Monday, October 13, 2008

Rescuing Creditors?! ... Setting An Empty Table

I read two interesting commentaries today. There is a piece in the Financial Times by George Soros titled "How to Capitalize Banks and Save Finance." There was also a piece by Michael Hudson over on Counterpunch. The Soros piece argues that the US Treasury should ask banks how much money they need to reach their capital reserve requirement of about 8%. Then, trusting that the bankers have not gilded the lily, send them some cash post haste in exchange for special company shares of stock that would protect shareholder value by not really counting as normal shares. The idea behind this and similar schemes (a similar scheme is, in fact, in the works) is to get the financial institutions to a place where they can extend more credit to a troubled economy.

Michael Hudson essentially covers the same ground in terms of describing the assorted and sundry "rescue operations" currently in the works. But Hudson is not happy about any of these schemes. They are, in effect, schemes to allow those who have profited hansomely over the past few decades to either (1) reflate the debt pyramid and profit some more using a business-as-usual bag of financial tricks, or (2) allow these same high-fliers enough cover to sell the toxic crap in the bank vaults to a greater fool and send the profits into various private accounts and leaving the remaining smoking heap to whatever fool takes it off of their hands (in this case, the United States Treasury -- and its tax payer).

But, Hudson adds more than just about anyone in the financial press has been discussing in the past several weeks. Hudson summarizes his reading of the schemes,
Making banks and insurers in the zero-sum derivative game whole, so that winners can collect their bets while losers can sell their bad investments to the Treasury, is supposed to re-inflate the credit pyramid. The idea is to solve the debt problem with yet more debt to prop up housing prices once again to unaffordable levels! This is not a long-term solution, but it would give insiders enough time to arrange a do-over and get out of the game more quickly, to sell out their junk mortgages and junk bonds to the proverbial “greater fool” – in this case, the “greater fool of last resort,” the U.S. Treasury.
But, and this is the part no one else talks about very often outside of the financial blogs,
The banks are to “earn” their way out of their negative equity position by selling more of their product – credit – to increase the economy’s debt levels and hence receive more interest payments. The problem is that most families are already “loaned up.” They have no more discretionary income to pledge to carry more debt. Without writing down their debts, there will be no fresh lending, and hence no source of credit and purchasing power for new autos, appliances, goods and services in general.
So, the idea is that we need to "make the banks whole" so they can start reflating the global debt bubble by offering minty fresh new credit to consumers around the world. Soros even suggests that once the treasury has recapitalized the solvent financial institutions to the 8% statutory capital requirement, that regulators allow them to lower minimum capital requirements so that they may once again loan out all of their capital and then some. The main goal, it seems is to get the credit out there and get it out there soon!

Ah ... but Hudson has thrown a wet blanket on the whole scheme. Debtors can not swallow more credit. Bankers can pretend that if they hand out credit to over leveraged borrowers, that the debtors will take on new debt, but wishing cannot make it so. So, the inevitable situation is that some creditors will be willing and able to extend the credit ... but the amount of new debt that borrowers take will not out pace the rate of credit destruction that occurs naturally when borrowers pay down their debts. New credit must constantly be introduced into the system to (1) replace the credit that is removed when borrowers make their payments and (2) cover the amount of interest owed on past credit extended. But, when borrowers cannot or will not take additional risks in betting on their future prosperity, new credit cannot bet turned into new debt at levels that will sustain the system at its peak, much less keep it growing. Doug Noland estimates that 2 trillion dollars of new credit must be created this year alone to keep the party from cratering. He's not optimistic (but hopeful). So, debt deflation is the inevitable outcome.

Ah ... so there's the 800 pound gorilla on the bankers table. They scream for any sort of state support to prop up their business, refusing to take any more losses after a decade on mindless financial shenanigans. They hope the consumer can swallow more of their junk to keep the current business model in place at least long enough to keep their net worth positive while off loading their bad bets onto the state. But, the real economy cannot possibly cooperate with the fantasy economy known as global finance. I suppose reality does bite after all.

Sunday, October 12, 2008

Reading about Finance in the LA Times 1 (part 1 of an ongoing series)

This is the first post of an ongoing series to see how finance is discursively* created in the mass media. Mostly, in the Los Angeles Times, since it is the Southern California paper that I read daily.

There is an interesting piece in the Oct 19, 2008 issue of the LA Times, Business section, entitled, "Sure, it's scary, but resist the impulse to flee, advisors say" by Josh Friedman and Peter Hono. The basic story here is that financial advisors are getting calls from their clients who are worried about losing their investments in the equities market and who would like to move their money to 'safer' investments (i.e., those investments that don't risk losing value over time). Here's a typical story in the piece,
Investor Mark Adelson sensed trouble in the stock market last month and decided to bail. The 59-year-old San Bernardino resident moved about $100,000 out of several stock funds into a corporate bond fund.

A couple of weeks later, Adelson, an engineer, decided the bonds weren't safe either, and he now has that portion of his nest egg in a money market fund.

Adelson is aware that most financial advisors advocate staying put during market downturns. But he really felt he had to do something to safeguard his retirement funds.

"I understand you can't really time the market, but I just feel uncomfortable leaving my money somewhere when I see the bottom dropping out," he said.
Adelson is looking to 'safeguard' his investments, essentially trying to find a class of investment where "the bottom" won't "drop out." Seems like a rational attempt to mitigate his losses to me.

The financial planners interviewed for the piece recognize that these are critical times for the investment minded. There is a belief that the risk for some sort of financial collapse is quite high at the moment. Bob Smoke is interviewed about the US Gov't plan(s) to "bail-out" the banking industry. He is quoted as saying,
"If this isn't done correctly, our whole system could come apart," Smoke said. "If banks can't lend money, we're going to have so much panic in the streets. We already have so many people out of work."
Smoke is implying that should the Federal Government's efforts fail, "panic" will take over "in the streets," implying that people will make irrational choices en masse perhaps moving their investments out of riskier classes all at once!

The story claims that it is a "natural impulse" to want to "do something" during times of great financial upheaval. So, the advice given here is to,
"guide clients into new, more conservative places to park just a portion of their assets, while leaving the rest in place. That way, people can feel as if they're doing something while avoiding selling their entire portfolio at the bottom of the market."
Note the emphasis here on the ability to "feel as if they're doing something" while not really doing anything of substance. The argument being that, in the long run, equities will always return the best rate of return on your investments. The other argument being, not to sell at the market bottom.... The irony being you are also warned about selling at the market top!

The logic here is to keep your invested money in place, to trust that the "system" will provide in the long term. For the anxious many, the advice is to do little things that make you feel less anxious. Brent Kessell (another financial planner) offers this advice to assuage investor anxiety,
Rather than shift investments during downturns, Kessel believes, people are better off cutting their spending 5% to 15%. Doing so, he said, "has a huge effect on financial security. If you decrease your spending, you need a lot less to retire."
Kessell is arguing that investment portfolios should be left to the market managers, while consumers manage anxiety by cutting consumption. Naturally, this would also have a HUGE impact on consumer spending (which amounts to about 70% of US GDP each year). While this is a gross simplification, this line of reasoning suggests that it is much better for the national economy to suffer a 3% to 10% decline in GDP rather than encourage investor's moving out of equities.

The piece closes on a bullish note, citing comments made by Mark Wilson, a planner for an ironically titled firm called the Tarbox Group.
Mark Wilson, vice president of planning firm Tarbox Group in Newport Beach, said he had seen some signs that stocks are undervalued -- which means that they could come back. Investors who buy undervalued stock in healthy companies now might profit when the market turns around, he said.
Note the overall trajectory of the news story.
  1. It starts with the idea that investors are nervous about keeping their money in risky asset classes like stocks. Some of these investors would like to move their money into lower risk categories like bonds or money market funds.
  2. The story moves on to financial planners, who are presented as expert managers of personal investments, their advice is to make little symbolic changes, while keeping the lions share of investments unchanged (notably those investments in stocks).
  3. The story finishes with a wholly bullish endorsement of equities by a financial planner, people who buy stock now "in healthy companies" might profit "when the market turns around."
In general, this story seems to fit a pattern that is very familiar in American culture.
  • That people should invest their money and take a risk in losing it.
  • That investments should generate a positive rate of return, year after year without fail.
  • That when people see their investments losing money, they "naturally" fear losing their investments and "impulsively" act to protect their money from further loss. But they are then advised to "stay the course" that, in the long run, they will see a "profit."
  • That investments should be entrusted to "the market" (meaning stock market) and its managers, who behave rationally and so do not act on "natural impulses" and "fear."
What is not overt in this story is how the market managers are positioned to profit from this advice, in the long run. Moreover, it is not clear whether or not anyone has any idea as to why there is a financial crisis at this time, with the notable exception Bob Smoke's comment,
"If this isn't done correctly, our whole system could come apart," Smoke said. "If banks can't lend money, we're going to have so much panic in the streets. We already have so many people out of work."
Smoke is worried that banks need to be able to "lend money" and if they cannot, "our whole system could come apart." Smoke is alone among his peers in this piece however, the other financial planners are of one mind: don't move your money around too much ... that locomotive that appears to be headed straight for you is likely only a figment of your anxious mind ... Indeed, now might be a good time to put more of your money right down in the middle of the train tracks, because you might profit when that train (the market) "turns around."

But, Smoke's comment is quite revealing, in the sense that it acts as a symbolic rupture in the otherwise dominant narrative of "stay the course," profit is inevitable, as markets always recover to the up side.

Smoke's comment suggests the precise reason for the bull market of the last 30 years, banks have been extending credit in greater and greater amounts. This is something called a "hyper-expansion of credit." Check out the following graph of credit market debt as a % of GDP from the St. Louis Fed.

1952 is a good year, because it is a relative low point after the credit hyper-expansion that preceded the deflation of that credit bubble in the 1930's (aka The Great Depression-- where credit debt reached about 270% of GDP). Note that where credit debt had remained relatively flat during the two decades between 1960 and 1978, the amount increased sharply after that.

What happened in the stock market during this period? Check out the following from

After the bull market of the early 1960's (and associated credit expansion), the overall S&P index flatlined for the better part of a decade, then just as credit expanded at the close of the 1970's, the S&P took off! That is until the dot com bubble burst in early 2001, this was followed by the real-estate boom that ended in 2006.

So, we are left with a question for our financial planners. Should we be planning for a boom in equities? A boom in any asset class for that matter? Bob Smoke seems to be on to something, the banks must continue the expansion of credit to keep the markets growing. Can banks do so? The total credit debt outstanding is now 350% of GDP. It has never been this high before!

Seems to me that the newspaper needs to review its assumptions. Running for the hills seems pretty rational given the current state of indebtedness. My bet is that banks cannot create more credit and individuals, businesses, and government cannot take on more credit debt (I owe Mike Shedlock & the mysteriously named ilargi and Stoneleigh a debt of gratitude for much of my understanding of these financial matters).

Bob Smoke's comments create an eruption in an otherwise business as usual piece of reporting that should command our notice, "our whole system could come apart."

In closing this post, I am reminded of a children's rhyme that seems more meaningful now than ever.

Humpty Dumpty sat on the wall.
Humpty Dumpty had a great fall.
All the kings horses and all the kings men,
Couldn't put Humpty Dumpty back together again!

PS: Don't read this post as investment advice. You are on your own in that endeavor!

PSS: Thought folks might like to see the pattern of nominal GDP growth for the period 1952-2006 to help make sense of the 1st graph above.

* Note: By discourse, I am thinking of how understandings of daily life are produced in the everyday use of language and symbols. Discourse is not merely in the symbols or language themselves, but emerges through the interaction between their authors and their readers. So, naturally, these investigations will inevitably involve my reading of the symbolic content, other may certainly come away with a very different interpretation of meaning.