The Current Global Financial & Economic Crisis
Economics / Credit Crisis 2008 Dec 02, 2008 - 09:32 AMBy: Dudley_Baker
Due to my unique service, I have numerous sophisticated and savvy investors among my subscribers. Some have become friends and supporters of my work.
Recently, Arnold Bock, a Canadian living in Mendoza, Argentina and Lorimer Wilson of Toronto, Canada, have agreed to become part of my editorial staff at Precious Metals Warrants and will be providing content from time to time.
The article below, admittedly lengthy, is a must read by all interested in understanding the reasons for and the why's of our current financial mess. It was written by Arnold Bock. Arnold also was the author of some of our previous articles, “Crazy Like A Fox”, which are available on our website .
The Current Global Financial & Economic Crisis
Preface : During the past several weeks of October and November 2008, I have been showered with questions from friends and acquaintances who are genuinely concerned about the current financial crisis. What they see on television and read in the print media has riveted their attention and created a considerable degree of unease. The evolving crisis has also become a frequent topic of conversation among those with whom they associate.
I invariably provide my perspective when asked, but I am frequently left frustrated because a few brief comments never come close to a complete answer. Moreover, I always experience an overwhelming need to provide context for anything. “Why” is the most important word in my vocabulary, which means I suspect others too might share that personal quirk. By writing this piece I have attempted to give a fuller and more comprehensive answer, which gives context and which tries to answer “why.”
Background to the Crisis :
I have been a serious student of political, economic and financial issues over the years. Therefore, I frequently wondered why there was so little interest and concern exhibited about financial excesses I found increasingly troubling. However, a sudden and deep concern, even fear, has replaced the relative indifference of the past. What is particularly apparent is that much of this elevated concern stems from the fact that so many people had apparently come to believe that their good life and high standard of living was somehow a normal condition of the developed countries of the western world in the new millennium. Most subscribed and had become paid up members of the Goldilocks Society.
The current financial hurricane is now an undeniable reality. However the breakneck speed with which it arrived has surprised almost everyone . It did me, in spite of my substantial interest in and awareness of economic and political issues. I can say with absolute certainty that no one predicted the sudden emergence and magnitude of the current unraveling of financial markets and global economy. As proof I recall how the US Congress was suddenly summoned into emergency session, with only four weeks remaining in the election campaign, in order to provide a $700 Billion bailout to the financial sector.
Believe me, the stock and trade of all politicians leading up to elections is to assure a feel good attitude among voters. How else does one explain the $160 Billion worth of $300 and $600 economic stimulus cheques mailed out to most US citizens during the summer of 2008? Yes, these cheques were merely bipartisan bribes to voters in advance of the election, using borrowed money on which those same taxpayers will pay interest for the indefinite future. But as usual, that kind of inconvenient truth is ignored, but will emerge as another problem sometime down the road.
The fact that the financial system became unglued before the November 4th election is proof of how serious the problem was and is . A favourite game at the start of each calendar year is to predict the nature of the economy and the financial markets in the twelve months ahead. For example, what level will the DOW, NASDAQ and S&P stock indexes be at the end the year? Most everyone points to historical data to demonstrate that politicians always try to do what is necessary to make the financial markets and the broader economy positive leading up to elections. Consequently, at the beginning of 2008 we quite naturally heard similar prognostications. My personal prediction while less optimistic, was only moderately so.
Knowing the desires and habits of politicians, I too said that the growing excesses of the financial markets did not bode well in the period ahead, but suggested that all levers would be employed to assure a kind of feel good, muddle through approach until after the November elections. I suggested all bets were off from that point forward and that a financial malaise would become apparent thereafter. Why so much pessimism? Simply because of the rampant excesses built up in much of the financial markets and economy during the past several years.
Characteristics and Causes of the Crisis :
Too many countries and people have been living above their means for too long . Family savings used to be about ten percent or more of income, whereas in recent years savings have dwindled to the neighbourhood of zero. Our society has gone from one that creates and produces wealth to one which consumes it. As proof, the US consumer has now become responsible for fully 70 percent of the nation's Gross Domestic Product (GDP). Without the gorging consumer coupled with Chinese manufacturing and financing, this level of consumption would not have been possible.
The US central bank (FED) Federal Reserve Board policies, encouraged by politicians, set interest rates considerably below the rate of inflation and made it easy for everyone to assume and carry debt. Moreover, easy money includes both low interest rates and easy credit . Anyone with a pulse was able to get credit to acquire all manner of things and lifestyle enhancements which constitute the attributes of the good life. In fact it became so universal that almost everyone assumed this was the natural order of things. Moreover, this kind indulgent lifestyle was thought to be normal. I don't know how many times I said that this kind of comfortable lifestyle was guaranteed to come to an end when the downside of the current economic cycle again emerged. However, I just did not know exactly when or what specifically would initiate the down cycle or how severe the wake up call would be.
We now are getting the message. The global financial system turned on a dime about the beginning of October 2008, four weeks before the US elections . It took the form of a quick and forceful blind sided slap to the consumer's head. Stock markets cratered followed by a stampeding horde of exploding and imploding financial institutions...commercial banks, investment banks, hedge funds and most other financial institutions on the fringe. The evolving disaster has not stopped and continues to this day. In fact it moved from the US and North America to Europe and beyond and continues to wreck its havoc on the prices of commodities and assets of all kinds from houses to stocks and pension funds . Less than two months ago most analysts were concerned about the gathering storm of price inflation, now asset price deflation is the overriding concern.
During the ten days leading to the $700 Billion Congressional bailout of financial institutions, other countries took a perverse pleasure in slamming the US for its irresponsible behaviour leading to the spiraling financial disaster which was then thought to be limited to the US . Smug utterances oozing schadenfreude prevailed. I remember watching the German Finance Minister on BBC sternly lecturing the Americans in a most forceful manner, only to see him bailout two German banks within days. The Argentine President did something similar on national television and she also was told within days that her request for new loans from the International Monetary Fund was denied because the country had not repaid its European creditors for loans several years prior. Now, a mere six weeks after the initial jolt, virtually all nations are affected to one degree or another .
Excessive consumer buying over an extended period, facilitated by excessively low interest rates and easy credit, are part of the cause . That is a simple but only a partial answer. As noted above, we have become a consumer society, not one of producers. Others call what we have become a Service economy. Asian countries make things which we buy and consume. We don't save, but we certainly consume like the power shopper in the mall who drives herself at a frantic pace until her plastic cards are about to melt. Oh yes, consumer debt which those cards created, as well as excessive government debt, is financed by many of those same Asian countries which make the stuff. In business a process like this is called vendor financing. Therefore what the consumers receive seems almost cost free...until the inevitable happens and the bill arrives...like now.
There are, however, more causes than excessive consumption. Those financial institutions we hear about but don't much understand, are key players in this crisis. It was the large Wall Street Investment Banks with names like Goldman Sachs, JP Morgan Chase and Lehman Brothers, along with a handful of others, who are the real villains . Add to them the big Commercial Banks like Citibank, Wells Fargo, Wachovia and others who threw investment caution and risk to the winds.
To these more familiar names we must include many of the 9000 Hedge Funds . This type of financial institution is not subject to the same supervision by regulatory authorities, does not have the same visibility and even fewer reporting requirements. Investors are usually very rich persons, pension funds and trusts who have large pools of cash. They also like to preserve their privacy. Unfortunately hedge funds also borrow much of the money they use to invest. For example, they have borrowed vast amounts of money from Japan and elsewhere at very low interest rates over the last several years. They then add this borrowed money to their investor's money for what is called Leverage. For example, they may invest one dollar of their own money and merge it with up to 30 dollars or more of cheap borrowed money. While a 30 to 1 ratio can be extremely rewarding, it also makes the fund highly vulnerable to even minor reductions in the value of its investments.
Leverage of this kind is one of the root causes of the current financial crisis . Yes, we often hear of the “Subprime Crisis” as the cause. The housing sector was and is an abysmal sinkhole of bad judgment by both lenders and purchasers. Greed prevailed throughout. It was not just low income purchasers who made bad decisions and who got beyond their financial capability to make their payments, it was most everyone in the process...realtors, mortgage brokers, appraisers, lenders, lawyers, title guarantors and builders. Everyone is culpable in some manner, at some time and to some degree. The entire residential housing sector created a price bubble which now must bear significant responsibility for the financial crisis .
The really egregious faults are present in the financing part of the housing sector. Mortgages, dishonestly priced and marketed, are the principal cause not only of the residential housing bubble, but of the unraveling financial products called derivatives and the financial institutions which made and marketed them . This is an undeniable fact. What made all of this nonsense even more problematic was how the large investment banks, together with the gigantic mortgage companies known as Fanny Mae and Freddy Mac , which processed these mortgages into derivative financial products called Mortgage Backed Securities (MBS's).
In addition, other derivative products were also made, packaged and sold globally. Derivatives are generally called Collateralized Debt Obligations (CDO's). If this isn't confusing enough, a form of insurance called Credit Default Swaps (CDS's) totaling more than $50 Trillion, were also created and sold as insurance on leveraged MBS's. Lastly, much of this financial alphabet soup of products was sold to hedge funds and various other institutions like pension funds and commercial banks around the world, many of whom borrowed much of the money used to purchase these toxic concoctions.
Purchase Leverage at ridiculous levels of 30 to 1, on this financial cauldron of crud, is the root cause of the current financial crisis . How could any person or any company borrow so much money involving so much risk? Why would anyone buy such overpriced and little understood investment products? Primarily because risk was discounted and the products were formulated to appear to be AAA investment grade by credit rating agencies such as Standard and Poors, Fitch as well as others.
The biggest and most powerful on Wall Street including Henry Paulson, the current Secretary of the US Treasury department and former Chief Executive Officer of Goldman Sachs, is one of those who led the parade of leveraged derivative destruction. He and other executives in the investment banks which created fraudulent derivative financial products, should be charged, convicted and jailed for the global financial damage they perpetrated. Instead, Mr. Paulson, along with his investment bank colleague cronies, are put in charge of dispersing Billions, perhaps Trillions, of government and taxpayer dollars to failing financial institutions for the ostensible purpose of fixing the mess they created. In other words, they get rewarded for their anti social behaviour. Incredible!
You may no doubt have surmised that when the price of these highly leveraged financial products lose market value, it creates an immediate and serious problem. For example, the lender of the borrowed money issues what is called a “margin call.” That means the borrower must come up with more cash...NOW. The cash comes from the sale of anything which the borrower owns that has value and which can be sold immediately. Since many of these MBS's had little or no market, they had no discernable current value. That being the case, anything else which has value is sold to realize cash.
This is the primary explanation for the recent rapid and precipitous drop in commodity and stock prices in the financial markets around the world . Equities/stock indexes have dropped over forty percent from their recent all time highs. The commodities sector has dropped even more. Some individual stocks are experiencing even greater declines. For example, the DOW index of the biggest stocks has come down from its high of 14,000 to about 8,500. It will invariably drop more before it bottoms out.
When are the markets and prices going to bottom out? Probably when all the “forced selling” or liquidation, created by margin calls and other redemptions as well as volitional selling based on fear, run their course . When will that be? No one knows because most financial institutions and the Treasury department will not say which institutions own what, how much of it nor its current or original value. Why would that be?
One can only guess, but a likely answer is that the quantities of bad assets, especially derivative products known as CDO's, is so great and the value so uncertain that it would scare the public considerably beyond its current level of concern. In other words, we mere mortals, known as taxpayers and voters, just couldn't cope with the hard facts. We would no doubt go into shock, join our fellow citizens to assault the barricades of power including government, the Central Bank, investment and commercial banks and other financial institutions as we rapidly lose our mental equilibrium.
Given that it is commonly agreed that the value of the world's entire derivatives products are between $500 and $600 Trillion, one can see why there is a certain reluctance to divulge factual details. The potential for this unfolding financial calamity to get much more severe is significant . These numbers are mind boggling when placed in perspective. For example, the total annual Gross Domestic Product (GDP) of the United States is only about $14 Trillion which is included in the total annual Global GDP of about $50 Trillion.
Incidentally, where did all these lost digital dollars go? Mostly they evaporated, they no longer exist. Needless to say, what that means is that various individuals and financial institutions are no longer as financially secure as they once were. Indeed they could be insolvent and close to declaring bankruptcy. In aggregate, the declining prices of assets of all kinds is what is called price deflation. There is more price deflation ahead in the pipeline .
What can we expect next? More of the same, at least for awhile. Yes price deflation of assets of all kinds is likely to continue. That means houses and stocks will continue to drop in price until the unwinding of unsustainable leverage is complete. Given that government, investment banks and hedge funds have not yet publicly divulged the extent of leveraged assets, there is no way of telling.
No one can develop a genuinely effective solution to a problem which can't be described, measured or understood . As a result, we will continue to observe lots of talk by governments and central banks about buying shares in banks and other financial institutions as well as using public money to buy large amounts of unmarketable derivative products from institutions. Lots of money will be borrowed and given by government to allow this process to continue.
The original $700 Billion in bailout money will no doubt be multiplied several times over resulting in Trillions of taxpayer dollars being committed to the cause of “financial liquidity.” That is merely a fancy term which means that some financial institutions will be given public money so they will not become insolvent or have to declare bankruptcy. These injections of public cash are also justified on the grounds that banks are encouraged to lend to each other and to consumers, otherwise the entire financial deck of cards would become frozen in place, causing untold harm to the global economy.
Financial System Dislocation first, NOW the Real Economy :
All the discussion about banks, leverage, borrowing, asset deflation and so forth, is merely preliminary to the main event. Real people seldom have much to do with high finance nor do they know much about banks or hedge funds. What the average person does know, however, is whether they have a job, what interest rates are on their mortgage and credit card purchases and what effect that has on her/his monthly payments and whether s/he continues to qualify for credit.
Persons closer to retirement wonder whether their Defined Contribution Pension Plan, such as a 401K or other employer or personally held pensions like an RRSP, are adequate to live in retirement. Even those fortunate enough to have vested defined Benefit Pension Plans, like most public sector workers or those employed by General Motors, should have cause for concern. Bankruptcies allow courts to cancel contracts and to readjust all manner of agreements previously thought inviolate.
Most people today are increasingly worried about their personal financial wellbeing, whether their lifestyle will be substantially and negatively impacted by the events they read about daily, as well as those we have not yet encountered. These concerns are real and valid. Moreover, no one can assure anyone else at this stage what the final consequences will be from the many rapid developments we continue to hear about. This uncertainty creates much anxiety which leads to fear of the unknown future.
Clearly, loss of a job and the income associated with it is life changing, as well as lifestyle changing . Equally, substantial asset deflation and losses in pensions of persons on the cusp of retirement, requires a total recalibration of retirement plans and lifestyle expectations. Even those persons in their working prime with family obligations, who will continue to have the income from a job, will live under the cloud of uncertainty.
Events unfolding daily will lead all of us to evaluate our assumptions and habits. The lifestyle we assumed was normal based on well paying and secure jobs may change. Frequent family outings for dinner, expensive foreign vacations, two new cars in the driveway, houses large enough for twice the number of current occupants have become realistic expectations over the recent past. Indeed, they are entitlements for many persons. All those little personal indulgences which we take for granted, and which in aggregate cost much more than pocket change, may have to be given up in the interest of saving for the proverbial rainy day.
In their place will be fewer trips to the shopping mall, older cars, less distance driven in the interest of fuel savings, more meals at home, fewer and more modest vacations, more saving, fewer credit card purchases, less debt and lower monthly payment obligations. This describes a lower standard of living ahead . It is guaranteed for most of us and it is likely to become permanent. Thrift will again become a value to which many will subscribe. It will become respectable, even cool, to be thrifty.
Ok, I have painted what some may characterize as a bleak future. I am not a sadist, therefore I don't get pleasure out of other person's misery. What this description of current economic and financial events and issues is designed to do is to give the reader a more or less composite picture of what is transpiring in front of us daily. The sudden onset of what we have been observing and hearing over the recent past has genuinely surprised me. Each day seems to bring new developments to the extent it is difficult to keep up with what is happening. Moreover, understanding each part and how the parts fit together and impact each other, is a real challenge.
What we all should understand is that, while this crisis started in the financial sector, the misnamed “subprime problem” has rapidly morphed into the real economy . That is where we all live and work and where we will mainly be impacted. My point is that even if government, central banks and the financial sector were able to gain firm control over financial processes and institutions, the problem is likely to be much more pervasive, deep and enduring in the broader economy . Anyone who suggests otherwise is not being honest. Equally, anyone who is able to give specifics in terms of length and depth of the current and deepening recession is simply guessing.
What bothers me more than anything else is how unhelpful government and politicians are in demonstrating leadership . National elections in the United States and Canada coincided with the onset of this crisis, yet precious little substance, other than statements which repeated the normal bromides of concern, was offered. This was the perfect opportunity to show real leadership, yet nothing of consequence emerged. I think I understand why. My understanding of politics and experience in government lead me to a couple of salient observations.
Politicians are for the most part a reflection of the voter...his values and expectations . Yes, the politician likes the perks of his job and wants to keep them by being re-elected. S/he has learned that one attracts votes by telling the voter what s/he wants to hear. What the voter wants to hear is determined by professional public opinion polling and through testing on focus groups representative of various voter profiles. Promises are frequently ignored after the election. In spite of this, the voter seldom makes the cynical politicians pay by tossing them out. Why is this?
My theory is that the voter, people in general, are resistant to bad news . Bad news is not only upsetting, it is almost paralyzing if one deems that s/he can not do anything about fixing the problem or crisis. That is perhaps why so many people were caught relatively flat footed and unaware of the issues which are behind the current crisis. People would rather avoid the bad news altogether. Denial is powerful . Politicians have learned there is a price for leadership which conveys bad news and sacrifice .
Once the problem or crisis is visible, however, it becomes very necessary for politicians to appear to be in charge and to be doing “something” useful to hopefully “fix” the problem. That is the stage we are at currently. I like to call it the phoney fix phase. It is phoney because much of the activity and money spent is primarily a public relations exercise .
Unfortunately, priorities are most often determined by political pressure from prominent special interests. For proof merely look at the current GM, Ford and Chrysler bailout process in which the union, management, shareholders and regional politicians join to unanimously demand large amounts of the medicine called taxpayer money. Think too of the earlier and imminent stimulus packages to voters of cheques of up to $600 for every person carried on the IRS rolls. These payments are recognized to be relatively useless in targeting specific economic problems, but they do convey to the voter action and concern by their government.
Lastly, I continue to believe that no genuinely effective solutions to the current plethora of actual and potential problems can be developed and implemented until all the facts are made public . That means we must know which financial institutions hold what derivatives (CDO's) issued by whom, what was the purchase price, current market value and what degree of leverage is involved. I know the numbers could be genuinely horrific, but without the facts, effective solutions absolutely can not be devised and implemented. Without the facts, the process will degenerate into little more than a public relations exercise designed to convince the confused public that leadership is being exhibited and something useful is being done “to fix the problem.
The current coordinated creation and distribution of copious quantities of new money around the globe will undoubtedly end in inflation during the next several years. My investment approach for sometime has been to invest in gold, silver, and the shares of natural resource and commodities companies. It is the best protection against the coming inflation, perhaps hyperinflation. Like all investors, with hindsight, it would have been great to have sold earlier at the cycle peak in late 2007 and avoided this wretched financial meltdown. But I have never lost sight of my reasons and convictions as to where we are headed and how best to manage our monies during this challenging period. Get yourself positioned and hang on as we are in for the ride of our lives.
In my next piece, I will be focusing on “How To Invest in This Global Crisis”.
December 2, 2008
Arnold Bock - Contributing Editor
December 2, 2008
Arnold Bock - Contributing Editor
Mendoza, Argentina
Email: support@preciousmetalswarrants.com
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