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Sat

31

Mar

2007

Duck and Cover (Your Assets)
Saturday, 31 March 2007 10:34
by Stephen P. Pizzo

The free enterprise system is a powerful force for both good and ill. Every Yin has it's Yang.

So I'm not a far lefty who believes that capitalism is at the root of all the world's ills.  Nor am I a free market moonie who believes that, if government would just get out the way, free enterprise could solve everything. The truth, of course, lays somewhere between those two extremes.

When economic times are good, advocates of laissez-faire markets are quick to remind us that the reason things are good is because free markets are self-correcting organisms. They say the many individual parts that make the economy perk along are so tightly dependent on one another that they self-regulate — out of self-interest. Why, the free marketeers ask, would one player in bountiful economic food chain abuse their role in a way that could cause that chain to collapse? And why would the others in that chain let him?

Nevertheless, even the most devout free market advocates admit the obvious, that bad apples, like Ken Lay and Charlie Keating, come along from time to time. But when that happens, they claim, the business-ecosystem cleanses itself of these pollutants,  not out of any sense of right and wrong, but out of pure self-interest and self-defense.

And it often works just that way — just not often enough. From time to time distortions in a vertical market segment (can you say, "sub-prime?") can create powerful perverse incentives, incentives that actually make doing the wrong thing collectively more profitable to everyone involved than doing the right thing.

I first saw this during what matured into what is now remembered as the savings and loan fiasco of the 1980s. While the good times rolled back then, nearly half a trillion dollars flowed in and out of the pockets of those in that financial food chain comprised of lenders, borrowers, developers, thrifts, title companies, appraisers and of course accounting firms. Lots of folks in each of those businesses knew —  in the gut if not in their head — that it couldn't last, and that when it ended that there would be hell to pay.

Nevertheless the incentives to keep the money flowing were enormous for each member in the S&L business-chain — which had devolved from a robust home lending industry into the business-world equivalent of a giant circle-jerk. Everyone was getting theirs so no one wanted to be the one to break up the party. Eventually, as all such Ponzi schemes do, it collapsed. And when the smoke cleared nearly half the savings and loans in the nation were insolvent, busted, leaving taxpayers and innocent shareholders holding the tab.

We saw this phenomena again when Mike Milken discovered how to game the junk bond market by making it worth the while of those up and downstream from him to play ball. Bond markets depend on complex interrelationships between issuers, insurers, buyers, sellers, fiduciaries and bankers and those accounting firms again. Milken couldn't have gotten to first base with his junk bond Ponzi without the eager cooperation of each and everyone of them.

The dot-com bubble is another object lesson,  and another instance where I “enjoyed” a front row seat. I was a founding employee of one of those dot-com juggernauts. In less than three years the company grew from 12 to over 430 employees. Venture capital firms elbowed one another out of the way to stuff tens of millions of dollars into our bank account, even though we were not making a dime and had no prospect of ever doing so. In March 2001, and $166 million later, the company lay stone-cold dead in bankruptcy court and disappeared, along with hundreds of similar dot-com mirages.

Once again the marketplace had created perverse incentives to all those involved. The venture firms told us not to worry our little heads that we were not making money. They said to just focus on using the money they gave us to grow, grow.. grow... grow like a tumor. Why? So they could get the company noticed by Wall Street, take it public and cash the hell out. After that they could care less what happened to the company – or all those the suckers that bought their stock in it.

During that process I kept saying things like, “Wait, this makes no sense. We have no tangible product, no articulable business plan, we are burning through $6 million a month and have virtually no income streams.”  All that earned me was heartache and a nickname. Whenever I came into a meeting the CEO would remark, “Oh, Oh. Here comes Mr. Trouble.”

It's human nature. When members of one of these business food chains are busy stuffing themselves like Jonestown geese, the last thing they want is for some killjoy pointing out that all that abundance may be the product of deceit, phony-baloney, cooked books, twisted numbers, slight of hand, winks and nods, scratching of backs, the greasing of palms, in other words, everything but sustainable, above board, by the numbers, by the book, "generally accepted accounting principles."

Which explains the reluctance we are witnessing today to recognize the clear and present warnings that another day of reckoning in the offing. Nevertheless the early signs that the end is near for this cycle of business excess abound, at least for those willing to pay a bit closer attention.

Just listen the next time Federal Reserve Chief, Ben Bernanke, goes before Congress and whistles past the graveyard, soft-peddling the impact of such major disturbances in the force now impacting one of the economy's central supports — new and existing home sales. And imagine the impact of an ongoing war that requires America to borrow $12 million an hour, every hour, everyday. Imagine that! Now try to imagine that kind of borrowing by your government for non-productive spending will not, at some point, impact the economic health of our economy. You'll need quite an imagination to pull that one off.

Watch the US stock market. The DOW now spends it's time crashing one day, then clawing it's way back up a wall-of-worry the next, only to crash again when investors reach the top of that wall are terrified by what they see on the other side. It's a classic see-saw chart pattern we've seen before just before the bottom falls out. The market rises as institutional investors sitting on large positions prop up the market just long enough to dump their positions. On who? Onn ordinary smucks who, every time, fall for their clap trap that, "it's just a market correction," and that “a down market is really just a buying opportunity.” You would think the smucks would be suspicious when big investors are more than happy to sell them their shares. ("Hey buddy. Take my shares — please!")

And where's the proof for that claim? Just have to follow the money, honey:

Assets in Money Funds Hit Record

Investors contributed $5.61 billion into money-market funds in the week ending Tuesdays, brining the total assets in money-market funds to a record $2.4 trillion breaking a previous record reach March 13." (WS Journal 3/29/07)

The doubters will retort, "Come on Mr. Trouble. That doesn't prove institutional stock investors are deserting stocks for the safety of money funds."

Oh yes it does. Read further.

"Institutional investors $7.3 billion (so far in March) compared to $1.69 billion by individual, or "retail" investors."

Oops.

Among other reasons institutional investors are bunkering down maybe found in a piece written by Dennis Berman that also ran this week in the Wall Street Journal. In that piece Berman disclosed that precisely the same kind of risky lending that sunk the home mortgage markets, is  alive and well and running full-throttle in the corporate bond market.

“Lenders have been doling out increasingly large sums of money and accepting increasingly crummy terms.... Remember those “low-doc” loans that got sub prime home buyers in trouble? These (loans) are their corporate cousins.” (Berman)

Last year alone corporate lenders issued over $145 billion in such sub-prime corporate loans, securitized them as bonds and pawned them off on investors thirsting for high returns. Like the dot-com venture capitalists of the 1990s, these lenders care less if the bonds go belly up once they've bundled them up and sold them to investors on Wall Street. (In the world of accounting such behavior even has a name... it's called  a "moral hazard.")

How can we  be sure that a corporate sub-prime crisis is in the offing? Because, you don't need to ask what's about to happen when you see the smartest rat jump off a ship. In this case that rat would be Bill Conway, co-founder of the Carlyle Group – a private investment house that serves a who's who of who's who in American business and politics.

This week Conway warned, that while Carlyle had made a bundle on corporate debt over the last few years, that the party is over and he is lowering Carlyle's exposure because of what he described as “a corporate debt bubble.” He also warned corporate lenders that they were sitting atop “a house of cards.

“The fabulous profits we have been able to generate (from corporate debt), Conway wrote to Carlyle's employees and investors, “resulted in large part from the availability of cheap debt.” The bankers,” he added, “are making very risky credit decisions. (Conway)

And they're still at it, because the fees generated issuing sub-prime corporate debt are staggering.

“In other words,” Berman ended his WSJ piece, “don't worry how it will end. Just know that everyone will be getting paid until that day arrives. No worries, indeed.”

Just as the evidence is now pouring in documenting the first negative effects of global warming, so too does evidence abound of severe stresses mulitplying within the business eco-system. Deniers can be found in both cases. For some global warming won't become a fact until it directly impacts them personnally. Even then some hardcore conservatives will still deny human excesses were the cause.

The same goes effects of the growing excesses and toxicities building within the US economy. I'm no longer interested in trying to convince my conservative friends on this count either. It's too late anyway. And I am under no illusion that, when the stuff finally hits the fan, that they will repent, admit they were wrong, and finally agree that some degree of government regulation is not only justified, but healthy. (And you gotta know that when all their econmic chickens come home to roost they will blame the woes on those who tried to sound the warning for "spooking the markets.")

 I will not elaborate further. Some reader recently accused me in my last post of being “long winded.” So I will shut up now and simply  provide you — and my conservative friends — a few links to just a bit of the freshest evidence.

Then you, and they, can decide for yourselves if I am a Chicken Little or realistic. Then act accordingly.

Race to The Bottom for US Wages: Circuit City to fire 3400 and rehire lower wage workers.

US Economy Leaving Record Numbers in Severe Poverty

U.S. Income Gap widest since Great Depression

Subprime Crash Threatens Bond Markets

Will Companies Go the Way of Sub-Prime Home Borrowers?

US Trade Deficit Balloons to $182 Billion

Risk of a Boomer Bust Grows

Total Consumer Debt climbs from $1.9 trillion to $2.4 trillion

http://www.federalreserve.gov/releases/G19/Current/

http://www.msnbc.msn.com/Default.aspx?id=3939463&p1=0

Can Economic Collapse be Avoided?

The US Economy as Seen from Abroad

Video of the Week

What We Call the News
| Send To Friends | Funny Animations at JibJab


I couldn't have said it better myself
(And didn't.)
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a guest said:

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Great article. I was stupid enough to invest all of my money in an aggressive growth mutual fund back in 1999. There were signs of a bubble growing then, but I ignored them and listened to those who predicted the DJIA would soon be at 15000. Seven years later, I still have have not recovered the money that I lost in 2000-2002.

I believe the stock markets today are behaving very similarly to the stock markets in 1999.

James
 
March 31, 2007
Votes: +0

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