Tag: finance

It’s the Leverage, Stupid!

With the stock market looking toppy and the unemployment rate still on the rise, the “green shoots” are starting to look rather brown (or more like a mirage) and some are calling for a second stimulus.  For now, leave the ridiculous fact that only a tiny percentage of first stimulus has been spent so far and let’s look at the facts.  The economic crisis was caused by excess leverage, first by consumers, then by companies, now by the government.  Is a second stimulus with more leverage what we really need?  If it is, will the Obama administration make a case for it that doesn’t use phony statistics like “jobs saved or created?”

To borrow from Bill Clinton’s first presidential campaign, Its the Leverage, Stupid!  Consumers borrowed huge amounts of money to live lavish lifestyles or to just keep up with the monthly bills.  The consumer savings rate peaked in the 1970s around 15%, but declined consistantly during the 80s and 90s.  It even went negative in 2007, right before the financial crisis.  This meant that consumers were, on average, spending more than they made.  Consumers resorted to using their homes as ATMs, borrowing vast amounts of money to keep the party going.  Clearly it was not sustainable.

Banks and non-bank banks stoked the flames and let the party rage on.  Banks offered mortgages to people who shouldn’t have had them, manufactured huge bets on CDOs and made billions moving money around.  After the government removed many of the leverage regulations, banks continued to go wild.  Other companies and hedge funds joined the fray, borrowing billions of dollars  for leveraged buyouts that left balance sheets riddled with debt.

When the economy started to slow down and the stock market fell out of bed, companies and consumers who were strapped with debt and little savings faced the brunt of the downturn.  Companies began to deleverage, cuting costs and jobs to be able to stay in business.  US consumers, scared by huge declines in net worth stemming from the stock market collapse and the real estate downturn, started to save, bringing the savings rate up to around 7%.  

The US government, which had started to run larger deficits during the Bush years, stepped in to fill the void.  The Bush administration pushed the first bailouts through and the Obama administration passed even more bailouts and a huge stimulus package.  The $740bn+ stimulus package pushed much of the spending two to three years down the road, funding tons of pork-laden projects that are probably unnecessary and have nothing to do with stimulus.  These programs saddle the government with even more debt at a time when the rest of the world is concerned about the value of the dollar.  The government should have advocated for $200-300b of immediate spending, or better yet, returned money to the people so that they could pay down their own debts.  Instead, we have record amounts of debt and even more leverage, not even taking into consideration the unfunded liabilities of Medicare and Social Security that will require even more leverage.

Now, as the stock market and the economy as a whole are showing signs of getting worse, there are calls for a second stimulus.  I fear that Congress will pass another massive bill, but most of the money won’t be spent fast enough and there will be even more waste.  I’m worried that many of the projects will be useless and ineffective at turning the economy around.

The only way to fix the problem and get through the bear market is to deleverage.  We need to squeeze the leverage out of the system, stop the insanity and go back to more rational debt levels.  With another round of mortgage resets set to take place late this summer, we are likely to have many more foreclosures in the next year.  Instead of spending money on projects in the future, the government should have made it easy for mortgage holders to renegotiate their mortgages in exchange for the bank having the rights to some of the upside of the house when the market turns.  This type of solution removes debt (leverage) from the consumers and bad debt (leverage) from the financial institution and saves consumers money right away, with a lower mortgage payment.  The government will have to spend a little more money, but it would be rational, compared to the huge stimulus package and bail outs that we have seen so far.

The government should be helping (forcing) companies to convert debt to equity in institutions that have bad balance sheets.  Instead of bailing out investors and companies who made bad decisions, the government should be converting debt to equity to shore up balance sheets and make the companies deleverage.

I think we are on the verge of another downturn in the stock market and rising unemployment.  The press seems to think (or hope) that the worst is behind us.  Most people are turing bullish and many Americans have come back into the market.  I fear that we face a repeat of the stock market’s performance during the Great Depression, where there was a prolonged bear market rally and then a second crash that wiped out more market value than the initial crash.

China and the rest of the world are already starting to pick at the reserve status of the dollar.  If the US keeps leveraging and then decides to inflate away the problem, the US dollar may lose its reserve status.  The government must make sure they do not make the crisis worse than it is.  Its not a Republican or Democrat issue. Its an American issue.  I am not confident that the government will make the right decisions.  With GoldmanSachs alums holding many key government jobs, I fear that they will do what they know best: continue to leverage and try to pick up the pieces later.  If you want to go farther, read Matt Taibi’s blog and latest piece in Rolling Stone.

I hope I am wrong, but I don’t see the US coming out of this without lots more pain.  What do you think?

Enron Documentary is Incredibly Interesting

I just watched The Smartest Guys in the Room, a documentary about the rise and fall of Enron.  I have a special interest in Enron, as I margined my entire stock portfolio and shorted it in my 10th grade mock stock competition for a few days, but relented to my partners advice that it couldn’t fall any more and went long Enron, only to finish dead last.  If we would have stayed with the original trade, we would have had a free trip to New York!  But enough of that.

The documentary has interviews with the journalist who first started to question Enron’s meteoric rise, former employees and executives and plenty of video from the companies many meetings and pep talks.  It is really well done and very interesting, notching an Academy Award Nomination in 2006.  If you are at all interested in the Enron story, or corporate fraud in general, check out this documentary.

The most interesting part of the documentary centered on Enron’s role in the blackouts that plagued California in winter 2001 and summer 2002.  I was always skeptical about claims of meddling and corporate scandal in the blackouts, but the documentary painted a very explicit case that showed overt meddling that caused up to $30b of losses in the California economy, the recall and end to the political career of Gray Davis and ultimately the election of The Governator to California’s highest office.

The documentary showed audio of Enron traders telling power plants to shut down, which caused rolling blackouts.  The traders also were taped diverting power from California power plants to other areas to try to drive up the price.  It worked.  Power was $40 per unit before they started their shenanigans and spiked to $1000 per unit at their peak and Enron made billions.  This part of the business was pretty much the only successful part, but was clearly unethical, if not illegal.

The rolling blackouts caused huge economic damage to California’s economy, ended a political career, caused traffic accidents and many other consequences so that Enron could make money.  Add this business practice to their cooking the books, it was pretty clear that Enron was very corrupt.  It was also interesting to see how complicit investment banks, ratings agencies, the Bush Administration, accountants and journalists were in allowing Enron to get away with fraud for so long.

There are many parallels to the current financial crisis in that so many people were blinded by greed, derelicting their moral and fiduciary duties.  They turned a blind eye to poor business practices and extreme risk taking.  Its interesting to see history repeat itself so quickly.  Check out the documentary.  Its playing for free on Mark Cuban’s HDnet channel for the next few weeks.

Is the Dollar America’s Achilles Heel?

“…the US government has a technology, called a printing press (or, today, it’s electronic equivalent) that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”  Ben Bernanke, 2002

Throughout history, the world’s economic powers have had to decide how they should be paid for their goods and services.  At first, gold, silver and precious stones were stores of value that could be exchanged for goods and services.  As currencies were developed and became widely accepted, countries had to decide which currency or currencies they would accept for their hard work.  The most widely accepted currency is usually known as the reserve currency.  Countries hold these reserves as a store of value and as national savings.

Until the early 1900s, there was no official reserve currency, but some currencies acted in a de facto reserve status.  Starting in the 1700s, the de facto reserve currency was a combination of the French Franc, the British Pound and the Dutch Gilder.  Later, in the 1800s, it was a combination of the British Pound, US Dollar and the Russian Ruble.

By the 1900s, many currencies were backed by gold.  This means that a person could exchange paper money for an exact amount of gold.  After World War II, the global powers signed the Bretton Woods Agreement, which made the US dollar the central reserve currency.  It allowed countries to exchange their currencies for dollars or gold at fixed exchange rates.  This system worked well while the US had a much stronger economy compared to other countries, but as Japan, Europe and Asia began to recover after WWII, the Bretton Woods Agreement began to to show signs of strain.  The US felt it was paying more than its fair share.

In the 197s0s, the Bretton Woods Agreement broke down as other countries rose to prominence and began demanding gold from the US in exchange for their US dollars that they had accumulated through trade.  After Nixon closed the gold window and permanently detached the US dollar from gold, the United States was in the unique position of being able to print the reserve currency, but not have it convertible into anything tangible.  The US could print money out of thin air and use it to buy cars from Japan.

Since the US can issue the world reserve currency, it receives huge economic benefits in the short term.  The US can simply print as much currency as it wants, as long as the rest of the world is willing to accept dollars in exchange for goods or services.  This process allows the US to live beyond its means for as long as foreign countries are willing to continue to accept dollars.  Countries, like China, accumulate US dollars and loan them back to us at low interest rates.

This process has been going on since the 1970s, but has accelerated since globalization has taken hold.  The United States lost its manufacturing base to China, India and Asia and has been paying for goods and services through increased leverage and increased running of the “printing press.”  Printing press is a misnomer, as most of the new money that is created is just created out of thin air and deposited by the Federal Reserve into the world economy via banking reserves.

As the US continues to go into more debt, we are forced to either raise taxes or print more money to pay off our debt.  Since raising taxes is politically unfeasible and cutting spending is even harder, the US will most likely pay off the debt by printing even greater quantities of dollars.  China now holds over 1.95 Trillion dollars in its foreign reserves, most of it denominated in US dollars.  They are worried that the US will simply print itself out of debt, rendering its hard earned savings worthless.

We saw how extreme debt and leverage destroyed the big investment banks.  I am worried that the US is in a similar situation.  The national debt is currently $11.2 trillion dollars, or $36,000 per man, woman and child in America.  We pay $3.6 billion dollars per day in interest.  It is compounding at its worst.

If China decides that it no longer wants to continue purchasing US paper, the dollar will decline precipitously and interest rates will rise.  There even could be a run on the dollar.  This would be disastrous for the United States.

China and Russia have already started to push for a new global reserve currency, either backed by gold or backed by a basket of currencies at the United Nations or the World Bank.  China’s equivelant to Ben Bernanke recently posted an essay advocating a new reserve currency.  I fear that the US dollar will lose its reserve status, as the rest of the world has grown tired of watching America print prosperity.  Its not logical that these countries will continue to allow this to happen.  They know that they cannot defeat US hegemony in a military war, so they realize that if they wish to dislodge the US as the hegemonic power, they must use a different strategy.  I believe it will be attacking the US where it is weakest: the reserve status of the US dollar.  It is our Achilles Heel.

There really is only one conclusion to this story: the standard of living in the United States is fated to fall.  Nobody knows how far it may fall, but there is no way that the last twenty years of prosperity, brought to you by leverage and the printing press, is sustainable.  At some point, China and the rest of the world will say enough is enough and will demand real, tangible payment for their hard work.  This will be disastrous for the average US citizen and for US power in general.

Iceland’s Meltdown

I’ve written about Michael Lewis’ take on the Wall Street’s meltdown in my post “The Financial Crisis Explained.”  He is one of my favorite commentators and is able to take complex issues and write about them in a way that is comprehensible to the average person.

He recently wrote an article about Iceland’s meteoric rise to prominence in the global world of finance and later its amazing crash when the bubble burst.  His article should be required reading for anyone interested in finance or the global economy.

Iceland’s de facto bankruptcy—its currency (the krona) is kaput, its debt is 850 percent of G.D.P., its people are hoarding food and cash and blowing up their new Range Rovers for the insurance—resulted from a stunning collective madness. What led a tiny fishing nation, population 300,000, to decide, around 2003, to re-invent itself as a global financial power? In Reykjavík, where men are men, and the women seem to have completely given up on them, the author follows the peculiarly Icelandic logic behind the meltdown.

I wanted to focus on an aspect of the article that I’ve written about in my post entitled “The Business School Way of Life.”  Lewis mentions that most, if not all, of the people who were involved in Iceland’s boom and bust had degrees from prestigious American and British business schools.  They learned the Business School Way of Life in America and brought it home to Iceland.  Everyone caught the fever and it has wrecked a once stable country.  Now, the currency is worthless and debt is 850% of GDP, higher than even the highly debt burdened USA’s 350%.

As an example of a person who fell into the Business School Way of Life is Stephan Alfsson. Lewis spends some time interviewing  Alfsson, a fishing boat captain turned financier, in his article.  Here’s Alfsson’s story:

Lean and hungry-looking, wearing genuine rather than designer stubble, Alfsson still looks more like a trawler captain than a financier. He went to sea at 16, and, in the off-season, to school to study fishing. He was made captain of an Icelandic fishing trawler at the shockingly young age of 23 and was regarded, I learned from other men, as something of a fishing prodigy—which is to say he had a gift for catching his quota of cod and haddock in the least amount of time. And yet, in January 2005, at 30, he up and quit fishing to join the currency-trading department of Landsbanki. He speculated in the financial markets for nearly two years, until the great bloodbath of October 2008, when he was sacked, along with every other Icelander who called himself a “trader.

So why would an expert fisherman, who began training to go to sea at age 16, promptly give up his job to turn to finance?  Why did he think that he could work in banks and be a “trader” when he had no experience and no training?  Similarly, who do students who leave business schools believe that they can accurately project risk?  Lewis tried to get Alfsson to answer:

“You spent seven years learning every little nuance of the fishing trade before you were granted the gift of learning from this great captain?” I ask.


“And even then you had to sit at the feet of this great master for many months before you felt as if you knew what you were doing?”


“Then why did you think you could become a banker and speculate in financial markets, without a day of training?”

Alfsson does not have an answer and Lewis lets him off the hook, but I think that it was pure greed.  Alfsson and people like him were willing to try to get rich quick.  They saw everyone around them getting rich and decided that they wanted in on the action.  In Alfsson’s case, he saw people younger than him returning from American business schools and starting banks, seemingly making fortunes overnight.  The contrast between the hard work of a fisherman and the paper shuffling that was the Icelandic banking system cannot be any more stark, yet nobody wanted to raise a concern.  As Lewis puts it,

 At the very least, in a place where everyone knows everyone else, or his sister, you might have thought that the moment Stefan Alfsson walked into Landsbanki 10 people would have said, “Stefan, you’re a fisherman!” But they didn’t. To a shocking degree, they still don’t.

We are experiencing this same phenomenon in the US.  Why didn’t anyone try to stop the hedge funds, banks and private equity firms by saying “Hey, you just graduated from college, what do you know about CDOs and assessing risk?”  Why do many people who work in these firms still believe that they can correctly model future risk?  Why do business school students still go into finance without someone asking them questions like this?