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The Current
Global Financial & Economic Crisis
December 2,
2008
Arnold Bock
Contributing Editor
PreciousMetalsWarrants.com
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.
Dudley Baker
Publisher,
Precious Metals Warrants
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
Mendoza, Argentina
Email:
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PreciousMetalsWarrants.com
Dudley Baker is
the owner and editor of Precious Metals Warrants. Articles are
written by Dudley Baker along with contributing editors, Arnold
Bock of Mendoza, Argentina and Lorimer Wilson of Toronto,
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information, nor the opinions expressed should be construed as a
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