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

Why The US SEC-Goldman Sachs Hoopla Is Likely A Charade

``In discussing the situation as it developed under the expansionist pressure on trade created by years of cheap interest rates policy, one must be fully aware of the fact that the termination of this policy will make visible the havoc it has spread. The incorrigible inflationists will cry out against alleged deflation and will advertise again their patent medicine, inflation, rebaptising it re-deflation. What generates the evils is the expansionist policy. Its termination only makes the evils visible. This termination must at any rate come sooner or later, and the later it comes, the more severe are the damages which the artificial boom has caused. As things are now, after a long period of artificially low interest rates, the question is not how to avoid the hardships of the process of recovery altogether, but how to reduce them to a minimum. If one does not terminate the expansionist policy in time by a return to balanced budgets, by abstaining from government borrowing from the commercial banks and by letting the market determine the height of interest rates, one chooses the German way of 1923.-Ludwig von Mises, The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money

Goldman Sachs, one of the top ‘too big to fail’ pillars of Wall Street have recently been sued by the US Security and Exchange Commission for allegedly intermediating mortgage securities that allowed several investors to ‘short-sale’ the housing market and for the buyers of the said securities a market that supposedly ``was secretly intended to fail”[1].

In my view, this is a bizarre case from a fait accompli standpoint.

From the news reports, unless there are signs of blatant manipulation or misrepresentations or procedural deviations or deliberate indiscretions, Goldman Sachs only acted as “market maker” or a bridge for parties that intended to bet on the opposite fence of the housing industry. This means that if there was a willing buyer and a willing seller, then obviously one of the two parties was bound to be wrong. Ergo, if the property boom had continued until the present and where the buyers benefited, would the SEC have sued the Goldman Sachs for the same reasons with respect to the losses incurred by the seller, particularly led by the popular hedge fund manager John Paulson, who allegedly orchestrated the creation of the controversial instruments?

Outside the technicalities of the suit, we can only sense political maneuvering out of the SEC-Goldman Sachs row.

Unless one thinks that regulators are divine interpreters and hallowed dispensers of the law, laws can be (or are many times) used as instruments to extract political goals, for the benefit of the regulator/s and or the political leadership and or some vested interests group in cahoots with the regulator/s.

Or unless President Obama is recast into a Thomas Jefferson, which means the next strike will be against the US Federal Reserve, only then, upon this new setting should we rethink of a vital shakeup in how things will be done. But this would seem hardly the case.

This brings us to the possible reasons why the Obama administration has resorted to such actions and if the attack on Wall Street will take the sails away from today’s inflation based markets.

It’s All About Politics

It’s public knowledge that following the forced passage of the highly unpopular Obamacare or President Obama’s signature health reform program, Obama’s job approval popularity rating has plunged to its lowest level[2], where the odds for his reelection is now in jeopardy[3], and worst, in a hypothetical match-up between libertarian champion Texas Congressman Ron Paul and President Obama, the odds appear to be dead-even[4]!

And if we are to interpret actions of politicians as a transfer of the “rational actor model of economic theory to the realm of politics”[5], then this only implies that as human being with a career to contemplate on, President Obama’s actions as seen through the SEC are merely designed as means to extend his tenure as well as expand the scope of his power.

As this LA Times article rightly argues, ``White House officials can't bank on a sudden surge in the economy coming to their rescue for the midterm elections. So they are hoping they can redirect voter anger by accusing the GOP of coddling large banks.[6]”

In short, it’s all about politics.

Moreover, it also seems ridiculous to perceive of a sustained path of attack, considering that Goldman Sachs has been more than a political ally to the Democratic Party. In fact the company has constantly played the role of key financier of the Democratic Party (Figure 4)

Figure 4: Opensecrets.org: Goldman Sach’s As Key Political Financier Of America’s Ruling Class

Goldman Sachs had even been the second largest contributor to Obama’s 2008 Presidential campaign[7]!

In addition, where action speaks louder than words, Goldman Sachs has been a key beneficiary from the US government’s bailout to the tune of $10 billion from the US Treasury’s Troubled Asset Relief Program (TARP)[8] which the company had fully redeemed in mid 2009[9].

More to this is that Goldman Sachs had also been a key beneficiary of the AIG bailout from which the company also recovered $12.9 billion out of the $90 billion of taxpayer funds earmarked for payment to AIG counterparties[10].

And these rescues merely demonstrate that as part of the “Too Big Too Fail” cabal, Goldman Sachs evidently has been operating under the protective umbrella of the US Federal Reserve.

As Murray N. Rothbard defines the principal roles of the Central Bank[11],

``The Central Bank has always had two major roles: (1) to help finance the government's deficit; and (2) to cartelize the private commercial banks in the country, so as to help remove the two great market limits on their expansion of credit, on their propensity to counterfeit: a possible loss of confidence leading to bank runs; and the loss of reserves should any one bank expand its own credit. For cartels on the market, even if they are to each firm's advantage, are very difficult to sustain unless government enforces the cartel. In the area of fractional-reserve banking, the Central Bank can assist cartelization by removing or alleviating these two basic free-market limits on banks' inflationary expansion credit.

So would President Obama afford a “possible loss of confidence leading to bank runs; and the loss of reserves should any one bank expand its own credit” from one of its major cartel member banks? The most likely answer is a BIG NO!

My guess is that the assault on Goldman Sachs seems likely a sign or an act of desperation, hence possibly miscalculated on the unintended impact on the markets via Friday’s selloff. Nevertheless, as noted above the markets appear to be extremely overbought and had been readily looking for an excuse or a trigger to retrench.

Yet even if under the scenario where President Obama may be politically desperate to shore up his image, a continued legal barrage on Wall Street that would send markets cascading lower betrays the populist ideals of a rising markets=rising confidence=economic growth, which is unlikely to achieve the intended goals.

It’s a silly thing for the perma bears to naively believe and argue that President Obama is on a warpath against the forces which brought him to power and against the oligarchy that has a strategic stranglehold on key US institutions and the US political economy.

Fighting Wall Street is essentially waging a proxy battle against the US Federal Reserve! And fighting the Fed is a proxy battle for Congressman Ron Paul, who not only wants an audit[12] of the Federal Reserve but also has been asking for its abolishment[13] (Yes, I am in Ron Paul’s camp!).

And this is why President Obama is shown to be quite in a tight fix where his actions could be read as publicity stunt or political vaudeville or an outright charade that is meant to be eventually unmasked.

The worst part is for the dispute to set a precedent and generate incentives from the losers of 2008 to lodge similar legal claims not only against Goldman Sachs but on different institutions. This will be tort on a massive scale, the unintended consequence.

Legal Actions As Counterbalance To Commodity Market Whistleblowers?

Yet there might be another angle to consider. It’s a conspiracy theory though.

Over the past weeks, there had been two accounts of whisteblowing[14] on the silver markets, where the precious metals have allegedly been under a price suppression scheme or have long been manipulated so as not to reflect on its market value, by a cabal of major institutions such as JP Morgan.

Since the exposé at the end of March, gold and silver has been on the upside (see figure 5)

Figure 5: Stockcharts.com/reformedbroker.com[15]: Counterattack on Whistle Blowers?

Could it be that the surge in gold and silver prices has put tremendous pressure on the precious metal naked shorts of major financial institutions that they have asked the US government to intervene by declaring an indirect war against the whistle blowers via the SEC-Goldman Sachs tiff as a subterfuge?

Remember the key personality involved in the political squabble is John Paulson, who currently owns more gold in tonnes compared to Romania, Poland, Thailand, Australia and other nations (based on Oct 2009).

Although Mr. Paulson isn’t part of the lawsuit, his involvement could be designed to put pressure on his investors so as to force him to liquidate on his gold holdings, and thereby ease the pressure on the colossal exposure of the clique of financial institutions on their “short” positions.

Unless the government can pin Mr. Paulson down to be part of the wrongdoers in the proceedings, this precious market “Pearl Harbor” isn’t likely to be sustained.

At the end of the day, whether it is an attempt to spruce up Mr. Obama’s image or an attempt to contain the sharp upside movements of the precious metal market, all these, nevertheless, reeks of dastardly politics in play.

The worst part would be to see the unintended consequences from such political nonsense morph into full scale disaster.

Revaluation of Asian Currencies and Market Outlook

So while we see financial markets, perhaps, may be looking for an excuse for a recess (anywhere 5-20% on the downside or a consolidation instead of a decline), it is not likely a crash in the making.

Politicians and bureaucrats, who watch after their career and status, more than we acknowledge, aren’t likely to roil the markets that would only defeat their goals.

Figure 6: IMF Global Financial Stability Report: Global Liquidity and Interest Rates

Under such conditions, we see global markets as likely to continually respond to the massive inflationism deployed by global authorities. And there could be rotational activities in the global asset markets instead of a general market decline.

With the recent revaluation of Singapore currency[16], we see this as a further positive force and a cushion on the markets as other Asian currencies will be under pressure to revalue and this applies to China too. Along with the Singapore Dollar, Philippine Peso surged 1.2% this week to 44.385 against the US dollar.

Though a global financial market may stem this dynamic out of the corrective pressures, any reversal would prove to be temporary.

So yes, we expect the markets to possibly look for opportunities to rest. But no, we don’t expect market to crash, not at this stage of the bubble cycle yet.

Finally, the Philippine Phisix nearly shares the same record with the US markets, of having gains in 6 out of 7 weeks, which only proves that the Philippines has not moved in an isolated manner, but rather in sync with region's markets, if not the worlds' markets. This also goes to show that Philippine elections have been eclipsed by global forces.

So like the rest of the markets, until we can establish self determinism, we see global dynamics to prevail due to the linkages of inflationism.

In my view any correction should pose as a buying opportunity as we are still in the sweetspot of inflationism.

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[1] New York Times, S.E.C. Accuses Goldman of Fraud in Housing Deal

[2] Gallup.com; April 12,2010 Obama Weekly Approval at 47%, Lowest Yet by One Point

[3] Gallup.com April 16 Voters Currently Divided on Second Obama Term

[4] Rasmussen Reports: April 14, 2010; Election 2012: Barack Obama 42%, Ron Paul 41%

[5] Shughart, William F. II, Public Choice

[6] Nicolas, Peter; Goldman Sachs case could help Obama shift voter anger, Los Angeles Times

[7] Opensecrets.org; Top Contributors, Barack Obama

[8] Wikipedia.org, Goldman Sachs

[9] Reuters.com, Goldman Sachs redeems TARP warrants for $1.1 billion

[10] Reuters.com, Goldman's share of AIG bailout money draws fire

[11] Rothbard, Murray N. The Case Against The Fed p. 58

[12] RonPaul.com Audit the Federal Reserve: HR 1207 and S 604

[13] Paul, Ron; End The Fed

[14] Durden, Tyler; Exclusive: Second Whistleblower Emerges - A Deep Insider's Walkthru To Silver Market Manipulation, Zerohedge.com and

Durden, Tyler; Whistleblower Exposes JP Morgan's Silver Manipulation Scheme, Zerohedge.com

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

[16] Businessweek, Singapore’s Revaluation May Spur China, South Korea, Bloomberg

The Return Of The Financial Industry

The financial industry has been returning to its old status-with a vengeance.



According to Bespoke Invest, ``The weighting of the Financial sector in the S&P 500 has made a huge move since the March lows. After being the biggest sector of the market for six years in a row, the weight of the Financials dropped all the way down to 8.9% (6th place) on March 9th, 2009. After the recent rally we've had, the Finanial sector has nearly doubled its weight to 15%, and it now ranks 2nd behind the Technology sector (18.8%). Technology, Financials, Industrials, Consumer Discretionary, and Materials are sectors that have gained market share during the bull market, while the other five sectors have lost share. The Financial sector has gained the most, while Health Care has lost the most (16.1% to 12.5%)." (all bold highlights mine)

Additional comments:

Financial industry epitomized the boom bust cycle six years prior to this rally

From leader to laggard to next to the leader (anew)- seem to signify the same dynamic of the past-another boom bust cycle with a cosmetically altered appearance.

US government has been massively backstopping the Financial Industry relative to the other industries

The resurgent financial industry accounts for as the impact from the massive reflationary measures engaged by policymakers

The implicit guarantees via the "Bernanke Put" and the "Too Big To Fail Syndrome" places a premium to financial industry, where investors (or even rescued institutions) have been stampeding into them.

David Einhorn: The Inevitable Ramifications Of Short-term Popularity Policies Over Solvency

Greenlight Capital's David Einhorn recently delivered a discerning speech at Value Investing Congress.

Here are some noteworthy quotes:

-Two basic problems in how we have designed our government.

The first is that officials favor policies with short-term impact over those in our long-term interest because they need to be popular while they are in office and they want to be reelected.

The second weakness in our government is “concentrated benefit versus diffuse harm” also known as the problem of special interests. Decision makers help small groups who care about narrow issues and whose “special interests” invest substantial resources to be better heard through lobbying, public relations and campaign support.

-With the ensuing government bailout, we have now institutionalized the idea of too-big-to-fail and insulated investors from risk.

-The lesson of Lehman should not be that the government should have prevented its failure. The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system.

-The bailouts have installed a great deal of moral hazard, which in the absence of radical change will be reinforced and thereby grant every big institution a permanent “implicit” government backstop. This creates an enormous ongoing subsidy for the too-big-to-fails, as well as making it much harder for the non-too-big-to-fails to compete. In effect, we all continue to subsidize the big banks even though we keep hearing the worst of the crisis is behind us.

-In addition, the now larger too-big-to-fails are beginning to take advantage of developing oligopolies. Even as the government spends trillions to subsidize mortgage rates, the resulting discount is not being passed to homeowners but is being kept by mortgage originators who are earning record profits per mortgage originated.

-CDS are also highly anti-social. Bondholders who also hold CDS make a bigger return when the issuing firms fail. As a result, holders of so-called “basis packages” – a bond and a CDS – have an incentive to use their position as bondholders to force bankruptcy triggering payment on their CDS, rather than negotiate traditional out of court restructurings or covenant amendments with troubled creditors.

-Over the last couple of years we have adopted a policy of private profits and socialized risks. We are transferring many private obligations onto the national ledger.

-As we sit here today, the Federal Reserve is propping up the bond market, buying long-dated assets with printed money. It cannot turn around and sell what it has just bought. There is a basic rule of liquidity. It isn’t the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because of both the size of the position and the signal my selling would send to the market.

For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up.

-When a country cannot reduce its ratio of debt to GDP over any time horizon, it means it can only refinance, but can never repay its debts.

-I believe there is a real possibility that the collapse of any of the major currencies could have a similar domino effect on re-assessing the credit risk of the other fiat currencies run by countries with structural deficits and large, unfunded commitments to aging populations.

-I believe that the conventional view that government bonds should be "risk free" and tied to nominal GDP is at risk of changing. Periodically, high quality corporate bonds have traded at lower yields than sovereign debt. That could happen again.

-And, of course, these structural risks are exacerbated by the continued presence of credit rating agencies that inspire false confidence with potentially catastrophic results by over-rating the sovereign debt of the largest countries. There is no reason to believe that the rating agencies will do a better job on sovereign risk than they have done on corporate or structured finance risks.

-Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible.

-When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.

-Events can move from the impossible to the inevitable without ever stopping at the probable.

The complete transcript (all bold emphasis and underscores mine)

"One of the nice aspects of trying to solve investment puzzles is recognizing that even though I am not always going to be right, I don’t have to be. Decent portfolio management allows for some bad luck and some bad decisions. When something does go wrong, I like to think about the bad decisions and learn from them so that hopefully I don’t repeat the same mistakes

This leaves me plenty of room to make fresh mistakes going forward. I’d like to start today by reviewing a bad decision I made and share with you what I’ve learned from that error and how I am attempting to apply the lessons to improve our funds’ prospects.

At the May 2005 Ira Sohn Investment Research Conference in New York, I recommended MDC Holdings, a homebuilder, at $67 per share. Two months later MDC reached $89 a share, a nice quick return if you timed your sale perfectly. Then the stock collapsed with the rest of the sector. Some of my MDC analysis was correct: it was less risky than its peers and would hold-up better in a down cycle because it had less leverage and held less land. But this just meant that almost half a decade later, anyone who listened to me would have lost about forty percent of his investment, instead of the seventy percent that the homebuilding sector lost.

I want to revisit this because the loss was not bad luck; it was bad analysis. I down played the importance of what was then an ongoing housing bubble. On the very same day, at the very same conference, a more experienced and wiser investor, Stanley Druckenmiller, explained in gory detail the big picture problem the country faced from a growing housing bubble fueled by a growing debt bubble.

At the time, I wondered whether even if he were correct, would it be possible to convert such big picture macro-thinking into successful portfolio management? I thought this was particularly tricky since getting both the timing of big macro changes as well as the market’s recognition of them correct has proven at best a difficult proposition.

Smart investors had been complaining about the housing bubble since at least 2001. I ignored Stan, rationalizing that even if he were right, there was no way to know when he would be right. This was an expensive error.

The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself to be a “bottom up” investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the longshort exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time. In a few minutes, I will tell you what Greenlight has done along these lines.

But first, I’d like to explain what I see as the macro risks we face. To do that I need to digress into some political science. Please humor me since my mom and dad spent a lot of money so I could be a government major, the usefulness of which has not been apparent for some time.

Winston Churchill said that, “Democracy is the worst form of government except for all the others that have been tried from time to time.” As I see it, there are two basic problems in how we have designed our government.

The first is that officials favor policies with short-term impact over those in our long-term interest because they need to be popular while they are in office and they want to be reelected. In recent times, opinion tracking polls, the immediate reactions of focus groups, the 24/7 news cycle, the constant campaign, and the moment-to-moment obsession with the Dow Jones Industrial Average have magnified the political pressures to favor short-term solutions.

Earlier this year, the political topic du jour was to debate whether the stimulus was working, before it had even been spent.

Paul Volcker was an unusual public official because he was willing to make unpopular decisions in the early ’80s and was disliked at the time. History, though, judges him kindly for the era of prosperity that followed.

Presently, Ben Bernanke and Tim Geithner have become the quintessential short-term decision makers. They explicitly “do whatever it takes” to “solve one problem at a time” and deal with the unintended consequences later. It is too soon for history to evaluate their work, because there hasn’t been time for the unintended consequences of the “do whatever it takes” decision-making to materialize.

The second weakness in our government is “concentrated benefit versus diffuse harm” also known as the problem of special interests. Decision makers help small groups who care about narrow issues and whose “special interests” invest substantial resources to be better heard through lobbying, public relations and campaign support. The special interests benefit while the associated costs and consequences are spread broadly through the rest of the population. With individuals bearing a comparatively small extra burden, they are less motivated or able to fight in Washington.

In the context of the recent economic crisis, a highly motivated and organized banking lobby has demonstrated enormous influence. Bankers advance ideas like, “without banks, we would have no economy.” Of course, there was a public interest in protecting the guts of the system, but the ATMs could have continued working, even with forced debt-to-equity conversions that would not have required any public funds. Instead, our leaders responded by handing over hundreds of billions of taxpayer dollars to protect the speculative investments of bank shareholders and creditors. This has been particularly remarkable, considering that most agree that these same banks had an enormous role in creating this mess which has thrown millions out of their homes and jobs.

Like teenagers with their parents away, financial institutions threw a wild party that eventually tore-up the neighborhood. With their charge arrested and put in jail to detoxify, the supervisors were faced with a decision: Do we let the party goers learn a tough lesson or do we bail them out? Different parents with different philosophies might come to different decisions on this point. As you know our regulators went the bail-out route.

But then the question becomes, once you bail them out, what do you do to discipline the misbehavior? Our authorities have taken the response that kids will be kids. “What? You drank beer and then vodka. Are you kidding? Didn’t I teach you, beer before liquor, never sicker, liquor before beer, in the clear! Now, get back out there and have a good time.” And for the last few months we have seen the beginning of another party, which plays nicely toward government preferences for short-term favorable news-flow while satisfying the banking special interest. It has not done much to repair the damage to the neighborhood.

And the neighbors are angry, because at some level, Americans understand that the Washington-Wall Street relationship has rewarded the least deserving people and institutions at the expense of the prudent. They don’t know the particulars or how to argue against the “without banks, we have no economy” demagogues. So, they fight healthcare reform, where they have enough personal experience to equip them to argue with Congressmen at town hall meetings.

As I see it, the revolt over healthcare isn’t really about healthcare, but represents a broader upset at Washington. The lack of trust over the inability to deal seriously with the party goers feeds the lack of trust over healthcare.

On the anniversary of Lehman’s failure, President Obama gave a terrific speech. He said, “Those on Wall Street cannot resume taking risks without regard for the consequences, and expect that next time, American taxpayers will be there to break the fall.” Later he advocated an end of “too big to fail.” Then he added, “For a market to function, those who invest and lend in that market must believe that their money is actually at risk.” These are good points that he should run by his policy team, because Secretary Geithner’s reform proposal does exactly the opposite.

The financial reform on the table is analogous to our response to airline terrorism by frisking grandma and taking away everyone’s shampoo, in that it gives the appearance of officially “doing something” and adds to our bureaucracy without really making anything safer.

With the ensuing government bailout, we have now institutionalized the idea of too-big-to-fail and insulated investors from risk. The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to make sure that no institution is too big or inter-connected to fail. The test ought to be that no institution should ever be of individual importance such that if we were faced with its demise the government would be forced to intervene. The real solution is to break up anything that fails that test.

The lesson of Lehman should not be that the government should have prevented its failure. The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie, Freddie, Bear Stearns, Citigroup and a couple dozen others.

Twenty-five years ago the government dismantled AT&T. Its break-up set forth decades of unbelievable progress in that industry. We can do that again here in the financial sector and we would achieve very positive social benefit with no cost that anyone can seem to explain.

The proposed reform takes us in the polar opposite direction. The cop-out response from Washington is that it isn’t “practical.” Our leaders are so influenced by the banking special interests that they would rather declare it “impractical” than roll up their sleeves and figure out how to get the job done.

The bailouts have installed a great deal of moral hazard, which in the absence of radical change will be reinforced and thereby grant every big institution a permanent “implicit” government backstop. This creates an enormous ongoing subsidy for the too-big-to-fails, as well as making it much harder for the non-too-big-to-fails to compete. In effect, we all continue to subsidize the big banks even though we keep hearing the worst of the crisis is behind us.

In addition, the now larger too-big-to-fails are beginning to take advantage of developing oligopolies. Even as the government spends trillions to subsidize mortgage rates, the resulting discount is not being passed to homeowners but is being kept by mortgage originators who are earning record profits per mortgage originated. Recently, Goldman upgraded Wells Fargo partly based on its ability to earn long-term oligopolistic mortgage origination spreads.

The proposed reform does not deal with the serious risks that the recent crisis exposed. Credit Default Swaps, which create large, correlated and asymmetric risks, scared the authorities into spending hundreds of billions of taxpayer money to prevent the speculators who made bad bets from having to pay.

CDS are also highly anti-social. Bondholders who also hold CDS make a bigger return when the issuing firms fail. As a result, holders of so-called “basis packages” – a bond and a CDS – have an incentive to use their position as bondholders to force bankruptcy triggering payment on their CDS, rather than negotiate traditional out of court restructurings or covenant amendments with troubled creditors. Press accounts have noted that this dynamic has contributed to the recent bankruptcies of Abitibi-Bowater, General Growth Properties, Six Flags and even General Motors. They are a pending problem in CIT’s efforts to avoid bankruptcy.

The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialized risks by moving the counter-party risk from the private sector to a newly created too-big-to-fail entity. I think that trying to make safer CDS is like trying to make safer asbestos. How many real businesses have to fail before policy makers decide to simply ban them?

Similarly, the money markets were exposed as creating systemic risk during the crisis. Apparently, investors in these pools of lending assets that carry no reserve for loss expect to be shielded from losing money while earning a higher return than bank deposits or T-bills.

Mr. Bernanke decided they needed to be bailed out to save the system. It is hard to imagine why this structure shouldn’t be fixed, either by adding them to the FDIC insurance program and subjecting them to bank regulation, or at least forcing them to stop using $1 net-asset values, which gives their customers the impression that they can’t fall in value.

The most constructive aspect of the Geithner reform plan is to separate banking from commerce. This would have the effect of forcing industrial companies to divest big finance subsidiaries, which would have to be regulated as banks. During the bubble, companies like GMAC, AIG Financial Products and GE Capital, with cheap funding supported by inaccurate credit ratings, took enormous unregulated risks. When the crisis hit, GMAC and AIG needed huge federal bailouts. The Federal Reserve set up the Commercial Paper Funding Facility to backstop GE Capital among others, and GE became the largest borrower under the FDIC’s Temporary Liquidity Guarantee Program, even though prior to the crisis it wasn’t even in the FDIC.

In response to the Geithner proposal, GE immediately let it be known that it had “talked to a number of people in Congress” and it should not have to separate its finance subsidiary because it disingenuously asserted that it hadn’t contributed to the crisis. We will see whether the GE special interest is able to stave-off this constructive reform proposal. Rather than deal with these simple problems with simple, obvious solutions, the official reform plans are complicated, convoluted and designed to only have the veneer of reform while mostly serving the special interests.

The complications serve to reduce transparency, preventing the public at large from really seeing the overwhelming influence of the banks in shaping the new regulation.

In dealing with the continued weak economy, our leaders are so determined not to repeat the perceived mistakes of the 1930s that they are risking policies with possibly far worse consequences designed by the same people at the Fed who ran policy with the short term view that asset bubbles don’t matter because the fallout can be managed after they pop.

That view created a disaster that required unprecedented intervention for which our leaders congratulated themselves for doing whatever it took to solve. With a sense of mission accomplished, the G-20 proclaimed “it worked.”

We are now being told that the most important thing is to not remove the fiscal and monetary support too soon. Christine Romer, a top advisor to the President, argues that we made a great mistake by withdrawing stimulus in 1937.

Just to review, in 1934 GDP grew 17.0%, in 1935 it grew another 11.1%, and in 1936 it grew another 14.3%. Over the period unemployment fell by 30%. That is three years of progress.

Apparently, even this would not have been enough to achieve what Larry Summers has called “exit velocity.” Imagine, in our modern market, where we now get economic data on practically a daily basis, living through three years of favorable economic reports and deciding that it would be “premature” to withdraw the stimulus.

An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.

This brings me to our present fiscal situation and the current investment puzzle. Over the next decade the welfare states will come to face severe demographic problems. Baby Boomers have driven the U.S. economy since they were born. It is no coincidence that we experienced an economic boom between 1980 and 2000, as the Boomers reached their peak productive years.

The Boomers are now reaching retirement. The Social Security and Medicare commitments to them are astronomical. When the government calculates its debt and deficit it does so on a cash basis. This means that deficit accounting does not take into account the cost of future promises until the money goes out the door. According to shadowstats.com, if the federal government counted the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are over $60 trillion.

And that was before the crisis.

Over the last couple of years we have adopted a policy of private profits and socialized risks. We are transferring many private obligations onto the national ledger. Although our leaders ought to make some serious choices, they appear too trapped in short-termism and special interests to make them. Taking no action is an action.

In the nearer-term the deficit on a cash basis is about $1.6 trillion or 11% of GDP. President Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook, $9 trillion over the next decade. The American Enterprise Institute for Public Policy Research recently published a study that indicated that “by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.”

As we sit here today, the Federal Reserve is propping up the bond market, buying long-dated assets with printed money. It cannot turn around and sell what it has just bought. There is a basic rule of liquidity. It isn’t the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because of both the size of the position and the signal my selling would send to the market.

For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up.

Further, the Federal Open Market Committee members may not recognize inflation when they see it, as looking at inflation solely through the prices of goods and services, while ignoring asset inflation, can lead to a repeat of the last policy error of holding rates too low for too long

At the same time, the Treasury has dramatically shortened the duration of the government debt.

As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.

Japan appears even more vulnerable, because it is even more indebted and its poor demographics are a decade ahead of ours. Japan may already be past the point of no return.

When a country cannot reduce its ratio of debt to GDP over any time horizon, it means it can only refinance, but can never repay its debts. Japan has about 190% debt-to-GDP financed at an average cost of less than 2%. Even with the benefit of cheap financing the Japanese deficit is expected to be 10% of GDP this year. At some point, as American homeowners with teaser interest rates have learned, when the market refuses to refinance at cheap rates, problems quickly emerge. Imagine the fiscal impact of the market resetting Japanese borrowing costs to 5%.

Over the last few years, Japanese savers have been willing to finance their government deficit. However, with Japan’s population aging, it’s likely that the domestic savers will begin using those savings to fund their retirements. The newly elected DPJ party that favors domestic consumption might speed up this development. Should the market re-price Japanese credit risk, it is hard to see how Japan could avoid a government default or hyperinflationary currency death spiral.

The failure of Lehman meant that barring extraordinary measures, Merrill Lynch, Morgan Stanley and Goldman Sachs would have failed as the credit market realized that if the government were willing to permit failures, then the cost of financing such institutions needed to be re-priced so as to invalidate their business models.

I believe there is a real possibility that the collapse of any of the major currencies could have a similar domino effect on re-assessing the credit risk of the other fiat currencies run by countries with structural deficits and large, unfunded commitments to aging populations.

I believe that the conventional view that government bonds should be "risk free" and tied to nominal GDP is at risk of changing. Periodically, high quality corporate bonds have traded at lower yields than sovereign debt. That could happen again.

And, of course, these structural risks are exacerbated by the continued presence of credit rating agencies that inspire false confidence with potentially catastrophic results by over-rating the sovereign debt of the largest countries. There is no reason to believe that the rating agencies will do a better job on sovereign risk than they have done on corporate or structured finance risks.

My firm recently met with a Moody’s sovereign risk team covering twenty countries in Asia and the Middle East. They have only four professionals covering the entire region. Moody’s does not have a long-term quantitative model that incorporates changes in the population, incomes, expected tax rates, and so forth. They use a short-term outlook – only 12-18 months – to analyze data to assess countries’ abilities to finance themselves. Moody’s makes five-year medium-term qualitative assessments for each country, but does not appear to do any long-term quantitative or critical work.

Their main role, again, appears to be to tell everyone that things are fine, until a real crisis emerges at which point they will pile-on credit downgrades at the least opportune moment, making a difficult situation even more difficult for the authorities to manage. I can just envision a future Congressional Hearing so elected officials can blame the rating agencies for blowing it, as the rating agencies respond by blaming Congress.

Now, the question for us as investors is how to manage some of these possible risks. Four years ago I spoke at this conference and said that I favored my Grandma Cookie’s investment style of investing in stocks like Nike, IBM, McDonalds and Walgreens over my Grandpa Ben’s style of buying gold bullion and gold stocks. He feared the economic ruin of our country through a paper money and deficit driven hyper inflation. I explained how Grandma Cookie had been right for the last thirty years and would probably be right for the next thirty as well. I subscribed to Warren Buffett's old criticism that gold just sits there with no yield and viewed gold’s long-term value as difficult to assess.

However, the recent crisis has changed my view. The question can be flipped: how does one know what the dollar is worth given that dollars can be created out of thin air or dropped from helicopters? Just because something hasn’t happened, doesn’t mean it won’t. Yes, we should continue to buy stocks in great companies, but there is room for Grandpa Ben’s view as well.

I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.

Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

A few weeks ago, the Office of Inspector General called out the Treasury Department for misrepresenting the position of the banks last fall. The Treasury’s response was an unapologetic expression that amounted to saying that at that point “doing whatever it takes” meant pulling a Colonel Jessup: “YOU CAN’T HANDLE THE TRUTH!” At least we know what we are dealing with.

When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.

Along these same lines, we have bought long-dated options on much higher U.S. and Japanese interest rates. The options in Japan are particularly cheap because the historical volatility is so low. I prefer options to simply shorting government bonds, because there remains a possibility of a further government bond rally in response to the economy rolling over again. With options, I can clearly limit how much I am willing to lose, while creating a lot of leverage to a possible rate spiral.

For years, the discussion has been that our deficit spending will pass the costs onto “our grandchildren.” I believe that this is no longer the case and that the consequences will be seen during the lifetime of the leaders who have pursued short-term popularity over our solvency. The recent economic crisis and our response has brought forward the eventual reconciliation into a window that is near enough that it makes sense for investors to buy some insurance to protect themselves from a possible systemic event.

To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable. As investors, we can’t change the course of events, but we can attempt to protect capital in the face of foreseeable risks.

Of course, just like MDC, there remains the possibility that I am completely wrong. And, personally, I hope I am. I wonder what Stan Druckenmiller thinks.