Friday, January 9, 2009

Christmas Past, Christmas Present and Christmas Future

This new post was created by Tim Chilleri, a former Wake Forest student in my ESE302 class. I have taught hundreds of young adults and Tim is among the very finest young thinkers that I have ever met. I sponsored him as an intern at a company that I had invested in and he did a brilliant job there. Several days after Bear Stearns collapsed, he called me (it was a Saturday, and I wasn't feeling too well) and we spent two hours on the phone discussing the fact that we had just seen "A Black Swan." In any event, Tim volunteered his work which is most thorough, and which I very much admire...I don't think I could have produced such a scholarly piece. Here you go (and if you want to reach Tim, just email me.)

From Tim Chilleri:

Christmas Past, Christmas Present, Christmas Future
By: Timothy Chilleri
25 December 2008

Alan Greenspan should wear a gold medal everywhere he walks. It wouldn’t be a medal for distinguished service but rather, a mark of ignominy as he is the worst Federal Reserve Chairman in history. Luckily for him, his replacement, Ben Bernanke is anxiously trying to usurp him. You won’t hear this on CNBC or Bloomberg, but these men will be more despised than President George W. Bush once the full ramifications of their policies become evident to the public. Let’s see why.

In early 2000, the tech bubble burst, sending asset prices down dramatically. A year and a half later, 9/11 sent fear down American’s backbone and markets tumbled to its lowest levels in years. The Fed attempted to spur the economy by bringing down the key Fed rate; and it did, to 1 percent keeping it there until June 2004. Americans used this opportunity to take on more debt, either through refinancing to lower mortgage rates (and spending that saved money) and/or tapping into a home equity line. The move worked and the 31 consecutive months of negative real rates brought upon the housing boom. American’s were flying high and feeling rich. Their property value(s) was/were soaring, their stocks pushed higher, and all was well on the home front.

Then unexpectedly, the tide began to shift in August 2007. American Home Mortgage, one of the largest U.S. independent home loan providers, filed for bankruptcy after laying off the majority of its staff. Short-term credit markets froze up after a large French bank, BNP Paribas, suspended three of its investment funds worth €2 billion, citing problems in the U.S. sub-prime mortgage sector. The European Central Bank (ECB) pumped €203.7 billion into the Eurozone banking system to ease the sub-prime crunch over the course of three working days as The Fed and Bank of Japan took similar steps. That same week, Countrywide Financial, the largest U.S. mortgage originator, drew down its entire $11.5 billion credit line. Australian mortgage lender Rams admitted it also had run into a cash crunch. On August 17, the Fed cut the discount rate by a half percent to help banks deal with the credit problems. Within a month, it was disclosed that Northern Rock, the largest British mortgage banker was bordering on insolvency, triggered by a bank run (the first time this had happened in a hundred years) (Soros xiii-xiv)! The tropical financial storm turned into a Category Five hurricane as numerous giants began to topple: Bear Stearns, Fannie Mae, Freddie Mac, Indy Mac, Lehman Brothers, Merrill Lynch, AIG, Wachovia, and Washington Mutual. The tide went out and they were all caught with their pants down. But before we jump to conclusions, who is really at fault? In my opinion, direct blame lies on the Federal Reserve. Why?

Let’s put it an analogous terms: Say a kindergarten teacher walks into her classroom and delivers an enormous bucket of candy and soda to her students. She (stereotypical I know) instructs the children to keep working and she’ll be back in an hour. Do you expect the children to be idly working on their coloring books when she returns? Of course not, they are going to be swinging from the rafters, pushing over chairs, throwing paint all over each other while screaming at the top of their lungs. Now who do you blame here? The teacher who provided the means for this to happen, or the five-year olds who went willy-nilly with all the free candy? Naturally you blame the teacher. In this example the teacher is the Fed and the children are the banks and lending institutions. Think about it. You’re a banker. You wake up in the fall of 2001 with hundreds of billions in nearly free cash. What do you do with all these Benjamin’s? Sit on it and count crisp hundreds of dollar bills, or lend it out in hopes of watching your bonus hit seven figures?

The entire housing bubble and bust was manufactured and distributed by former Fed Chairman Alan Greenspan. He artificially suppressed interest rates to stimulate the economy. If he had let the natural free market work, we would have experienced a harder and longer recession beginning in 2001-2002 but am certain we would not be experiencing the current housing meltdown.

While banks and lending institutions do hold some responsibility for manufacturing exotic derivatives with huge leveraged risk (up to 35:1), you cannot expect them to idly sit on their hands. However, it is clear that these institutions held a prevailing misconception about market; that is, these securitized bundled “assets” were dependent on housing prices to rise.

This brings us back to Mr. Bernanke who on December 16, 2008 slashed interest rates to 0-.25 percent. Not only that, the Fed Chairman intends to leave interest rates at this level for “some time” to fight off deflation and is willing to print as much money as needed to stimulate our economy. In fact, on November 21, 2002, then Federal Reserve Governor Ben Bernanke gave an address before the National Economists Club in Washington D.C. The infamous speech which is now known as the “The Helicopter Theory”, Bernanke outlined a plan to avoid Japanese style deflation saying, “The U.S. government has a technology, called a printing press that allows it to produce as many U.S. dollars as it wishes at essentially no cost” (Wiggin 81). Scary? I think so.

I believe that the U.S. economy is a house of cards. Our economy is entirely predicated on credit expansion and without it we collapse under our own weight. 70% of our GDP is consumer spending. What happens when there is significantly less money to borrow and spend? We are a sustainable economy only if the rest of the world continues to lend us money. For the past several decades, we have shifted from a manufacturing based economy that produces and sells things to the rest of the world, to a service based economy in which we borrow money from the rest of the world, import the things we want to buy, and then send our borrowed money back to them. Does anyone see why this is a problem?

In my opinion, our day of reckoning is finally upon us. The rest of the world now realizes that there is no way we will be able to pay them back. The finance minister of India hinted as early as 2004 that they were reducing the amount of U.S. dollars it holds in its reserves. Soon after, South Korea made the same announcement. In August 2007 (the same time that the mortgage markets became unpinned), the central banks of Japan, China, and Taiwan sold U.S. Treasuries at the fastest rate in as many as seven years. In all, Asian banks have decreased its holdings of U.S. Treasuries by about $52 billion in the final summer weeks of 2007. Not a titanic sum considering they hold a little more than $1 trillion but certainly indicative of a trend, particularly since these countries are looking to stimulate their economies in the face of the current global recession . A few months later, the U.S. Treasury’s TIC data revealed that Japan, China, the Caribbean banking centers, Luxembourg, Hong Kong, South Korea, Germany, Singapore, Mexico, Switzerland, Turkey, Canada, the Netherlands, Sweden, France, Russia, Ireland, and Israel were all net sellers of U.S. Treasuries in September. The central banks of these countries will conclude that it’s smart to move their funds into other currencies, or to demand higher returns on their money (Wiggin 135-36).

There is little doubt that we are on the eve of destroying our currency. Individuals who think it is safe to hold U.S. bonds and/or currency are going to have no idea what hit them. Interest rates are now at 0%. Bernanke has made it crystal clear he is going to keep rates low and “add liquidity” to the system by buying all the stuff no private investor would touch. Where is it going to end? Recently, major developers across the country petitioned Congress for a $200 billion bailout. This is Socialism, pure and simple. More importantly, Bernanke is running the printing presses day and night to pump cash into this economy which will ultimately lead to massive inflation. This is an extremely dangerous precedent. Why?

Once the United States came off the gold standard, it gave the Fed complete reign over the money supply. And just like every other fiat currency in history, the Fed has lost discipline, printing money whenever needed. However, the Fed is very clever; they realized they needed a way to deflect or hide how much cash they were introducing into the economy.

The official rate of inflation is given through the Consumer Price Index (CPI). When more money is introduced than goods and services produced, prices will rise. So how is the CPI calculated? Each month, the U.S. Bureau of Labor Statistics (BLS) goes shopping, figuratively, by running around grocery and department stores, purchasing goods and adding it all up (Buchholz 22). The next month, they pick up the “same” goods and recheck the prices (you will understand why I put the “same” in quotations soon.) The delta or rate of change is the CPI.

While most focus on the CPI, it is an unreliable measure of the inflation rate. First, the BLS will purchase the “same” basket of goods regardless of price discounts, coupons, etc. Second, the BLS does not account for price fluctuations among products and substitute if necessary (Buchholz 23). For example, if you usually purchase fillet Mignon but lose your job, odds are you’ll begin purchasing hamburgers instead. Further, most forget that inflation is about overall prices, not just prices for a few items in the basket of goods.

Here is where the story takes a dramatic turn. The government began rigging the “basket of goods” in order to make it seem that inflation is low. Why? It turns out that the CPI was used to adjust Social Security payments annually for changes in the cost of living. In the early 1990s, press reports surfaced saying that the CPI was actually overstating the real rate of inflation. As such, it became costlier for the government to pay out higher amounts to retirees every year. So two financial “geniuses”, Michael Boskin, then chief economist to the first Bush Administration and Alan Greenspan, Chairman of the Fed issued some new directives. While the political uproar killed any consideration of Congress moving forward with the new changes (and rightly so), the BLS quietly moved forward with the changes under the Clinton Administration.

How did Boskin and Greenspan pull it off? Let’s say that Item A in their usual basket of goods goes up 14% over the course of a given year (the BLS finds that number unacceptably high). Well, instead of using the “same Item A”, they substitute “Item A” for “Item B”, which only went up 3%. Thus, they are able to wipe out an 11% increase in the price of goods by pure substitution.

Second, they use a term called geometric adjustment. Say one item in their basket of goods is a chocolate bar whose standard weight is one ounce (28 grams). If the price rises more than the government likes, they simply “adjust” its geometric properties, using only 24 grams, instead of the usual 28 grams. If the price of an item drops, they add “properties” to it reducing inflation further. And just like that, inflation isn’t all that high after all!

So, if the government is rigging the inflation rate, can’t we look at the money supply to truly see how much money they’re printing? The money supply consists of several measurements: M1, M2, and M3. The M1 consists of coins, dollar bills, and checking account deposits and are all added up. To calculate the M2, the search for money is expanded to include the M1 plus savings accounts and small CD’s. And lastly the M3, which is the M2 and includes large CD’s. So by looking at the M3 number, we can accurately see how much money is in the economy and how much more is being added correct? Well, that is now an impossible number to obtain because after March 23, 2006 the Fed stopped publishing the data! This is most likely the case because they are too embarrassed to tell the public how many dollars are actually sloshing around the world. What does this all mean? It tells me that there are massive inflationary pressures coming down the pipeline.

Now getting back to Bernanke and Paulson, they said the economy was robust and flexible a year ago. If they believed the economy was so strong then, does it mean they didn’t know what was going to happen? And if so, are they qualified to steer us out of this crisis? It’s clear that they didn’t understand the problem and now they’re pursuing the wrong solution. So the question ultimately becomes, will the government change the policies, eg low interest rates, printing money, bailouts, and stimulus packages that will only serve to hurt our economy? I don’t know. I hope so, but the longer we stay on this course, the harder it will be to stop in the future. If our government isn’t willing to deal with the problems we face now, why would they deal a problem ten times its size in the future?

If you follow mainstream financial news, you will hear all sorts of theories as to why the United States isn’t in that bad of a position relative to the rest of the world. They will cite things like we were the first ones into the recession, so we’ll be the first ones out. Well, why? They say things are so much worse in other countries (with no empirical evidence) and/or we’re the engine that drives economic growth which is no longer true. Go look up the yield on the 30-year Treasury bond. As of Christmas Eve, it’s paying a dismal 2.633%. No one in their right mind is actually buying a 30-year note with the intention of clipping coupons for the next 30 years collecting 2.6%. For all we know, the only buyer in town is the Fed as they are attempting to suppress short term interest rates. In fact, I hold the belief that foreign central banks are selling their bonds back to Fed and taking the dollars they receive and dumping them into foreign currencies. Just take a look at Treasury prices and foreign currencies. Treasury prices have risen (remember that bond prices and yields are inversely related) while the dollar has dropped against every major currency pair since the dollar rally ran out of steam .

This is a very important moment in our history and it is time to make some very important decisions about your financial future. What risks are you willing to assume? Are you willing to see it out that the Keynesians are right? That the inflationists are right? Are you going to trust your wealth to central planners; to Socialist and Marxist ideologies? If you have faith in these ideologies, I recommend holding your wealth in U.S. dollars. But if you believe in free markets, capitalism, in the writings of Adam Smith, and the founding fathers, you need to get out of U.S. dollars and you need to get out now.

Every time you hear the word economic stimulus or bailout, you need to associate another word with it, such as annihilation, destruction, and/or obliteration. Every single time the government bails out another industry we are simply amplifying the longer term pain. President elect Obama has recently said that he plans on pushing through a New Deal style stimulus package. He somehow seems to forget to mention that we are completely dependent on the willingness of foreigners to supply the necessary funds. In light of an ever weakening dollar, it makes foreign governments much less likely to purchase Treasuries. For example, Obama wants to work on is our infrastructure to build new roads and bridges. Now let’s think about this from an individual perspective. Say I’m $100,000 in debt and I go to a credit counselor. I tell them my issues and they say, hey, you know what, why don’t you finish your basement. Yeah, wouldn’t you like a two more guest rooms, another living area, and bathroom? And you say, of course but how is that going to get me out of debt? And that’s exactly what these politicians are saying. Building our infrastructure isn’t an asset, it’s a liability. We can’t put these roads on an eighteen wheeler and sell it to foreign countries.

So what’s the moral of the story here: the government and Federal Reserve are not letting the free markets operate. The market wants to fix itself but cannot. I do not know when these inflationary pressures will be released out of the bag. I just know it will and when it happens, the tsunami wave that follows will destroy everything in its path.

Buchholz, Todd. From Here to Economy. USA: A Plume Book, 1996.

Soros, George. The New Paradigm for Financial Markets: The Credit
Crisis of 2008 and What It Means. New York: Public Affairs, 2008.

Wiggin, Addison. The Demise of the Dollar…and Why It’s Even Better
For Your Investments. Hoboken, New Jersey: John Wiley & Sons, Inc., 2008.

(1) Remember that sub prime borrowers were the first victims of the credit crunch. This occurred because the low teaser rates offered by banks and lending institutions ended after a two year period and the borrower’s mortgage rates ballooned. This is extremely indicative of what is about to happen as many standard teaser rates (non-subprime mortgages) which go up after five years. The reason why the Fed cut rates to effectively 0% on December 16, 2008 is because they are attempting to drive down mortgage rates. Why? Because these higher rates are about to kick in for many U.S. borrowers and the Fed is terrified these people will default. The Fed is attempting to lower mortgage rates so these borrowers can re-finance at lower rates so housing prices will not crash (this is going to happen regardless of government intervention as you cannot fool free markets!)
These countries have been saving up U.S. debt for a rainy day. Now that rainy day has finally arrived. When China wants to spend hundreds of billions to stimulate its economy and decides to sell U.S. Treasury bonds back the Fed, how will the Fed pay for it all since we’re broke? No worries, Bernanke can use his favorite toy, the printing press.
The artificial dollar rally from July through the end of November was pure trading: it was because of financial deleveraging, a reflexive flight to “safety”, speculation, and momentum. None of it had anything to do with market fundamentals.

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