[A-List] Financial Monsters

[Bill Totten <shimogamo@xxxxxxxxxxxxx>]

by Alice Friedemann

Culture Change  (October 26 2007)


We are entering the Money/Energy Transition. (The term was coined by Tom
Robertson, moderator of the energyresources listserve.) This is when
people will realize they can't fuel their cars with dollar bills - that
money is meaningless and all that really matters is energy. M King
Hubbert, the original peak-oil visionary, proposed an energy currency
half a century ago so that people would understand how critical a role
it plays in our survival. But it isn't practical to carry tanks of gas
around or bits of uranium in your pocket.

So we spent our energy foolishly, plundering and poisoning the planet
for a blip-in-time of pleasure, and now the "Limits to Growth" boas of
peak oil, climate change, and natural resource shortages are tightening
around us.

But most people don't see the world ecologically. Nearly everyone is
brainwashed to see the world through economic and political filters. As
we sink into depression - both individual and economic - brought on by
increasing population, pollution, and decreasing energy and natural
resources, most people will blame politicians, the Federal Reserve, and
"evil" foreign governments for our woes. So we should start recognizing
our personal, national and global financial monsters.

It appears the United States is succumbing to what all governments have
been tempted to do over time: run the money printing presses overtime to
pay for wars, debts, and corporate welfare. In anticipation of
completely worthless money, we ought to at least design it in colors and
shapes to make origami and something to do, since most of us will be out
of work (you can start practicing at members.cox.net/crandall11/money).

The subprime market is just the first tremblor bursting out of the
ground to suck the life-blood out of your bank account and "disappear"
your job.


Other Economic Monsters

Derivatives. Originally used to hedge risks, then as leverage, that is,
"swaps", derivatives allowed hedge funds to get around the leveraged
limits the SEC instituted after the 1929 crash.

Warren Buffett has been warning for years that derivatives are
endangering the financial system. He believes that the widespread use of
swaps makes the leverage that preceded the 1929 crash "look like a
Sunday school picnic" (Smith 2007). He warns that derivatives are
financial weapons of mass destruction (BBC 2003):

* An explosion in derivatives contracts could create serious systemic
risks; derivatives are like time bombs waiting to explode the economic
system. Large amounts of risk have become concentrated in the hands of
relatively few derivatives dealers.

* Outstanding derivatives contracts - excluding those traded on
exchanges such as the International Petroleum Exchange - are worth close
to $85 trillion.

* Some derivatives contracts appear to have been devised by "madmen".
Buffett warns that derivatives can push companies onto a "spiral that
can lead to a corporate meltdown", like the demise of the notorious
hedge fund Long-Term Capital Management in 1998.

* Derivatives also pose a dangerous incentive for false accounting. The
profits and losses from derivatives deals are booked straight away, even
though no actual money changes hands. In many cases the real costs hit
companies many years later. This can result in nasty accounting errors.
Some of them spring from "honest" optimism. But others are the result of
"huge-scale fraud", for example, with the US energy market, which relied
for most of its deals on derivatives trading and resulted in the
collapse of Enron.

Many derivatives don't trade often, making it hard to value them
accurately. Institutions don't trust each other because no one knows
who's got the most skeletons to hide. It's hard to make financial
instruments like leveraged loans transparent if the asset has never
traded, or no one's buying. Institutions tend to put as much gloss on
their numbers as possible, and investors, lenders, and shareholders are
very suspicious. (Davies 2007)

If hedge funds ever have to put an accurate price on what they own, the
outcome could be scary - that's why the Bear Stearns subprime debacle
caused such concern, because it could start a chain reaction of other
hedge funds forced to truly discover their asset values and adjust them
sharply downward. Banks have about 375 billion dollars in leveraged
loans. Bank, private equity, brokerages, and hedge fund failures are
likely as assets continue to decline in value. Hedge funds have used
derivatives to dampen volatility, and act like shock absorbers against
market risk. But if the real value of derivatives has been exaggerated,
then when these "shock absorbers" break down, there could be a hard
landing (Patterson 2007).

The Great Unwind: Leveraged Debt. Not since the Great Depression has
there been so much leverage in the stock market. Hedge funds, private
equity firms, and Wall Street have found ways to work around the legal
limits of leverage via derivatives and other complex financial
instruments. Part of the reason we got into this mess was that banks,
which are regulated and supposed to be transparent, don't control credit
or money anymore.

Hedge funds and private equity firms are not regulated. If there's a
serious market downturn, leverage can create a snowball effect, as
stocks are dumped to raise cash, spiraling prices ever downwards. Wall
Street analysts call this "The Great Unwind". The Wall Street Journal
summarized this risk by saying, "No one is sure what will happen with
this complex web of borrowing and derivatives in the event of a serious
market downturn".

Larry Fink of BlackRock, says that lenders to highly indebted companies
are making the same mistake as the subprime mortgage market, and will
become "tomorrow's problem" as leveraged buy-out and junk-rated lending
grows. The Bank of England also warned that cheap corporate lending with
loose credit standards "has increased the vulnerability of the global
financial system", and cautioned against weak standards of risk
assessment for repackaged bank loans that are sold to the rest of the
financial system (Beales 2007).

In the Economist magazine (June 21 2007), Daniel Arbess, of Xerion
Capital Partners, said that "perhaps the most worrying thing for
financial institutions holding mortgage-backed paper is not the subprime
market, but the unnerving parallels with an even bigger one to which
they are also exposed: leveraged loans to companies". Subprime might
well be "a dress rehearsal for something bigger and scarier".

Private Equity & Hedge Funds. These financial devices and firms are not
subject to regulation, so the risk they're adding to the financial
system is unknown. Worse yet, they're given special tax rates of less
than ten percent (which amounts to a public subsidy), and that, combined
with investor money, is used for leveraged buyouts. Then, these
companies are stripped of assets and the employees outsourced and
offshored. Jobs are lost and established companies destroyed. The big
winners are the managers who engineer the buyouts, and who can earn
billions in just one year (Monks 2007).

The time horizon of asset-stripping is short - just three to four years
- and ignores the long-term interests of investors, employees,
customers, and suppliers. The Chairman of Germany's Social Democratic
party in 2005, Franz Munterfering, described private equity groups as
"swarms of locusts" (Gordon 2007).

After asset stripping and outsourcing, these companies are laden with
debt, which will become a serious problem when borrowing costs rise and
an economic downturn occurs.

Distribution of Wealth. The gap between rich and poor has never been as
great as it is now. The top one percent of households in the USA
received eight percent of national income in 1980 and sixteen percent in
2004. During that period, the tax burden on the top one percent
decreased from 44.4% to 30.4%, increasing their income even further.
Wealthy individuals and corporations know how to hide their wealth
offshore, or put money in questionable tax shelters, so the gap is even
wider than what Piketty has been able to glean from tax records (Piketty
2007).

The Pew and Brookings Institutions have done research which shows that
men in their thirties earn twelve percent less than their fathers did in
1974 adjusting for inflation (Guha 2007).

Such huge and fundamental unfairness often leads to social chaos, civil
war, or revolution.

Federal Debt. The long-term economic health of the United States is
threatened by $53 trillion in government debts and liabilities that
start to come due when baby boomers begin to retire. Many leading
economists say that even the world's most prosperous economy cannot
fulfill these promises without a crushing increase in taxes - and
perhaps not even then - as each household has an obligation of about
$475,000 (Cauchon 2004).

Public Debt. The average American household in 2004 was $85,000 in debt
from the $9.5 trillion owed on mortgages, cars, credit cards and other
personal debt. The average American has negative savings.

Energy Costs. McMansions and sprawling suburbia will force families to
dedicate dollars to heating their homes and driving that they would have
rather spent eating out, and on vacations, electronic toys, and so on.

Job Loss: Offshoring. Check out the US Department of Labor "Occupational
Outlook Handbook" at bls.gov/search/ooh.asp?ct=OOH which lists job
categories and statistics in America. A large percent of these have been
or can be outsourced overseas to the billions willing to work for less
money than Americans in clerical, administrative, accounting, actuaries,
analysts, bookkeeping, et cetera. Up to forty million jobs are
potentially offshorable (Wessel 2007). Work that must be done here often
goes to immigrants who don't have legal papers.

Job Loss: Real Estate. Nationally, real-estate-related industries
accounted for 74 percent of new jobs over the past five years (Irwin
2005). In 2004, there were 460,000 real estate brokers, one million
construction laborers, plus millions of other jobs dependent on real
estate in furnishings, lumber, and other industries.

As the subprime meltdown expands, millions will earn less or lose their
jobs. David Richards, in Barron's, estimates that the housing industry
accounts for six percent of the US economy. Others, using wider
boundaries, estimate it's more like ten percent of the US economy. This
many people spending less will affect everyone else in the economy; it's
already happening in Florida and other hard hit states

The last time the housing market nose-dived was in the early 1990s when
Americans had half as much debt as they do now.

Job Loss: Automobile Industry. The August 02 2007 issue of the Los
Angeles Times article "Imports now lead car sales in the US" reports
that for the first time, Americans bought more imported cars than those
made here. That will reverberate through the economy as well, since the
supply chain for autos represents such a large part of the economy, at
one time, one out of every six jobs.

Medicare/Social Security. Medicare is running out of money, may be in
worse shape than SSN (Alonso-Zaldivar).

Underfunded Pension Funds (Schwanhausser 2002). For pensions that are
not based on defined benefits plans, bad investments in pension funds
will unwind, and as auto companies and other large companies decline or
fail, their pension insurance is vastly under funded by hundreds of
billions of dollars - most people aren't going to collect what was promised.

Sudden drop in value of the dollar. What if foreigners decide to stop
buying our treasury bills? As the Fed keeps printing more and more
money, foreigners won't want to be inflationary dupes. Currently,
foreigners own $3 trillion of our assets - equal to about a third of US
GDP. Middle East countries have been plowing their winnings into
treasury bills, but they may prefer to get more of a return on their
money in China and India to buy off their increasingly angry citizens.
China and India will spend their increasingly valuable currency on
importing food, energy, and other resources, so Americans are going to
continually be experiencing a lower standard of living. It will be hard
to cut back because there is such a sprawling infrastructure,
petrochemical-agriculture, and minimal rail and mass transit.

Hidden Inflation. Economist John Williams has worked out that using
Consumer Price Index (CPI) calculations in effect during Clinton's
presidency, the CPI would be about six percent now, more than double the
current CPI, which has had drastic changes made to how it's calculated
(that is food, energy, et cetera aren't taken into account). So a bond
paying five percent will actually lose you money, given a more realistic
six percent inflation rate. If you use the government CPI figures, then
the dollar has lost about twenty percent of its value since 2000,
meanwhile gold went up 150% over the same period.

The Federal Reserve stopped reporting the M3 value, the US money supply,
in 2006. Adrian van Eck, however, guesses that it is increasing at about
a ten percent rate (and others by twelve percent). He figures that $1
trillion of additional 'money' will be put into the financial system in
2007 alone, four times faster than GDP growth. This means that your CD
paying five percent is really losing five to seven percent a year
because currency is devalued when that much is printed or electronically
made available. Consumer price inflation typically follows.

Wars are always inflationary. To keep the oil flowing, we are likely to
bleed our finances to death until the oil runs out in the Middle East,
Columbia, Nigeria, et cetera. This will be a huge drain on the economy.

Ecological Inflation. Food. Food prices are going to rise dramatically
as we continue to lose cropland to pavement and development, topsoil
losses, extreme weather from climate change, increasing population, and
aquifer depletion. As the energy used to fertilize, plant, douse with
petroleum insecticides, harvest, process, distribute, and cook food
grows more expensive, food prices will rise even further. Grain will be
exported to the highest bidder, countries like China with huge cash
surpluses. Food is now eleven percent of the average household budget.
In 1900 it was forty percent, at a time when over a quarter of Americans
still lived on farms and had much larger yards to grow some of their own
food. Growing crops to make ethanol and transporting ethanol by truck
and train from the Midwest to the coasts will increase food costs as well.

California grows a third of the nation's food, but as global warming
shortens the growing season by depriving farms of much-needed snowmelt
water in the summer, and the cost of energy to electrically pump water
for irrigation (25% of on-farm energy), everyone in America will feel
California's pain in their pocketbooks.

Corporate Fraud & Ecological Destruction. As Bakan points out in The
Corporation: The Pathological Pursuit of Profit and Power (Free Press,
2005), corporate charters state that the corporation must do whatever
will benefit the stockholder. So even if the CEO wants to save the
environment, he can't do it if it will cost the shareholders more money
than destruction. Unless we can enact the reforms Bakan recommends, we
can't make the necessary U-turn back to sustainability, and corporations
will continue to strip-mine the earth at an exponential rate to the
point that many scientists believe will drive us extinct (if it isn't
too late already).

Massive Illegal Trade. Moises Naim, former editor of Foreign Policy,
makes the case in Illicit (Doubleday, 2005) that illegal trade may
comprise ten percent of the world economy now. It's gotten so
sophisticated that small groups don't specialize - they'll run drugs,
people, weapons - whatever pays best. This trade isn't taxed, leads to
immense corruption, and makes it much easier for terrorists to
potentially smuggle nuclear weapons.

Your Money Market Fund may lose money. Money funds hold subprime too
(Richardson 2007). Worse yet, according to Catherine Austin Fitts,
former Assistant Secretary of Housing-Federal Housing Commissioner in
the first Bush Administration, Fannie Mae and Freddie Mac are not in
good shape (Fitts 2004), and these federal agencies are NOT insured.
Most money market funds own bonds in Fannie Mae & Freddie Mac.

Glass-Steagall Act no longer in effect. After the 1929 market crash, the
Glass-Steagall Act was enacted to keep banks doing the business of
banks, and not getting into the stock market or insurance business. This
act has slowly been eroded to the point where it's non-existent. Now you
have banks doing everything, including gambling with energy derivatives.

Deflation, Inflation, or Both? Because of oil shocks, runaway debt,
massive amounts of money "printed" by the Feds and other governments,
and other liquidity in the market, there's been a debate for at least
five years about whether there'll be deflation, inflation,
hyper-inflation, or a mix of all three when the financial system
crashes. Bill Bonner (Bonner 2007) argues for deflation. He thinks the
Fed is wrong about the risk of inflation, and here's how he sees the
crisis evolving: Liquidity dries up, and then lenders don't want to lend
and spenders don't want to spend, they want to hang onto what they have.
And it's a downward spiral, the more prices fall, the more consumers are
reluctant to spend because they might get a better deal if they wait.
Basically, they turn Japanese and hoard money. Takeovers and leveraged
buyouts came to a stop.

Bonner asks "What can the Feds do?" Sure they can print more money, but
how are they going to get it into the hands of people who will spread it
around? Once deflation kicks in, people won't borrow because they're not
sure they can pay it back. Prices fall, so money paid back on a loan is
more valuable than the borrowed money.

Bonner quotes Ben Bernacke, who is fully aware of the dangers but says
the Feds can get around it with "a technology ... called a printing
press ...", and if need be can drop dollars from helicopters to get
money into circulation (if you start subscribing to
thedailyreckoning.com, that's why he's called "Helicopter" Ben). Of
course Bonner says, Ben was being fanciful, the Fed won't actually do
this or the dollar would inflate faster than in Zimbabwe, where
inflation is over 5,000% a year.

Basically, the Fed would prefer inflation - they're already printing too
much money. But they won't be able to inflate their way out of the
economic crisis, because the Feds won't be able to get the money into
the hands of the people who need it most, so we'll eventually end up
with deflation.

When Japan's real estate and stock bubbles popped, everyone had a lot of
savings, the country had a huge trade surplus, and there was no subprime
lending problem. But in America the average person is in debt. Bonner
asks "Can America afford a liquidity crunch ... a credit contraction ...
a deflation? We don't know ... but if we were Ben Bernanke, we might
want to make sure the printing presses and helicopters were in good
running order."

Real Estate Bubble. The sub-prime debacle has only just begun and is
likely to widen to other sectors of the economy. Until the 1990s,
homeowners owned about seventy percent of their homes, free of debt. Now
their equity has dropped to 52%.

Japan's equivalent of our baby boom generation began retiring and
selling their homes in the late 1980's, which burst their real estate
bubble. By 1989 Japanese real estate and the stock market had gone down
by sixty percent. Our baby boomers begin turning 65 in three years.

Renters are now becoming victims of the subprime mess. When landlords
foreclose, tenants in some states are given only three to thirty days to
get out. Just a few states protect tenants from foreclosures. Many of
these apartments were bought by speculators who intended to flip them
before rates rose. Fewer places to rent will drive rental prices higher
(Evans 2007).

Nationally, real-estate-related industries accounted for 74 percent of
new jobs over the past five years (Irwin 2005). In 2004, there were
460,000 real estate brokers, one million construction laborers, plus
millions of other jobs dependent on real estate in furnishings, lumber,
and other industries.

Alan Greenspan pointed out the market has a lot further to fall, due to
a very large inventory of unsold, shoddy new homes that are
deteriorating rapidly, which puts pressure on builders to sell them
quickly, which could lead to far bigger price declines (Greenspan).

Other Bubbles the past 35 years:

In the 1970s: sugar went up 45 times, oil stocks on Wall Street thirty
times, and gold and silver went up 24 times

1980s: NIKKEI went up eight times

1980s - 1990s: NASDAQ went up fifty times, the DOW went up fourteen times
(Saxena 2006)


Black Swans. Taleb, in his book The Black Swan (Random House, 2007),
warns that the world is not the nice, predictable place we see it as.
Rather, it's full of awful and wonderful surprises that are likely to
hit us over the head from out of nowhere. So to protect yourself against
a financial Black Swan, you should invest ninety percent of it very
conservatively, so you don't lose it all. Some of the Black Swans on the
horizon are World War III over the remaining energy resources, a sudden
decline in the value of the dollar, energy shocks, terrorists blowing up
supertankers in the straits of Hormuz (which would prevent nearly half
the world's oil supplies from being delivered), a large earthquake in
Tokyo or San Francisco, hurricanes knocking down refineries and oil
platforms in the Gulf, any sort of major disruption in global trade
since we're so dependent on "just-in-time" delivery, a revolution in an
oil state (that is Saudia Arabia, Nigeria), the collapse of Mexico (see
theoildrum.com, "Mexico: A nation-state dissolves?" by Jeff Vail), a
major nuclear disaster, et cetera.

In addition, China is in a massive speculation bubble, growing
exponentially at rates of over nine percent per year that can't possibly
be sustained. China's history is one of cataclysmic paroxysms, so when,
not if, they explode, let's hope it's inward and not outward.

Dailyreckoning.com has been writing about these issues in highly
entertaining and intelligent prose for over a decade - they foresaw the
dot.com and housing bubble busts, and explain derivatives, CDO's and
other lurking financial monsters far better than I do. If you want to
weather the coming storms financially, then subscribe to their email
newsletter, and read anything Bill Bonner has ever written, especially
Financial Reckoning Day (Wiley, 2003) and Empire of Debt (Wiley, 2006).

Only recently have the mainstream papers begun to sound the alarm - the
Wall Street Journal started to warn their readers about a year ago that
"benign conditions will one day come undone. But for now, nobody can see
how or why" (Sender 2007), "Eventually this confidence game will end"
(Murry 2007), and "The longer the credit cycle lasts, the worse it will
be when it ends" (Conway 2007).

Wall Street has always been Win-Lose, with the rich raking the chips in
at the end of the game at the expense of the middle class suckers, who
play with stocks for years, lulled by steady gains in the DOW. They stop
paying attention, too distracted by TV, working overtime, and are
brainwashed by conventional financial propaganda spouted by the few
remaining news conglomerates. Then, Bam! Wall Street swoops in on 401K
and pension nest-eggs, smashing them apart.

The Bottom Line: Any investments outside of commodities will vaporize,
any job that can be offshored will be, and the culture is about to
change - like it or not!
_____

Alice Friedemann is a San Francisco Bay Area-based writer who has
appeared in Culture Change as well as Energy Bulletin. Her seminal piece
Peak Soil, on the fallacy of biofuels on a massive scale, appeared in
both those online websites. Her own website is energyskeptic.com.

References:

Alonso-Zaldiver, R (December 20 2004) "Medicare's Troubles May Be
Sleeping Giant. The program could run out of funds two decades before
Social Security is forecast to, experts say", Los Angeles Times.

BBC News (March 04 2003) Buffett warns on investment 'time bomb'.

Beales, R (April 26 2007) "Fink warns of fallout from leveraged loans".
Financial Times.

Bonner, Bill (August 06 2007) thedailyreckoning.com
and "Financial Reckoning Day" and "Empire of Debt"

Cauchon, D (October 03 2004) "Part I: The looming national benefit
crisis". USA TODAY. usatoday.com.

Conway, William (April 24 2007) "Secretive sector steps into the glare
of publicity". Financial Times.

Davies, P (September 13 2007) "So what's it worth when there's no
regular market?" Financial Times. ft.com.

Evans, K (October 11 2007) "Mortgage Turmoil Hits Renters". Wall Street
Journal.

Fitts, Catherine Austin (May 27 2004) "America's Black Budget &
Manipulation of Markets". Financial Sense NewsHour. scoop.co.nz

Gordon, M (February 16 2007) "Do we condemn or cheer the flight to
private equity?" Financial Times.

Greenspan, Alan (September 17 2007) "Greenspan's Dismay Extends Both
Ways". Wall Street Journal.

Guha, K (June 05 2007) Graduates in US not immune to earnings
inequality. Research will fuel middle class unease. Bargaining power of
workers reduced. Financial Times.

Irwin, N (April 05 2006) Is Reliance on Real Estate a Crack in the
Foundation? Washington Post.

Monks, J (June 04 2007) Europe should not give in to casino capitalists.
Financial Times.

Murry, Alan (January 2007) Alan Murry. "Money Is Everywhere, but for how
long?" Wall Street Journal.

Schwanhausser, Mark (September 29 2002) 'Accounting Gimmick' Based on
Pensions Needs Rethinking, Analysts Say. Knight Ridder/Tribune.

Sender, Henry (January 2007) "Investors Riding the 'Cash' Rapids". Wall
Street Journal.

Patterson, S (July 02 2007. Subprime Flu Sheds a Light on Derivatives.
Wall Street Journal.

Piketty, T (January 11 2007) "How the Income Share of the top 1% of
Families has Increased Dramatically". Wall Street Journal.

Richardson, K; Reilly, D (August 13, 2007) "Money funds may hold
subprime, too". Wall Street Journal.

Savinar, Matt: financial and other preparation advice at
lifeaftertheoilcrash.net

Saxena, P (April 21 2006) "Cash is Trash" (re Other Bubbles the past 35
years).
financialsense.com/editorials

Smith, R (April 20 2007) "As Funds Leverage Up, Fears of Reckoning Rise.
Fed & SEC Question Wall Street on Policies; 'A Mockery' of Margin". Wall
Street Journal.

Wessel, D (March 30 2007) "Pain From Free Trade Spurs Second Thoughts".
Wall Street Journal.


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