Managing Structural Economic Change and the Financial Markets

The second quarter of 2013 was particularly challenging for investors. The last two months, in particular, were impacted by the market turbulence which emerged from concerns that the Federal Reserve Bank would change its current low interest rate policy. The current policy of maintaining low interest rates was intended to support economic growth in the United States by making credit more affordable. They have done this through what is known as their quantitative easing program, which is essentially buying bonds with money that does not exist until they create it. While the historical data does not necessarily support the belief, many investors, nonetheless, associate increasing interest rates with poorer stock market performance. The prospect of a change in interest rate policy created additional uncertainty and a shift in investor sentiment from the irrational exuberance equity investors had during the first two months of the year to more anxious concerns as to the sustainability the equity markets.

What may well be a more fundamental issue, however, is that bond investors also seized upon the prospective change in the Federal Reserve Banks policy and started exiting from bonds. Trim Tabs, an investment research firm, says that investors liquidated over $60 billion from bond mutual funds and exchange traded funds in June. If this is true, that would be the single-largest monthly redemption in history. Some commentators are calling this the end of a 30 year bull market in bonds.

This drove interest rates higher causing losses for traditionally bond investments. Bonds have traditionally, and historically, been considered conservative investments. With bonds as well as stock losing value, this left very few “safe harbors” for refuge from this storm. Cash is one option that some investors will flee to, and an allocation to some percentage allocation to cash is certainly warranted as a prudent allocation strategy. However, with dollars being created without backing by anything other than the “full faith and credit” of a government that does not appear to be capable of operating in a solvent manner, it is doubtful that this is the safe refuge it might appear to be. Moreover, cash offers very little in investment return. While cash is a valuable component of an investment strategy, just as with any other asset, having too much of it has its own hazards.

In my view, while there are many economically sound justifications for higher interest rates to exist, the markets have severely over-reacted to the prospect of a policy change in the Federal Reserve Bank. Having listened to Ben Bernanke’s entire speech, I heard him say that depending upon economic conditions the Federal Reserve Bank would adjust its policy. If the economy was doing well the Federal Reserve would gradually reduce the $85 billion per month of bonds it is buying to keep interest rates low. If the economy is not doing so well, it would continue its policy, and if conditions warranted, it would even increase the amount. From what I can see, given economic conditions, the Federal Reserve Bank seems more likely than not to continue its policy longer than expected. While there can be other factors than the Federal Reserve Bank affecting interest rates, it appears to me that investors have over-reacted toward the downside during the last few months, just as they over-reacted to the upside in equity markets during the first two months of the year. These last few months of stock and bond market behavior appear to be more panicked emotional reactions of market traders rather than the economically sound reasoning of longer-term investors.

In my analysis, I would be surprised to see the Federal Reserve Bank make any significant change in the near future. The consequences for doing so would be too severe in its impact on our anemically growing economy. Were they to change their policy and allow interest rates to rise, the most recent market response to these prospects suggests that at least the initial market response would be decline in both the stock and bond markets. The result would be a further damper on economic growth because of what economist call the “wealth effect” When account values go up, people are more willing to spend and consume. When account values go down the reverse is true which results in slower economic growth. Additionally, the housing market plays a very big role in the strength of our economy. With the housing market appearing to be in the recovery stage, higher mortgage rates, resulting from a change in Federal Reserve Bank policy, could quickly kill the housing recovery, again stalling economic growth. The other important factor is that when interest rates rise, the debt servicing liabilities of the U.S. government and municipalities also start to increase. At present, the servicing of the existing debt is not financially sustainable, even given historically low interest rates. Consequently, taken together, it does not seem likely that we will see a change in Federal Reserve Bank policy anytime soon. An unknown, however, is how much control the Federal Reserve Bank really has left in capping interest rates. There have been reports of Central Banks throughout the world selling their holding of U.S. Treasury bonds. This would put additional pressure on interest rates to rise.

Overall the global economic system is drowning in debt. Were it not for the heavy debt loads that are being carried, the underlying latent economic vigor would look promising. The real challenge to policy makers is how to manage an unwinding and restructuring of that debt. This must be done in the context of continuing demands for financial resources. The real danger is having the management of this process get out of control and become a collapse rather that a slower burn process. If there is a systemic economic collapse the trajectory of where events will lead is unknown. At this point, while I do see economic turbulence ahead, I do not place a high probability on a general overall economic meltdown, at least in the near future.

Diversified Investment Strategy

Investment markets over the last quarter have been driven primarily by uncertainties with respect to outcomes in resolving the debt crisis in Europe. As in the United States, Europe has been having its own political gridlock as to its way forward in the face the potential government insolvencies. Most recently, Greece had been the foremost concern. Having been in a severe recession for several years because of budget cuts required per terms of previous financial bailouts by the other countries of the European Union, Greece had called an election to determine whether or not it would stay in the European Union and adhere to the austere budget required by their financial bailout. The alternative was to leave the European Union and default on billions of Euro’s worth of debt. A good portion of this debt was held by major European banks, as well as some major U.S. banks. The fear was that if Greece defaulted, the fallout would be far reaching perhaps undermining the solvency of major global banks and financial institutions. Greece narrowly voted to remain in the Union, but with a significantly divided parliament. No sooner did this occur, than Spain rose to front and center as a problem area. Spain being one of the largest economies in Europe required a new approach to this entire European issue. Germany and France had been forcefully advocating an austere approach to dealing with the over-indebtedness of the countries in the middle of these financial crises. The problem was that the programs of austerity were also damping growth to make it even more difficult for countries like Greece and Spain to deal with their debt problems. Elections in France changed the leadership from Sarkozy to Hollande who was much more sympathetic to relaxing the programs of austerity and do more to stimulate growth. Only Germany’s Angela Merkel remained as the lone, but powerful voice of the austerity programs, and consequently political gridlock. Most recently, Merkel appears to be relaxing her position and the framework of a structural agreement to deal more comprehensively with the issue emerged. Whether the agreement will accomplish this remains to be seen. It did, however briefly, give hope to the investment markets which reacted very favorably to the news.

To compound the uncertainties and the implications surrounding the European financial crisis, lurking in the background, ready to jump forward at any instant, is the financial and economic situation in the United States. More and more frequently, reports are being aired on the mainstream media of an approaching fiscal cliff the United States will be facing at the end of the year. This refers to the prospect of increased taxes and mandatory federal budgets cuts. The outcome is a result of the political gridlock in the United States and is a default position in the event Congress is not able to reach an alternative agreement. Given the extreme ideological polarization of our Congress, the probabilities seem small that an alternative agreement will be reached. There seems to be a fairly wide economic consensus that this is likely to result in the weakening of the already weak US economy. Moreover, even if an agreement is reached, as in Europe, the fixes seem to do little more than “kick the can down the road” a little further without really developing a sustainable solution to very real structural problems. Needless to say, the situation is very complex, and we could continue for some time to discuss it. All of these uncertainties create a very unstable economic and investment environment. The outward appearance is a great deal of volatility as investors swing from the extremes of fear and hope. The relevant question for us is: what is the best investment strategy in this type of environment? There is no shortage of opinion predicting where the investment markets are headed. They range from catastrophic calamity, to the cusp of a new bull market. For over two decades, on a regular daily basis, I consider countless numbers of these viewpoints. I have come to value some commentary and analysis more than others, and I certainly form my own opinions. I have, however, learned several important lessons over the years. One is that no one has a perfect crystal ball. Another is that the reporting media seems to create its own spin. When things are going relatively well, a general impression is created that happy days will never end, creating a type of euphoria. On the other hand, when events turn toward the negative, it sometimes appears that the end of the world is approaching, creating an atmosphere of fear and panic. It is a well documented that investors over-react to news. For example, Dalbar Inc. is a company which studies investor behavior and analyzes investor market returns. The results of their research consistently show that the average investor earns below average returns. For the twenty years ending 12/31/2010 the S&P 500 Index averaged 9.14% a year. The average equity fund investor earned a market return of only 3.83%. While I cannot absolutely dismiss either of the extreme outcomes from occurring, my observation has been that the fundamental principle of risk management, diversification, should still serve as the foundation for a prudently managed investment portfolio. This does not mean that the portfolio will be resistant to all market downturns, and it does not mean that diversification adjustments should never occur. It does suggest, however, maintaining focus and investment discipline is a critical component of navigating what are sometimes, very stormy seas.

Looking forward, it would be great to say that the worst is behind us. Unfortunately, that does not appear to be the case. It is likely that the global economy and investment environment will get worse before it gets better. It will require patience and fortitude whatever the investment allocation is. The silver lining, however, is that unless you believe the world will be ending as a result of these issues, the foundation of future economic health is being established. Despite the grim shorter term picture, my opinion is that the global economic challenges and issues now being confronted will be worked through and resolved, and that the world will not end.

A Review Primer on the Components of Diversification – if needed

The four broad categories, or asset classes, of investments are cash, bonds, or equities. Included within these categories are such things as real estate, commodities such as energy, food, as well as precious metals. Each has its own particular characteristic strengths and weaknesses, and consequently a prudent risk management approach would not allocate 100% to any one of these asset classes.

If we consider cash, for example money market funds, we recognize that this can provide liquidity and stability, but very little investment gain. It is not without risk. In fact, when interest rates are as low as they are today, the risk is known as purchasing power risk. This means that if you have $100,000 in an account today, and $100,000 in the account one year from now, will the $100,000 one year from now be able to purchase what is can purchase today. If inflation is running at 2.5%, one year from now you will have a guaranteed loss of 2.5% in the purchasing power of your account. Currently, by the government’s statistics, this is around the range inflation is running, other independent analysts believe the real inflation number is higher. And some analysts believe that the future rate of inflation will be significantly higher. This suggests to me that while it makes sense to have a portion of an investment portfolio in cash, or cash-like investments such as a money market, 100% would probably be unbalanced in failing to address the unique risks of cash.

This brings us to bonds. Bonds, in general, have traditionally been considered a conservative investment. This is a broad generalization, and it is important to understand some of the unique characteristics of bonds to appreciate their role in an investment portfolio. An attractive characteristic of bonds is that they pay interest on a regular basis, which is of course if the issuer continues to have the ability to pay. The risk that the issuer may not be able to continue paying the interest, as well as the principal at maturity is known as solvency risk. Depending upon the type of bond this risk can be higher or lower. Historically, government of developed economies had been considered low risk, with the United States having the least solvency risk. Municipal bonds have also been considered safe, conservative investments. These days we hear of the developed country bonds being less safe because of over-indebtedness, as well as municipalities in the United States declaring bankruptcy. Another risk of bonds is known as interest rate risk. This is the risk that if interest rates increase, bonds already owned will decline in value. Some investors say this is not a problem because if they do not sell the bonds until they mature, they expect to receive all of their principal back, as well as the promised interest payments. What these investors neglect to consider is that if interest rates increase, it is usually for a good reason, such as higher inflation. They are stuck with lower interest paying bonds they had previously purchased. The bottom line is that bond can also decline in value, sometimes significantly. In historically low interest rate environments, as we currently have, this risk is elevated. These risk management implications imply that while bonds are an important part of an investment portfolio, they also should not represent 100%, and the portion of an investment portfolio that is in bonds should itself be diversified with respect to the types of bonds and the unique risks for each type.

This brings us to equities, or stocks. As with bonds there are a wide range of offerings, as well as a wide range of approaches to investing in them. They have their own unique set of risks, as well as presenting opportunities. Despite regular variations in value, sometime significantly so, they offer income opportunities through dividend payment, and/or growth opportunities through their increase in value. Needless to say they can also decline in value. With a diversified investment position, for example in fund of utility companies, the main risk seems to be primarily psychological. The belief that, for example, that all of the strongest and largest utility companies in a fund will simple become worthless is placing a disproportionate weight on the occurrence of something with an extremely small probability of happening. Despite periodic declines in value, sometimes having nothing to do the real merit of the investment itself, these funds can pay annual dividends of 4% per year or more. In an environment where interest rates are so low, having some component of a portfolio in equities, or stocks, is part of a well diversified portfolio. One way in which the potential volatility can be managed is by having a smaller percentage.

It is interesting to note that some of the same investors in bonds who claim that it does not matter if the bond declines in value because they intend to hold the bond until maturity, will consider it unacceptable to own a utility fund paying 4% or more because of the potential for it to decline in value.

Nonetheless, each type of investment has its own unique set of risks as well as opportunities. There is no one safe harbor. The best overall way to construct and manage a portfolio is with a diversified selection of different types of investments. In some cases, there will be significant declines in value. Some investors believe it to be possible to time when the declines and when the increases are coming, thereby avoiding declines while riding the increases up. Even if this were consistently possible, and there is reason to doubt this, from a prudent investment decision-making perspective, there needs to be some rational decision-making basis, other than an environment of fear and panic driving the markets. With the outcome of so many hugely impactful global issues pending resolution, trying to respond to these unresolved issues offers little other than randomness as a foundation. This is unacceptable, and argues all the more strongly, for holding a well structured portfolio comprised of cash, bonds and equities despite the volatility, and periodic declines.

Creditors of the World Are Not Necessarily Captive to the Debtors

In response to Martin Wolf's article in the Financial Times,  I offer the following commentary.

The conceptual framing of this argument is somewhat misleading. To begin with the phrase indicating a belief by creditors that they will inherit the earth suggests a context for concentrating wealth and power that is more benign than the underlying capitalist and human drive for dominance and control. There are enough examples in human history, and biology, be it modern or ancient, that one does not have to be much an historian to be compelled to believe that a basic survival instinct is to attempt to manage one’s environment so as to better the chances of surviving and thriving. Because of the complex web of relationships there is often some sort of mutual interdependence, sometimes beneficial, sometimes not so much.

The heart of Martin Wolf’s argument seems to suggest that the relationship between creditors and debtors is such that there is some sort of “lock” binding specific sets of creditors and debtors to one another. While perhaps the world cannot trade with Mars, specific parts of the world can rearrange their trading relationships and thier drivers of growth. For example, while no doubt the western developed world does serve an important function in sucking up the exports of China, it is also possible that through a combination of weaning itself from such heavy dependence on an export driven economy by developing its domestic aggregate demand, and shifting its trade relationships to for example Brazil, or even Russia, to meet some of its export needs it can transition from its heavy dependence its current export targets. As to being held captive because of its $3,200bn of currency reserves, it should be keep in mind that it is only held captive as long as the currency reserve exists in its current form. If these reserves begin to be exchanged for foreign equity positions representing control in strategic future resources that China needs, the current foreign reserves cease to be a control on China’s behavior, and rather serve to further concentrate power and wealth in the hands of those with capital.

Is this so different than when the Native Americans in New York sold Manhattan Island for the equivalent of $24 in baubles, or when the Soviet Union dissolved, dispersed shares of ownership of formerly state owned enterprises among the people, only to have aspiring oligarchs acquire and concentrate these assets for controlling interests in exchange for perhaps teh equivalent of a supply of vodka for a short period of time. There are innumerous other examples which can be given wherein the exchange of future earnings capacity (read indebtedness) for a more immediate gratification leads to servitude.

To suggest that because we are all on the same planet, as Martin Wolf does in his argument, the fix to the current capital imbalances are compelled by some notion of constraint by reciprocity is to have blinders hindering one’s vision as to the fuller range of feasible alternatives.

Recapitalize the Banks?

The concern about a Greek default is really more about the contagion effect. The central question is how does one contain the impact arising from a disorderly Greek default. From this follows the discussion about potential bank recapitalization. There are all sorts of sub-plots in the recapitalization schemes, from the moral hazard issue, to the inequity inflicted on those who have been fiscally responsible, to whether or not an effective scheme can really be created to many more. Politicians have been receiving the brunt of criticism because of the perceived lack of leadership in dealing with an extremely complex, and perhaps insoluble by mere mortals problem. I would be one of the last ones to come to the defense of the politicians, however, the political posture of the “deer in the headlights” when facing public outcry to “do something, do anything”, is understandable giving the mutually check-mated position the global financial situation has emerged into.

The idea of recapitalization is lacking unless one can quantify with some reasonable degree of confidence the extent of recapitalization that would be needed to effectively resolve the issues. I have heard plausible figures of up to $2 trillion dollars worth. I have not, however, seen much discussion of potential derivative exposure, and counter party risks which might amplify the amount of fiscal deficiencies,  and the number of systemically important institutions which may be impacted. If there is one thing that the institutional failures of 2008 should have taught us, it is that with the degree and scale of economic and financial integration that currently exists, it is all but impossible to see where the chips may fall, or the ensuing consequences. Moreover, when talking recapitalization, ultimately one is talking about using public money to enable those who, either directly or indirectly, were responsible for egregiously imprudent financial behaviors to retain their private ownership interest with minimal risk of loss. The backlash from this sort of thinking is emerging at the main street level that potentially will threaten governments if it continues. As evidence witness the emerging demonstrations in Greece and on Wall Street, and the rising pervasive discontent among so many of the affected citizenry. Perhaps a more honest and equitable approach to allowing Greece to default, and stabilizing the banking system would be an outright state takeover of those systemically important institutions to give the funding public an equity stake rather than a debt holders stake in future recovery. When looking at the impact of the US TARP program the argument is made that the US actually made money from many of its bailouts. I think, however, that this misses the point, if governments are going to use public money to bailout out private institutions, it should be done with the focus of maximizing the return of the investing public, as well as a policy measure to provide a consequence to those who have acting so financially imprudent, directly, or through agency. It really is time to start acting like responsible adults.

Critique of Roger Altman's Financial Times Commentary

Roger Altman, founder and chairman of Evercore Partners and former US deputy Treasury secretary under President Bill Clinton offered commentary in the Financial Times suggesting America and Europe are on the verge of a disastrous recession. While he may be correct, I see several problems in his analysis.

 http://blogs.ft.com/the-a-list/2011/09/21/america-and-europe-are-on-the-verge-of-disastrous-recession/#axzz1YNL9mxwW

Roger Altman’s analysis and proposed resolution to the unfolding European financial debacle leaves much to be desired. Interspersed with a review the ongoing events are a great many hypothetical conjectures followed by conclusions presented as some sort of deterministic inevitability. Moreover, his proposed resolution, when compared to an existing model of what he proposes, does not appear to conclusively lead to a better result.

For example, he asks “How do we know that another recession is approaching?”. A more accurate statement would be “it is probable that another recession is approaching”. The simple fact is that none of us has a perfect crystal ball, and from what I can see there is no deterministic cause and effect mechanism that provides a conclusive outcome. Altman may be right, and then again, he may not be. To assert anything more than a probabilistic conjecture is at best an error of judgment and at worse hyperbole directed at serving some sort of agenda.

Altman follows by asserting that “there is no other credible explanation for the relentless fall in interest rates”. I suspect that there are readers who could provide other explanations. Whether they were credible may be more in the mind of the beholder. This is but one more example of the “in-the-box thinking” that keeps potentially great minds bouncing of the walls of the conceptual framework of worn out economic models. A failure to explore other potential outcomes and ways to reach them is more an indication of intellectual impoverishment than a deterministic economic conclusion.

Altman’s proposed resolution is “A single currency representing 17 separate nations inevitably requires a unified balance sheet behind it and, following that, a form of fiscal union. The time for denying the latter is over.” However, we already have an operating model of many separate governments with a unified balance sheet and some sort of fiscal union; that would be the United States. Clearly the observable evidence shouts out that this remedy is more than a little problematic as well.

Financial Meltdown; Part Two?

How fast things can change; in either direction. I studiously try to avoid thinking in short term time frames. It usually leads to sub-optimal, emotionally driven decision making, rather than longer term strategicially driven decision making. Sometimes, however, near horizon events are compelling enough to warrant shorter term tactical changes of direction.

I do not see the global financial system being on the verge of a financial apocalypse, at the present time. Last year, at this time, presented a distinct possibilty that we were. Nonetheless, there are a number of very troubling signs on the near term horizon. One of these is an increasing probabilty of a sovereign debt crisis acting as a catalyst for global financial meltdown part two.

A number of countries and regions, such as China, Brazil and India, appear to be economically strong and gaining traction. In and of itself, this might lead one to believe in the underlying attractiveness of some portion of capital allocation to these regions. I concur in the the underlying premise of longer term opprtunity in theses regions. However, there are a number of factors which temper my longer term view of these opportunites, and their derivative considerations, to warrant shorter term tactical changes.

Among these considerations is the growing potential of sovereign debt crises acting as a catalyst for "Global Financial Meltdown, Part Two". The United States and the European region, in general, are seriously problematic. Several countries, in particular, are at the leading edge of a potential governmental solvency crisis. These are Greece, Spain, Italy, and England. S & P recently lowered the debt worthiness rating of the second largest economy in the world, Japan. Because of the growing deficit problem in our own country, and a Congress that may not be able too deal with it, even if the U.S. Congress were to be functional, it appears that the United States may not be too far behind with respect to a solvency crisis within the next five to ten years. This is but one of a number of signifcant factors which should prompt some additional strategic thinking away froma "full steam ahead", business as usual mentality.

As should be quite evident from our recent experiences of the 2007-2008 global financial meltdown, as people ruah for the exit, even assets which have strong underlying fundamental strength get painted with the same brush of value deterioration as panic sets in. Indeed, from a longer term perspective, these can be rare opportunities for the investor, assuming the emotional, pyschological, time, and financial abilities to withstand the ensuing trauma and economic dislocation.

In my opinion, a more prudent approach would be to err on the side of caution. After the financial market runups from March 2008, it appears to me unreasonable to expect, and improbable to achieve an immediate followup to this. The chances are that if we have really turned the corner with regard to a sustainable economic turnaround, there will be many years of compelling opportunties ahead. On the other hand, if reconsideration of the financial landscape leads one to believe in at least a reasonable prospect of financial meltdown, part two, it would be prudent to consider a more defensive portfolio allocation.

These are soome of hazards of the economic and investment landscape at the present time. It does nott consider unaccounted for contingencies, which seem to always arise in some form or other. It presents a set of risks, as well as a set of opportunities. In my opinion, the best way in which to deal with this environment is to maintain a vigilent and critical view of ongoing events. It is necessary to be responsive, while not over-reactive, as to how they may impact our longer term strategic outlook. It is important to keep in mind is that no one has a perfect crystal ball, and that because of institutionalized imprudence, there really is no safe harbor left. The most effective management will how well potential risks and rewards can be balanced in the midst of growing global economic dislocations and the financial restructuring resulting thereof.

Where Are We Now?

While many of us began this new year with hopes for an economic and financial recovery, unfolding events suggest that we have a ways to go before we are on the other side of this global crisis. The economy has continued to deteriorate with huge job losses, real estate prices continue to plunge, and our major financial institutions and industries continue their financial hemorrhaging. I have been studying and monitoring events with sharply focused attention. Below, I share some thoughts regarding what is currently going on. Hopefully, you will find these thoughts helpful in better understanding this environment.

Current View
Towards the end of 2008 the United States Congress agreed to provide $700 billion to keep the financial system from imminent collapse. The Secretary of the Treasury of the United States, Henry Paulsen, and the nation’s top banker, Ben Bernanke, had testified that the United States was within days of financial collapse. Congress provided for two installments of these bailout funds.

Several months later, we have had an opportunity to get some idea of the effectiveness and efficiency of the use of these funds.

The fallout from the failure of several large financial institutions had caused the global credit markets to freeze, consequently bringing global commerce to an abrupt slowdown. The public presentation of this strategy said the bailout funds were supposed to prop up the remaining mega financial institutions of the United States and stimulate the continuing flow of money, via increased lending, necessary for commerce to continue. How unsurprising that reports now emerging present a somewhat different picture of what was really going on. A recent news article reported that the CEO of a large US bank, as well a recent PBS Frontline presentation, said the bailout funds, TARP money, was essentially forced upon some banks. The apparent reason, which was supposed to be kept quiet, was to provide money for some banks to buy out smaller, weaker banks. Shortly after the TARP funds were distributed, there actually were reports of these types of bank acquisitions occurring. To the extent that this would “privatize” dealing with failing banks, this might make some sense.

One of the ways in which these TARP funds were distributed to the banks was to buy some of their “Troubled” (read toxic) assets. If the government paid a fair price for these assets, injecting money into them would be a fairly clean process. Unfortunately, however, this would not have accomplished the objective of stabilizing the financial system any better than they actually did, as I will explain.

If the government bailout funds purchased these assets for what their actual market value was, the financial system would experience an additional shock beyond what was already occurring. In order to try to make banks appear healthier than they actually were, the government needed to pay more for these assets than they were really worth. Indeed, a recent report by a congressional oversight committee headed by chairwoman Elizabeth Warren, a professor at Harvard, came to the conclusion that of the $350 billion spent on this program, the government overpaid for what it purchased by $78 billion. An additional research report by Goldman Sachs said that the real losses in the financial system will be around $4 trillion by the time this crisis is worked through. This is in the same range as estimates by economist Nouriel Roubini, who has estimated around $3.6 trillion of losses. The last estimate I read as to the already acknowledged losses in the financial system was around $1.1 trillion.

To draw the picture more anecdotally, a commenter to an economic blog, www.nakedcapitalism.com, on February 23, 2009, put it this way:
I have a personal anecdote about Citi and the difficulty of spotting how bad their loans actually are. I'm involved with a $300 million condo-hotel development in the Caribbean. Citi has the whole loan (i.e., they didn't securitize or otherwise sell participations in the loan). Even now, we expect the hotel needs at least another $100 million to finish construction and open (we are no longer under any delusions that more than a handful of buyers will close on the condo portion of the condo-hotel). So, in other words, Citi is $275M into this project, and it's not certain that the completed hotel will even be worth the extra $100M required to complete and open. Hence, one might plausibly value this $275M loan at zero (i.e., a complete write off). I cannot imagine any stress test would uncover what a huge loss is on the way in the next 12 months. In fact, this loan has not even been pawned off to the nonperforming/distressed debt/workout section of Citi because the interest reserves make it "seem" like the loan is still performing, not to mention that completely out of date pro formas make it "seem" like (i) equity will come in to finish the project and (ii) condo sales will pay down a huge part of the principal once construction is complete. This scenario must be present in a large number of Citi loans, especially in their somewhat active foreign development divisions. Citi must be so far from solvent that it's not even funny. Only hyperinflation in the dollar could ever make it possible for the borrowers to pay back some of these loans. I'd bet that the sooner we face reality on some of these loans and just halt future fundings, the less money the taxpayers are going to lose. As it is, it's almost too late. Too bad for the US taxpayer.

This suggests that we may have quite a ways to go before we are on the other side of this crisis. Other emerging areas of troubled assets are the commercial real estate sector, as well as car and credit card debt. In an economy which is continuing to deteriorate it would seem as though these problems will get worse. The new Obama administration’s continuing efforts at intervention has not inspired much of a vote of confidence by the markets as to its probability of success.

Looking Forward
There are several take-aways from all this. There is quite a bit a rot left at the core institutions of our financial system. These banks, insurance companies, and other related institutions, provide the backbone for commerce and economic growth. Sustainable and healthy investment markets require the foundation of a healthy economy. Most fundamentally, however, the ongoing financial crisis highlights the importance of rethinking assumptions about risk.

The belief that major financial institutions such as banks and insurance companies provided the “safest” investments arose from the time when these types of institutions conducted themselves in financially prudent ways. The ongoing massive financial institutional failures we have witnessed over the last year are evidence which refutes this belief in a massive way. Moreover, because of the necessity of the United States government having to bailout these institutions in order to try to save the entire global financial system from collapse, it may call the solvency of the United States government into question.
As a consequence of these ongoing events, the challenge of trying to identify potential financial safe harbors in this environment becomes all the more important. It needs to be recognized that “safety” is relative because there are many types of risks, and consequently no absolutely “safe” investment. However, in my analysis and conclusion, trying to balance out these risks points me to reconfirm my conclusion that investments which have a “real use” value such as energy, food, and utilities, will maintain a baseline of economic value in recessionary times, as well as provided the most accelerating growth opportunities when economic conditions improve. This is not to say that these types of investments will not also experience price volatility. Maintaining sizable positions in a safe money market, both for added stability to portfolio values, as well as to take advantage of future opportunities is an additional defensive measure. Having a modest position in precious metals is intended to provide an additional measure of safety. The challenge of this investment environment is to try to have some exposure to the upside of a possible rapid economic turn-around, as well as to provide downside protection from continuing economic deterioration.

From the personal financial planning strategy perspective, a prudent response to these conditions is to seriously re-examine personal spending and expenses with an eye towards belt-tightening. Because many of us have become accustomed to a living standard which includes discretionary expenses which enhance our lives, this is never a pleasant topic. The other side of the coin, however, is that we may find that may of the things we believe we need as discretionary expenditures do not necessarily add to the quality of our lives, or our health. These are times in which we need to have an adaptive response, where we refocus on the things which are really important and take proactive steps to maintain health and manage stress. The bottom line is, I believe, that we will, at some point, emerge from this crisis wiser, stronger, and with some incredible opportunities looking forward.

Addendum
Banks must be in compliance with certain regulatory requirements. These requirements are intended to ensure a minimal degree of financial strength to protect depositors. A peculiar characteristic of banking system accounting requires that assets be carried in the bank’s accounting records at what is called historic cost. This is what the banks actually paid for these assets. When an asset, such as an investment is sold, the bank accounting record is then adjusted to reflect the actual price at which the asset was sold. This means that if a bank paid $50 million for an investment in some type of sub-prime real estate investment, and it was now worthless, as long as the bank did not sell this investment, it would appear on the banks records as being worth $50 million. Consequently, a very financially sick bank could appear healthy as long as it did not sell, or adjust (called mark to market), its troubled assets.