Daily Investment Interpretations

September 20, 2008

2008-9-20:   Amber woke up with a fever this morning, so it will be after noon before I can finish preparing this.
    Thursday afternoon, if the U. S. government hadn't intervened dramatically, I suspect that there would have been massive sales of mutual funds starting yesterday, and that there might have been runs on our banks starting next week. I know I was worried about what to do to safeguard Tommie's and my savings and investments. Should we open Swiss bank accounts? Buy gold? Are U. S. treasury bonds safe? The Federal Deposit Insurance Corporation is running low on money, and in any case, it wouldn't be possible to instantaneously return all the cash invested in all U. S. money market funds and bank accounts. As some commentators have put it, we were staring into the abyss Thursday morning. And in the abyss was a cratering of the world's economies. Fortunately, the U. S. government is taking dramatic steps to restore confidence in U. S. financial markets.
    So how did we get to this point, and where might we go from here?
    In 1933, Senator Carter Glass and Representative Henry Steagall introduced the Glass-Steagall Act that banned commercial banks from underwriting stock issues. The reason for this was that, during the Roaring Twenties, banks hyped the Initial Public Offerings (IPOs) of companies they were underwriting to unsuspecting bank customers, relying on their conservative banking credentials to promote overpriced stocks of shaky companies. As the linked article puts it, "[Oct. Nov. 1999] After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic.".
    "The Glass-Steagall repeal was the worse domestic policy decision that the Clinton Administration ever made, and that’s saying something. Furthermore, it’s only going to get worse from here going forward."
    Prescient commentary!
    Fast forward to 2000: In May, 2000, the Federal Reserve raised the federal funds rate to 6% in an effort to reduce inflation associated with the dot.com boom. This had the desired effect of withdrawing money from circulation, slowing the economy, and lowering the rate of inflation. As an unwanted side effect, it slowed the economy sufficiently that it tipped the U. S. into a mild recession, starting in the third quarter of 2000, and lasting through the second quarter of 2001. The recovery that followed was a jobless recovery, with many high-paid manufacturing and professional jobs outsourced and their former employees forced into much lower-paid service positions. 
    The Federal Reserve began cutting the federal funds rate in January, 2001, in an effort to stimulate the economy, and continued to reduce it until it reached 1.75% in December, 2001. It then slowly declined to 1.25% in November, 2002, dipping to around 1% until May, 2004 (perhaps to aid President Bush in the upcoming election?) and then rising to 4% by the time of the election. This meant that, for 2½ years, the federal funds rate remained below 2%.
    Banks immediately took advantage of the repeal of the Glass-Steagall Act. After all, if your competitor was offering stocks and bonds, you'd better offer them, too, or risk falling behind. At the same time, 30-year fixed-mortgage interest rates fell to 5+%---levels not seen since the 50's and 60's. Borrowing rates for banks,  savings and loans, brokerage firms, etc., themselves, became less than the rate of inflation, and lending took place on a massive scale. Banks found a way to partially offload the risk of mortgage defaults by selling the mortgages to professional mortgage companies, and later, by slicing up mortgages (to spread the risk) and repackaging them as CDOs (Collateralized Debt Obligations) with one mortgage spread among several CDOs. In addition, techniques were devised to leverage these CDOs so that for every $1 in "real" assets (based up appraised housing prices), $10 or $20 in "paper value" could be sold to unsuspecting customers who thought they were getting secure fixed-income investments. Also, packages of CDOs could be bundled into super-CDO's, with mixing and matching, to the point where it became unfeasible to unravel the tangled webs they wove.
    In the meantime, banks and mortgage companies were loosening mortgage requirements and pushing mortgages the way credit card companies were pushing credit cards. The baby boomers, perhaps because they were sending their children through college or perhaps (in some cases) to live beyond their means or flip houses, were borrowing money as never before. They were encouraged to borrow back the principle they had built up in their home loans in order to pay off their usurious credit card debt. And so the housing bubble developed, with toxic mortgages interlarded with high-quality mortgages in CDO's and CDO's of CDO's.
    Among the consequences of this tangled web that financial intermediaries wove are (1) banks keep declaring greater losses as home prices continue to fall and the value of their collateral continues to diminish, and (2) banks have become reluctant to loan money to each other, or to anyone else. It doesn't matter how much money the Fed prints or how large M3 becomes if banks simply hoard money to beef up their banking reserves.
    While this was taking place, the Bush administration cut taxes, primarily for the rich, while simultaneously boosting the DoD budget to the point where the U. S. has by far the highest per capita military costs of any country on the planet. The U. S. has 5% of the world's population, but 47% of its military budget... 18 times the average, per capita military expenditure of the rest of the world! (In the interest of truth in advertising, it needs to be stated the U. S. military budget as a fraction of U. S. Gross Domestic Product, has been falling over time, so. although our military budget is high compared with what it would have been if we hadn't decided to invade Iraq and Afghanistan, it isn't unusually high compared to its Cold War levels.) As a result, our budget deficit began to grow rapidly during the Bush administration, since the administration was financing the our tax cuts, our wars and our "constabulary duties" by borrowing money from foreign investors. (We have to borrow the money from foreign investors to pay the interest on our national debt because U. S. savings rates have fallen to their lowest levels in our 227-year history.) This, combined with our appetite for foreign oil, is leading our leaders to sell parts of the income-producing properties in the United States (our banks and brokerage houses, for example) to foreign investors. In other words, not only are we borrowing money to pay the interest on our national debt (while the national debt climbs higher and higher); in addition, we're selling foreign investors more and more of the income-producing properties that we need to pay down our national debt. This has led legendary investor, Warren Buffett, to liken our situation to that of a farmer who sells off more and more of his income-producing land to finance his high-rolling lifestyle. ("Another day older and deeper in debt.") When the day of reckoning finally arrives, the farmer will be as poor as a church mouse.
    With the economy slowing down, the government is taking in less money. At the same time, the cost of the bailouts of Bear, Stearns, Fannie Mae, Freddie Mac, AIG, and perhaps other financial institutions to follow, plus guaranteeing money market funds to the tune of $50 billion, the federal government is on the hook for 700-billion additional dollars.
    Talk about a perfect storm!
    So where do we go from here?
    The editor of the Wall Street Journal said last night that politics is ruling what happens for the next month-and-a-half. Our politicians are desperate to postpone a financial collapse at least until after the November elections, since many of them are running for re-election. And had the government not moved to staunch the leaking of red ink, the world's economy would have... They generally don't publicly go beyond this point... possibly to avoid frightening the public? 
    Todd Harrison, who's been prophetic so far, believes that the Fed's latest moves have sold the future to buy the present. Todd Harrison has this to say about the government's current moves: Freaky Friday Potpourri: Martial Law For the Markets, Random Thoughts: Tying History Up With a Bow. Also, here's an article by Kevin Depew, Five Things You Need to Know: Where Were You When the Fun Stopped?, and another by , Short Sellers' Brave New World that give their takes on what's coming next. 
    There is some belief that the glow over the government's moves, at a cost quoted at $700 billion, requiring an increase in the national debt ceiling from $10.6 billion to $11.3 trillion, will stimulate the stock markets only temporarily. (To paraphrase the late Illinois Senator Everett Dirksen, "A trillion here, a trillion there, and the first thing you know, you're talking about real money!") At the moment, I'm inclined to this point of view and plan to use this breathing space to sell most of my few remaining mutual funds, and to convey myself even further into cash. I may also hedge my few remaining mutual funds (closed funds like the Janus Overseas Fund and the Fidelity Contrafund that I can't buy back if I sell) by buying shares in an S&P 500 ultra inverse fund. But of course, no one can be sure just what's going to happen next.