An interesting (if rather long) post from the Raging Bull site. VERY long, in fact, as I realized when I began reformatting it. But perhaps a comprehensive and historically-based view:
From:Vilnis
Reply To: None
Saturday, 31 Oct 1998, 2:50 PM EST
Post # of 31
The primary trend is down and the bounce of the dead cat is over. It is time to be a short seller.
Economic cycles are the result of human economic activity, which correspond to cycles of optimism and pessimism and so credit expansion and contraction. When people are very pessimistic they are
less inclined to accept promises of future performance and so money in hand is more highly valued than a promise to pay some time in the future. Correspondingly, during periods of economic expansion, all sorts of promises, stocks, bonds etc., are often very highly valued. People are less forgiving concerning broken promises and expectations during periods of economic contraction than during periods of expansion. When everyone is making lots of money, people naturally tend to live and let live. When time are hard, people tend to be more judgmental. Embezzlement and fraud happen during good times and bad. During periods of economic contraction, people tend to be less forgiving and so more people are found to have committed embezzlement and fraud. It should therefore come as no surprise that we are now beginning to see more financial and accounting irregularities disclosed in the financial press concerning public companies. These are just straws in the wind and can be expected to get much worse if the July 1998 top ended the bull market, which started with the August 1982 low. The adjustment needed to correct for all of the misallocation of resources during sixteen years of credit expansion will be much more severe and prolonged than anything in the living memory of 97% of today's investors. It is likely that only 3% of investors in will make significant profits during the next few years. If you wish to be among that 3%, read on.
The cost of living in the USA in 1941 was the same is in 1790. Every depression before 1930 started with a financial panic during which banks defaulted on their obligation to deliver gold against bank notes and ended with banks again honoring the obligation to deliver gold against bank notes. The bank notes were receipts for gold as the USA dollar was defined as a fixed amount of gold and gold coins were also in circulation. Banks expanded credit and consequently the money supply, by issuing more bank notes then the amount of gold they had on deposit. This was profitable for the banks in that they could charge interest on lending out their own bank notes. This was possible only to the extent that they could find clients who would be willing to hold their bank notes rather then hold gold. The willingness of the public to hold banknotes rather then the physical gold was dependent on the reputation of each bank, the collateral services they provided and economic conditions. If too many people asked to have the physical gold in exchange for bank notes and the bank did not have the gold to deliver, and then the bank would be bankrupt. A bank's reputation for prudent financial management was its most important asset. If the bank suffered a crisis of confidence and people were not willing to hold its notes, then it could not make money from lending its bank notes. This was and continues to be the primary method by which commercial banks and lenders make a profit i.e., the monetizing of instruments of debt. During periods of optimism, banks could issue more bank notes and so inflate the money supply. During periods of pessimism, banks found fewer people who were willing to accept promises and so the supply of bank notes in circulation contracted. One of the basic problems with this system is that it is, at least linguistically, fraudulent.
When the bank issues a certificate of deposit, savings account passbook or checking account statement in return for the money given to it by the depositor, it deliberately and knowingly creates the impression that the money is on deposit. The reality is that the bank lends that money out to, for instance, General Motors or maybe a hedge fund. Once the money is lent, it is spent like the cup of sugar you lent to your next door neighbor. It is no longer on deposit anywhere. The bank deposit is really a loan by the depositor to the bank and the bank hopes to get equivalent money back with interest from General Motors or the hedge fund some time in the future. Some times lenders are able to get loans repaid and some times they are not. Modern banking is often traced back to medieval goldsmiths who issued receipts for gold on deposit from clients. The receipts were used in commercial transactions to settle accounts. They were treated as money. There is no record of whether the first goldsmith who issued more receipts then he had gold on deposit was charged with embezzlement and fraud. Today, we simply call it fractional reserve banking and it is how the modern banking system operates. During this last credit expansion cycle the reserve requirement for commercial bank holding of treasury debt was dropped to zero. The critically important thing to remember, when everyone else is panicking during some part of the contraction phase of the credit cycle, is that the money was spent at the time the credit was extended. When debts are in default, is simply the time at which it is recognized and acknowledged that the wealth is gone. The reality is that the money was gone when it was lent. Most people understand this when they lend money to a brother in law or mistress. During the latter part of a credit expansion cycle, loans become particularly doggy. A Federal Reserve Bank president, in a private conversation, once explained: "USA banks' loans are just as good as their deposits."
The people running the Federal Reserve know exactly what they are doing. They are amongst the brightest financial minds in the worlds. They understand credit cycles, the political component of their task and the importance of maintaining public confidence. The contraction of credit during the 1930s was the first cycle, which did not end with the return to convertibility for gold for the domestic holder of banknotes and other financial instruments. Public tender laws required that federal reserve notes, which were not longer redeemable for gold, be accepted for all public and private debts. Convertibility, however, was maintained for international central banks until the gold window at the NYC Federal Reserve Bank was closed during Nixon's first term in the 1960s. The financial regulator has sought, in each cycle, to shore up the financial system and to smooth out the cycle and promote stable economic growth. The most important tools in maintaining public confidence in the commercial banking system, to assure the depositor that their money is safe, has been: deposit insurance and bank examinations to assure that there are adequate reserves for loans made by the banks. The formula is: the deposits are secure so long as they were covered by the loans, which are counted as assets on the books of the banks, plus the banks' capital including reserves for bad debts. In order for this formula to work, the bank examiners must be able to examine all of the credit extensions actually made by the banks. A brief explanation and history may be helpful.
When a loan is made to a borrower, the bank must set aside a certain percent of the principal amount lent as a reserve based on the expectation that a certain percent of such loans will not be repaid. That is pretty straightforward and easy enough to understand. If the expectation is, that from a hundred loans, five will not be repaid, and then a five- percent dad debt reserve would be adequate. Bank regulators need only to verify that no more than five percent of the loan will go bad. If more than five percent go bad, then bank regulators can require that the bank set aside more reserves for bad debts.
Businessmen, both bankers and borrowers, have often sought to get around the rules imposed by bank regulators. Rather then make a direct loan; various indirect means have been used to get around the regulatory regime. Letters of credit are one example. These are not direct loans but the promise that at some future date that the bank would pay money to the order of the beneficiary stated in the letter. For a time, bank regulators did not require banks to reserve for such future liabilities because they were not yet loans. After some nasty bank failures caused in part by liabilities from letters of credit, reserve requirements were imposed at the time of the issuance of the letter of credit. Then letters of credit were written not only for future payment but also contingent on the happening of some future event. Again the regulators did not require reserves because the loan may never have to be made. Again, in the next cycle of credit contraction, some banks failed because, in part, they had many contingent letters of credit upon which they had to pay which resulted in loans for which they did not have adequate reserves. In each cycle of credit contraction, when the full facts are examined in light of the loan defaults, there are allegations of fraud. The use of lease financing is another example. This is not a loan. We own the property. We are simply collecting rent. Again the same result.
The most recent off balance sheet financing mania is derivatives. The regulators have not required that reserves be set aside to cover the risks assumed. The argument goes something like this. If we have one client that is long the British pound and another client who is short the British pound, then the full amount of the risk that the pound will go up or down is borne by one or the other client. We therefore do not need to set aside any reserve for the risk we are taking as a bank since we are only facilitating the transaction as an intermediary. The bank regulators have bought into this logic and currently there are virtually no reserves to meet the potential future loss from counter party default risk. What has been totally ignored is that when one or the other party defaults on half of the transaction, the bank will be asked to make up the loss to the other side. The bank is extending its credit when it acts as the intermediary and will be called upon to pay up when one side defaults. There are at least three trillion dollars of such liabilities assumed by the NYC money center banks. If just 10% of the clients default, that would more than wipe out all of the money center banks' capital. It is not difficult to script a number of situations under which this could occur. That is what is different this time. That is why the Federal Reserve has bailed out Long Term Capital Management LP and that is why interest rates are being dropped. There is a significant systemic risk for which there are no adequate reserves.
New technology has not eliminated the business cycle. It has however permitted the risks to be multiplied many fold. All of the solutions on offer thus far involve extending more credit. During the contraction phase of the credit cycles of the last fifty years, various reforms and micro management including the extension of more credit have been used in an attempt to smooth out the business cycle and keep consumer prices from falling. It has also served the cause of promoting political stability. In the time frame between roughly 1965 and 1982, when after tax family income is adjusted for inflation and the percent of women in the work force, real family incomes dropped almost by half and the DJIA dropped by more then 80%. On inflation adjusted basis the August 1982 DJIA low was the same as the 1930s depression low. Inflation hid the stock market crash and depression level drop in real income. The existing economic order survived a military defeat in Vietnam, a sexual revolution and the civil right crusade. This ranks, in our view, as one of the most brilliantly successful financial monetary policy programs in history. The accomplishments since 1982 are equally impressive.
In 1982, many of America's largest financial institutions, when all assets were marked to market had negative net worth. Worthless loans to third world countries, a 23% prime rate, 15% inflation and corresponding yield on 30 year government bands had left multi billion dollar holes in the balance sheets of the likes of Equitable Life and many of the money center banks. The solution was to make
the USA the world's largest tax haven for foreign nationals not resident in the USA. This was a deliberate conscious policy choice made by the people who control USA monitory and fiscal policy. This was done by first making bank deposits and Federal Government debt tax-free and then later extending that to state and municipal government debt and finally too private corporate debt. Trillions came pouring in. Since the DM, BP, FF, and SFr could be used to buy foreign goods and services, this permitted a higher level of spending without domestic consumer inflation. The inflation in asset prices has been spectacular: over 1,000% for the DJIA. Trees do not grow to the sky. Everything has its limit and the DJIA reached its limit for this cycle on July 20, 1998 at 9,412-intra day. Will the masters of USA monitory policy be able to execute a third equally brilliant plan and so guaranty the continuation of USA economic and political dominance into the next millennium? |
