Servias Ministries Blog

The television show mentioned above takes place in New York City.  NYC is a vibrant, never sleeping city known as the financial center of the universe.  The waters around the city are shark-infested.  No, not those from the Animal Kingdom Phylum Class Order Family Genus Species, Animalia Chordata Chondrichthyes, this group is from the legalis attorneyicum class.  The lawyers are ready "to roll" in this derivative crisis.  New York City is suing Countrywide, Officers, and Underwriters. See http://www.reuters.com/article/businessNews/idUSN2536805820080125?feedType=RSS&feedName=businessNews

The executives of the company cashed out with bonuses of over $700 million.  As I wrote in a previous blog many pension funds can only invest in "investment grade" securities.  The ratings agencies define "investment grade" based on the data and information presented to them.  You can be sure that there will be a multitude of fingers pointing everywhere.  Individuals will "plead out" early in order to minimize the impact to their personal lives.  This lawsuit is just the tip of the iceberg.  There will be many more lawsuits to come.  The lawyers will be the winners.  Countrywide will lose, the pension fund will lose, Countrywide stockholders will lose,…

Greed produced this debacle.  Perception displaced reality among the lenders, underwriters, regulators, stockholders, Congress, and the Fed.  The rich and famous went for a joyride with our hard earned money.  In the end, the global taxpayer will pay for the ride.  If we run out of money, which is possible, there will be a calamity of Biblical proportions.  The people who have been running the monetary system are nearly out of tricks.  The courts will be busy for years to come.  The recent surprise rate cut was in response to the volatility of the the world markets.  The U.S. economy has been the economic juggernaut over the last sixty years.  Interest rate declines are inflationary and negative to the value of the U.S. Dollar.  Gold and silver will continue their climb to $1,600/$50 and beyond.  Inflation is the silent killer of the elderly’s savings.  The bigger the problem, the greater the cleansing.  Cleansing cycles are Biblical, whether is be 76 days, weeks, months, or years.  Cleansing removes the worthless and unproductive.  Pruning time is upon us.

Could Ben Bernanke, Fed Chief, be thinking, "Why didn’t I keep that job at the University?"

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/01/25/bcnswiss125.xml

When I was a Chief Financial Officer (CFO) our growth was dictated by a formula known as the "sustainable growth rate" formula.  Basically our growth was restricted by the amount of profit that was added to the retained earnings at the end of the year.  Retained earnings is a category of Owner’s Equity in the company.  Secondarily growth could be enhanced by improvement of asset turnover.  For instance, if you sold $50 million a year of inventory and kept $10 million of inventory in stock, your turnover rate is 5.  If you could reduce your inventory to $7 million and still maintain enough to satisfy customer demand, your turnover rate would exceed 7.  You would free up $3 million to help grow the business.  The sustainable growth rate formula took into account these factors in determining how fast we could expand the business.  Another factor was the debt to equity ratio.  If we had liabilities of $4 million and Owner’s Equity of $2 million, our ratio was 2.  Our bank watched these ratios as we did.  If we could increase our leverage thus expand our assets and liabilities by $4 million, then our debt to equity ratio would be 4.  Banks kept historical statistics by industry of acceptable financial ratios in order to compare the industry to our ratios.  This was the way they did business 25 years ago. It is not important for you to understand the financial terms, it is important to understand that the financial institutions have had plenty of tools to monitor their lending practices.

By relaxing credit analysis standards you accelerate expansion of the economy at an increasing rate of change- Accelerator Factor.  The sustainable growth rate formula restricted the rate of change of growth due to the consistent restriction of leverage.  What is leverage? It is the use of borrowed funds to complete an investment transaction. The higher the proportion of borrowed funds used to make the investment, the higher the leverage and the lower the proportion of equity funds.  We were restricted from growing our company too fast by over leveraging our assets.  Why is this a problem?  It is all about cash flow.  Cash pays interest expense.  Cash pays down the principal of you note to the bank.  Cash "makes" payroll.  Cash is the "oil" of the business to keep it running.  Too much investment in non-cash assets works against the ability to repay debt.

There are three types of borrowers.  The hedge borrower is one who can meet all his debt payments with cash. The second type is the speculative borrower who can meet interest payments but must constantly roll over his debt to be able to repay the original loan.  The third type of borrower is the "Ponzi" borrower; he can repay neither the interest nor the original loan. This borrower relies on the appreciation of the value of his assets to refinance their debt.  This type of borrower’s philosophy is a "greed" based philosophy.  This borrower hopes that the asset will continue to appreciate forever.  As long as his assets appreciates in excess of the original loan plus interest, he is in good shape.  This borrower wears rose colored glasses.  The sub-prime mortgage loans promoted this type of borrower.  The lending institutions virtually created Ponzi borrowers by appealing to the "greed" factor.  Why not buy a bigger house than you can afford?  The problem did not stop there.

Financial institutions allowed hedge funds to "leverage up" their assets by 20 to 30 fold in order to achieve unbelievable returns for their investors.  This avenue of lending raised the stakes of failure dramatically.  This accelerated the growth of financial instruments and funded excessive growth in various sectors of the economy.  The insatiable appetite of borrowers was welcomed by the lending institutions who threw out their "credit analysis" handbooks!  CEO’S of these institutions received large bonuses based on the yearend profit results of the institution.  Greed raised its ugly head again.  The underlying motivation of the Accelerator Factor is greed.  This motivation is the rocket fuel for the increasing rates of change in credit expansion through leverage.  However, this is a two edged sword.  The other edge is fear.

Once the market moves from greed to fear, the Accelerator Factor works in the opposite direction.  The Leverage Factor is reduced and the balance sheets shrink at an increasing rate of change.  Its like an accordion.  The Fed and other central banks are now trying to manage fear.  In the markets, fear tends to be a stronger emotion than greed, thus the ramifications of mismanaging fear on a global basis can have disastrous effects.  Since in the history of man there has not been a similar financial environment to compare, those in charge are forging new territory.  Are you ready to trust your financial future to them?

Federal Reserve Board Chairman Ben Bernanke pauses while discussing the near-term economic outlook during testimony before the House Budget Committee on Capitol Hill in Washington in this Thursday, Jan. 17, 2008 file photo. (AP Photo/Dennis Cook. File)

The underlying economic issues I’ve been writing about are gaining publicity.  The following article from The Economist explains the latest problems:

All fall down?

Jan 18th 2008 | NEW YORK
From Economist.com

Huge new problems in the capital markets?

Shutterstock

AMERICA’S big bond insurers, which have underwritten some $2.4 trillion of private and public-sector bonds, usually go about their business largely unnoticed. But now they are looking distinctly wobbly they have started to attract attention. If one or more of them were to topple over, there will be a huge knock-on effect on banks and other financial institutions that rely on their guarantees. This in turn will further worsen the credit crunch and cause an even bigger headache for policymakers already grappling with a sharp slowdown in the American economy.

The threat of such a financial domino effect looms large. Moody’s, a credit-rating agency, has signalled that it might downgrade the AAA-ratings of two of the biggest bond insurers, MBIA and Ambac, in the near future. On Friday January 18th, Ambac said that it had dropped a plan to raise $1 billion of new equity capital to preserve its rating—making futher downgrades even likelier. In response, Fitch, another rating firm, cut Ambac’s rating.

MBIA, which recently managed to raise $1 billion of new capital on top of another billion that it received from Warburg Pincus, a private-equity firm, will almost certainly need even more money if it is to preserve its AAA-rating. ACA Financial Guaranty Corporation, another insurer, is in even direr straits. In December its single-A credit rating was cut to junk status. The firm begged its trading partners to give it more time to sort out its problems. But by Friday it had still not come up with a rescue plan. The state insurance regulator of Maryland, where ACA is incorporated, has already assumed responsibility for some of its operations.

Bond insurers in effect “lend” their top-notch ratings to lower-quality debt, raising its value in the eyes of investors. Any cut in those ratings may make it impossible for the bond insurers to take on new business and would reduce the value of the securities they have already underwritten. Such cuts are now a distinct possibility because the insurers have underwritten billions of dollars of mortgage-backed securities, including those notorious collateralised-debt obligations (CDOs) that have now gone sour……

  http://www.economist.com/daily/news/displaystory.cfm?story_id=10553166 

In the Book of Daniel, The Lord gave Daniel, Hananiah, Mishael, and Azariah (Shadrach, Meshach, and Abednego) knowledge, skill, wisdom, and understanding.  The current economic problems stem from the fact that knowledge and skill were used to leverage investments against the market without wisdom and understanding.  Technical traders did not understand the fundamentals of investing and assumed that technical analysis was sufficient to beat the market returns.  The Derivative Instruments assumed theory to equal reality.  We are on the verge of a reality check!

I recently wrote about MBIA and Ambac.  As of this writing, the world markets are responding negatively concerning the subprime crisis.  Many markets lost over 5% in one day.  Volatility will continue to be the norm.  The world’s central banks are in uncharted territory.  If you are highly leveraged, reduce your leverage immediately.  Raise cash, cash is king!  If you own commodities, don’t get rid of them.  The central banks will flood the market with cash which in turn will be inflationary.  Hard assets will rise.  Food and energy costs will rise.  Brace yourself!

I sincerely believe… that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale. — Thomas Jefferson

This is a lengthy and somewhat technical article.  It is not as important to understand the specific statistics as it is to get a perspective of the downward economic spiral that plagues the current economic system.  The numbers are large and history has shown that those in authority soon forget what previous generations learned.  The Great Depression was preceded by the Roaring 20’s.  The current environment has many parallel themes occurring.  The super-charged egos of those in charge believe that they can defy the compression aspect of economic cycles.  Compression is good.  Delayed compression can be life threatening.  We are currently at risk of an economic depression in the 2009-2010 time frame.  Read on…

The financial industry operates on leverage.  It loans other people’s money and collects interest income.  For instance, if you are paid 5% on your bank certificate of deposit (CD), the bank will use that money to loan out at a rate typically at least 2% higher.  The bank makes its money on the "spread" of 2%+.  Only the best customers receive the bank’s prime rate.  A standard savings account may receive 2-3% interest whereas the bank is loaning money at 7-12% interest.  The financial industry is inherently structured to make money.  The assumption of this model is that the lending and investment practices adhere to strict guidelines to insure minimal loan/investment losses.  Regulators closely monitor loan loss ratios.  They are also expected to closely review investment portfolio valuations.  This is currently where the problem lies.

SIVs are investment companies that use short-term borrowings to buy a higher-yielding asset.  When I was in banking in the 1970’s, I discovered an opportunity- borrow at 7% for 36 months and invest in 30 year Treasury Bonds at 8%.  I would simply pocket the 1% profit.  I would use the Bond as collateral.  All is good.  However I had a couple of problems.  First, I did not have the capacity to borrow much.  1% on $10,000 would only yield $100 per year, hardly worth the effort.  I would need to be able to borrow $1,000,000 to create a notable return.  Since I knew that my balance sheet would not support that kind of loan, I dismissed the opportunity.  Things have changed in the financial industry.  Hedge funds raised large amounts of money and were able to leverage their investing by 20 to 30 times.  Additionally, they could justify their investments by buying "insurance" on the asset or its stated interest rate.  What a complex arrangement!  In simple terms, the risk was spread among multiple players.  The problem is that the investment was only as good as the weakest player.  If the security was devalued, there were problems.  If the insurer became weak, there were problems.  If the bank lost money and was required to reduce its lending and thus "call" the note, there were problems.  As you can see there are many things that could go wrong in these complex transactions that base "leverage" as the underlying fuel to high returns. If the SIV invested in subprime mortgage backed securities, all of the participants would be severely impacted if the valuation of the underlying asset (houses) substantially dropped.

The housing bubble is bursting in the developed countries.  Speculators were allowed to borrow money outside the normal, historical lending criteria.  The participating banks were not innocent in this fiasco.  The mortgage lenders (equivalent to bank loan officers) were also complicit in this fraudulent activity.  Technology has provided the lending institutions with plenty of "no brainer", "fill in the blank" loan/credit analysis tools to insure safe lending practices.  Credit reporting agencies provide an easy means to verify payment history.  Once again, corporate greed has raised its ugly head and will severely impact the global financial system.  There will be many to lose their home and any savings they have accumulated.  Those marginal families will be at risk of bankruptcy.

Another bubble of equal concern is the upcoming baby boomer retirement bubble in the U.S.  The unfunded liabilities on the U.S. Government’s Balance Sheet dwarfs any potential source of revenue.  How will the U.S. be able to survive this liability?  The Federal Reserve will cut down all the trees in the country to print money.  This will be hyperinflationary.  The elderly who saved their entire lives will suffer with reduced purchasing power of their savings.  Those who are marginally surviving will become welfare recipients.  The 2007 Medicare/Medicaid insurance trust fund report reveals an unfunded liability of $40.9 Trillion on Page 190 of their latest report.  See the following link: http://www.cms.hhs.gov/ReportsTrustFunds/downloads/tr2007.pdf.  In USA Today, the overall unfunded liability to the taxpayer was $59 Trillion. http://www.usatoday.com/news/washington/2007-05-28-federal-budget_N.htm

The third bubble is peak oil.  The globe is not out oil, it is just more difficult to extract with the current, available resources.  "Peak oil" suggests that production from new discoveries no longer exceeds the production decline in output of existing fields.  The largest discovered fields around the world are in decline.  No new fields of a similar size/output have been found in decades. The world’s largest field Ghawar in Saudi Arabia was discovered in 1948 and put on stream in 1951.  With all of the technology available, oil companies have not found a larger field in the last 70 years.

The Derivative Crisis is the fourth bubble.  There are many other derivatives not tied to the subprime mortgage crisis.  In 2003, Warren Buffett warned that derivative securities were a "mega-catastrophe" and "financial weapons of mass destruction" in the annual letter to shareholders of Berkshire Hathaway, published in the Fortune Magazine:

[T]hese instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction–with your gain or loss derived from movements in the index…

…Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

This derivative industry has grown into the trillions of dollars.  The Bank of International Settlements (BIS) report:

Data from the BIS Statistical Report Q4 2006
• OTC Notional Amount of Derivatives is over $414 Trillion
• 70% of Notional are Interest Rate Contracts
• Credit Default Swaps are the fastest growing product
– Over $28 Trillion
– 65% Single Name Instruments
– 35% Multi – Name Instruments

As of June, 2007 the Derivatives total stood at $516 Trillion. see: http://www.bis.org/statistics/otcder/dt1920a.pdf

Why would I put all of this information in this writing?  The average person will never hear about all of these global risks in a summary similar to the above.  The average person would not comprehend the inherent risk to his or her future that these bubbles represent.

These four bubbles combine to represent a perfect storm.  Tax hikes or other changes to the current global economy can affect the outcome, the timing, and the severity of the expected compression.  What should one do to prepare?  Reduce your leverage and borrowings.  Protect your assets from the financial institutions that may fail.  Take possession of your stock certificates (if you are fortunate to own stock).  Keep cash on hand.  Invest in gold and/or silver (hard money).  Tangible assets will ride out the storm.  People need a place to live, food to eat, and energy for heating, cooling, and transportation.  Will the severe compression take place?  A good businessman hopes for the best but plans for the worst.