Denninger: The Challenge Before America
From Karl Denninger:
Thursday night, readers of The Ticker are aware, I gave a speech while receiving the AIM 2009 Grassroots award in which I dealt with "The Bezzle" within our modern finance system.
I wish to spend today's Ticker focusing on that concept - what it means for the broader economy - and why it is absolutely critical that our government and regulators put a stop to it - right here and now.
First, some facts - some 2/3rds of all capital in the marketplace, whether in the form of credit or cash, is private. Some of it is owned by people like you and I, some by sovereign funds (e.g. Saudi Princes) and some by large foreign and domestic institutional interests (e.g. Pension funds.)
All of this capital has one thing in common: It cannot be forced to enter or stay in any particular market. It is, in fact, entirely possible for that capital to decide to head straight for "the mattress" (that is, to remain in cash) at any point in time, or to allocate itself in any particular asset class it so chooses.
Policymakers are incapable of replacing this capital with public funds (e.g. "new reserves", TARP or other such silliness.) To put this in proper perspective some numbers are in order - with some $50 trillion in total private and public debt outstanding in the United States the debt base alone involved here is roughly $30 trillion in private capital.
This is why The Fed's and Treasury's "commitment" of some $10 trillion (thus far) in loan guarantees and direct spending has done nothing to stem this crisis - and they can't possibly come up with another $20 trillion without collapsing the bond market and destroying both The Fed and The Government.
Policymakers must realize that there is exactly one - and only one - way out of this mess.
"The Bezzle" must be eradicated.
I fully realize that this is extremely difficult politically, but let's face the facts here.
Every "private capital source" that has been enticed into this morass over the last two years has been destroyed, including Warren Buffett (Goldman Sachs and others) and The Saudis (Citigroup among others.)
Then you have Bernie Madoff and Stanford Financial, two alleged frauds that were "known" to the government more than ten years ago and yet were either not investigated or intentionally allowed to continue to operate, robbing people of literal billions of dollars.
Finally, you have AIG which reported a $61.66 billion loss, or $22.95 a share - for a stock trading under two bits. Stripping out capital losses and "accounting issues" you'd still have a loss of $37.9 billion, or $14.17/share. The government has "agreed" to provide another $30 billion to the firm in addition to the previous $150 billion that has been sucked into a black hole. Once again AIG has been deemed "a systemically significant failing institution" that has to be propped up, according to Treasury.
And who were the beneficiaries? Goldman, Merrill, and now overseas banks. Instead of putting the firm into receivership and running down its portfolio over time, forcing the losses to be netted and taken, we are instead rewarding "The Bezzle" by protecting those who did imprudent and even outrageous things with unlimited taxpayer dollars.
Every last one of those "investments" has been wrecked as a direct consequence of "The Bezzle" - that is, our government's refusal to uphold the law and force the truth to be disclosed both publicly and to investors. Our government and its agencies have gone so far as to intentionally mislead in many cases, including claims related to nationalization of banks and respect for capital structures just before people were wiped out in investments that should have had preference.
What's worse, in some cases such as AIGs, not only has "The Bezzle" ripped off private investors it is also ripping off the taxpayers - multiple times - with no indication that we're going to stop this course of action any time soon!
The market no longer sees these "rescues" as positive - it now sees them as what they in fact are: coverups for papering over raw fraud and abuse, and thus when each new "rescue" is announced the market tanks instead of stabilizing.
Fact is that intentional and willful misconduct by our government agencies, both as acts of omission and commission, has resulted in these firms, institutions and nations suffering crippling losses.
These acts of malfeasance and misfeasance in government agencies include (but are not limited to):
- "23A Exemption" letters
- Willful and improper classification of funds (IndyMac) which kept the FDIC from taking enforcement action in a timely fashion
- Willful removal of leverage limits (championed by and granted as a consequence of Henry Paulson's request before he joined Treasury; every one of the 5 firms that has blown up had 2x or more the formerly legal limit)
- Willful removal of bank leverage limits and reserve ratios by The Fed and Congress in permitting "sweeps" along with allowing The Fed authority to set reserve ratios wherever it would like, including to zero.
- Willful failure to police CDS margins and capital adequacy (e.g. AIG and others) thereby leading firms to be deeply insolvent yet continuing to operate as if nothing was wrong - until the cash ran out and we suddenly had a systemic crisis.
- Willful failure to enforce suitability regulations on mortgage lenders, along with intentional preemption of state predatory lending laws.
- Willful blindness related to the blatant and outrageous false statements made by both lenders and borrowers; the essence of "liar loans."
- Willful blindness related to both Madoff and Stanford Financial
- Willful blindness related to ratings agency conflicts of interest, "ratings shopping" and known-flawed ratings models.
- Willful blindness with regards to firms selling securities to customers which they were shorting at the same time - without disclosing this fact to the customer they were marketing to.
- Refusal to take action related to the false statements of executives on the health of their firms on national TV networks such as CNBC, when reliance on those statements led to complete wipeouts (Bear Stearns and Lehman)
- Misleading statements related to the health of Fannie and Freddie made by administration officials, leading to near-total losses for both common and preferred shareholders.
- Most recently, misleading statements related to the intended path for banks and capital adequacy, including Citibank.
This is a serious problem for our capital markets and economy generally as without this private capital we are doomed to a massive economic contraction. Conservatively speaking, assuming our government can actually fund the $9-10 trillion they've promised, which I believe is a pure fantasy (it would represent nearly a tripling of the public float of US Debt!) we would suffer a 30% contraction in GDP over the next 18-24 months.
If they cannot fund those commitments much beyond the $1 trillion already spent, the contraction would be more on the order of 50%.
This would take us back to roughly 1994 levels in GDP terms, looking at constant dollars, a setback of some 15 years.
The damage, however, would be much worse than it appears at first blush, because in conjunction with the expansion in GDP state and local governments, along with government spending, have expanded, expecting that "GDP never goes down" (doesn't that sound familiar to those who believe that "house prices never go down"?)
Were we to contract to a $7 trillion GDP, for example, our current federal budget would reach nearly half of GDP! This would be impossible to sustain as tax revenues would collapse under such a scenario.
We have exactly one opportunity to stop this, and that opportunity is now.
Government simply must stop "The Bezzle" in all parts of our economy and capital markets, and must do so right here, right now, today.
If we fail to demand this as Americans or our government fails to implement this across the board then we will suffer a Depression worse than the 1930s.
This is not conjecture.
It is not a prediction, nor drawn from how I "feel".
This is mathematics; it is a fact that we cannot possibly maintain anything close to our current standard of living unless private capital decides to re-enter our marketplace - a decision that government cannot force.
The consequences of an economic Depression of this magnitude are almost too serious to contemplate. They include unemployment topping 20%, an average annual income decrease for Americans of some 30% (for those who remain employed!), a 70-80% decrease in retirement accounts such as IRAs and 401ks and the decimation of both private and public pensions, resulting in a reduction in benefits of 50% or more.
Should government attempt to "replace" that private capital the result will be a bond market collapse. This too is inevitable; into an environment of falling tax receipts (down 15% already) foreign governments and investors would have to be insane to continue purchasing US Treasury debt.
THAT event, should it occur, would result in The Federal Government being forced to contract to 1/3rd of its current size almost literally overnight. The only way to accomplish this would be to entirely eliminate all Social Security, Medicare and Medicaid funding, cut Defense spending by 75%, and cut all remaining discretionary programs by 50%.
Needless to say such an event would be catastrophic for our society - far worse than a "mere" Depression. In fact, that latter outcome has a very high probability of destabilizing our government and political system entirely.
Let me be crystal clear: the very real possibility exists that our government could collapse.
The time to play games and fiddle hoping for a turn in the housing market or some other miracle has passed. Bernanke himself said if the financial system cannot be stabilized our economy will not recover.
He is correct - but our financial system, including both credit and stock markets, cannot stabilize (say much less recover) until and unless private capital re-enters the market.
That simply will not happen until "The Bezzle" is driven out.
We either act now or suffer the consequences - the utter destruction of our middle class, a collapsed stock market with the DOW headed to 3,000 or worse and the S&P 500headed into the 400 or lower range, unemployment topping 20% and GDP falling by 30% or more, complete destruction of both private and state-run pension systems, and a very real possibility that our nation collapses.
Your choice, America.
This is math - not politics.
What if, just as a hypothetical, the objective actually is to destroy America as a prerequisite to establishing a collectivist Utopia?