Tips from Dr. Doom, and Understanding His Doomsday Scenario

This is a pretty gloomy, yet surprisingly lighthearted interview with Marc Faber, otherwise known as Dr. Doom. I'm glad he can keep his spirits up in light of how he feels about our future!





Faber (and the other fellow in this interview) is obviously as contrarian as one can get. However, in the ten years I've been following him, unfortunately, his opinions have been on the mark. I give him a lot of credit for being able to look at things objectively and for being willing to go on record with unpopular opinions. From my perspective, I like to gather all points of view. Blinders off, so to speak. I then try to form my own ideas based on all of the inputs.

In this video, Faber shares a few ideas on how people can protect themselves financially in the face of what he believes is a coming high-inflation environment. Faber is an advocate of buying "hard assets" that benefit from inflation, such as gold, farm land, and other real estate. This then raises the question of why he believes we'll have high inflation.

The situation is that we will about double our national debt in the next decade. Obama has been very up-front about this. Since this will be during a time when America is doing everything it can just to get back on its feet, there is no expectation that Americans will somehow become wealthier in that time frame, and therefore more capable of paying down that debt. Hence, the likely scenario is that the government will simply print money to do what's known as "infalting away" the debt. In other words, if $200 billion in bonds that China is holding come due, we would simply print the money to retire the bonds. Naturally, that would devalue our currency, which would then make everything we buy from other countries more expensive; i.e., inflation. In addition, it would make issuing additional debt in the future more expensive, as our international lenders got burned last time by getting a devalued currency in return for their bonds. After all, who wants to lend a dollar and get the equivalent of, say, 80 cents in return?

With everything then being more expensive, people would have to cut back on spending, which would create a recession and increase unemployment. With higher unemployment, the government would have to increase entitlements and deficit spending, thus exacerbating the debt problem by having to borrow more at ever-increasing interest rates. This perpetuates the cycle and accelerates our trek towards ruin, which is the doomsday scenario these guys are talking about.

Essentially, people, companies, and countries reach a tipping point when they take on too much debt, and it inevitably takes them down. This is the problem many Latin American countries ran into in past decades, and this is where the so-called "PIIGS" countries (Portugal, Ireland, Italy, Greece, and Spain) are headed today. These two gents are saying we're probably looking at the same fate in about 10 years. Frankly, I'm looking for reasons to refute what they're saying, and I'm having a hard time finding any. Fun, huh?

The Greek Debt Debacle: Likely Winners and Losers

I think this matter of banks having facilitated Greece's hiding of the magnitude of its debt is going to get a lot more interesting before its all over. Here's an update on the story from the NY Times: "Banks Bet Greece Defaults on Debt They Helped Hide." Here's the short story:

• A number of European banks and America's own Goldman Sachs engineered a number of complex currency swap transactions that allowed Greece to understate its debt.
• Since these banks had inside knowledge that Greece's financial position was much less secure than it appeared, being good opportunists, the went out and bought credit default swaps (insurance against default) on Greece's debt. So, they made big fees setting up the scheme, and they stand to benefit if the scheme falls apart.
• Who did they buy the credit default swaps from; i.e., who was the unwitting sucker to take the bet? Probably multiple issuers, but it looks like the brain trusts at AIG were among them, which means that the American taxpayer would be on the hook in the case of Greece's default, given that the U.S. now owns 80% of AIG.
• So, if Greece gets closer to default, this means that the U.S. either bails out Greece to avoid losses at AIG, or it just steps up and bails out AIG yet again. Once again, the financial industry wins, and the taxpayers lose.
  

From a translation of an investigative piece from the German newspaper Frankfurter Allgemeine Zeitung:

London investment bankers name AIG as a further CDS-seller. That company had to be nationalized during the financial crisis due to its having written insolvency insurance on American mortgages. This debt-load would have led to the collapse of the world’s biggest insurer. Prior to the financial crisis AIG is said to have widely held State credit-risk. If yet-larger insurance positions on Greece exist, then the American government would have a strong interest in preventing that country’s insolvency.

The Flawed Compensation System in Investment Banking

Here's a good article from the prolific Edward Harrison that explains the differences between conventional corporations (including commercial banks) and the big Wall Street firms relative to how people are compensated and who's really calling the shots on risky decisions. In the Wall Street firms (Goldman Sachs, and the now-departed Lehman and Bear Stearns), the top execs are often clueless about the risks their firms are taking (which is a major problem, of course), and you have much lower level people pulling off hugely risky deals. If they win, their payouts are huge. If they fail, they get fired, but just move down the street to another firm. This is why we can't give the same protections to Wall Street that we give to commercial banks. They should be allowed to take risks, but not with government backing. That's what the proposed Volcker rules are all about.

From Mr. Harrison's article:

Corporate hierarchies

In a normal corporate environment, there is a strict hierarchy in which those at the top earn more than those at the bottom. In order to rise to the top (and earn the salary and huge bonus – I might add), one needs to be considered successful. And that means putting in years of effort for which one receives performance reviews.

If you do well on these reviews, you might even receive accolades, awards and so on – the point being you are a rising star with talent. So you get promoted. “The way you’re going, you might even rise to CEO one day!” That’s the kind of praise you might hear. So the whole hierarchical apparatus is designed to align high achievement with other external signs of success: good evaluations, promotions, more money, more responsibility, more underlings, larger budgets, awards, and accolades and so on. All you need to do is look at an org chart and you get a pretty good sense of who’s supposed to be the stars. And by the way, this is how it works in commercial banking as well.

Investment banking hierarchies

But, that’s not how it works in investment banking at all. When one deal or a series of trades can mean billions in profit, even a relatively junior person can have influence on the bottom line far beyond what her title suggests. This is certainly true in the advisory business, but it is even more true in trading – especially proprietary trading, a major reason that proprietary trading is inherently risky and would be restricted under the Volcker Rule. By the way, this is also a major reason that investment banks that are public companies and not partnerships are risky companies with notoriously poor managers.

A slovenly 32-year old junior trader with terrible social skills, zero management ability and no one reporting to him can make millions of dollars a year. He’s the guy you read about in the newspaper making three times the CEO’s salary. He’s the guy that all the other firms are trying to poach. And he’s the guy that used to be referred to admiringly as a “big swinging dick.” You don’t see that at Acme Incorporated. That’s what I mean when I say it’s all about the money. You learn very quickly in investment banking that status is not all about the titles, it’s more about the money.

Read any account from investment banking like Predator’s Ball or Liar’s Poker you will quickly notice that even the higher level guys are driven to earn a lot of money, not only for the money itself but for what that money says about their status and value relative to their peers.

You can read his full article on Seeking Alpha here.

Conservatives targeting their fringe

On the heels of the Scott Brown victory in Massachusetts, it looks like Republicans are finally learning that they don't need to kowtow to the far right. I wrote about the need for this back in October.

From the Politico article:

After months of struggling to harness the energy of newly engaged tea party activists, the conservative establishment — with critical midterm congressional elections on the horizon — is taking aim for the first time at the movement’s extremist elements.

The move has been cast by some conservatives as a modern version of the marginalization of the far-right, anti-communist John Birch Society during the reorganization of the conservative movement spearheaded by William F. Buckley Jr. in the 1960s and 1970s.

“A similar effort will be required today of conservative political and intellectual leaders,” former Bush speechwriter Michael Gerson wrote in his column in The Washington Post. “It will not be easy. Sometimes it takes courage to stand before a large crowd and proclaim that two plus two equals four.”

Read the full article on Politico here.

Capitalism, The System of

Given that I call myself The Raging Capitalist, I can't miss an opportunity to provide a good example of what the capitalist spirit is really all about. Such is provided in the linked article by David Brooks, particularly in his discussion of Lincoln and Hamilton. Brooks writes:

They rejected the zero-sum mentality that is at the heart of populism, the belief that economics is a struggle over finite spoils. Instead, they believed in a united national economy — one interlocking system of labor, trade and investment.

In their view, government’s role was not to side with one faction or to wage class war. It was to rouse the energy and industry of people at all levels. It was to enhance competition and make it fair — to make sure that no group, high or low, is able to erect barriers that would deprive Americans of an open field and a fair chance. Theirs was a philosophy that celebrated development, mobility and work, wherever those things might be generated.

Brooks' concern is that populist rage over abuse of the financial system will ultimately lead to the suppression of the capitalist ideals that have been so fundamental to our prosperity as a nation. His concern is valid, and the public's rage needs to be properly addressed, and without focusing that rage on a condemnation of capitalism itself.

Capitalists in no way want to turn a blind eye to those who have corrupted and co-opted our financial system. True capitalists aren't about gaming the system, or buying political influence, or hoodwinking the masses. They believe in the rule of law, creating open and fair playing fields, and allowing funds to easily flow between investors and entrepreneurs. Therefore, it would be high on the typical capitalist's agenda to want to dispense justice to those who have abused the financial system. However, those efforts need to be intelligently targeted and the penalties should be in proportion to the crimes (see my post on Obama's financial crisis fee). Similarly, we must enhance regulation, but we must take care to not strangle the system. We must ensure that risks taken with capital are in-line with investors' intentions, but capital must be allowed to flow freely. We must give the public free and fair access to the resources of the financial system, but we must not do it in such a way that checks and balances are ignored and unintended consequences result.

Importantly, we must remember that capitalism is a system. It has no political or social agenda. It doesn't think, or feel, or have opinions -- no different from the plumbing in your house. Attempts to weave the social agenda into capitalism (e.g., to make housing "affordable") have always failed, as they interfere with the "laws of nature" that apply to capitalism, such as having to live with the risks that you create. It is implicit in the capitalist system that its "users" -- the public -- can decide for themselves how hard they want to work, and how much risk they want to take. Some will succeed, and some will fail. Like Mother Nature herself, capitalism turns a blind eye to personal tragedy and hardship. Some will go out on a limb and run their own businesses, and others will choose to become human resources in those businesses. Capitalism makes no value judgments. Businesses generate profits, and their owners evolve into investors who bankroll the next generation of entrepreneurs. That's the cycle. That's how the system works. For all its harsh realities, capitalism is simple, self-correcting (when not interfered with), elegantly pure, and time-tested. We need to protect it with everything we've got.

Obama's Financial Crisis Fee -- sounds SO good, but oh, SO wrong

President Obama announced plans today to levy a “Financial Crisis Responsibility Fee” on the nation’s largest banks — those with more than $50 billion in assets. Basically, it will be computed as .15% (i.e., 15/100ths of 1%) of the banks’ liabilities, excluding deposits covered by FDIC insurance (because a separate fee is assessed on them).

To a revenge-starved public, this may sound SO right and be SO overdue, but it is SO wrong. Once again, Obama has proposed a solution — as he did with health care reform — that is so lacking in nuance that it is clear that he doesn’t truly understand the problem. Either that, or it’s simply more evidence that he’s in Goldman Sachs’ hip pocket.

So, what’s wrong with this solution? Answer: it penalizes conservative, well run institutions, and once again, lets those who are the real troublemakers off the hook. The troublemakers that are left alive, that is. Keep in mind that most of the institutions that caused the crisis are now out of business or were merged into more responsible firms and are now under new management. By far, the biggest culprit still standing — and thriving, as no financial reforms have yet been implemented — is Goldman Sachs.

Although Obama and the media refer to “banks” as a homogeneous group, it is important to separate routine commercial and consumer lenders from super-large “money center banks” (e.g., Citibank, BofA, Wells Fargo, and JP Morgan Chase) and Wall Street “investment banks,” the latter of which (e.g., Goldman Sachs) were not actually banks at all until the financial bailout. Although they’re called investment banks, they never had bank charters, weren’t regulated as banks, and didn’t have FDIC-insured deposits until Treasury Secretary Hank Paulson allowed them to convert into chartered banks in order for them to qualify for TARP bailout funds. It was a slight of hand to do a solid for his friends on Wall Street, plain and simple. The investment banks are the firms that engage in the most risky trading and derivatives activities, and such activities constitute a huge percentage of their overall businesses. Money center banks also engage in risky investment banking activities — “thanks” (I say facetiously) to the Clinton administration’s successful efforts to repeal the Glass-Steagall Act — but because they are so large and diversified in their activities, such risky activities are a much smaller percentage of their overall businesses. Even among the money center banks, however, some were much less careful than others in managing their risks: Citibank was perhaps the worst, and JP Morgan Chase seems to have been the best. Indeed, despite having a diversified portfolio of low-risk businesses, Citibank was nonetheless almost brought down by its relatively few higher risk businesses. (You remember the old saying about one bad apple, right?) Long story short, banks are very different from one another, and they need to be penalized based on the risks they take, not how big they are.

To illustrate the problem, I downloaded the September 30, 2009 financial statements for Goldman Sachs and a pretty “plain vanilla” large bank, U.S. Bancorp, from the Federal Reserve’s website. The financial statements show how much of the banks’ revenues come from routine banking activities versus high-risk trading operations, which are the “casino” activities that got us into so much trouble. Goldman’s assets as of September 30 were about 3.3 times greater than U.S. Bancorp’s, so I'll need to make some adjustments in my math for that. For the first 9 months of 2009, Goldman generated $28.3 billion of trading revenues and interest on trading assets. Essentially, rolling the dice, albeit, in a casino that they seem to have pretty much rigged most of the time, except for when things go terribly wrong. In comparison, U.S. Bancorp generated a paltry $125 million from trading. This is a staggering differential. Adjusting for the difference in the sizes of the two firms, for every dollar of assets deployed in their businesses, Goldman was conducting about 68 TIMES more casino activity. This helps put the difference in the nature of these two banks into some perspective. Relatively speaking, one is like a plodding old electric utility, whereas the other is a powder keg waiting to explode if any of its risk assumptions prove to be faulty, which is exactly what happened in 2008.

Recall, however, that Obama’s proposed fee will be based on liabilities exclusive of FDIC deposits. Granted, that helps equalize things just a bit, in that such deposits make up a much larger percentage of U.S. Bancorp’s liabilities. In other words, it will get a much larger exclusion from the fee than Goldman precisely because it is a more conservative institution, which is exactly what we want. Even so, however, when looking at casino activities for every dollar of liabilities to be taxed, Goldman is still conducting 25 TIMES more casino activity than U.S. Bancorp. Yet, they will both pay exactly the same fee on each dollar of assessed liability. Not exactly fair, is it? Relative to what it makes on high-risk activities, the fee/tax Goldman will pay will be insignificant.

Granted, I’m a financial professional, but it took me all of about 15 minutes to do this work. Importantly, though, I took the time to validate what I suspected intuitively. As I said in my second paragraph, solutions can sometimes seem so obvious and so clear, and yet be entirely wrong. This is an obvious trap to anyone who has ever done any serious analytical work, so trained professionals are always on the lookout for the biggest booby trap of all: things you think you know, but really don’t. That’s why solutions should be based on real analysis, conducted by bona fide professionals who know how to maintain their objectivity. As I have stated in previous articles, important decisions should not be based on hearsay, anecdotal evidence, or preconceived notions. Popular, but erroneous, decisions may sound good, but they don’t solve anything, they’re often unfair, and they often encourage the exact opposite behaviors of those we really want.

I know I sound like a broken record, but we simply need to demand a higher quality of work from our government.

Big surprise: Geithner lines Wall Street's pockets again

Well, speak of the devil (in reference to my previous post), Tim Geithner comes through again... for Wall Street, not the American people.

Once again, Bill Black provides a cogent narrative of the latest shenanigans. Is Geithner just the most incompetent boob to ever hold an office, or is he the devil incarnate? I'd love to say that time will tell, but somehow I think this guy will always be two steps ahead of the law. No one in Washington seems to be interested in holding him accountable.