The direction of change of international oil prices during the remainder of the year will, in our view, heavily influence the near-term fate of the global economy and international financial markets. Falls in global oil prices, of the kind we have seen over the past few days, clearly brighten the prospects for the global economy. Conversely, a possible return to rapid increases in oil prices could have a disastrously negative influence on global growth.
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Why No Outrage?
By James Grant
July 19, 2008
Through history, outrageous financial behavior has been met with outrage. But today Wall Street's damaging recklessness has been met with near-silence, from a too-tolerant populace, argues James Grant
"Raise less corn and more hell," Mary Elizabeth Lease harangued Kansas farmers during America's Populist era, but no such voice cries out today. America's 21st-century financial victims make no protest against the Federal Reserve's policy of showering dollars on the people who would seem to need them least.
Long ago and far away, a brilliant man of letters floated an idea. To stop a financial panic cold, he proposed, a central bank should lend freely, though at a high rate of interest. Nonsense, countered a certain hard-headed commercial banker. Such a policy would only instigate more crises by egging on lenders and borrowers to take more risks. The commercial banker wrote clumsily, the man of letters fluently. It was no contest.
The doctrine of activist central banking owes much to its progenitor, the Victorian genius Walter Bagehot. But Bagehot might not recognize his own idea in practice today. Late in the spring of 2007, American banks paid an average of 4.35% on three-month certificates of deposit. Then came the mortgage mess, and the Fed's crash program of interest-rate therapy. Today, a three-month CD yields just 2.65%, or little more than half the measured rate of inflation. It wasn't the nation's small savers who brought down Bear Stearns, or tried to fob off subprime mortgages as "triple-A." Yet it's the savers who took a pay cut -- and the savers who, today, in the heat of a presidential election year, are holding their tongues.
Possibly, there aren't enough thrifty voters in the 50 states to constitute a respectable quorum. But what about the rest of us, the uncounted improvident? Have we, too, not suffered at the hands of what used to be called The Interests? Have the stewards of other people's money not made a hash of high finance? Did they not enrich themselves in boom times, only to pass the cup to us, the taxpayers, in the bust? Where is the people's wrath?
The American people are famously slow to anger, but they are outdoing themselves in long suffering today. In the wake of the "greatest failure of ratings and risk management ever," to quote the considered judgment of the mortgage-research department of UBS, Wall Street wears a political bullseye. Yet the politicians take no pot shots.
Barack Obama, the silver-tongued herald of change, forgettably told a crowd in Madison, Wis., some months back, that he will "listen to Main Street, not just to Wall Street." John McCain, the angrier of the two presumptive presidential contenders, has staked out a principled position against greed and obscene profits but has gone no further to call the errant bankers and brokers to account.
The most blistering attack on the ancient target of American populism was served up last October by the then president of the Federal Reserve Bank of St. Louis, William Poole. "We are going to take it out of the hides of Wall Street," muttered Mr. Poole into an open microphone, apparently much to his own chagrin.
If by "we," Mr. Poole meant his employer, he was off the mark, for the Fed has burnished Wall Street's hide more than skinned it. The shareholders of Bear Stearns were ruined, it's true, but Wall Street called the loss a bargain in view of the risks that an insolvent Bear would have presented to the derivatives-laced financial system. To facilitate the rescue of that system, the Fed has sacrificed the quality of its own balance sheet. In June 2007, Treasury securities constituted 92% of the Fed's earning assets. Nowadays, they amount to just 54%. In their place are, among other things, loans to the nation's banks and brokerage firms, the very institutions whose share prices have been in a tailspin. Such lending has risen from no part of the Fed's assets on the eve of the crisis to 22% today. Once upon a time, economists taught that a currency draws its strength from the balance sheet of the central bank that issues it. I expect that this doctrine, which went out with the gold standard, will have its day again.
Wall Street is off the political agenda in 2008 for reasons we may only guess about. Possibly, in this time of widespread public participation in the stock market, "Wall Street" is really "Main Street." Or maybe Wall Street, its old self, owns both major political parties and their candidates. Or, possibly, the $4.50 gasoline price has absorbed every available erg of populist anger, or -- yet another possibility -- today's financial failures are too complex to stick in everyman's craw.
I have another theory, and that is that the old populists actually won. This is their financial system. They had demanded paper money, federally insured bank deposits and a heavy governmental hand in the distribution of credit, and now they have them. The Populist Party might have lost the elections in the hard times of the 1890s. But it won the future.
Before the Great Depression of the 1930s, there was the Great Depression of the 1880s and 1890s. Then the price level sagged and the value of the gold-backed dollar increased. Debts denominated in dollars likewise appreciated. Historians still debate the source of deflation of that era, but human progress seems the likeliest culprit. Advances in communication, transportation and productive technology had made the world a cornucopia. Abundance drove down prices, hurting some but helping many others.
The winners and losers conducted a spirited debate about the character of the dollar and the nature of the monetary system. "We want the abolition of the national banks, and we want the power to make loans direct from the government," Mary Lease -- "Mary Yellin" to her fans -- said. "We want the accursed foreclosure system wiped out.... We will stand by our homes and stay by our firesides by force if necessary, and we will not pay our debts to the loan-shark companies until the government pays its debts to us."
By and by, the lefties carried the day. They got their government-controlled money (the Federal Reserve opened for business in 1914), and their government-directed credit (Fannie Mae and the Federal Home Loan Banks were creatures of Great Depression No. 2; Freddie Mac came along in 1970). In 1971, they got their pure paper dollar. So today, the Fed can print all the dollars it deems expedient and the unwell federal mortgage giants, Fannie Mae and Freddie Mac, combine for $1.5 trillion in on-balance sheet mortgage assets and dominate the business of mortgage origination (in the fourth quarter of last year, private lenders garnered all of a 19% market share).
Thus, the Wall Street of the Morgans and the Astors and the bloated bondholders is today an institution of the mixed economy. It is hand-in-glove with the government, while the government is, of course -- in theory -- by and for the people. But that does not quite explain the lack of popular anger at the well-paid people who seem not to be very good at their jobs.
Since the credit crisis burst out into the open in June 2007, inflation has risen and economic growth has faltered. The dollar exchange rate has weakened, the unemployment rate has increased and commodity prices have soared. The gold price, that running straw poll of the world's confidence in paper money, has jumped. House prices have dropped, mortgage foreclosures spiked and share prices of America's biggest financial institutions tumbled.
One might infer from the lack of popular anger that the credit crisis was God's fault rather than the doing of the bankers and the rating agencies and the government's snoozing watchdogs. And though greed and error bear much of the blame, so, once more, does human progress. At the turn of the 21st century, just as at the close of the 19th, the global supply curve prosperously shifted. Hundreds of millions of new hands and minds made the world a cornucopia again. And, once again, prices tended to weaken. This time around, however, the Fed intervened to prop them up. In 2002 and 2003, Ben S. Bernanke, then a Fed governor under Chairman Alan Greenspan, led a campaign to make dollars more plentiful. The object, he said, was to forestall any tendency toward what Wal-Mart shoppers call everyday low prices. Rather, the Fed would engineer a decent minimum of inflation.
In that vein, the central bank pushed the interest rate it controls, the so-called federal funds rate, all the way down to 1% and held it there for the 12 months ended June 2004. House prices levitated as mortgage underwriting standards collapsed. The credit markets went into speculative orbit, and an idea took hold. Risk, the bankers and brokers and professional investors decided, was yesteryear's problem.
Now began one of the wildest chapters in the history of lending and borrowing. In flush times, our financiers seemingly compete to do the craziest deal. They borrow to the eyes and pay themselves lordly bonuses. Naturally -- eventually -- they drive themselves, and the economy, into a crisis. And to the scene of this inevitable accident rush the government's first responders -- the Fed, the Treasury or the government-sponsored enterprises -- bearing the people's money. One might suppose that such a recurrent chain of blunders would gall a politically potent segment of the population. That it has evidently failed to do so in 2008 may be the only important unreported fact of this otherwise compulsively documented election season.
Mary Yellin would spit blood at the catalogue of the misdeeds of 21st-century Wall Street: the willful pretended ignorance over the triple-A ratings lavished on the flimsy contraptions of structured mortgage finance; the subsequent foreclosure blight; the refusal of Wall Street to honor its implied obligations to the holders of hundreds of billions of dollars worth of auction-rate securities, the auctions of which have stopped in their tracks; the government's attempt to prohibit short sales of the guilty institutions; and -- not least -- Wall Street's reckless love affair with heavy borrowing.
For every dollar of equity capital, a well-financed regional bank holds perhaps $10 in loans or securities. Wall Street's biggest broker-dealers could hardly bear to look themselves in the mirror if they didn't extend themselves three times further. At the end of 2007, Goldman Sachs had $26 of assets for every dollar of equity. Merrill Lynch had $32, Bear Stearns $34, Morgan Stanley $33 and Lehman Brothers $31. On average, then, about $3 in equity capital per $100 of assets. "Leverage," as the laying-on of debt is known in the trade, is the Hamburger Helper of finance. It makes a little capital go a long way, often much farther than it safely should. Managing balance sheets as highly leveraged as Wall Street's requires a keen eye and superb judgment. The rub is that human beings err.
Wall Street is usually described as an industry, but it shares precious few characteristics with the metal-fasteners business or the auto-parts trade. The big brokerage firms are not in business so much to make a product or even to earn a competitive return for their stockholders. Rather, they open their doors to pay their employees -- specifically, to maximize employee compensation in the short run. How best to do that? Why, to bear more risk by taking on more leverage.
"Wall Street is our bad example because it is so successful," charged the president of Notre Dame University, the Rev. John Cavanaugh, in the time of Mary Lease. He meant that young people, emulating J.P. Morgan or E.H. Harriman, would worship the wrong god. The more immediate risk today is that Wall Street, sweating to fill out this year's bonus pool, runs itself and the rest of the American financial system right over a cliff.
It's just happened, in fact, under the studiously averted gaze of the Street's risk managers. Today's bear market in financial assets is as nothing compared to the preceding crash in human judgment. Never was a disaster better advertised than the one now washing over us. House prices stopped going up in 2005, and cracks in mortgage credit started appearing in 2006. Yet the big, ostensibly sophisticated banks only pushed harder.
Bear Stearns is kaput and Lehman Brothers is reeling, but Morgan Stanley perhaps best illustrates the gluttonous ways of Wall Street. Having lost its competitive edge on account of an intramural political struggle, the firm, under Chief Executive John Mack, set out to catch up to the rest of the pack. In the spring of 2006, it unveiled a trillion-dollar balance sheet, Wall Street's first. It expanded in every faddish business line, not excluding, in August 2006, subprime-mortgage origination (the transaction, intoned a Morgan Stanley press release, "provides us with new origination capabilities in the non-prime market, which we can build upon to provide access to high-quality product flows across all market cycles"). Nor did it pull in its horns as the boom wore on but rather protruded them all the more, raising its ratio of assets to equity to the aforementioned 33 times at year-end 2007 from 26.5 times at the close of 2004. Naturally, it did not forget the help. Last year, Morgan Stanley paid out 59% of its revenues in employee compensation, up from 46% in 2004.
Huey Long, who rhetorically picked up where Lease left off, once compared John D. Rockefeller to the fat guy who ruins a good barbecue by taking too much. Wall Street habitually takes too much. It would not be so bad if the inevitable bout of indigestion were its alone to bear. The trouble is that, in a world so heavily leveraged as this one, we all get a stomach ache. Not that anyone seems to be complaining this election season.
Gold And Oil For Soros; Illiquidity At Merrill
Robert Lenzner
07.17.08
Wealth destruction took a day off Wednesday as illiquidity surfaced as a top issue at a major investment bank.
The market rallied in the wake of a lower oil price, Federal Reserve Chairman Ben Bernanke promised that Fannie Mae and Freddie Mac were solvent, and new rules began to lean against avaricious short-sellers of bank shares.
Undoubtedly, this spike in bank shares was due in large part to hedge funds, which began covering some of the massive short positions they've built up over the past 18 months. For example, billionaire George Soros--Croesus was told--has covered much of his shorts in financial stocks. Why chance another public policy move by regulators to shut off this automatic feeding trough?
Soros finally shorted oil at $137 a barrel and put on a long position in gold; he expects to see gold hold its ground even if oil continues to decline. In fact, the gold bug clique believes in a consistent 10-to-1 ratio for gold and oil. It holds that either gold will rise to 10 times a barrel of oil ($1,350 an ounce) or oil will fall to $96 a barrel--one-tenth the present market price of gold. Croesus was told Tuesday that statistics spanning many decades support, on average, this 10-to-1 ratio.
As for the second issue of the day, Croesus has been informed about a disheartening problem at Merrill Lynch--$6 billion of illiquid securities, called auction rate preferreds, that are owned by some 40,000 customers of the thundering herd.
It seems these 40,000 investors can't sell these supposedly secure money-market-type instruments, which require auctions, and turn them into hard cash. And the issuers of these securities--closed-end mutual funds, like some in the BlackRock group, municipal authorities and student loan organizations--can't raise the cash to pay off investors.
It was some months back that a shocked Croesus learned about auction rate preferreds, which represent an asset class worth $360 billion in the market. Soros and others of his ilk even admitted to Croesus that they had never, ever heard of them.
As a Comerica Securities memorandum explains why cash doesn't always keep pace with these instruments: "Recent failed auctions appear to have been caused by volatility in and tightening of the credit markets and waning investor confidence. Although there are no obligations for firms to back ARS [auction rate securities], auction agents that collect fees for running auctions used to step in with their capital to prevent failures when bidding faltered. However, these firms and broker-dealers have grown unwilling to commit their money to ARS after suffering significant credit losses stemming from write-downs of mortgage debt and various corporate debt instruments."
The memo bluntly states: "In other words, the credit crisis is still alive and causing intense investor suffering."
Imagine that. In the year 2008, you can't turn shares into cash, especially when cash is king!
Faber says global economy at tail end of growth
Marc Faber, who told investors to bail out of US stocks before 1987's so-called Black Monday crash, said the global economy is at the ``tail end'' of its growth.
"What you've had since 2001 is a global synchronized boom,'' Faber, publisher of the newsletter the Gloom, Boom & Doom Report, said at an investment forum in Sydney.
"In the history of capitalism this is most unusual. When it comes to an end it should affect all countries.''
Stock indexes worldwide have tumbled this year as financial institutions piled up more than US$400 billion (HK$3.12 trillion) in losses from credit investments, and investors braced for a US economic recession amid soaring fuel and food prices.
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