How Financial Madness Overtook the world ?

In January 2001, at the G7 meeting in Washington, the participants came out with a New Strategy, “The New Order”,  on how to boom the world economy: Banks will lend money to any and all good and bad risk countries including China and to any and all good and bad risk private investments in industry, service and real estate. This will generate phenomenal consumption that will easily cover payment default of bad risk countries and bad risk private investments.

That beautiful strategy ended with catastrophic bad results!  Payment defaults were more phenomenal than consumption. Thus, today I do not say and none of us would say thanks to George, Jacques, Gerhard, Tony, Yasuo, Sylvio and Jean.

Now, let’s get back to what happened, what is happening and what our crystal ball is saying for the near future.

If you're having a little trouble coping with what seems to be the complete unravelling of the world's financial system, you needn't feel bad about yourself. It's horribly confusing, not to say terrifying; even people like me, with a combined 20 years of writing about economy, banking, finance and monetary policy, are much frightened about what's going on. Some of the smartest, savviest people in this political and economic world find themselves reacting to problems rather than getting ahead of them. It's terra incognita, a place no one expected to visit.

The subprime story started 14 month ago and Lehman's collapse precipitated the latest chapter of that crisis, causing banks to stop lending to each other out of concern they may not get their funds back.

Since that collapse, every day brings another financial horror show, as if Stephen King were channelling Ben Bernanke, Jean Claude Trichet and Toshihiko Fukui to produce scary stories full of negative numbers. One weekend, the US Federal Government swallows two gigantic mortgage companies and dumps more than $5 trillion — yes, with a t — of the firms' debt onto taxpayers, nearly doubling the amount Uncle Sam owes to his lenders. While we're trying to get our heads around what amounts to the biggest debt transfer since money was created, the same US let Lehman Brothers to go broke - strategic mistake led by incompetent US officials-  and Merrill Lynch to feel compelled to shack up with Bank of America to avoid a similar fate. Then, having sworn off bailouts by letting Lehman fail and wiping out its shareholders, the Treasury and the Fed reverse course for a rescue of creditors and policyholders of American International Group (AIG), a $1 trillion insurance company. Other once impregnable institutions may disappear or be gobbled up.

There are two ways to look at this. First, there is the stock markets way, which features theories and numbers and equations and gobbledygook and, ultimately, rationalization. Second, there's the right way, which involves asking the questions that really matter: How did we get here? How do we get out of it? And what does all this mean for Jo the Plumber? So take a deep breath and bear with me as I try to explain how financial madness overtook not only worldwide stock markets but also banks and businesses. And why, in the end, almost all of us, collectively, are going to pay for the consequences.

Going forward, there's one particularly creepy thing to keep in mind. In normal times, problems in the economy cause problems in the financial markets because hard-pressed consumers and businesses have trouble repaying their loans. But this time — for the first time since the Great Depression — problems in the financial markets are slowing the economy rather than the other way around. If the economy continues to spiral down, that could cause a second dip in the financial system — and we're having serious trouble dealing with the first one.

How did this happen, and why over the past 14 months have we suddenly seen so much to fear? Think of it as payback. Fear is so pervasive today because for years the financial markets — and many borrowers — showed no fear at all. Stock Marketers didn't have to worry about regulation, which was in disrepute, and they didn't worry about risk, which had supposedly been magically whisked away by all sorts of spiffy nouveau products — derivatives like credit-default swaps. This lack of fear became a hothouse of greed and ignorance on major Stock Markets. When greed exceeds fear, trouble follows. Stock markets have always been a greedy place and every decade or so it suffers a blow resulting in a bout of hand-wringing and regret, which always seems to be quickly forgotten.

This latest go-round featured hedge-fund operators, leveraged-buyout boys (who took to calling themselves "private-equity firms") and whiz-kid quants who devised and plugged in those new financial instruments, “hedge funds” and “derivative products”, creating a financial Frankenstein the likes of which we had never seen. Great new fortunes were made, and with them came great new hubris. The newly minted masters of the universe even had the nerve to defend their ridiculous income tax break — much of the private-equity managers' piece of their investors' profits is taxed at the 15% capital-gains rate rather than at the normal top federal income tax rate of 35% — as being good for society. 

Warren Buffett, the nation's most successful investor, back in 2003 called these derivatives — which it turned out almost no one understood — "weapons of financial destruction." But what did he know? He was a 70-something alarmist fuddy-duddy who had cried wolf for years. No reason to worry about wolves until you hear them howling at your door, right?

Besides a few prescient financial sages, though, who could have seen this coming in the fall of 2006, when things were booming and the world was awash in cheap money? There was little fear of buying a house with nothing down, because housing prices, we were assured, only go up. And there was no fear of making mortgage loans, because what analysts call "house-price appreciation" would increase the value of the collateral if borrowers couldn't or wouldn't pay. The idea that we'd have house-price depreciation never entered into the equation.

As for businesses, there was money available to buy corporations or real estate or whatever an inspired dealmaker wanted to buy. It was safe too — or so Wall Street claimed — because investors worldwide were buying U.S. financial products, thus spreading risk around the globe.

Now, though, we're seeing the downside of this financial internationalization, many of the mortgages and mortgage securities owned or guaranteed by Fannie Mae and Freddie Mac were bought by foreign central banks, which wanted to own dollar-based securities that carried slightly higher interest rates than boring old U.S. Treasury securities. A big reason the Fed and Treasury felt compelled to bail out Fannie and Freddie was the fear that if they didn't, foreigners wouldn't continue funding our trade and federal-budget deficits.

You've heard, of course, that subprime mortgages — subprime is Wall Street's euphemism for junk and for Jo the plumber— are where the problems started. That's true, but the problems have now spread way beyond them. Those predicting that the housing hiccup wouldn't be a big deal — what's a few hundred billion in crummy mortgage loans compared with a $13 trillion U.S. economy or a $54 trillion world economy? — failed to grasp that possibility. It turned out that Wall Street's greed — and by Wall Street, we mean the worldwide stock markets and the world of money and investments, not a geographic area in downtown Manhattan — were supplemented by ignorance. Folks in the world of finance created, bought, sold and traded securities that were too complex for them to fully understand.

Here's how leverage works in reverse. When things go well, as they did until last year, Lehman is immensely profitable. If you borrow 35 times your capital and those investments rise only 1%, you've made 35% on your money. If, however, things move against you — as they did with Lehman — a 1% or 2% drop in the value of your assets puts your future in doubt. The firm increasingly relied on investments in derivatives to produce profits, in essence creating a financial arms race with competitors like Goldman Sachs. Even though the Fed had set up a special borrowing program for Lehman and other investment banks after the forced sale of Bear Stearns to JPMorgan Chase in March, the market ultimately lost faith in Lehman. So out it went.

The market lost faith in AIG too, but the government was forced to save it. A major reason is that AIG is one of the creators of the aforementioned credit-default swaps. What are those, you ask? They're pixie-dust securities that supposedly offer insurance against a company defaulting on its obligations. If you buy $10 million of GM bonds, for instance, you might hedge your bet by buying a $10 million CDS from AIG. In return for that premium — which changes day to day — AIG agrees to give you $10 million should GM have an "event of default" on its obligations.

Didn't the folks in the major stock markets, who are nothing if not smart, know that someday the music would end? Sure. But they couldn't help behaving the way they did because of stock markets ' classic business model, which works like a dream for employees (during good times) but can be a nightmare for the customers. Here's how it goes. You bet big with someone else's money. If you win, you get a huge bonus, based on the profits. If you lose, you lose someone else's money rather than your own, and you move on to the next job. If you're especially smart — like Lehman chief executive Dick Fuld — you take a lot of money off the table.

I predicted this financial crisis two years ago. Revert to my analysis dated August 2006.

What is that catastrophe? 

Threats of global financial meltdown, stocks plunging, corporate capitalization disappearing, bursting of housing, equity, bond, credit, commodity, hedge-fund and private-equity bubbles, Lehman brothers already forgotten, worldwide banking system on the edge of bankruptcy, global recession looming, starting of deflation, beginning of crash landing of some better- performing economies such as Brazil, Russia, India and China, unemployment growing, social unrest increasing, et cetera.

Commodities also plunged along with the stock markets. That brings me to say that I was right saying oil barrel price raise was only due to speculation by hedge funds, and definitely not by high demand.

What is the quick action undertaken ?

Led by very efficient French President Nicolas Sarkozy, central bankers, finance chiefs, worldwide heads, and moreover, G7 meetings after meetings, pledge to ``take all necessary steps to unfreeze credit and money markets'', vow to prevent the failure of the economic system and confirm launching of new rules and regulations of “doing banking”.

However, all that so far,  without detailing how that would be accomplished; failing to unveil new initiatives for thawing credit markets; refraining from specific fresh measures.

Global central banks cutting in emergency interest-rate, pumping in emergency more cash into markets, backing ``systematically important financial institutions'' –they forgot my banking institution, but they know I have been very wise-  making encouraging speeches.

The Americans electing Barack Obama, a very competent top executive,  with the Congress and the Senate fully supporting the President  -this is a historical situation-  his political, social, economic, monetary,  and social security programs,  will definitely provide a relief in the coming years.

Mr Obama is calling for increased rules; he is casting away partisan predispositions; he is restoring confidence that has been badly shaken; he is adding the just-right measure of regulation and oversight to the mix; stock markets agree. Yes.

Even Jean Trichet, the European Central bank Chief, is bringing interest rates lower. However, opposing President Sarkozy,  Trichet is a Chirac man, acting like Don Quichote fighting against windmill, until few weeks ago, has been using higher and higher interest rates financial tools, he said to combat higher invisible inflation, while behind him, because of that tightening interest rates, European growth was disappearing, companies were filing chapter 11, unemployment was growing, social unrest was developing.

The CAM Plan:

There's no question that the crisis has gone so deep that it cannot be halted by one stroke. Banks, industrial, commercial and service corporate around the globe are struggling to pull themselves out of this mess. Rebuilding will take time, vast amounts of money and constant attention. Sooner or later, the hundreds of trillions of Euros and dollars that the central bankers are throwing into the markets, the New Banking Order, the regulation of the wild capitalism, will stabilize worldwide economy.

I suggest the following marshall plan, called “CAM Plan”, first, a three simultaneous action in the US:  Dear Mr Obama, first, please  let the US dollar go higher –I would say 1/1 to euro-  so as to attract foreign investments and develop growth and absorb unemployment, second, please let interest rates be lowered to zero, so as to increase export, in order to get liquidity and growth, and third, please control commodities prices in order not to destabilise inflation rates.

In Europe, the “CAM Plan” urges French President Nicolas Sarkozy to establish a worldwide new “New Order.” He is the only charismatic head of state in the world to be able to carry out that project successfully.

The “CAM Plan” suggests  Central Banks to launch an ambitious and coordinated plan to tackle the financial crisis in lowering to “zero”  key lending rates as part of a coordinated easing of monetary policy with global counterparts. Central Banks should offer to banks unlimited funding every week at the main refinancing rate. After that, stock markets need to accept that these ``measures take time to work''.  To salvage the markets, maturing process will be long.

It suggests total new banking rules and regulation, policy and procedures and recapitalization in worldwide banks.  No more hanky-panky investments.

The “CAM Plan” suggests thus to shake-up global financial architecture and to map out stable, integer and regulated plan and high-quality accounting standards, to overcome the financial turmoil, to deepen cooperation, to improve world banking policy and procedures, rules and regulation, to supervise the overall functioning of the world's financial markets and to avoid the go-it-alone protectionist trade strategies that worsened conditions during the Great Depression of the 1930s..

It urges China to allow faster appreciation of its Yuan. I view excess volatility in exchange rates as detrimental

It proposes countries with current-account deficits and those with surpluses to maintain orderly financing of deficits and ``avoid a disorderly adjustment of such imbalances.'' And not to limit the flow of goods, services or capital isolationism and protectionism and to offer a way to contain the spreading damage.

The “CAM Plan” suggests that indecent cash revenue and savings accumulated by oil rich producing countries go to help developing countries facing growing misery. 

Coping in this new world will require adjustments by millions of investors and hedge funders. We all will have to start living within our means  -or preferably below them-  If you don't overborrow or overspend, you're far less vulnerable to whatever problems the financial system may have. And remember one other thing: the four most dangerous words in the world for your financial health are "This time, it's different."  My answer is: It's never different. It's always the same, but with bigger numbers.

What my crystal ball is saying:

On short and medium terms, hedge funds deleveraging soon will push stock markets lower another 20%; volatility will remain; worldwide economy will slowdown until 2010.

US dollar will go higher so as to attract foreign investment so as to absorb unemployment; this policy is on line with President Obama’s commitments. Moreover, barrel prices will go lower, maybe back to US dollars 10 (ten) so as to limit inflation, on line with lowering interest rates to zero to boom growth; and as democrats politicians are not oil producers.

If such monetary policy, “CAM Plan” is well managed, thus achieving and anchoring stable inflation, I see no element that will push gold prices higher.

And last but not least are some observers cautious because government’s commitments "have not been tested", i.e. investors will only trust them after governments have actually paid interest or capital of a bond of a supported bank. We still expect conditions to improve as pressure on banks to sell troubled assets is abating. And we regard the commitment of the governments to support the banks as given. Yet the normalisation will take some time.

Recapitalisation of the banks being the right strategy, money market tensions will ease soon, while the credit market will remain tight. Investors should already look one step ahead and focus on the impact of the economic slow-down on the quality of their holdings, in terms of shares, commodities and precious metals.