About Me

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Geopolitical issues such as trade and fiscal deficits, resource supply and demand, and political and corporate malfeasance significantly influence the direction of global markets. I also happen to believe that much of the thinking on these subjects is the repetition of old story lines. As a consequence, public discourse on these subjects generally sheds very little real light on the issues of our day. In particular, my interests lie in identifying and clarifying the current and prospective risk and opportunity environment, as well as strategies for availing oneself of the opportunities and minimizing exposures to the risks. I am the author of The Emperor's Clothes: A Look at the Megatrends Affecting Your Financial and Investment Decisions. Published February 2007, this work accurately discussed much of what was to occur in global financial crisis of the following several years.

Wednesday, February 25, 2009

Where Are We Now?

While many of us began this new year with hopes for an economic and financial recovery, unfolding events suggest that we have a ways to go before we are on the other side of this global crisis. The economy has continued to deteriorate with huge job losses, real estate prices continue to plunge, and our major financial institutions and industries continue their financial hemorrhaging. I have been studying and monitoring events with sharply focused attention. Below, I share some thoughts regarding what is currently going on. Hopefully, you will find these thoughts helpful in better understanding this environment.

Current View
Towards the end of 2008 the United States Congress agreed to provide $700 billion to keep the financial system from imminent collapse. The Secretary of the Treasury of the United States, Henry Paulsen, and the nation’s top banker, Ben Bernanke, had testified that the United States was within days of financial collapse. Congress provided for two installments of these bailout funds.

Several months later, we have had an opportunity to get some idea of the effectiveness and efficiency of the use of these funds.

The fallout from the failure of several large financial institutions had caused the global credit markets to freeze, consequently bringing global commerce to an abrupt slowdown. The public presentation of this strategy said the bailout funds were supposed to prop up the remaining mega financial institutions of the United States and stimulate the continuing flow of money, via increased lending, necessary for commerce to continue. How unsurprising that reports now emerging present a somewhat different picture of what was really going on. A recent news article reported that the CEO of a large US bank, as well a recent PBS Frontline presentation, said the bailout funds, TARP money, was essentially forced upon some banks. The apparent reason, which was supposed to be kept quiet, was to provide money for some banks to buy out smaller, weaker banks. Shortly after the TARP funds were distributed, there actually were reports of these types of bank acquisitions occurring. To the extent that this would “privatize” dealing with failing banks, this might make some sense.

One of the ways in which these TARP funds were distributed to the banks was to buy some of their “Troubled” (read toxic) assets. If the government paid a fair price for these assets, injecting money into them would be a fairly clean process. Unfortunately, however, this would not have accomplished the objective of stabilizing the financial system any better than they actually did, as I will explain.

If the government bailout funds purchased these assets for what their actual market value was, the financial system would experience an additional shock beyond what was already occurring. In order to try to make banks appear healthier than they actually were, the government needed to pay more for these assets than they were really worth. Indeed, a recent report by a congressional oversight committee headed by chairwoman Elizabeth Warren, a professor at Harvard, came to the conclusion that of the $350 billion spent on this program, the government overpaid for what it purchased by $78 billion. An additional research report by Goldman Sachs said that the real losses in the financial system will be around $4 trillion by the time this crisis is worked through. This is in the same range as estimates by economist Nouriel Roubini, who has estimated around $3.6 trillion of losses. The last estimate I read as to the already acknowledged losses in the financial system was around $1.1 trillion.

To draw the picture more anecdotally, a commenter to an economic blog, www.nakedcapitalism.com, on February 23, 2009, put it this way:
I have a personal anecdote about Citi and the difficulty of spotting how bad their loans actually are. I'm involved with a $300 million condo-hotel development in the Caribbean. Citi has the whole loan (i.e., they didn't securitize or otherwise sell participations in the loan). Even now, we expect the hotel needs at least another $100 million to finish construction and open (we are no longer under any delusions that more than a handful of buyers will close on the condo portion of the condo-hotel). So, in other words, Citi is $275M into this project, and it's not certain that the completed hotel will even be worth the extra $100M required to complete and open. Hence, one might plausibly value this $275M loan at zero (i.e., a complete write off). I cannot imagine any stress test would uncover what a huge loss is on the way in the next 12 months. In fact, this loan has not even been pawned off to the nonperforming/distressed debt/workout section of Citi because the interest reserves make it "seem" like the loan is still performing, not to mention that completely out of date pro formas make it "seem" like (i) equity will come in to finish the project and (ii) condo sales will pay down a huge part of the principal once construction is complete. This scenario must be present in a large number of Citi loans, especially in their somewhat active foreign development divisions. Citi must be so far from solvent that it's not even funny. Only hyperinflation in the dollar could ever make it possible for the borrowers to pay back some of these loans. I'd bet that the sooner we face reality on some of these loans and just halt future fundings, the less money the taxpayers are going to lose. As it is, it's almost too late. Too bad for the US taxpayer.

This suggests that we may have quite a ways to go before we are on the other side of this crisis. Other emerging areas of troubled assets are the commercial real estate sector, as well as car and credit card debt. In an economy which is continuing to deteriorate it would seem as though these problems will get worse. The new Obama administration’s continuing efforts at intervention has not inspired much of a vote of confidence by the markets as to its probability of success.

Looking Forward
There are several take-aways from all this. There is quite a bit a rot left at the core institutions of our financial system. These banks, insurance companies, and other related institutions, provide the backbone for commerce and economic growth. Sustainable and healthy investment markets require the foundation of a healthy economy. Most fundamentally, however, the ongoing financial crisis highlights the importance of rethinking assumptions about risk.

The belief that major financial institutions such as banks and insurance companies provided the “safest” investments arose from the time when these types of institutions conducted themselves in financially prudent ways. The ongoing massive financial institutional failures we have witnessed over the last year are evidence which refutes this belief in a massive way. Moreover, because of the necessity of the United States government having to bailout these institutions in order to try to save the entire global financial system from collapse, it may call the solvency of the United States government into question.
As a consequence of these ongoing events, the challenge of trying to identify potential financial safe harbors in this environment becomes all the more important. It needs to be recognized that “safety” is relative because there are many types of risks, and consequently no absolutely “safe” investment. However, in my analysis and conclusion, trying to balance out these risks points me to reconfirm my conclusion that investments which have a “real use” value such as energy, food, and utilities, will maintain a baseline of economic value in recessionary times, as well as provided the most accelerating growth opportunities when economic conditions improve. This is not to say that these types of investments will not also experience price volatility. Maintaining sizable positions in a safe money market, both for added stability to portfolio values, as well as to take advantage of future opportunities is an additional defensive measure. Having a modest position in precious metals is intended to provide an additional measure of safety. The challenge of this investment environment is to try to have some exposure to the upside of a possible rapid economic turn-around, as well as to provide downside protection from continuing economic deterioration.

From the personal financial planning strategy perspective, a prudent response to these conditions is to seriously re-examine personal spending and expenses with an eye towards belt-tightening. Because many of us have become accustomed to a living standard which includes discretionary expenses which enhance our lives, this is never a pleasant topic. The other side of the coin, however, is that we may find that may of the things we believe we need as discretionary expenditures do not necessarily add to the quality of our lives, or our health. These are times in which we need to have an adaptive response, where we refocus on the things which are really important and take proactive steps to maintain health and manage stress. The bottom line is, I believe, that we will, at some point, emerge from this crisis wiser, stronger, and with some incredible opportunities looking forward.

Banks must be in compliance with certain regulatory requirements. These requirements are intended to ensure a minimal degree of financial strength to protect depositors. A peculiar characteristic of banking system accounting requires that assets be carried in the bank’s accounting records at what is called historic cost. This is what the banks actually paid for these assets. When an asset, such as an investment is sold, the bank accounting record is then adjusted to reflect the actual price at which the asset was sold. This means that if a bank paid $50 million for an investment in some type of sub-prime real estate investment, and it was now worthless, as long as the bank did not sell this investment, it would appear on the banks records as being worth $50 million. Consequently, a very financially sick bank could appear healthy as long as it did not sell, or adjust (called mark to market), its troubled assets.

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