February 24, 2014
One of today’s economic myths is that the money that the Federal Reserve has created through its quantitative easing programs has not found its way into the money supply, and, as a result, no significant inflation has occurred.
The theory is that QE has only resulted in bank reserve creation, but little new money. Money and Banking 101 takes students through the “money multiplier” concept, where $1 of excess reserves can turn into $10 of new money if reserve requirements are 10%. Because there has been little net new bank lending since the Great Recession, the conclusion has been that there has been little money growth, and, therefore, minuscule inflation.
Those who tout this theory simply don’t understand how the money creation process works. In addition, inflation isn’t just measured by the narrowly defined and downwardly biased Consumer Price Index. Inflation means prices are rising, and, as I show below, we have plenty of that.
To show how the process actually works, assume that Citizen X buys $100,000 of securities from Citizen Y, and pays for it with a check drawn on X’s account at Bank XX. Citizen Y deposits the check in Bank YY. In this example, no new money has been created. An existing deposit at Bank XX was transferred to Bank YY.
Now assume that the Fed is the buyer of the $100,000 asset from Citizen Y. When Y deposits the check into his or her account at Bank YY, reserves in the banking system do rise by $100,000 as Bank YY ends up with a new deposit at the Fed.
But, also note that Citizen Y now has $100,000 in a deposit at Bank YY, a deposit that did not exist in the banking system prior to the transaction. Going back to Money and Banking 101, while the $100,000 may not be “multiplied” into $1,000,000 because the banks aren’t lending, the first step — the creation of $100,000 — did, indeed, occur.
The explosion in the assets on the Fed’s balance sheet of more than $3.3 trillion since the beginning of the QE process has resulted in the creation of at least that much new money. Using a back-of-the-envelope calculation, the change in currency in circulation as well as demand and savings deposits at commercial banks since the start of QE has been about $4.2 trillion. Net loan growth at those institutions has been about $1.1 trillion.The $3.1 trillion difference is, as expected, close to the growth of the Fed’s balance sheet.
So, why haven’t we had inflation if the money supply has grown so much? Well, we actually have had inflation. The only place we don’t find it is in the Bureau of Labor Statistics’ CPI calculation.
But, rather than dwelling on this single measure, consider that the form that inflation — rising prices — takes very much depends on what Citizen Y does with the newly created money, and what those who receive the money from Y do with it. More concretely, the Fed purchases from the large Wall Street institutions. So, it is likely that we will find inflation if we followed the path of the newly created money from those institutions.
As I have been discussing, about 25% of the newly created money over the past five years has gone into net new lending. Where did the rest of it go? It is a pretty sure bet that, given that these are Wall Street banks, much of it went into the equity and real estate markets. Equity prices as measured by the S&P 500 have risen by 150% over the five-year period, and by 29.6% in 2013 alone. Meanwhile, real estate prices as measured by the Case-Shiller 20-City Composite rose 13.7% last year.
It is also a pretty sure bet that the newly created money found its way into the emerging markets, where interest rates have been higher and the Fed’s promise of low U.S. rates for a long period of time (known as the “carry-trade”) significantly reduced the risk of the trade.
The latest 12-month official data show that inflation in Brazil is 5.6%, in India 8.8%, in Indonesia 8.2% and in Turkey 7.8%. Of course, we are all aware that the currencies of these countries have been crushed over the past six weeks, as hedge funds and other large investors have, en masse, withdrawn their funds as the prospect of a Fed tapering has become reality, along with expected rising rates.
Despite the so-called taper, the Fed continues to create a huge amount of money each month. Currently it’s $65 billion. This money has to find a home. It appears to be more than coincidental that, despite a 5.75% mini-correction in the equity market in January, prices have once again continued their upward trek.
More than $3 trillion of new money has been created by the Fed. It is sloshing around and causing prices to rise in equities, real estate and, until recently, in emerging markets. The money now coming out of the EMs will find another investment, causing those asset prices to rise.
We have inflation: asset inflation. The Fed continues to create money which finds its way into the financial markets. Is it any wonder why Wall Street loves QE and hangs on every word from the Fed? If history is any guide, asset inflation will continue as long as the Fed is printing. Just think what could happen to the money supply and inflation if the banks actually start to lend again.
And what might happen to asset prices if the Fed ever started to tighten?
January 27, 2014
Until inflation becomes recognized, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period.
Historically, the price of gold protected the purchasing power of the currency invested in it, as the price rose in some reasonable correlation with existing or expected inflation of that currency. But today, the price of gold is set in a speculative market where traders and hedge fund managers make bets, and little or no attention is paid to gold’s traditional role. (See the first part of this article, Why Gold Prices Dropped in 2013.) According to John Hathaway of Tocqueville.com, in 2010, the physical gold market consisted of 121 million ounces. With a growth rate of about 1.5% per year, there are currently about 127 million ounces in existence, as of Hathaway’s writing. Using futures and options data, and OTC clearing data from the London Bullion Market Association, Hathaway calculates that the paper gold market is 92 times that of the underlying physical market. If each investor in a paper gold ounce believes it is backed by an ounce of physical gold, then each physical gold ounce must have been loaned or hypothecated, on average, 92 times. If everyone decided that they wanted physical possession, which of the 92 paper gold ounce owners really owns the physical metal?
That, of course, explains why it took so long (17 months) for the London banks to deliver the physical gold that Hugo Chavez’s Venezuela demanded. They either didn’t have it and had to purchase it in the open market, or they had to unwind trades where the gold was loaned or pledged as collateral, or both. As for the seven years that it will take for the US Fed to deliver Germany its gold, the only conclusion can be that the web of hypothecation must be long and complex.
Let’s now consider the characteristics of the London financial markets, where gold’s price is fixed twice each day. Nearly every well-known financial calamity over the past 20 years has originated from London offices of major financial corporations. That’s because in the UK, financial institutions have little regulatory oversight. Just think about JPMorgan’s (NYSE:JPM) $6+ billion 2012 loss from its London trading office. We learned from the MF Global (OTCMKTS:MFGLQ) fiasco that client assets can be hypothecated and re-hypothecated an infinite number of times, and that there are no customer protection rules. If you have been wondering what happened to Jon Corzine’s (MF Global’s CEO) clients’ funds, you now have a pretty good idea.
Recently, we’ve seen major UK financial institutions pay hefty fines for manipulating certain commodity prices and for fixing the price of LIBOR, a short-term rate that plays a key role in the world’s financial markets. Apparently, the illegal activity had been going on for years. There are five London banks that control the two daily London gold price fixes. Given the known shenanigans of the London banks regarding LIBOR and other commodities, and the infinite re-hypothecation allowed, how much confidence should we have that the daily gold price-fixing is impartial, that in a crisis or panic the hypothecations can be unwound with every paper claim on gold made whole, or, in fact, that some of the underlying gold even exists in the vaults? As Hathaway says, “It would be hard to imagine that the culture of [London] did not extend to gold.”
There has been a great deal of political angst by Bernanke and Co. over the demand by some members of Congress for a Fed audit, and great political maneuvering to avoid it. Some commentators, like John Williams (Shadowstats.com), believe that the Fed and government officials disdain rising gold prices because that suggests that the government and the Fed are not doing their jobs in maintaining price stability. Hence, Williams believes that heavy selling in 2013 was an orchestrated government intervention. In his January 8, 2014 issue of Hyperinflation 2014 – The End Game Begins, Williams says, “A number of times, very large sell-orders from one customer were placed in the global markets before the open of US trading. For someone looking to move out of gold, orderly sales would make the most sense in terms of getting the best prices. Instead, these actions were designed to pummel the gold markets, and they did.”
Remember what happened to credit default swaps, issued by AIG (NYSE:AIG), just five years ago? Remember what happened to AAA-rated mortgage-backed securities that turned out to have a lot of sub-prime loans? Could something like that happen to the paper gold market?
If it’s discovered that some of the underlying gold has disappeared from the vaults, or in a panic the competing hypothecations for the underlying gold ounces tie up the assets in a long-term court battle, or, as in the case of General Motor’s (NYSE:GM) senior secured bondholders and some depositors in Cypriot banks, it becomes politically correct to single out a class to bear losses, some holders of paper gold could be out of luck. It might be very painful one day to wake up to find that the paper gold investment you thought you had turns out to have not been collateralized.
So, what should gold investors do?
First, understand the difference between hedging and speculating. If it is your intent to hedge against an inflation that you believe will inevitably come due to current worldwide monetary- and fiscal-policy excesses, then the systematic purchase of gold, like mutual fund dollar-cost averaging, is a good practice.
In what form should you hold your precious metal assets? What about the ETFs traded on the exchanges? If you want to keep the gold in your brokerage account, there are some funds or ETFs that say that they hold bullion in a vault and do not hypothecate it. You need to do careful research to make sure this is the case and know if the paper you hold is convertible into the underlying asset. Gold mining stocks are another way, since the gold is there in the ground. Unfortunately, the typical gold mining company continuously dilutes shareholders with new rounds of equity offerings as they continue their search for the “mother lode.” So, research here is also essential.
The safest way, of course, is to hold the gold yourself, i.e., take physical possession and put it into a safety deposit box or in your own safe. Many Americans are doing this, but the Chinese and Asians are way out ahead in this area. To do this you need to find a reputable gold or coin shop that will sell to you for a reasonable commission, say 3-4%.
Today’s gold investors must also understand that the price of gold is currently a 100% function of hedge fund speculation. In the future, as inflation becomes recognized, this may change, but until it does, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period — oh yes, and the ironclad belief that the laws of economics haven’t changed, i.e., that “this time is different” is a lot of bunk.
January 14, 2014
Most seasoned investors have some allocation to precious metals in their portfolios, most often gold. They believe that such an allocation protects them, as it is a hedge, or an insurance policy, against the proliferation of paper (fiat) money by the world’s largest central banks. Fiat money is not backed by real physical assets. In concept, I agree with this sentiment. Most investors who invest in precious metals ETFs, such as the SPDR Gold Trust ETF (NYSEARCA:GLD), through the supposedly regulated stock exchanges (“paper gold”) believe that they actually have a hedge against future inflation. In what follows, I will try to explain why they may not, and why their investments in paper gold may just be speculation.
On February 5, 1981, then Fed Chairman Paul Volcker said that the Fed had made a “commitment to a monetary policy consistent with reducing inflation…” Contrast that with the statement of outgoing Fed Chairman Bernanke on December 18, 2013: “We are very committed to making sure that inflation does not stay too low…”
During 2013, the price of gold fell more than 28% (from $165.17/oz. to $118.36/oz.) despite the fact that other assets like real estate and equities each rose at double-digit rates. It is perplexing that the price of the hedge against inflation is falling in the face of a money-printing orgy at all of the world’s major central banks. Despite the fact that these central banks have fought the inflation scourge for half of a century, suddenly they have all adopted policies that espouse inflation as something desirable. The fall in the price of gold is even more perplexing because there are reports of record demand for physical gold, especially in Asia, and that some of the mints can’t keep up with the demand for standardized product. In his year-end missive, John Hathaway of Tocqueville.com says that “the manager of one of the largest Swiss refiners stated that after almost doubling capacity this year, ‘they put on three shifts, they’re working 24 hours a day…and every time [we] think it’s going to slow down, [we] get more orders…70% of the kilo bar fabrication is going to China.'”
One would also think that the price of gold should be rising because of a growing loss of confidence in fiat currencies. Here are some indicators:
The growing interest in Bitcoin as an alternative to government-issued currencies. One should ask, why did the price of Bitcoin rise from $13.51 on December 31, 2012 to $754.76 on December 30, 2013 while the price of gold fell? As you will see later in this essay, the answer lies in leverage. The gold market is leveraged; Bitcoin is not (at least, not yet).
The volatility that the Fed has caused in emerging market economies by flooding the world with dollars at zero interest is another reason the price of gold should be rising. The Fed’s announced zero-rate policy with a time horizon caused huge capital flows into emerging market economies by hedge funds looking for yield. The inflows caused disruption to the immature financial systems in those emerging markets. And then, with the utterance of a single word, “tapering,” all of the hedge funds headed for the exits at once. The Indian rupee, for example, which was trading around 53 rupees/dollar in May 2013, fell to 69 near the end of August, a 30% loss of value. Such behavior has stirred up new interest on the part of major international players (China, Russia) to have an alternative to the dollar as the world’s reserve currency. Don’t dismiss this as political posturing. It is based on irresponsible Fed policy in its role as the caretaker of the world’s reserve currency. As the world moves toward an alternative reserve currency, the dollar will weaken significantly relative to other currencies, and, theoretically, to gold (and even Bitcoin).
The loss of confidence on the part of some sovereign nations that the gold they have stored in foreign bank vaults is safe. Two examples immediately come to mind: Venezuela and Germany. In August of 2011, the President of Venezuela, Hugo Chavez, demanded that the London bullion banks that were holding Venezuela’s gold ship it to Caracas. (Again, don’t dismiss this as political posturing.) Despite the fact that the shipment could have been carried on a single cargo plane, it took until late January 2012 (17 months), for the London banks to completely comply. One should wonder why. Then, the German Bundesbank asked for an audit of its gold holdings at the Fed. One knows how the Fed has resisted audits from Congress, so why should a request from a German bank meet with any different result? After political escalation, a German minister was permitted to see a room full of gold at the New York Fed. In early 2013, the Bundesbank publicly announced that its intent was to repatriate its gold from the vaults in Paris, London, and New York. We have now learned that it will take seven years for the New York Fed to ship the gold earmarked as belonging to Germany in the Fed’s vaults. One should wonder why such a long delay.
In the face of all of this — unparalleled money printing, the rise in the prices of real estate and equities in 2013, and the creeping suspicions regarding the real value of fiat currencies — how is it that the price of gold fell 28% in 2013? The answer lies in leverage and hypothecation, the modus operandi of Wall Street, London, and financiers worldwide. The paper gold market, the one that trades the ETFs such as the SPDR Gold Trust, is 92 times bigger than the physical supply of gold according to Tocqueville’s John Hathaway. Think about that. It means that each physical ounce of gold that actually exists has been loaned, pledged, and re-loaned 92 times on average. Each holder in the paper gold market thinks that the ounce of paper gold held in the brokerage account is backed by an ounce of real gold. But there are, on average, 92 others who apparently have a claim on the same real, physical ounce.
The answer to the question, why did gold fall 28% in 2013 when, theoretically, it should have risen, is that Wall Street, London, and hedge funds have turned the paper gold market into a market of speculation, where the price rises or falls, not based on the purchasing power of currencies (the hedging characteristic of gold), but on such things as whether or not the Fed will taper, what impact Iranian nuclear talks will have on oil flows, if the interest rates in the eurozone periphery are likely to rise or fall, etc.
In my next article, I will explain how all of this occurred, and what investors who want to hedge and not speculate should do.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
November 19, 2013
The Fed’s ‘Bizarro World,’ Part II
The “Seinfeld” TV comedy series (1989-98) had a set of episodes, known as “Jerry’s Bizarro World,” where everything “normal” was turned upside down and inside out. I have referred to this world in a previous column, and continue to find such Bizarro patterns in our real world.
The Fed was established in 1913 to act as a lender of last resort to a financial system that had been plagued with “panics” and deep recessions. At inception, its main policy tool was the “discount rate” and “discount window” where banks could submit eligible collateral to obtain needed liquidity when such options had dried up in the capital and financial markets.
Open market operations
Beginning in 1922, the Fed began to use a tool known as Open Market Operations (OMO), the buying and selling of government securities to add or subtract liquidity from the capital markets, reserves from the banking system, and to impact interest rates. OMO has traditionally been considered to be the Fed’s main policy tool. But that ended in late 2010 with the implementation of Quantitative Easing II (QE2).
In 2009, as the financial system was experiencing one of those financial panics, the Fed did what it was created to do, and provided liquidity to the markets where none was otherwise available. Many argue that Fed action via QE1 was instrumental in stabilizing the U.S. and world banking systems
Look at those excess reserves!
But, then, because the U.S. rebound from the ensuing recession was too slow, in late 2010 and again in 2012, the Fed announced more QE. Today, the latest figures show excess reserves in the banking system of $2.23 trillion. The reserves required on all of today’s existing deposits are $67 billion ($0.067 trillion). Today’s excess reserves are so massive that they can support 33 times current deposit levels without the Fed creating one more reserve dollar. Yet, with QE3, it continues to create $85 billion/month.
While they sit in an account at the Fed, excess bank reserves don’t directly influence economic activity. This, of course, has been the issue for the past five years. But, when banks do lend, the newly minted money gets into the private sector, impacting economic activity with the well-known “multiplier effect” described in money and banking textbooks. When such bank lending occurs, if the labor market is tight or there is little or no excess capacity in the business community, inflation ensues. Just think of how much money the banks can create if their current excess reserves are 33 times more than they need!
Sell side of OMO is impotent
So, how is the Fed going to control bank money creation in the future? They can’t use their most powerful traditional tool, OMO, because they would have to sell trillions of dollars of securities into the open markets before reserves would become a restricting issue for the banking system. The utterance of the word “tapering” last May sent rates up 100 basis points in a two-week period. This is just a taste of what would happen to interest rates if the Fed actually began to sell (instead of just buying a lesser amount, which is what “tapering” means).
Furthermore, long-term fiscal issues have become a real concern. With somewhere between $85 and $120 trillion of unfunded liabilities rapidly approaching as the population ages (as a comparison, annual U.S. GDP is only $16 trillion), huge fiscal deficits are a certainty barring entitlement, Social Security, Medicare and Medicaid reform. To keep the cost of the debt manageable within the U.S. government budget, the Fed must continue to keep interest rates low. With foreign criticism of U.S. policies on the rise, purchases of U.S. Treasury debt by foreign entities are likely to diminish in the future. That leaves the Fed as the major lender (lender of last resort!) to the Treasury via OMO purchases.
The borrowing window in reverse
Unable to use the “sell” side of OMO to influence the banking system, the Fed is now stuck with only one tool, the discount or borrowing window. Only now, because the financial system is drowning in the sea of liquidity, the borrowing window and discount rate must now work in reverse!
In the traditional use of the borrowing window, the Fed used the discount rate (short-term borrowing rate) to encourage (by lowering rates) or discourage (by raising rates) banks from borrowing to lend to the private sector. But, in today’s Bizarro World, the Fed will have to use the rate it pays (currently 0.25 percent/year) to the banks with excess reserves to encourage or discourage bank lending. Yes! Not the rate the banks pay to the Fed to borrow, but the rate the Fed pays to the banks to encourage them to keep their reserves instead of lending them. The original concept of the Fed as the lender of last resort has been turned on its head. It’s backward — it’s Bizarro!
Implications for investors
It is difficult for investors to deal with a system turned on its head. The bond market gets spooked whenever there is talk of the Fed “tapering” its bond purchases. The return on those bonds is simply too low for the risk involved, so the best advice here is to avoid them unless you are exceptionally skilled. That leaves equities — but that is a topic for another column in this new and Bizarro World.
July 9, 2012
• Corporate health (economics): Large corporations are extremely healthy with large cash hoards and many have low cost and low levels of debt.
• Politics (policy): Americans are tired of special interests’ ability to pay for political favors.
• European Monetary Union (policy): A Greek exit from the euro is still probable after recent election and is likely to spread contagion to Portugal, Spain and even Italy. There is also danger here to America’s financial system.
• Brazil, Russia, India, China or the BRIC, Growth Rate (economics): China appears to be in danger of a hard landing, as is Brazil. India is already there. This has serious implications for commodity producers like Canada and Australia.
• Fiscal cliff and policy uncertainties (policy): A significant shock will occur to the U.S. economy if tax policy (Bush tax cut expiration and reinstatement of the 2 percent payroll tax) isn’t changed by Jan. 1, 2013.
• Housing (economic & policy): In the U.S., housing appears to have found a bottom, but because of falling prices and underwater homeowners, a significant recovery is still years away. Housing is a huge issue in Europe, especially Spain, and it will emerge as an issue in Australia and Canada if China has a hard landing.
• Energy costs (economics & policy): The current high cost of energy is killing worldwide growth (see “Positives” above).
• U.S. taxmageddon (policy): The U.S. tax system discourages savings and investment (needed for growth), encourages debt and favors specific groups.
• Too Big To Fail (TBTF) (policy): The U.S. financial system is dominated by TBTF institutions that use implicit government backing to take unwarranted risk; TBTF has now been institutionalized by the Dodd-Frank legislation; small institutions that lend to small businesses are overregulated and are disappearing.
• Debt overhang (economics): The federal government, some states and localities and many consumers have too much debt; the de-leveraging that must occur stunts economic growth.
• Inflation (economics & policy): Real inflation is much higher than officially reported. If a true inflation index were used, it is likely that the data would show that the recession still hasn’t ended.
It is clear from the points above and from the latest data reports that worldwide, most major economies are slowing. It is unusual to have them all slowing at the same time and thus, the odds of a worldwide recession are quite high.
In the context of such an event or events, the U.S. will likely fare better than most. But that doesn’t mean good times, just better than its peers. There is also greater potential of destabilizing events (oil and Iran, contagion from Europe, Middle East unrest), which may have negative economic impacts worldwide. Thus, in the short-term it appears that the U.S. economy will continue its lackluster performance with a significant probability of an official recession and vulnerable to shock type events. (Both the fixed income and the equity markets seem to be signaling this.)
Looking back at my blogs over the years, I have always been early in identifying trends. The positive trends are compelling despite the fact that the country must deal with huge short-term issues that will, no doubt, cause economic dislocation.
The only question is when the positives will become dominant economic forces, and that is clearly dependent on when enabling policies are adopted. 1) In the political arena, there is a growing restlessness by America’s taxpayers over Too Big To Fail and political practices where money and lobbyists influence policy and law (e.g., the Taxmageddon code). 2) The large cap corporate sector is healthier now than at any time in modern history. Resources for economic growth and expansion are readily available. Only a catalyst is needed. 3) America is on the “comeback” trail in manufacturing. Over the last decade, Asia’s wages have caught up.
Cultural differences and expensive shipping costs are making it more profitable and more manageable to manufacture at home. 4) Finally, and most important of all, unlike the last 40 years, because of new technology, the U.S. has now identified an abundance of cheaply retrievable energy resources within its own borders. As a result, just a few policy changes could unleash a new era of robust economic growth in the U.S. Let’s hope those changes occur sooner rather than later!
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
One of the reasons for all of the stress in Europe is the fact that their banking system holds huge amounts of periphery country debt (Greece, Spain, Portugal, Italy) with no capital backing. On a mark to market basis, most, if not all, of the capital of the periphery banks disappears. In fact, the European Central bank (ECB) itself is still carrying the Greek debt it holds on its books at par, as if there is no chance that they won’t be repaid in full.
Since the financial crisis of ’08-’09, Western banking systems have come to rely on government, at first as the capital provider of last resort, but now, at least in Greece and Spain, as the capital provider of first resort (most likely because there is no other). In a symbiotic relationship, those same governments have come to rely on the banks to purchase their excessive supply of debt. The capital rules favor this unhealthy relationship. In effect, we now have a banking DNA bias against private sector lending.
We have heard the politicians in Washington rail against the banks for not making loans to the private sector. Yet, all of the rules, regulations, and enforcement processes make it difficult, if not impossible, to do just that. The overbearing regulatory process strangles private sector lending at small community banks. And, as indicated above, the capital regime itself, which impacts all banks, discourages private sector loans. For example, a $1 million loan to the private sector requires $200,000 in capital backing plus an additional $20,000 to $30,000 in loss reserve contribution from the capital base. That same $1 million loan to the US Treasury, via purchases of Treasury securities, requires no capital or reserve contribution. The ultimate result is that, since the financial crisis when western governments found out that it was politically okay to “save” (i.e. recapitalize) large banks with public monies, they also found out that the capital and regulatory regime now made those same banks major buyers of excessive government debt.
Unfortunately, while governments like this and will continue to promote it because it keeps the cost of borrowing low and provides them with a ready market for deficit spending, government is not the economic engine. That is what the private sector is. Simply put, the banking model in the west now promotes moral hazard (banks making bets that are implicitly backed by taxpayers) and Too Big To Fail (TBTF) policies while it stifles private sector lending. The Dodd-Frank legislation has institutionalized this model with government intervention now seen as the first response to a banking issue. If it hasn’t, then why did President Obama say on The View the business day after JPMorgan Chase (JPM) announced its trading loss that it was a good thing that JPMorgan had a lot of capital else the government would have had to “step in.” Or why has Jamie Dimon, JPMorgan’s CEO, been required to testify before both House and Senate Committees about a loss of less than 3% of the bank’s $190 billion capital base? As further proof of government control of the banking system, the FDIC recently announced that, under its Dodd-Frank mandate, it is ready to take over any TBTF institution, “when the next crisis occurs.” Isn’t it clear that the relationship between the US federal government and the banking system is unhealthy, perhaps even incestuous, to the detriment of the private sector? That very same banking model is emerging in Europe with the emergency funding by the European Financial Stability Fund (EFSF) to recapitalize the Spanish banks and talk of a pan-European regulatory authority and deposit insurance.
The emerging banking model is one in which central governments and the money center banks co-exist in a mutual admiration society where government capitalizes the banks and the banks are the primary buyers of excessive government debt. Because government doesn’t create any real economic value (it regulates it and transfers it from one group to another), the domination of government assets on bank balance sheets in place of private sector assets spells real trouble for the future economic growth in the Western economies.
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
June 18, 2012
Besides, if a sovereign country wants to exit, what, short of war, could prevent it? If Greece decided to exit now, it would repudiate its external debts and, as a result, banks and important European institutions could face insolvency. Greek society could deteriorate into chaos, including rioting, civil unrest and economic dislocation of many Greek citizens. Such contagion could well spread to Spain, Portugal, and even Italy.
Here’s some of the challenges Greece is facing:
• A return to the drachma means radical devaluation of the liquid assets held by Greek citizens;
• Greece imports all of its energy and most of its raw materials. Already, Greek utilities are in arrears to their Russian power suppliers because citizens are not making utility payments. And the Russians are threatening to cut off the power supplies;
• Money is already fleeing the country, so Greece would have to impose capital controls to further prevent money, capital and assets from fleeing, including restricting free access to and from the country via military operations;
• There would be significant impacts on Cyprus, or even on Turkey;
• The European Central Bank holds a huge volume of Greek bonds; in a chaotic exit, with Greek debt repudiation, the solvency of the ECB could be called into question (imagine, one of the world’s premier money printers having to deal with insolvency). Worse, the central banks of Germany and other stronger EMU countries will have to write off significant Greek assets, which have resulted from Greek citizens making euro deposits in the banks of these stronger countries.;
• There are implications, too, for the other external lenders like the International Monetary Funds and the European Financial Stability Facility;
• Bank runs, considered silent until now, would erupt in the other suspect countries (Portugal, Spain and Italy).
If Greece leaves the EMU under these conditions, what is to prevent Portugal and/or Ireland from doing the same? A Greek chaotic exit would make the capital markets skeptical as to whether the aforementioned countries plus Spain, and even Italy, could remain in the EMU. And the capital markets will test their resolve by raising rates in these countries to unacceptable levels until action is taken.
Portugal, Spain and Italy are repeats of Greece on a much larger scale. While aid from the other EMU countries for Spain’s insolvent banking system appears to have been forthcoming, at this writing, the terms of such aid have not been clearly established. Furthermore, the Spanish citizens are up in arms (literally) that the banks are being saved with nothing for the common citizen. And, if Spain’s banking Portugal’s, Italy’s or Ireland’s? Unfortunately, after Spain, the funding source, the EFSF, is essentially out of cash.
The Greeks go to the polls today and may elect leaders who will repudiate the austerity deals that the former government made in return for bailout funds. Or, as happened in the May elections, no one party may end up having enough influence to form a government. Furthermore, the Greek government is set to run out of money by June’s end. Let’s hope that Syriza’s party leader, Alexis Tspiris, if he heads the government, is just posturing about debt repudiation to get a better deal from the other EMU countries.
There are grave implications for the capital markets. The chaos and contagion in Europe could well spread to the U.S. financial system because, as we recently saw at J.P. Morgan, no one, including Jamie Dimon, knows what is on the balance sheets of the large U.S. banks. Any crack in the financial system foundation could well cause chaos even in the U.S. In addition, financial chaos always causes large equity market downdrafts.
Today’s elections in Greece are key, and the results of those elections will determine if Greece will even cooperate. If it doesn’t, sometime in late June or early July, it will run out of money. Given the track record of the European politicians, the probability appears low that Europe can avoid the chaotic Greek exit. Greece isa big deal, and I believe that we will find out just how big very soon.
Exchange Commission of the United States. A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.
June 6, 2012
of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor. Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
Advisors (UVA), Reno, NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the
Investment Committee. Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.
May 24, 2012
The turmoil in Europe, trading losses at JPMorgan (JPM), and recent revelations about naked short-selling by Goldman Sachs (GS) and Bank of America-Merrill Lynch (BAC) should be giving every American and every policy maker heartburn because each and every one of these issues has potential to cause systemic financial shocks. It all ultimately comes down to the continuing saga of “Too Big to Fail,” or TBTF. TBTF nearly brought the financial system down in ’08 and ’09. It was supposed to be fixed by the Dodd-Frank legislation. But today, the TBTF institutions are even bigger than they were in ’08.
On a daily basis, reports indicate that instability is growing in the European Monetary Union’s (or EMU) banking system. There have been outright runs on Greek institutions and rumored runs on Spanish banks. In Greece, it’s been reported that some businesses will not accept euro notes (i.e., the paper currency) issued by the Greek central bank for fear that if Greece leaves the EMU, those notes will be turned into new drachmas, which will be worth only a fraction of what real euros are worth.
In the US, the paper currency is issued by a Federal Reserve Bank. There is a number on each bill (1 to 12) that shows which Federal Reserve Bank was the issuer. Like the US, each participating central bank in the EMU can issue currency; the first letter of the serial number is coded to indicate which bank issued it. Currency issued by the Greek central bank is coded with a “Y.” Some Greeks are demanding currency coded with an “X” ( i.e., Germany).
There are growing worries about European bank solvency, and Moody’s recently downgraded a significant number of the larger Spanish and Italian banks. If Greece leaves the EMU, contagion could result. If funding markets for European banks freeze (causing one or several institutions to be unable to meet their daily liquidity requirements), there is a high probability that any contagion would spread to US financial institutions.
At the very least, the interrelationships between large US and European institutions will cause significant issues if a fat tail event occurs on the continent.
In fact, on March 21, Fed Chairman Bernanke warned Congress that the risks of impacts from such events on US banks and money market funds appeared to be significant.
Lack of Internal Controls at TBTF Institutions
On May 11, Jamie Dimon announced that JPMorgan had lost $2 billion or more in a failed “hedge” trade. Since then, the estimates of the loss have escalated; some think it could be as much as $5 billion – $7 billion. This shows that even the best-of-breed bankers, like Mr. Dimon, are unable to place sufficient internal controls over the riskiest of operations.
Over the past several years, we’ve seen such trading blow-ups at several of the TBTF institutions. The so-called “Volcker Rule,” a portion of the Dodd-Frank legislation that is supposedly effective this fall, should prevent “proprietary trading” at the TBTF institutions. But many think that such rules will be easy to get around; Mr. Dimon has indicated that this huge loss was due to a failed “hedge,” and not proprietary trading. JPMorgan had $182 billion in capital according to their March 31 filings, so the loss of a few billion isn’t going to put this institution in any danger or require any taxpayer assistance.
However, on the Monday after the JPMorgan announcement (May 14), President Obama appeared on ABC’s The View and commented that it was a good thing that JPMorgan had plenty of capital, noting that had this happened at a weaker bank, “[W]e could have had to step in.”
Think about this statement. The first reaction to stress in the financial system is for the government to step in! Compare that to the first Chrysler bailout in 1979. At that time, Lee Iacocca, Chrysler’s Chairman and CEO, had to beg Congress for nearly four months for a loan guarantee (not a direct loan) of $1.5 billion.
In fact, the day before Mr. Dimon announced JPMorgan’s large loss problem, the FDIC’s acting Chairman, Martin Gruenberg, announced plans and procedures for the FDIC to seize large financial institutions “when the next crisis brings a major financial firm to its knees.” Instead of getting rid of TBTF, it is now institutionalized. The FDIC’s announced plans are simply in accordance with Dodd-Frank.
During the week of May 14, the lawyers representing Goldman Sachs and Bank of America-Merrill Lynch in a lawsuit filed by Overstock.com filed an unredacted set of documents with the court (i.e., the whole document was submitted instead of only certain parts), thus putting them into the public domain.
Those documents revealed that these TBTF institutions knowingly ignored the laws and regulations against “naked” short-selling. When one sells “short,” one must first borrow the stock, or else there is nothing to prevent someone shorting (i.e., selling) so many shares as to significantly and negatively impact the market price for the stock (which is what a short-seller hopes for). “Naked” short-selling occurs when the stock is sold without borrowing it from another owner, and three business days later, the seller “fails” to deliver the stock.
Because of their size and power, the TBTF banks could depress the stock price of any company they choose. If one of their units puts a “sell” recommendation out and the trading department “naked” short-sells, then the “sell” recommendation becomes a self-fulfilling prophecy. This, in fact, is what Overstock.com’s lawsuit has been about.
So let’s review:
4. It has come to light that some TBTF institutions have skirted laws and regulations.
If there were no TBTF institutions in the US, then little of the above would be of concern. Instead:
4. Without the power that comes with being TBTF, the “naked” short-selling and other abuses would be much less effective or profitable.
5. The TBTF institutions are so complex that even the likes of a Jamie Dimon can’t provide effective internal controls and risk management. Smaller institutions that have such issues won’t cause systemic risk.
The lessons of the ’08-’09 near systemic meltdown were clear: TBTF is a huge policy issue. Unfortunately, after Dodd-Frank, not only are TBTF institutions bigger and systemically more risky, but we now have a government all too willing, and maybe even eager, to “step in.”