Remember the Depression

In the book by Liaquat Ahmed, Lords of Finance, he recounts the major bankers whose actions through and post WW I led inevitably to the Depression of the 1930s. He also intertwines Keynes as a shadow like figure lurking in and out of the process. However he makes two interesting points.

First, one immediate result of financial instabilities of then and now is massive inflation. This inflation benefits some and disadvantages many. It benefits those with hard assets, the land owners, and it benefits the civil servant, since Government keeps raising their salaries and benefits. I can recall my mother's fear that after WW II we would face another Depression and that my father should take a job with eh Police Department as her father had worked with the Ports and Harbors Department. It would guarantee an income. The logic here befuddled me then and now. In New Jersey the State workers are now compensated at industry levels if not higher and their benefits are massive. This places a burden on the state taxpayers which is exploding. However we now hear outbursts from the people about the state workers and the state workers response are hostile, not a good way to deal with those who are putting gold in their mouths! It may be different this time around. But the ones who did poorly in the Depression were doctors, professionals of many types, and the laborers. Also not to mention the entrepreneurs just disappeared, and they and they alone are the engine that drives the US economy, more than any other country.

Second, the collapse of London as the world's financial capital occurred since the US, especially New York, was the financier of the European parties in WW I. This was the tipping point for the loss of London's preeminence. This time around the swap may be from New York to Shanghai.

In the Appendix, there is reference to a 1999 Time magazine cover story about "The Committee to Save the World" composed of Alan Greenspan, Robert Rubin, and Larry Summers. Somehow one always gets to the top and then descends again. The Camus tale of the Myth of Sisyphus as played out again and again. Clearly there is a mapping between the Lords of Finance and the Committee to Save the World, I leave the details to the reader.

Now back to the G20, one of my favorite issues. The BBC quotes Sarkozy as saying, "Capitalism must be given a new foundation!" The BBC continued:

"....As well as greater supervision of all financial markets and instruments, leaders underlined the need to reassess the issue of pay at finance firms. Mr Sarkozy added said people could "no longer tolerate the reward package system for traders and bankers". There has been much criticism of bankers' bonuses, which have been high despite their bank's poor performance. Leaders also said they wanted to crack down on tax havens. Ms Merkel said: "As far as uncooperative players, tax havens or areas where non-transparent business is carried out are concerned, we need to develop sanction mechanisms. These must be made very concrete," she said She added that a list would be drawn up "clearly showing which the uncooperative jurisdictions are.""

Sarkozy is playing a dangerous hand. He fells that France is in a strong position and that now he can dictate to all the others. Sarkozy is not DeGaulle. DeGaulle, a French father and Irish mother, was French. Sarkozy still is Hungarian in many ways. That results in a dissonances that must be dealt with, for it is a historical world view that will not lead to a safe conclusion for all.

The China People's Daily states:

"In view of the seriousness of the ongoing, surging global financial crisis, leaders participating in the meeting called for assuring, without fail, the success of imminent London financial summit. The crisis can be phased out only when the structural reform is done to the international financial system, they noted. At a news conference held at the end of the meeting, Chancellor Angela Merkel called for adopting a "sanction mechanism" to penalize "tax havens" and establishing a blacklist of those unwilling to adhere to the international cooperation prior to April 2. The incoming April London Summit, the follow-up meeting of the Washington Summit on Financial Market and World Economy which was convened on 14-15 November 2008, is primarily up to the task of designing a suitable response to the global financial crisis. To this end, said Chancellor Merkel, the Berlin meeting is hoped to contribute in reforming the international financial system. "A clear message and concrete actions are necessary to engender new confidence in the markets and to put the world back on a path toward more growth and employment," Merkel said. Leading EU nations, nevertheless, have their own respective expectations for the London financial summit."

China is watching to Europe talking and to the US swinging in the breeze. There may very well be a repeat of what occurred a century ago. The names are different but the characters are the same. This time, however, there is a sleeping giant in China on the edge, safe and secure, able to redirect its stored up resources for internal infrastructure buildup, and when this ends they will emerge a true giant against a very injured United States.

Another Day of Disaster

This is another day of disaster. Looking at or Baseline Portfolio, such as Verizon, Kraft, DuPont, Dow, J&J, Alcoa, and no financials, just food, soda cans, drugs, stuff we use every day, has taken another nose dive.

The Figure below shows in the first Figure of the Portfolio value and its return. The drop from Inauguration Day is unrelenting. These are NOT financial stocks. They are core stocks in companies that make what we live on day to day. They are telephone calls, mac and cheese, vanilla wafers, aluminum cans, band aids, drugs. They are core chemicals and the other items which make up or economy.


















The second is the effective yield curve if we were to purchase this portfolio today and seek only dividends, assuming no change in dividends.


















We are seeing a 6.8% dividend yields starting from 5.5% in December. As we have said before the above yields are indicators of future massive inflation and the drops in stock value show that we may readily hit a DOW 6,000 or even lower. Thus we are looking at 20% inflation and a collapsing DOW. And things are very well most likely to get worse!

Vraiment, les Occidentaux divisés

Truly the West is divided. On Friday last week Le Monde published a story regarding the G20. Again I am amazed as to the total lack of coverage of this event since it may very well become a defining moment for the new Administration.

Le Monde states:

"Français et Allemands ont travaillé en pleine entente sur la régulation, Berlin acceptant largement les propositions françaises. "Notre ministère des finances avait rédigé un papier qui était plus ennuyeux. Celui des Français était plus politique", commente Ulrich Wilhelm, porte-parole d'Angela Merkel. Mais les deux pays font face à un raidissement britannique et à une inconnue américaine. Londres est soupçonné de vouloir faire diversion, en élargissant l'ordre du jour du sommet de Londres."

Simply stated, the French and Germans have a plan and the US and UK are left in the dark. Regarding the specifics, Sarkozy is quoted as:

"Sur les hedge funds, les Européens veulent pouvoir enquêter en profondeur sur leurs comptes quand les plus libéraux se contenteraient de simples informations données volontairement par leurs gestionnaires aux autorités de contrôle."

Namely they are seeking to have a strong and transparent and international regulatory body control hedge funds. This would have a dramatic effect on the US based industry which albeit having its problems is not as bad as the regulated banks.

Finally Le Monde states:

"Unies sur la régulation financière, les deux capitales connaissent encore quelques tensions. Mme Merkel a envoyé vendredi aux capitales européennes ses propositions de conclusions pour la réunion de dimanche : coordonner les plans de relance économique et lutter contre le protectionnisme, pour protéger le marché intérieur européen."

Merkel has become the salesperson and Sarkozy the strategist. Merkel is going about with the over sale of the new regulatory regieme. The question is what is the US doing, for even the UK is concerned and attmpting to see its way through. This could lead to closed markets in the financial world, akin to trade barriers in the 1930s, these would become financial trade barriers. The result could make for a total tail spin into the dirt!

Finally there is a lack of credibility in the new Administration. Le Monde states:

"C'est le second souci. "Obama est du côté des Européens" continentaux, assure M. Wilhelm. Mais le calendrier est défavorable, le sommet intervenant trop tôt. M. Obama est préoccupé par le sauvetage de l'économie américaine, beaucoup plus urgent que la refondation de l'architecture financière mondiale à long terme. "Les Américains ne seront pas prêts sur la régulation pour le 2 avril. En revanche, ils vont accuser les Européens de n'avoir investi que 1,5 point de leur produit intérieur brut (PIB) dans la relance de l'économie, alors qu'eux y ont consacré 5 points", explique un ancien ministre français."

The US will not be ready by April 2nd for discussions on regulation. The question is what was the problem. The European view was lack of regulation but as we demonstrated yesterday there are many reasons, interlinked and some obvious and some subtle. The Europeans must beware of the law of unintended consequences and the fact that all too often the heavy handed Germans combined with the intellectually arrogant French can be a deadly mix!

Rumblings from the G20 Again

As we stated several weeks ago in a detailed White Paper, the New York Times today reports that Merkel and Sarkozy are planning an assault on the US regulatory structure at the G20 meeting in London early April.

The Times states:

"French President Nicolas Sarkozy said that ''Europe wants the system to be refounded,'' and stressed the importance of the April meeting.

''We all want London to be a success and we are all aware that it's (our) last chance,'' Sarkozy said. ''We cannot afford a failure in London.''

European leaders also backed Merkel's call for a ''charter of sustainable economic activity'' that would subject all financial market activities around the globe to regulation, including credit rating agencies.

Merkel's proposal envisions giving increased powers to the IMF, which the leaders agreed needed to receive double its current funding in order to help members respond ''swiftly and flexibly'' to a crisis."

It will be another crisis moment for the new Administration and we believe that this may be additive to all of the other issues. We will be following this closely.

The details reported by Reuters today makes the sense of confrontation ever more clear. Specifically Reuters states:

"Below are highlights from a "chair's summary" of conclusions from the meeting that was seen by Reuters:

RENEWING GLOBAL FINANCIAL MARKET REGULATION IS A PRIORITY

.......

- We have today underscored once again our conviction that all financial markets, products and participants must be subject to appropriate oversight or regulation, without exception and regardless of their country of domicile. This is especially true for those private pools of capital, including hedge funds, that may present a systemic risk.

- We also agreed that credit rating agencies should be subject to mandatory registration and oversight.

- We have today agreed on advocating reforms to ensure that banks build additional buffers of resources in good times.

- A list of uncooperative jurisdictions and a toolbox of sanctions must be devised as soon as possible.

- The Financial Action Task Force, OECD and FSF should submit proposals in their respective fields to the G20 Finance Ministers meeting in March, for review at the London Summit.

- We will strongly advocate (at the London summit)...the development of an effective early warning system by the IMF and FSF, working in close cooperation.

- We will strongly advocate (at the London summit)...the adoption of principles on compensation practices to prevent bonus payments that contribute to excessive risk-taking."

This is further exacerbated by the massive drops in Central European currencies such as the Polish zloty and the Czech currency. The Russian currency also continues to drop. In many ways this appears as if it were 1930 again. That presents many real threats to the Administration which may lack both the understanding of long term European history as well as that of the early part of the 20th century.

History has a strange way of repeating itself again and again.

An Interesting Chart: The Rear View Mirror

The Congressional Research Service recently published a paper on the Causes of the Financial Crisis. It is a very good compilation of all the things that people think may have led to where we are.

They list 26 things that led to the crisis. Twenty six things and the same people in Congress who asked for and obtained this backward looking report never saw one of them in the past two years or even more!

This is like a patient arriving in your office who is morbidly obese, with a three pack a day habit for thirty years, who lives a rather profligate life, also does crack, and then presents with small cell lung carcinoma, renal failure, has an MI on the table, and well you get the point. These problems were a long time coming. You could see the weight gain, you could smell the cigarette smoke, you could see the drug use in the eyes, and on and on. It was more than just a light at the end of the tunnel and finding out it was the train.

These 26 causes as seen by CRS are:

1. Imprudent Mortgage Lending
2. Housing Bubble
3. Global Imbalances
4. Securitization
5. Lack of Transparency and Accountability in Mortgage Finance
6. Rating Agencies
7. Mark‐to‐market Accounting
8. Deregulatory Legislation
9. Shadow Banking System
10. Non‐Bank Runs
11. Off‐Balance Sheet Finance
12. Government‐ Mandated Subprime Lending
13. Failure of Risk Management Systems
14. Financial Innovation
15. Complexity
16. Human Frailty
17. Bad Computer Models
18. Excessive Leverage
19. Relaxed Regulation of Leverage
20. Credit Default Swaps (CDS)
21. Over‐the‐Counter Derivatives
22. Fragmented Regulation
23. No Systemic Risk Regulator
24. Short‐term Incentives
25. Tail Risk
26. Black Swan Theory

This is worth the read. Each of these has in some way been accused as being the dominant element in the crisis. Each has its advocate and in a way it was the perfect storm. Could this have come about with only one of these, how about two, maybe three, or do we need all 26. The following chart depicts a possible cause and effect relationship amongst these causes. That is there were early causes and causes of causes. This means that there were canaries that were dying off well before the ultimate deaths.



















Some of the causes are derivative of the others and some are just ways of rephrasing one or a few of the others. The Black Swan theory of Taleeb is an artifact that sells well, but it is the generally accepted Court Jester theory of evolution, also the one phrased by Eldredge and Gould and known as punctuated equilibrium. Simply changes occur when major events disrupt equilibrium. The direction of the change in a Darwinian sense in towards the survival of the fittest. However in an economic sense, the fittest may or may not be to those in power. Things happen that tend to disturb what we would commonly look towards as the fittest.

Sub Primes in New Jersey

The New York Fed published a paper on Sub Prime Mortgages in New Jersey and the data is quite enlightening. The first Table depicts the defaults as of August 2008 by state and shows that New Jersey if 5th in ratio of sub-primes in foreclosure on the basis of total homes. Namely the Table states that NJ has 3 of 1,000 housing units in foreclosure as compared to 6.2 for Florida and 4.6 for California.

Now the details of the counties can be shown in the following map. The highest foreclosures were in Union, Linden, Irvington and Plainfield. All of these towns have a well established housing base and are major Democratic strongholds. They are used again and again for carrying the New Jersey Democratic vote. Other counties, especially Republican counties account for only 64 of the 10,500 foreclosures!

























The third Table depicts the default by Zip codes. The green boxes are zip codes where 75% or more of the sub prime loans are foreclosed. This is for Essex County. This is a county of older houses as is Union and the problem is clearly one of providing mortgages to people who clearly cannot afford them.

In addition, this was the Congressional District of Senator Robert Menendez before he went to the Senate. He pressured the banks to lend the funds and as seen in the following chart the lending went to those least able to afford them. 75% of the defaults were in ten zip codes! This was not a county as one finds in Florida or California where there was a great amount of new development. In fact there has been little or no development here in fifty to seventy five years. These were houses with well defined prices that were flipped and sold to those who clearly could not afford them, apparently driven by very strong political pressure.












Our observation and possibly conclusion is that the Democrats through their influence may have actually created circumstances which led to this collapse. The data at least for this part of New Jersey appears to bear this out.