The End of an Era

This investment era began on Monday, August 16, 1982. On Friday the 13th, Mexico had threatened to nationalize all foreign banks and default on its debt. That weekend, the world’s central bankers were meeting. They agreed to start pumping in new money. They negotiated new terms with Mexico. On Friday, the 13th, the Dow Jones Industrial Average bottomed at 777.

The week of September 14, 2008, will go into the textbooks as the end of an era. It marked the end of the investing public’s confidence in the Powers That Be.

When the Dow Jones fell 504 points on Monday, September 15, in response to the failed bailout Sunday night of Lehman Brothers Holdings, it was obvious that the public’s faith was shaky.

On September 7, Treasury Secretary Henry Paulson, acting on his own authority, nationalized Fannie Mae and Freddie Mac. Nothing like this had ever been done in American financial history. Presidents have done things like this in crisis periods, but never a lame-duck Treasury Secretary.

One week later, Merrill Lynch was bought by Bank of America, Lehman went bankrupt, and Paulson justified this on the basis that he did not want to bail out another company or a pair of companies. It was intended to sound inspirational. Here was a man who had transferred $5 trillion of mortgage liabilities to the Federal government on his own authority the previous Sunday. Yet here he was, valiantly informing the public that enough was enough: there would be no government bailout.

Fast-forward 48 hours. The Federal Reserve released a press release at 10 p.m., eastern daylight time, that it will loan AIG $85 billion in exchange for 80% of the company. This is the biggest bailout in American history. There was no discussion of it in Congress. The next day the Dow Jones Industrial Average fell 449 points.

What reversed the fall was an announcement on Thursday of a $700 billion bailout at taxpayers’ expense. If Congress approves of this, there will be more emergency requests. Call this $700 billion a follow-up on Tuesday’s $85 billion. This was a world away from Sunday’s assurances that there would be no more bailouts.

The people in charge are riding the whirlwind. They have pulled us on board.

What I find amusing in retrospect is that on Monday, the government asked Goldman Sachs and J.P. Morgan to pony up $75 billion to lend to AIG. They ignored the opportunity. What was Paulson thinking of? A loan to a near-bankrupt giant? How? Goldman Sachs shares had been $240 in November 2007. Down they went, month after month. On Wednesday, Goldman Sachs shares fell to $100, then recovered to $115.

This was a follow-up on an equally preposterous scheme on Sunday. Paulson had assembled 10 financial institutions to bail out Lehman. One of the 10 institutions was Merrill Lynch. Before the bailout was nixed by Barclays Bank, Merrill Lynch had gone out of business as a separate institution. Paulson was so out of the loop that he did not realize that not only could Merrill Lynch not come up with $7 billion as its share of the proposed bailout, it would cease to exist as a separate institution before the day was over.

If ever there was a man who is out of the loop it is Treasury Secretary Paulson. Yet he was CEO of Goldman Sachs before he was Treasury Secretary. He saw no signs that Merrill Lynch was about to go belly-up.

To give you some idea if how far removed from reality Paulson has been for months, read his September/October article in Foreign Affairs. This is the most important journal of opinion in the United States and probably in the world. His article is a long discussion of trade with China. There was not a word on the looming collapse of America’s banks.

The story of the merger is amazing. I saw the CEO of Bank of America interviewed on Monday. He gave a cheerful assessment of what a great idea it was for Bank of America to buy Merrill Lynch for $50 billion in BofA stock. Understand, this is the man who oversaw the purchase of Countrywide Financial. So, when he gives cheery analyses, I tend to be a bit skeptical.

He went on to say that he got a call from the CEO of Merrill on Friday afternoon. By Saturday, they had discussed the merger in person. On Sunday, the two completed the merger. Neither of them had discussed this with their boards of directors. There was no warning to investors in either company that a merger was required in order to save Merrill from bankruptcy.

On Monday, Standard & Poor’s rating service dropped the Bank of America from AA to AA—. At the same time, the stock market rendered its vote of no-confidence. On Friday, Bank of America shares sold at $34. The stock opened at $28 on Monday morning. By Monday’s close, it sold for $27. Yet the CEO assured us that this was just a terrific merger that would be beneficial to both organizations.

It was obvious by Monday afternoon that the investing public was not buying any of it. It had just had one weekend surprise too many. It was clear to the public that the people at the top did not have a clue as to what was taking place. They did not know how to solve the problem.

Then, late Tuesday night, the Federal Reserve issued its press release. There was no discussion by Bernanke. There was no discussion by any senior FED official. There was a statement from some unnamed Federal Reserve staffers who assured the public that this was not the nationalization of AIG. Yet it was obviously the nationalization of AIG. It was a nationalization comparable to the nationalization of Freddie Mac and Fannie Mae. That nationalization was called a conservatorship.

The leaders of American finance apparently believe that the secret of saving the financial structure is through word magic. If they re-name what the bailout process is, somehow it will be palatable to the investing public.

Lehman has gone bankrupt. All of its assets, totaling $639 billion, will have to be sold into a market that is in crisis mode. No one knows what market value these assets possess. No one knows what degree of toxic waste is in the asset column of Lehman’s balance sheet. We are going to find out very soon.

MASTERS OF THE UNIVERSE, EMERITUS

The public has been trained to believe that the people making the decisions at the top of the American financial system are masters of the universe. These were the best and the brightest. They had invented all of these wonderful new contractual obligations that made billions of dollars of profits for their companies. It was going to go on forever.

Then, like toppling dominoes, the masters of the universe were exposed as bunglers of the universe. They took their severance pay of tens of millions of dollars each, and went off into the oblivion that is reserved for ex-masters of the universe.

These stories kept coming before the public, beginning with the forced sale of Bear Stearns in March. One by one, the organizations that supposedly are at the heart of American financial capitalism have been exposed as barely functional operations that have been run by men who did not have any understanding of the new finance.

All of these leveraged securities had been designed by mathematical geniuses. So had Long-Term Capital Management, which went bust in 1998. The problem is, the heads of these organizations are not mathematicians. They took the word of a bunch of “quants,” who had no experience making money, that these incredibly complex contractual arrangements would make above-average profits, year after year, and not expose the issuing organizations to gigantic risk. In other words, they trusted mathematicians and computer geeks with the future of their companies.

Anyone who has dealt with computer geeks knows that some of these people have trouble balancing a checkbook. They are whizzes at constructing arcane codes that nobody understands. It is even worse with the mathematicians. They thought that you can evaluate risk in advance and shield yourself against risk by establishing co-party agreements. AIG wrote $447 billion of these agreements. No one knows how the Federal government will pay off any of them in a market collapse.

Meanwhile, all over the world, these agreements are now coming due. The bankruptcies have forced the contractual parties to come up with the money to pay off the people on the other side of the contracts. The trouble is, there is no mechanism, no court system, no nothing that is able to enforce these contracts. The organizations have become dependent upon them, trusting in their liquidity and their enforceability to protect them against downside moves of the market. Lots of luck to everyone who believes that the person on the other side of the contract is going to have enough money to pay off that contract. Lots of luck in dealing with his lawyers.

The entire system is unraveling. Nobody has a handle on it. Nobody knows how many agreements are out there, or how much money is at risk, or how many bankruptcies we can expect. All that the experts know is that this system has been designed by mathematicians and computer geeks.

The people in charge of sorting out the mess are tenured, salaried economists who work for the Federal Reserve System and the Department of the Treasury. These are the fellows who were not good enough at mathematics to become mathematicians. Yet these are the people who are expected to produce a cure for the developing catastrophe that is threatening the capital markets of the entire world.

Why should anyone have believed that the people in authority knew anything about the system which was being constructed in terms of Alan Greenspan’s expansion of the money supply after 1995? Yet they did believe that these people knew what they were talking about. They put faith in these people. Now that faith has been betrayed. The masters of the universe, whether in the private markets that have been subsidized by the fiat money of the Federal Reserve System, or hired by the Federal Reserve System, are now perceived as what they always were: people who did not know what was happening.

THE SKEPTIC WHO SOUNDED A WARNING

One man who knew that they didn’t know what they were doing was Dr. Kurt Richebächer. From the year 2000 until his death in August of 2007, he issued a monthly 12-page analysis of why Greenspan had created the largest asset bubble in history. He warned, month after month, that this system would break. He said that when it breaks, it will bring down capital markets all over the world. He had been a German central banker, and he knew better than to believe that central bankers were in any position to administer the capital markets by injections of fiat money. He died in the month that the first crack in the system began.

If you look at any of the stock market charts, beginning in May 2007 until today, you see an interesting pattern. There was a significant fall in the value of shares in August 2007. Then, very rapidly, the market rebounded. All the indexes went back up. They peaked in October 2007, when the Dow Jones Industrial Average for one day went over 14,000.

On November 5, I posted an article on my website to alert my subscribers that it was time to short the American stock market. I recommended that they short the Standard & Poor’s 500. I later updated this to include the Russell 2000 index. It was clear to me that when the Standard & Poor’s 500 index fell from 1550 to 1500, the game was over. I was convinced that there was no way that the bull market would go back above 1550. I was convinced that what Richebächer had said was accurate, and what Austrian economic theory says about the business cycle is accurate. I believed the stock market was headed down. I have not changed my view.

The stock market really is past the point of no return. I believed that we were beyond it last November. Nothing has convinced me since that time that we did not pass the point of no return in October of 2007. The stock market is down. All over Asia, stock markets are down by 50% this year. I warned my subscribers this would happen, and I told them not to buy any Asian stocks. The Asian stock market went down faster and more sharply than the American stock market has.

NO PORT IN THIS STORM

There is no national port in the storm that has now begun to hit us. This storm is like Hurricane Ike. Hurricane Ike was gigantic in terms of its diameter. It was as big as the state of Texas. Like Hurricane Ike, the financial storm we are in is not yet a Category 3 or higher. It is more like a Category 1. It will not stay a Category 1. It is going to go to Category 2 or 3. And, like Ike, it is going to cover a lot of territory.

Experts now say that this is going to be a mild recession. They have said that it will last six months. These are the same people who said there would be no recession. They did not tell you to short the stock market in 2007. These are the people who have been perma-bulls since 1982. They tell you to have a balanced portfolio of stocks and bonds.

The storm is coming. You have been warned that the storm is coming. Those of us who have been critical of Alan Greenspan since 1987, because we knew that he believed he could outsmart the capital markets of the world, were amused to hear him say on Sunday, September 14, that the capital markets are entering into a crisis period that we see once in a century. Thanks, Alan, for you are the engineer who created it.

There comes a time to face reality. The reality is this: the best and the brightest in America’s financial institutions were blind as bats. They thought that risk was minimal. They took gigantic risks with the capital of their companies and investors’ capital to squeeze out an extra percentage point of return on investments that should never have been made at all. They are matched in blindness by the economists at the Federal Reserve System and the United States Treasury.

We have a lame-duck President, a lame-duck Treasury Secretary, and an academic economist who is running the Federal Reserve System. The best and the brightest in the private sector have been dismissed. They took their tens of millions of dollars and wandered away. Now we are left with tenured government bureaucrats who are in charge of Fannie Mae, Freddie Mac, and the largest insurance company in the United States.

CONCLUSION

Investors last week began to figure it out. A lot more investors are going to figure it out. They are going to have two years to figure it out. This is if things go well. They may have three years to figure it out.

Whoever is elected President in November is going to preside over the worst financial disaster in American history in the postwar era. Some lucky soul is going to lose this election.

You had better batten down the hatches.

September 23, 2008

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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