• Is 2012 a Reprise of 2008? – Charles Hugh Smith
• No Freedom – No Money – No Markets – Bill Buckler
• Bernanke and Germany Wake up to a Merda Storm – Russ Winters

The essence of these articles: financial institutions, and more importantly the central banks of governments, are sitting on a vast amount of seriously devalued or worthless collateral.  In layman’s language regarding this flawed empire of debt: “the emperor has no clothes.”

The LTRO Program

The Long Term Refinancing Operation (“LTRO”) is a program of the European Central Bank (“ECB”).  This program permits unlimited lending to banks and, importantly, relaxes acceptable forms of collateral.   Its purpose was to relieve worsening credit conditions in Europe. See LTRO: A User’s Manual for a more complete discussion.  Although initially greeted with acclaim and stock and bond market rallies both in Europe and the US, its effect quickly wore off.

Italian banks took €354 billion in LTRO cash and Spanish banks took around €300 billion. Portuguese bank dependence on ECB borrowing rose to a record €56 billion. So in total, these countries’ insolvent banks have now placed over €710 billion in merda collateral with the ECB. The fact that these infected banks are halting trading about every other day should also be transmitting in spades the signal that the ECB literally owns said banks and inherits their losses and their merda collateral, which has been pawned off.

In truth, only four European countries backstop all of the ECB, EFSF [“European Financial Stabilization Fund” edit.], and other schemes. Unfortunately, two of them are the “merda-storm” (per Russ Winters’ coined term) countries of Spain and Italy. That means all of the losses that would normally be distributed across a number of larger nations will now fall on the remaining two: Germany and France.  See Bernanke and Germany Wake up to a Merda Storm (“merda” is Latin for excrement or dung).

The Crumbling Pyramid

Charles Hugh Smith’s recent article succinctly describes the trigger for the Great Financial Crisis:  “…the collateral that supported this great inverted pyramid of leveraged debt vanished, and as a result the entire pyramid crumbled.”  See Is 2012 a Reprise of 2008? Since that time the government has played a game of “extend and pretend.”  Governments and their central bank agents are pumping up asset markets to deflect our suspicion that dubious collateral is supporting the debt pyramid.

Mr. Smith gives the all too real example of a $500,000 house purchased by a subprime buyer with only 3% down ($15,000).  The homeowner is thus leveraged 33-1.  Banks in turn packaged outrageously unsound mortgages like this one into mortgage backed securities (“MBS”), and then used these amalgamated pieces of financial trash as collateral for yet more loans.  Further, the banks then wrote credit derivatives on these securities and further expanded the inverted debt pyramid.  When the real estate market rises, all is well:  buyer, bank, MBS holder, and derivative purchaser all get bailed out.  However, when the real estate market falls, the financial implosion of a Great Financial Crisis ensues.

The banks refuse to deal with the underlying problem.   Instead, they rely on financial games.  Thus, in the above example:

… the mortgage is still valued on the books at $450,000, but the actual collateral — the house — is only worth $250,000. The idea being pursued by central banks around the world is that if they pump enough free money and liquidity into the system, and buy up impaired debt (i.e. debt in which the collateral has vanished), then the illusion that there is still some actual collateral holding up the market can be maintained.  See Is 2012 a Reprise of 2008?

Moments of Realization

Bill Buckler highlights the first moment of realization that collateral was irrevocably impaired.  During the Bear Stearns crisis, two of its hedge subprime hedge funds lost nearly all of their value due to the rapid decline in the subprime mortgage market.  To deal with the crisis Bear Stearns sought to sell the collateralized debt obligation in its funds:

For the one and only time in the GFC so far, a money centre bank tried to sell Collateralised  Debt Obligations (CDOs) on an actual market. That attempt lasted hours. When the auction was closed, the bids were coming in at 30 percent of the face value of the paper. The jig was up, the valuation of the collateral underpinning the entire banking system was revealed as fictitious.   (Emphasis in article)  Not much more than a year later, that collateral was transferred from the US banking SYSTEM to the Fed, which has maintained its fictitious “value” ever since. See No Freedom – No Money – No Markets

Mimicking the Federal Reserve, The European Central Bank is now accepting impaired collateral, including rapidly declining sovereign debt from Italy and Spain.  The dangerous fiction continues.

Are We About to Revisit the GFC of 2008?

The real question is whether or not we are about to reprise the Great Financial Crisis of 2008.  I would strongly suggest that Ben Bernanke and others are aware of the tenuous nature of the current iteration of the financial system.   Clearly Bernanke and company are self protecting:

Tying all the loose ends together is Wizard of Oz Ben Bernanke’s sudden attention to words like “shadow banking,” “collateral” and “vulnerabilities” in his speeches. For those with an elementary ability to connect the dots, this suggests that collateral in general — including the merda-storm variety — has been the subject of some late-night calls during Weekend at Benny’s.

And then there’s Ben, the master of obfuscation and butt covering. When this crisis hits, Ben will attempt to disassociate the bad collateral as a European problem and nothing with which he would ever be involved.  He will argue that owning several trillion in 1-2%-yielding long-duration sovereigns in a country (the US) with a 105% debt to GDP is nothing like what the ECB has done. A few years ago, a trillion-dollar portfolio of housing mortgages would have been considered a big deal. See Bernanke and Germany Wake up to a Merda Storm

Paraphrasing the author, Daniel Silva, only idiots and dead men ignore coincidences.  Three articles suddenly and recently appear which discuss the issue of impaired collateral supporting a vast financial inverted debt pyramid.    Coincidentally, the last time this confluence of warnings happened was 2008.  Turned out, the emperor was buck naked then.   Is 2012 a reprise for our sartorially and financially challenged emperor?

Related posts:

1. Collateral Damage
2. You Say You Want a Revolution Part II
3. Often Wrong, But Never in Doubt

Mr. Smith outlined his reasons for leaving the firm:

…the environment now is as toxic and destructive as I have ever seen it. To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money…I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them. If you were an alien from Mars and sat in on one of these meetings, you would believe that a client’s success or progress was not part of the thought process at all. It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets….”  See Why I am Leaving Goldman Sachs

Attacking the Messenger

Goldman CEO Blankfein and President Gary Cohn immediately went on the attack:

• We employ 30,000 people, so someone is going to be disgruntled.
• Smith does not accurately portray our values and culture.
• It was wrong of the Times to offer Smith’s complaint its massive forum, while not considering the intensive internal feedback provided by Goldman’s own employees.
• 89% of Goldman employees feel the company provides exceptional service to its clients.
• Internal firm mechanisms were available for Mr. Smith to express his views.
• When Goldman sees a problem it responds.

Goldman supporters joined in the attack on Smith, and characterized him as a publicity seeker.  They further deemed him naïve, unoriginal in his criticisms, disgruntled, disloyal, cowardly, or greedy (i.e., Smith made his fortune at the firm and now can financially afford to attack it).  See e.g., Mean Street: Goldman’s Problem is Destiny, Not Greg Smith

Some Thoughts on the Goldman Response

Sadly, attacking the messenger and isolating Smith as a “lone gunman” prevents Goldman from seriously analyzing its deficiencies.  These deficiencies are obvious from its response.

Goldman does surveys internally.  While it is commendable to have employee opinion surveys, isn’t the real problem at Goldman the views of external stakeholders, such as  clients, business partners (including other Wall Street firms), former employees, regulators, elected officials and law firms?  Further, while 89% of employees believe that Goldman provides exceptional service to clients, 11% believe that Goldman provides less than that.  That is approximately 3300 employees who have questions and doubts about client service.  Also, Goldman relies on the fact that customers have not deserted the firm.  Unfortunately, in many instances, clients are virtually forced to do business with the firm based on Goldman’s dominant market position and diminishing competition within the industry (failure of major competitors such as Bear Stearns and Lehman).

One of the most difficult problems I had as a corporate attorney was to convince a client to separate the message from the messenger.  That is, a whistleblower may be a horrible, unethical and poorly performing employee, but he or she may be right about the corporate offense being exposed.  Given Goldman’s response, I doubt whether its management can make such a separation.

A second problem as a corporate attorney is to convince clients that while a particular practice may be within the letter of the law or in a gray area, it is not worth risking the firm’s reputation to engage in a practice that puts the firm at the very edge of legality. Further,  just because a practice is legal does not necessarily make it an ethical business practice. Courts have a peculiar way of finding that what one thought was legal was now viewed as over the line.

Problems in the Goldman Culture

Should we be giving Goldman the benefit of the doubt?   Recent history suggests that Mr. Smith has accurately portrayed an avaricious culture which pushes the outer boundaries of legality.  Fabrice Tourre, another Stanford-educated Goldman vice president, proudly wrote in an email how he created complex, highly leveraged derivatives which no one understood (other than “Fab”) to short the housing market at the expense of other Goldman clients.  See Goldman Sachs Scandal: Fabulous Fab and Masters of the Universe.

The Tourre testimony led to an SEC lawsuit against Goldman for misleading investors.  Despite initially denying the charges, the firm settled with the SEC for $550m.   Sen. Carl Levin, head of the Senate’s investigation of the financial crisis detailed Goldman’s role in misleading investors and profiting from the housing collapse at the expense of clients. See Wall Street and the Financial Crisis: Anatomy of a Collapse

In another example, a Delaware Chancery judge recently almost terminated a merger between Kinder Morgan and El Paso Corp., because of Goldman’s conflict of interest in advising both sides of the transaction. See Wise Up on Goldman.

Ethics and American Corporations

With the inception of the Corporate Sentencing Guidelines, corporations have appointed compliance officers and provided executives with extensive ethics training.  With the accounting scandals at Enron and WorldCom, Congress passed Sarbanes-Oxley, holding corporate executives responsible for the financial integrity of their companies.

We now have more laws and more training on ethical corporate behavior than ever before.  With all this training and the strict guidelines, why do we still have daily reports of unethical conduct?  Some thoughts:

• Ethics come from early parental training about right and wrong.  As one of my colleagues remarked “who were their parents?”
• Training does not come from lawyers teaching executives in corporate conference centers, but from family values and religious training or a combination of both.
• We have become a far less religious society and we have rationalized away the concept of sin;  indeed, in many cases we have expunged evil and reworked it with a myriad of self-justifications and excuses.
• The focus has shifted from doing the right thing to making the most money,  a culture of “greed is good.”
• By failing to prosecute the malefactors of the financial crisis, we only encourage and reinforce unethical behavior.

Mr. Smith may be on to something.  Who will hear his message?

Related posts:

1. Goldman and the Winner Take All Society
2. A Reputation as Good as Goldman Part II
3. Watershed Event in the Financial Crisis – SEC v. Goldman

Mr. Schiff is Not Alone

Mr. Abelson further describes the fears and anxieties of Wall Street employees.   Bonuses on Wall Street fell 14% this past year to $19.7 billion, the lowest since 2008, with the resulting protestations of catastrophe utterly hyperbolic.   One recruiter referred to this situation as a “disaster.”  Wall Streeters responded in the following ways to this “disaster”: canceling ski trips to Whistler, Aspen and Tahoe; driving to Fairway Market to buy salmon on sale; selling two unused motorcycles (but keeping a Porsche); contemplating the horrors and ignominy of putting children in public school; reducing summer home rentals from four months to only one; turning down an offer to judge a wet T shirt competition in New Orleans;   shopping with coupons.   Oh the misery!

Wall Streeters lucky enough to have money have been able to continue luxuries such as $500 a month parking spots, owning (and garaging) two cars in New York City, $7500 a year for golf club membership, $17,000 a year for dog care, and membership in a gun club.

The Waning of Finance

After a well-earned cynical and sardonic chuckle, the serious response to the ludicrous descriptions above ought to be a different perspective on the “pity party pattern” itself.  The elimination of these egregious excesses could be a harbinger of a better, more moral and appropriate communal and economic future.  In “The Waning of Finance“, Martin Hutchinson describes the rising share percentage of financial firm profits compared to US Gross Domestic Product:

The increasing share of financial services in GDP has been inexorable since World War II. Taking the “finance and insurance” sector of the national accounts as a benchmark, its share of GDP rose from 2.4% of GDP in 1947 (the first year available) to a local peak of 4.3% of GDP in 1972. Then it was flat for a few years, surged during the 1980s to 6.0% of GDP in 1987 and surged again in the 1990s to a peak of 8.2% in 2001. That later peak was not surpassed during the housing finance boom of the mid-2000s, surprisingly, but was finally topped in 2010, in which the sector represented 8.5% of GDP. Thus the surge in financial services activity is consistent and long-term, nearly quadrupling as a share of GDP over the last 63 years.  See The Waning of Finance

Mr. Hutchinson is predicting the end of the economically unhealthy dominance of financial firms.   Federal Reserve largesse, coupled with zero interest rates, have until now provided the support for many of the most profitable financial activities.  However, in a new regulatory and tax environment, and with further tightening if there is another financial crash, many drivers of financial firm profits will become unprofitable:

• Securitization -  a main driver of the housing bubble and subprime mortgage fiasco
• Derivatives – meant to hedge exposure, but in reality smoke screens obfuscate corporate balance sheet problems
• Credit Default Swaps – “The legal and payment uncertainties surrounding these instruments in any case make them almost pure gambling contracts. There will doubtless be another financial crash shortly, in which CDS are heavily implicated….”  See The Waning of Finance
• High Frequency Trading – “institutions position their machines at the stock exchange in order to get earlier information of trading flows, on the basis of which they trade, is pure rent-seeking and a form of insider trading.”  See The Waning of Finance
• Hedge Funds – their excessive fees eliminate any fiction of outperformance of traditional funds
• Government Debt – because of central bank intervention, these funds have been encouraged to borrow short-term to buy long term government debt, a recipe for disaster.  See The Waning of Finance

What Will Bring About the End of the Financial Domination of the Economy?

Three factors, according to Hutchinson, will synergistically end the finance bubble:

First, there is a natural reaction against the excesses of recent decades, in which some of their more egregious business practices will no longer work and will be abandoned. Second, an end to the current excessively loose monetary policy will result in a dampening of speculation and a reduction (much of it the hard way, through bankruptcy) in systemic leverage. Finally, the surge of regulation through Dodd-Frank and the equivalent EU regulations will itself dampen activity in the sector, forbidding some practices and making others uneconomic. Just as deregulation from the 1970s encouraged the growth of the financial services sector so new regulations, imposed ineptly, will cut it back as they did in the 1930s. See The Waning of Finance

And I can cite one more personal anecdotal harbinger of the coming end of the financial bubble:   A fund manager of one of the premier Wall Street firms lamented how difficult it was for his firm to attract the best talent out of business school.  The best and the brightest young and new business professionals are gravitating to Silicon Valley and to the emerging social media companies.

Where talent flows and the bubble blows, so does the next big one?  But further discussion of the bursting of this bubble is a blog for another day.  Perhaps some of this talent will migrate even into math, science and manufacturing.

Related posts:

1. Goldman and the Winner Take All Society
2. War on Prudence
3. Bring Back the Robber Barons

2012 is an election year.  Republicans and Democrats seem to be drawing battle lines, but in fact little difference exists between the two parties.  Both espouse statist solutions to America’s economic woes.  The Republicans would utilize the state to enforce a conservative social agenda (pro-life, marital fidelity, “family values”) and channel money to the defense complex.  Democrats would utilize the state to enforce a seemingly different agenda: pro-choice, mandatory medical insurance, social equality and a secure network of social services (unemployment insurance, social security, welfare).  Except for Ron Paul, who has been marginalized, no one debates the proper role of the state.  All the candidates give lip service to reducing budget deficits, but little serious discussion to the proper role of the state.

The Long Emergency

Current economic policy demonstrates the state’s overbearing hand.   Doug Noland, in A New Bull Market?  analyzes current government economic policies.   We have had four years of unprecedented economic stimulus with, among other artifices: zero interest rates, Federal Reserve asset purchases, economic stimulus, and Federal Reserve participation in worldwide liquidity operations (outright money printing).  Further, these unprecedented economic interventions show no signs of abating.   On the contrary, The Federal Reserve trumpets that it will keep interest rates at near zero through 2014.  Further, the Fed and the Treasury have assumed the role of supporting the stock market, housing prices, Fannie Mae, Freddie Mac, private banks and virtually decreeing the current artificial 2% inflation rate.  And even worse, no one in a position of policy or decision making seems self consciousness or regretful that these policies go on and on without an exit strategy.

We arrived here through past government interventions and bailouts.  The history of bailouts is long and undistinguished:  The Penn Central Railroad (1970); Lockheed (1971); Franklin National Bank (1974); New York City (1975); Chrysler (1980); Latin American Debt Crisis (1982); Continental Illinois National Bank (1984);  Savings &Loans (1989);  Mexico (1994); Russia (1998); Long Term Capital Management (1998);  Airline Industry (2001);  Bear Stearns (2008); Fannie Mae and Freddie Mac (2008); AIG (2008); Auto Industry (2008);  Troubled Asset Relief Program – leading banks (2008); Citigroup (2008); and Bank of America (2009).  See History of U.S. Gov’t Bailouts; Top 6 U.S. Government Financial Bailouts; A Brief History of Government Bailouts; Are Financial Crises Alike?; A New Bull Market?

In every bailout we pay a high price for these statist solutions to economic problems.  A bailout is nothing more than a monetary transfer.   Instead of bondholders or shareholders in flawed enterprises taking a loss, the US taxpayer, essentially all of us, are paying for the mistakes of others.  This practice is a cowardly undermining of the essence of capitalism.   In true capitalism we would punish failure and reward success.  This government cowardice also distorts the legal system, as the government unilaterally claims a superior economic right over other creditors to economic relief.

Statism, Capitalism and Freedom

Ideally, capitalism and freedom are intertwined; that is, we are free to make mistakes. Yes, in this scenario our mistakes are punished in the marketplace.   But the rule of law in this scenario can also proceed as intended; that is, a poorly run enterprise can go through bankruptcy and either liquidate or reorganize.   If we want political freedom, we need economic freedom.  It is risky and sometimes painful, but the imprudent among us need to be economically punished and the rightful parties, rather than the entire electorate, need to bear the losses.

What Questions Should We Be Asking?

The political debate should ask the hard questions:

• Why is the Federal Reserve keeping interest rates at zero until 2014 when we are supposedly in the fourth year of a recovery?

• If we are in the fourth year of a recovery why are we fiddling with the capital markets with Operation Twist and talk of QE 3?

• With unprecedented levels of fiscal and monetary stimulus, why has government intervention produced only below average and mediocre economic growth? Why is there no recovery in housing prices?  Or no growth in jobs?

• Why is the Federal Reserve targeting 2% inflation when the legal mandate is no inflation?

• Why is the Federal Reserve artificially supporting the stock market?

• When will we ever return to a “normal economy” without the need for outsized deficit spending and monetary stimulus?

• Why are we privatizing profits and socializing losses?

These are but some of the important questions.   The key question to ask is where did genuine capitalism go?  We pride ourselves as the land of free market capitalism.  Unfortunately, it has not been practiced in the United States since the 1920’s.  Right now we have fascism, state socialism, crony capitalism, but certainly not the real thing.  And that is scary.  Someone should be asking where free market capitalism went.

Related posts:

1. Economics and the Welfare State: Oil and Water?
2. Are We a Socialist Country?
3. Who Pays?

The Great Financial Crisis in the fall of 2008 led us on this path.  Perhaps it started with the best of intentions to save the financial system, but the unintended consequences of intended financial actions has negated any good from these efforts.  Let’s look at the particular elements of this sad condition:

• Zero Interest Rates – When a market sets interest rates, important information is conveyed to market participants.   Interest rates in a free market environment measure risk of repayment, a fair rate of return and the potential for inflation.  When the Federal Reserve anchors interest rates at near zero for “an extended period of time,” investors can no longer make long-term rationale investment decisions. Thus, money is likely to be mal-invested in uneconomical projects or speculation increases in economically sensitive commodities such as oil, metals and grain.
• Suspension of Mark to Market Accounting – At the start of the financial crisis, Congress leaned on the Financial Accounting Standards Board to suspend “mark to market” accounting (that is, the valuing of an asset in the most honest way, that is, taking into account its impairment or loss of value) .  In its most basic form, this is just plain dishonesty.   This dubious practice spread to banks in Europe as well.   Thus, there is no transparency in bank balance sheets; we (and even the banks themselves) simply can no longer believe the numbers on any institutional balance sheets. The result is that European banks are no longer willing to lend to one another.   Why?  These banks are now leveraged as much as 50-1, thus only a 2% drop in asset prices puts them at risk of failure.  We know that sovereign European bonds have dropped much more than 2%.   Thus, it is likely there is little or no real collateral to support a loan. See Art Cashin Exposes the Behind the Scenes Panic in Europe. With housing prices continuing in decline in the United States, I would suspect that many US banks too are hiding losses, and are in more dire straits than they or the Administration admits.
• Stress Tests – To reassure the public, both the Federal Reserve and the European Banking Authority ran stress tests on large banks.  Dexia (Belgium’s largest company) passed the most recent round of these “stress tests,” and then failed within three months.   Irish banks failed four months after their 2010 round of these tests.  See How Did Europe’s Bank Stress Test Give Dexia a Clean Bill of Health?  Bank of America and Citigroup shares have plummeted in 2011.  The Federal Reserve performed similar stress tests on these and other major American banks.  How credible were our “stress tests?”
• Eroding the Sanctity of Brokerage Accounts – The collapse of MF Global revealed that a brokerage firm could appropriate segregated customer accounts for its own uses.  It appears that MF Global circumvented US laws on account segregation by pledging customer accounts against a repo agreement in London.  Now, customers may never recover their monies.  See MF Global: The SERIOUS Issue Reaches Mainstream Media.  Karl Denninger points out that the standard brokerage agreement permits hypothecation and re-hypothecation, meaning that your brokerage account can be pledged to support a brokerage company or bank loan.  Since derivatives have preference over depositors, customer’s segregated accounts funds are at risk.
• Eroding the Sanctity of Real Property – To speed securitization of mortgages, the banks created an alternative mortgage registration system which bypassed centuries-old rules of settled property law.  A recent report documents the disastrous consequences:

… “thanks to the Mortgage Electronic Registry System’s (MERS) failure to accurately complete and/or publically record property conveyances in the frenzy of banks securitizing home loans and ins subsequent foreclosure actions, neighbors of a foreclosed property (with a sequential conveyance) as well as a foreclosed property itself will have unclear boundaries and clouded/unmarketable titles making it difficult, if not impossible, for these homeowners to sell their properties and for subsequent purchasers to obtain title insurance on the property.”

The report goes on to point out that courts have criticized the MERS model as flawed and have ruled against MERS’ stance to foreclosure. MERS is described as being “wholly inaccurate and not allowing homeowners to fight foreclosures because it [MERS] shields the true owner of a mortgage in public records.” See Study Claims that MERS Destroyed the Chain of Title and Consequently, the Housing Market

And worse yet, in sorting through the avalanche of subsequent foreclosures, mortgage servicers have filed fraudulent affidavits and false documentation. See e.g., Nevada Files First Criminal Charges in Robo-Signing Case

• Greek Credit Default Swaps – In good faith, buyers purchased credit default swaps on Greek bonds to hedge against a potential default.   The European authorities strong-armed banks and other investors to accept “voluntary” 50% haircuts on Greek bonds.  Because of this “voluntary” characterization the credit default swaps were not triggered.  With Spain, Ireland, Italy, Portugal and other countries suffering huge losses on their bonds, is it likely that investors will invest in these bonds when the hedge of a credit default swap can be negated through European financial authority fiat?   See Credit Default Swaps Useless as Hedge Against Default
• Federal Reserve Intervention in Markets – So far, when stock markets have faltered, the Federal Reserve has come to the rescue through quantitative easing (QE1& 2) or Operation Twist.  Thus, investors cannot know the true value of any stock since the Federal Reserve will not allow it to fall to a market-determined price.   Similarly, with zero interest rates and purchase of mortgage- backed securities, the Federal Reserve will not allow house values to fall to market clearing prices.
• Failure to Prosecute – Outside of a handful of insider trader prosecutions there has been no attempt to prosecute the malefactors of Wall Street. Excuses range from opining that the practices were legal, to the difficulty in building a case.  In the Savings and Loan crisis of the early 1990s the same difficulties existed, yet 1100 prosecutions were brought with 800 banks executives sent to jail.  See In Financial Crisis, No Prosecutions of Top Figures

Real World Consequences

We have eliminated price discovery from our markets.  We have neither permitted stocks to fall nor interest rates to rise.  Instead of prosecuting the banks that caused this problem, we shower them with interest free loans from the Federal Reserve so they can speculate or earn risk free profits by re-depositing funds with the Federal Reserve.  Thus, capital is being diverted from sound investments and used for speculative purposes or worse.

European financial authorities have destroyed the efficacy of hedging sovereign bonds in their handling of the Greek bond haircuts.  And thus another important market is being destroyed.

More ominously, Karl Denninger reports that in the wake of the MF Global failure, farmers are eschewing the hedging of crops through commodity futures and instead selling directly to food companies.  Thus, price stability will be diminished and consumers will ultimately pay higher prices.

The failure to “mark to market” and run honest stress tests has resulted in a freezing of interbank loans (a classic credit squeeze) and resulted in a silent run on banks, as UBS reports (bold face type in original text):

European banks are making great use of the ECB’s overnight deposit facility. Last night they parked $590 billion at the ECB breaking the record they had set the night before. They are clearly unwilling to lend to other European banks, highlighting the distrust and fear in the interbank marketplace.

The distrust on the streets is said to be growing also. Barroom gossip says that safe-deposit boxes are in a demand that borders on frenzy. They allow you to take your Euros and covert them into something of value (gold, Swiss Francs, etc.) and sock it away in a safe place.

 Others are said to be buying property in London and elsewhere lest you awake one day and discover that your Euros have reverted to drachmas or lira.

 Savvy bankers are said to be setting up personal and communal trusts domiciled in places like the Bahamas, the Caymans or the Isle of Jersey. Some banks are offering depository accounts denominated (and repayable) in alternate currencies like the dollar or the yen.

 We think a Lehman-like event would most likely be triggered by a run on a bank or a series of banks. The scramble for currency (value) protection among the public could turn into that bank run in the same way that a crowd can instantly turn into a mob. Watch the money flows out of Greece and Italy very carefully. The pot continues to bubble. See Art Cashin Exposes the Behind the Scenes Panic in Europe

If the Administration, The Federal Reserve and the European Authorities had set out to destroy capitalism, free markets and the current financial system, they could not have done a better job.   Free markets and a free people are intertwined.  The road to financial nihilism is ultimately a very dangerous path.

Related posts:

1. Elements of an Unstable Financial System
2. Surfing the Financial Crisis
3. Watershed Event in the Financial Crisis – SEC v. Goldman

Dimon was responding Wednesday to a question at an investor conference about the hostile political environment towards banks.

“Acting like everyone who’s been successful is bad and that everyone who is rich is bad — I just don’t get it,” said Dimon at the conference, which was organized by Goldman Sachs Group Inc.

Dimon said he’s worked on Wall Street for much of his life and contributed his fair share.

“Most of us wage earners are paying 39.6 percent in taxes and add in another 12 percent in New York state and city taxes and we’re paying 50 percent of our income in taxes,” Dimon said in defense of his fellow Wall Street bankers. See Jamie Dimon Rails Against “Rich is Bad” Talk

Are We Bashing the Rich or the Well Connected?

America is a land of opportunity.  Children of poor immigrants can grow up to be President, entrepreneurs, brilliant scientists or even CEOs of Fortune 500 companies.  Thus, Americans venerate a Steve Jobs or a Bill Gates.  Not that these individuals are without detractors, but they are admired for starting from scratch, innovating, and filling a market need.  Often these individuals single-handedly create the market for their products and services. See All Millionaires are not Created Equal

Let’s examine why Jamie Dimon and other bankers are less admired and often vilified.  Note the deft sleight of hand in Mr. Dimon’s answer to the question: the question posed concerned the hostile environment toward banks.  Mr. Dimon’s response is that he does not understand why the public thinks that everyone who is successful is bad.  He in fact never answered the question of why everyone hates banks.

At the core of the hatred of banks (and perhaps Mr. Dimon himself) is crony capitalism.  Mr. Dimon’s “success” is owed largely to the unholy alliance between the Bush and Obama Administrations and the Too Big to Fail Banks.  Let’s examine the blessings the government has bestowed on Mr. Dimon:

• Bear Stearns – JP Morgan Chase and Mr. Dimon merged with the “failing” Bear Stearns, paying $10 per share for a company that had recently traded at $93 per share.  The Federal Reserve then made a $29b non-recourse loan to JP Morgan secured only by the mortgage backed securities of Bear Stearns.  Thus, the Federal Reserve could not seize JP Morgan Chase assets, if the Bear Stearns collateral proved insufficient to repay the loan.  See Seeking Fast Deal, JP Morgan Quintuples Bear Stearns Bid, Wikipedia

• Secret Loans from the Federal Reserve – From 2007-2009, the Federal Reserve made $7.7 trillion of secret loans to 190 financial institutions, resulting in profits of $13b.  These loans were at below market rates, virtually free, ensuring profit for the banks. Bloomberg, which made the Freedom of Information Act request, estimated that JP Morgan profited in the amount of almost $458m.  Mr. Dimon did not disclose these loans or the banks’ need to his shareholders:

JPMorgan Chase & Co. CEO Jamie Dimon told shareholders in a March 26, 2010, letter that his bank used the Fed’s Term Auction Facility “at the request of the Federal Reserve to help motivate others to use the system.” He didn’t say that the New York-based bank’s total TAF borrowings were almost twice its cash holdings or that its peak borrowing of $48 billion on Feb. 26, 2009, came more than a year after the program’s creation. See Secret Fed Loans Gave Banks $13 Billion Undisclosed to Congress

• Zero Interest Rates – The zero interest rate policy of the Federal Reserve continues to permit banks to borrow at below market rates, thus enhancing bank profits at the expense of savers.
• Compensation – While being rescued by the Federal Reserve, JP Morgan Chase’s board awarded Mr. Dimon a $17m bonus for 2009. In 2010, Mr. Dimon made $20.8m.  JP Morgan partisans will argue that this was modest compared to industry peers.  Should US taxpayers, those of us who ultimately stand behind these loans, reward executives with large compensation packages?  Unlike the situations of most of the rest of us, JP Morgan Chase makes available to its top executives tax advantageous programs such as the permitting tax deferral of compensation, 401k plans, a defined benefit pension plan and use of the company plane.  If terminated without cause, Mr. Dimon would receive cash and stock awards valued at $16.7m. See Are CEOs Paid too Much: Not All of Them; JP Morgan Chase CEO Gets $17 Million N0-Cash Bonus; Elements of Executive Compensation (JPM); JP Morgan Chase 2010 proxy

Being Rich Isn’t the Problem

Yes, there is income inequality and we have heard endlessly about the elite 1% profiting at the expense of the 99% of ordinary Americans.  But the real hostility goes deeper than just these income disparities.   There is a good reason why Mr. Dimon chose not to discuss the hostile environment toward banks.  He is well aware of why it exists:  the American public has been treated to the spectacle of secret loans to banks; CEOs have been permitted to keep their jobs after nearly destroying their own banks and the US economy; too generous executive compensation practices and perquisites continue which ignore the fact that taxpayers needed to bail out these institutions (and will probably have to do so again);  banks still fail to undertake serious loan modification programs for underwater homeowners; they hoard excess reserves at the Federal Reserve rather than make loans to stimulate the real economy; they attempt to impose fees on cash withdrawals from ATMs;  and finally and disgracefully,  these banks have not been  prosecuted.

Mr. Dimon, the focus is on you and other bankers, not necessarily “the rich.”   Perhaps we need more hard hitting articles like the Bloomberg piece on secret loans to banks, to focus the attention on the true issues, not bogus articles of class warfare.   Unfortunately, neither the press nor the Administration has been rough enough on Mr. Dimon.

Related posts:

1. The Meal Was Great…Part II
2. The Failure of Extrapolation
3. Are We a Socialist Country?

It is too easy to blame this behavior on the decline in morality evinced by Wall Street scandals and the behavior of our political class.  A deeper point needs to be addressed.  We have become a society of numbers and meaningless symbols.   How much do you make per year?  What school did you attend?  How much is your house worth?

Hiring by the Numbers

For much of my career, a significant part of my responsibility was the hiring and supervision of attorneys in a large legal department.   At best, hiring is a crap shoot.  Despite a glossy resume, one can never tell why someone is in the job market at any given time, or how that person will actually meet the standards and fit the profile of the job for which they are interviewing.  Usually complicating the decision making process is  the legal department’s need to hire  experienced attorneys with a minimum ten years experience. In this environment a new hire was expected to perform at an extremely competent level with little or no training or supervision, the proverbial “hit the ground running” paradigm.

One of my peers hired strictly by the numbers.  A candidate had to be a graduate of one of the top 41 law schools, and had to have more than a 700 LSAT.  My colleague preferred a candidate to have a background as a prosecutor with US Attorneys’ Office or the Judge Advocate General.

After a while, I broke the code on my colleague’s idiosyncratic requirements.  I discovered that he used the Gourman Report of Graduate Programs.  Dr. Gourman does not reveal his exact methodology or statistics.  Generally, the Gourman Report methodology asks university graduate departments to rate each other, and assess which they think are best in their field.   By definition then, this questionable methodology yields a self-reinforcing cycle of the top programs continuing to nominate each other in a reciprocal and mutual admiration society.  See Caveat Emptor: The Gourman Report for a critique of the report’s methodology.   The same large prestigious universities continue to populate these lists.  Page 1 of the Gourman Report list of law schools had exactly 41 names; my colleague’s law school alma mater happened to be number 41.  Thus, I deciphered my colleague’s “scientific” method of hiring and the inherent folly of using numbers to find good people.  (Soon thereafter, for amusement I confronted him and pointed out that to be really scientific he would have to find the Gourman report related to the year that the candidate graduated law school to really ascertain whether he was hiring a true “top 41” candidate.)

In another example of this folly, we later merged with a company which would only hire candidates who had combined SATs over 1500, LSATs over 700, a top 15 law school degree (thank goodness for Gourman) and experience in a prestigious law firm or prosecutor’s office.

I am still amazed that I was ever hired, promoted or retained after we completed several major mergers.  I fit none of these criteria nor did many of the best attorneys in our legal department.

The Hard Work of Hiring; the Harder Work of Assessing Job Performance

The SATs are primarily predictors of how well one will perform on tests like the SAT’s.  Since they were instituted as a method of evaluation, they have been repeatedly called into question as predictors of college success. Further, how well one performs in college and law school is not a total predictor of how well one performs in that first law job.  At each step, real life intrudes, essential character and temperament inserts itself into the process, and a lawyer has either learned to practice law competently or not.

No short cuts or quantitative formulas exist in making hiring decisions.  Generally, every candidate I interviewed had a good academic and work record.   Intelligence, analytical prowess and certainly test numbers were merely table stakes to get in the door.  Other more important factors determined whether or not an attorney would be successful in a corporate environment.  In evaluating candidates, I tried to ferret out the following:

• Can they work under pressure, or under attack?
• Can they take on a project with minimal supervision?
• Are they willing to put in long hours, including nights and weekends, to accomplish the job?
• Are they patient and persistent; can they see a project to its conclusion?
• Are they creative; have they ever displayed ingenuity? Can they work with and lead a team of lawyers and business people?
• Do they communicate clearly in speech and writing?
• Can they accept criticism?
• Do they respect subordinates as well as superiors?
• Do they display emotional intelligence; can they intuit the atmosphere as well as the facts of a situation?
• Is integrity clearly a part of their makeup?  Has it ever been tested?

The Education Testing Service and testing results cannot measure any of the above-listed factors.  And in my 32-year corporate career I firmly believe that one cannot be successful on a long-term basis without meeting the above criteria.

Despite conducting rigorous interviews and extensive background checks, an honest hiring supervisor will admit that it is difficult to judge these non-numerical factors.  Further, if a hiring supervisor is correct 50% of the time, he or she has beaten the odds.  I was lucky and was able to hire many attorneys who rose through the corporate ranks and became senior corporate leaders.  Some went to the “best” law schools, some did not. I was also required to ask some of my hires to leave.  While difficult each time, that too is the nature of hiring and corporate management.

Looking for the Easy Way Out

This returns us full circle to the Long Island SAT/ACT cheating scandal.  As a society we look for the easy way out in decision making.   Perhaps those Long Island students were thinking: if I can just achieve a high enough test score, I can attend a prestigious university which will guarantee me access to a great job or graduate program, which in turn will assure my success in life.  Success is more complicated than that.

We have deteriorated to a society of numbers and brands.  The ideal political candidate goes to the right schools, has the right tickets punched on his or her resume, gets elected to the right office and now is the right candidate for higher office.  We fail to delve into the more important factors of character, grace under pressure, emotional intelligence and integrity.  The epiphany, long since necessary for all of us, is that we entrusted our money and our government to Wall Street and Washington charlatans who went to all the right schools, held  all the right jobs and had all the right  connections.  And look what happened.

Given all of this, it is no surprise we now have a group of students on Long Island willing to sell their souls for $3500 or less.

Related posts:

1. Mission Creep
2. Ask Your Congressional Representative to Do Nothing
3. Labor and Employment Laws: The Hidden Job Killer

Retirement ended these excuses.  In retirement I have embraced the notion that I’d like to try things outside of my comfort zone.  What is anyone going to do, fire me?  Not likely, and so what if they did.  And after years of competitive corporate life, my mindset in this project was that I wanted to excel at raising money and do better than past campaigns for this organization.     The short answer is I succeeded, but it was not easy.

Attitudes towards Charity

The Bible is clear that there is an obligation to tithe.   Numbers 18:21; Deuteronomy 14:29.   Mormon and Orthodox Jewish believers take upon themselves the obligation to tithe.  But my guess is that this obligation is followed more in the breach.

We live in a society of self-indulgence and immediate gratification.  During the boom period of the 1990’s onward, our peers built McMansions and bought luxury cars in record numbers.  Any societal self-governor of modesty, self-restraint, and proportionality disappeared.  The ethic became, I want it, I want it now and I deserve it, so why wait?

While pampering ourselves, how much did we think about charity? Charity is a mindset.  A clergyman explained the sin of Joseph’s brothers who cast him into a pit.  The brothers probably had cause to be angry at Joseph as he flaunted his new coat, told of self-aggrandizing dreams, and denigrated his brothers and parents.  Nevertheless, after the brothers cast Joseph into the pit, they sat down to a feast.  They ignored Joseph’s cries and continued to enjoy their meal.

Ignoring the Cries

It is easier to avert our eyes from the need to give charity than to focus squarely on the need to give. Before we began this charity campaign, I spoke to a professional fundraiser.  He said I would soon learn that there are a thousand reasons not to give charity:  “I have kids in college…I am supporting my mother-in-law in a nursing home…I don’t like how the charity allocates funds” and so on.

But the next time we  take an expensive vacation, buy Stub Hub tickets at exorbitant prices to a “must see” concert or  sporting event, go out to a lavish dinner or upgrade a 3-year old car to an even more expensive model, maybe we should think about whether or not we could do with less.

During the campaign, many people who did not have a lot of money made small contributions.  I was more heartened by these small gifts than larger contributions from the rich.  I knew that the rich person was making little or no sacrifice while the poor person’s smaller contribution was financially significant. Maybe the old adage is true: “give until it hurts.”

Every day I go out of my way to personally contribute a dollar or some change to a poor person.  It obviously helps that poor person, but it also helps me to remember that I have had a blessed life: here but for the grace of the Almighty go I.  So when each of us sits down to our Thanksgiving feasts, maybe we can stop for a moment and listen to the cries of whatever brother Joseph we encounter in our own lives.

Related posts:

1. Wildfires and the Economy
2. “My Word is My Bond”
3. That Time of Year

The Potent Director Fallacy

Robert Prechter in Conquer the Crash coined the term the “potent directors” fallacy.  The fallacy in a nutshell:

 It’s nearly impossible to find a treatise on macroeconomics that does not assert or assume that the Federal Reserve Board has learned to control both our money and our economy. Many believe that it also possesses immense power to manipulate the stock market. The very idea that it can do these things is false. It is what I call the ‘Potent Directors’ Fallacy.”

In reality — the Fed has no such power.  See The Fed is Not in Control: Potent Directors Fallacy

Prechter catalogs the stop and start policies of the Fed which led to the internet stock boom and crash.  The centerpiece of poor policy making was the post internet boom decision to slash the federal funds rate thirteen  times from 2001-2003, which led to the housing boom and the subsequent seventeen   increases from 2004-2006, which led to the housing bust.

Even the start of QE1 could not stop the 2008-2009 plunge in the stock market.  The market did not bottom for several months until March 2009.  QE2 petered out in June of this year, the economy slowed, and once again the market declined.

Perception Management

Charles Hugh Smith points out that we have stopped serious policy making.  Instead policy makers have focused on managing the perceptions of stock market investors and consumers, and now deal in marketing.   American and European central banks and politicians wish to project the illusion that they are still in control.  In his critique of the endless reassurances from Angela Merkel and Nicholas Sarkozy that European banks can be recapitalized and the Euro saved, Smith exposes the vague programs of both of these leaders and our Federal Reserve Bank:

Merkel and Sarkozy’s dog and pony show is perception management ripped right from the Federal Reserve’s playbook. The ontological foundation of the Fed’s playbook is this: the problem is all perception. If the great unwashed populace of debt-serfs perceives that all is well and secure, and the Mommy State has tucked them safely into bed, then they will once again start borrowing and spending without a care for either reality or the future. See The Uncredible Dog and Pony Show: Merkel and Sarkozy

 Fundamentally, the perception management approach is incorrect.  Rather, we must look at the facts of our situation, the bottom line as it were, the areas of real inequities, incompetence and fraudulent policy.  At some point, we must lift the fog of spin surrounding what is really happening:

The problems of the global economy are not based in perception, but in the reality of prices, balance sheets and income statements, vast concentrations of wealth and power, precarious systemic imbalances, ruthless exploitation, and command economies mismanaged by Central State/Bank policy and manipulation.  See The Uncredible Dog and Pony Show: Merkel and Sarkozy

Cargo Cults, Deus Ex Machina and Other Delusions

On October 10, we had yet another monster rally based on vague bank rescue plans.  Previously markets have rallied on yet another in the endless series of Greek bailouts or speeches from Ben Bernanke hinting at QE3.  Each time investors are sucked into markets only to have their hopes dashed by reality.

Sometimes, great literature uses a plot device known as deus ex machina.  An inextricable problem is solved through a contrived, unexpected or implausible intervention.  In Lord of the Flies, a naval officer suddenly appears to rescue the wayward boys stranded on an island.  Similarly, “cargo cults” appeared during World War II, wherein primitive societies observed Japanese and American soldiers unloading manufactured goods from airplanes.  After the war, the natives would establish elaborate religious rituals, such as building landing strips or copies of radios emulating the Japanese and Americans, hoping that “cargo” would soon land.

Financial media watch every move of the Federal Reserve, and European central bankers and politicians hope to divine when the recovery will appear.  Each time the “solutions” deliver less than promised and the economy and markets sink.  Why does anyone continue to believe the central bankers and politicians?  Why is there so little independent thinking and critical analysis? How far have we progressed from belonging to our own version of a cargo cult?

Related posts:

1. Exploding Myths, Eroding Confidence
2. Collateral Damage Revisited, or “Merda Incorporated?”
3. Perception is Reality

Also simply put, credit growth unsupported by income growth has distorted the economy.  In essence, the “easy money” fostered in a lax credit environment has sent the wrong signals to the real economy.  Some examples:

Real Estate

Lax bank lending and governmental programs encouraged homeowners to take on more debt.  The mantra was that house prices always rose. So bankers were eager to lend too much and borrowers were anxious to borrow too much, both believing that house price inflation would sustain the process.  Both parties ignored simple economic principles.  Incomes have been stagnating for more than ten years.  The housing boom expanded the supply of housing beyond demand.  Worse, the peripheral costs of owning a home (taxes, insurance, utilities and the like) ate into the income available to service those over-sized mortgages.   Loans were secured with little or no money down.

In the commercial real estate market, we massively overbuilt.   Again we mistakenly believed that inflation would bail out lenders and owners.   The demographic trend is for large companies to reduce use of commercial space.  Increasingly, employees work from home and technology requires fewer workers and less commercial space.  Internet shopping further lessens the need for brick and mortar retailers.  As with homes, the peripheral costs of commercial ownership kept rising.

Government

A falsely expanding, credit driven economy also sends false signals to government and their employees.   Tax receipts were on the rise from real estate transfer fees, expanding income taxes and capital gains from a rising stock market.    But these gains were bogus, a chimera.  And they did not benefit the average consumer.    Why shouldn’t the largesse of rising tax receipts be shared with employees, who also happen to be a powerful voting bloc?   Politicians were all too willing to grant pay increases, job security guarantees and costly pension and post-retirement benefits to government employees, especially those represented by powerful public unions.  Soon total compensation packages for public employees exceeded their private sector counterparts.

Sovereign Debt

And so the good times seemed to roll. What better way to finance government projects and even foreign wars than through inexpensive sovereign debt?  Dick Cheney once loudly proclaimed that “deficits don’t matter.”  Republicans and Democrats seemed to compete to see which party could run the largest deficits.  Believing that debt could be paid off through ever rising tax receipts, the government made more promises (like expanding Medicare coverage to include prescription drugs).   What were they thinking?  Borrow today and worry about repaying and credit collapse tomorrow?

Macro Trends

The credit binge occurred against a background of unfavorable macro economic trends.   First, US and European population growth, and therefore the supply of workers, slowed.  Second, free trade and free movement of capital and technology has exposed the American worker to foreign competition.  Seventy-dollar an hour (fully-loaded cost) Big Three unionized auto workers cannot compete with their Asian counterparts.   [Heritage Foundation study].  Third, technology has viciously cut into employment in the retailing, telecommunications, banking, insurance, travel and other industries.   Software programs now perform the job functions formerly executed by highly-paid skilled workers.  Fourth, zero interest policy has cut the income of savers and pension funds, impoverishing a class of consumers who supported the economy in the past.  Fifth, regulation is on the rise, increasing business operating costs.

The Debt Bubble

Thus, we have inflated a giant credit bubble without the resources to repay these debts. It is happening both here and in Europe.  Each government maneuver to save a bank (Bank of America) or a country (Greece) is merely an attempt to hide the real problem or shift it from private parties to taxpayers.  We undertook debt that we cannot repay.   We need to write off or restructure this debt, and yes, it will result in losses to the government and major financial institutions.  Restructuring could take the form of increasing the time to repay, reducing the interest rate or swapping equity for debt.  This outcome is unfortunately unpleasant but necessary.

Governments continue to conjure exotic, “cutting edge,” “outside the box” programs which merely delay the day of debt reckoning.   We borrowed too much and we now need to pay the piper.

Related posts:

1. Zero Interest Rates Equals Zero Jobs
2. It Isn’t That Easy to Avoid a Crisis
3. Endangered Icons