Economics

Editor’s note: Four months ago, I wrote an article about inflation couched in terms I thought anyone could understand. My good friend Jim E. has written an epilogue to the story, a story without a particularly happy ending unless you happen to work for the federal government. I never knew Jim was such an eloquent writer. This isn’t the first time there’s been a guest writer at the Experiment but certainly one of the best. — Brett

Currency Wars Part … redux. Or how I stopped worrying and learned to love deflation.

In the Land of People with Below Average Dental Hygiene, Hermione has worked her whole life and managed to save a waffle for her retirement. The waffle was important to Hermione because Hermione planned on buying-and eating-organic butter and clotted cream to make up for all the years of working and doing with less so that she could save. It is not quite time to retire, so Hermione is looking for a “risk free” place to keep her waffle.

A government official, who will by tradition remain faceless and nameless, decided that the government could do more … well, governing … if only the government had more waffles. So, this faceless and nameless government official determined that the government could borrow waffles. That way, the government could have more waffles and, consequently, govern more, without the pesky problem of waiting to accumulate waffles.

Only one problem. How to repay the waffles? Borrowing can be expensive. Then, Bob — you remember Bob who makes the excellent organic grass fed butter — shows up in Carl’s office. And, our faceless and nameless government official see’s Carl’s plan of doubling the number of waffles and our faceless and nameless official has an epiphany. Wait for it. It is coming.

So, with his epiphany, our faceless and nameless official decides that he can borrow waffles by selling government backed bonds. And, he decides to call these bonds a “risk free” investment because, well, it is the government. Who can you trust if you cannot trust your own government? (Don’t answer that. That would be skipping ahead). With his plan in hand, our faceless and nameless official prints up government bonds and offers them for sale: one bond for one waffle. Like a match made in … the other place. Hermione buys a “risk free” bond from the faceless and nameless official with full expectation of being repaid her waffle next year. And, Hermione will receive a very small amount of Bob’s organic butter to compensate her for lending the government her waffle.

If you remember in the original story, Carl then doubles the number of waffles. And, at that point, our faceless and nameless official’s epiphany is almost reality. The following year, after the number of waffles had doubled, Hermione redeems her bond and receives her one waffle. A freshly baked waffle. Unfortunately, her waffle will now only buy half the organic butter and clotted cream that the same waffle would have bought a year ago. Hermione’s dream of living on organic butter and clotted cream is shattered. She is dismayed.

But our faceless and nameless official has managed to keep one waffle after repaying one to Hermione. Our faceless and nameless official is elated (that would be the big word for happy). Someone is happy, so this must be the happy ending? Not exactly.

When the number of waffles is doubled, the government became the big winner and the hard working, hard saving Hermione … well not so much. A long time ago, in a galaxy far away from waffles and crumpets, this was called stealing. Here. Now. It is called Fed policy.

And, the above is not some fanciful story. If you bought a US 1984 30 year bond in 1984 (and that would be with 1984 dollars), that bond would be worth about 40 cents on the 1984 dollar in 2014 — last year — when it was repaid. Not some far off future date. Last year. For someone who retired in 1984 on a “fixed income”, they face Hermione’s problem and have 40 cents of buying power compared to the day that they retired.

And, that 40 cents on the dollar? That is found using the US government’s own official inflation numbers. For some reason, I am not so trusting that the government correctly calculates inflation. It is not in the government’s best interest to correctly calculate inflation. I suspect that the 40 cents on the dollar is much worse: maybe even 10 or 20 cents on the dollar. But, maybe that is just me.

The above is a simple story without much of the detail. But, it illustrates the effects of inflation even when using the official government inflation numbers.
All governments use taxes to collect revenue. As illustrated, inflation has the same effect on the government finances as raising taxes. Causing inflation — an official policy of the US government — taxes the old and the poor. It is a hidden tax. Hidden in plain sight. But, you never hear it called a tax for some reason. All the unnumbered faceless and nameless government officials as well as the elected with actual faces and names simply keep quiet about it.
As an excercise, re-read the above and instead of doubling the number of waffles, cut the number of waffles in half. That would be called deflation. And, with deflation, our faceless and nameless official would have a real problem repaying Hermione. And, that would be exceptionally painful for this faceless and nameless official.

The Fed and the rest of the government recognizes that deflation might be so bad that the faceless and nameless would have to find something else to do and maybe actually get a face and a name. And, that is never going to happen if they can help it.

Warren Buffett recently released the annual report for his company, Berkshire Hathaway. You can read that report in its entirety here. In it, Buffett gives us his insight into investing in the modern times. Buffett has a long history of being extremely successful in the investing world, a reputation that we would be crazy to ignore. However, like any human being, Buffett has biases, biases that might negatively affect his ability to accurately examine the world and accurately deploy capital in an attempt to gain a significant return on investment. Any time you read the opinion of someone on anything (including the one you’re about to slog through), it’s important to understand the motivations and biases that said person might be trapped by.

I don’t make it a habit of reading Berkshire’s annual report though I may start. However, I ran across it this year when Kent Beck linked to this excerpt and cited it as an example of persuasive writing. Since I’m both a writer and an investor in gold, I was naturally intrigued to see what Mr. Buffett had to say about the topic. Sadly, I fail to concur on both points. The writing is clearly done by someone with a somewhat outdated understanding of the current economic system and someone who has clear biases against investing in commodities, particularly the supposedly non-productive metal gold. The excerpt linked above is only a part of Buffett’s delineation of three categories of investments. While it’s nice to excerpt only the part you find mentally comforting, it’s far more important to read the entire section to get an idea of what Buffett is saying.

Starting on page 17 of the report, Buffett details the three main categories of investments he defines: currency based assets, non-productive based assets and productive based assets. Examples of these classes are (1) money market funds and bonds, (2) gold (and poorly, tulips according to Buffett) and (3) most everything else including farms, real estate and stocks. The excerpt linked above deals only with the section on gold but let’s take a look at the classes and Buffett’s writing in their entirety.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control

Buffett opens up with this description of the first class of assets, namely currency denominated assets. There are several key ideas here to glean from Buffett’s writing. The first is that contrary to popular wisdom he feels that currency assets are actually quite dangerous and from the standpoint of a long term view point with the greatest return on investment, they are very dangerous. The ugly spectre of inflation, insidious and often silent, will destroy any perceived value of these investment vehicles because as Buffett so aptly points out “governments determine the ultimate value of money.” So we can assume that Buffett is keenly aware of the negative influence on inflation and manages Berkshire in a way to exceed the negative inflation tax. The second interesting thing to note is Buffett’s choice of time frame. “Over the past century” is certainly a long time frame, one that is undoubtedly picked because it fits the narrative Buffett is trying to create. This is the first example we see of a specific period of time and it’s worth a small discussion.

As always, the discussion and interpretation of time is fundamentally dependent on the context of the parties being discussed. Six months might be long term for a terminal cancer patient while sixty years might be long term for an entity like Berkshire Hathaway. More importantly, time frames on the individual level are qualitatively different that time frames from an organizational or societal level. An individual investor has a long term time frame of 30-40 years to acquire enough wealth to satisfy any financial goals he might set for retirement. Unfortunately, at the macro level where the statistics are often quoted, 30-40 years is a tiny fraction of a time slice as evidence by the Dow over the past 12 years being essentially flat with a annual negative return once inflation is considered. A full 25% of a long term investor’s time frame has returned nothing if said investor had the misfortune of being born in a period where the Dow just didn’t appreciate. The usage of a century as the time frame for examining the performance of this first class of assets is convenient for Buffett’s argument but meaningless for anyone who is interested in investing at the individual level. One hundred year time frames tell you and I almost nothing.

Continuing with his discussion of the first class:

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human

Again, there is a wealth of information here. First, we notice that Buffett has now narrowed his time frame to the 47 years he’s been investing. This is much more useful as it’s a time frame we can understand and profit from as individual investors. Explicitly showing how inflation destroys the value of savers wealth, we begin to get a fuller picture of Buffett’s ideas. It’s clear he does not trust any government, much less the United States, to preserve the value of its currency and because he cannot trust them, he views the instruments they control as poorly suited for his hard earned investments.

This is a critical point because it directly contradicts what he goes on to discuss in the following section on so-called non-productive assets. We now know that Buffett distrusts governments and their currencies as investment vehicles because throughout history, both at the individual and macro level, governments have never shown an interest in preserving the value of their currency. Exactly the opposite, all fiat currencies throughout time immemorial have lost value. Some times quickly, sometimes slowly, almost never orderly, the value of any given governmental currency has disappeared over time.

However, it is interesting to note that while Buffett is disdainful of this class of asset, he states that at times in the past, Berkshire has discovered mispriced markets and profited in this class based on that mispricing. While largely focused on the long term, Buffett works on a daily basis on the short term, especially as it relates to the economic outlook of a given time. This points out yet another contradiction in the coming discussion of gold. While over the long term, investing in currency based assets has been detrimental and destructive to an individual’s capital, in the short term there have been opportunities to capitalize on market irrationality and profit in this class. This is also true for gold and it seems inconceivable to Mr. Buffett that we might currently be in a time when we can profit from exposure to metals in our portfolios.

Let’s turn to the second class of assets Buffett discusses.

The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the futur

This is only a partial representation of this class and unfortunately, it is poorly represented by the example given by Buffett of tulips. I would argue that there are two subclasses of this class. The first subclass represents those items that have a shelf life. Examples are food commodities, cattle and of course, tulips. These items have value because somewhere at the end of the buying chain lives a person who is willing to pay retail price for the item. No one invests in tulips with the express intent of storing wealth over time.

The second subclass is represented by things without a shelf life at least in human terms and includes things like metals and oil. This class can be thought of not only as investments but as stores of wealth. A store of wealth is an alternative to currency and actually encompasses most things we buy. For example, I have a set of noise canceling headphones on my desk. At some level, they are a store of wealth in that at no point in the future will they have a value of zero. We can assume that if they continue to work, I can always sell them to someone even though the sale price may be a tiny fraction of the price I paid. A tulip clearly does not fit into this category. The problem with the headphones is that once I took them off the proverbial lot, they have depreciated in value at every single moment since and will continue to depreciate unless some strange confluence of events emerges that misprices the market for old headphones.

Hard commodities like oil and the metals on the other hand have throughout time, both long and short term, experienced periods where economic factors have created an increase in value of their wealth. We are experiencing one currently. This happens for a variety of reasons but it is often related to that very fear Buffett outlines in his section on the first class of assets, namely that governments cannot be trusted to preserve the value of their particular currency. Gold, as a store of wealth, has no overseer other than the market and the price that market is willing to support. It is fundamentally different in type from tulips and shouldn’t be discussed in the same way at all.

Further on, Buffett details what he believes motivates the buyers of gold:

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while

First off it’s important to note the pejorative distinction of bandwagon investors. The scare quotes alone are enough to tell us what Buffett thinks of those people currently buying gold in today’s market. There are two fundamental things wrong with this usage. First, at some level, all investors are bandwagon investors unless they are exceptionally lucky or exceptionally foresighted. Markets by definition in any growth industry are about the accumulation of more investors over time who believe the price of the market will go up. And secondly, a large part of Buffett’s strategy for acquiring wealth over the long term stands on his ability to identify markets where bandwagon investors will drive the market higher. While he clearly denigrates people who jump on the bandwagon of some market, his success is fundamentally dependent on that continuing to happen at some level. Also interesting to note is the usage of “for a while”. Again, time comes into play and just as Buffett has in the past made money on currency assets when the price was right, one would think that he would be open to making money on hard commodities when the time was right. All markets are right “for a while”. The key is knowing when that time is. And that brings us to what Buffett most likely thinks about gold and that is that the time is not right. He most likely believes that gold has reached the end of its run and will thus at some point in the not so distant future begin to lose value perhaps dramatically. The question is, is he right? We’ll look at that more in a bit.

Buffett then goes on to talk about two recent bubbles, Internet stocks and housing. The issue there is of course that those bubbles were driven largely by a Federal Reserve policy that eased the money supply in exactly the way Buffett outlines in his first section. Those bubbles were driven by cash chasing return. I believe the current gold boom is being driven by a completely different impetus and that is the collapse of the dollar as the world reserve currency though certainly the gold market is aided by the fact that the Federal Reserve, with the implicit and explicit support of the Treasury and an inept Congress, is greatly increasing the money supply forcing people to find alternative stores of wealth for their cash because the US Government is actively destroying it in an attempt to prop up a broken financial system.

If we look at the next ten years as it relates to the financial picture of the US Government, we see that the Federal Reserve has expanded its balance sheet in a manner unheard of in history. US Debt to GDP may reach 159% or more by 2020 which in and of itself may not be the death knell but is certainly the symptom of a very sick patient. Because the US Government will likely never default on its debts, the only other reasonable solution is to inflate our way out of the mess. When we do this, the dollar will be worth much, much less and gold will be worth much, much more. The important key here is see that the market for hard commodities including gold has a time frame. Buffett believes that the time frame is near the end of the bull run and thus he is not interested in investing in it. I, and many other people far smarter than me, believe that we are nowhere near the end of the bull run because I see no way out of the mess we are currently in short of inflating our way out of it. Our government could wake up tomorrow realizing the error of its ways and move onto a path of fiscal responsibility that included drastic cuts in spending. However, that would cause immense short term pain in the economy and I think we all know how likely our politicians are to implement something that directly affects their ability to get reelected.

When it’s all said and done (and I promise, I’ve about said everything I can), the outlook for hard commodities including gold is promising over the next 8-10 years in my opinion. I do not see the world economies stabilizing substantially until we either rein in run away spending or a collapse happens. Either way, gold will serve as a store of wealth in the interim, not as a fifty year investment but instead as a way to protect our wealth from the vagaries and shortsightedness of our political leaders. Until a balance can be returned to the financial markets, gold (and possibly far more profitably, silver) will be attractive to investors throughout the world including large governmental buyers like China who most certainly can see the writing on the wall for their investment in US debt and who are even now moving to acquire large reserves of other currencies including gold.

I largely admire Buffett and his success. Fundamentally, his outlook on the US economy is similar to my own in that I think the US is the best place for investing in the future and will continue to be so. However, our time frames are fundamentally different and that leads to a divergence on our views of the yellow metal, among other things. While Buffett has no interest in putting Berkshire’s money into the metals, I believe the bull market will run for at least another 8 years and at that point, depending on the economic factors of the time, perhaps a reevaluation of owning gold will be in order. Until then, I plan to acquire not sell gold until I’m proven otherwise wrong in the market.

I recently started receiving Kiplinger’s magazine, a Christmas gift from my dad. I was working through the first issue I received when on page 9, I ran into an article of such glaringly bad advice that I almost thought it was parody. Thankfully, though Kiplinger’s is fomenting stale financial advice on their readers, they have joined the 21st century and put their content online so here’s the article for your perusal as we go along. The article argues that people who choose 15 year mortgages over 30 year mortgages or who prepay their principal down throughout the mortgage are making a big financial mistake.

Right off the bat, an astute reader can see where this is going:

When it comes to home loans, we’re a nation of debt-a-phobes.

This is in fact not true. Homeownership rates are actually higher than they were 40 years ago but the equity in the homes have steadily fallen since World War II. That actually means we, the citizens of the US, are the opposite of debt-a-phobes. While it’s true that the last few years have seen a huge deleveraging in the consumer sector, it’s akin to coming down to base camp on Mt. Everest from the summit. While the height has changed dramatically, we’re still badly in debt. The average consumer is deleveraging because of poor economic outlooks after years of being told that consumption was the path to the holy land of happiness. This is completely rational behavior and yet, Kiplinger’s, in all their infinite wisdom, is now arguing that not only should you own a home, you should buy it with a 30 year mortgage instead of a 15 year mortgage and that you should never pay down the principal.

They argue that the 30 year loan confers tax advantages on the owner (true) and that by leveraging that advantage, your effective mortgage rate is 2.9%. They then make the amazing leap of conclusion that there is a good chance you can make more than that in the stock and bond market over the long term, conveniently leaving off the necessary qualifier for what “long-term” means in this scenario. Based on the last 10-15 years of the stock market performance, it seems safe to think “long-term” might be much much longer than what the average Kiplinger’s reader might feel comfortable with.

The next whopper is this:

You can save a lot of interest by choosing a 15-year loan over a 30-year — about $63,000 after taxes on a $200,000 loan for someone in the 28% tax bracket. But ask yourself whether you can really afford the higher monthly payment — in this case, $1,420 versus $955. Have you maxed out your 401(k) and built up an emergency fund? Paid off credit cards? Funded insurance policies and, if you desire, college savings? If you haven’t, choose the 30-year loan. And if you have, choose the 30-year loan anyway and put the difference between the two payments in a savings or investment account.

There are so many problems with this paragraph it’s hard to know where to start. First of all, this is akin to arguing that you should buy a TV with a credit card instead of cash if you can’t afford the TV. Here’s a bit of advice: if you can’t afford the 15 year payment, you’re buying too much damn house. The author just handwaves away that $63,000 in interest as if it’s meaningless in terms of your financial freedom when in fact it’s a HUGE issue for why people stay in debt. Then after trying to dismiss the interest, she says to do it even if you can afford the 15 year and use the difference to fund other savings, ignoring the fact that if buyers don’t have the discipline to pay for a 15 year mortgage, they probably don’t have the discipline to pay for a 30 year and use the difference to fund other savings. Again, if you haven’t funded your savings and if you have substantial credit card debt, you shouldn’t be buying a house to begin with, much less a house with a 30 year mortgage that will cost you $63,000 over the course of the loan. This is fundamental financial advice that we the American consumer have ignored for 30 years to our own peril.

The logic gets even more twisted:

There are few better hedges against inflation than a mortgage. If inflation rises, so will interest rates. But you’ll have borrowed at a low, fixed rate while savings rates climb and you’ll pay the loan back with increasingly cheaper dollars.

If this is true (which it is in a way), it’s even more true with a 15 year mortgage since the rates on 15 year mortgages are EVEN LOWER than 30 year mortgages. So this little gem actually proves the counterpoint.

Overall, the entire advice is based on the now horrifyingly broken assumption that home prices will rise over time. While this was true for the first part of the rush to own a home in America, there is little evidence that it is now, or will become, true. The housing boom was driven by a cycle of extremely easy money provided by a lax Federal Reserve who refused to believe that a bubble was blowing up right in front of their eyes. The glut of homes in foreclosure will continue to surpress prices and the exceptionally gloomy economic outlook will keep the housing market from any kind of rebound for the foreseeable future. Telling people to lock themselves into a 30 year debt that may very well be worth less money when they sell it is like telling people they should buy a car with a 6 year loan.

Debt is not a bad thing, in and of itself if you are disciplined and if you have a way to leverage that debt to your advantage. However, the days are long gone of buying a house and watching the price go up, essentially becoming a built in savings account. Debt has to be used intelligently and infrequently by consumers and there is no evidence most consumers are capable of the discipline required. Seeing this kind of advice in a major financial outlet just shows we have an exceptionally long time yet to go before the economic picture becomes anything resembling rosy.

The privileged have regularly invited their own destruction with their greed. — John Kenneth Galbraith

If you follow the financial news on a semi-regular basis, you know that MF Global, a futures fund run by Jon Corzine, former governor of New Jersey, went bankrupt last week. If you don’t read the financial news, well God bless you. As far as things go, the fact that MF Global went bankrupt isn’t particularly important, in and of itself. In the current financial ecosystem we live in, companies go bankrupt. What makes the MF Global bankruptcy so different is that it was quickly discovered that customer assets to the tune of $600 million went missing when regulators showed up to figure out what the hell happened. Right off the bat, you should be a little nervous. Sure, this is a hedge fund probably catering to high end clientele but there were also plenty of normal people who traded with MF Global. And their money is gone. Missing. Permanent vacation. This is the very scary story of how the oligarchy is looting the proletariat and it has wide ranging implications for the financial system we all operate in and trust in.

Some MF Global history is in order. Even though they were a derivatives broker, they weren’t particularly profitable and somewhere along the way, Mr. Corzine made the decision to start trading with the firm’s own money. Now typically, in more normal times, brokers and trading firms made money by clearing customers’ trades. For example, when you sell or buy a security at Fidelity, they make money on the commission they charge you for handling that transaction. Once upon a time, when the world was flush with cash and the Nasdaq was screaming towards the stratosphere, clearing trades could be pretty profitable without much risk. Then 2008 came and suddenly, people didn’t think trading in the stock market made that much sense any more. The easy money dried up. For the larger firms, they could handle that but firms like MF Global immediately started losing money.

At the time Corzine come on board, two thirds of MF Global’s revenue was based on clearing trades and that wasn’t working out too well. Corzine decided to take the firms’ own money and make leveraged bets on a variety of gambles in an effort to shore up the falling revenues. One of his biggest bets, to the tune of $6.3 billion, was on European sovereign debt with an emphasis on Italy, Portugal and Spain. That sovereign debt was due to mature in 2012.

So what happened? Well, as with so many of the horror stories over the past three years in the financial world, this story begins with the word “leverage”. If you look at the holdings of MF Global as compared to its assets, what you find is that MF Global was using leverage of about 40 to 1 to make these bets. That means for every $40 in securities that MF Global held, it only had $1 backing it. At those levels, the proverbial shit can hit the fan faster than you can imagine. For comparison’s sake, Lehman Brothers was leveraged at about 35 to 1 back in 2008 when it nearly took down the world’s financial system.

How this all went down is slightly complicated, especially if you’re unfamiliar with how the bond market works. And frankly, I’m pretty unfamiliar with it all and thus, the discussion below may be riddled with errors. It’s my understanding based on reading a variety of sources on the MF Global debacle.

Much of the financial media is commenting that this all happened because the proprietary bets that MF Global was making with their own money went south in a hurry two weeks ago when interest rates on Italian debt started going north. But that’s not quite what happened with MF Global. Their bets weren’t based on the expected performance of the bonds. They were essentially a liquidity trade where they used the bonds in a repurchase agreement or repo. What that means is that they bought the bonds then sold them to a counterparty in exchange for cash. The catch is that in a repurchase agreement, the seller–in this case MF Global– had to agree to buy the bonds back at maturity from the counterpart whereupon they could return the bond and collect their coupon value plus the interest. A very simplified example would help.

Let’s say you would like to upgrade your kitchen. It’s going to cost $1000. You don’t have $1000. So you come to me and say that you’d like me to buy a bond from you. If I buy a $1000 12 month bond from you, you will use the $1000 I give you to upgrade your kitchen. The agreement you make with me is that in 12 months, you’ll give me my $1000 back plus an agreed upon interest payment, let’s say 10% or $100 in this case. So I get $100 out of the deal in return for loaning you $1000, you get a new kitchen and everyone is happy. This is a basic bond transaction. Happens all the time. In our MF Global example, you would be a European country in need of cash, say Italy, and I would be MF Global.

But MF Global wasn’t that interested in 10% in 12 months. They needed cash. So they did a repo with counterparties. In our simplified example, let’s say I can’t wait 12 months for the cash but that I don’t turn you down. What I might do is go to our friend Lloyd and say “I have this bond. I’d like to do a repo with you where you give me $1000 in exchange for the bond and pay you $1050 in 12 months.” What I’ve done is cut my $100 profit in half by agreeing to give half of it to Lloyd in exchange for having my $1000 back. But if the going rate for borrowing money is 1%, I’m making a killing with that 5%. And because all this is “financed to maturity”, i.e. nothing really happens until the bond matures, it’s considered to be extremely low risk. On top of that, if I’m a business, I can book the $50 in profit immediately, which if I happen to be reporting to shareholders, is a good thing. And because the original coupon rate of the bond, in our example $1000, is going to get repaid regardless of fluctuations in the bond market, it’s considered a safe way to provide liquidity.

In theory, this is all straightforward, practically risk free. When you’re dealing with sovereign debt, even with a country like Italy, the chance of them defaulting is almost negligible (ignore for the moment the fact that Italy does not have a lender of last resort and thus shouldn’t be considered in the same way a country like the US would be–that’s the subject of another exceptionally long blog post). The only way this situation can get ugly is if the counterparty (our friend Lloyd) decides that maybe I’m not going to have the money to repurchase the bond from him. If for example I get in deep with my bookie who happens to also be Lloyd’s bookie, rumor might get out that I don’t have the money to repay the bookie much less Lloyd. Well Lloyd might come back to me and increase my margin by asking for half the payment of the bond. For $500, maybe I scrape that up by working at WalMart for a month. When we’re talking about the $6.3 billion MF Global had leveraged, that calls for rather desperate measures.

This is essentially what happened with MF Global. The counterparties that had entered the repo agreements with them decided that maybe they weren’t going to have the cash to pay them back, especially given the rather disappointing conference call October 25th reporting a $191 million loss, the largest in the firm’s history, a history that includes annual losses the last three years. You can imagine if you’re Lloyd and the losses are really starting to mount, you might want to protect yourself. So he did. As that news spread, clients of MF Global, the people who are really screwed in this situation, started trying to get their money out. Some probably did. Others seem to have been given checks that bounced. Imagine if you tried to take the money you have in Fidelity out and not only would they not wire you the money as is normal but they sent you a check that bounced. That might just cause a run on Fidelity.

That’s exactly what happened at MF Global. Combine the counterparties with the MF Global clients trying to bail out along with a 40 to 1 leverage problem and suddenly, bankruptcy is the only way out. However, they made one last desperate move before the bankruptcy filing. And it’s sickening. Someone at MF Global decided that there was a chance they could manage the crisis if they could just get through the weekend. Specifically, they were trying to unwind the bets in Europe with Blackrock’s help among others. So what they did either late Wednesday October 26th or very early in the morning October 27th was take a mixed bag of assets and securities out of their clients accounts and moved them into a house account to the tune of about $700 million. These assets were Treasuries, securities and commodities, all things that wouldn’t be noticed very quickly. They then made an agreement with someone as yet unnamed (but who was undoubtedly complicit) to loan them money based on those assets. That party probably refused to loan anymore than about half the amount of the assets values knowing full well the likelihood of a pending MF Global bankruptcy. So MF Global probably got around $400 million for this little agreement. The plan was probably to make it through the weekend, unwind the bond assets, find another lender, repay the lender of last resort and then put the “borrowed” assets back in clients accounts, no one the wiser. Unfortunately, the gambit failed and they had to declare bankruptcy Monday morning.

When MF Global declared bankruptcy, whoever that unnamed last resort lender was took ownership of all those assets. What they probably did was immediately liquidate them to cover their loss. That means the MF Global clients money is GONE. It may never return. This is the part that’s so important to all of us. Someone in power at MF Global essentially looted their clients accounts in attempt to save their own skin. And if you think anyone at MF Global is going to be prosecuted for this travesty, you have a great deal more unfounded faith in the system than I do. The implication here is that no money in the system is safe. This rapidly can become a credibility trap, one in which no one feels that the money they have in the financial market is safe. If that happens, bad shit is going to go down. As Jesse notes above, this is a major test for the Obama Justice Department. If you don’t see perps prosecuted to the fullest extent of the law and all the money returned one way or the other, you can know that this behavior is largely condoned in a very explicit manner.

Our financial system is teetering on the brink. We pushed it to the edge in 2008 and instead of pulling back and reforming the destructive behavior of those who took us there, we built a small glass platform on the edge and told everyone in the world to jump on. That glass platform is growing increasingly unsteady. It will only take one small increase in the load to send us all right over the precipice. And it’s the elite, the oligarchy at the highest levels who are pushing us all out there with little regard for any of the possible destruction. These are extremely dark days and not many of us know it. I’m beginning to think it’s not a matter of “if” we see another collapse but just “when”. Our politicians have shown no interest in accepting the necessary pain required now to avert us from that future disaster. No one is explaining this to the people in a clear and concise manner. We are all just drifting along in a rudderless boat in extremely rocky waters. It’s only a matter of time before we end up with a huge hole in the side of the boat that can’t be patched.

Imagine if you will a friend–perhaps imaginary, perhaps not–who spends money as if it grew on trees. He buys things constantly, upgrading to the latest and greatest, always drives a new car. None of this is a problem if he’s independently wealthy but let’s say he’s not. Let’s say he makes $40,000 a year but has outstanding debt $66,400. At first, this isn’t a problem. Nik makes the minimum payments, creditors are happy and Nik goes on his merry way. One month though, Nik misses a payment. Suddenly, one of the credit cards he has jumps from 9.9% to 18.9%. Not a deal breaker for his lifestyle but a sign that maybe things aren’t going too well. Then something bad happens. Nik loses his job. Lucky for him, he finds another one but it only pays him $35,000 a year and in the meantime, he’s missed a payment on another credit card, jumping that rate up to 18.9% too.

Suddenly, Nik is in a bit of a spot. He’s making less money, still has the same debt but has to pay more on that debt just to service it because his overall interest rate has gone up. In the real world, Nik has a few options. He can try to get a better job and make more money. He can drastically cut back on his spending, lowering his quality of life and make larger payments towards the debt. He can try to approach his creditors and negotiate his debt down, either by lowering the interest rate or the amount or both. Or he can default, declare bankruptcy and try to get a fresh start. What he chooses depends on his particular situation but as his friend, you are in impartial observer for the most part.

However, let’s change the story a little. Let’s say that late in the game, Nik decided to go to the local loan shark, Heinrich. He wants to borrow some money from Heinrich to keep the lifestyle going. Heinrich, normally the lender of last resort, takes one look at Nik’s balance sheet and says, “yeah, not so much. There’s no way you’re going to be able to pay me back so I’m not loaning you any money.” Nik tells you this sob story over coffee one day and you get a brilliant idea to make some money off Nik. You’ll go to Heinrich and tell him that you’ll sell him an insurance policy that essentially says, if Nik declares bankruptcy, you’ll pay Heinrich for Nik. You’re a model upstanding citizen with a large bank account so Heinrich agrees. He gives Nik the money and then every so often at agreed upon intervals, Heinrich gives you a small insurance payment. Everybody is happy.

Unless Nik declares bankruptcy. Then, you’re not so happy because you have to pay Heinrich back. Suddenly, you have some skin in the game. Now in normal circumstances, you’d probably never agree to sell Heinrich that insurance policy no matter how much money you had or how good a friend Nik was. It’s just not very smart. But what if you had a pretty good idea that the insurance policy was guaranteed, e.g. there was no way Nik would default? Nik would never default, Heinrich would keep paying you insurance and you were guaranteed never to have to pay off the policy. Well then, it’s free money! Yay for free money! Even if it wasn’t guaranteed that Nik wouldn’t default, you’d have a strong self-interest in making sure he didn’t. You might even act in ways that were contrary to Nik’s long term success just to keep him from defaulting, if you could. Man, you’re a shitty friend.

While this is a highly simplified little story, it’s somewhat analogous to what’s going on on the world’s economic stage right now, as best as we can tell. Imagine if you will that Nik is Greece, Heinrich is Germany and you are the hedge funds and money markets of America. Most countries look at Greece’s finances and say, “no way in hell are we loaning them any more money, they can’t pay back what they already owe.” But somewhere along the way, American hedge funds and money markets thought to themselves, “There’s no way that Greece is defaulting, the EU won’t allow it. It would cause huge catastrophe. On top of that, our own government has shown in the past that they will step in and backstop companies like AIG and Lehman Brothers if need be. We could sell insurance on Greek debt that would essentially be guaranteed not to be collected on and make a mint.”

This is the very definition of moral hazard. And while we have no explicit proof of the above scenario to my knowledge, we have some pretty good circumstantial evidence that it’s going on:

And the Europeans are very angry that a few weeks ago Tim Geithner, the bank lobbyist, came over and insisted that Europe not forgive Greece’s bank loans, not let Greece write down the loans, and indeed that it not even claim that Greece should do what Argentina is and write down the loans as a premise. Mr. Geithner explained to the Europeans that the largest insurers of the Greek debt are American money market funds and hedge funds. And he said American hedge funds and banks would lose money and actually would crash the U.S. economy, if Europe made a concession to Greece to bring debts down to the ability to pay. So, instead of a debt write-down or a haircut, the banks said, “OK, we will agree with what the Americans are insisting on, and we will ask for a voluntary write-down by the banks on the Greek debt they hold.” Obviously, European banks who are not part of the credit default swaps have disagreed with this. So the Americans are putting immense pressure on Europe, saying, “We will wreck your economy, if you don’t wreck Greece’s economy.”

Last week, when a deal for a supposed bailout for Greece was announced, the market celebrated. Monday, when the Greek Prime Minister said he was going to put it to a vote of the Greek people, the market tanked. Today, when the referendum was yanked back off the table, the market celebrated. Why do we think that is so? Because the market knows that bailouts for Greece are good for the market whether they are good for the Greek people or not. The Greek people are starting to see that bailouts when they come with the conditions of severe austerity programs are not actually good for them. It is fun for certain people to say this is what they deserved all along, that they should have lived within their means. But this continued insistence that the only people at fault in these situations are the debtors is ludicrous. In every agreement between a creditor and debtor, blame lies equally with both. Without one, you cannot have the other. The countries that continually loaned money to Greece well beyond the amount they could possibly pay are equally to blame for this crisis as are the Greeks. But the major players on the stage do not care one whit about the Greek people. They only want to keep making money. They knew–or thought they knew–that loaning money to an EU partner that that partner could not possibly repay would be guaranteed by someone. Moral hazard has created a situation where the financial elite and the oligarchy make decisions based on what they expect from some governmental entity in the future.

Satyajit Das has pointed out that the European debt crisis can end in one of three ways:

The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults.

Of the three, the first is almost completely out the window. Even if the German populace would agree to it, they don’t have as much wiggle room as would be necessary to fix the debt problem of all the weaker EU countries. The European Central Bank (ECB) has a set policy against expanding its balance sheet which makes number 2 difficult as well. That leaves us with sovereign defaults which means all the bailouts in the world only kick the can slightly farther down the road until the market forces the politicians’ hands.

So what happens if we get a sovereign default or two? Well, contrary to the many people in America who think they are largely insulated from such an occurrence, if the above scenario is true and the hedge funds and money markets of America have engaged in selling insurance (credit default swaps) on Greek, Italian and other European debt, we have a situation where economic collapse could easily happen in America. If those CDS are cashed in, people may discover that they can’t pull any money out of their money market funds. That could cause a run on banks and we all know how that ends up.

We had a chance to handle instances of moral hazard back in 2008. Our politicians completely let us down at the time and only reinforced the idea for the banks and the oligarchy that the government will always backstop them. By doing so and refusing to significantly reform the financial system, they opened up a scenario where a small country in Europe could possibly bring down the financial system around the world. They kicked the can a little farther down the road but we’re all going to be paying for it for a very long time.