The Bright Side of Catastrophe

Bernie Madoff is a giant in his field. He out-ponzied Charles Ponzi. He out-princed Chuck Prince. He could have taught the Egyptians how to build pyramids. In the history of high-stakes grifting, he outdid them all. A Robin Hood with Alzheimer’s; he stole from the rich. If he’d only remembered to give to the poor he’d be a hero!

Who can honestly say he isn’t enjoying this financial crisis? It has unhorsed cavalier fund managers …it has turned the masters of the universe into servile waiters…it has made Nobel Prize winners look like morons. The rich…the proud… the pompous…the vain…the incompetent…Wall Street – surely there is a God…an ‘invisible hand’…giving them all a whack on the head!

And there are the regulators too! Under their very noses the biggest scams in history went unnoticed. America’s SEC alone – to say nothing of the countless other cops on the financial beat – had 3,371 employees playing the piano in 2006. If you can believe it, not a single one of them noticed what was going on in the back room. Even after rummaging through Bernard Madoff’s back office twice in the last three years, they still didn’t know. They must have been like pets watching an orgy…with no idea what to make of it, but wagging their tails and vaguely wanting to get in on the action.

Between Tuesday and Wednesday of last week, Madoff’s managed accounts were thrown into a “spiral of horror” said one fund manager. Tipped off by his own sons, the feds went to Madoff’s apartment. They gracefully asked if there was perhaps a misunderstanding. No, replied Madoff, “there was no innocent explanation.” And so, they put the cuffs on him and acted as though they had Lucifer himself in custody.

Bernie Madoff is a giant in his field. He out-Ponzied Charles Ponzi. He out-Princed Chuck Prince. He could have taught the Egyptians how to build pyramids. In the history of high-stakes grifting, he out did them all. A Robin Hood with Alzheimer’s; he stole from the rich. If he’d only remembered to give to the poor he’d be a hero!

Madoff’s charm was that he out-foxed the foxes and out-scammed the scammers. How hard was it to give away new houses to people who didn’t have any money…or get people who didn’t speak English to sign toxic mortgage documents? Child’s play, really. And the executives with their millions in bonuses… and humbuggers like Richard Fuld – their marks were mostly ordinary stock market investors; low hanging fruit compared to the coconuts Madoff plucked. Rather than go after the widows and orphans, he swindled the smartest money in the world…money managed by family offices…the old Jewish money from New York and south Florida…London’s Man Group…Switzerland’s Union Bancaire Privee. He even flim-flammed the hedge funds – including Fairfield Greenwich for $7.5 billion. And Tremont, a fund of hedge funds, put in more than $3 billion. How cool is that?

And he was remarkably democratic about it; he took money from his own tribe, his own clan, and his own golf club buddies. Billions of it. Even more impressive, he did it not with hyperbole, but with relative modesty. He produced only about 10% per year – which didn’t seem like much during the Bubble Epoque.

How could he guarantee steady 10% per year returns from stocks? Like so many of the conceits and delusions of La Bubble Epoque, it was absurd on its face. How come the SEC, with its legions of accountants, didn’t notice that the numbers were fraudulent? And how could the entire financial industry – with its Nobel winners and it business school graduates – not have noticed what was even obvious to us feral economists here at The Daily Reckoning? For years, we warned that the whole thing was a scam, a fraud and a delusion. And The Daily Reckoning is free!

And now, historians look back and wonder: how could people have been so stupid? The answer is simple: in a bubble, it pays to be stupid. You buy something at a lamebrained price…and it goes up. Not only did stupidity pay, it paid well. Running a bank paid better than robbing one. Hedge fund managers got paid more than contract killers or stick-up men.

“When the tide goes out, you see who’s been swimming naked,” says Warren Buffett. We haven’t seen the tide so low in many years; the view is nauseating…hideous…but never before have we seen so many skinny dippers nor had such a laugh. More than $15 trillion has been lost…so much that it threatens to turn the lights out on the entire world economy. The investment banking industry has disappeared. Regular banks have been nationalized. The auto industry is broke. Investors stagger. And mobs break shop windows protest.

Historians will try to make sense of it. But all historians lie. Not intentionally. It’s a professional requirement. They look back and think they see a plot. From then on, every circumstance is bent, greased and wedged into the story line. The basic facts are the same any way you look at it; the dramatis personae don’t change. But the historian can make readers laugh or cry. He can turn it into morality play or an amoral farce. He can focus on the struggle of the masses or the failures of leaders, the triumph of a caste…the defeat of a class…or the perfidy of an entire profession. Already, they’re telling their tale: the system failed…now, we need to fix it. We need more regulation; another Nobel Prize winner, Joseph Stiglitz, says so in the current issue of Newsweek Magazine.

Too bad they can relax and enjoy the elegant mischief of capitalism. In the space of 6 months, it has scratched 10,000 Porsches…destroyed more monuments than Cromwell…and squeezed the rich harder than Mitterand. It would have taken an army of dreary Bolsheviks decades to redistribute so much wealth; and it wouldn’t be half as much fun.

Enjoy your weekend,

Bill Bonner
The Daily Reckoning
December 19, 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.

It seems simple enough to us. Almost too simple.

Birds gotta fly. Fish gotta swim. The feds gotta print money. Why? Because there isn’t any other good way for them to get it. And because the economy is getting worse…not better. The feds feel they have to “do something” to fix the situation. That is the depth of their simpleton machine philosophy – a correction is a “problem”…problems need to be fixed.

The problem as they see it is that Americans don’t have enough money. And since they don’t have enough they don’t spend enough. And because they don’t spend enough, the whole consumer economy sinks.

Yesterday, the Dow lost another 219 points – it has given up almost all the post-ZIRP gains. You remember ZIRP? Zero interest rate policy. The Japanese tried it; it didn’t work. So, now it’s America’s turn. After the Fed announced its ZIRP, the Dow shot up more than 300 points. Now, the Fed has used up its last 100 basis points…and the Dow is back to where it started.

We’ll give you the rest of our market update and then return to our point:

The Washington Post suggests that hedge funds might go extinct as a result of this downturn. That would be a shame; they are such a convenient way to separate fools from their money.

We didn’t notice it when we were in LA last week, but California has been especially hard hit. House prices in many areas are down 40%. Towns are going bankrupt. And the state has had to stop billions of dollars’ worth of new projects in order to protect its remaining cash. Bankruptcy…drought…fire and brimstone – our California Babylon seems to be getting an almost Biblical judgment.

And now we’re seeing the Revenge of the Dustbowl. You remember, during the ’30s, there was a drought in Oklahoma, Kansas, and parts of Texas. The rich earth turned to dust and practically blew away. The poor farmers couldn’t pay their mortgages…and couldn’t raise crops. So, they loaded what they could salvage onto their Tin Lizzies and drove to California, where they tried to get jobs picking fruit.

The natives weren’t always friendly. Californians had their own problems. They didn’t want any more Oakies on the job market. So, they tried to turn them back at the border.

Now, 75 years later, it’s the Californians who are pulling up stakes. For the first time in history, more people are leaving the Golden State than entering it.

And pity the poor old folks in Palm Beach. The island was one of Bernie Madoff’s favorite haunts. And the island’s rich retirees and trust fund heirs were his among his favorite prey. He bilked them out of billions. And now, the Chicago Tribune reports that the pawn shops in Palm Beach are doing a jolly business…

Gold fell $7.90 yesterday…the price is now $860, still well above where it began the year. Gold is the only thing we know that has resisted this bear market. Why so? Because investors suspect that this drama has another act or two. Which brings us back to our point.

The outlook is too simple…too obvious.

*** The feds want to give people money. They’ve already cut interest rates to zero – as a practical matter, they can’t go lower. And Obama is talking about a new stimulus program of more than $850 billion.

The last major stimulus program was $700. So far, only half that money has been skimmed. It takes time to work a hustle of that scale. The money is destined for the accounts of Paulson’s friends and colleagues on Wall Street; everybody knows it. Still, you don’t want to be too transparent about something like that. You have to pretend that you’re not giving away hundreds of billions to the richest people in the country. Instead, you’re helping to “recapitalize the financial system.” And that takes time. In this case, you have to pretend that you are smarter than the market…that you are putting one over on Wall Street by buying its castaway “assets” at bargain prices. Heck, you might even make a profit for the taxpayer.

Paulson has gotten his hands on only half the money that Congress authorized. He wants to be sure there aren’t any Madoff-style blow-ups – at least until the rest of the loot is under his control.

Obama’s additional $850 billion sounds like a good idea to most people. People need cash. They’re not too particular where it comes from…and don’t seem to mind that it belongs to someone else.

But where does all this cash really come from? There are only two choices…up or down…honest or corrupt…inflation or deflation. It is either borrowed…or it is counterfeited.

If they borrow the money, they can bailout cronies and prop up amigo industries. But it does nothing for the economy as a whole. They are just taking money from one person and giving to another. Even this is pretty sleazy…since it is really nothing more than redistributing wealth…from the people who earned it to the people who didn’t. It’s corrupt; but at least it is honest corruption. That is, people are used to it and don’t seem to mind.

Trouble is, Japan proved that it didn’t work. You can borrow and spend all you want. Prices still fall. Unemployment rises. People go broke. They whine and moan. And the pols think they still have to “do something” more.

The United States has an additional problem…even if the feds wanted to borrow every penny of their bailout money, they couldn’t do it – not without driving up interest rates much higher and making the situation much worse. Americans don’t save that much. And the foreigners have their own bailouts to finance.

That leaves no choice. Birds gotta fly…and the feds gotta print.

Stick with us here…we’re getting somewhere…

*** And here, a Dear Reader, puts the question to us:

“I’ve read Empire of Debt and considered the current recession long and hard, and it seems to me the question of the century is: will money destruction caused by stock market declines, housing market declines etc., and the concomitant deleveraging, result in classic deflation like the 1930s? Or will Quantitative easing and our reliance on the kindness of foreigners to buy (and hold) our treasury bonds result in a dollar crisis and subsequent inflation? It seems to me that as a debtor nation we are at great risk for a dollar crisis as former buyers of our bond auctions turn inwards, but this morning’s largest CPI decline on record has me questioning that. Do you still favor hard assets and avoiding the dollar?”

The answer is yes. Deleveraging will (and is) giving us a bout of ’30s-style deflation. But, yes, the feds are coming to the rescue – like an exterminating angel. Bernanke has said as much himself recently. They’re going to print money. And Alan Greenspan spelled out what printing money would mean, speaking to Congress back on February 15, 2005:

“We can guarantee cash benefits as far out, and at whatever size you like, but we cannot guarantee their purchasing power.”

We don’t know what their purchasing power will be. Gideon Gono was so successful in avoiding deflation, he got consumer prices rising at 230 million percent per year. We doubt Ben Bernanke will be able to keep up with him.

Still, what seems OBVIOUS to us is that after a period of ’30s-style deflation, the feds will get the hang of inflation…the dollar will fall…and gold will rise.

What makes us nervous is that it seems too obvious. What must happen does happen. The bubble in finance had to burst. It did. Prices have to come down…and they are coming down. Now, the feds have to inflate. And everyone knows it…everyone sees it coming.

Everyone is now saying: stick with Treasuries during this down leg…switch to gold, TIPS, stocks, or other asset classes when inflation turns up.

This trade is too crowded for us…too obvious… What could go wrong?

We can think of two possibilities:

1) It could take too long. Every major downturn produces at least one major rally on the way down. If the rally lasts long enough, investors could forget what’s behind it. They could begin to think that the rally is a new bull market…that inflation really is under control…and that have no need to protect against it. They may feel that the rally is their only hope of getting their money back…and they may be loathe to give up on it. Then, when inflation finally does hit, they will be unprepared for it.

2) It could happen fast. If China, for example, were to panic out of the dollar…the greenback could collapse. Treasury bond yields could double…and triple…almost overnight. Gold could pass the $2,000 mark in a few trading sessions. This could all happen like a blitzkrieg, paralyzing investors who wait for a correction before they take action. .

Best bet: Stick with the formula – sell dollar-based assets on rallies…buy gold on dips. Don’t wait for a clear signal that inflation is increasing. And don’t be misled by a sustained countertrend – if we ever get one.