Oh almighty Schumpeter, what ye say is wrong with our markets?

by Christopher Bounds

To find an answer to the roller coaster ride the major indices gave us this week, we will look to the writings of Joseph Schumpeter (pictured) and the other Austrian School economist.

First, this week a long awaited announcement was made by the S&P Credit Rating analysts that over $1 TRILLION of AAA-rated outstanding debt may not be AAA-rated. This mishap will spell problems for all of us. Friday's news release of new home sales being down "substantially" is nothing new to anyone. Yet little is understood regarding the implication of this fact, at least as reported in the media.

What I call "The Greenspan Push", names the most profound series of events this century will endure. While Chairman of the Federal Reserve, Mr. Greenspan set the financial markets on a new course of action. Historically when banks make loans they have to protect themselves against the risk of loss those loans bring. This was done by holding sufficient reserves of gold, then when the gold standard was dropped in the early 1970's, it was accomplished by holding sufficient reserves of cash and "risk free" U.S. Treasury bonds. Then came Mr. Greenspan's Push. Under his regime, the banking industry changed in the way that they account for that risk of loss. By "Pushing" the risk out of the banking industry and into the Investment market, the banks were be able to substantial lower their liabilities...as they issued the loan and sold (or bought against) the risk of loss. By creating derivative instruments, what you may have heard in the news as "Mortgage-Backed Securities (MBS)", "Collateralized-Debt Obligations (CDOs)", "Default Swaps", "Credit Swaps", etc, all of which are essentially insurance policies against loan losses. The same as when you buy a car and purchase auto insurance coverage to "Push" the risk of loss away from you and to the insurance company. And in freeing up the reserve ratio required by banks to hold...a percentage of assets to liabilities...the banks are able to write more loans, because they "Eliminated" the prior liability while holding the asset.

No way, how is that possible? Why would the investment industry cooperate? Well as you know it is not legal to use borrowed money to invest in the stock market. Because the markets are to risky for the use of bank funds, you must use margin to accomplish leverage and that level is limited to $0.50 on the $1, allotted to certain types of securities. When added to all of your marginable assets, your leverage ratio is 1.5 to 1. Meaning you can buy $150 of something per $100 of marginable assets. When banks create derivatives they are rarely "pure" instruments, meaning that if a bank writes a $10 million loan to GE, which would typically be syndicated meaning that the bank would put up $4 million, another bank $4 million, $1 million from another bank, and $500,000 from two others. The GE loan would rarely be sold in full, the bank would "strip" the GE loan into 1000 equal parts ($10,000 each) and add each part with other "stripped" loans made to other clients. Typically the basket of loan strips would contain a high level of high grade debt...such as U.S. Treasury bonds...by combining T-Bonds with loans to customers with good credit and to those with bad credit the rating on the basket would be relatively high. When a basket of this type, a MBS or CDO, is marketed to the investment industry, typically to hedge funds and Mortgage Real Estate Investment Trusts, the leverage ratio is sky high so long as the basket credit rating is high. It is standard to borrow 15 to 1 when buying AAA-rate derivatives, meaning a fund can borrow $15,000,000 per $1,000,000 of assets. And because the basket holds a large number of U.S. Treasury bonds, the risk of default is artificially low, as the ratings are dependent on the "odds" of default and not the odds of partial default. An average spread on a loan might be 3%, the difference between the Fed Funds Rate (5.25%), which banks borrow from the Federal Reserve, and the Prime Rate (8.25%) at which banks lend to their best customers. When you strip down, combine, and sell the risk of losing that 3% spread to a fund borrowing 15 to 1 to buy it, they (the funds) earn 15 times 3% = 45% on their money.

Where does the 15 to 1 money come from? The banks. By originally writing risky loans to sub prime borrowers, then stripping and combining them with enough low risk debt that the total earns a AAA-rating, the bank sells the original loans to the investment funds by writing them (the funds) new loans secured by the basket of loans. Since the basket is of a good credit rating, the banks can write bigger loans for these instruments as they are rated higher even though, collectively, they are the same (baskets containing) good and bad loans. Plus, since banks make much higher fee's underwriting loans than just collecting the interest on them, they have a great incentive to quickly get ride of low risk loans and sit on the high risk, high interest rate ones, while selling enough stripped loans to lower their risk, and getting back the higher rated basket as collateral to keep the process going. All of this possible because of the never ending printing press of money at the Federal Reserve. It also brings up political questions as to whether the government should continue manipulating the economy, by printing money at will and adjusting interest rates artificially. As the loan market starts to overheat, the bad loans begin to default, and all of those baskets start "leaking" value, as their streams of income drop due to the defaults, their ratings will drop. And when a system so dependent on the process of fluidity...lots cash transferring hands rapidly...the banks will realize that they have far too many risky loans, either as assets or as collateral, even to the point of their obligations to depositors outnumbering their dependable assets. At this time a shiver will be sent through the world in the sense of the nineteenth century bank run. As people realize that their money in banks, and their retirement (because pension funds are the largest investors in hedge funds) have been recklessly managed, they will demand withdraw. At that point people will learn of the fact that, by definition, the bankrupt banking industry's use of fractional reserves...only holding a small percent of assets to liabilities...will be unable to pay the people's due money, unless the Federal Reserve prints that much more, diluting to value of all the cash already present...and raising our costs as most commodity markets are priced in US dollars...giving great discounts to foreigners.

This should serve as a wake up call to our political and economic leaders. Because, of the fact that the Greenspan Push was likely not intended to be deceitful, it was more likely a symptom of "elitism". The old argument of does higher income bring prosperity or does prosperity bring higher income, is in full effect. As Schumpeter wisely stated that Capitalism will serve as the source of its own demise, entrepreneurship is the only element to prevent the destruction of capitalism and the onset of socialism. This is proved by virtually all of the gains and new money printed by the push, being retained by the wealthiest or most productive individuals. The "creative destruction" of the economy, as required by Schumpeter, evidenced by new industry creating new services and employing new groups of people...destroying old industrial lines and employment sectors...has not been effectively present. Blockades in the economy in terms of minimum quotas (labor unions, government spending, minimum wages, etc) and preferential treatment (government spending, taxes, licensing, government printing money, etc) adds difficulty to entrepreneurship.

What elitist would believe, that a retailer could earn more money by focusing on the poorest of consumers? Well look at Wal-Mart. That is the focus politicians should have, eliminating political blockades. Because once again the belief of money creating its own demand fails, only the use of money will determine the demand. As the economy moves away from productive use...giving too much to those who waste it or wont pay it back...it will not create a sustainable appreciating demand. Resulting in the process needing to correct. No matter if its in the form of loans to sub prime borrows, taxes paid to wasteful elitists, or whatever...I say that the people earning the money should have the decision to waste it or not, rather than the banks and politicians doing it for us. Leave the economy with as little centralization as possible, so parts of it can respond to the parts with ailments, while earning reasonable profits...Adam Smith's "Invisible Hand". Otherwise, socialist Hillary Clinton-type economic centralization will continue to build momentum in effort of solving the problems associated with socialist economic centralization.

HAIL TO THE CHIEF

Former presidents cost U.S. taxpayers big bucks; tab from 1977 to 2000 is pegged at $370 million

By BENJAMIN ALEXANDER-BLOCHBLADE STAFF WRITER

http://toledoblade.com/apps/pbcs.dll/article?AID=/20070107/NEWS09/70107004

The presidency of Gerald Ford was unlike any other in U.S. history. He was the only president never elected to the office, and he was the only president to pardon another president.He held another distinction after he left office — he received the biggest federal pension of any former president.Besides the $183,500 he received last year from his presidential pension, Mr. Ford also received $120,247 in a congressional pension. Former Presidents Jimmy Carter, George H.W. Bush, and Bill Clinton each received presidential pensions of $183,500 last year.Mr. Bush also received a congressional pension estimated at $65,000 a year.Presidential pensions are rising to $186,600 this year.Including the cost of Secret Service protection, ex-presidents’ personal allowances totaled $370 million from 1977 to 2000, according to a 2001 federal report.The federal government began paying former presidents an annual “allowance” in 1958 after Congress decided former President Harry Truman should not have to answer his own mail and buy his own stamps. Because of his financial limitations — he had an Army pension that paid him $112.56 a month — Mr. Truman was unable to staff his office, according to the Library of Congress.The Former Presidents Act of 1958 was established to help ease former presidents back into private life and was retroactively applied to the two living former presidents at the time — Truman and Herbert Hoover.

Congress set a pension of $25,000 a year for former presidents in 1958, but that has grown steadily over the years. The General Services Administration reports presidential pensions will reach $188,000 in 2007. They are now pegged to the salaries of current cabinet officers.Pensions for former U.S. presidents are comparable to the pensions for former leaders in Great Britain, while Canada’s elder statesmen get substantially less.Prime Minister Tony Blair reportedly will receive about $343,000 annually as an allowance, which includes costs to maintain an office.In Canada, former prime ministers’ pensions are tied to the amount of time served. If they were in office for at least four years, they are given an allowance of two-thirds their annual salary — or about $90,000.In addition to pensions, former U.S. presidents receive annual office allowances to pay staff salaries and benefits, office rents, printing, stationary, local and long-distance telephone service, travel funds, and of course free use of the mail.Mr. Ford, who died on Dec. 26, spent $17,000 on office supplies in 2006, more than any other former president.In addition to his love for pens, pencils, and stationery, Mr. Ford did his fair share of traveling. He tallied up $45,000 in travel expenses, more than Jimmy Carter, but less than George H.W. Bush’s $54,000 and Bill Clinton’s $63,000.In 2006, Mr. Clinton also ran up quite a phone bill — $75,000. This topped any other former president by $60,000.And despite all the office supplies, Mr. Ford evidently wasn’t using them to write letters, spending the lowest on postage at $9,000.But none of this compares with the cost of Secret Service protection for former presidents, estimated in 2000 at $24 million a year, according to the 2001 federal report.In 1985, former President Richard Nixon terminated his Secret Service protection. According to a 2002 Saturday Evening Post article written by his daughter, Julie Nixon Eisenhower, her father gave up the round-the-clock protection because of his concerns about the costs to taxpayers.

But questions are being raised about whether today’s ex-presidents need the government funds they receive.Now multimillionaires, many sitting on corporate boards and receiving more than $100,000 for speaking engagements, ex-presidents are no longer in the Harry Truman mold.Pete Sepp, spokesman for the National Taxpayers Union, wonders about “the exorbitant level of presidential pensions in an age where ex-presidents are solid gold.” “The presidential pension system is probably the only system of perks that outdoes the cushy benefits for members of Congress,” Mr. Sepp said. “In an age where ex-presidents can rake in millions of dollars, it seems pointless to guarantee them a system of extremely lavish lifetime benefits.”Yet President Ford received about $304,000 in pension money from the federal government in 2006, according to the taxpayers union, a nonprofit organization based in Alexandria, Va., that works for lower taxes, restrained federal spending, and accountability.Mr. Ford’s congressional pension stems from his representation of Michigan’s 5th District in the House of Representatives from 1949 to 1973. He was House minority leader for eight years before being appointed vice president in 1973 after Spiro Agnew resigned. Mr. Ford then became president when Mr. Nixon resigned Aug. 9, 1974.While Mr. Ford was in office for only 2½ years, Larry Sabato, director of University of Virginia’s Center for Politics, said Mr. Ford deserved his full pension because “these weren’t easy years.” But he says one day the allowance system may run into problems.“One day we will have someone that serves [as president] for just a week or two… and then what are you going to do? Does that monthlong tenure entitle him to all these perks?” Mr. Sabato asked.George H.W. Bush is now the only ex-president to receive a congressional pension. Based on his four years as a Texas congressman, two years as United Nations ambassador, two years as chief of the Central Intelligence Agency, and eight years as vice president, he will receive about $65,000 this year in a congressional pension, on top of his presidential pension, according to the National Taxpayers Union.The U.S. Office of Personnel Management said the specific amount of a congressional pension — not presidential pensions — “is protected information under the privacy act.”Mr. Sabato said that while “presidents are being paid so lavishly” there are reasons for the federal expense.“We saw a six-day funeral for Gerald Ford. Presidents are obviously very significant people long after they have served in office,” he said. “We don’t have a royal class in the United States, but presidents come close.”
Presidential offices

The federal government provides former commanders-in-chief with office staff and “suitable office space, appropriately furnished and equipped, at a location within the United States designated by a former president, for the rest of his or her lifetime,” according to a report by the General Services Administration.By law, staff salaries are capped at $96,000 a year, but former presidents can pay for additional staff out of their own funds or through foundations they set up.According to a 2001 federal report on former presidents’ spending habits, offices of former presidents had anywhere from 6 to 19 employees.Although staff members are not considered federal employees, they are eligible for federal retirement and health insurance.Both Mr. Ford and Mr. Bush maintained primary offices in addition to summer offices in other locations, according to the 2001 report. Mr. Ford’s primary office was located in Rancho Mirage, Calif., and his summer office was in Vail, Colo.Mr. Bush’s primary office is in Houston and his summer office in Kennebunkport, Maine. Mr. Carter’s only office is at the Carter Presidential Center, in Atlanta.The federal government pays the highest office rent for Mr. Clinton’s lease on a Harlem penthouse suite. He was initially considering a Manhattan apartment that would have topped $800,000 a year, but, after a media frenzy, he looked elsewhere.Mr. Clinton’s office rent will cost taxpayers $498,000 in 2007. The next highest office rent is Mr. Bush’s at $175,000.In 1994, the Former Presidents Act was amended to only permit staff and office allowances for former presidents to last up to five years. But, in 1998, just before the provision would go into effect, lifetime staff and office allowances were restored.Mr. Ford lobbied Congress to reinstate this lifetime allotment so he could keep his office in Rancho Mirage, Calif.

A matter of protection
In addition to federal pension and retirement allowances, former presidents receive, Secret Service protection, medical expenses, and state funerals and burials with military honors.The Secret Service does not disclose protection costs for former presidents for reasons of security, but a 2001 federal report said Secret Service protection for former presidents cost a total of about $24 million in 2000.In 2000, the Secret Service was protecting former Presidents Nixon, Carter, Reagan, and Ford, their spouses, and Lady Bird Johnson, widow of former President Lyndon Johnson, who died in 1973.Lifetime Secret Service protection for former presidents and their spouses began after President Kennedy was assassinated in 1963. But the protection is now limited to 10 years by federal law for former presidents who began their presidential terms after 1996 — meaning that as the law stands today, Mr. Carter, Mr. Bush, and Mr. Clinton have lifetime Secret Service protection, but that protection will end for President George W. Bush at the start of 2019.In 1994, the Former Presidents Act was amended to authorize the federal government to give each former president up to $1 million annually, and his spouse up to $500,000 annually, for security and travel-related expenses if needed after the 10-year term of Secret Service protection expires.
After death Federal law does not treat former first ladies nearly as well after their husbands die.A presidential widow is provided a $20,000 annual lifetime pension plus “franking” privileges, to send mail free of charge.Ms. Johnson, 94, is the only former first lady receiving a presidential widow’s pension.To receive a pension, a presidential widow must waive her rights to any other federal pension.For this reason, Betty Ford likely will refuse the presidential widow’s pension and instead choose her other option, 55 percent of Mr. Ford’s congressional pension, or about $65,000 a year.

The libraries
Besides presidential pensions and other postpresidential expenses, the federal government pays to maintain and operate presidential libraries.They must be built with private funds, but the National Archives spent about $97 million in 2006 to operate the 11 presidential libraries. And the archives likely will add a 12th library this year, taking the currently privately funded Nixon Library in Yorba Linda, Calif., under its federal embrace.Contact Benjamin Alexander-Bloch at: babloch@theblade.com or 419-724-6168.

"The dollar is a basket case," said Peter Schiff, president of Euro Pacific Capital Inc. "We are going to pay the piper for years of having the underlying fundamentals of our economy disintegrate beneath our feet."

Euro Hits New High Against U.S. Dollar

...So, call your banker and ask if you can convert your deposits to Euros or British Pounds! Buy select stocks that are based in Europe, select (international-non US) commodity stocks, futures contracts, or very short term treasuries...3-month.

**Click on chart for larger view

Artificial Money Supply Inflation with the USE OF REPOs (Repurchase Agreements), very similar to the Federal Reserves purchase of Acceptances during the 1920s...And its effect on the markets.

M3=M2+CDs+Eurodollars+REPOs (the biggest portion by far)
M2= M1+Savings Accts+Money Mkt Accts+Small Time Deps+CDs (under $100,000)

M1= M0+bank "vault cash"+demand "checking" accts

M0= physical currency+accts at FRB

*This chart is the proportion of M3 to GDP

* And GDP

* 1971, Nixon officially drops Gold Standard in the US allowing gov to print money at will. Note M3 (from chart No. 2) jumped from 60 to 70% of GDP during the prior 2 yrs. Nixon blames the change on unmanageable inflation even though the money supply to GDP increases 17% within two years. Alan Greenspan is an Advisor to Nixon, on the Council of Eco Advisers 1974-77 and Fed Chair 8/11/1987-2006. Bond market has biggest one day drop in 5-yrs after he is confirmed.

* A debt financed revolution, 1980-2006 total debt in US to GDP goes from 140% (in 1980) to 285% (in 2006), approx. Of which federal gov proportion drops from 20% to 13%, meaning the Federal Reserve member banks benefit from very fast growing consumer (and therefore other financial sector) indebtedness

*The extra money supply created brings down interest rates on both the 3-month TBill and the 10-year Note

* The excess money finds its way to the "far from consumer" industries making up the "High Order sectors of production", in this case the S&P 500 index compared to the 10-yr Note interest rate. 9/22/1985, The Plaza Accord is signed=5 major industrialized countries agree to depreciate the Dollar v. the Yen & Mark (causes the Japanese asset price bubble of the late 1980s (& helped with the US's in the 1990s))

*Here is the Dow Jones industrial average, Note Chart number 1 (above) shows M3, well the private equity and hedge fund industries used REPOs to finance their stock market activities...increasingly after 1999' crash, Greenspan stated is objective of "spreading liquidity", and look at the volume portion of this chart following its employment.

In 2006 the Federal Reserve stopped publishing (and measuring) M3 because they said it's cost out weighs its benefit, saying that the velocity of money, the rate at which money transfers hands, takes precedence over needing to maintain the money supply to the time preferences of the public, i.e. the savings-consumption rates of the economy. Regardless to the fact that the Federal Reserve and its 21, hand picked, primary dealers make up nearly all of the velocity. As did the Federal Reserve and member banks did in the 1920s and 30s.

In the Austrian theory of the boom-bust cycle, monetary intervention, specifically the expansion of bank credit, causes a “cluster of errors” in business investment throughout the “orders or production”. In the economy some of the money is spent on consumption with the remainder being saved and invested throughout. The proportion of consumption to savings and investment is based on the population’s time preferences, the less present preference the public has, i.e. the less consumption, the lower will be their time preference rate and therefore the lower will be the pure interest rate. This low preference will reflect a greater proportion of investment to consumption, a lengthened structure of production (in terms of the furthered allocation of funds in industries far from the consumer), and a buildup of capital with lower loan interest rates. As new money created by banks via the Federal Reserve’s expansion pours into the loan market, it lowers the loan rate of interest, because the supply of funds in relation to the rate of profit in business and the purchasing power of the currency is raised, business takes advantage of the cheaper money and invests in what they believe to be more profitable production lines.

But if the increase is due to credit expansion instead of a change in time preferences; as the new money streams through the economy and trickles down to the consumer by way of higher wages, rents, and basic inflation. Business will need to gamble on whether the new excess of funds were due to a real change in time preferences, which will result in justified credit expansion, or artificial money growth resulting in the public allocating their newly inflated money base into their old time preferences, thereby creating “clusters of errors” of business investment that’s not justified by time preferences. The Federal Reserve under Alan Greenspan claimed that the economy can absorb the expansion by using the funds to further productivity and raising the rate of profit and thereby the purchasing power of the dollar. However as the banks allocate their newly inflated monetary base into areas of the economy with higher rates of return…to riskier recipients…the flow of capital would neglect the lower orders of production, i.e. commodity markets.

Under the direction of the Fed, and with the use of derivatives, banks transfer the increased loan risks throughout the economy, however the risk is just that…transferred not eliminated…and it comes to a question of who is it transferred to…stronger hands or weaker hands? As time passes by and the economy realizes that time preferences have not changed enough to justify the broadened allocation of funds…reflected by the lower (neglected) orders of production receiving inflationary pressures by the inflated “higher orders of production” and the consuming public.

Today it looks as if the “higher orders of production” receiving the excess funds are the financial markets itself. The private equity & hedge fund industries are inflating the stock market by bidding up companies to quickly extract years worth of value and future earnings. Several sectors of the stock market are overvalued…reflected by its capitalization rates vs. the yield curve. “Low order sectors” such as consumer goods, commodity, and food and beverage providers (close to consumer sectors) are so highly valued that not only is there no risk premium but there is in some cases what would appear to be risk discounts, relying on earnings growth in the near future or higher interest rates. On the other side of the pivot, if the fed raises interest rates or cuts the money supply, it would put recessionary pressures on the economy as tightening an already weakening and bloated economy is troublesome. That is not to say every sector or every stock is bloated. But the amount of debt created liquidity that has propped up the financial markets is in my opinion unsustainable unless Schumpeter’s creative destruction ever steps up to the level that the Fed believes our businessman should be at, or if foreign time preferences shift to much higher levels, to where they will step up the acquisition of capital goods from us, without so, the over-priced sectors of the market will need to adjust for reality…the bust part of the cycle.

A unique situation to our chapter in history is the leadership derivative exchanges have on general prices. The Crude Oil market at the NYMEX currently has listed, or open interest of, about 955 million bbls of oil for the front 12 months, and in which time the consumption of oil in the US alone is almost 10 times that figure. Yet the industry uses the quotation as its basis. One contract of Crude Oil is 1,000 bbls at around $66/bbl, but margin requirements are only about 10% or $6,600 per contract. So for a mere $660 million one can control 100,000,000 bbls of oil or over 1 day of world consumption. This is similar to what the hedge fund Amaranth Advisors accomplished, before they imploded. Amaranth controlled enough Natural Gas to supply the entire United States for several days. The price inflation, while building up that massive position, heavily impacted the end users of Natural Gas, as did the deflation after their demise. The volatility adds risks and businessman respond by accounting for them with price hikes or market avoidance. Once the error in the market reveals itself…either that the large budget for inputs were artificially high, and an excess in corporate profits are present, or that the futures market proved to be incorrect (in its pricing), following more of a momentum based technical trade pattern than the realistic relationship of supply and demand the market compensates the owners of capital with higher wages, that are invested through different time preferences…confusing as to whether they’re one time wage gains or recurrent payroll increases. Also, this is demonstrated by a speech Greenspan gave in 2005 praising the financial markets for “opening up credit” to the sub-prime mortgage market and that the extension of financial services to that sector will benefit all…as it did with higher house prices and equity buildup, yet when the market realized that the extension and price inflation was overdone…by way of sub-prime borrows being sub-prime borrows unable or unwilling to service their debt, the market pulled back.

The bottom line is this, in my opinion, it’s not a sign of strength that the credit cycle is peaking at 5.25% or around that, and with capitalization rates so low, basically no risk premiums, T-Bills discounted to the Fed Funds rate, and continued talk of policies that should increase risks…ethanol is more risky than petrol as agricultural production is more volatile and weather dependent than petroleum’s volatility based mainly on transportation risks. More and more inefficient centralization through government or patrons of the stock market will mark more errors that will need to be liquidated at some point in the future. Yet as history shows, more of it has to do with perception rather than reality. Recession and depression could be a good thing…it liquidates the inefficient participants in the economy, while deflation lowers the cost of living, cost of business, opens up opportunities, fixed income groups are ruined during inflationary times…and so they receive a total benefit during deflation. On the other hand, people can exaggerate reality and cause panics and stints of unwarranted ruin, resulting in a question of time preferences.

Boston Properties (BXP) serves as a fine example of time preference. The company is a real estate investment trust that I bought in August 2001 to take advantage of strong fundamentals in the high end office market. Today the capitalization rate on its FFO (funds from operations) is about 3.8%, illustrating that either time preferences have lengthened, that the market will demand much more office real estate and if not built rental rates will go up. Or that credit expansion caused an abundance of liquidity in the debt markets, allowing for inflation and leaving investors wanting tangible assets for protection, meaning market demand does not warrant an inverted cap-rate to treasurys and the disequilibrium (“error”) will need to correct one day.

The Prisoner's Dilemma (in PDF)
Blind Faith (in PDF)

Origion of the Whiskey Ring

Not the same specifics, but the ideals imposed on today's financial/political scene