We are now headed towards a replay of the early 1930s. Not in terms of economic misery, but rather a new FDR – Franklin Delano Roosevelt – striding onto the scene...
Dear Taipan Daily Reader,
Your e-mails continue to flood in.
While we haven’t dipped into the mail bag in a while, believe me, I’m reading. I’m grateful (and honored) by the breadth and depth of your thoughts, questions, and requests.
In varying levels of detail, you’re asking very good questions like: What’s going to happen next? Why hasn’t gold gone up more in this time of crisis? What should I be buying (or selling) now? I’m heavy on cash and t-bills and riding things out... do you think this is a good idea? I’m holding tight to good values in my portfolio... is this wise? What kind of opportunities will arise from the carnage? I’ve got X dollars I can commit to stocks.. where should I look?
I’m thinking hard on all these questions (and the best way to answer them). By all means, keep 'em coming: justice@taipandaily.com.
A few of you have also shared interesting bits of research, ranging from century-old economic essays to cutting edge research reports. Thanks much for those too. One never knows where the next flash of insight will turn up.
Heavy Hitter Weekend
It’s more important than ever now to develop a sense of how things will play out. No one expected what happened last week – not even the grizzliest of grizzlies anticipated the threat of full-scale global collapse.
With that in mind, I spent the weekend immersed in facts and data. In addition to a news-and-event flow three to four times more intense than the norm, I absorbed three timely interviews with top financial minds: Warren Buffett, George Soros and Paul Volcker.
Buffett needs little introduction. George Soros, too, has earned a spot on the investor’s version of Mount Rushmore; most famous for scoring a billion bucks in one day back in ‘92, Soros racked up thirty-percent-plus returns for decades in his Quantum Fund.
Paul Volcker, last but not least, is regarded by many as the true greatest central banker of all time. In sharp contrast to that toadying fraud, Alan Greenspan, Volcker actually did his job and did it well. In the teeth of great opposition, Volcker raise interest rates to record levels in the early 1980s; this broke the back of inflation, and ushered in the long stretch of prosperity that followed. Greenspan, meanwhile, sacrificed prudence for popularity at every turn. (You can read more about the contrast between Greenspan and Volcker in an April 2008 issue of Taipan Daily.)
The Return of FDR
A few market historians have argued that the Panic of 2008 – and it will go down in the history books as that, believe me – is less like the Crash of 1929 and more akin to the Panic of 1873. Some have also compared Buffett’s actions to those of J.P. Morgan (the man, not the bank) during the Panic of 1907.
Whichever year fits best, it seems clear that we are now headed towards a replay of the early 1930s. Hopefully NOT in terms of 20% unemployment and extended economic misery... but rather in regards to a “new FDR” (Franklin Delano Roosevelt) striding onto the scene.
There’s a lot of ground to cover here, so we’re probably looking at a multi-part series to cover it all. Today I want to give you a sense of what’s happened and why... how we’ve gotten to the place we’re in now.
Then tomorrow we’ll talk about the nationalization trend sweeping the globe... and following that, we’ll look at various aspects of the “Green New Deal” and beyond.
No Oxygen
In describing one of the panics of his day (I believe it was 1907.), Jesse Livermore invoked the image of a mouse in a glass bell. As oxygen was slowly but surely sucked out of the bell, you could the see the poor little mouse breathing faster and faster, its chest heaving and gasping for air.
This was Livermore’s analogy for the “money men” of the day. It was also the analogy Warren Buffett used in a recent interview on the Charlie Rose show.
“Confidence in markets and in institutions – it's a lot like oxygen,” Buffett said. “When you have it, you don't even think about it. I mean it's indispensable, but you can go years not thinking about it. When it's gone for five minutes, it's the only thing you think about.”
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SHOCK REPORT: Recession-Proof Cash From Today's Housing Crisis |
A lack of “oxygen” – meaning confidence in the banking system – is at the root of the panic we saw last week.
Stock market movements are the most visible sign of oxygen depravity. The Dow is what gets reported on, and so that’s what people fixate on... especially when the Dow drops 7.3% in one session and investors lose $900 billion worth of equity value, as happened last Thursday.
But really, stock market declines are a symptom, rather than a cause. The cause of all this mess is what’s happening behind the scenes. Consider the following data points:
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Before the big dropoff, the U.S. residential housing market was worth roughly $20 trillion (according to Buffett).
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The total value of “credits” – mortgage backed securities, corporate bonds and the like – is around $10 trillion (according to Volcker).
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The total value of the Credit Default Swap market – unregulated contracts traders can use to make bets – is somewhere between $35 and $60 trillion. (Estimates vary widely; there’s no direct way to track.)
So what we’ve got here is a massive market – the U.S. housing market – that took Wall Street by surprise when home prices started to fall.
Not to put too fine a point on it, a bunch of high-paid idiots thought home prices would never fall, and bet the ranch on this dumb assertion... and so when home prices did start to fall, these same high-paid idiots got themselves into epic trouble.
Buffett, in his usual sharp yet folksy style, puts it like this:
300 million Americans – their lending institutions, their government, their media – all believed that housing prices were going to go up consistently. And that got built into a $20 trillion residential home market. Lending was based on it, and everybody did a lot of foolish things. And where people really behaved in a fraudulent way or something, we'll go back and find the culprits later on. But that isn't really the problem we have. I mean, that's where it came from though. We leveraged up. And if you have a 20% fall in the value of a $20 trillion asset, that's $4 trillion dollars. And when $4 trillion dollars [in] losses lands in the wrong part of this economy, it can gum up the whole place...
Now you can better see why Wall Street went kablooey. Four trillion bucks worth of downside landed on their thirty-to-one leveraged heads.
And, as we now know, it wasn’t just the Wall Street banks getting mixed up in this stuff. Banks all over the land, in countries all over the world, had to get their taste. The banking crisis went global because everyone got involved. Subprime loans in Ohio blew up overexposed banks in Belgium. (Now that’s globalization, baby.)
A Truly Wild West Market
Oh, and that Credit Default Swap market? The one with a notional value of forty to sixty trillion? No one was regulating it, and no one really understood the trades being made.
Think about that for a second. A wild west trading market with a notional value bigger than the net worth of the entire global economy was, to whit, left completely bereft of adult supervision.
When you buy, say, a futures contract or a stock options contract, you can know it’s traded on a central regulated exchange. You can track the paper trail and confirm who your counterparty is if need be. Just as important, your counterparty also has to pass muster with the exchange in question; he (or she or it) has to have enough money in a verified account before trading with you in the first place.
Not so with Credit Default Swaps. These “CDS” trades – tens of trillions worth – aren’t traceable back to any exchange. They are 100% “over the counter,” i.e. “swim at your own risk.”
Because there was no supervision of the Credit Default Swap market, you could have done a hundred-million-dollar CDS deal with a hedge fund in Antigua if you so chose. Heck, you could have put on a seven figure trade with your Uncle Fred. Or the hairdresser down the street. Or your neighbor’s cat.
Nobody was paying attention, so the solvency of the counterparty (i.e., their ability to pay up) didn’t really matter... until it all went to hell.
Thus, not only did we have a bunch of high-paid idiots making leveraged bets on the assumption home prices wouldn’t fall… we had them making these bets in completely unstructured fashion, with no real due diligence as to whom was on the other side (or whether they could pay).
Back Office Nightmare
So imagine you run the back office for a reputable banking house. You’ve got a pile of boxes nine feet high, all of them stuffed to overflowing with paper documents. This paper mountain represents all the CDS trades – hundreds of billions of dollars worth – that your in-house trading department made in the past two years.
Half these trades were made through instant messenger. Some of the printouts and scribbles you can’t even read. You don’t have a prayer of sorting out who traded what or with whom... not without a few months of digging and sorting anyway. You don’t know how many of your trading counterparties are out of business, let alone solvent.
As if that weren’t enough, you don’t even know if your own trading department is on the hook for tens of billions... or whether tens of billions are still owed to you!
Can you imagine being the CFO in a situation like this?
Where do we stand, Johnson?
Well sir, we’re either in mighty fine shape or we’re bankrupt. We’ll know which in about three months time, once we get this nine-foot-high pile of papers sorted out...
Is it any wonder everything came screeching to a halt?
Epic Dumbness
I can hardly believe the stupidity, the sheer dumbness, of this whole mess. Just thinking about it makes me want to punch Greenspan in the face – and Hank Paulson too. (Greenspan was a huge cheerleader for deregulation throughout his term as Fed Chief. Paulson was instrumental in getting the “big five” exempt from leverage caps back in 2004.)
Like Buffett, Paul Volcker was interviewed on Charlie Rose. Here’s Volcker’s take:
We built an extremely flimsy super-structure. I think the financial markets that we built up are kind of a Potemkin Village. You know, $60 trillion dollars worth of nominal insurance against credits, and they only had $10 trillion in credits! I mean what’s going on here, why did we need $60 trillion worth of protection, because people are trading with each other, speculating in effect, and you know, in trading markets, trying to make some money... and now when people have questions it begins to clog up the system, because all the money he needs – margin requirements, he needs collateral... it’s kind of a dead use of credit, dead use of liquidity to have to be margining all these requirements. And that’s where we are, we’re stuck.
Fear the Time Bomb
Even now – right now, today – there are bank trading departments all over the world still trying to figure out what they own. It’s like having a potential time bomb in your basement... except your basement is so damn cluttered that if a time bomb is down there, you don’t know where it is or how you can get to it.
So this credit freeze-up, in a nutshell, is why the stock market collapsed last week. Not only did banks all over the world pick up huge exposure to falling home prices, they did so in a completely insane way via the Wild West CDS market. When it became clear how widespread the problem was, every bank viewed every other bank as a huge blowup risk.
This filters into the “real” economy because credit is the lifeblood of the real economy. When lending stops, everything stops. Lots of day-to-day businesses rely on credit for mundane things like ordering supplies and making payroll. So when the banks really and truly stop lending – for fear of not knowing who will blow up next – it ultimately grinds everything to a halt.
If the authorities were to truly fail at getting the credit flowing again, it would only be a matter of time before gas stations and grocery stores started shutting down. Without functional credit markets, we’re on the path to the bottled-water-and-bullets scenario. It’s deadly serious stuff.
Haphazard Made It Worse
What’s more, the seemingly arbitrary manner in which things unfolded made all the problems worse. Flip-flopping day to day, Bernanke and Paulson seemed to change their plans with the weather. One player fails but another gets rescued... ABC bondholders are saved, but XYZ bondholders are toast… this inconsistency only served to further confuse and scare everyone.
Not only were the banks afraid to lend, shareholders (and bondholders) were afraid to keep skin in the game for fear of getting randomly burned by their government. As Volcker put it, “So the way all these things came out, it looked like, in a way, nobody was in charge...”
The reason equity markets finally unclenched – apart from sheer panic fatigue – is because the governments of the world started getting their act together. In the past few days, for example, we’ve seen country after country enacting “Super FDIC” measures: blanket guarantees on all deposits in the system, with no account ceiling.
The government measures kicked off a chain reaction. As soon as Ireland guaranteed its bank deposits, money started flowing from London to Dublin, and so Britain had to take emergency confidence measures too. In a very short period of time we saw an “intervention wave” sweep the world; countries that now guarantee all deposits include Australia, Germany, Denmark and Greece.
It was soon widely felt, and agreed upon by investors in the know, that this problem is so big, and so global, that only mass intervention on a global scale could stop the panic. And thus, it was only a demonstration of strong, coordinated government involvement that calmed investors’ nerves.
Volcker summed up the feeling last Thursday night (the same day the Dow fell 7.3%):
I hate this business that the government has to step in to protect the private market! But we’re there. And let’s do it... We want to stabilize the economy, and let’s get in there, get it done, and then we’ll rebuild the financial system.
Next we’ll talk more about what that means...
Warm Regards,
JL
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