Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

17 December 2011

The Casinos Won, so Buckle Your Seat Belts

[For a 12/18/11 update on market volatility and what it means, click here.]

In an earlier post, I reasoned that nothing important has changed in finance since the Crash of 2008. We still have unrepentant casinos getting ordinary banks and investment houses to bet billions and trillions on uncertain future events.

The total tab is now around $600 trillion. That’s the amount of outstanding derivatives, most of which represent this sort of bet.

Instead of evaluating loans and investments on their business merits, as banks used to do, they now go to the casino for “risk management.” They buy “innovative” financial instruments, called “derivatives,” which are supposed to protect them against any downside. They hope to foist the real risk of their businesses onto clueless buyers, who know nothing about the banks’ businesses and do even less “due diligence” than the banks themselves do.

The sub-prime-mortgage fiasco, which caused the Crash of 2008, is just a special case of this exploding practice. So our global “financial” system has become little more than a gigantic, high stakes casino.

When you look at it closely, the casino analogy is actually quite good. The casinos are the “elite” investment banks, led by Goldman Sachs and its many spawn. The gamblers are the ordinary banks and lesser investment banks who place bets in the vain hope of gambling away the real risks of their businesses.

Remember the rule from ordinary gambling that “the house always wins”? Just so for these casinos. The’re very good at what they do, and usually they guess right. When they’re uncertain, they sell bets to gamblers on both sides and take a commission. When they’re confident but their gamblers are weak, they take collateral to make sure that losers can pay. When even the collateral fails, they get governments and taxpayers to bail them out.

So the casinos can’t lose, because they or the gamblers they fleece are “too big to fail.”

Lest you think I exaggerate, I offer three pieces of evidence, all within the last two months. In October, an obscure European bank named “Dexia” became insolvent and had to be rescued by the governments of Belgium and France. The reason: Goldman Sachs, with whom the bank had placed derivative “bets” on risky instruments, made a collateral call. Readers with good memories will recall that’s exactly what triggered the Crash of 2008: Goldman making a collateral call on companies “too big to fail,” including AIG.

In 2008 Goldman got its money, and the threatened financial system stabilized because the US Treasury bailed everyone out. This time Goldman got its collateral, and Belgium and France bailed Dexia out. But we don’t yet know the rest of the story because we don’t know how many other Dexias are out there.

My second piece of evidence came out in the New York Times last Thursday: the complete story of the debacle that was MF Global, former New Jersey Governor Jon Corzine’s baby. Anyone who invests in the markets should read this story three times and compare it with the debacles of Lehman Brothers and Bear Stearns in 2008.

The highlights are three. First, as CEO of MF Global, Corzine “pushed through a $6.3 billion bet on European debt—a wager big enough to wipe out the firm five times over if it went bad[.]” Second, the firm made the bet using an obscure form of derivative called a “repurchase-to-maturity,” which allowed the bet to be kept off the firm’s balance sheets. (The firm’s auditors, PricewaterhouseCoopers, insisted that it disclose the bet in a footnote in the annual report.) Third, “[s]ome $1 billion in customer money remains missing[,]” and thousands of clients may have lost up to a third of their money.

But here is the kicker. In testimony before Congress a week ago, Corzine had the gall to say, “There actually were no losses.” He was referring to the firm’s big debt bets, not the unexplained losses of customers’ money. Those bets had actually made money for the firm, although too late to save it. Corzine is a Goldman spawn; he used to be its co-CEO.

My third piece of evidence comes from a recent NYT story on the new EU bailout fund led by Germany’s Chancellor Merkel. The story buries the following key sentence in the middle, as if to hide it. But the sentence is so important and so troubling that it deserves highlighting:
“The [EU] leaders sent an important signal to the bond markets by scrapping a pledge to make private investors absorb losses in any future bailout for a euro nation.”
In other words, the EU and Chancellor Merkel—who I had hoped would save global finance from itself—caved in to the casinos.

That’s all I know the about EU’s apparent capitulation, just that one buried sentence. But it’s enough. Who else but a reporter from New York, the den of Wall Street, would bury it in the middle of a story and try to make it sound positive?

The bottom line is this: it’s all going to happen again. Sooner or later the whole house of cards is going to fall. Why? Three reasons.

First, no individual positioned to do anything about it cares about the big picture, and no one at all really understands it.

No politician—including the current President and the last two presidents—understands any of this. President Obama delegates to Goldman Sachs’ alumni like Tim Geithner, just as Dubya did to Hank Paulson. Bill Clinton, no doubt on the advice of similar worthies, signed into law the Gramm-Leach-Bliley Act that started the whole collapse off [search for “single event”]. And if presidents don’t understand this stuff and therefore don’t care about it, do you think anyone in Congress does?

Let’s face it. Banking is a dull business. It’s a bunch of boring numbers, without content. Even the hardiest policy wonks can fall asleep in a discussion of finance. It appeals only to greedy people for whom the fact that those numbers are dollars makes them interesting. That simple truth has allowed rogue bankers to steal the wealth of our otherwise thriving industrial economy and drive it into the ground.

As for the people making the derivative trades, they have every incentive not to understand the big picture because they are making too much money ignoring it. Willful ignorance is their modus operandi.

Second, there have been no consequences to any casino, or any big gambler for that matter. No one responsible for any losses has gone to jail. None has lost his job. After all the government bailouts, no one has even lost money. The big casinos are still running the show, and their collective tab is up to $600 trillion.

The two big SEC suits so far—against Goldman and just this week against Fanny and Freddie, are essentially suits for fraud: telling investors one thing while thinking and writing another. There have been no suits against casinos or gamblers as such. Why? Apparently because, in our fantasy world of freedom-as-license, gambling with our economy is not illegal, although it destroyed the economy once three years ago and is very likely to do so again.

Making it illegal is the job of the Dodd-Frank legislation and regulations under it. But the casinos and gamblers, using Wall Street’s control over the nation and now foreign governments, have been highly effective in watering the legislation down and diluting, delaying and avoiding regulations under it. And they haven’t yet even begun to stonewall and litigate.

By the time the legislation and regulations under it have any real teeth, the next crash likely will already have occurred. All this makes rational people envy China and its ability to rule by decree.

The only people who might have a clue about what is about to come down are Ben Bernanke and the folks at the SEC. But they are under incredible pressure not to disturb “The Markets,” which of course are just fallible human institutions, now controlled by the bankers and Wall Street. So if you think a man on a white horse is going to ride in from any direction, think again. All the gates are locked and barred.

Finally, the casinos so far have been making piles of money. Like all of their kind, the gamblers have the illusion that gambling will bring their businesses greater security. What incentive do either have to stop?

So who are the losers? Just as in Las Vegas, they are us, the rubes. Unbeknownst to them, they are also all the industrial capitalists and shareholders, whose earnings and substance are being dissipated in this orgy of gambling. In the end, they are the governments and taxpayers who bail the gamblers and casinos out in a vain attempt to keep them afloat. They are countries like Belgium, France, Greece, Iceland and their taxpayers, who bail out the losing side, while the winners count their money.

Oh, and did I forget to mention us Yanks and our drowning-in-a-bathtub government? Sorry! How quickly we forget, in our manic news cycle of irrelevancies and willful malefactors like Newt!

This is all really, really sad. Outside of rotten finance, the global economy is puttering along well. If rogue banking casinos hadn’t upset the applecart, we could be looking at a new global Golden Age, just as I speculated seven years ago. Our excellent “ABC companies,” as well as their counterparts abroad, are doing good business making real things. Even our cars are selling again.

But the bastards in finance are going to blow the whole thing up again.

The did it a little less than a century ago, kicking off the Great Depression. Our industrial economy was booming. Electric power, with all its uses in homes and industry, was just reaching it growth peak. The revolution in radio, which later would morph into television, was just beginning. But along came finance and upset the applecart. Our economy didn’t get back on track again for seventeen years.

And funny thing. The immediate trigger for the Crash of 1929 was just another so-called financial “innovation”: buying securities on margin. That “innovation” was a simple one for simple times. It was so simple that even the rubes could use it and be burned. J.P. Morgan famously said that he sold out when his cab driver started giving him stock tips.

Today’s financial “innovations”—derivatives—are infinitely more complicated, so much so that only professionals use them. But the same principles apply. The huge pyramid of derivatives, to which no one is paying any attention, is just as bound to collapse as the huge pyramid of margin sales did under margin calls in 1929—and as the pyramid of subprime-backed mortgage securities did in 2008. The play and results don’t ever change, only the names of the players and their “innovative” instruments of financial mass destruction.

So the house of cards will fall again. You can bet on it.

How certain am I? About 70%. People don’t change their behavior without consequences. And for the small clique of supremely selfish and self-confident men who’ve made themselves enormously wealthy by gambling away the substance of the West’s industry, there have been absolutely no consequences so far.

And should they expect consequences? They control or know all the right people. As “experts,” (never mind the inherent conflict of interest) they have the ear of all the West’s leaders. So where is help going to come from, outer space?

Lest readers think I’m just alarmist, I’ll mention how I saved my own retirement fund the first time around (2008). I did it with a futile search for an honest man in American finance, which I called the “Diogenes Test.” But the immediate trigger was the sudden collapse of a real estate firm in Australia, where I happened to be at the time. I sold everything.

You don’t have to rush to the exits right now. No one can tell precisely when the next crash will come. Certainly I can’t. It could come next week, next month, next year, or in two or three years.

But one thing is pretty clear right now: the global gambling won’t stop until there are really unpleasant personal consequences for the casinos and gamblers. And with the collapse of my hope that the EU would stand up, there is not the faintest sign of such consequences on the horizon, anywhere in the world. Apparently there won’t be any until after something like a replay of the Great Depression.

So I wouldn’t urge you to sell everything that might go down in value and buckle your seat belts. But that’s what I did in late 2007. And that’s what I’m doing now.

This week’s market dive was not necessarily the next crash. Most probably, it was people selling to realize year-end losses for tax purposes. Investors also want to spend time with their families during the Christmas season, without always glancing over their shoulders at volatility induced by unregulated programmed trading.

But make no mistake about it. When the next crash comes—and barring some deus ex caelo, it will come—it will be much, much worse.

Concluding Thought: Gambling is a vice. We deride it in gentle Chinese ladies playing mahjong, while we gamble away an economy based on two centuries of science, technology and industry. Gambling is tolerable only when the gambler (1) can afford it and (2) can control his/her impulses. The mahjong ladies can do both; we, apparently, can do neither.

Footnote 1: You should read the footnotes to financial statements before you read the balance sheets. Why? Because footnotes usually mean the auditors wanted something on the balance sheet that the firm under audit would rather not disclose. A footnote is the usual compromise: the law requires disclosure but doesn’t say exactly how.

Update 12/18/2011:

It’s nice when, as is happening ever more frequently these days, mainstream media corroborate my analysis within a few days of posting. That’s what happened today, when Bloomberg.com published a must-read story on volatility in the stock markets.

Two key facts were among the gems this piece revealed. First, the three-month historic measure of volatility, derived from the VIX volatility index, reached “a record 191.59 on Oct. 31, above the 92.56 median over the past decade and surpassing the prior peak of 190.44 from December 2008.” Second, the correlation of individual stocks in the S&P 500 index to the index itself last month reached 0.86, on a scale in which 1.0 would reflect perfect correlation, i.e., all stocks moving in lockstep.

This second fact means, in essence, that general economic conditions—i.e., fear of a new meltdown—drives 86% of the movement of stocks. The companies’ respective business, management, prospects and profits account for only 14%. As the story reports, even seasoned stock-pickers are complaining, because their expertise just doesn’t matter any more.

The doubling of volatility from its median over the last decade reflects the same phenomenon. In general, no company’s fortunes or real business prospects change often and rapidly enough to create that kind of volatility, which some hedge-fund managers describe as the greatest they’ve seen in their entire careers. (One hedge fund even shut down because of it.)

The only thing that can create that sort of volatility is alternating greed and fear about the general economy. In this case it’s evanescent hope for some gargantuan bailout of the casinos and gamblers (the manic phase), followed by a more realistic fear of what happens when the music stops and governments and taxpayers are asked to pick up trillions in gambling losses (the depressive phase). Get used to our new, bipolar markets.

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