High Wire Act

Arriving back at the apartment late at night on Wednesday, I found my son Jules, 13, watching television. We have not had a TV for many years. But this one came to us by chance, when an American neighbor decamped for the U.S., leaving us with some household plants and unwanted furniture.

The kids took to the TV like it was a lost puppy.

Jules was watching a show called “Celebrity Death Match.” I did not watch the show, but Jules reported that it was very funny. His mother decided to get rid of the TV as soon as possible.

The point? Only that it introduces another modest prediction: In the years ahead, dear reader, people will create even more appalling TV shows. They will build new weapons of destruction. And they will find innovative ways to get themselves into financial trouble.

Mr. Alan Greenspan gave a speech yesterday to bankers in Chicago. His topic, “The financial safety net,” described some of the trouble people had gotten themselves into in the past.

“Market discipline,” said he, “in one form or another was the major governor of bank risk-taking from the early years of the Republic. Advancing technology – telegraph, railroad, and transatlantic cable – disseminated information, the raw material for market discipline, ever more rapidly. In this environment, banks competed for reputation, and hence deposits, by advertising their high capital ratios.

“Equity capital ratios, which were as high as 50% in the 1830s, were still a third in the 1860s and more than 15% at the time the Federal Reserve began operations in 1914.

“But if market discipline was such an attractive governor for managing risk, why were the nineteenth and early twentieth centuries punctuated by those periodic banking collapses known to historians as panics? ‘Panic’ was, in fact, a good description, since participants felt it necessary … to rush to the bank window to obtain their share of what all understood was the limited stock of liquidity before being beaten in the race by others driven by the same incentive.”

It was to neutralize this incentive – the rush to claim the cash in a bank before another depositor could get to it first – that the U.S. Congress and the Fed rigged up today’s “safety net” provisions: various insurance programs and regulations, as well as implicit and explicit assurances that the federal government will come to the rescue when the need arises.

Henceforth, the asset in question – money – would no longer be strictly limited. Instead, liquidity (a.k.a. cash, scratch, moolah, dough, fric, dead presidents, green, etc.) would be made available in whatever quantities necessary. This, then, is the modern period in American financial history: Anno Domini Federalis Reservum, over which the emperor, Alan Greenspan of Brooklyn, now reigns.

Yesterday, we discussed the troubles that beset America during the 1930s. Many of today’s ‘safety net’ features were stitched up after that episode. Others have been added in the 6 decades that followed. So vast is the net, with so much spring and such fine weaving, that it is widely believed that a person can fall in almost any direction at almost any time and still not get hurt.

This too – like being able to predict the future, or finding a decent tort lawyer – must represent some deep, fundamental affront to natural law. How could it be possible that people would borrow, invest, lend and spend recklessly – and suffer no damage?

It is, of course, not possible. The ‘safety net’ concept – applauded by Mr. Greenspan for having prevented any major bank run for 60 years – does not prevent losses, dear reader, it merely spreads them out among more and more people. Instead of reducing risk, the government has nationalized it.

“Take a look at Fannie Mae and Freddie Mac,” wrote a Daily Reckoning reader the other day. “These two institutions are out of control. In only 3 and a half years their assets have grown by $400 billion…

“What they do is buy up mortgages from banks. The banks know they can unload any mortgage they make onto Freddie and Fannie…so they collect fees for giving some guy a mortgage. They don’t have to worry about how risky the mortgage is, because they sell the mortgage to these GSE [Government Sponsored Enterprises]. The banks then have cash in the till that they lend out. I mean, they’re creating new money. And taking on risks that they can’t possibly cover. Of course, maybe they don’t have to worry – ultimately, you and I and other taxpayers will get the bill. We’ll pay in two ways – by inflation, and by being forced to bail them out when they run into trouble. This whole matter needs some sober reflection…”

I left the office last night intending to give it some sober reflection…but semi-drunken reflection was the best I could do…

Consumers enjoyed boom times, during the late ’90s, with plentiful jobs and rising asset prices. There was no shortage of people ready to borrow money to buy a house. Inflation was low. Housing prices were rising. And if a borrower slipped up and was unable to make his mortgage payments, both he and Fannie fell into a safety net so supple and so resilient that both bounced back almost immediately.

But if times were good for Americans, generally, during the last decade, they were especially good for Fannie and Freddie. Fannie Mae, for example, saw her net income rise 500% and assets increased nearly as much. But long gone are the days when lending institutions had capital ratios of 50%. Thanks to the safety net, and an implied government guarantee, Fannie’s equity to asset ratio is only 3%.

Six months ago, Gene Spencer, speaking for Fannie, explained to Grant’s that “Losses are at historically low levels. For that reason, credit risk is not a real issue for us at this point.”

But conditions that were once ideal might be reasonably expected to be less-than-ideal at some point. Homeowners might lose their jobs and be unable to make mortgage payments. Home prices might go down rather than up.

Even if housing prices fell by 5% nationwide, says Fannie, it would only mean a ‘gross credit loss’ of $1.065 billion. Laying off most of the loss on counter-parties, or hedges, Fannie would still survive. But what if housing prices fall more than 5%? And what if the hedging institutions are in trouble themselves? Ultimately, the taxpayer will pick up the bill.

“Perhaps the most troubling aspect of Fannie and Freddie,” says a report from the Washington Business Journal, “has to do with their belief that they can take a risky asset – mortgage debt – and turn it into a virtually risk-free one – GSE debt. There have been many times in the past that financiers thought they had figured out how to turn risky assets into non-risky ones. None has had a happy ending.”

Buffett sold his Fannie Mae shares last year, saying only that he could not calculate the risk. I cannot calculate the risk either, but my guess is that it is more than most people think.

Your correspondent, enjoying a beautiful day in Paris,

Bill Bonner
Paris, France
May 11, 2001

*** The European Central Bank cut interest rates yesterday by a quarter point to 4.5%. One European economist described it as “the biggest monetary shock of the new millennium.” Modest prediction: There will be others…

*** “It’s Unanimous,” proclaimed David R. Kotok of New Jersey-based Cumberland Advisors Inc. “The ECB rate cut means all the world’s money-printing machines are operating at high capacity.”

*** Like a “good soldier” the ECB had been holding fast to its duty: fighting inflation, first and foremost. But duty can be interpreted to fit the circumstances…European markets rallied anywhere from 1% to 3%.

*** Stateside, investors learned before the U.S. market opened yesterday that unemployment and inflation in the States are no longer a problem, at least according to the Labor Department. Initial jobless claims plunged by 41,000 to 384,000 in the week ended May 5, their lowest level since the last week of March.

*** The Dow rallied more than 100 points in the morning. The Nasdaq too joined the fete, up more than 2 percent before Greenspan had finished his morning bath. But by day’s end, the jubilation had subsided a bit. The Dow clung to a 43-point gain. The Nasdaq struggled, finishing down 27 points.

*** “It was not good action,” one New York trader told Grant’s Investor’s Eric Fry. “The market rallied strongly early on and then landed flat on its back late in the day. It was not good action at all.” Is the rally nearing an end? We will see, dear reader, we will see.

*** “OK, let’s try for some perspective here,” writes Christopher Byron, commenting on the boost in the Nasdaq of late. “Does anybody remember that it was only a year ago – in the spring of 2000 – when Cisco Systems, Inc. sported a $500 billion market valuation on Wall Street? At the time, the company’s CEO, John Chambers, sounded off at every opportunity about how the Internet was transforming people’s lives and permanently boosting productivity for the whole human race.

*** “Unfortunately,” Byron observes, “anyone who believed those messages about worker productivity, and is still sitting with Cisco’s stock a year later, has been badly beaten up.” Cisco is now worth barely a quarter of its former value, and data are accumulating by the week that the so-called “productivity miracle” that pumped up the tech sector in the 1990s amounted in a sense to little more than a statistical mirage.

*** Gold closed down 90 cents. But the gold stock indices managed to stay in a plus column. And Newmont Mining, what’s the deal with this stock? It’s taking on a life of its own, gaining almost 3%, after gaining more than 10% yesterday.

*** Earnings are falling…inflation rising…productivity dropping… consumers tapped out…the WSJ reports that “Fewer Americans Save for their Retirement.” What money will they spend? Will they sell stocks? “The bear market is likely to go on for years,” writes Doug Casey.

*** “Buy recommendations from major Wall Street brokerages,” observes the Fleet Street Letter’s Chris Matthai, still “outnumber sells by a staggering 72 to 1.” Why is Wall Street so bullish? “Fees from a single [IPO] offering could reach $75 million,” Chris explains.

*** Maria began her modeling career last night. Elizabeth reports: “The models were pretty, but the clothes were ridiculous.”

*** “What a great city,” Addison remarked yesterday. Spring finally caught up with Paris, arriving on Wednesday afternoon. The last two days have been beautiful. The sun is shining this morning…the trees are leafed out, flowers in bloom…and the women…oh la la! Quelle beaute.

*** Harry Schultz sends a note with his rating of the “world’s best major cities to live in.” Paris is rated #1 – followed by London in the 2nd spot. But Harry leaves the #3 spot empty “to make it clear #1 and 2 are far ahead of all the others.” No American city made Harry’s top-ten list.

*** Elizabeth and I went to the Comedie Francaise last night – where we watched a version of Gogol’s “The Inspector General,” a rich, frolicking look at the cupidity of Russia’s provincial officials in the 19th century.

*** After the performance, we walked across the rue de Rivoli and had a late dinner. It was early morning before we finished. There were just a few people crossing the square between the Louvre and the Palais Royal. “What a great city,” Elizabeth said as we made our way home.