UNPRODUCTIVE ASSETS, WASTED PRODUCTIVITY
Jim Willie CB January 10, 2008
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Jim Willie CB is the editor of the "HAT TRICK LETTER"
Use the above link to subscribe to the paid research reports,which include coverage of several smallcap companies positioned to riseduring the ongoing panicky attempt to sustain an unsustainable systemburdened by numerous imbalances aggravated by global village forces. Anhistorically unprecedented mess has been created by compromised centralbankers and inept economic advisors, whose interference hasirreversibly altered and damaged the world financial system, urgentlypushed after the removed anchor of money to gold. Analysis featuresGold, Crude Oil, USDollar, Treasury bonds, and inter-market dynamicswith the US Economy and US Federal Reserve monetary policy.
The US system has been the dog led by the financial sector tail, asthe tail wags the dog, for over two decades. Systematically, the UnitedStates has abandoned manufacturing in favor of financial sectordominance with futile attempts to manage inflation, and money changerspushing to foreign lands the capacity that actually makes things andadds value. Such is the painful costly consequence of chronic monetaryinflation. Unfortunately, the nation has invested heavily for decadesin unproductive assets like military hardware and recently homes. Theentire USEconomy was made heavily dependent upon the housing boom andmortgage finance craze. Now that a housing crisis and mortgage debacleseems a nightmare without end, we are treated to utterly moronicopinions that the USEconomy will glide through the storm. It will not.A recession has begun even after the false 4% lift given to the GrossDomestic Product, as in the recession is soon to be worse than a 4%contraction, and soon. The nation has squandered its productivity, themost important achievement next to innovation. The major innovation inrecent years has been in lunatic option-laden adjustable mortgages, notmuch to write home about to mother lately. The major productivity hasbeen in the assistance of outsourcing of job overseas by replacing USworkers with advanced equipment. The nation is witnessing the viciousbackfire of decades of destructive investment in unproductive assets,wasted productivity, and innovation in devices which kill the bankingsystem.
Gold has noticed, poised to reach $1000 before the daffodils andjonquils break ground in the spring flower beds. The gold price willrespond on all continents from uniform policy by central banks tostimulate economies enough to avoid recession. Today, the Euro CentralBank talked about a rate cut, but choose no action. The major theme forgold will be rampant money supply growth on the front end, accompaniedfinally by rising price inflation on the back end. With theUSEconomy reeling toward recession, the US Federal Reserve has nochoice but to cut interest rates again and again. Even Goldman Sachs(aka Dept Treasury) and JPMorgan (aka USFed itself) expect a 50 basispoint rate cut at the next FOMC meeting at the end of January. Aninterim cut could occur. The prevailing guesses have become how far theUSFed will cut rates, currently way too high at 4.25% now. GSax thinks the official Fed Funds rate goes all the way down to 3.0% before the autumn ends.We have a strange situation where the real economy is contracting whilethe financial sector attempts a massive monetary inflation effort. Thestorm vortex is building, from competing high pressure and low pressurezones.
Meanwhile, gold will march upward. The USDollar might not suffer acollapse just yet, as the Europeans will be forced into cuttinginterest rates soon. The competing currency wars continue to weaken alleconomies. The global stimulus to ward off recession will lift goldtremendously. Gold might zip past $900 soon, but might consolidate alittle more above the $850 breakout level. It don't mattah! The nextchapter for gold has been written. If one peeks ahead to read twochapters forward, a glimpse can be snatched at a gold price past $1500.Fortunately for mining firms, energy prices will relax from the slowereconomies. What follows is an attempt to tell the story of how theUnited States painted itself into a corner. Its banking system is inthe process of collapse. Its value added economy centers largely onservices, including bankruptcy counseling and mortgage lawsuits. TheUSDollar has become a ballot for global votes cast against the USstewardship of the world reserve currency, against the reckless designof the bond & risk management model, against blank checks writtenfor Medicare, against the management of the US war machine. Trulydangerous times lie ahead.
US FINANCIAL SYSTEM FAILURE
Whenthe Vietnam War was triggered in the 1960 decade, the US$-gold standardbound by the 1971 Bretton Woods Accord was doomed. The Great Societypushed by Lyndon Johnson in the same decade sealed the USDollar's fate.However, it would take three more decades before the system wouldundergo its final gasps. That is now! The payment for the huge $1trillion cost of the Vietnam War sent the USGovt federal budget intodeficit for the first time. The seeds of socialism widened thosedeficits. The 'Guns & Butter' theme was a boast, but also it wasmuch more an obituary title. History repeated itself in the1990 and 2000 decades, as the staggering costs of the Medicare programdelivered a socialist death blow to a reeling system. Then in 2001, abizarre mysterious attack occurred, which laid the cause for waragainst Iraq and Afghanistan. Certain groups might have wanted war,greater funding, and control. The costs associated are againstaggering, enough to render the budget as permanently broken. Theentire privatization initiative for some military functions is a finalmetastasizing cost cancer.
As a coincident effect of war and socialism, the USEconomy sufferedchronic price inflation, all deemed essential for prosperity by theincompetent compromised cast of economists. The resulting higher wagestructure rendered the United States exposed to foreign competition.The 1980 decade saw the technology industry migrate to the Pacific Rimand Japan. The 1990 decade developed the PacRim Tigers and theireconomies into powerhouses. The 2000 decade, after the Most FavoredNation was granted to China, finished the process of industrialmigration away from US shores.
The chronic inflation ravaged the USEconomy on a structural level. With lost industry, the USEconomy was forced to rely on an increasing basis upon asset inflation as a power generator.Greenspasm blessed the process as legitimate. It bought him enough timeto leave town. In the 1990 decade, it was the stock market. In the 2000decade it has been the much larger twins of the housing market and bondmarket, whose combined size is at least 5 to 6 times larger than thestock market. Worse, the credit derivative market pyramid is closelyattached to the bond market, rendering the housing/bond complex evenmore dangerous. Nobody knows who counter-parties are anymore, or howstrong they are, or whether they are already dead. The ripple effectsfrom mortgage bonds have already hit the derivatives in the form ofCollateralized Debt Obligations. The CDO bonds typically have leverageof 3 or 6 or 10 times, depending upon level of desired client risk. Thebank system has close ties to the bond market, asset backed bonds,dominated by mortgage bonds. Most interbank commercial paper ismortgage bonds. The housing crisis and mortgage debacle have delivered a death blow to the US banking system.It is dead, only full accounting remains. The big banks are one by onegoing to suffer very public deaths, labeled at first as struggles withinsufficient capital. Right now, many are vampires, as in walking dead.That is why they are lending much less. Their own executives areunclear of their own solvency, as illiquid markets conceal their ownbankruptcy. Most of them are loaded to the gills with bad loanportfolios and severe losses on mortgage bonds. Where CDO bonds areinvolved, losses are amplified. The biggest players in CDOs will be thefirst banks to die. Losses have been huge, but it is very early.Ultimately, bank losses will be ten times larger than those disclosedto date.
The overdone housing construction boom has left hundreds ofthousands of workers without jobs, since they embarked on a path out ofcontrol. The banking system initiated and urged on the structures tofinance the housing boom, seen now as a suicidal course. The mortgagebonds have a $10.4 trillion size, steadily falling. The housing markethas a $22 trillion size, steadily falling. In its motivated need tosustain the housing boom, the banking executives and Wall Street firmsmade conscious decisions to bend the lending rules for loans andsecuritized packages. Not only did subprime mortgages become popular,but on a much bigger scale innovative adjustable prime mortgages wentout of control. Bankers pushed the limit until the process ran out ofavailable sucker buyers of homes and willing buyers of acidic bondsacross institutions worldwide.
UNPRODUCTIVE CAPACITY STRESSED
The tragedy has a theme that is a consequence of the military & socialist emphases, in the form of investment in 'Unproductive Capacity' of two types.In the 1980 decade, a tremendous surge occurred in military spendingwith Star Wars technology. The Arms Race with the Soviet Union killedthe Soviets quickly, but contributed quietly to set the stage for theUS demise also. The stronger USEconomy permitted many more years ofsystemic dismantlement, as the world's biggest and most diverse economywas gradually gutted, one industry at a time, from technology to steelto machine tools to cars to household appliances to housewares.Investment in military weapon projects does little to createefficiency, to encourage a lengthy trickle down, so that the end of thesequence is either an idle wasting weapon or a destroyed targetcomplete with backlash damage. In Iraq and Afghanistan, we arewitnessing destroyed targets and entire fleets of vehicles destroyed bysand erosion, brutal wear & tear. ON THE DOMESTIC SIDE, theUSEconomy was forced under Greenspan leadership and encouragement toinvest in unproductive capacity in the form of residential housingstructures. They do lead to jobs, with a certain supply chain, butthey are not ongoing productive structures where value is added in ancommercial sense like an office building. People eat, sleep, socialize,endure weather, and entertain in homes. They do not sustain theeconomy, except with continued outrageous consumption of things likeoversized home electronics, Jacuzzis, cool gadgets, spiffy furniture,stylish kitchens, the latest in textured wallpaper designs, andunending room additions.
The tragedy of the USEconomy is outlined in unproductive capacityinvestment gone hogwild out of control, with truly mindbogglingunprecedented economic planning stupidity. The United States has hostedthe worst economic counselors, stewards, and banking managers in modernhistory. The failure of the banking system is their testament. Thefinal throes of the bank system failure can be diagnosed with my threefavorite themes: Ripples, Momentum, Feedback. These themes havebeen periodically brought up in my analysis. The ripples now extendfrom subprime mortgages to CDO bonds to interbank commercial paper tohalted loan processing to strains on LIBOR. Ripples extend from fallenhome values to lower magnitude home equity loans to reduced consumerspending. Ripples extend from unsold homes to job layoffs to harmedhouseholds. The ripples are working in complex powerful interconnecteddirections. The momentum factor is powerful, as bank losses mount. Asmortgage bonds lose value, they build strong forces within the bondmarket for further losses, since sales are forced by both banks andinstitutions. Debt ratings agencies issue downgrades, like gasolinetossed onto the fires. When entire firms collapse, heavy liquidationvolume sales occur, further pushing down prices.
The feedback loops are only recently being seen in action. They willbe powerful in 2008 as the prime adjustable rate mortgages (ARM) beginto fail in volumes perhaps five times greater than the subprimes. Theprocess has already begun, not well covered by the financial medianetworks. The Mortgage Bankers Assn reports an overall 5.6% mortgagedefault rate at end September, the highest since 1986! Offoreclosures in progress, 18.7% are prime ARM holders, and 17.6% areprime fixed rate mortgages. That means one third of foreclosures arefrom prime borrowers. One key element of the feedback loop isthe CDO bond derivative package itself, which places subprime and primemortgages together in adjacent tranches. They are all sold together asthe leveraged CDO bond fails from subprime lost value. Another feedbackloop is the sale of homes from adjustable mortgages giving the optionto underpay interest, now underwater and facing doubled monthly paymentincreases. We are witnessing the failure of the US financialengineering monster. We are witnessing the failure of the US riskpricing model and of the leveraged financial security products. Bankassets are collapsing under the weight of the housing bear market andrampant fraud. The reckless lending standards practiced have only addeddownward pressure. We are vividly witnessing the failure of theGreenspan Legacy, and the catastrophe led by his reckless leadership,but without the blame. The relentless housing decline, lastingeasily through 2008 and 2009, will break the entire US banking systemas wave after wave of newer mortgages default and fail. Greenspannow advocates using USGovt cash to help defaulting homeowners. As banksshow distress, they have lent less and will continue to lend less inmore feedback loops. They will manage foreclosed properties, puttingthem onto the market for sale, forcing prices even lower via addedsupply. FORECLOSURE IS THE MOST WICKED OF FEEDBACK MECHANSIMS, BY BANKSONTO THE HOUSING MARKET ITSELF.
THE BASEL BOYS LOWER THE BOOOOM
TheBasel 2 accounting rules are not discussed much in the financial press.This refers to Basel Switzerland, home of the Bank for IntlSettlements. My deep seated suspicion, more like incrementallyreinforced conclusion, is that the powerful Swiss bankers have begunthe process of receivership. They are forcing through the bankruptcyprocess in an international pull of the rug from under the corrupted USbanking system. They have taken steps partly motivated by the globalcontamination of US mortgage bonds into the world's banking system,which must be addressed. The first step in the process is more properfull accounting of the horrendous damage done to US banks, principallyWall Street banks. Basel 2 requires banks to maintain an 8% minimum oncapital ratios versus debt. In England, the capital ratio has fallen to 2.5% (ex goodwill) compared to 5% in year 2000. York University professor Peter Spencer is chief economist of the ITEM Club. He asks, "How on earth did the Financial Services Authority [of England] let this happen?... Brown hadn't a clue what he was doing."The reference to Lord Brown pointed to changes pushed through in 1998as Chancellor of the Exchequer, which caused the defacto cash andliquid assets to collapse from post-war levels above 30% to near zero. The UK Current Account deficit is at 5.7% of their Gross Domestic Product, more than that of the US.The effect of the Basel 2 Rules on US banks in recent months are toforce massive bond losses to come onto the balance sheets. Shrinkingasset backed commercial paper coincides. One really must wonder if theobjective the United States was to kill the banking systems, enablingSwiss control, with the British system collateral damage.
In the course of packaging mountains of securitized bonds, filledwith mortgages and related derivatives like credit default swaps(insurance policies against loan portfolios) and interest rate swaps(contracts shifting risk from short-term to long-term), Wall Streetfirms were caught holding their own enormous inventory. Domesticinstitutional investors and finally foreign institutional investorshalted their purchases. Additionally, private equity investors, akin toBlackstone, halted their purchases. Wall Street big banker brokers wereleft holding hundreds of billion$ in damaged asset backed bonds beforethey were fraudulently sold to investors.
Thus, the Wall Street firms choked on their own fecal securities held in inventory, unable to sell them. The old saying of "Do not defecate where you work" holdstrue. Wall Street firms were selling acidic lethal bonds, as the gamestopped and investors wised up. Now Basel is forcing, along with USregulators, the process of taking the dreadfully damaged asset backedbonds and CDO bonds onto the Wall Street balance sheets, where they areabsorbed and felt painfully. The initiators of the fraud mightactually suffer the greatest financial losses of all, since they weredoing a grandiose volume of packaging and sales. That is justice.They earned gigantic fees in the process. The entire drama of provedfraud will be interesting to observe. Some investors have begun thelawsuit process. See the Barclays lawsuit of Bear Stearns. The game ison, and will not relent. A Special Report is to be posted for theJanuary Hat Trick Letter on lawsuits and fraud. Unfortunately, therescue programs have been very slow to take root, partly because theUSGovt and Congress do not wish for Wall Street firms to benefit frombailouts. They deserve criminal prosecution instead, complete withheavy fines and prison terms. The climate will be mixed with confusion,shock, anger, and desperation when the first Wall Street bank goesbankrupt. My forecast is that the first Wall Street bankruptcy will not be Citigroup, but rather Bear Stearns.The lawsuits will overwhelm them. Their cash infusion in exchange forcapital stakes will be inadequate to cover writedowns and set asidefunds to litigation and lawsuit awards. The Citigroup bankruptcywill occur next year, with a possibility that a huge breakup of theconglomerate will coincide with bankruptcy restructuring of ailingsubsidiary businesses so as to conceal their bankrupt condition.Other Wall Street firms will be the subject of great debate andcontroversy within rumor mills, since wider recognition will come thatmost are bankrupt. Other big lawsuits are also in progress. Classaction lawsuits are only beginning. Their insolvency will lead tofurther problems on cash flow, enough to freeze them and forcebankruptcy notices.
INNOVATION GONE AMOK
One of the true testaments to a national economy is its ability to pursue and delivery on innovation. Cleverapplication of intelligence through innovation results in addedproductivity, improved efficiency, lower costs, more competitiveproducts, and thus more savings to invest through plow back into theeconomy. In technology, that means faster computer processing,quantum leaps like with fiber optics in communications, biggerbandwidth and channels for cell phones, greater fuel efficiency withcars & trucks & jetplanes, reduction of viruses creeping intothe computer networks, reduction of spam email into inboxes, moreresponsive supply chains to connect inventory with sales, cheaperproduction of photovoltaic cells to capture sunlight into electricity,and much more. In the United States, since the fatal loss of itsmanufacturing sector, its economy turned to financial innovation. Themfg sector was lost from active avoidance of higher cost structuresinside the USEconomy. As the financial sector dominated, the innovationeven had an absurd name, financial engineering, often to scarf lazybond yield differentials, attempting to manage the inherent risk. Thisinnovation involved carry trades to capture differentials betweenforeign government bond yields and domestic USTBond yields (calledcarry trade), to capture differentials between mortgage bond yields andUSTBond yields (called yield spreads), to capture differentials betweenmortgage bond yields and short-term corporate paper (called structuredinvestments). To manage the risk, an array of other risky contracts wassuper-imposed, such as basic currency hedges, basic USTBond futurescontracts, interest rate swaps and credit default swaps. In an effort to be thorough, one should regard USGovt fraud in the inventive doctored statistics as more misplaced innovation. Instead of creating growth and jobs without price inflation, they have used innovative techniques in grotesque deceptions.
What flowed in the last two decades is a series of bubbles puffed soas to attempt to create wealth, since legitimate wealth was no longercoming from value added enterprises such as manufacturing. Without muchdispute, the USEconomy relied heavily upon its service sector, but alsoupon its financial sector to generate bubble after bubble on phonyillicit wealth. The economic and banking leaders then engaged insystematic propaganda and false inculcation to deceive the public intoaccepting the doomed philosophy. Thus chapter after chapter of economicmythology followed, such as the Trickle Down during the Reagan years,the Macro Economy (aka Bretton Woods II) early in this decade, and theAsset Backed Economy in recent years (Greenspan's problem child). Theywere each devastating to the USEconomy. War played a key role to revivethe moribund USEconomy during the early 1980 decade in the Cold Warwith the Soviet Union, and during the 2000 decade in the so-called Waron Terrorism with the Islamics.
D-Day came on a quiet day in mid-August, when the initial shocks came to the mortgage arena.Since then, the nation and world is witnessing the backlash destructionof the phony financial innovation, the slow motion degradation of therisk offload model, and the failure of the US banking system itself.The process will continue through several stages without interruption.In the last few months, the subprime mortgages were the principalfactor to break the system, by means of loan portfolios and relatedmortgage bonds. The next stage will be dominated by prime mortgage failures, and their usually pristine mortgage bonds.Here in year 2008, the banking system will be wrecked by the failure ofinnovative prime adjustable mortgages. Perhaps half of those originatedsince 2002 are under-water. Many newer mortgages have loan balancesgreater than their current home value. Many newer mortgages will not reset upward only by 20% to 30% in monthly payment cost, but rather by 100% to 200%.They violated the negative amortization limit, and past unpaid mortgageinterest is overdue! Leverage employed by the madcap financialengineers has amplified the damage. The bank system has responded withprofound distrust of assets placed as collateral in commercial paper.The banking system is much more seized up in the United States than inEurope, although England is doomed to follow the US lead down thehorrible path. The US bankers have turned increasingly to the Londonbankers, using the LIBOR rate. Notice the rise in the spread of theUSTreasury over the EuroDollar recently. The TED Spread measures creditrisk, defined nowadays at the difference in the 3-month bond yield ofthe EuroDollar (corporate risk) over the USTreasury Bill (no risk).
The Anglosphere, as it is sometimes called, led by English speakingnations, followed the US established model, instilling economicdependence upon asset inflation (houses), and lacing its banking systemwith toxic mortgage bonds. Given their commodity riches from naturalresources, Canada and Australia will delay their appointed date withthe wrecking ball. WE ARE WITNESSING THE FAILURE OF THE US FINANCIALMODEL, ALL ITS HERETICAL PRINCIPLES, AND THE END OF THE ROAD WITH NOAVAILABLE BUBBLES. In reality, the final bubble is the commoditybubble, a revolt played against worthless fiat currencies. As thecommodities rise in price, led by crude oil on the commercial side andby gold on the financial side, the USEconomy will crater from severe cost inflationmuch worse than seen a few years ago. Wages and product prices must beforced higher, or permitted to rise, if the USEconomy is to survive.Higher prices are prevented by the Asians, who continue to export to USshores. Higher prices are not desired by the USTreasury Bond complex,which will be killed quickly if price inflation doubles.
THE BANK SYSTEM WILL BE KILLED IF HOUSING PRICES CONTINUES DOWNWARD.THE BANK SYSTEM WILL BE KILLED IF PRICE INFLATION ON A BROADER BASIS ISSUCCESSFULLY GENERATED. THE USFED IS TRAPPED. This is discussed andanalyzed in the January Hat Trick Letter.
HISTORY REPEATS ITSELF, SAME PLAYERS
History has repeated itself, with the same players even in the first chapter of crisis.In the 1980 decade, the US Congress deregulated the banking industry,which permitted Savings & Loans to approve and grant mortgages. Agrand debacle ensued. At one point, almost $1000 billion was committedto the 1991 Resolution Trust Corp, laden with loans gone bad. Theultimate cost to the USGovt in the bailout was $265 billion, after afew years of salvage in liquidation. At a low point, Citibank wascalled 'Too Big To Fail' at a time when Saudi Prince Al-Waleed enteredthe picture with a giant cash rescue of Citibank, in exchange for acapital stake. THIS IS THE EXACT OPPOSITE OF CAPITAL INFUSION, BUTRATHER EXPORT OF CAPITAL, PAID BY CASH. The Prince is not a fool. Hesupplied fresh cash in return for bank equity (capital) only afterbeing assured of massive USGovt guarantees. The deal is the US keepsthe Saudi robber barons in power, their sheiks buy USTBonds en masse,and then they come to our rescue when our inflation games go amok.Well, history repeated itself, worth saying twice. Once again, anotherhousing bust has occurred, and once again, Prince Al-Waleed stepped inwith a giant cash rescue in return for an outsized capital stake.
THIS TIME AROUND, THE BANK SYSTEM WILL FAIL, AND THE EVENTUALBAILOUT COST WILL BE ASTRONOMICAL, AS IN AT LEAST $2000 BILLION. Theage of financial engineering struck the bank a lethal blow. Many lossesare amplified. Mortgage bonds are leveraged in reckless derivatives,and in contrast moronically destructive predatory time bombs werecreated, posed as adjustable mortgages. The 2000 housing crisis isaccompanied by a mortgage debacle, whereas in 1980 no insane mortgagecondition was concocted. The current problem seems intractable, beyondsolution, since so deeply engrained within the entire system, frombanks to bonds to mortgages to the economy. The current problem is morethan one order of magnitude dangerous and out of control, and at leastten times larger.
CONCLUSION
The privatesector, led by the US Federal Reserve, seems entirely unable to fix thecurrent mess with monetary policy, which means using interest ratechanges and easier refunding measures, from lower bank ratios. TheUSGovt must enter the picture with some fiscal solutions and broadprograms. Let it be said further. The problem appears to have grown tothe entire banking system and the economic system, inviting thequestion if this cycle refers to the 60-year cycle and entire systemicrestructure. The solution, if one exists, will require far more thanwhat the USFed can do by adjusting spigot flow. The USGovt muststep in with truly massive aggressive action, and even their directivesmight be insufficient, first because they will act timidly, secondbecause they will act to protect their cronies before they directattention to the system itself. Their urgent moves will cut 10% to15% off the value of the USDollar, maybe more, all in time. The privateUS banks cannot be revived without direct monumental infusions of cash(corporate welfare) to reinvigorate absent capital. ALL THE TALK OFCAPITAL INJECTIONS IS THE LATEST PROPAGANDA, WHEN CASH IS INJECTED IN EXCHANGE FOR CAPITAL,AS THE MAJOR US BANKS LOSE CONTROL OF THEIR OWN COMPANIES. TheUSEconomy grew overly dependent upon the housing bubble and themortgage finance bubble. Lower interest rates will accomplish little,but they will be given. The universal central bank stimulus willgreatly lift gold, as they combat economic slowdown and recession.Monetary inflation will be joined by realized price inflation thisyear. The rise of gold will be the main investment story of 2008. It isalready.
