Batten down the Hatches

Most economists are saying what most Americans have been saying for some time. This doesn’t feeling like a recovering economy. But is it just another calm before yet another storm? I earlier reported on a new thesis called “The Doomsday Cycle” and the attention that it had been receiving in academic circles. The idea is that the Fed and other central banks have just been increasingly feeding private sector debt to grow bubble economies and that despite several downturns that have been not so severe (the dot com or tech bubble) and severe (the housing or sub prime bubble), we continue offering easy credit that’s not supporting real growth in the world economy. There is now a report coming from some of my favorite Cassandras that suggests we’ve yet to work out on the problems of the last few years and it’s likely to get worse. This would include Nobel prize winning economist Joseph Stiglitz, Public Watchdog of Bailout Funds Elizabeth Warren, and Rob Johnson of the United Nations Commission of Experts on Finance. The report argues that a down turn is coming that will be much worse than the recent one. The central cause of these continuing blow outs are those banks that continually speculate rather than lend to businesses that actually produce and do something which are being continually enabled by Federal governments everywhere.

The report warns that the country is now immersed in a “doomsday cycle” wherein banks use borrowed money to take massive risks in an attempt to pay big dividends to shareholders and big bonuses to management – and when the risks go wrong, the banks receive taxpayer bailouts from the government.

“Risk-taking at banks,” the report cautions, “will soon be larger than ever.”

Again, financial innovations are at the center of the maelstrom.

“While manufacturers have developed iPods and flat-screen televisions, the financial industry has perfected the art of offering mortgages, credit cards and check overdrafts laden with hidden terms that obscure price and risk,” Warren writes. “Good products are mixed with dangerous products, and consumers are left on their own to try to sort out which is which. The consequences can be disastrous.”

Frank Partnoy, a panelist from the University of San Diego, claims that “the balance sheets of most Wall Street banks are fiction.” Another panelist, Raj Date of the Cambridge Winter Center for Financial Institutions Policy, argues that government-backed mortgage giants Fannie Mae and Freddie Mac have become “needlessly complex and irretrievably flawed” and should be eliminated. The report also calls for greater competition among credit rating agencies and increased regulation of the derivatives market, including requiring that credit-default swaps be traded on regulated exchanges.

At the same time, we’re seeing the reform bill that was intended to stop a repeat of the 2008 global financial crisis being watered down to the point of uselessness by congress and the FIRE lobby. You can watch at Bloomberg which is livestreaming the conference here at the Roosevelt Institute. It’s called Make Markets Better. I know it’s finance and economics, but you’re better off knowing, believe me.

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Death by Bubble

cosmic-bubbles-fEconomist Andy Xie says Lehman Brothers died in vain and that it’s just a matter of time before we get hit by another deadly bubble. His guest post at Caijing Magazine is just so dead on that you must go read it.

There has been plenty to learn from last year’s miserable economy and near collapse of key financial markets but U.S. policy makers appear to rebuilding the same system with the same ghastly mistakes in place. We cannot afford to be complacent about this because if it’s done, another huge mishap can’t be far behind. Xie explains that the entire financial system is one big Lehman now and has become much more costly to bail out.

So Lehman died in vain. Today, governments and central banks are celebrating their victorious stabilizing of the global financial system. To achieve the same, they could have saved Lehman with US$ 50 billion. Instead, they have spent trillions of dollars — probably more than US$ 10 trillion when we get the final tally — to reach the same objective. Meanwhile, a broader goal to reform the financial system has seen absolutely no progress.

‘Absolutely no progress’ may actually be an optimistic estimate of the current situation. No progress would mean, to me, we’re not rebuilding the same time bomb. Xie’s article is remarkable in that it deconstructs the arguments one-by-one that we’re hearing that things are really changing, What we actually have is the proverbial shuffling of the chairs on the financial Titantic.

Top executives on Wall Street talk about having cut leverage by half. That is actually due to an expanding equity capital base rather than shrinking assets. According to the Federal Reserve, total debt for the financial sector was US$ 16.5 trillion in the second quarter 2009 — about the same as the US$ 16.6 trillion reported one year earlier. After the Lehman collapse, financial sector leverage increased due to Fed support. It has come down as the Fed pulled back some support, creating the perception of deleveraging. The basic conclusion is that financial sector debt is the same as it was a year ago, and the reduction in leverage is due to equity base expansion, partly due to government funding.

This, of course, leads to the most fundamental question of all. What happens when the government funding disappears? I admit that I see no end to that infusion unless the Fed or some other central bank becomes spooked by the possibility of inflation. These institutions would have to be rebalancing their portfolios in lieu of all the M&A activity they’ve undertaken this year to be able to live with out cheap government funds. Some of them may be repaying the TARP funds, but the real deal happens when Quantitative Easing and ZIRP ends. We’ve had no indication from the FOMC or Bernanke that that’s in the works any time soon but I can tell you, one little glimpse of inflation and the game ends there.

Now, here’s my favorite point. It’s this bull market where the shadow banking system profits from churning and running up your own portfolio by selling it back and forth between the parent and subsidiaries to create a false sense of momentum.

…financial institutions are operating as before. Institutions led in reporting profit gains in the first half 2009 during a period of global economic contraction. When corporate earnings expand in a shrinking economy, redistribution plays a role. Most of these strong earnings came from trading income, which is really all about getting in and out of financial markets at the right time. With assets backed up by US$ 16.5 trillion in debt, a 1 percent asset appreciation would lead to US$ 16.5 billion in profits. Considering how much financial markets rose in the first half, strong profits were easy to imagine.

Trading gains are a form of income redistribution. In the best scenario, smart traders buy assets ahead of others because they see a stronger economy ahead. Such redistribution comes from giving a bigger share of the future growth to those who are willing to take risk ahead of others. Past experience, however, demonstrates that most trading profits involve redistributions from many to a few in zero-sum bubbles. The trick is to get the credulous masses to join the bubble game at high prices. When the bubble bursts, even though asset prices may be the same as they were at the beginning, most people lose money to the few. What’s occurring now is another bubble that is again redistributing income from the masses to the few.

Yup, there it is. The idea that many of the bigger players are just trying to run up the market enough to entice the suckers back near the top. Catch the one about redistribution? We’re basically using cheap money to finance the reverse Robin Hood scenario one more time.

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