Markets Ignore US SEC-Goldman Sachs Tiff, More Political Dirty Dancing

``Popular opinion ascribes all these evils to the capitalistic system. As a remedy for the undesirable effects of interventionism they ask for still more interventionism. They blame capitalism for the effects of the actions of governments which pursue an anti-capitalistic policy.” Ludwig von Mises, Interventionism an Economic analysis

Adding more arbitrary laws or “regulations”, which are usually founded upon noble goals, have been used as the main pretext for expanding political power by the incumbents.

This unfortunately is what people refuse to see yet has been a critical cause of much of today’s ills.

For the political economy, regulations can unilaterally skew the distribution of power from the ruled to the ruler. If there is such a thing as “income or wealth” inequality, the obverse side is the “political inequality”.

Professor Lawrence White[1] on the difference of rule of law and rule of men, ``The contrast between the rule of law and the rule of men is sometimes traced still further back to Plato’s dialogue entitled Laws. In that work the Athenian Stranger declares that a city will enjoy safety and other benefits of the gods where the law “is despot over the rulers, and the rulers are slaves of the law”. In other words, government officials are to be the servants and not the masters of society. The rule of law is vitally important because it allows a society to combine freedom, justice, and a thriving economic order.”

When government officials elect to end up as “masters of society”, one of the main acts to attain such goals is to deliberately trample upon with laws of the land to allow laws to work to their favor.

In short, despots legitimize their power grab by coercively instituting their own set of laws. The Philippines is no stranger to this as seen through former President Ferdinand Marcos’ proclamation 1081, ``Marcos ruled by military power through martial law, altered the 1935 Constitution of the Philippines in the subsequent year, made himself both Head of State as President and Head of Government as Prime Minister, manipulated elections and the political arena in the Philippines, and had his political party--Kilusang Bagong Lipunan (KBL) (English: New Society Movement) control the unicameral legislative branch of government called the "Batasang Pambansa". All these allowed Marcos to remain in power and to plunder.[2]”

And since the manipulation of laws tends to rearrange the political economic order according to the whims of those in power by restraining civil liberties and economic freedom, ergo, the benefits or privileges will be partial to those within the ambit of the administration.

Said differently instead of having resources distributed through the marketplace, resources will be allocated politically in accordance to the order of importance as seen by the authorities. Nevertheless when the concentration of power is left to a few to decide, then price signals will be distorted and that lobbying, favouritism, corruption and cronyism will be her common feature.

The Phony War Against The “Cockroaches”

So what has these to do with the current state of the markets?

Alot.

The emergence of proposed regulatory reforms by the Obama administration for Wall Street comes timely with the US SEC-Goldman Sachs brouhaha.

Aside from the noteworthy coincidence[3], the US markets appears to be validating our view by ignoring the impact of the US SEC-Goldman tiff (see figure 1).

Figure 1: Political Act Slowly Unraveling

In contrast to the camp that sees the Goldman controversy as an issue of fraud, by looking at the incentives that drives the actions of political authorities, we have argued otherwise[4].

Besides, it is not within our ambit to comment on juridical merits of any legal case and neither are those who claim that it is about ‘fraud’. Commenting on the legal aspects based on news accounts signifies nothing but “trial by publicity”.

If Goldman had been truly a “cockroach”, then there must be other cockroaches too from which the sudden apostasy of the Obama administration must mean a total “war on cockroaches”.

And true enough, we find that Goldman’s practice hasn’t been isolated but an industry practice especially among the TOO BIG TO FAIL institutions.

According to the New York Times[5], ``Many banks on Wall Street and in Europe were even bigger players in the types of complex investment deals that Goldman is now defending. Merrill Lynch was at the top of the heap, assembling $16.8 billion worth between 2005 and 2008, according to a new report by Credit Suisse.

``UBS put together $15.8 billion worth of similar products, according to the Credit Suisse estimates, while JPMorgan Chase and Citigroup each created more than $9 billion worth. Goldman Sachs was a comparatively small issuer, at $2.2 billion.”

Yet if one looks at the market, except for Goldman Sachs (GS), the SPDR Financial Select Sector (XLF) [where JP Morgan, Citigroup, Merrill and GS is 24.3% of index weighting] and the S&P Bank Index (BIX) has simply shrugged off any “contagion” against a so-called “war on cockroaches”.

Noticeably, the broad based US markets as shown by the S&P 500 (SPX), which includes the Dow Industrials, the Nasdaq and the mid cap Russell 2000 all went to a bullish rampage by breaking to the upside as of Friday’s close.

Oddly too that the so-called aggrieved party in the controversial case was also reported as practicing the same allegedly skulduggery employed by Goldman, this from John Carney[6],

``It was a piece of regulatory arbitrage: In essence, IKB was investing in complex mortgage bonds without having to set aside regulatory capital or report the increase in risky assets to its regulators or auditors.”

``In short order, Rhineland became one of the biggest buyers of the complex investment products puked out by the likes of Lippman at Deutsche Bank, JP Morgan Chase—and Goldman. One banker told Euroweek that IKB—through Rhineland and similar tactics—had become one of the five or six largest investors in Europe. Thus, Goldman found them a willing buyer for the junk piled into Abacus” (underscore mine)

Take note of the word: regulatory arbitrage.(as we will be using this later)

More Dirty Dancing Politics

As the days go by, more and more Goldman-Washington ties are being uncovered.

In contrast to common knowledge that the Democratic Party has been less affiliated with Wall Street, this is turning out to be untrue, according to the Politico, ``The Democratic Party is closer to corporate America — and to Wall Street in particular — than many Democrats would care to admit.” A chart from the New York Times can be seen here.

Moreover, we discovered that there are five former employees of Goldman currently employed in the Obama administration. This perhaps reveals the extent of connection between the two supposed rivals.

In addition, the timing of Friday’s government lawsuit likewise coincided with SEC’s report about its “failure to investigate alleged fraudster R. Allen Stanford”[7]. This may seem like an effort to possibly dampen media’s impact from regulatory failure by exposing a much bigger news. Apparently this succeeded.

And speaking of regulatory competence, one cannot help but guffaw at news reports where 33 SEC employees, including high ranking officials, spent much time during the crisis in porno browsing!

According to the NY Daily News[8], ``The shocking findings include Securities and Exchange Commission senior staffers using government computers to browse for booty and an accountant who tried to access the raunchy sites 16,000 times in one month.”

Perhaps, Madoff, Standford and Goldman people were trying to arbitrage falling markets with “porno” finance-whatever that means. This resonates clearly of the quality of the bureaucratic mindset.

Moreover, there have been pressures for Goldman to amicably settle with the SEC even if “they’re right on the merits of the case”[9].

And surprisingly, President Obama despite earlier reports to verbally assail Wall Street turned up with a conciliatory voice at a recent speech ``Ultimately, there is no dividing line between Main Street and Wall Street,” Obama said in his speech at Cooper Union, about two miles from the financial district. “We will rise or we will fall together as one nation.”[10]

We read a popular American blogger offer a bet against anyone who thinks Goldman will win the suit. Apparently this perspective is looking at the wrong issue.

Goldman can lose a case and still win the war. In the game of chess, this is called sacrifice or even queen sacrifice. Yet in a staged or scripted dispute, like in wrestling, one party’s loss is just a part of drama to fulfil other goals. A real life example of a staged battle is the US-Spanish “Battle of Manila”[11].

History As Guide To Future Actions

Let us put the issue in historical context.

Rightly or wrongly banks and financial institutions have been in the public “hot seat” from nearly time immemorial[12]. But in contrast to having reduced power from financial reforms, the banking system had even acquired more political clout in spite of these. The Federal Reserve was even stealthily hatched amidst scepticism over the banking industry.

Here is G. Edward Griffin’s speech[13], Author of The Creature from Jekyll Island, on the inception of the Federal Reserve (all bold highlights mine),

``Why not? why the secrecy? what's the big deal about a group of bankers getting together in private and talking about banking or even banking legislation. And the answer is provided by Vanderlip [Frank Vanderlip president of the National City Bank of New York] himself in the same article. He said: "If it were to be exposed publicly that our particular group had gotten together and written a banking bill, that bill would have no chance whatever of passage by Congress." Why not? Because the purpose of the bill was to break the grip of the money trust and it was written by the money trust. And had that fact been known at the get-go, we would never have had a Federal Reserve System because as Vanderlip said it would have had no chance of passage at all by Congress. So it was essential to keep that whole thing a secret as it has remained a secret even to this day. Not exactly a secret that you couldn't discover because anybody can go to the library and dig this out, but it is certainly not taught in textbooks. We don't know any of this in the official literature from the Federal Reserve System because that was like asking the fox to build the henhouse and install the security system.

``That was the reason for the secrecy at the meeting. Now we know something very important about the Federal Reserve that we didn't know before, but there's much more to it than that. Consider the composition of this group. Here we had the Morgans, the Rockefellers, Kuhn, Loeb & Company, the Rothschilds and the Warburgs. Anything strange about that mixture? These were competitors. These were the major competitors in the field of investment and banking in those days; these were the giants. Prior to this period they were beating their heads against each other, blood all over the battlefield fighting for dominance in the financial markets of the world. Not only in New York but London, Paris and everywhere. And here they are sitting around a table coming to an agreement of some kind. What's going on here? We need to ask a few questions.

``This is extremely significant because it happened precisely at that point in American history where business was undergoing a major and fundamental change in ideology. Prior to this point, American business had been operating under the principles of private enterprise--free enterprise competition is what made American great, what caused it to surpass all of the other nations of the world. Once we had achieved that pinnacle of performance, however, this was the point in history where the shift was going away from competition toward monopoly. This has been described in many textbooks as the dawning of the era of the cartel and this was what was happening. For the fifteen year period prior to the meeting on Jekyll Island, the very investment groups about which we are speaking were coming together more and more and engaging in joint ventures rather than competing with each other. The meeting on Jekyll Island was merely the culmination of that trend where they came together completely and decided not to compete--they formed a cartel.”

In other words, the trend towards consolidation of the industry via “financial reforms” has empowered more cartelization than less. And today’s proposed financial reform bill will enhance and not reduce such relationship in contrast to opinion of the reform advocates.

John Paulson And The Survivorship Bias

I’d like to show the relevance of hedge fund manager John Paulson’s reputation during the latest boom-bust cycle (see figure 2).

Figure 2: Google Trend/Wall Street Journal: John Paulson’s Popularity

As we have earlier argued, the SEC-Goldman dispute is a fait accompli argument (Wall Street seems to agree[14]).

That’s because Mr. Paulson, among the 12,400 hedge funds as reported by Hedgefund.net during the 3^rd quarter of 2007, only shot to fame in early 2008 (left window) after profits in his fund skyrocketed (in mid 2007) which left the field biting his dust (right window).

In most of 2007, John Paulson, like Manny Pacquiao in the early 90s, was relatively an unknown figure (Mr. Paulson has hardly been searched by anyone)! This means that counterparties when appraised of Mr. Paulson’s participation in early 2007 would have simply ignored him as he was just one among the many “mediocre” aspiring hedge fund managers.

This also reveals that many people tend to read and value information based on today’s account and not during the time when the controversial transactions was developed. This cognitive error is known as the survivorship bias, or the ``the logical error of concentrating on the people or things that "survived" some process and ignoring those that didn't[15].”

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[1] White, Lawrence Avoiding and Resolving Financial Crises: The Rule of Law or The Rule of Central Bankers?

[2] Wikipedia.org, Proclamation No. 1081

[3] Norris, Floyd, Fortunate Timing Seals a Deal

[4] See Why The US SEC-Goldman Sachs Hoopla Is Likely A Charade

[5] New York Times, Questions for Banks That Put Together Deals

[6] Carney John, Goldman’s Dirty Customers, The Daily Beast

[7] Wall Street Journal, The SEC's Impeccable Timing The Goldman suit helped to hide the IG report on the Stanford debacle.

[8] NY Daily News; While economy crumbled, top financial watchdogs at SEC surfed for porn on Internet: memo

[9] Bloomberg, Goldman Sachs Should Cut Losses in SEC Standoff, Lawyers Say

[10] Bloomberg, Obama Challenges Financial Industry to Join Regulatory Overhaul

[11] Wikipedia.org, The Battle of Manila (1898)

[12]see Quote of the Day on Wall Street: After Nearly A Century, Hardly Any Change

[13] Bigeye.com; A Talk by G. Edward Griffin Author of The Creature from Jekyll Island

[14] See SEC-Goldman Sachs Row: The Rising Populist Tide Against Big Government

[15] Wikipedia.org, survivorship bias

Chart of the Day: John Paulson's Gold Holdings Bigger Than Reserves Held By Many Central Banks

The interesting chart below from The Reformed Broker is an estimate of Hedge Fund manager John Paulson's gold holdings which could be larger than gold reserves held by many central banks.

Read the rest here

Our Mises Moment Answers Mainstream’s Conundrum of Market-Fundamental Disconnect

``But on the other hand inflation cannot continue indefinitely. As soon as the public realizes that the government does not intend to stop inflation, that the quantity of money will continue to increase with no end in sight, and that consequently the money prices of all goods and services will continue to soar with no possibility of stopping them, everybody will tend to buy as much as possible and to keep his ready cash at a minimum. The keeping of cash under such conditions involves not only the costs usually called interest, but also considerable losses due to the decrease in the money’s purchasing power. The advantages of holding cash must be bought at sacrifices which appear so high that everybody restricts more and more his ready cash. During the great inflations of World War I, this development was termed “a flight to commodities” and the “crack-up boom.” The monetary system is then bound to collapse; a panic ensues; it ends in a complete devaluation of money Barter is substituted or a new kind of money is resorted to. Examples are the Continental Currency in 1781, the French Assignats in 1796, and the German Mark in 1923.”-Ludwig von Mises, Interventionism: An Economic Analysis, Inflation and Credit Expansion

The mainstream is obviously very perplexed.

They can’t seem to figure what’s going on with market prices that can’t seem to match “fundamentals”.

Take this as an example. ``With oil inventories high and demand down year on year, yet prices surging, "fundamentalists" are puzzled” observes Liam Denning of the Wall street Journal.

Skeptical of the fundamental –market disconnect, the unconvinced Mr. Denning concludes his article with, `` Ultimately, however, the danger for China, and commodities bulls, is that Beijing's efforts fail to fully offset the harsh realities afflicting the world economy as a whole.” (bold highlight mine)

Figure 6: Wall Street Journal: China Watch The Body Language

Many have attributed the rise in oil or iron ore prices primarily to China see figure 6. But the unpleasant fact is that this isn’t just about oil or iron ore or China.

It’s about policy induced inflation whose growing influences are being ventilated on markets and which has been percolating and distorting the real economy.

And the primary mechanism for such release valve has been the US dollar.

As we wrote in last week’s Mainstream Denials And The Greenshoots of Inflation, a broadening category of the commodities have been experiencing price gains. So it’s not only oil or iron ore or gold but a whole range of commodities which includes food prices.

In addition, it isn’t just China or Sovereign Wealth Funds, but a broader spectrum of participants have joined the bandwagon as buyers of commodities. As we noted in Hedge Funds Pile Into Commodities, hedge funds have been growing exposure to commodities.

Even life insurance outfit as Northwestern Mutual Life Insurance Co. ``has bought gold for the first time the company’s 152-year history to hedge against further asset declines” (Bloomberg) could be signs of possible major reconfigurations of investments flows towards commodities.

My recent post which surprisingly turned out with a high number of hits, deals with Hedge Fund Ace John Paulson who made an amazing allotment of 46% of his portfolio into gold and gold related investments [see Hedge Fund Wizard John Paulson Loads Up On Gold]! He didn’t say why, but the message was loud and clear! What a statement.

Aside, Bond King and regulatory arbitrageur Bill Gross recently wrote to warn the public to diversify away from US dollar before ``central banks and sovereign wealth funds ultimately do the same amid concern about surging deficits” (Bloomberg)

He thinks that the US has reached a “point of no return”, again from the same Bloomberg article, ``“I think he’ll fail at pulling a balanced rabbit out of a hat,” Gross said from Pimco’s headquarters in Newport Beach, California. “They are talking about -- once the economy in the U.S. renormalizes -- the move back toward balance or much less of a deficit. I suspect that will be hard to do.”

Moreover, a public gold fever (not swine flu) appears to have infected ordinary Chinese sparked by the revelation of massive gold accumulations by the China’s government. According to the China Daily, ``Inspired by the increase in the government gold reserves, the more savvy investors are also buying shares of Chinese gold producers on the Shanghai Stock Exchange and the smaller Shenzhen Stock Exchange.”

Furthermore, drug trades have reportedly been reducing transactions based in the US dollar and could have possibly been replaced by trades in gold bullion (telegraph).

This Dollar based concerns won’t be complete without Russia’s continued outspoken campaign to replace the US dollar as the world’s international reserve currency, which apparently not only got support from major Emerging Markets as China and Brazil, but even the IMF has reportedly jumped on the bandwagon saying that replacing the US dollar is possible.

This from Bloomberg, ``The IMF’s so-called special drawing rights could be used as the basis for a new currency, First Deputy Managing Director John Lipsky told a panel discussing reserve currencies at the St. Petersburg International Economic Forum today.

``“There are many, many attractions in the long run to such an outcome,” Lipsky told a panel discussing reserve currencies at the St. Petersburg International Economic Forum today. “But this is not a quick, short or easy decision,” he said, adding that it would be “quite revolutionary.” (bold highlight mine)

And worst of all, US dollar as a safehaven status has been scoffed at by Chinese students! Incredible.

This from Reuters, ``"Chinese assets are very safe," Geithner said in response to a question after a speech at Peking University, where he studied Chinese as a student in the 1980s.

``His answer drew loud laughter from his student audience, reflecting skepticism in China about the wisdom of a developing country accumulating a vast stockpile of foreign reserves instead of spending the money to raise living standards at home.” (bold highlight mine)

It’s obviously a question of what degree of the Chinese population has been represented by the adverse reactions of Chinese students on Mr. Geithner’s statement. If these students account for a majority of China’s sentiment, then it is quite obvious that the public will likely be shunning the US dollar as mode of payment or as transactional currency or as medium of exchange (sooner than later) despite the Chinese policymakers’ avowed insistence to buy US dollar assets (but on a short term basis) which is no less than politically premised, as previously discussed here and here.

All these account for votes of displeasure over policies governing the US as reflected on its currency the US dollar, which mainstream can’t seem to comprehend.

As I wrote in my March outlook Expect A Different Inflationary Environment (emphasis added), ``This leads us to surmise that most of global stock markets (especially EM economies which we expect to rise faster in relative terms) could rise to absorb the collective inflationary actions led by the US Federal Reserve but on a much divergent scale. Currency destruction measures will also possibly support OECD prices but could underperform, as the onus from the tug-of-war will probably remain as a hefty drag in their financial markets.

``And this also suggests that commodity prices will also likely rise faster (although not equally in relative terms) than the previous experience which would eventually filter into consumer prices.

``In other words, the evolution of the opening up of about 3 billion people into the global markets, a more integrated global economy and the increased sophistication of the financial markets have successfully imbued the inflationary actions by central banks over the past few years. But this isn’t going to be the case this time around-unless economies which have low leverage level (mostly in the EM economies) will manage to sop up much of the slack.”

So far everything that we have said has turned out to be quite accurate.

But we seem to be transitioning to the next level.

This brings us to the question why the public seems to be gravitating towards commodities?

Ludwig von Mises has an explicit answer which I unearthed in Stabilization of the Monetary Unit? From the Viewpoint of Theory,

``If people are buying unnecessary commodities, or at least commodities not needed at the moment, because they do not want to hold on to their paper notes, then the process which forces the notes out of use as a generally acceptable medium of exchange has already begun. This is the beginning of the “demonetization” of the notes. The panicky quality inherent in the operation must speed up the process. It may be possible to calm the excited masses once, twice, perhaps even three or four times. However, matters must finally come to an end. Then there is no going back. Once the depreciation makes such rapid strides that sellers are fearful of suffering heavy losses, even if they buy again with the greatest possible speed, there is no longer any chance of rescuing the currency. In every country in which inflation has proceeded at a rapid pace, it has been discovered that the depreciation of the money has eventually proceeded faster than the increase in its quantity.”

So let us break these down into stages:

First, the loss of the currency’s purchasing power.

Second, is the loss of a currency’s function as medium of exchange or the “demonetization process”.

Third, is the accelerating feedback loop between the first two stages which brings upon the irreversibility of the process and

Finally, the total collapse of the currency.

So there you have it. The public’s increasing exposure to commodities is fundamentally a question of the viability of the present monetary standards.

So far the political path and market responses have been behaving exactly as described by Prof. von Mises.

Hence, I call this the Mises Moment.

Hedge Fund Wizard John Paulson Loads Up On Gold

Interesting trivia on Hedge fund manager John Paulson.

According to Casey Research,

``Not familiar with Paulson & Company, or founder John Paulson? You should be, and here’s why:

Picture from Businessinsider.com

• Paulson’s bet on the subprime mortgage debacle earned $3.7 billion in 2007.

• The company made an estimated £606 million profit selling short British bank stocks in September 2008.

• John Paulson ranked #2 on Alpha’s Highest-Earning Hedge Fund Managers of 2008.

• Two of Paulson & Co.’s funds ranked #1 and #4 on Barron’s Top 100 Hedge Funds 2009 list."

So what has the top notch been loading up lately?


The answer is gold and gold mining stocks.

Again Casey Research, ``The privately owned hedge fund sponsor Paulson & Co. added over $3.7 billion in new gold positions during the first quarter of 2009, increasing its total investment to $4.3 billion. About 46% of the equity portfolio is now allocated towards gold and gold stocks."

Why?

Telegraph's Ambrose Pritchard thinks this has been due to reflation.

``The world's top hedge fund manager John Paulson has built a gold position of at least $5.5bn, the biggest such move since George Soros and Sir James Goldsmith bet on Newmont Mining in 1993...

``Paulson & Co has bought $2.9bn in SPDR Gold Trust, the biggest of the gold exchange traded funds (ETFs), which now holds 1106 tonnes − three times the Brown-gutted reserves of the United Kingdom.

``Mr Paulson has also built up a $2.3bn holding of Anglo Ashanti, Goldfields, Kinross Gold, and Market Vectors Gold Miners. The fact that he is launching a "Paulson Real Estate Recovery Fund", reversing the bet against sub-prime securities that made him rich, tells us all we need to know about his thinking. This is a liquidity-reflation play."

On the contrary having 46% of one's portfolio in gold suggests that it isn't just a liquidity reflation play, since reflation suggests of an economic recovery which should translate to a more diversified portfolio.

Instead it does seem to look more like a "super" or "hyper" inflation play.