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One of the great conceits of the credit expansion was that “finance” was, if not a noble trade, at least it was an honest one. Mothers wanted their babies to grow up to work for Goldman Sachs. Why not? Nothing paid better…and there was no heavy lifting. But what do they actually do ‘in finance’ and how come they get paid so much for it? Bill Bonner explores…

“Discontent as bank bonuses shrink…” began a story in Wednesday’s International Herald Tribune. The story referred to ‘the City’ in London, the U.K.’s equivalent of Wall Street. Bonuses – usually ranging from 100,000 to many millions of pounds – are said to be down 16% this year. Those who toil in finance are unhappy.

But the trouble with recent news financial news is that the press doesn’t know what to do with it. Just today, former crime buster and now New York governor Eliot Spitzer charged the feds with being “partners in crime” with predatory lenders. What do you do with an article like that? Should it go with the crime stories? Or in the Health section? Is it a matter for the police to deal with, in other words…or psychiatrists?

England was made bully prosperous by its dark, satanic mills. But now, spiders build their webs in front of the mill doors, confident of being unmolested. In the City, meanwhile, people come and go in such fury of busyness that the whole world stands back in admiration or disgust.

The City’s new Jerusalem makes up one third of Britain’s entire economic output… and last year accounted for nearly half of U.K. GDP growth. It pays one third of all corporation tax…contributes a surplus of nearly £20 billion to the trade balance…and there are now more finance sector workers in Britain than there are construction workers, farmers and factory workers COMBINED. So rich and important has the City become that you cannot drive through drunk without running over a millionaire. Every day, it turns over a third of the entire world’s foreign exchange – more than $1 trillion.

“London has 40% of the global foreign equity market… trades 70% of all Eurobonds… and is the world’s leading market for international insurance,” reports the Fleet Street Letter. “Currently the business and finance sector accounts for 28% of Britain’s GDP… some £306 billion per year. “That’s 21 times more money contributed to the economy than the construction industry… 35 times more money than the automotive sector… 47 times more money than the pharmaceuticals industry… “

But what kind of City on a hill has the City built?

One of the great conceits of the credit expansion was that “finance” was, if not a noble trade, at least it was an honest one. Mothers wanted their babies to grow up to work for Goldman Sachs. Why not? Nothing paid better…and there was no heavy lifting. But what do they actually do ‘in finance’ and how come they get paid so much for it?

They ‘add value’ by ‘allocating capital efficiently,’ comes the answer. But what kind of value has actually been added to Britain’s economy…or America’s?

In these Daily Reckoning columns, we have made the point that the financial boom was a fraud. It was based on phony money…and produced phony growth. At the end of it, the average American is worse off than when it began. He has more debt…and a lower, real hourly wage.

In Britain, the story is very similar.

Personal debt in Britain has reached £1.3 trillion…(about $2.5 trillion) up 137% since 1993 and greater than the U.K.’s GDP for the very first time. Much of that debt is the notorious ‘subprime’ mortgage debt. Nearly 20% of all new U.K. mortgages written last year were either “subprime” or were “made to a homebuyer who offered no proof of income”, reports the FT. Consequently, 21% more people were forcibly evicted from their homes in 2007 than 2006. The Council or Mortgage Lenders expects repossessions to jump another 50% in 2008! More than 500,000 Britons have missed a mortgage payment in the last 6 months. “

On the institutional side, an estimate coming out of the G7 meeting put losses from sub-prime lending alone at $400 billion. So far, only $120 million has been revealed. If the estimate is correct, there is surely more subprime debt hiding in a Wall Street and City basements.

Colleague John Stepek, in the London office, puts it this way: “Our consumers are in more debt than their American counterparts. Our houses are more overvalued. We are even more dependent on a small niche area of the economy – the City of London – than Americans are. So we have even further to fall.”

He might have added that the FTSE is already down 13% this year, while the Dow is down only 8%. And while the dollar has rallied, the pound has fallen.

Blame the City? Call in the cops to investigate?

It’s true, practically all the deals made by Wall Street and the City over the last few years have a bit of Ponzi in them. As long as the volume of credit kept expanding, an investor could hope that a greater fool would buy out his positions at a higher price. Subprime mortgages, liar’s loans, private equity finance, Chinese stocks, residential housing, SIVs, CDOs – they all needed more and more leverage, more and more finance, just to stay even.

Many of the new financial products, too, were based on false pretenses. Mathematicians crossed their fingers, calculated the odds based on historical prices, and then passed off the results as though they were as reliable as the periodic tables. If wheat had never traded at $10 a bushel, the $10 figure was an “outlier,” not worth worrying about. What they didn’t realize, or didn’t admit, was that prices are neither fixed nor random – but subject to influence. By speculating on “normal” patterns, they were leaning against the very price curves they said were eternal. And when enough speculators crowded on… the price curve bent, and then collapsed under their weight. “Stability creates instability,” as Hyman Minsky used to say.

But prosecutors would have a hard case. No one held a gun to investors’ heads. Instead, they asked for it. he whole show was more a slapstick farce than a police thriller.

Enjoy your weekend,

Bill Bonner
The Daily Reckoning

February 15, 2008 — London, England

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.

Yesterday, Bernanke “failed to relieve gloomy sentiment,” says the International Herald Tribune. Testifying before Congress, the Fed chairman must have made things worse, because investors promptly decided to stop buying stocks; instead they began to sell them. The Dow ended down 175 points.

Oil rose $2.19 to over $95…and gold held steady.

One thing that bothers us about our dim outlook for the U.S. economy is that so many others seem to see things the same way.

Tim Bond, strategist at Barclays Capital says the “world faces a future of inflation, higher interest rates, lower house and share prices and economic volatility.”

Yep, that’s what we think too.

He goes on to forecast, “rising real resource prices and a degenerating ecosystem, in turn catalyzing changes to the fundamental structure of the economy.”

We’re not sure about that last part, but we were with him up to there.

The reason for this assessment is also the same as ours. The world is over-leveraged. People have too much debt. And there are only two ways of reducing debt – either it is actually paid down, which would mean higher savings…less spending…and less “growth” for a consumer economy. Or it could be inflated away…which would bring problems of its own – a collapse of the dollar, most likely…collapse of the bond market…and a collapse of the dollar-based world financial system. The paths are much different, but they both lead to the same place: lower living standards in America…and Britain.

Mervyn King, head man at the Bank of England, said on Wednesday that it’s time to face up to a “genuine reduction in our standard of living.” He went on to predict that England would most likely see a combination of lower growth…and higher inflation.

Yes, dear reader, it’s our old friend stagflation…back after 25 years. And yet, he looks just the same. More than 2/3 of fund managers surveyed by Merrill Lynch (NYSE:MER) say they see stagflation coming for a visit. Which worries us, because we see it too. And these are the same fund managers who were buying subprime debt and borrowing money so they could speculate on Chinese shares at 40 times earnings. Now, the managers are moving to cash. “Risk aversion hits 7-year high,” says the newspaper.

Stagflation is a devilish mixture. One part slump… one part inflation… and one part who-knows-what. Of course, the feds are eager to put more inflation into the brew. If they had their druthers, the concoction would have more of a kick – with more exciting price increases and less depressing slump. And to that end, they’ve come up with a number of rotgut proposals. For example, there is the “stimulus package’ signed into law Wednesday. You’ve heard about it on the news, so we won’t give the details. President Bush, signing the new law, applauded the U.S. economy with such gusto – it was as if he didn’t realize he had just signed a rescue measure.

“The genius of our system is that it can absorb such shocks and emerge even stronger,” said the president. But if the system were so robust, why was the doctor injecting $170 billion of adrenaline? He didn’t explain.

Meanwhile, the next article in the same issue of the Financial Times (yesterday’s) tells us that the feds also tossed a ‘lifeline…to floundering borrowers.’ You wouldn’t think such a resilient economy would need to give borrowers a lifeline too. With all that adrenaline in their blood, you’d think they could swim up Niagara Falls without a paddle, as they say. “Project Lifeline” is meant to replace the last project called “Hope Now Alliance,” for which all hope seems to have given out. How does “Project Lifeline” work? As near as we can tell, the people who took Alan Greenspan’s advice to mortgage their houses aggressively, and who now find themselves ‘upside down,’ with more mortgage than house, can call a toll free number and buy themselves some time.

Meanwhile the news continues to encourage us. Not because it is good, but because it is bad.

Auto loan delinquencies are at a 10-year high. “Repo lots overflow with reclaimed cars,” says the USA Today.

The Wall Street Journal reports that more families are falling behind on their heating bills.

And the Guardian, in the U.K., tells us that American students are the “next victims” of the credit crunch. Poor things, they’re unable to get financing to continue wasting their time in school; now they’re going to have to get a job.

From subprime, to prime, to home equity, to credit cards, to car loans, to buyout financing…the whole credit structure has been hit, some parts worse than others.

Today’s news, for example, also tells us that Switzerland’s biggest bank has fessed up to $11 billion in subprime related losses…sending the stock to a four-year low.

*** It is always worrisome when people in positions of responsibility agree with us. It troubles us, for example, that so many people think they see a recession coming. Maybe we won’t have one after all.

Or…maybe we won’t have the recession they all expect.

The experts are all said to be gloomy. But what kind of gloom is it when stocks in a communist country trade at 37 times trailing earnings? When Picassos and dead animals still sell as if they were works of great art? And when the yield on a 10-year T-note is still below the going rate of consumer price inflation? We know Treasury debt is supposed to be the safest investment in the world – but most of the holders are not U.S. taxpayers. They’re foreigners, for whom a U.S. Treasury obligation is a wild (and to us, reckless) speculation on the dollar.

Are investors really risk averse – with the Dow selling near an all-time high and selling at 18 times earnings? Are they really running scared with house prices down scarcely 10% after a 70% run-up? Are they desperately worried when the price of gold is still only about 40% – in real terms – of its previous high set 26 years ago?

To return to the housing news, the SF Gate reports that it takes an annual income of $196,000 to be able to afford, comfortably, the average house in San Francisco. In Marin County, you need to earn $218,000. How many people actually earn that kind of money?

The story is the same throughout much of the nation. Housing prices in California are down 15% to 20%…but the average house is “still unaffordable” for the average house buyer.

And when Bernanke delivered the bad news to Congress yesterday, the news he gave out was not as bad as you might expect. He said the economy would be softer than expected, but that it would recover before the end of the year. That is the message that practically all the experts are peddling: look for a slump in the first part of the year, recovery later on.

Yesterday, we noted that homeowners typically believe that the downturn in housing prices may last one or two years. They still believe that “house prices always go up in the long run.” Stock buyers seem to think the same thing. Many are talking about a bottom already. Some think the bottom has already come and gone – in January. They believe we’re now in a new phase of what is, for them, an eternal bull market.

Mr. Market always has a trick up his sleeve. What if his big surprise is that this downturn doesn’t go away after six months? What if house prices grind downward for five years…or more? What if we have begun a major bear market on Wall Street, with the Dow falling, in real terms, for the next 15 years? And what if Warren Buffett is wrong? What if America has topped out? What if, after 232 years of coming up in the world…it will go down for the next 232? What if it is now smart to short the United States – its currency, its stocks, its labor and even its military?

The U.S. enjoyed an extraordinary run of good luck. It had rich farmland…with huge oil deposits under it. It had energetic labor and low taxes. It had innovators, risk takers…and a government that left them alone. It had thrifty, hard-working people who asked for nothing but the chance to work. This combination of hard work and good luck put America on top of the world. But that’s the trouble with being on top of the world; there’s no where to go but down. Now, the U.S. is a net importer of food…and fuel. Its government seeks to control not only the lives of its citizens, but the fates of other peoples half way around the globe. Its citizens work harder than ever…but they are now competing with people who work even harder than they do…people who are willing to work for one tenth the compensation and then save half of what they earn. These same U.S. citizens are bending under the heaviest burden of private and public debt the world has ever seen, while their government encourages them to spend more.

Here’s a surprise for you, dear reader. What if this great economy didn’t “emerge even stronger”…but instead was crippled, and never recovered?

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The Daily Reckoning