23 years to create this business. There were many years where I couldn’t take a penny in income because every dollar was being dedicated to expanding the business. There were tough times when it took every dollar of revenues to replenish our inventory and cover your paychecks. During those times I earned nothing. If you want to see those tax returns, just let me know.
OK … I know I’m repeating myself here. I don’t hire stupid people, and you are probably getting it now. So let me just ramble for a few more minutes. Most Americans don’t realize that when the Democrats talk about raising taxes on people making more than $250 thousand a year, they’re talking about raising taxes on small businesses. The U.S. Treasury Department says that six out of every ten individuals in this country with incomes of more than $280,000 are actually small business owners. About one-half of the income in this country that would be subject to these increased taxes is from small businesses like ours. Depending on how many of these wonderful new taxes the Democrats manage to pass, this company could see its tax burden increase by as much as $60,000. Perhaps more.
I know a lot of you voted for President Obama. A lot of you voted for Democrats across the board. Whether you voted out of support for some specific policies, or because you liked his slogans, you need to learn one very valuable lesson from this election. Elections have consequences. You might have thought it would be cool to have a president who looks like you; or a president who is young, has a buff body, and speaks eloquently when there’s a teleprompter in the neighborhood. Maybe you liked his promises to tax the rich. Maybe you believed his promise not to raise taxes on people earning less than a certain amount. Maybe you actually bought into his promise to cut taxes on millions of Americans who actually don’t pay income taxes in the first place. Whatever the reason .. your vote had consequences; and here they are.
Bottom line? I’m not taking this hit alone. As soon as the Democrats manage to get their tax increases on the books, I’m going to take steps to make sure that my family isn’t affected. When you own the business, that is what you’re allowed to do. I built this business over a period of 23 years, and I’m not going to see my family suffer because we have a president and a congress who think that wealth is distributed rather than earned. Any additional taxes, of whatever description, that President Obama and the Democrats inflict on this business will come straight out of any funds I have set aside for expansion or pay and benefit increases. Any plans I might have had to hire additional employees for new stores will be put aside. Any plans for raises for the people I now have working for me will be shelved. Year-end bonuses might well be eliminated. That may sound rough, but that’s the reality.
You’re going to continue to hear a lot of anti-wealth rhetoric out there from the media and from the left. You can chose to believe what you wish .. .but when it comes to Carrington Automotive you will know the truth. The books are open to any of you at any time. I have nothing to hide. I would hope that other small business owners out there would hold meetings like this one, but I know it won’t happen that often. One of the lessons to be learned here is that taxes … all taxes … and all regulatory costs that are placed on businesses anywhere in this country, will eventually be passed right on down to individuals; individuals such as yourself. This hasn’t been about admonishing anyone and it hasn’t been about issuing threats. This is part! of the education you should have received in the government schools, but didn’t. Class is now dismissed.

Contemporary unchecked finance

Doug Noland of Prudent Bear tackles the flaws in credit and interventionism practiced by our government and concludes: “… it is my view that a flawed Credit apparatus, ill-advised government intervention, and dysfunctional market dynamics ensure economic maladjustment gets worse before it gets better.” His commentary on the current state of economic thinking and what it will produce appears below.

The Governator and the Market Operator I’ll begin with an excerpt from Bill Gross’s latest Investment Outlook: “But California’s problems, while somewhat unique and self-inflicted, are really America’s problems, and not just because the California economy is 15% of national GDP. While California’s $26 billion deficit is not directly comparable to the federal gap of $1 trillion-plus, they both reflect a lack of discipline and indeed vision to perceive that the strong growth in revenues was driven by the same excess leverage and same delusionary asset appreciation that was bound to approach cliff’s edge.” It’s contagious. Both at the state and local level and in Washington, policymakers “lack discipline and indeed vision…” It is said that “bull markets create genius.” I’ll suggest that the downside of the Credit cycle fashions lousy policymaking. I feel for the “Governator” and the California legislature, and I feel for our new President and members of Congress. They confront the harsh post-Bubble reality of no win circumstances – wearing big bullseyes on their backs in an age of slings and arrows. As much as I respect Bill Gross – and can’t take strong exception with much of what he has been saying and writing of late – I just can’t find it within myself to move on. Newer readers might be unfamiliar with my long-standing – and one-way debate – with the McCulley/Gross view of the financial world. They have over the years been leading proponents for the popular consensus ideology that I have labeled “inflationism.” It is a basic tenet of Credit Bubble theory that if the system inflates the quantity of Credit it will be spent. Credit Bubbles are fundamentally about a lack of discipline – one could say a confluence of undisciplined behavior. Credit Bubbles evolve specifically because of undisciplined monetary system management, undisciplined lending, undisciplined borrowing, undisciplined investment, undisciplined speculation and, at the end of the day, undisciplined spending throughout. And there are some absolutes: Inflated mortgage Credit, home price gains, and elevated incomes will absolutely inflate the propensity for undisciplined consumption. Inflated tax receipts will absolutely inflate government expenditures – in California, Washington D.C., and all across the country. The discipline problem goes way back but commenced within the bowels of the Credit system. Mr. McCulley, in particular, was a vocal proponent for post-technology Bubble reflation. This reflation doubled total mortgage Credit in about six years and unleashed Monetary Disorder all over the world. In the process, this historic Credit inflation inflated asset prices, incomes, corporate profits, and government receipts. The state of California was at the epicenter of this massive inflation. Going back to fiscal year 2002-2003, California general fund revenues were about $71 billion. By the beginning of the 2007-2008 year, the state was budgeting for general revenues of $101 billion. In percentage terms, state revenues inflated about 40% during the five-year boom. And with receipts rising each year, of course legislators were going to extrapolate and increasingly inflate state spending. There’s no mystery here. Keep in mind that in typical Bubble economy form, much of the rising expenditure was the result of rising costs all along the chain of state services. Those campaigning earlier this decade for aggressive monetary ease to fight deflation got, not surprisingly, more than they bargained for. In hindsight, it is amazing to contemplate the complete and utter lack of vision that afflicted policymakers throughout the golden state and all across the country. How could they not perceive that sophisticated Wall Street financial leveraging and resulting asset Bubbles were only temporarily inflating their coffers? When seemingly everyone bought into the notion of endless prosperity, why couldn’t they have kept their heads? Just because everyone believed the enlightened Federal Reserve had forever mastered the business cycle, why couldn’t they have been more skeptical? And that the economic community, the regulator community, the Federal Reserve and the marketplace all missed this Credit Bubble dynamic is, apparently, no excuse. As I have often written, I sympathize with post-Bubble policymakers. It is a tenet of Credit Bubble theory that politicians – given the opportunity – will inflate. There is ample history illuminating the dangerous propensity to run the government printing press. Contemporary analysis gets more complex because of the nature of private-sector Credit and the penchant for government (explicit and implicit) guarantees. During the boom, “money” was burning a hole in policymakers’ pockets, but it was Wall Street and the GSEs commanding the electronic printing press 24/7. By far the most precarious absence of discipline and vision belonged to those Operating in and accommodating this historic private-sector Credit Bubble. I disagree with the policy of massive deficits. Yet the California and U.S. budget quagmires are the direct consequences of the bursting of the Wall Street/mortgage finance Bubble. And as much as greed and leverage have provided easy scapegoats, responsibility lies first and foremost with the nature of contemporary unchecked finance and flawed “activist” monetary management (trumpeted, not coincidently, by our era’s preeminent market Operators). And as much as the consensus view believes that previous financial maladies have been largely rectified, I see a continuation of the same malignant Credit system dynamics. In short, massive government intrusion into the market pricing of Credit continues to fuel economic maladjustment and Bubble dynamics. Why did Wall Street issue Trillions of ABS, auction-rates securities, CDOs, and private-label MBS? Because they could. Why did the hedge funds and others leverage so egregiously? Because they were making a bloody fortune and the marketplace was more than ok with it. Why did the GSEs increase their MBS guarantees by $400 billion over the past year, and why did the Treasury issue $1.9 Trillion of Treasuries the past twelve months – and will likely do only somewhat less over the next year? And why are cash-strapped state and local governments borrowing so aggressively these days? It’s because the marketplace continues to readily accommodate Credit excess. Who is demonstrating a lack of discipline and vision – the borrower or the lender? The “Governator” or the market Operator? Is this the way the market pricing system is supposed to function? Why is the marketplace inherently incapable of disciplining the egregious borrower – whether mortgage debt during that Bubble or government debt today? First, there are no inherent system restraints on Credit creation. Recalling the mortgage finance Bubble, recent massive increases in the supply of government debt have been met with a collapse in borrowing costs. Second, the marketplace perceived that fiscal and monetary policymakers were backstopping mortgage Credit during the boom. Today, the market is confident that policymakers are firmly behind the Treasury and agency securities markets. Borrowers are undisciplined for one reason: the distorted market mechanism not only fails to discipline them – it accomplishes the exact opposite. I could ramble on for pages on the myriad costs associated with unchecked, undisciplined and mispriced finance. Mr. Gross touched upon a key cost, noting today’s uncompetitive California and U.S. economies. This is a key aspect of Bubble economy distortions. The dangerous flaw in inflationism dogma is that the Federal Reserve and policymakers can manipulate the cost and quantity of Credit with positive systemic results. In reality, the consequence of increasingly bold policy activism over time include a more distorted and unbalanced economic structure, as witnessed today. And it is my view that a flawed Credit apparatus, ill-advised government intervention, and dysfunctional market dynamics ensure economic maladjustment gets worse before it gets better.

stock and bond markets

To paraphrase Houston Command Central: America, The Ego Has Landed. And not smoothly.

Today’s Copenhagen announcement was a political disaster heard around the world. It further raises issues concerning the  image and competency of the President. Regardless of one’s politics, another failed Presidency is not good. Given the current geopolitical and economic situation, it might be especially dangerous as discussed earlier. Unfortunately the  Copenhagen fiasco along with the disastrous job report today enhance the perception and probability of a failing Presidency.
One wonders at the level of stock and bond markets. How much longer can Alice-in-Wonderland financial markets continue in light of continuing deterioration in economic and political fundamentals? The Ego landing does not make it easier for markets to continue to levitate.
A harsh political evaluation was offered today by the American Thinker (a conservative website):

Thomas Lifson
Dude, where’s my charisma?
In a huge slap in the face for Barack, Michelle, and the Oprah, Chicago was the first city eliminated from Olympic consideration.
It turns out the world is getting sick of Mr. Know It All. The President of France openly mocks him, and now the Olympic Committee is unimpressed with his wonderfulness.
He is having even a worse day than David Letterman. He made it all about himself.  Ben Smith of Politico wrote before the decision:
Obama’s pitch to the International Olympic Committee this morning is very much about his and America’s identity, and not the IOC’s sometimes transactional politics, raising the stakes for the decision:

We stand at a moment in history when the fate of each nation is inextricably linked to the fate of all nations — a time of common challenges that require common effort. And I ran for President because I believed deeply that at this defining moment, the United States of America has a responsibility to help in that effort, to forge new partnerships with the nations and the peoples of the world….

Richard Baehr adds:
It would be hard to exaggerate how humiliating is the IOC vote with Chicago going out in the first round, with  the lowest score of the 4 cites. So much for the theory that the world loves America more under Obama.This is a huge embarrassment  for Obama, given he shoed up for the presentation. Obviously, he neither can count, or control votes on the IOC, the way he may in the Congress. This will not help him with any part of his domestic agenda.  A key part of his message has been that he is not Bush, and presents a different America to the world. Andrew Young won the 1996 games for Atlanta during the first Bush presidency. Obama could not do it for Chicago.
Ed Lasky adds:
He has done zero since elected — except cause some damage internationally.
Stimulus bill was cooked by Congress, not him. Health Care: stalled; Card Check: stalled; Cap and Trade: stalled.
He has empowered unions and the left wing-which is causing businesses to postpone investment and hiring. I have a radiologist friend who told me his practice and the hospital re postponing purchase of equipment because they have no idea how much they will earn in the future.
How is that for health care “reform”?

Commercial banks’ balance sheets

We got exactly what I expected, a kind of wishy-washy, “hedging our bets” statement from the Fed. You have to remember that Bernanke was Greenspan’s right hand man for much of the bubble days of the ‘90s and early ‘00s, so the guy is an expert at walking both sides of the line when it comes to policy and public statements.

For instance, the Fed announced it would keep interest rates between 0% and 0.25% for an “extended period.” No surprise there. As I’ve noted previously, 80%+ of the $200+ trillion in derivatives sitting on US commercial banks’ balance sheets are related to interest rates.

For the Fed to hint at raising rates (let alone raise them) would kick off a systemic implosion that would wipe out the very guys the Fed has been bailing out. Suffice to say the Fed won’t be raising interest rates now or anytime too soon (within the next 3-5 years, unless inflation destroys the dollar).

The Fed also announced it would be slowing its purchase of Mortgage-Backed Securities (what I call the Fed’s “cash for trash” program). The Fed has stated previously that it will buy $1.45 trillion in mortgage-backed securities from US banks and that this program will end by the end of 2009. However, last week the Fed said it will be extending the program (but not the amount of money spent) until the first quarter of 2010.

Again, this is not much of a surprise. The Fed performed a similar act with its Quantitative Easing Program (extending but not increasing the amount). However, given the increasing public outcry about the Fed’s balance sheet, this issue of buying toxic debt (and the mortgage backed securities the Fed is buying are nothing if not that) may become a hot topic in the near future. If there is ever a successful audit of the Fed’s balance sheet, kiss the big banks’ equity (and share prices) good-bye.

The Fed did announce that it would let its Quantitative Easing program end in October. If you’re not familiar with this program, it’s basically a fancy way of saying that the Fed has been buying US debt in order to finance Obama et al’s massive deficit.

This particular development is key. A little known fact (and one totally ignored by the mainstream media) is that the Fed accounted for nearly half of all Treasury purchases in the second quarter ($164 billion out of $339 billion). In fact, the Fed bought more Treasuries than the next three largest purchasers combined!!

The Fed’s purchases outnumber foreign holders (foreign governments), US households, and Primary Dealers (mega banks) combined. One should also note that foreign holders reduced their purchases of US debt from $159 billion in 1Q09 to $101 billion in 2Q09 (a 40% decrease).
In simple terms, these numbers indicate that if it were not for the Fed, the US Treasury market would have almost assuredly had numerous failed auctions in the second quarter. It also shows us that foreign holders (China, Japan, etc.) are reducing their purchases of US debt at an incredible rate. This tells us two things:

1) China and pals are putting their money where their mouths are: refusing to service our debt as they did in the past
2) Treasuries will have to become a lot more attractive (higher yields) for foreign investors to start buying again
I’ve often stated that the Fed will have to sacrifice stocks or the US dollar. If the Fed does in fact end Quantitative Easing in October (as it has stated it will in last week’s FOMC), then we’ll see what the market really thinks of US debt as an investment class. It’s clear from the above data that foreign holders want higher rates (yields) in order for them to start buying more heavily. However, as I’ve stated before, the Fed cannot afford higher interest rates without blowing up US banks.

Keep your eyes on the Treasury market going forward. This could very well be the next major crisis brewing. It will certainly be our first taste of how a market operates without life support courtesy of the Fed.

I’m guessing the results won’t be pretty.

When interest rates are held artificially low

A recovery in the economy can only occur via recovery in the private sector. Much of what has been hailed as “green shoots” results from government stimulus. It is not clear what is being stimulated other than reported GDP, because there are few signs of private sector recovery. One area that has received enormous stimulus is the housing market, even though its reported numbers are still dismal.

In the mortgage issuance area, the private sector has disappeared (see previous post by Chris Martenson). Is this because banks are unwilling to lend? Is it because there are no creditworthy borrowers? The answer to both of these questions is a resounding No! Then why is this happening? The government has driven down interest rates so low in a (foolish) attempt to support housing prices that they have made it unattractive for banks to risk money at these rates. In that sense, the government is subsidizing low interest rates with taxpayer money/risk. Private firms make mortgage loans at interest rates commensurate with risk. When interest rates are held artificially low, there are few loans that meet this requirement. Another way to state this is that the government is taking on risks with your money that prudent investors would not take on with their own money. It is precisely that strategy that gave us the Fannie and Freddie debacle. This is not rocket science. The results are predictable and inevitable as evidenced by the following quote:

Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize the bad risks and to defray the losses. They encourage people to “buy” houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief in the long run they do not increase overall national production but encourage malinvestment.

The above is a nearly perfect description of what happened in our housing market. Perhaps it could be marginally improved by adding references to “liar” loans and negative amortization loans. But this excerpt was written by Henry Hazlitt in 1948 as a prediction. Its veracity was as true then as it is today. Now it is, as Yogi might say, “deja vu all over again.” We are in the process of repeating the same mistakes. This time the vehicle will be the FHA and the Fed. The results will be just as painful for taxpayers as Fannie and Freddie were (and continue to be).

Effectively confiscating gold

Mish has a take on the Arthur Burns memo to President Ford regarding gold price suppression that is worthwhile. Mish downplays its current significance, suggesting that markets ultimately are stronger than governments. He does provide a valuable caution that all gold investors should heed:

The fear should not be of government to government agreements that can never work in practice, but rather a fear that governments may tax gold sales profits at some phenomenal rate, thereby effectively confiscating gold a second time.

Such a “confiscation” would be relatively easy to impose on ETFs like GLD or SLV. It would be more difficult to impose on physical gold itself.

Future buying power of the dollar

In a post dealing primarily with Bill Ackman’s hedge fund, gold as a holding or non-holding is discussed. Ackman holds none, but his position does not appear to be at odds with others.

One last paragraph we want to focus on is Ackman’s brief mention of the risk to one’s purchasing power. Due to quantitative easing and money printing by the Fed, he acknowledges that there are concerns about future buying power of the dollar. Ackman highlights that many investors have turned to gold to hedge these risks, but not Pershing Square. Instead, they have decided to fight this risk by owning “high quality businesses that have pricing power due to market position and/or business model, and/or that earn their profits globally.”
This is interesting to see his stance on the matter as we can’t really recall him addressing it before. You’ll remember that David Einhorn and Greenlight Capital made a large gold investment and now are storing physical gold. Additionally, John Paulson’s hedge fund Paulson & Co bought gold via GLD (the exchange traded fund) to hedge their share class denominated in gold. It’s interesting to see each fund manager’s individualistic approach and hedging vehicle of choice. However, the main thing to take away from all of this is the fact that they see inflation as a potential threat in the future and are trying to mitigate this risk accordingly.

The entire economy/stock market

“New Normal,” a term coined but not yet copyrighted by the principals at Pimco, is bandied about to describe the prospects for the economy and financial markets. It is  undefined and hence irrefutable. It provides a glib way to state the obvious: the future will differ from the past. Its definitional elasticity ensured its widespread acception.

A more appropriate term might be the  “New Abnormal.” While this term could be criticized in the same manner, it offers one significant advantage. It more strongly implies lack of continuity with the past. This “advantage” is in the eye of the beholder. If you are the common investor, this message is the one that should be absorbed. If you are part of the sell-side hucksters of Wall Street, you prefer the current euphemism, because it is wonderfully clever. It conveys the obvious – things have changed – in a somewhat soothing way.  Optimism (the purpose of the sell-side) is promoted in the sense that “understanding” will be enable you to “manage” the future. It turns lemons into lemonade.  It advances the “Lipstick on a Pig” tactic from boiler rooms to the entire economy/stock market . It is pure Marketing genius.
Despite the “genius”, I am not buying this “used car.”

More modern macroeconomic models

The econometricians and empiricists “explain” the effects of the stimulus

Is the American Recovery and Reinvestment Act of 2009 working? At the time of the act’s passage last February, this question was hotly debated. Administration economists cited Keynesian models that predicted that the $787 billion stimulus package would increase GDP by enough to create 3.6 million jobs. Our own research showed that more modern macroeconomic models predicted only one-sixth of that GDP impact. Estimates by economist Robert Barro of Harvard predicted the impact would not be significantly different from zero.

The natural tendency of government

We are embroiled in a great debate over health care reform. There are two aspects of the debate that are often not identified. The first is whether healthcare is a “right.” The second is the best way to deliver healthcare. When one does not separate the two issues, one biases the solution.

While I do not agree that healthcare is a right (you cannot morally produce a “right” for some by violating the rights of others), let us assume for the moment that it is so deemed. Then the issue becomes how is this “right” best delivered. It seems that the US has answered the first question and now struggles with the answer to the second.
It is the natural tendency of government to want to run things, hence we have the preoccupation with the single payer system or a competing government insurance company. The latter, using the concept of competition and government, is oxymoronic. Is there anyone outside of Washington DC that believes the government at the Federal or local level can run anything efficiently? The empirics regarding this issue are devastating — social security, Amtrak, medicare, medicaid, financial system regulation, the school system, potholes in the streets, the post office, infrastructure maintenance, the court system, garbage collection, department of motor vehicles, etc. etc. ad nauseum. One might reasonably argue that everything government touches deteriorates.
Back in the days of the Cold War, a joke that was popular in Europe went something like this: QUESTION — What would happen if the Soviet Union took control of the Sahara Desert? ANSWER — Initially no changes would be apparent; eventually there would be a shortage of sand.
Doug French has written a timely article that provides real-life context for the joke. His illustration focuses on Venezuela, although thousands of other illustrations could be provided.

They have reduced their purchases

Interest rates on Treasuries must increase. China, India, Russia and many other countries have admonished us on our profligacy. They have reduced their purchases and rearranged their holdings to the short-end of the curve. At the same time our funding requirements have soared. Official projections (probably understated) indicate these excessive funding needs will  be with us for at least a decade. This situation is not sustainable much longer. J. D. Steinhilber expands upon the issue.

It is a reasonably concise presentation

If you have not watched “The Crash Course” by Chris Martenson, I highly recommend it and that you pass it on to your friends. It is a reasonably concise presentation and very well done. It explains quite clearly how we have gotten into this mess. It will provide you with lots of information that, I am pretty sure, is new and disturbing. It is apolitical and economically non-ideological. It is more of a detached presentation of facts and the mathematical impossibilities inherent in where we are. 

Extend strategy will not work

The FDIC is broke (although not without additional Fed/Congress credit access) so is not closing banks that should be closed. Bank closures are occurring when they collapse under their own weight rather than FDIC guidelines. Thus, losses are bigger and taxpayers pay more as this game of pretend and extend goes on. I believe we are in much worse shape than we are being told and that it is a bigger problem than the government can handle. I also think the government knows this and that facing up to it would destroy the dollar and/or country). Hence the pretend game. Unfortunately the extend strategy will not work because underlying asset collateral continues to decline and will probably do so for the next several years. The pretend cannot go on for that long.
The banking system is insolvent, period! Using honest accounting would reveal that condition and expose the house-of-cards economy created via credit over the past 2 or 3 decades. The problem is probably still economically solvable but politically intractable so the government hopes to paper it over. Enron-type accounting is allowed to enable banks to keep exposure on non-consolidated subsidiary books. Banks are allowed to value assets at whatever they deem them to be worth rather than accounting standards that have been in place for centuries. Condoning this fraud may defer the political problem. It cannot solve the economic problem and likely makes it unsolvable at some point. Market forces will eventually overwhelm the charade, and put our entire economic system at risk of implosion. The following article from David Reilly at discusses the issue.

David Reilly
Banks Need to End $1 Trillion Kick the Can Game: David Reilly
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Commentary by David Reilly
Sept. 3 (Bloomberg) — Banks have known for a while that they would eventually have to face up to some of the assets they had stashed in off-balance-sheet vehicles. Now that day is looming, and regulators are concerned that lenders might need even more time to deal with such items.
Enough already. It’s time for banks, and their regulators, to stop playing kick the can. Either banks have — or can get — the capital they need to support assets on their books, or government watchdogs should take action.
Instead, regulators last week raised the prospect of giving banks a one-year, phase-in period to fully recognize for capital purposes what may be about $1 trillion in assets coming back onto balance sheets next year. This breathing room may ostensibly help some banks avoid having to quickly beef up regulatory capital, the buffer that helps them absorb losses.
Such a delay is unwarranted. Banks have had almost two years to prepare for accounting-rule changes adopted this spring that will place greater restrictions on the use of off-balance- sheet vehicles.
And it was just such hemming and hawing that helped get the banking system into its current mess. After the implosion of Enron Corp., accounting-rule makers tried to shut down off- balance-sheet games.
Bank Fight Back
Banks fought back, and the Financial Accounting Standards Board watered down the restrictions. That helped fuel both the rise of off-balance-sheet lending vehicles during the credit- bubble years as well as the so-called shadow-banking system.
These vehicles allowed banks to shuffle assets off their books — everything from mortgages to credit-card debts to auto loans — even though they often still bore some risks from them. By seemingly shedding these assets, banks were able to hold less capital. That helped boost returns and profit. It also allowed risks to build up out of the sight of investors, regulators and in some cases the banks themselves.
As Federal Deposit Insurance Corp. Chairman Sheila Bairsaid in an op-ed article in the New York Times this week, “the principal enablers of our current difficulties were institutions that took on enormous risk by exploiting regulatory gaps between banks and the non-bank shadow financial system.”
Those gaps were exposed when the financial crisis hit, and many banks were saddled with assets, and losses, from those previously out-of-sight, off-balance-sheet vehicles. The best- known case involved Citigroup Inc., which suddenly had to absorb about $25 billion in collateralized debt obligations.
Strained Balance Sheets
Even smaller banks such as Zions Bancorporation had to help off-balance-sheet vehicles, straining already-stretched balance sheets.
This spring, the FASB tightened the rules. In light of that, bank regulators — the FDIC, Office of the Comptroller of the Currency, the Federal Reserve and the Office of Thrift Supervision — have to decide how these returning assets will be treated for capital purposes.
Regulators allow banks to hold different amounts of capital against different kinds of assets, which is why regulatory capital can differ from a bank’s stated shareholder equity, or net worth. Those deliberations gave rise to the possibility of the year-long phase-in period.
A year may not seem like a long time; it is certainly less than the three-year grace period sought by some banks.
Don’t Dilly-Dally
Yet regulators, including the FDIC’s Bair, acknowledge that the new accounting rules are needed. More than that, in a television interview last week, Bair said if banks had faced stricter treatment for off-balance-sheet vehicles “a few years ago, I think there would have been more capital in the system.”
If these rules would have helped to prevent the current crisis, that is all the more reason not to dilly-dally.
Bair and other regulators haven’t said whether they would support a phasing-in of capital requirements. Bair has said, though, the 2010 start date for the new rules “is a little troublesome.”
Big banks in particular should have to face up to reality from the get-go since the government’s stress tests of 19 large institutions acted as if about $700 billion in off-balance-sheet assets had already returned.
The big four banks — Citigroup, JPMorgan Chase & Co.,Bank of America Corp. and Wells Fargo & Co. — are expected to see about $550 billion in assets return to their books under the accounting-rule changes, Barclays Capital analyst Jason Goldberg estimated in a recent report.
Besides having had time to prepare for the changes, there is another reason to avoid delay. Any postponement opens the possibility that banks will use the phase-in period to argue for further forbearance.
That is a time-honored tradition in Washington — if you can’t kill something outright, just delay it into oblivion.
Bank lobbyists shouldn’t be given that chance. Banks need to take their off-balance-sheet medicine now, without delay.

Overstaying bad investments

This is the first article in the Investing series. It is introductory and provides a range of observations. Sophisticated investors may want to skip it as it is basic and aimed at novice investors. It does, however, contain some elements that will recur in subsequent articles.

Market Efficiency

The late James Lorie, from the University of Chicago, was one of the early investigators of what is known as the Efficient Market Hypothesis (EMH). Early research begun in the 1960s concluded that stock markets were efficient in the sense that one could not design trading rules (technical analysis) that would consistently outperform markets. It was also determined that fundamental analysis (the Graham-Dodd value approach) was no better.
Mr. Lorie, in his inimitable fashion, described the market in light of these conclusions as “a game worth winning, but not worth playing.”
Much controversy has arisen regarding the validity of the EMH. Some of this criticism is misguided in that it attributes claims never made by proponents. For our purposes, I would like to differentiate between short and long-run, without precisely defining these periods. In the long-run, markets can clearly become over or undervalued. However, even those who make such claims usually do so after the fact rather than during the bubble or distortion. As examples: In 1999 who predicted an imminent dot com collapse or in 2005 predicted the housing collapse? Some did, but they were dismissed as “wingnuts.”
I believe that EMH holds in the short-term but less so in the long-term. Thus, whether markets in general are priced correctly or over or undervalued, individual stocks within markets are “correct” in the sense that it is difficult to find stocks that are over or undervalued. That is, stock picking cannot produce excess returns on any sustained basis.
More will be said about short-run and long-run differences later in this series.

We are Average

Most of us have the “Lake Wobegon” disease and believe we are above average and can generate superior returns. With respect to investing, I would almost guarantee that is not true for anyone reading this post (including the writer). We are all “average” investors and we should never forget that. Hubris is often responsible for our biggest blunders.
The fact that we are “average” should not be discouraging. It is consistent with the findings of the Efficient Market Hypothesis. It does not mean that we cannot make money investing, merely that we cannot obtain superior (outperform the benchmarks) returns on a consistent basis. Don’t feel bad, highly paid “experts” running mutual funds overwhelmingly fail to equal their market benchmarks.
Recognition that we are “average” is important to investing success. It should prevent us from getting overextended in positions and overstaying bad investments.

Average Investors Can Earn Market Returns

In the section above you were insulted by being referred to as average. Because you are average, it means you can achieve market returns. Actually, even below-average investors can achieve this result. All you have to do is diversify your portfolio to approximate the market and you will approximate market returns.
That is easy to do, even for small investors. Simply buy an index fund that mirrors the average you want to match. There are mutual funds that reproduce the performance of the Dow, S&P 500, Wilshire, Nasdaq, etc. You can buy one of these and forget everything else. You will virtually equal the market as you have defined it. Exchange-traded funds (ETFs) are also available that provide the same benefit.
Fully diversified portfolios will approximate market returns. Index funds and some ETFs provide that diversification for you.

What Happens If You Expect the Market to Underperform?

If you expect that the stock market is going to go down say 20%, why would you feel comfortable investing with an expected return of negative 20%? It is little consolation to be able to say that you did as well as the market if the market loses money. Of course neither you nor anyone else would be happy unless you were required by law or charter (as some mutual funds are) to remain in the market.
Investors with such expectations would likely reduce their positions in stocks. The strength of your expectations and the costs of being wrong are two factors that influence your portfolio allocations.

How Average Investors Might “Beat the Market” or “Underperform the Market”

In periods when you expect market returns to be unsatisfactory, you might reasonably decide to detach your performance from the stock market. The simplest strategy is to get out completely. That is usually not a wise strategy because there is no guarantee that your expectation of the future will be fulfilled.
Two other ways are to reduce your exposure to stocks and/or shift your weightings.
Reducing your exposure to stocks involves taking money out of play. You might move some funds out of equities into bonds, thus reducing your exposure to equities. On the other hand, you might leave all your funds in equities but shift the allocations. Of course both strategies can be used – reduce exposure and shift weightings.
One of the simplest ways to change weightings is via the use of sector funds. Sector funds specialize in various sectors of the economy. If you believe retailers or manufacturing might outperform the general market, you might want to overweight these sectors. Doing so, puts you in position to either over or underperform the general market, depending upon what develops.
For investors who prefer to approximate the market, an index fund or an ETF is efficient. Taking some money out of this index fund and placing it into one or two sectors is an effective way to retain some diversification while weighting a bit more heavily toward those sectors you perceive as having value.

Wave Effects

Stocks tend to move together. Studies show that about 50% of an individual stock’s performance can be attributed to the general market. The other 50% is unique to the company. Market statisticians refer to this correlation as “beta.” Other than mentioning the concept, there is no reason for delving further into the intricacies of how beta is calculated. In my opinion, it is virtually a useless concept.
If you believe the general stock market will not do well, your favorite stock or sector will be heavily influenced. If your expectations are particularly negative, you might want to deploy your assets to alternative investments.
Even so-called low beta investments are not immune to market waves as witnessed by the sell-off of precious metals when the markets turned down in 2008.

Expectations

Investing first and foremost depends upon expectations. Current prices are determined by expected future performance, not by past performance. Unsophisticated investors frequently reveal themselves when a company’s earnings report comes out and they say: “Earnings went up but my stock went down?”
The past is useful information only to the extent that it enables you to make better judgments regarding the future. It has no relevance to current prices.
To be a superior investor, you must be able to anticipate the future both earlier and more accurately than others. James Lorie recognized this exception to the efficiency of markets. Despite all of the mathematical testing, he asserted that some people were capable of beating markets. Their methods were suspected to be the ability to see the future better than the rest of us. Evidence for this, according to Mr. Lorie, is the people on their yachts at St. Tropez who do not reveal talk about their methods.

Your Expectations may be Correct but Your Investments can be Wrong

Having accurate expectations of the future is the only way to obtain superior returns, but it is no guarantee. Often you are right in your prognostications but too early.
Being correct and too early generally results in double disappointment. The first is when you take your initial position and underperform because you are ahead of market expectations. The second arrives after you have given up the position, believing your analysis to be incorrect. Then the market finally catches up to your “wisdom” and the investment moves up. By this time, you are out of your position.
Thus, what you are really trying to do is to forecast what market expectations will be in advance of their changing. You can be right regarding reality and still lose money if you are too early. John Maynard Keynes colorfully expressed this anomaly thusly: “The market can remain irrational longer than you can remain solvent.”
I have personal trading records vividly demonstrating the “too early” problem. For quite a while I was convinced that the banks and especially Fannie and Freddie would collapse. I shorted (via the use of puts) these entities. I entered and exited these trades many times without making any money (actually losing money). Finally, out of frustration, I threw in the towel only to see my expectations fulfilled but not my net worth. I was correct but too early.

Investing is Not Easy

Given the above discussion regarding expectations, it is easy to see why markets seem so confusing. The early basis for the Efficient Market Hypothesis likened stock prices to a random walk process.  There is no easy way to “make a killing in the market,” at least legally. But this is the reality that we must deal with. In the words of Frank Knight, a great economist from the University of Chicago, long retired before the EMH studies:

We have to adapt and overcome, that’s all we can do.

His advice was not directed at the stock market but at life in general. It is advice we all should heed as this economy continues to deteriorate.

Where Do We Go Next?

The next article in this series will lay out a set of expectations regarding the future.
Subsequent articles will deal with personal objectives. Three different set of objectives will be established for generic investors. The first will deal with a retiree or near-retiree. The second will deal with a middle-aged worker and the final one with someone just beginning their working career.
For each of the three generic investors, expectations of the future and personal objectives will be used to develop an investing strategy. Markets beyond the stock and bond markets will be included in the discussions.

Forget about restraining

we beginning to see the end of the bubble for long-term Treasury Bonds? This article, Friday Showed More Signs Of A Revolution In The Bond Market, seems to believe we might be:

Why the stinky price action when we get a big miss on NFP number? QE and the talk of stimulus done it. The numbers were so bad that by 9:30 talking heads and pundits concluded that the tax cuts were coming and we might just get a break on Social Security payroll deductions any day. Forget about restraining QE-2; the talk went straight into high gear with the only question; “How big might QE-3 be?”

Most investments and investment strategies

For those investors looking for ideas, here is an interesting post from ZeroHedge.
It represents a portfolio designed for rising inflation. However, note Tyler Durden’s preliminary comments regarding controlled inflation versus hyperinflation. To me, that is the critical issue and the one that I am trying to protect against. After all, it is the one that can wipe out most investments and investment strategies if it occurs.

Harley Bassman’s Model Portfolio For 2011, And Why “It Is Just A Matter Of Time” Before The Fed Creates Inflation

Submitted by Tyler Durden on 01/05/2011 20:08 -0500

Harley Bassman, who used to head Merrill’s RateLab, and who was one of the most erudite sellside voices on rate matters, and doubly so on mortgage issues, and subsequently moved to Merrill’s prop side, has kept a low profile recently. Which is why we are happy to present his model portfolio for 2011. Bassman is a firm believer in inflation (synthetic or real), and we for one would pay good money to see the redux of the Rosenberg vs Grant debate in 2011 be Rosenberg vs Bassman. Bassman’s conclusion, even though obtained in a circuitous way to our own, is comparable to the Zero Hedge thesis that the Fed will have no choice but to eventually create inflation. “In a nutshell, the FED (with the help of the Govt), is going to engineer some type of Inflation to reduce the value of both our Private and Public Debt.  Since Inflation is the only solution, it will happen; it is just a matter of time. Since the entire G-7 is in the same boat, trading in Euro or Yen is purely a short-term speculation since all these currencies will be heading south.” Where Zero Hedge and Bassman, however, differ, is that we are certain that the Fed will be unable to contain said inflation once it has finally been unleashed, resulting in a complete wipeout of all assets that are directly or indirectly a rate derivative (ref: a very notable reparation paying, post-WW1 central European state), which means all fiat derivatives, leaving only hard assets in the wake.
Bassman’s Model Portfolio for 2011
1a)  Long “Big Oil” + “Big Pharm” + “Big Tobacco” + etc equities.  I am precluded from making naming names, but you know what I like.  Mega Cap international stocks with patent and pricing power.  P/Es of 13ish (an earnings yield of 7 1/2%) and Dividend of 2 1/2% to 4 1/2%.  FED will encourage Retail to reverse out of Bonds and into Stocks.
1b)  For “non-stock pickers”:  Buy the S&P five years Forward at a discount to Spot.  Sell Ultra long dated (five to ten year expiry) calls.
2)  Buy Brazilian Local Currency Bonds.  Yes the “Real” at 1.67 is rich, but the 10 1/2% yield for three to six years will more than offset the Govt’s efforts to weaken the Currency.  Unlike China or India, Brazil is a “hard asset” country.
3)  Buy Russian // Mongolian // Southern Caucus Equities.  I want “hard assets”, not cheap labor.  Yeah, this region is sort of lawless and it is unclear if your legal claim will be upheld.  But at some point Russia, etc, will need to bring in Capital and reform is likely.  Most importantly, this region is a “negative beta” to the G-7 race to the bottom.
4a)  A diverse portfolio of Long-dated Municipal Bonds. You can find a selection of AA bonds in the 10 to 20 year sector that yield 5% or more.  Since rates can only rise if the FED is successful in reflating the economy, a higher rate world would tighten Muni ratios. Also, I do not see taxes declining anytime soon.  Muni’s have a massive negative spread correlation to Treasury rates.  Long Muni bonds will simply not sink below 4% on the downside and will start to compress at 5% to 6% on the upside. These “retail” bonds are super sticky at these coupon levels.
4b)  Buy Closed-End 35% leveraged Muni Bond funds.  Either National or Single State. They trade at a 5% to 8% discount to NAV and sport yields near 6.0%
5)  It goes without saying I hate Treasuries, especially 3yrs to 7yrs.
6a)  Buy 10yr into 10yr 6.0% swaption payers (puts) at 435bps.  This trade is analytically “Positive Carry” for the first three years as 9yr, 8yr and 7Yr payers also struck at 6.0% costs 450bpb, 465bps, and 475bps respectively.
6b)   A variation of above:  Sell 3y-10y 5.35% payer vs Buy 10y-10y 6.00% pyr for zero cost. This trade is long a 10% delta, so there can be some severe mark-to-market risk.  Nonetheless, this trade is a carry monster.  Moreover, I do not think we can break T10yr above 4.05% as long as the FED is on hold, which should be sometime into 2012.  Pure “roll down” on this package is 175bps for the year and the net delta decays from 10% to 3%.
7)  I hate to say it, but I kinda like owning some GOLD.  I would execute via either a costless collar trade (buy OTM call vs sell OTM put) or via our famous “Quiet Bull” structure (long call spread funded by short an otm put).

8)  And of course, CMM vs CMS for 6 months, now offered at 59 3/4bps

SUMMARY:  In a nutshell, the FED (with the help of the Govt), is going to engineer some type of Inflation to reduce the value of both our Private and Public Debt.  Since Inflation is the only solution, it will happen; it is just a matter of time.  Since the entire G-7 is in the same boat, trading in Euro or Yen is purely a short-term speculation since all these currencies will be heading south.  The question is:  “When will the non-Western USD/EUR/Yen buyers take actions that will defend their longer-term Purchasing Power ?
If you are reading this note, congrats on having survived the Great Wall Street meltdown.  As I have noted, this period is nearly identical the last great Financial Meltdown from 1989 to 1994….and I can assure you, it will end in a similar manner:  FED steepens Curve to allow banks to re-cap via carry.

Reaching hyperinflation

I am long overdue with this installment of the promised investment series. The holidays obviously got in the way.
In Part 3, I detailed what I was anticipating with respect to the economy. Most of you know there is no guarantee with respect to the future, so these musings refer to what I intend to prepare for, rather than what may actually occur.
My best guess is an environment bordering or reaching hyperinflation. That is also the judgment of Matterhorn Asset Management:

We now live in a world where governments print worthless pieces of paper to buy other worthless pieces of paper that combined with worthless derivatives, finance assets whose values are totally dependent on all these worthless debt instruments.  Thus most of these assets are also worth-less.
So the world financial system is a house of cards where each instrument’s false value is artificially supported by another instrument’s false value. The fuse of the world financial market time bomb has been lit.  There is no longer a question of IF it will happen but only WHEN and HOW.  The world lives in blissful ignorance of this.

The world has reached the end of a multi-decade bacchanalian credit romp made possible only because of fiat money and irresponsible governments (dare I suggest that this last phrase is redundant?).  Around the world, governments are applying the same medicine that created the mess as a cure. It is all they know, and we are past the point of a solution. In typical fashion, “doing something” is perceived as better than doing nothing, even if the “something” creates more harm.
Despite what is obvious to clear-thinkers, the world mostly seems oblivious to what is about to happen. According to Matterhorn, there are several reasons for that:

Firstly, because this is what totally clueless governments are telling everyone and this is what investors want to hear.

Secondly, whether governments apply austerity like in parts of Europe or money printing as in the US, investors want to  believe that any action by government is good, however inept.

Thirdly, market participants are in a state of false security due to shortsightedness and limited understanding of history.

Fourthly, as long as they can benefit from inflated and false asset values, the market participants will continue to manipulate markets.

Fifthly, there has been a very skilful campaign by the US to divert the attention from their bankrupt economy and banks `to small European countries like Greece, Ireland or Portugal. These nations, albeit in real trouble, have problems which are miniscule compared to the combined difficulties of the US Federal Government, states, cities and municipalities.

Ben Bernanke worries about deflation as a risk to the economy. That “worry” is nothing but cover for his need to print money so that the government can continue paying its bills. It is an attempt to dampen expectations regarding inflation.  People hold less money or no money at all when they expect inflation to steal away their purchasing power. In economic terms, this behavior drives the velocity of money skyward and is the precursor to hyperinflation. Thus, Bernanke must convince you that the risk to the economy is deflation. Yet, Matterhorn describes reality:

Commodity prices have increased 26% in the last 12 months and 77% in the last 24 months based on the Continuous Commodity Index (CCI). So whilst most economies publish inflation rates of 1-3%, the real cost of food and energy is surging. The US government, which doesn’t eat or use energy, recently published the adjusted 12 months’ Consumer Price Index (ex food and energy) of 0.8% per annum. Whilst most people are struggling with a massive increase in their cost of living, the US government is continuously adjusting and manipulating the published figures.  There are lies damn lies and US government statistics. Who are they fooling!

I encourage you to read the fine Matterhorn report. It provides detailed information to support their belief that hyperinflation is coming. It also provides a strong case for owning gold.
In the next part of this analysis, we will expand on other investments in addition to gold. Two important points will be stressed:

1. Keeping Score – Because the numeraire (the dollar) is becoming worthless, nominal valuations measured in dollars (or other fiat money for that matter) are becoming meaningless. We could very well be entering a period where your investments produce a 100% return in nominal dollars, yet lose purchasing power. The new way to keep score will be in purchasing power, not nominal fiat currency.
2. If the dollar is going to lose value, then dollar-denominated contracts are going to be diminished to the extent of loss of purchasing power. This fact has serious implications for pensions, fixed income investments, social security, debt, etc.