Sunday, October 14, 2007

The Beauty and Bane of Capitalism (Expanded for more Clarity)

preface: I wrote this because I think it is important to understand where we are, and, regrettably, where we may be going. Also, I'm not just talking out of my ass, although at time it might sound like that. To be sure I am showing off a bit, but also I hope there is a higher purpose: namely helping you make a killing by investing in recession resistant companies like supermarkets, cosmetics creators, and alcoholic beverage purveyors.

If we were to take a poll of the populous we would probably find severe negative metrics for the question, Is our economy healthy? The warning signs of a troubled economy are all obvious. We know the housing market is hurting and the dollar is on the skids. Most people also must realize that their paychecks have been stagnating or falling, and a number of important product prices are inflating. For all my friends in San Francisco all of this economic pessimism might sound odd, but there is a reason why we don't feel it yet, which I will get to, so keep reading.
On the other hand, we have a white hot stock market that has been hitting all time highs. No one is bullish about the future and yet security prices have gone up and up. What do they know that we don't? And who are the they anyway? Are the people that are pushing stocks up to all time highs calm and calculating investors seeking long time returns on their capital?
The short answer is no.

I think that we are in trouble, serious trouble. The economy is off kilter in a bad way. Economic fundamentalism has brought us to a precipice last visited, and fallen from, in 1929. By either willful mismanagement or gross ignorance we have failed to protect the American economy from those who seek a quick buck. The dangers are real and the threat is gathering.

So who is to blame? To start off with, Alan Greenspan. If name recognition were the measure of success we'd be doing great. But we all know that Americans tend to pick poor heroes. What Alan did was stave off readjustment in the financial markets by band-aiding up the wounds with easy cash, compounding the problem. To put it more simply, Alan lowered the interest rates on borrowing, allowing more borrowing, thus more capital, to be used to buy assets, stocks, companies, etc. Usually this would create price inflation - more money going after less goods causes inflation - but because the rest of the world agreed to fund us, by buying our debt, we could continue to spend.
Why would lower interest rates superficially help us from between a rock and a hard place? After the dot-com bubble the economy looked as if it were going to take a nose dive because, like today, people had put tons of money into worthless ideas and companies. Remember the day-traders? To make sure that people could continue to spend money, which keeps the economy going, Alan decided to make it easier to borrow. This easy borrowing created the next bubble, this time in the housing market. Because capital was so cheap to get, people took out loans for houses without having the financial means to support the loan if - a question of when really - the rate on the loan rose. I will discuss later why bad borrowers were able to get loans so easily - it's another reason why we are in a bad mess today.
The problem with Greenspan's lower interest rates was that eventually inflation was going to rise, it was inevitable, and high inflation is a bad thing. And when inflation rises too high something must be done, like raise interest rates. We have about reached that day of reckoning.

Moving on with the blame game brings us to rich people. The rich are, most of the time, greedy. That's what got them rich. I'm not talking about the six-figure salary rich people. I'm talking nine-figures. Starting a long time ago, but expedited recently because of low interest rates, rich people's financial planners found ways to make huge amounts of money with little to no regulation. The results were financial constructs such as hedge funds and private equity groups. These private investment schemes are invitation only and require proof of financial soundness - i.e. do you have a billion dollars to spare? But once they get everyone together boy do they have power. It is estimated that Hedge Funds control $1.7 trillion of capital today and private equity has around $600 billion. And remember, none of that is regulated. NOT REGULATED! But there is more. Not only are hedge funds and private equity not regulated, but they are in debt in a big way. They wouldn't call it debt though. Their debt is euphemistically called leverage. So, for instance, lets say Joe billionaire has $10,000 he wants to invest (a triffle, really). So he goes and borrows at ten to one, so for every one dollar he has he gets ten from the bank. Now, instead of a measly $10,000, this rebel billionaire has $100,000 to play around with. All this leveraging is a result of cheap credit - thank you Mr. Greenspan - without which private equity and hedge funds would probably not have been created in their present incarnations.
All this adds up to trouble. The trouble has been noted before. In 1997 a successful hedge fund called Long-Term Capital Management had a hiccup that almost brought down the U.S. financial markets. It was the Federal Reserve Bank of New York that came to the rescue and bought the beleaguered hedge fund out.

Also, the hedge fund managers have been under increasing pressure to bring home the bacon to their money hungry plutocrats (as well as other investors like pension funds and trust funds). This pressure creates a huge incentive to be loose with the ethical rules of investment and can lead to outright lying and manipulation. Tack that on to the worrying fact that these hedge funds are huge goliaths, lacking any regulation, and highly in-debt and you've got one helluva nightmare scenario. On top of all that bad news hedge funds are also victims of complexity. They have their money invested in so many different things and in so many different ways, and they keep it so secret, that it has become almost impossible to know what will happen if they fail.

Sub-prime mortgages - bad lending. This is the last of the bad guys; an anthropomorphized fuck up. (There are more bad guys and complexities then what I have jotted down. Lots to learn). This one also harks back to good old Alan. Because credit was so cheap lenders could, and were almost obligated, to take more risk lending to bad or no credit individuals. Lenders compensated for the higher risk by building in a variety of lending schemes that were far from transparent and user friendly. These sub-prime loans were bundled (put together) in complex financial "instruments" that allowed the crappy loan to be hitched with better ones (from borrowers with better credit), in the end creating the illusion that the "mortgage-backed security" - the new financial instrument created by the bundling of sub-prime and good loans - was less risky, i.e. worth buying. So as I hopefully made clear, by putting good loans with bad loans into one financial instrument (a thing that can be sold to a willing investor) the risk of the loan was diluted. The problem of diluted risk was made worse by the fact that the companies that put ratings on these mortgage-backed securities (MBS - this is what the financial instrument is called) had a conflict of interest: they were being paid to give the MBS's good ratings by the very banks trying to sell the MBS's. It's kind of like if Hoover payed Consumer Reports to rate their vacuums and we expected Consumer Reports to be unbiased. So in the end, as interest rates have risen to stave off inflation, and the poor borrowers were squeezed to the point of defaulting on their loans (not paying), the MBS's have begun to crumble, hurting all the investors that knowingly or unwittingly held these risky loans. Some of those investors are hedge funds, although no one how much bad debt the hedge funds hold.

All that stuff above that I have written are descriptions of the bane of capitalism. They are examples of markets gone amuck. We have only begun to witness the victims. However much we like to tell ourselves that, "economics will never happen to me," the sad truth is that economics happen to everyone; we only notice the stuff when shit goes wrong.

But there is also a beautiful side to Capitalism. Capitalism has the natural ability to check itself. Man can only speculate on a tulip for so long before he realizes that it's just a tulip and is worth about as much as it takes to grow the darn thing, and reap a little profit. It is only so long before that natural check will set in. The question is, do we want a whiplash experience or do we want an airbag? We are about to break our necks, but it does not have to be so. The indicators are all inflamed. It is estimated that each day over 20% of all the value of global trade is speculative, meaning that 20% of trade does not create any new wealth; it just pads the collective pockets of the financial sector. We have not seen this sort of gross inequality and secrecy since the gilded age; you know, the time before the Great Depression. What is needed now is decisive action to regulate and stop this madness. We must move away from the economic fundamentalism that this country recently, and Herbert Hoover in the past, are famous for. Managed capitalism is what is desperately needed before something goes wrong and the markets wake up and realize that reaching new highs while the American economy is stagnating does not make any logical or economic sense. Will our politicians wake up and do something? I am pessimistic. So maybe a good walloping is in order after all. Stay posted.

Oh, and San Francisco folks: how do you suppose our dot-com industry behemoths will hold up when there are no more companies wanting to take out advertisement to entice their newly impoverished clientele. Not too well. Hopefully they have more of a business model then being completely ad supported or else the Bay Area is in for some hard times.

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