News from The 1990s Foretold of this Crisis

Debating who had been responsible for this crisis can take lots of academic vernacular to support or debunk the premises.

But we don’t need it.

By looking at the past, we can note that some news reports during the ‘90s appear to have actually “sensed” or predicted today’s fateful occurrence.

This excerpt from an LA TIMES article…

Minorities’ Home Ownership Booms Under Clinton but Still Lags Whites’

By Ronald Brownstein May 31, 1999

``All of this suggests that Clinton’s efforts to increase minority access to loans and capital also have spurred this decade’s gains. Under Clinton, bank regulators have breathed the first real life into enforcement of the Community Reinvestment Act, a 20-year-old statute meant to combat “redlining” by requiring banks to serve their low-income communities. The administration also has sent a clear message by stiffening enforcement of the fair housing and fair lending laws. The bottom line: Between 1993 and 1997, home loans grew by 72% to blacks and by 45% to Latinos, far faster than the total growth rate.

``Lenders also have opened the door wider to minorities because of new initiatives at Fannie Mae and Freddie Mac–the giant federally chartered corporations that play critical, if obscure, roles in the home finance system. Fannie Mae and Freddie Mac buy mortgages from lenders and bundle them into securities; that provides lenders the funds to lend more.

``In 1992, Congress mandated that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers. Operating under that requirement, Fannie Mae, in particular, has been aggressive and creative in stimulating minority gains. It has aimed extensive advertising campaigns at minorities that explain how to buy a home and opened three dozen local offices to encourage lenders to serve these markets.

``Most importantly, Fannie Mae has agreed to buy more loans with very low down payments–or with mortgage payments that represent an unusually high percentage of a buyer’s income. That’s made banks willing to lend to lower-income families they once might have rejected…

``The top priority may be to ask more of Fannie Mae and Freddie Mac. The two companies are now required to devote 42% of their portfolios to loans for low- and moderate-income borrowers; HUD, which has the authority to set the targets, is poised to propose an increase this summer. Although Fannie Mae actually has exceeded its target since 1994, it is resisting any hike. It argues that a higher target would only produce more loan defaults by pressuring banks to accept unsafe borrowers. HUD says Fannie Mae is resisting more low-income loans because they are less profitable."

From the New York Times article by Steven Holmes Fannie Mae Eases Credit To Aid Mortgage Lending, September 30, 1999

``Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

“In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the saving and loan industry in the 1980’s.

“‘From the perspective of many people, including me, this is another thrift industry growing up around us,’ said Peter Wallison a resident fellow at the American Enterprise Institute. ‘If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.’”

Hat tip Prieur Du Plessis

As author Steven Landsburg reminds us, ``Most of economics can be summarized in just four words: People respond to incentives. The rest is commentary." (Hat tip Mark Perry )

Asia Joins the Panic! Japan’s 1987 Déjà vu; Indonesia Suspends Trading

This is fear written all over.

One, in the US the Fear Index hit record highs and is superbly on the extremes.

Two global markets are in a meltdown mode.

And Asia hasn’t been spared…

Japan's 1987 experience relived...

New York Times ``Japanese stocks suffered their biggest one-day fall in more than 20 years on Wednesday, plummeting more than 9 percent, as fears of the financial crisis and global recession shook markets throughout the Asia-Pacific region and prompted a trading halt in Indonesia.

``The Nikkei 225 index dropped 9.4 percent to 9,302.32, bringing losses for the past five days to nearly 19 percent. It was the largest percentage point drop since October 1987.

Hong Kong shares the same plight…

Worst is in our neighboring Indonesia whose benchmark fell by 10.4%…Where trading has been suspended.

From Bloomberg ``Indonesia's stock exchange halted share-market trading for the first time in eight years after a 10 percent plunge in the benchmark index.

``Trading will remain suspended until further notice, the exchange said in an e-mailed statement. Trading was last halted in September 2000 when a car bomb damaged the exchange building and killed 15 people. Exchange President Erry Firmansyah couldn't be immediately reached on his mobile phone to comment.”

This from International Herald Tribune…``The decline was driven by huge losses in commodities stocks. The index has fallen more than 20 percent in three days, and is off 47 percent since the start of the year.”

The Phisix wasn’t spared to and commiserated with its neighbors. It closed 4.8% lower.

What do all of these exhibit?

The success expectations from concerted government rescue efforts have been now visibly corroding.

Markets are getting to accept the fact that painful adjustments have to be made. Though, probably we can expect more actions from government probably-an emergency RATE CUT by the US Fed as next.

But any bounce can be construed as a “relief rally” from severely oversold conditions.

Of course markets can always overshoot. When the smug from the disaster area clears, markets will likely be more discernful.

Wall Street's Agenda Seem to Dictate on US and Global Policies!

When faced with strong political pressures from the ongoing disorders of social, economic or financial nature, as we said, it is NEVER a question about governments NOT doing anything, but a question public expectations on the outcome of such actions.

Despite the passage of the $850 billion Emergency Economic Stabilization Act (yes Virginia, additional $150 billion on added porks! From Congressman Ron Paul ``In fact, it wasn't until the Senate had a chance to load it up with even MORE spending, when it was finally inflationary and horrible enough, at $850 billion instead of a mere $700 billion, that it passed – and with a comfortable margin, in spite of constituent calls still coming in overwhelmingly against it. 57 members switched their vote!” How Pork Barrels can easily switch votes is not only a Philippine phenomenon but elsewhere like in the US too!), markets continued to display brutal rioting yesterday and today.

So the Fed came up with even more actions; it doubled its auctions of cash lending to banks to as much as $900 billion, announced the changes in debt issuance which reintroduced 3 year notes and began implementing the paying of interest in bank reserves (Bloomberg).

Nonetheless pressures from various influential quarters of Wall Street “suggesting” to them on how to solve the problem. Example, William Gross of Pimco recently wrote, ``We believe that the Federal Reserve must now act as a clearing house, guaranteeing that institutional transactions clear (and investors receive) their Big Macs at the second window. They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past.”

From the New York Times today (emphasis mine), ``Under a proposal being discussed with the Treasury Department, the Fed could buy vast amounts of the unsecured short-term debt that companies rely on to finance their day-to-day activities, according to officials familiar with the discussions. If this were to happen, the central bank would come closer than ever to lending directly to businesses.

``While the move would put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has virtually dried up.”

Nonetheless as the Bernanke's FED and Paulson's US Treasury deliberate on agreeing into Wall Street's formula to further use taxpayer money to thaw the frozen credit markets, Australia's central bank cut its interest rate benchmark by one percentage point to 6 percent from 7 percent signifying ``the biggest reduction since a recession in 1992, to cushion the nation's economy against fallout from a global credit freeze." (Bloomberg).

Most likely both the "suggestions" of lowering interest rates and FED buying of commercial paper will be effected with the former being a "common policy" adopted by most embattled OECD economies.

It's funny how global policymakers seem to tow the line of Wall Street's elixirs when the latter haven't been able to resolve their own problems, to borrow Kenneth Rogoff's quote on the bailout enactment, ``the central conceit is that government ingenuity can disentangle the trillion-dollar “sub-prime” mortgage loan market, even though Wall Street’s own rocket scientists have utterly failed to do so."

This basically serves as an example of regulatory capture where "a government regulatory agency created to act in the public interest instead acts in favor of the commercial or special interests that dominate in the industry or sector it is charged with regulating." (wikipedia.org )

Hopefully if the US government decides to abide by the recommendations of Wall Street despite the conflict of interest issues, global markets will finally embrace this for good.

The Origin of Money and Today's Mackarel and Animal Farm Currencies

Contrary to common perception money originated not from governments but from free markets,

According to Murray N. Rothbard in What Has Government Done to Our Money?, `` Now just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media--in almost all exchanges--and these are called money.”

What ideal place to demonstrate this than in the ultimate government controlled living place-Prison Facilities!

In the US, a Californian prison where the US dollar has been banned to circulate within its premises, inmates have elected by implicit virtue of the above dynamics as their alternative currency of choice-cans of Mackarels!

Wall Street Journal

This interesting article from Wall Street Journal (emphasis mine),

``When Larry Levine helped prepare divorce papers for a client a few years ago, he got paid in mackerel. Once the case ended, he says, "I had a stack of macks."

``Mr. Levine and his client were prisoners in California's Lompoc Federal Correctional Complex. Like other federal inmates around the country, they found a can of mackerel -- the "mack" in prison lingo -- was the standard currency.

``"It's the coin of the realm," says Mark Bailey, who paid Mr. Levine in fish. Mr. Bailey was serving a two-year tax-fraud sentence in connection with a chain of strip clubs he owned. Mr. Levine was serving a nine-year term for drug dealing. Mr. Levine says he used his macks to get his beard trimmed, his clothes pressed and his shoes shined by other prisoners. "A haircut is two macks," he says, as an expected tip for inmates who work in the prison barber shop.

``There's been a mackerel economy in federal prisons since about 2004, former inmates and some prison consultants say. That's when federal prisons prohibited smoking and, by default, the cigarette pack, which was the earlier gold standard.

``Prisoners need a proxy for the dollar because they're not allowed to possess cash. Money they get from prison jobs (which pay a maximum of 40 cents an hour, according to the Federal Bureau of Prisons) or family members goes into commissary accounts that let them buy things such as food and toiletries. After the smokes disappeared, inmates turned to other items on the commissary menu to use as currency.”

Oh well, this is definitely a lot better than for society to utterly eschew government’s mandated legal tender similar to that in Zimbabwe where its 531 BILLION PERCENT hyperinflation (Voanews.com) rate has virtually ravaged or evaporated the purchasing power of its currency, enough for the people to reject it and find an alternative...

Courtesy of Zimbabwean

From “The Zimbabwean” Thomas Ncube, 58, who also lives in Dongamuzi, told IRIN he had exchanged all his goats and had nothing left to barter with. "The people who are selling maize are refusing cash, saying the Zimbabwean dollar loses value fast and they only exchange the grain with livestock, and most villagers have become poor from exchanging their livestock for grain." (highlight mine).

Welcome to the Barter economy!

Lesson: When governments take away or devalue money, people will always find an alternative.

Selling the Bailout: The Fear Factor

``For historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general." Charles Kindleberger, Manias, Panics and Crashes A History of Financial Crises (New York: Basic Books, 1989), p. 16.

Proponents of the bailout package have focused on two major concerns to advance their cause: fear and the allure of profits.

In marketing, sales pitches generally have to connect with emotions to create the necessary interests or conditions required to generate the desired outcome: sales. And what emotion could be easily trigger quick response or reaction than fear! According to marketing savant Seth Godin, ``Marketing with fear is a powerful tool. Fear is a universal emotion, it's viral and people will go to great lengths to make it go away.”

So when officials go to the extent of contriving Armageddon scenarios in order to secure the political capital required to pass their sponsored legislation as this…

From Federal Reserve Chairman Bernanke (quoted by New York Times) ``If we don’t do this…we may not have an economy on Monday.”

…we understand this as nothing but a hard sell meant to ram into throats of the Americans the notion that Wall Street and Main Street needs a “savior” by constant government intervention of the marketplace.

Think of it this way, it has been MORE than a year where the Bernanke-Paulson tandem have peddled this mirage in myriad ways to no avail: the $163 billion fiscal stimulus at the start of the year, various assorted alphabet soup of bridge financing facility some of which had been enabled by the rarely used legal authority under Section 13(3) of the Federal Reserve Act (Wall Street Journal), overseas swap lines, 325 basis points Federal interest rate cut, the takeover of Fannie Mae and Freddie Mac and AIG, the forced marriage of JP Morgan and Bear Stearns with the backstop from the Federal Reserve, tapping the $50-billion Exchange Stabilization Fund to offer insurance to money-market fund investors to stop a run on the funds (WSJ) and others…

Yet at the end of the week, global world financial markets remain under severe duress, see figure 1.

Figure 1: Danske Bank: Credit Stress and Liquidity Crunch

So even as the Bernanke-Paulson team (B&P) managed to secure the much needed mandate via Emergency Economic Stabilization Act (originally the Troubled Asset Relief Program-TARF) for the use of $700 billion at their discretion to support domestic markets (including foreign banks with domestic exposure), US equity markets fell sharply over the week: Dow Jones Industrials tumbled 7.34% (year to date down) 22.16%, S&P cratered 9.4% (down 25.14% y-t-d) and Nasdaq crashed 10.18% (down 26.58% year-to-date).

As a side comment, US markets appear to be fast catching up on the loss statistics of the Philippine equity benchmark the Phisix, whose decline has interestingly been mild (relatively speaking amidst this turmoil) and could have signified sympathy selling (down 1.19% this week and down 29.14% year-to-date) than a traditional rout.

The credit crisis seem to worsen with the apparent collapse in the US commercial paper market- (investopedia.com) “An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days” or market facilities which enables corporations to gain access or utilize short term financing (see right pane courtesy of Danske Bank). Aside the skyrocketing cost of funding seems to reinforce the indications of the ongoing stress on interbank lending or as some analysts insinuate a “silent bank run” (right pane).

According to Steen Bocian of Danske Bank, ``First, perceived counterparty risk went up as fears of other bankruptcies swept through the system. Banks therefore became even more reluctant to lend money to other banks. Second, the collapse of Lehman Brothers led to big losses for the oldest US money market fund, Reserve Primary MMF, which “broke the buck”. This means that investors experienced real losses on funds invested in the Reserve Primary MMF, as net asset value went below USD1. This was the first time since 1994 that a money market fund had broken the buck. The incident led to a flight of money out of money market funds in the US.” (underscore mine)

This is the critical link between Wall Street and Main Street. When the cost of funds shoot skyward, many ongoing or expansion projects are likely to grind to a halt and companies or institutions surviving on the margins end up filing for bankruptcy. Even states like California have quietly sought funding ($7billion) from the US Treasury.

Interventionism Doesn’t Seem To Work

So in spite of the so-called interventionist nostrums you have the markets generally rioting or becoming more dysfunctional.

This could mean one of three things:

one- measures have not been enough ($700 billion is not enough) or

two-measures don’t address the root problem but instead deal with the symptoms or

three-market could be reacting to the law of unintended consequences.

Economist and author of More Sex is Safer Sex Steven Landsburg in the Atlantic.com wrote a very eloquent poignant piece about the current banking crisis (emphasize mine),

``So what's special about banks? According to what I keep reading, it's that without banks, nobody can borrow, and the economy grinds to a halt.

``Well, let's think about that. Banks don't lend their own money; they lend other people's (their depositors' and their stockholders'). Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other.

``That's one reason I feel squeamish about the official pronouncements we've been getting. They tell us bank failures will make it hard to borrow but never that bank failures will make it hard to lend. But every borrower is paired with a lender, so it's odd to state the problem so asymmetrically. This makes me suspect that the official pronouncers have not entirely thought this thing through.

``In the 1930s, a wave of bank failures did make it hard for borrowers and lenders to find each other, and the consequences were drastic. But times have changed in at least two relevant ways. First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent. Second, as any user of match.com can tell you, the technology for finding partners has improved since then. When a firm wants to raise capital, why can't it just sell bonds over the web? Or issue new stock? Or approach one of the hedge funds that seem to be swimming in cash? Or borrow abroad?

``I know, I know, the rest of the world is in crisis too. But surely in the vast global economy, it should be possible to find someone capable of introducing a lender to a borrower. (Note that I'm not talking about going to foreign lenders, though that's another option. I'm just talking about the same American borrower and American lender who would have found each other through Bear Stearns finding each other through Barclays instead.)

``In other words, I'm not sure these big Wall Street banks are really necessary, and I'm not sure we'd miss them much if they were gone. Maybe there's something I'm missing, but if so, I think it should be incumbent on Messrs. Bernanke, Paulson and above all Bush to explain what it is.”

Or a similar thought from Bill King (hat tip Barry Ritholtz), ``The cause of our current financial morass is Big Government + Big Business = Crony Capitalism + Funny Money = concentration of wealth and risk + declining US living standards.”

``The solution is decentralization of the financial system, like the tech industry, which will lower systemic risk, foster competition and yield better ideas, services and companies.”

Like us, Mr. Landsburg and Bill King acknowledges that the banking system is no less than one huge cartel organized and operated by a network of central banks led by the US Federal Reserve living off under the platform of US dollar standard fractional reserve banking system whose basic premise is one of institutionalized leverage (legally required to keep only a fraction of deposits relative to lending). And whose boom bust policies foster banking oligopolies and crony capitalism.

The Opportunity Cost of A Wal-Mart Bank

Proof? In 1999 Wal-Mart’s attempt to buy a savings bank in Oklahoma was foiled by the Gramm-Leach-Bliley Act. In 2002 Wal-Mart was again interdicted from acquiring the California ILC by the California legislature. In 2005, community and regional banks closed ranks to defeat Wal-Mart’s application banking license on fears that it might grab away their businesses (sfgate.com).

The point is not to defend Wal-Mart attempted entry in the banking industry, but to accentuate the example of the use of laws to prevent entry of new competition.

And this has been the essence of the Wall Street bailout: to sustain the clique on the premise of the sustenance of systemic concentration-“too big or too interconnected to fail” whose functionality has been “too embedded in the economy” which requires today the poor and mid class Americans to pay for the sins of a flawed currency system based on the rule of elite.

A financial and economic model where the poor subsidizes the rich, very much in resemblance to today’s global current account imbalances paradigm (poor emerging countries with current account surpluses subsidizing rich current account deficit countries). Free market failure anyone?

Conditions That Pave Way For Greed

The fact that the essence of today’s bust is one which stemmed from excessive leverage has been principally reflected on the operating principles of fractional reserve banking system. Where one can get away with piling on more leverage to gain additional profits why then stop? “As long as the music keeps playing we keep dancing”.

Is it all about greed? Think of it, when borrowing rates offered you is at ZERO rates or money for “free” what would you do? Take up the money and speculate. You chase for yields. You lever up. You lengthen your time preference based on false signals that the credit offered have been backed by real savings. And since everybody seemed to doing the same, why not seek the “comfort of the crowds”? You chase momentum on assets that have been popularly boosted by inflation or speculation. You flip stocks or houses. That’s exactly what the public did upon the implicit prodding from government policies.

US Banks which has signified as the main pillar of the fractional reserve bank system, has essentially transmitted the same principles to the society by: overextended gearing, overspeculation, adopted computerized quant risk models, went around regulatory loop holes as the net capital rule (New York Times), morphed into a new business model of “originate and distribute” which passed the credit and repayment risks to end-users freeing up more capital to lever, utilized innovative “hedge” instruments (structured finance and derivatives) to accrue incremental gains, relaxed lending standards to produce economies of scale, and moved out of the regulated sphere to establish the Shadow Banking System.

As for government policies, responsible for twisting incentives that led to these boom: Fed policies (aside from monetary policy, remember Greenspan’s advanced the idea of Americans moving to ARMs?), the implicit guarantee of the Government Sponsored Enterprises, Mark to Market Accounting Rules and the Community Reinvestment Act (which forced lending to less qualified candidates based on the concept of expanding homeownership or protecting the American dream).

Moreover, regulatory oversight became lax when the boom flourished! This very insightful quote from Robert Arvanitis Risk Finance Advisers, Institutional Risks Analystics, Seeking Beta: Interview with Robert Arvanitis (highlight mine)``Being mortal, the bureaucrats desire to avoid pain is as dear to them as the desire by their counterparts in private industry to seek gain. And it is far more profitable to game the rules, for example, than to enforce them. And any system can be gamed.” Yes indeed why get blamed for stopping the music while everybody is dancing? (hat tip: Craig McCarty)

In other words, Wall Street under the backstop of US Federal Reserve inflated the system until it became evidently unsustainable and thus collapsed.

So what is the basic problem? Inflation, overspeculation, overvaluation, oversupply and excess leverage or having taken on too much debt more than one can afford to pay. Essentially the ongoing bust represents market forces unraveling the massive distortions imposed on it or the reassertion of the universality of economic laws.

And $700 billion would seem like a spare change relative to the degree of market distortions that need to be cleansed from the system or the current high level of debt needs to be reduced to the level where the US economy can afford to pay them.

Markets have simply been telling Wall Street and the US, particularly Bernanke and Paulson and the US leadership, that it won’t be cowered by threats, and that market forces have been revealing the truth and realities about the untenableness of the imbalances within the system.

Perhaps it is about time to reconsider accepting the non-traditional non-cartelized sources of financing.

Will US Taxpayers Profit From The Bailout? Unlikely

``We have a lot of money to play with. As long as foreigners have a lot of confidence in our ability to solve our problems, we can borrow the $1 trillion to $2 trillion we need to solve it….The real constraint is not a bookkeeping one…It is a sense of faith on the part of foreigners that the U.S. government will repay its debt. Our most precious asset is that credibility.”-Kenneth Rogoff, an international economist at Harvard (NYT).

In the carrot and stick approach towards negotiation, threats of a market meltdown to get the necessary votes represents as the stick. The carrot approach could be accounted for by bailout adherents suggesting that US taxpayers might be able to “profit” from the present bill.

They contend that the US could be faced with a “once-in-a-lifetime” opportunity to profit from the “greatest” of all carry trade by earning from 1) the spread of borrowing cheaply via US treasuries relative to prevailing mortgage rates and 2) profiting from future appreciation of depressed asset values.

One of the fundamental contention from which led to the earlier defeat in the lower house of the US Congress of the $700 billion out has been the issue of pricing.

It is said that if the US government were to acquire existing mortgages at lower prices, any transaction would thus be set a benchmark that would essentially exacerbate the price discovery problems via loss recognition (mark-to-market regulation) and thus require the necessary adjustments (raise capital or shrink balance sheets).

Remember, the reason why banks have been reluctant to lend to each other is because they don’t trust the underlying collateral within their contemporary’s balance sheets (which is why they can’t be priced-aside from being illiquid, their values are undetermined). Thus, the role of the government’s bailout is one of market maker.

On the other hand, concerns about the US government overpaying on illiquid assets would lead to unnecessary taxpayer losses.

Given that the US Congress has upheld the Bailout plan, it is so decreed that the relatively lesser evil would be for the US government to pay for higher prices on the worst possible assets held by major financial institutions in order to regain market confidence and reinstitute the normal flow of credit.

Opportunity Cost of Productive Investments

Let us set a hypothetical example to see whether such claim of profitability for the US taxpayers is valid.

Rewind to 2000; let say that US decided to pay 70 cents to a US dollar to all those who were unfortunate enough to have invested in the late stage mania of the dot.com boom as part of the bailout scheme.

Figure 2: Bigcharts.com: Nasdaq Bust Hasn’t Recovered After 8 years!

Since the peak of the boom was at 5,000, 70 cents would mean the index at 3,500. Let us therefore further assume that every investor had been given a chance in 2001 to partake upon the US government’s “tender offer” to liquidate at the designated level at profit or loss to the account of the US taxpayer.

In figure 2, 8 years after the 2000 peak, the Nasdaq has hardly regained 50% of its losses even during the latest peak last October and is now 60% below its 2000 apex.

In finance 101 we have been taught in TIME VALUE of Money that a Dollar or Peso today is worth more than a Dollar or Peso tomorrow. And the reason we agree to defer spending today’s money is to get compensated for with a premium over our principal at a given future date or what is known as the interest rate.

Given that bailout schemes are commonly undertaken by either borrowing or printing (the last option would be the most politically unpalatable- raising of taxes), this means that the taxpayer losses from a theoretical Nasdaq rescue program even considering its annual dividend yield (.66%-Nasdaq 100 as per indexarb.com) would have not been sufficient to cover its deficit from borrowing in US treasuries (between 4%-6% for one year bills in 2001) or even considering Nominal (not inflation adjusted) terms.

In short, US taxpayer loses real money and continues to bleed aside from the opportunity cost of gaining from higher yielding return on productive investments.

Now going back to reality. The problem of today’s housing boom turned into a bust has been UNPRECEDENTED in US history since 1980! (take a look at figure 3.)

Figure 3: New York Times: Unparalleled Housing Boom!

According to Satjayit Das, ``Analysis by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined US$1.5 trillion in high-interest-rate, high risk loans.” (highlight mine).

This means the US government would be paying for very high or steep prices for mortgages issued during the boom days even considering hefty discounts from the TOP. Using the above chart, at 50% off from the peak of 200 or at 150 from the baseline yardstick of 100 (since 1890), housing prices would still be about 35% higher than its 1950-2000 averages!

Besides, any profit assumption hinged upon an immediate recovery seems far fetched even when seen from the standpoint of the Nasdaq experience. The US would need to undertake another frenzied bout of PONZI pyramid type of credit bubble in order to push up housing prices back to its most recent highs…something which we think would seem unlikely even for the next ten years.

Thus the argument that a profitable carry trade exists seems to be illusionary or part of the political legerdemain, especially considering today’s highly charged political environment.

The Inflation Tax; Massive Inflation Amidst A Snowballing Deflationary Setting

Next is the issue of inflation.

Because of the limitations of charts I can attach to every issue of my newsletter, I posted how the US Federal Reserve has been undertaking an astounding series of intensive liquidity injection program largely unknown to the public but published on my blog post last Friday The Mises Moment In Pictures.

Yes, while the headlines carryover the riveting debate about the $700 billion of bailout, our favorite fund flow analyst CFR’s Brad Setser estimates that the US Federal Reserve have issued about $1.25 trillion in liquidity support, nearly double the cost of the fiscal bailout! And its not about to stop here.

Let us revert first to the theoretical Nasdaq bailout example above.

Figure 4: BLS.gov: Inflation Calculator

You’d realize that based on the US government’s Bureau of Labor Statistics’ Inflation calculator, in figure 4, a US $100 in the year 2000 has an equivalent buying power of $127.23 today. This means that aside from cost of borrowing deficit and nominal deficits from asset values, US taxpayers would incur an inflation tax of about 1.5% per year! Thus this adds to our evidence why bailouts won’t be profitable for US taxpayers.

Besides, with the extent of inflationary “do something” measures being conducted to preclude what central bankers fear most as the “debt deflation” spiral this could likely add up tremendously to the future cost of today’s bailout.

While today’s environment would be considered “deflationary”, governments from around the world have been collaborating to address such concerns by flooding the world with money, from which if a recovery should take hold, we could likely see an inflationary spiral over the longer horizon. We could be sowing the seeds for the next more fatal crisis.

As a reminder, bank or investment losses are not the fundamental causes of deflation, because money issued will always be spent somewhere. It is the secondary effects from the negative feedback loop of reduced income and spending and the lack of borrowing and lending or specifically the “decrease in the velocity of the circulation of money (an increase of demand to hold cash balances)” are what the Austrian economist consider as “secondary deflation” (John Egger, The Contributions of William Hutt, p.18).

Figure 5: Wall Street Journal: FED FUND Rates Below Target Rates

To consider, part of the proposed bill is to allow the US Federal Reserve to go around the cumbersome way of injecting money into the system by pumping money while at same time sterilizing money by way of the Fed’s buying of US Treasuries, which at present has led to Fed Fund Rates below its target as shown in figure 5.

The bill thereby allows US Federal Reserve to pay interest rates to bank deposits held at the Federal Reserve giving enough leeway for them to pump money at liberty; since banks will not be required to lend to each other and thus put a floor to the Fed target. In short, Fed Chairman Ben Bernanke’s Helicopter seems ready for takeoff for the next sortie.

In addition, it is likely that given the sharply deteriorating conditions in the US and Europe, there is a strong chance for OECD central banks to embark on a coordinated simultaneous interest rate cut aimed at restoring liquidity conditions despite the ongoing solvency issue.

Yet we can’t discount or rule out extreme measures similar to a blanket guarantee on ALL deposits such as the recent actions by governments of Greece and Ireland. To reckon that in the US only 63% of the $7,063 billion deposits are insured, while leaving out $ 2,457 billion of uninsured deposits in the US could be a source of a destabilizing run.

Of course one may always argue that the collateral damage from a system wide failure could be nastier and costlier compared to charging the taxpayers for mitigating today’s crisis. But that would be speculation on our part.

As in the Japan experience, the TARF’s version was the Cooperative Credit Purchasing Corporation (CCPC) established in late 1992 which failed to bring about the end to Japan’s crisis whose crisis lasted for more than a decade.

According to Takeo Hoshi of RGE Monitor Asia, ``There is no guarantee that the TARP will be able to avoid those mistakes that the CCPC made. There are no tools that the Treasury can use to force the financial institutions to sell substantially all troubled assets. Even with the tax-related motivation, the Japanese banks were reluctant to sell bad loans to the CCPC. With the TARP, the restrictions on executive pays and others may discourage some financial institutions from coming forward. Similarly, how the Treasury will dispose of the purchased assets is not clear, yet.”

At the end of the day, it won’t be the issue of governments’ not doing anything but would be the issue of the public’s expectations that government actions will succeed even though the risk is that they won’t.

Have you not noticed, this has been going on for over a year and yet the crisis seems to be getting even worst!

Bureaucracies Exist To Spend Money Not To Earn You A Profit!

Besides even assuming that government does end up “profiting” from today’s undertaking, it is unlikely that US citizens will be mailed with their dividend checks from their share of capital appreciation profits or from the revenues streams from the profitable mortgage arbitrages. This isn’t how governments function.

Eventually, all these so called surpluses will end up in the coffers of the politicians who would, in no time, quickly find new boondoggles to spend it with.

As Ludwig von Mises wrote in the Bureaucracy (pp. 48–50), ``The objectives of public administration cannot be measured in money terms and cannot be checked by accountancy methods… In public administration there is no connection between revenue and expenditure. The public services are spending money only; the insignificant income derived from special sources (for example, the sale of printed matter by the Government Printing Office) is more or less accidental. The revenue derived from customs and taxes is not "produced" by the administrative apparatus. Its source is the law, not the activities of customs officers and tax collectors. It is not the merit of a collector of internal revenue that the residents of his district are richer and pay higher taxes than those of another district.”

So it wouldn’t be advisable to expect government actions today to be seen in the light of “profitability” but rather from the perspective that they could buy enough time for the global economies to recover in order to give a lift to the US.

Phisix and Asia: Watch The Fires Burning Across The River?

``We want to use cash…there are times when cash buys more than other times, and this is one of those times where it buys more.'' '' Warren Buffett, interview with CNBC’s Charlie Rose

It’s interesting how we Filipinos get to observe the ongoing turmoil abroad from the perspective of kibitzers, especially considering that what used to be known as the most indomitable industry that has now been besieged by the question of survivorship.

Yet, I am not sure if ever our constituents realize the risks conditions and the lessons or opportunities presented thereof. For me, today’s development clearly exhibits that there is nothing called as a guaranteed or risk free investments or a risk free system. Evolving dynamics ultimately cause dislocations for the better THAN for the worse or in Joseph Schumpeter’s words “creative destruction”. Hopefully.

For most of Asia it would seem the same way too. In the “Secrets Of War: The 36 Stratagems” published by an unknown writer during the Ming Dynasty 300 years ago, one of the war stratagems include “Watch the Fires Burn Across the River”, which means to watch over your enemies wreak havoc upon themselves before making your move. As senseis.xmp.net interprets ``This is a kind of long-term, strategic version of the idea behind an inducing move. Before you intervene, see that the flow of the game started by action elsewhere brings the opportunity to its peak.”

It is a wonder if the rest of Asia, especially if our leaders have these on their thoughts or if Asia itself has been greatly impacted by the ongoing ruckus.

Circumstantial evidence tells us we could be in the former state than in the latter.

As an example, in terms of corporate Mergers and Acquisition, the credit crisis induced global economic slowdown has filtered into the scene with a broad based weakness EXCEPT for Asia. According to a news report in Bloomberg, ``Companies announced takeovers valued at $2.37 trillion in the first nine months of the year, down from the record $3.29 trillion in the year-earlier period, according to data compiled by Bloomberg. The value of U.S. mergers dropped 35 percent, while dealmaking in Europe and the Middle East declined 28 percent, the data show. Only takeovers in Asia, excluding Japan, increased, showing an 11 percent gain.” (highlight mine)

So maybe Asia’s business sector are indeed watching over the extent of the ongoing spillover damage and taking up defensive positions by either consolidating nationally (e.g. Li-Ka Shing on Bank of East Asia) while taking advantage of the bear market and/or awaiting the right moment to grab opportunities overseas.

If the US took the hegemon away from the UK after the latter had suffered immensely from harrowing years of devastation wrought by World War II, could Asia be in a seemingly parallel position in terms of fortuitously eluding the systemic calamity of a banking crisis besetting the West?

Phisix: Another Divergent Week

Back to the Phisix it has been a delight to see our Phisix ignore the deteriorating sentiment seen in the US and elsewhere. But it isn’t so for most of Asia. Although we are not sure if this tranquility signifies as the proverbial “calm before the storm”, albeit there is a good chance that the recent developments has been part of the growing “divergence” trend.

Here is what I wrote last week in Phisix: Back To The Global Divergence Mode, ``But as what we have been saying before, if the estimates of foreign liquidation relative to the previous years of inflows have been accurate, then the pressure from another round of AIG-type of forcible liquidation has probably peaked and should be declining.”

Present comment: The Phisix fell mildly by 1.19% amidst a global rout.

Again from last week, ``And if we continue to see this trend reinforced, then the threat from any future selling pressures is likely to emanate from local retail investors who are the easiest to be swayed or spooked by media reports. Thus, perhaps the diminishing trend of foreign selling plus future risks of “contagion dynamic” from local retail investors are likely to be indicative of the bottoming process we have long talking about.”

Figure 6: PSE: Lull in Foreign Selling (left), Spike in Number of Trades (right)

Present comment: Last week’s action seem to validate our prognosis: One foreign buying propped up the Phisix and two, the spike in number of trades clearly points to domestic retail investors in panic!

Two weeks doesn’t a trend make but we seem to be moving in the right direction!

Figure 7: stockcharts.com: Phisix in Rangebound Trading

Lastly, again from last week, ``And a bottom process entails rangebound trading or gradual confidence building recovery.”

Q.E.D.

Media Sentiment: The US is in a Depression! Warren Buffett Buys!

The US is in a DEPRESSION! That’s if we are to measure depression in the context of FEAR than the actual economic depression itself!

According to the Economist, ``MANY comparisons may be made between the devastation being wrought on America's financial system today and the Wall Street crash of 1929. One similarity that the world is desperate to avoid is a repeat of the depression of the 1930s. Hopes are pinned on the American bail-out plan that the House of Representatives is set to reconsider on Friday October 3rd. If the fear of depression is anything to go by, the future looks bleak. A survey of newspaper articles over the past two decades shows a sharp spike in mentions of the dreaded D-word, as commentators have started to think the worst. The prognostications may possibly turn out to be true, or perhaps the only thing we have to fear are the fears of journalists themselves.” (underscore mine)

Courtesy of the Economist

Growing fears of “A Mother of All Banking System Run” or its downright collapse emanating from the unresolved gridlocked in the global credit markets have aggravated such an outlook, compounded with the rapidly deteriorating economic environment.

Even Warren Buffett, the world’s most successful stock market investor, acknowledges part of this anxiety and analogizes the present conditions to one of the US Economy lying "flat on the floor” and undergoing a “Cardiac Arrest”.

In a recent CNBC interview with Charles Rose, Mr. Buffett said,

``Paramedics have arrived…and they shouldn't argue about whether to put the resuscitation equipment a quarter of an inch this way or a quarter of an inch that way, or they shouldn't start criticizing the patient because he didn't have blood-pressure tests.” In reference to his advancement of the bailout package, which was recently approved by the US Congress.

He relates the impact of the credit crunch as ``sucking the blood out of the economic body of the United States”.

Anyway, the Mr. Buffett in apparent empathy with the US, ``In my adult lifetime, I don't think I've ever seen people as fearful, economically, as they are right now….They are not wrong to be worried.''(highlight mine)

Plainly said, the fear the US faces from the present risks environment seems justified, although Mr. Buffett believes that these presents itself as opportunities from which to profit over the long term, ``The prices make a lot more sense now…You want to be greedy when others are fearful and you want to be fearful when others are greedy.''

A classical Mr. Buffett act.

From our end, we understand this as nothing really new.

Boom and Bust always bring about attitudinal change. Inflation is followed by deflation. Greed turns to Fear, Panic and ultimately to depression. Aggressive risk taking morphs into morbid aversion to risk. Generosity turns into frugality. Profits segue into losses. Debt level falls. Collateral values fall. The negative feedback loop of margin calls from reduced collateral values reinforces downward price spirals on asset values. Company Balance sheet shrinks. Unemployment rises. Conspicuous consumption shifts into consumption based on necessities. People’s time references are lowered. Real currency values rises as people and corporations hoard cash. Government fiscal deficits rise as rescue efforts mount or as contingent liabilities are realized as losses. Zero savings can mean more savings. Current account deficits could become surpluses. So what else is different?

Eventually most of the malinvestments and excess levels of gearing or leverage will be reduced to the point where the economy affords them. All these take time. But the adjustments won't be painless.

It’s what history has repeatedly shown. It’s what all cycles are all about. It’s the nature of human beings, especially when misdirected decisions have been impelled by policy incentives that lead to such behavior.

Besides, is this not the essence of capitalism: Profits and losses? We can't say capitalism is purely a one way street of profits, while loses need be socialized. That's the Keynesian brand of capitalism. And that's what has got us into this in the first place.

As US President Franklin D. Roosevelt in his First Inaugural Address on a Saturday of March 4, 1933 ``So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”

While there is nothing to fear but fear itself, eventually there will be a resolution to the crisis as it always had been. It's not the end of the world as we know it. Although we are hopeful that in learning from history we could avoid taking on the similar paths that would risk actualizing these fears.

The Mises Moment In Pictures

In Global Markets: From “Minksy Moment” To The “Mises Moment” we characterized our Mises Moment as ``governments faced with a crisis will run the printing presses to reflate the system at the expense of its currency system.”

We have long said that politicians REACT to developments than PREMPT them arising from populist political concerns whether real or imagined. The belief that authorities can “do something” basically means manipulating varied legal tools (fiscal or monetary) aimed at controlling market forces for political objectives.

The problem is that such intuitive attempt to defeat or suppress business cycles by perpetuating boom conditions has been the root of today’s crisis. In other words, deflating markets are a consequence of previous inflationary activities which has distorted price signals in the markets and has similarly led to capital misallocation in economies.

Yet, it appears that massive efforts are underway to reinflate, which risks intensifying or prolonging the crisis conditions.

To quote Friedrich Hayek in Monetary Theory and Trade Cycle, ``To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection -- a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end.”

So even without the bailout package, the Federal Reserve has undertaken a massive campaign to flood the world with money.

And signs have been all over…

In the monetary system (data from St. Louis Federal Reserve)…

Federal Reserve Lending…

Changing Fed Balance sheet composition…

Courtesy of Cumberland advisors

Aside, the recent enhancement on TAF and swaplines with global central bank as declared by the Fed,

``Actions by the Federal Reserve include: (1) an increase in the size of the 84-day maturity Term Auction Facility (TAF) auctions to $75 billion per auction from $25 billion beginning with the October 6 auction, (2) two forward TAF auctions totaling $150 billion that will be conducted in November to provide term funding over year-end, and (3) an increase in swap authorization limits with the Bank of Canada, Bank of England, Bank of Japan, Danmarks Nationalbank (National Bank of Denmark), European Central Bank (ECB), Norges Bank (Bank of Norway), Reserve Bank of Australia, Sveriges Riksbank (Bank of Sweden), and Swiss National Bank to a total of $620 billion, from $290 billion previously.”

So the US isn’t just inflating its own financial system. As we have been saying it has also been inflating the world.