Inevitable and Disgraceful, But Still Unpredictable

Here at The Daily Reckoning, we take the part of the underdog…the downtrodden and the despised.  Who fits that description now?  Who is held in lower esteem than child molesters?  Who gets less respect than smokers? Who is in a lower caste than hewers of wood and drawers of water?  We’re talking, of course about the toilers on Wall Street.  So today, we take their part, because no one else will.

Who’s to blame for the worldwide financial meltdown, a crisis that has so far wiped out a notional $30 trillion dollars…give or take a trillion or so?

"Lax central bankers…reckless investment bankers…the hubristic quants," says Niall Ferguson, writing in Vanity Fair.  "Regulate them," is the universal cry.  "Tax them," say the politicians.  "Hang them," say investors.

First, let us look at the charges:

They skinned millions of investors – with their outrageous bonuses, spreads, fees, incentive shares, performance charges, salaries, and "profits" – leaving the financial industry severely under-capitalized…and unprotected.

Guilty as charged.

They ginned up "securities" that no one really understood and sold them to unsuspecting investors, including widows, orphans, colleges, pension funds and municipal governments.

Uh…guilty again.

They put the whole financial world in a spin – churning positions back and forth between each other in order to collect commissions…leveraging…flipping…stripping assets…securitizing…derivatizing…making wild bets based on flim flam mathematics….

No point in going on about it…guilty.

Yes, the financial hotshots did all these things.  And more.  They sold the world on ‘finance,’ rather than making and selling things.  Then, it was off to the races.  Everybody wanted to bet.  Perfecta, place bets, odds-on…double or nothing.  Of course, investors would have been better off at the race track.  The track takes about 20%.  In the financial races, Wall Street took 50% to 80% of all the profits.

Before 1987, only about one of every 10 dollars of corporate profits made its way to the financial industry – in payment for arranging financing, banking and other services.  By the end of the bubble years, the cost of ‘finance’ had grown to more than 3 out of every 10 dollars.  Total profits in the United States reached about $6 trillion last year; about $2 trillion was Wall Street’s share.  What happened to this money?  Other industries use profits to build factors and create jobs.  But the financial industry paid it out in salaries and bonuses – as much as $10 trillion during the whole Bubble Period.  And now that the sector finds itself a few trillion short, it waits for the government to open its purse.

But Wall Street’s critics have missed the point.  Yes, the financial industry exaggerates.  But so does the whole financial world.  Both coming and going.  It’s madness on the way up; madness on the way down.  Investors pay too much for "finance" when the going is good.  And then, when the going isn’t so good, they regret it.  This regret doesn’t mean the system is in need of repair; instead, it means it is working.

The financial industry was just doing what it always does – separating fools from their money.  What was extraordinary about the Bubble Years was that there were so many of them.  There is always smart money in a marketplace…and dumb money.  But in 2007 there were trillions of dollars so retarded they practically cried out for court-ordered sterilization.   What other kind of money would pay Alan Fishman $19 million for 3 weeks work helping Washington Mutual go bust?

Whence cometh this dumb money?  And here we find more worthy villains.  For here we find the theoreticians, the ideologues…and the regulators, themselves, who now offer to save capitalism from itself.  Here is where we find the bogus statistics, the claptrap theories and the swindle science.  Here is where we find  the former head of the Princeton economics department, too, Ben Bernanke… and both Hank Paulson and his replacement, Tim Geithner.  Here, we find the intellectuals and the regulators – notably, the SEC – who told the world that the playing field was level…when everyone could see that it was an uphill slog for the private investor.

"Six Nobel prizes were handed out to people whose work was nothing but BS," says Nassim Taleb, author of The Black Swan.  "They convinced the financial world that it had nothing to fear."

All the BS followed from two frauds.  First, that economic man had a brain but not a heart.  He was supposed to always act logically and never emotionally.  But there’s the rub, right there; they had the wrong guy.  The second was that you could predict the future simply by looking at the recent past.    If the geniuses had looked back to the fall of Rome, they would have seen property prices in decline for the next 1000 years.  If they had looked back 700 or even 100 years…they would have seen wars, plagues, famines, bankruptcies, hyperinflation, crashes, and depressions galore.  Instead, they looked back only a few years and found nothing not to like.

If they had just looked back 10 years, says Taleb, they would have seen that their "value at risk" models didn’t work.  The math was put to the test in the LongTerm Capital Management crisis…and failed.  Their models went sour faster than milk.  Things they said wouldn’t happen in a trillion years actually happened while Bill Clinton was in still in office.

In the real world, Taleb explains, things are stable for a long time.  Then, they blow up.  Then, all the theories and regulators prove worthless. These blow ups are inevitable, but unpredictable…and too rare to be modeled or predicted statistically.  "And they are almost always much worse than you expect."

Enjoy your weekend,

Bill Bonner
The Daily Reckoning

November 28, 2008

Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.

Bill’s latest book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, written with co-author Lila Rajiva, is available now.

"I think Obama should get Gideon Gono on his new team," writes a friend.

Never heard of Gideon Gono, dear reader?  Well, he is one of the best economists who never won a Nobel prize.

Why?  Because Mr. Gono is a proven deflation-fighter.  No one knows more about avoiding deflation that Mr. Gono.  That’s why he was such an obvious choice for Secretary of the Treasury.  If America’s top financial challenge is preventing a deflationary meltdown – as everyone says it is – than Mr. Gono is our man.  Other economists – notably, Ben Bernanke – have studied the question academically, but Mr. Gono has years of practical experience in the field.

He probably should have stayed in the field.  Perhaps hoeing tomatoes.  Instead, five years ago, the old crony was appointed to head up Zimbabwe’s central bank.

Reuters reports on the results: "Zimbabwe’s inflation estimated at 89.7 sextillion percent

"Johannesburg – Zimbabwe’s central bank Governor Gideon Gono has been re-appointed for a second five-year term…. Appointed in December 2003, Gono’s term has spanned the economic collapse of once-prosperous Zimbabwe, highlighted by shortages of basic goods and the highest inflation in the world, which the government put at 230 million percent in July. Washington-based Cato Institute foundation estimates Zimbabwe’s inflation at 89.7 sextillion percent.

"In an effort to deal with hyperinflation, Gono has introduced higher denomination notes and lopped a total of 13 zeros off the currency – 3 zeros in August 2006 and 10 in August 2008 – but it has continued to lose value. Currently, the highest denomination banknote is Z$1 million, not enough to buy a loaf of bread and consumers have to carry huge amounts to make simple purchases."

But instead of bringing in someone who really knows how to keep prices from falling, Obama has appointed Timothy Geithner to head up the Treasury department.  As head of the New York Fed, Mr. Geithner was practically in the room when the ‘bad stuff was going down.’  He was the  G-man…the government’s eyes and ears…right on-the-scene when Wall Street was packing its pipe bombs with subprime debt…filling its molotov cocktails with unsecured commercial debt…building its WMD with more than $400 trillion of derivatives.  Apparently, he didn’t see a thing!

Two of our English colleagues went to see economist Robert Shiller (of the Case-Shiller real estate survey) at the London School of Economics this week.   They report that Shiller says he sent warnings to the NY Fed, while Geithner was in charge.  But the feds didn’t seem to care for his gloomy messages and stopped asking his opinion.  Then, Shiller studied Geithner’s remarks during the bubble period and came to this conclusion:

"He had no idea."

Now, Wall Street has blown itself up…and the whole U.S. economy seems to be caving in.  Bring in Gono, is our advice.  There’s a man who knows how to gin up a little inflation when you need it.  Or even a lot.

*** "Black Friday," they are calling it.

Today is usually the biggest shopping day of the year.  Many people take the day off.  Traditionally, they’ve got time on their hands and money in their pockets.

But not this year.  According to one report, consumers are so tight "the holiday shopping season is already over."

"It’s pretty grim," said an American friend with whom we had Thanksgiving dinner last night.  "But at least people are reacting.  That’s what’s nice about the U.S….people react.  You can make deals.  You can fire people.  You can try to get back on your feet.  Here [referring to France] it takes so long and costs so much money to fire someone that businessmen figure the recession will be over before they get rid of anyone.  And cut prices?  It’s against the law!"

Our friend had just bought a new car.  It’s an Audi, made in Germany, only a few hours drive from here.  But he bought it in America.  Now, he’ll ship it back to back to Europe.

"Is it worth it…I mean, with the shipping costs?  And then, you’ve got to reconvert it…to European standards…" we wanted to know.

"Oh yes…they will make you a very good deal in America.  I saved a lot of money this way…"

*** Meanwhile, the rescue teams are at work.  They’re trying to squander hundreds of billions of dollars.  But they’re short-handed, says the Wall Street Journal.  Apparently, a lack of staff is keeping the pork in the barrel.

"It’s not just that," continued our friend, a government contractor.  "Everybody expects instant results.  But it doesn’t happen that way.  They have procedures that have to be followed…definition of the work…engineering and architectural designs…bids…legal and administrative hoops you’ve got to jump through.  It will be two years before any of these projects are actually begun.

"Of course, they can streamline the process, like they did for the Iraq War, but that just results in a lot of waste and corruption…"

Waste and corruption?  No!

But you ain’t seen nuthin’ yet.  This is the biggest government project in the history of mankind.  Bigger than the pyramids…bigger than WWII.  And there will be no overseers whipping the slaves…and no visible enemy threatening rape and pillage.  Mightn’t some grease help the whole process of spending?   Will a few dollars slip through the cracks?  Will a few insiders score some sweetheart deals?  Will a billion here…and a billion there…possibly end up the hands of people who really don’t deserve it…maybe even the very same people who are most to blame for causing the problem in the first place?

Oh dear reader…that’s too easy…ask us something harder!

*** After the turkey had been put away, Americans started thinking…what’s all this rescuing going to cost?

The $1 trillion deficit forecast for 2009 may turn out to be underestimated, says Forbes.

At the beginning of the week our old friend, Jim Davidson, had this calculation:

"Here’s how this bonanza breaks down:

?       $29 billion for Bear Stearns

?       $143.8 billion for AIG (thus far, it keeps growing)

?       $100 billion for Fannie Mae

?       $100 billion for Freddie Mac

?       $700 billion for Wall Street, including Bank of America (Merrill Lynch), Citigroup, JP Morgan (WaMu), Wells Fargo (Wachovia), Morgan Stanley, Goldman Sachs, and a lot more . On top of  $45 billion for Citibank, comes a guarantee of $306 billion in bad loans.$800 billion to buy mortgages issued or backed by Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks.

?       $200 billion for the auto industry

?       $200 billion to buy securities tied to student loans, car-loans, credit card debt and small business loans.

?       $8 billion for IndyMac

?       $700 billion to $1 trillion stimulus package (from January)

?       $50 billion for money market funds

?       $138 billion for Lehman Bros. (post bankruptcy) through JP Morgan

?       $620 billion for general currency swaps from the Fed

"The numbers change so fast, it is hard to even add them up. Rough total: $3,651,800,000,000 .00

"Note: This list will almost assuredly be out-of-date when you read it."

He was right about that…by the end of the week, it was out of date.  Kathleen Pender at the San Francisco Chronicle reports:

"The federal government committed an additional $800 billion to two new loan programs on Tuesday, bringing its cumulative commitment to financial rescue initiatives to a staggering $8.5 trillion, according to Bloomberg News.

"That sum represents almost 60 percent of the nation’s estimated gross domestic product.

"Most of the money, about $5.5 trillion, comes from the Federal Reserve, which as an independent entity does not need congressional approval to lend money to banks or, in ‘unusual and exigent circumstances,’ to other financial institutions.

"Only about $3.2 trillion of the $8.5 trillion has been tapped so far…"

*** Let’s see, Mr. Market has almost cut stock prices in half.  And he’s taken about 20% off housing prices.  That’s a loss of about $11 trillion.  Hmmm…the government might be a little short.

Or looked at another way…how much spending has been taken out of the U.S. economy?  Americans enjoyed "home equity withdrawal" of about $800 billion per year – at the height of the bubble two years ago.  And they saved nothing.  Now, their saving rates must be going up fast (we have no data on this…yet)… and home equity withdrawals have almost disappeared.  If the savings rate were to go to 10% of GDP that would mean about $1.4 trillion taken out of the consumer economy.  Minus also the $800 billion in home equity withdrawal that no longer happens.  If the government wanted to replace this, it would have to spend about $2.2 trillion MORE each year.   That would be on top of the budget deficit for 2008 – about half a trillion.

How about a deficit of $2.7 trillion?

Does anyone have Mr. Gono’s phone number?