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.

Reflection and Analysis

A Look Back

Shock, confusion, and fear are probably some words which describe many people’s overall experience of 2008. As difficult and challenging as the year was, it is important to try to make some sense out of what happened, what is happening, and provide some analysis towards a sense of where things are likely to go. To this end, I am offering my thoughts on this subject with the recognition that the complexity and magnitude of world economic events can cloud even the best crystal balls. Having said this, those of you who have read my book, The Emperor’s Clothes, know that I discussed many of the issues of this global financial crisis prior to their occurrences.

The news of the past year has been filled with details of the institutional pillars of American finance, such as Merrill Lynch, Lehman Brothers, Washington Mutual, Fannie Mae, Freddie Mac, and many others, collapsing or being taken over because of pending collapse. This has been followed by the frenzied attempts of the world’s Central Banks, such as the U.S. Federal Reserve Bank, coming up with one scheme after another to try to prevent a complete breakdown of the global financial system. Indeed, while trying to get support from Congress for a $700 billion bailout package to save the U.S. banking and financial system, the chairman of the Federal Reserve Bank, Ben Bernanke, and the U.S. Secretary of Treasury, Hank Paulson, testified before Congress that the U.S. financial system was within days of collapsing.

Massive indiscriminate selling pressure was created as a result of this financial turmoil. These institutions were forced to raise capital to meet their regulatory requirements. At the same time the credit markets froze up, capital very difficult to acquire. This made the situation even worse. Hedge funds are investments for institutions and very wealthy individuals. They operate by borrowing huge amounts of money using their invested positions of stocks, bonds, and more the esoteric derivative investments, as collateral. Some of these funds borrow 30-40 times the amount of actual dollars directly invested in them by their investors. The lenders who provide this money to the hedge funds have lending requirements which require the hedge funds to come up with more money if the value of their investments drops too much. During the financial turmoil, the decline of the investments in these hedge funds forced the hedge fund managers to start selling their investments whether they considered them good investments or not. This amplified the overall selling pressure and made a bad situation even worse.

Today, there appears to be some degree of stabilization from the worst of the turmoil. It will be many years, keeping many scholars employed, trying to sort out the details of what actually happened. The one thing that is abundantly clear is that financial imprudence at all levels of our society, and throughout the world, became institutionalized into an acceptable form of conduct. Imprudent lending, and imprudent borrowing, created a vicious destructive cycle of over-consumption and over-indebtedness. As with many extreme indulgences, when the party is over, we are left with a big hangover and a big cleanup job. Right now the United States in particular, and the world economy, in general, has one gigantic hangover, and a daunting clean up job.

Looking Forward

Currently the governments of the world have made massive commitments toward maintaining financial and economic stability. On a global scale, I have read estimates of up to $7 trillion dollars already committed to various bailout type endeavors. The bailout line also seems to be getting longer each time the government responds to an industry or business in financial crisis. The auto industry is the latest example. Following this bailout, I have read accounts of state and local municipalities, and the commercial real estate industry lining up to be next. When the government starts handing out money, there is no shortage of willing, ready, and potentially deserving takers.

Even if one considers these policies to be necessary to prevent an even more disastrous financial collapse, a number of issues arise which impact what the outcomes are that we can expect. One of these issues is the implementation of these policies. For example, the early reports on the banking system bailouts leave much to be desired as to the accountability of the use of the funds. The reports indicate that many of the recipients of the bailout funds are unable or unwilling to account for their use. Other reports suggest a business as usual attitude for many of these troubled institutions. They seem to feel at liberty to pay huge bonuses and compensation packages, and provide extravagant perks to the very management personnel who contributed to bringing about this disastrous situation. It was only when the spotlight of public opinion focused on some of these issues that public relations considerations brought about a more contrite demeanor in these institutions. This suggests to me that the only thing that has really changed is the public relations campaign.

Another issue, which I refer to as the elephant in the living room is: How are all these bailouts going to be paid for? In addition, the other component of trying to climb out of what is being referred to as the worst financial crisis since the Great Depression, is the massive economic stimulus package being put together by the incoming Obama administration. It may, perhaps, be necessary, but there are also consequences. It is the consequences that, in my opinion, will provide both the hazards, as well as the long term opportunities from an investment and financial planning perspective.

Current discussions of the economic stimulus package lead me to believe that by the time it becomes policy it will have a cost ranging from $1-$2 trillion over a two year period. The funding for this will be added to the operating budget deficit of the United States. Prior to all these bailouts and economic stimulus packages, the United States had already needed to borrow $60-$70 billion per month in foreign money in order to continue funding its operations. Luckily, China, the petrodollar countries, and the other countries accumulating U.S. dollar reserves were doing well and were quite willing to continue lending money to the United States. The question that must be asked now is: How willing and how able are these countries going to be to continue loaning money to the United States to fund its budget deficit?

Many of these countries are having a more difficult financial time themselves in the present financial crisis. Many of these countries were, prior to this financial crisis, considering reducing the amount of money being loaned to the United States. In addition, because of this financial crisis the credit worthiness of the United States has deteriorated, and there are alternative places where these countries can deploy their financial resources which may be more directly beneficial to themselves. The funding requirements of the United States its meet the Budget Deficit needs may rise above $150 billion per month; the conclusion is inescapable of a potential funding crisis as being one of the major consequential fallout of the current attempts to contain this financial crisis.

It is exactly here that both the risks and the opportunities reside. In my estimation, the results of these circumstances will result in escalating interest rates, which is another version of credit availability reduction, and a damper on economic growth. This would be an unacceptable outcome for our government whose interests are critically tied to economic growth. The policy response will be an attempt to create vast amounts of money in order to effectively devalue debt, and consequently the dollar. Current economic policy discussion focuses on the immediate deflationary impact of the global financial crisis. However, I believe we will be seeing a very real potential of rapidly escalating inflation by the later part of 2009.

If we remember that the basic function of money is as a store of value and the viability of this function becomes impaired, it is important to consider where economic value will be best preserved, or even increased. Some of investment areas which I will be scanning for appropriate opportunities will be in areas such as precious metals, as well as real use assets such as energy, food, and materials. The added benefit to these areas, apart from providing a potential defense against some of the forces I discussed, is that when the global economy begins to get through this financial catastrophe, these will be among the things which will be crucial to growth and in consequently high demand, with limited supply.

No Free Lunch

The extraordinary measures being taken by central and governments in an effort to stabilize create markets, and intervene in cases of prospective institutional insolvencies, will result in a huge funding need by these governments. In the United States, the Congressional Budget Office has estimated that the Budget for the United States will exceed $750 billion next year. Other estimates are for a U.S. budget deficit in excess of $1 trillion. This is before possible and probable additional costs for an economic stimulus package, $300-$400 billion, and other funding demands arising from this financial meltdown. Questions which should be of interest are: Where will this funding come from; and what be be the implications of funding these needs?

The United States has had the benefit of foreign sources of capital to meet its need of $60-$70 billion per month. This was prior to this financial meltdown and the new capital funding requirements ensuing. Countries like China, and petro-dollar beneficiaries were accomodating enough, for whatever reason, to meet these needs. If the U.S. budget deficit doubles, while probably not a strictly linear relationship, one might estimate that the capital funding requirements of the United States from foriegn capital sources might rise to $110-$120 billion per month. What would be the willingness, ability, and desirability of foreign capital sources to meet this need?

In the context of a global economic slowdown it would appear that foreign reserves of US $'s would diminish from decreases in exports as well as lower oil prices. This would leave less funds available for re-investment back into U.S. Government debt instruments. One might also expect that as the U.S. financial picture becomes more impaired by its crushing debt burden, potential investors may well look more closely at alternative choices, as well as the redeployment of capital back into their own countries. In any case, this suggests that in order to secure the funding necessary for ongoing operations, the costs, ie interest rates, will be pushed up my market conditions. As the United States and other central banks have become the "bailouters of last resort", who has the ability and willingness to bailout these governments and institutions? I suspect there is no one to do this. If so, this may well make the current financial meltdown look like a picnic on a nice spring day.

If the current operational strategies offered by Central Banks and governments are any indication, we might expect that a high interest rate environment(read impaired credit availability), in a severe recessionary environment would be unacceptable. It would then seem like the strategy of the printing press for the manufacturing of money would be the only feasible choice available. One might then conclude that despite this current period of asset deflation and a strengtening of the dollar, this may well be a period that is relatively short lived.

While there is no free lunch, there may well be soup lines.

Economic Policy Direction Shortcomings

The public policy edge of managing this global financial crisis has been focused on opening up the credit markets and re-establishing solvency in select financial institutions. As emergency interventions, they represent a monumental attempt to resuscitate a seriously damaged global economic system. The actual results, so far, have been only marginally convincing, if at all convincing, as to their successful outcome.

It is more than a little ironic that a primary reason this state of affairs arose is because of imprudent lending decisions. Financial institutions damaged their balance sheets, to the point of impairing their continuing business viability. Credit markets contracted and liquidity dried up. Credit is the lifeblood of our global economic system. Unfortunately, or fortunately as the case may be, prudent extensions of credit are based upon the credit worthiness of the borrower.

It should be fairly clear, by the increasing foreclosures and bankruptcies, that prospective borrowers do not, in general, represent good credit risks at the present time. It is also widely agreed that we are looking at a potentially severe and drawn out recession (depression?). We can reasonably expect that prospective borrowers will find themselves in even more distressed economic circumstances in the near future. As such, one must ask why a lending institution, after already getting its fingers burned through imprudent lending practices, would want to extend credit to prospective borrowers with deteriorating solvency prospects.

Additionally, the question should also arise as to why, a borrower already overextended, and facing a deteriorating economic picture, would wish to borrow more, other than as an act of desperation, or other irrationality. Perhaps it is a case of “if there is nothing left to lose, why not go for broke at the expense of an imprudent lender.”

It is not surprising then that despite massive capital injections, the credit markets are still sluggish. After shoring up their balance sheets, at public expense, lending institutions are possibly returning to their roots of being some of the more rational players (this is not a high bar to cross these days) in their economic and business decisions. The wiser deployment of capital would be to acquire distressed assets rather than extend credit to borrowers with poor prospects.

The dilemma facing policy-makers is still how to prevent, or at least mitigate, a global economic slowdown. What are the drivers of economic growth to be if growing debt financed consumption cannot be counted on? Several possibilities arise. As an example, China, and the Asia region, has the potential of stimulating their own internal domestic consumption. Inflation fears may have restrained efforts in this regard before. Now, however, prospects of an economic slowdown, and a more benign (at least for the time being) inflation outlook may open this up as an expeditious policy direction.

From the perspective of the West, and the United States in particular, there is a great deal that needs to be done to re-establish a strong and competitive economy. There are immense infrastructure needs and well as immense needs to fortify the intellectual capital base of the country through adequate funding of education and research. An assessment needs to occur in order to determine what the competitive and comparative advantage and long-term needs of the United States really are. This needs to be done in the context of the United States as a global citizen and its constructive relationship to other global economic players. Once this is determined focused attention and political will must be directed in this direction.

Financial Crisis Solutions

Congress has passed the Paulson Mega Bailout Plan. Much of the public dialogue around this issue appears to confuse the two major factors underlying this crisis. These two factors are liquidity and solvency.

The credit markets are the lifeblood of a healthy functioning global economy. This financial crisis has resulted in a “freezing up” of the credit markets. Despite Central Banks flooding these markets with access to funds, the credit markets had remained frozen. The ostensible reason is that there is an underlying fear of institutional insolvency arising from exposure to toxic assets on their balance sheets. Because of the complexity of the financial structure of these assets, valuation becomes, more or less, conjecture. At the very least there is an asymmetric knowledge regarding the real quality of these assets. Probably, however, this even overstates the value assessment of these assets because, apparently, even the holders of these assets have exercised poor judgment regarding their value.

A more nefarious explanation as the why the credit markets continue to remain frozen after hundreds of billions of dollars have been injected into the system, could be a “money cartel strategy”. In this case, the fear generated by this credit crisis provides great cover for the institutional withholding of credit. The resulting worsening of financial market conditions result in more institutional and corporate failures and an increased availability of distressed asset sales for those who have access to capital.

Whichever explanation may be partially, or wholly, representative, the recently passed Paulson Plan is intended, at least at face value, to address the frozen credit market conditions by alleviating the institutional solvency concerns.

Unfortunately, as the point has been made by Roubini, and others, this only partially addresses the real problem which is the crushing personal debt burden. This is an underlying weak point which has lead to the deterioration in home values, and the associated mortgage securities. The idea that making more credit available to an economic system whose members are already drowning in debt seems to leave something to be desired as to this strategy’s future efficacy and effectiveness.

Because of the immense magnitude and pervasiveness of this financial crisis, it is likely that $700 billion will not be sufficient to successfully address this problem because the dollar value is insufficient, and its focus is incomplete. The other aspect which must be addressed is how to provide relief to an overly indebted population who cannot adequately service its debt, and how to do it equitably so that those who have acted prudently do not feel penalized for their more prudent financial behavior.

From my perspective the inevitable public policy which will arise will be monetizing the debt, and creating enough inflation to diminish the real value of the existing debt. This appears the only real option if the global financial system will not collapse in a shambles. This would be the case where the number of losers is maximized, and a result would arise from either an immensely stupid public policy decision, or a monumental geopolitical miscalculation. My inclination is to believe that because the vested interests are at stake of so many who truly are mentally sharp, as well as business and worldly-wise, the inflating option will be the direction we find ourselves going in. Given the monetary and fiscal policy apparatus, mechanisms, and policy maker predispositions, this seems the most probable outcome.

The next step in this would be to more directly address the personal solvency issues. This is a bitter pill to swallow, but this would be a natural consequence of the imprudent financial behaviors on the scale we have witnessed over many years. There are many creative ways in which this could be done. I would think, however, that a policy this is bold, and demonstrably decisive would be what is really required to breathe life back into the system. The follow-up, if we were to really correct the error of our ways would be to put in place regulations as well as financial education, training, and counseling programs, and a rethinking of our values, as to not get ourselves, globally, back into these circumstances.

Mega Bailout

For a financial crisis of the monumental proportions now officially acknowledged to exist, the thought that a well thought out “solution” can be cobbled together in the time period of a week or so, has more of the hallmarks of an act of desperation rather than of sound public policy. Though it may be a needed response, the probability of success is anything, if not unclear. Moreover, the ramifications of the indirect effects, let alone the direct effects would require, from a more prudent perspective, some more in depth analysis before committing a potential $700 billion to this end. It is tempting and, at least temporarily, reassuring, judging by the market’s response to such a sketchy proposal, to believe that throwing a massive amount of money at this problem will make it go away. There are many unanswered questions.

Some observations, thoughts, and questions are:

In billions of $s:
AIG Bailout $85
Fannie-Freddie Rescue $200
New Bailout Proposal $700
Next $??

It looks like we're talking some pretty big money. We already depend upon about $65 billion per month being loaned to the U.S. to continue operations from foreign sources. Essentially, the U.S. was already insolvent before this latest bailout proposal. It is difficult to see how the U.S. dollar won't be adversely affected. The actions of the Government seem to lend credence to the idea that the "ultimate" solution will be to "monetize" debt. This would be a very inflationary factor.

How long will foreign sources continue to lend to the U.S. under assumptions of high credit worthiness. The U.S. is no longer considered the best credit risk in the world by some rating agencies. This may push the cost of continuing to finance U.S. government operations with foreign capital higher. Control of the U.S. economic and financial future has been effectively transferred to foreign sources of capital.

If this new bailout entity is to purchase toxic assets from banking institutions, how are these assets to be valued if dubious models and assumptions came up with spurious results to begin with, what model and assumptions are now to be used to assure the use of public funds is not directed towards supporting fictitious valuations? Moreover, if the capital requirements of institutions holding these assets requires raising more capital now, presumably the thinking is that by taking these assets off the balances sheets if these financial institutions will allow them to more easily raise capital. Even is this were true, if would seem that with the U.S. Governments need to raise capital to fund these bailouts, and quasi-bailouts, with the entry of institutions also entering the capital markets to recapitalize, might there be some degree of competition for funds and a “crowding out” effect? If so, wouldn’t this push up the cost of capital and put a additional damper on economic growth?

The manic response of the markets to a very sketchy solution to an enormous problem defies a rational context of financial analysis. The events of the last several weeks demonstrate how greatly sentiment, and the absence of sound thinking, appears to be driving market responses.

Russia

The recent episode of Russia's response to Georgia's military intervention in South Ossetia, and the response by the West just happened to occur about the time of my initial visit To Russia. Needless to say, despite having invested positions in Russia, many of my perceptions had been formed from the context of the cold war rhetoric of the past, current geopolitical rivalries, and whatever books and articles I could assimilate about the region, including an excellent one by the eminent scholar Marshall Goldman, Petrostate: Putin, Power, and the New Russia. I could not help but to have some trepidation about going to Russia during this time.

From a professional perpective, while in Russia, I had the good fortune to be able to meet and talk with people in Russia'a emerging financial planning profession; meet a well respected economist, an oil & energy analyst, an asset manager, and a managing director of Troika Dialog, a Russian investment bank; perhaps equivalent to a Russian Goldman Sachs. Additional meetings with the Lukoil State Pension Fund rounded out the opportunity to learn about, and understand better Russians, and their current political and economic environment.

From a personal perspective, I had the opportunity to have my education about Russian history deepened by at least half a dozen native guides, and visits to Russian cultural and arts venues. Looking back at approximately the past 100 years in Russia's history, I could not help being extremely impressed at the intelligence, resilience, and strength of the Russian people. Having gone through two revolutions taking it from a Tsarist empire to the communist country of the Soviet Union, two world wars during which in the Second World War estimates of up to 27 million Russian people died, including around 2 million in St. Petersburg alone, watching the communist state dissolve and re-emerge into a rudimentary democracy, and having it crumble economically around 10 years later, only to have it re-emerge as a economic, and strategic, geopolitical power on the world stage represents a remarkable testiment to the human spirit of resilience.

What also became apparent during my visit is how poorly it seems Russia and the West understand one another, as well as the fears generated by the threat of disturbing the global status quo.

As an investment advisor, my experience suggests to me that the recent decline in value in the Russian markets may be seriously undervaluing the investment potential of an emerging economic power that appears to be destined for an increasingly strong role in global affairs. This is not to imply that the risks are negligible with respect to these investments. Looking, however, at some of the fundamentals, such as Russia's extremely high literacy rate, a vast need for infrastructure development, the need to economically uplift the majority of Russia's population to an emerging middle class, and Russia's vast natural resource and energy assets, suggests a huge potential over the next 10-15 years.

Unless politicians allow themselves to become locked into a cycle of escalating adversarial rhetoric, increasing the possibility of misjudgement and miscalculation, Russia and the West will likely work out their issues into a new balance of power arrangement. This will likely not be a clearly delineated point, but rather an ongoing process with contributions from other major global players such as China. If this perpective is correct, the investment potential outcome may well warrant the assumption of some degree of the risk in these positions. At present, in particular, this period of crisis and declining Russian asset values may represent an opportunity to secure a piece of Russia's future prosperity.

More Balderdash!

Yesterday the media reported that China was going to increase oil prices by approximately 18% by reducing subsidies. This news was generally received by the investment community as a positive with regard to reducing the global price of oil. The price of oil dropped substantially on global markets. Presumably, the thinking, what little of it that there was, was that by increasing the price of oil Chinese consumers paid, a reduction in overall demand would be created. As a consequence, the overall supply, relative to this demand would increase, and global prices would drop.

The amazing part about this event is how well it illustrates the level of shallow thinking and the consequent behavioral response. Modern financial theory, increasingly being debunked by real life events, attributes some greater overall knowledge of incorporating all known information into aggregate market response with respect to efficient disclosure of asset valuations. This most recent event, however, is more representative of how poorly markets incorporate and reflect information into asset prices. Consequently, it is one more example of how inefficiently markets reflect appropriate valuation.

Even a superficial follower of the Chinese financial and economic system would know that China is facing a serious inflation problem. At the same time, because of its uneven distribution of economic development, it also has millions of people it needs to keep productively employed. The problem faced by China, and a good part of the rest of the world, is containing inflation while, at the same time, maintaining reasonably strong economic growth. It is difficult to see how the new Chinese policy of increased oil prices would contain inflation.

A more reasonable expectation is that the response to increased oil prices will be to pass the added cost along to the end consumers. The upward wage pressures China was already experiencing is likely to be increased in response to a higher income need among its workers. A later consequence would likely be to see the price of Chinese exports increase. Since much of the rest of the world is hooked on Chinese goods, it would be reasonable to see increased inflationary pressure in those countries importing Chinese goods. The United States and Europe are large importers of Chinese goods. As a consequence, we can expect to see increasing inflationary pressure in these regions arising from this event.

While there has been increasing pressure on China to strengthen its currency vis a vis the US dollar, this event would suggest that one way to try to contain the Chinese inflationary factor would be to keep the US dollar stronger vis a vis China's currency in order to retain purchasing power. At the same time, China has huge US currency reserves, and oil is traded primarily in US dollars on global markets. This means that China stabilizes its purchasing power of oil, reduces political policy pressure to strengthen its currency relative to the US dollar, and preserves a sustainable core rate of economic growth. As usual, this appears to be a masterful, strategically thoughtful Chinese policy move.

Economic Stimulus Plan?

The current stimulus plan in just more ineffectual arm waving. Whether it is a rebate of $600, $1,200, or $5,000, the current debt problems, both institutional and personal, suggest the money has already been spent.

I believe the current economic stimulus plan being proposed is not any more than political window dressing in response to public clamor. The idea that putting $600-$1,200 in the hands of an already extremely indebted consumer to go out and purchase more would be ludicrous, if it were not so tragic. It perpetuates the idea that economic growth derived primarily from growing disposable consumption can be the basis of a healthy and sustainable economic system.The true values from which real wealth is created, which were esteemed ideals of founders of the United States are thrift, hard work, and reinvestment into productive assets.Anyone looking for a quick fix and easy solution to the country’s economic ills needs to sober up. Politicians and worn out economic theories will not provide the solution. If there is a long term fix it will not come in the form of tax cuts and rebates to stimulate spending. It will come from a public policy which focuses on rebuilding the productive and innovative capacities, and, consequently, the competitiveness of the nation. This means a public policy directed towards rebuilding infrastructure and a commitment to funding the development of more minds capable of ingenuity and innovation, namely cutting edge education. It also means a shift from a consumption based society driving economic growth to saving and investment driven economic growth model.The alternative, as we can now see happening, is a selling off of the assets of the United States and becoming a people subservient to the economic and political interests of other nations.

How To Pull a Rabbit Out of a Hat

Increasing numbers of foreclosures, among other things, have created financial havoc in the credit markets. Writedowns in asset valuations have necessitated increasing loss reserves, and credit availability is tightening in the context a higher likelihood of insolvencies at the personal, corporate, and governmental levels. One of the first public policy attempts to deal with this was to create a Super Bailout Fund in the attempt of establishing a fictional floor on valuations of financially impaired assets.

Apparently, the next public policy foray into establishing a floor on impaired assets is the proposed freeze on resetting ARM interest rates. The number of actual mortgagees this would actually help appears to be small; the number of mortgagees who would actually be deserving of help is even smaller. Moreover, numbers I have read suggest that even if this plan were able to be cost effectively implemented in a timely way, over 50% of these mortgagees would likely be in financial distress within several years later. In a deteriorating economy, likely to be in recession, and a projected continued decrease in property values, it is reasonable to ask where the soundness is in this policy prescription.

As I alluded to in an earlier post, it appears that the real benefits accrue to the troubled institutions at the root of this episode in financial folly. After thinking further about this, it becomes apparent that the deterioration in the asset values of the CDO’s, MBO’s, etc arises from the increased numbers of non-performing loans. If these loans, and mortgages, can be restructured to appear to be performing loans, voilà, we have created a floor in the valuation of the derivative assets, and at least a temporary slow down of the financial hemorrhage. On the plus side perhaps this at least buys some time to either come up with some other more effective solutions, or at least to think up another charade to defer the day of reckoning to someone else’s watch. Whether this buys time to allow accountable parties to fade into the sunset, or it buys time to reconstruct a seriously damaged financial system is an open question. Judging, however, from the fat severance packages we have seen some of those bearing responsibility walk away with, with relative impunity there is likely to be at least a good portion of the former.

Sub Prime Freeze Helps Whom?

We should be clear about one thing, the proposed rescue plan for struggling ARM homeowners, is primarily directed at slowing down the collapse of beleaguered financial institutions. The inputs for the plan were heavily influenced by those institutions most impacted. The veneer of beneficent social policy suggesting that these homeowners would be significantly helped does not appear to be supported by the evidence. An article in the Financial Times[1] cites a Barclays analysis that only 12%, or 240,000 homeowners would be helped by this freeze. It is patently obvious that this proposal amounts to nothing more than an additional attempt to bailout institutions whose imprudent actions lead to this set of circumstances.

Aside from the theoretical issues such as violation of contract law, establishing a precedent for the institutionalization of moral hazard (the Governmental Put, if you will), and State sanctioned erosion in the one primary concept serving as the foundation of the US, and consequently the global financial system, trust and faith in established US property rights, there is the question of equitable treatment of economic players. If we consider the context for the current economic calamity, it arose through the generation of incredibly huge profits for the players in these schemes. What appears to be being proposed is that, under the guise of the threat of global economic collapse, the policy response should be to reduce the consequences of the imprudent actions of the players who have benefited so handsomely. To make the pill easier to swallow, the sugar coating is spun to be the benefit to the “homeowners”.

As I’ve alluded to before, in other blog contributions, it is dubious as to whether “homeowner” is an appropriate term when little or no equity exists. Moreover, even if we granted the dubious theoretical justifications for the implementation of such a plan, the operational practicality of implementation is unlikely to be accomplished in a timely and cost effective manner.

It is interesting to note that in the last few days, eminent analysts, economists, and commentators, whom I’ve regularly viewed as having sober, well-reasoned opinions, even if I did not agree with all of them, appear to be becoming infected with a contagion of panic. Paul Krugman’s opinion piece uses words like “spooky”, in Robert Shiller’s Bloomberg interview several days ago I felt I heard an undertone of panic, and in Nouriel Roubini’s blog he appears to be appealing to ad hominem type support for his arguments by such statements as

“Thus only folks who are so blinded by their free markets fundamentalism and opposition to any government intervention in market failures would be so obfuscated by their ideological blinders that they would realize that this plan –however modest and partially faulty and incomplete – implies a better market-oriented resolution and much lower losses to private investors than a disorderly and “mission impossible” case-by-case workout of millions of actual or threatened mortgage defaults.”

This, in itself, is a good indication of how serious this issue is.

Ryan Darwish
Author of The Emperor’s Clothes: A Mosaic Look at the Megatrends Affecting Your Financial and Investment Decisions
[1] Financial Times, Bush Faces Subprime Loan Freeze Opposition, December 7, 2007.

US Dollar Fate

Gazprom May Switch Oil, Gas Sales to Rubles as Dollar Weakens
By Dan Lonkevich
Nov. 29 (Bloomberg) -- OAO Gazprom, the world's largest natural-gas exporter, may start selling its crude and gas production in rubles rather than dollars and euros after the U.S. currency weakened.
``We are seriously thinking about selling our resources in rubles,'' Alexander Medvedev, Gazprom's deputy chief executive officer, told reporters today in New York. He didn't give a specific timeline for the decision.
The switch would happen ``sooner, rather than later,'' Gazprom Chief Financial Officer Andrei Kruglov told the same gathering of reporters.
To contact the reporters on this story: Dan Lonkevich in New York at dlonkevich@bloomberg.net .
Last Updated: November 29, 2007 14:04 EST
It is interesting to note that a primary concern other countries have with the drop in the US dollar relative to their currency is the fear that their trade export position, and consequently,thier export driven ecomonies would suffer. In the case of Gazprom, referenced above, considering repricing in rubles rather than US dollars signals a perception of the decreasing significance of ruble strengthening relative to the dollar. It suggests when the demand is relatively inelastic for an export, such as energy, the concern about the likelihood of decreased exports is diminished. Moreover, it is somewhat of a two edged sword. As the ruble strengthens the purchasing power, and consequently the real wealth of ruble holders increases. It is a win on two fronts, increased purchasing power and increased accumulation through continued export driven growth.
Absolutely brilliant. Wait until some of the other petro powers catch on to this.
Ryan Darwish
Author of The Emperor's Clothes: A Look at the MegaTrends Affecting Your Financial and Investment Decisionshttp://www.investmentmegatrends.com/

Economic Decoupling

Nouriel Roubini, an eminent global economist, has made the point that if the US experiences an economic slowdown, other countries, such as China, would also experience a slowdown because our economies are dependent upon one another.[1] This is known as being coupled together. There has been ongoing discussion which suggests the alternative hypothesis, that economic decoupling has occurred, and the rest of the world is not economically dependent upon the US anymore.

While there are many well made points in Roubini's, as usual fine analysis, I believe there is something lacking in several respects. The idea of decoupling is contextualized as a black and white issue; either other countries have decoupled, or they have not. The preponderance of evidence, a posteriori, is that those other countries now have more developed economies, and by extension greater internal, as well as intra-regional, demand. The statement “"For now it is clear that it is still the case that when the US sneezes the rest of the world gets the cold.” may be an overstatement. I see little evidence to support this conjecture. It appears more likely that a more accurate representation would be "the rest of the world gets something between a sniffle and a cold". Whether the rest of the world gets more of a cold than a sniffle remains to be seen.

I see several possible mitigating factors which were not mentioned in this analysis. One factor would be how rapidly US demand deteriorates relative to geo-specific, intra-regional, and country specific internal demand increasing. Another factor are those elephants in the living room known as sovereign wealth funds, and country specific economic stabilization funds. It is no secret that a number of countries who have been beneficiaries of petro-dollar and trade surplus dollars have strategically identified the risk of a US slowdown. It may be a gross under-estimation of the intelligence of these entities to assume that they have not factored in contingency planning. Considering the infra-structure build-out needs of these emerging economies, a hypothetical alternative to being dragged down by a declining US economy would be to redeploy surplus reserves, and/or borrowing capacity, to developing, for example, their economic and physical infrastructure such as roads, telecommunications, environmental cleanup, etc. The US, in fact, presents a model of such an endeavor during the early 20th Century with the Civilian Conservation Corp. A major difference, nowadays, is that the US is financially broke, while these other emerging economies are relatively financially flush.

Ryan Darwish
Author of The Emperor’s Clothes: A Mosaic Look at the MegaTrends Affecting Your Financial and Investment Decisions
http://www.investmentmegatrends.com/

[1] http://www.rgemonitor.com/content/view/228535/85/

A Hard Landing or Stagflation?

Predicting a "hard landing" recession is not much more than making the observation that the horse is already out of the barn. It is also an intellectual hedge, to not go too far out on the limb, from making the observation that what we are facing is not just an economic "hard landing", but a period of stagflation. Looking at escalating food and energy costs, while not core items in "Fed Think", are certainly core items in living. Moreover, the pervasiveness of the dependency of the pricing of other goods on the production and availability of food and energy, suggests a very ugly outlook. This is compounded by increasing demand in the context of supply limitations for these items. It begs the question to hold the position that a slowing economy will dampen the demand for these goods. Externalities such as weather, geopolitical unrest, and strategic hoarding of vital resources, at the very least, cast doubt upon the premise of decreased demand because of slow, or recessionary, economic growth.

Author of The Emperor's Clothes; A Look at the Megatrends Affecting Your Financial and Investment Decisions
www.investmentmegatrends.com

The Current Financial Crisis and its Likely Outcome

As the current credit market crisis continues to unfold, it goes from bad to worse. Credible commentaries are now emerging in the mainstream press citing estimates as high as $500 billion(1) of losses that financial institutions may incur before it runs in course. It is unclear to me what the actual implications will be of a systemic loss of this magnitude, and indeed, since none of us has a perfect crystal ball, it can only be the subject of conjecture and speculation. That there will be an increase in insolvencies, massive economic displacement, and economic restructuring is appearing to be more and more a given. We appear to be at a global economic watershed point. If history is any guide, previous bouts of monetary folly have resulted in hyperinflationary environments, followed by collapse(2). In the past, however, there was relative economic containment because of the absence of the degree of globalization and economic integration we currently have in the world, with the exception, possibly, of the Great Depression era. In any event, an economic crisis of the magnitude we are currently facing, quickly becomes a political crisis. In considering possible strategies which may be attempted, short of the transparent charade recently proposed of the SIV Super Bailout fund, it appears the corner strategy will be monetization of the debt through hyperinflation. Indeed, we have already seen the evidence of this occuring, and it is well known that it is not a peripheral strategy for Ben Bernanke.

If we assume, for purposes of discussion, that this is the direction in which economic history will move, it becomes useful to consider some of the implications of this scenario for asset deployment purposes. While there is a great deal of discussion regarding the demise of the US dollar, it is often followed by considering other currencies as a safe harbor refuge. This may be a false sense of security. Considering that one of the reasons for the US dollar's problem is the lack of monetary discipline because of the fiat nature of the currency, the same problem exists with other currencies. There appears to be an inherent instability with a fiat monetary system. Consequently, in my opinion, it is a mistake to believe that other currencies might be anything other than a temporary refuge.

Let us also consider the question of debt. The initial reaction is to want to minimize indebtedness in a financial crisis. This may well, generally, be the prudent course to take. However, as circumstances amoung market participants differ, holding a fixed liability during a time of hyperinflation can become an asset as long as the ability to service the debt remains in place. For example, if I have a mortgage of $300,000, a hyperinflationary environment will reduce the value of that liability, in real terms, while at the same time possibly increasing the value of that asset in nominal terms. If I have a fixed mortgage payment of $1,500 per month which I can continue to service, a hyperinflationary environment may reduce that nominal figure in real terms, ie adjusted for inflation.

Let us also consider assets which might best retain or increase in value. It seems clear, and current market behavior suggests there is growing recognition of this, that assets which have a real use value, such as commodities, energy, food, water, etc. will continue to be in growing demand. At the same time, the constraints on the supply of these resources continues to grow. Economics 101 would suggest that a highly probable way to successfully deploy assets would be to own assets which are in growing demand and diminishing supply.

Traditonally, institutional creditors would be the one's to lose big time in inflationary environments. Nowadays, these institutions also appear to be some of the biggest debtors.


(1) Banks Face $100 Billion of Writedowns on Level 3 Rule, John Glover Nov. 7 (Bloomberg)
(2) Manias, Panics, and Crashes, A History of Financial Crises, Charles Kindleberger.

Moral Hazards and Free Riders

"High concentrations of money and power provide trigger points for economic calamity that can be brought about by relatively few individuals or institutions. The potential harm which can arise from acts of malfeasance represents a moral hazard in our investment environment. Some financial theorists would argue that this risk is “priced in” to our investments so that what we invest in is fairly valued with respect to its risks. I see little sound rationale to accept this point of view. Risks that can be perceived and quantified can perhaps be priced in to arrive at an estimate of fair value for an investment. Many risks, such as the moral hazard of malfeasance, cannot be effectively quantified. The media, institutional, and governmental approach to representing these types of risks to the general investor seems to be to marginalize these risks. This approach gives a false sense of security and the impression that these risks are non-significant. This may be necessary to manage the perceptions of the general investor and retain confidence in the financial markets. From the perspective of the individual, this approach breeds complacency where there should be vigilance in the wise management of one’s assets."

Excerpt from: The Emperor's Clothes: Megatrends Affecting Your Financial and Investment Decisions
http://www.investmentmegatrends.com/

Financial Magic or The Disappearing Elephant Act

When a financial system is based solely upon the faith people have in it, maintaining this faith becomes of paramount importance. In the absence of sound financial and economic policy, maintaining people's faith in the system becomes the politics of spin management where public policy reduced is to a confidence game.

The problems in the global credit markets, wrought by overzealous financial institutions, taking advantage of imprudently lax credit standards, are throwing a wrench in the spokes of the global economic and monetary systems, particularly in the United States. The latest proposal to try to manage this potentially monumental financial crisis is the creation of what, in my opinion, should be called a super bailout fund. This is essentially a fund, created by a consortium of banking institutions, that can be used to dump assets into when they believe there is not an acceptable alternative buyer. Wouldn't it be nice if, whenever we wanted to sell something and couldn't find a buyer that would pay what we wanted, we could just create a fictional buyer to take the asset off our hands.
One of the best analyses I've seen on this subject was done by economist Nouriel Roubini, and can be found at his blog http://www.rgemonitor.com/blog/roubini/220816.
The timing of putting this plan together is interesting. This push was reported to occur last weekend. Interestingly enough at least three major banks report earnings this week. Citibanks presentation of its dismal result are already known, with a decline in profit of 57%. It looks like quite a bit of spin managment going on here, in order to keep the confidence of potential new money boosted. From accounts I've read this fund will be seeking new money coming in to it. An interesting bit of financial sleight of hand; create a buyer to support a price on suspect assets and we now have a market pricing mechanism, then suck in new money until the real solvency issues cause it to implode.

Valuation Issues

The key metric in being able to evaluate an investment is knowing what it is worth. With a publicly traded investment such as a share of common stock, there is ongoing price disclosure generated by prices offered, and the prices accepted by a multitude of buyers. Reoccuring episodes of irrationality and over exuberance suggest that this may not be the perfect method of determining the true value of a given security. However, since what a willing buyer will pay a willing seller is the final arbitor of current value, the transparency of price disclosure by the market forces of the multitude at least has the merit of establishing a more level playing field as a starting point. Indeed, some financial theorists argue that markets are efficient to the extent that current prices determined by market forces are an accurate representation of true value. Be that as it may, an entirely different issue arises when investments are illiquid. Alternatively, if the value is determined by reference to a valuation model, this may contain self-serving, or otherwise erroneous assumptions.

For example, one of the problems, recently creating turmoil in the global financial markets, has been the valuation of Collateralized Mortage Obligations(CMO). When subprime mortgages are bundled together and packaged with other mortgages, assumptions need to be made about such things as the default rates of these mortgages. With a minimal history of these mortgages, there is also minimal information about default rates. Nonetheless, this had not stopped trillions of dollars of these securities from being created, and consequently being valued by, at best, an arbitrary method, and at worst a self-serving procedure of malfeasance. Consequently, when these valuations were challenged by the real market conditions of defaulting mortgage holders, these valuations became glaringly inadequate.

The latest example, after a litany of tens of billion of dollars of losses being claimed by the likes of Bear Stearns, Citigroup, Merrill Lynch, Deustche Bank, and having the Central Banks of the world pump $500 billon into the global banking system to try to avert a global financial catastrophe, is Ellington Capital Management, a $5.2 billion debt-focused hedge fund which recently announced it had restricted withdrawals from its fund because of the difficulty of valuing the securities in its portfolio. Along the same line, a Wall Street Journal article(Pricing Tactics Of Hedge Funds Under Spotlight, October 6, 2007) cites academic research findings which show that hedge fund managers sometimes "cherry pick" valuations to give a more positive appearance.

The bottom line is that these shenanigans, under the guise of free market capitalism, are anything but champions of free market capitalism. At core, these tactics erode the strength of a vital and strong economic system by distorting the efficient allocation of capital based upon fundamentally sound information.

Latest Delusional Market Behavior

The latest "sugar rush" to keep the market pumped has been the implicit promise of Big Daddy Fed coming to the rescue of the United States' economy and financial system. The concept of lowering interest rates to make credit, and consequently liquidity, more available is an idea which would have more play in an environment where solvency issues were not the context in the background.

The chorus of more sober voices highlighting the serious underlying economic issues are, as usual, being drowned out in favor of the voices of hyperbole espousing more faith based investing themes such as "stocks always go up in the long run", the worst of the credit crisis in behind us, etc. These spinnings, by and large, invite a "trust me" perspective in the absence of a more evidentiary decision process.

What remains largely unsaid is that we appear to be at the later beginning stages of a collapsing housing market, rather than at the end stages. The consequences are likely to be felt in job losses, decreased consumer demand, and increasing insolvencies and foreclosures. These latest exhuberances of the financial markets are likely to end poorly after having sucked in a multitude of additional naive investors impressed by its glitter.