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.

George Soros' European Crisis Solution

If one accepts George Soro’s solution to preventing a second Great Depression, the prognosis is indeed grim. His solution, while in itself conceptually problematic, appears in a pragmatic context to reside in never-never land. The bold steps he presents as necessary conditions to prevent a second Great Depression require the cooperation and coordination which would transcend the polarization and fractionalization of regional narrow self-interest at such a scale that defies observable reality. Moreover, while the conditions he proposes may or may not be necessary, he has not presented a convincing argument that they are sufficient conditions.

A nebulous foundation block of his strategy is to provide time for “Europe to develop a growth strategy, without which the debt problem cannot be solved”. The development of a growth strategy is central to every economic and business interest, as he well knows. The question which must be asked is what the potential drivers would be of any effective growth strategy, what are the competitive and comparative advantages that Europe could bring forth, and what the time frame for implementation would be? If this proposed growth strategy would be a palliative to the “debt problem”, one is assuming a sufficient rate of growth to offset the burden of debt service. Even assuming a growth strategy could be developed; getting a realistic idea of whether the growth rate would be sufficient to counter the demands of debt servicing takes us into the unquantifiable speculative realm. While George Soros is a demonstrably recognized master in the realm of speculation, a no small part has been his ability to be adaptable and flexible as changing conditions warrant. Unfortunately governmental and national policies rarely show the same nimbleness in response to changing realities.

http://blogs.ft.com/the-a-list/2011/09/29/how-to-stop-a-second-great-depression/#axzz1ZHNkRk4j

European Union Debt Crisis

The majority of the global economic discourse these days revolves around a central thesis; too much debt, and burdensome deficits. To some degree, the debt problem contributes to the deficit problem because of the requirements of servicing the debt. The actions of policy makers are decried as lacking in leadership as they stumble around seeking politically acceptable ways to resolve these issues, while at the same time being economically effective in really addressing the issues. The results have been skewed towards being politically acceptable via some form of “kicking the can down the road”. The economic realities suggest the end of the proverbial “road” may be near. The debt issue is more of a global issue than regional issue; or at least global with respect to the indebtedness of the western developed economies. Questions such as whether Greece remains part of the European Union seem a little flat when one considers that regardless of whether Greece is or is not part of the EU, the outcome of resolving this issue in any manner other than some sort of default is unlikely. Because of the integrated scale of connectedness, I doubt anyone, or any institution really fully knows what the unanticipated consequences and effects will be. Consequently, talk of “ring fencing” or containment of these issues smacks more of intellectual arrogance than a sober acceptance of the magnitude of the problem. I suspect that after all the “shucking and jiving” is done what we a headed for, and what seems inevitable, is a global restructuring of monetary regimes with some attempt at a functional global monetary unit, be it a basket of currencies, or for that matter a basket of commodities. Along the same line, it would seem that the only effectively managed way out of this global financial mess will be some sort concerted global effort to inflate away the real value of the debt burden.

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.

Pending Global Financial Crisis

The situation in Europe is very serious. From my research and analysis, my conclusion is that a Greek default is already “baked in”. If this situation were limited to a Greek insolvency, it would probably be manageable by the EU. Unfortunately, there are a number of other European countries that
represent a much larger potential problem because of the size of their economies and banking system, Spain and Italy being among them. I have even heard reports that there are some German and French banks that may have some capital adequacy issues. Fundamentally, the real problem is the potential contagion effect that arises. A number of factors are at work here. One is that bond investors start to demand higher interest rates because of the greater risks they perceive in the markets. This only makes the problem worse because it increases the cost of borrowing specifically for countries like Greece. This in turn, makes their financial situation even more challenging. More generally, it would be reasonable to expect borrowing costs to increase because of greater
demand for scarce capital. So far governing bodies in the European Union such as the European Financial Stability Fund, the International Monetary Fund, etc, have been trying to make capital available, or restructure existing debt. While these efforts have taken a potentially explosive situation and put it on a slower burn, they have not been effective in resolving the issues. As in the
United States, even if a theoretically economic effective solution were possible, political differences interfere with the implementation. In my opinion, there will be sovereign defaults. However, even if we are “only” talking about write downs of loan balances, the question arises of the impact on the banking system’s in the individual countries, and globally. Here we have another aspect of the potential contagion effects because banks and insurance companies throughout the world, including the United States, hold these impaired assets as part of their own investments. Moreover, a major risk factor which is very opaque, is what “derivative” exposure these various institutions hold. Derivatives are complex artificially constructed investments that may magnify greatly the risk on the books of these major financial institutions.

So far, one response of investors has been more what I would call a conditioned reactive response, rather than a response that reflects economic fundamentals. That response has been to migrate toward what are perceived to be “safer” assets. These have included US government bonds and
precious metals. This has helped hold down interest rates of US debt. In my opinion, while some position may be warranted in US Government bonds, the US financial system is on the precipice of a disaster waiting to happen. It should be kept in mind that one of the largest; if not the largest holder of US debt is China. They are increasingly expressing misgivings about the US financial situation. We are also seeing an increasing migration of capital into assets like gold. This would be capital that presumably would have been available for additional debt purchases. Both from the governmental side as well as the banking and financial institution sides have capital adequacy issues.

At this point I do not see much that gives me encouragement of a constructive resolution to these issues. In my opinion, at least for the near to medium term future, we are looking at increasing financial and social turbulence. The historical evidence suggests that the way in which policy makers will focus their efforts will be to try to inflate their way out of extreme over indebtedness by creating more and more money. Ultimately this will probably not work, and if I were to have to speculate, I don’t think it out of the question that within three years there will at least be serious discussions among global policy makers about the creation of new currency regimes.

Since we are in uncharted territory on a global scale, this is a time a great uncertainty in which events could move more or less rapidly depending on what the precipitating factors are. For example, the effects of a major natural disaster, a terrorist act, or who knows what else, are impossible to determine in an already fragile global financial system.

In my opinion, and reflective of the strategy we are currently being guided by, the best defense will be diversification which is targeted toward addressing the realities of the geopolitical and economic environment for the foreseeable future. This doesn’t mean there won’t be some volatility, but the objective is to be better able to weather the storm, retain value, and take advantage of the opportunities that will arise in what appears to be an oncoming global financial crisis.

If Only One Investment Could Be Made

The following is a piece I contributed to the investment website Seeking Alpha:
http://seekingalpha.com/article/213381-just-one-etf-safe-haven-concerns-favor-gold-producers-inflation-or-not?source=email

One of the basic functions of money is as a store of value. If the viability of this function becomes impaired, it is important to consider where economic value will be best preserved, or even increased. When making investment decisions, the objective is, at a minimum, to preserve value, and if we choose wisely, to increase the real value of our net worth. Implicit in the idea of value is what preserves and increases our purchasing power Because of the privileged position the US dollar has held as the reserve currency of the world, the mystique of power and safety has become an assumed fact in the perception of most financial players. In my opinion, it would be an error of judgment to assume that the United States has been divinely exempted from the laws of economics, or that the US dollar has any value other than a faith based presumption of economic entitlement.

There is a growing awareness that a fundamental structural shift has occurred, or is in the process of occurring in the power arrangement of the global economy. Events of recent years should have served as a wakeup call that placing blind faith in institutions such as investment banks, banks, insurance companies and governments is likely to be hazardous to an investor’s financial health. One thing that should be abundantly clear is that financial imprudence at all levels of our society, and throughout the world, has became institutionalized into an acceptable form of conduct. Imprudent lending, and imprudent borrowing, has 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.

With a trillion dollar plus budget deficit, the United States will need likely need to borrow over $70 billion per month from foreign sources in order to continue funding its operations. The question that must be asked now is: How willing and how able will these foreign funding sources 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 turbulence. Many of these countries were, prior to this financial turbulence, 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 conclusion is inescapable that a potential funding crisis will be one of the major consequences of the current attempt to contain this financial crisis.

Governments of the world have made massive commitments toward maintaining financial and economic stability. On a global scale, trillion of dollars have been committed to financial and economic stabilization. Each time a government responds to a financial crisis in an industry, business, another sovereign county, or municipality, the financial hole gets deeper. Looking forward to what pending financial crises of global significance crises are likely to emerge, there is no shortage of candidates. On the front burner is the unfolding European financial meltdown. A prudent view would be to assume that as bad as it looks, it is likely to be much worse when one factors in the amplification effect of derivative positions likely held by systemically important institutions. On the back burners, waiting for their chance to emerge are the rapidly deteriorating conditions of the pension systems, the FDIC, as well as state and local municipalities.

The biggest player is the US Government itself. The trillion dollar plus budget deficit projected indefinitely into the future does not even take into consideration expensive contingencies, which seem to inevitably arise, such as natural and man-made disasters, wars, and other Black Swan events which will necessitate additional funding requirements. How will all the unfunded liabilities and current operating expenses be paid for? One might argue that incurring these expenses is necessary, but there are also consequences.

That there will be increasing insolvency, massive economic displacement, and economic restructuring is appearing to be more and more a given. We are at a global economic watershed point. A recent book, This Time Is Different, by two eminent economists, professors Carmen Reinhart and Kenneth Rogoff, is based upon a compilation and analysis of data looking at government’s financial behavior over the past 800 years. Among their conclusions is a pattern which emerges as a constant. Governments overspend, over borrow, and then default. The two basic methods of default are an outright refusal to pay their debts, or an implicit default. In an implicit default the intent is to debase the currency with the objective of repaying existing indebtedness with a lower value currency, in effect, an attempt to inflate away the real value of a currency.

Given the current operating deficits, as well as future liabilities, the United States is on a trajectory that is financial unsustainable. Considering the position of the US dollar as the reserve currency of the world, the question of default must be addressed by an investor who considers that somehow events occurring in the world matter to the investing results achieved. In my view, an outright default by the United States of its debt is a probability so small as to be insignificant. On the other hand, an implicit default, where the United States attempts to inflate its way out of its financial hole is extremely likely, especially when there is no limit as to how much money the government can create.

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 consideration of other currencies as a safe harbor refuge. This may be a false sense of security. 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.

It is the consequences that follow which will provide both the hazards, as well as the long term opportunities from an investment and financial planning perspective. It is exactly here that both the risks and the opportunities reside. In my estimation, the outcome 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 a debate as to whether we are looking at a deflationary or inflationary future. In my opinion, while I harbor the view that we will experience a severe hyperinflationary and stagnant economic future, I consider this to be somewhat of a secondary consideration. A more primary consideration, which is, and will continue to shape investor behavior, will be the economic uncertainty and dislocation which arises, whether it is inflationary or deflationary. This economic instability is already creating a greater shift in the view of what is perceived as a more desirable asset class to act a as reserve of reservoir of economic value.

Considering assets which might best retain or increase in value, it is clear that current market behavior suggests there is growing recognition that investors have starting voting with their feet. One investment areas which has highlighted these opportunities is precious metals, in particular gold. The evidence derived from reports of shortages of gold coins to the increase in bullion reserves by central banks such as China, India, Russia, and Saudi Arabia, make a compelling case that we are not witnessing merely a speculative thrust at a trading position, but rather a sustainable shift in perception of an asset that will withstand the rigors of the economic storms we are facing.

Aside from owning gold directly, there are now opportunities with exchange traded funds such as GLD, to take positions that very much mimic the economic characteristics expected of a currency. In my analysis, this provides a compelling reason to expect the demand for gold to continue to increase. It follows that if one expects the demand for gold to increase, the value of those entities which hold reserves of gold, as well as the productive capacity to bring it to market, can be expected to be beneficiaries of these circumstances. It is from that perspective that if I had to choose only one investment, I would select GDX, an ETF of gold miners as my investment of choice.

What Could Go Wrong

One thing I have learned from over twenty years of investment decision making, and corroborated during the experiences of my younger years working in research laboratories, is that no matter how well thought out and rational a position is, it does not necessarily mean that is what is. As a consequence, it is important to examine and identify where the potential risks lie in our expectations. The year 2008 gives provides us with a great opportunity to examine what happened to gold during that time of extreme financial duress.

Deleveraging caused massive indiscriminate selling pressure. Institutions were forced to raise capital to meet their regulatory requirements. At the same time the credit markets froze up, making 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 the more 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. It did not matter whether an investment had merit or not, it was going down, and gold did likewise. It is certainly possible for this to occur again. It should also be noted that GDX seems to trade more like a stock than GLD, hence one might expect higher volatility. One of the only assets which did well in 2008 in comparison was US Treasury debt, due to the perception of safety.

If we fast forward to the emerging European crisis of 2010 and examine market conditions, we can see growing investor perception recognizing gold as a safe harbor. Additionally, the gut reaction of flocking to the US dollar as a safe harbor seems to be becoming somewhat more muted. In my view, I see this as a growing trend that will greatly benefit GDX over time. By the same token, does this suggest to me that it would be appropriate to bet the family farm on this position? Absolutely not! Even if an investor sees merit in my analysis, each individual investor needs to evaluate his own risk tolerance and circumstances to arrive at an appropriate allocation to GDX even if it is the only investment position they are taking.

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.

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/