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Economic DUI

(As seen in the November 2011 issue of the APB)

As I watch the economy unfold lately, I’m reminded of the couple of “Reality TV” shows I have watched, ever so briefly, that seem anything but realistic. Our worldwide economy, like reality television, has flare for the dramatic. Rumors swing financial markets hundreds of points in every direction.

For someone who likes to study the fundamentals of our economy and markets, this can be a very frustrating time. Today, (Oct. 10, 2011), for example, the DOW is up 330 points on rumors that European leaders are going to step in to save their banks. Actually it is more than a rumor as Germany and France leaders say they will ride to the rescue, with details of their plan to be unveiled by the end of the month.

This strikes me a bit odd. First the financial markets were up nearly 500 points on these same rumors last week and second, if one had a plan it would seem like the plan itself should be the driving force, not some plan that will be unveiled three weeks from now. We are in a new era on Wall Street where many traders are in and out of stocks within milliseconds, driving equity markets into wild swings. This kind of investing has nothing to do with fundamentals, but everything to do with short term profits as affected by information and rumors, whether accurate or inaccurate.

Let me explain my ‘theory’ just a bit more. Remember the old saying, “Information is power.” Well on Wall Street information is money (profits & bonuses) and the more money you control and the quicker you are at maneuvering that money the more you can make. In other words, there is an advantage to controlling money and being the first to receive information… including rumors that will move markets. Now this is not a new reality, but the speed and magnitude at which insiders can trade is a new reality and it is all about the instant rewards with no consideration given to the long term affects. This is how we seem to have financial bubble after financial bubble and seem incapable of learning from our past mistakes in this very area.

We have managed to create a new age of rewarding risk and leverage without those taking the risk having little, if any, ownership in their actions. The incentive system we have built in our financial institutions create no incentive to do the right thing long term, but rather every incentive make a killing now before everything collapses around us. The victims of this financial insanity are the fiscally disciplined and savers; those who rely on markets functioning based on fundamentals and sound reasoning for the long term. Who are your biggest losers from this new economic reality of short term profit at the expense of long term stability? The biggest losers are benefit plans, particularly pension plans, which rely on markets functioning in their own interest for the long term. However, never has there been more of a disconnect between motives based on incentives and the long term health of an enterprise. ENRON is a case study in just how invasive perversion can become in a corporate hierarchy.

The worst thing about the profiteers of our day is that our government and Central Bankers have decided it is their responsibility to bail out the very financial institutions that created this investment destruction in the first place.

I like to say that for the past couple of decades we have lived in an era of borrowed prosperity. We started by borrowing from our futures; then we moved into borrowing from our children’s future and now we are borrowing from our grandchildren’s future. There are consequences to creating financial markets that represents casinos. There are consequences to bailing out failed institutions. There are consequences to leverage, debt, derivatives, Ponzi schemes, wrongly incentivized bonuses, failed regulatory agencies, failed rating agencies, failed morals, and ultimately failed monetary policy.

It is difficult for me to hear how underfunded pension plans are and how they will never earn their actuarial assumed rate of return from their investments. I happen to agree that it is unlikely that pension plans will earn the rate of return they need to fund long term benefits, which for CalPERS is 7.75 percent, but for reasons that no one seems to address. We have systematically undermined our own financial system and economy and continue to do so. This will affect what we consider “normal” investment returns for many decades to come. However, austerity for the sake of bailing out gamblers who destroyed our time-tested methods of investing is the height of hypocrisy and absurdity. Now those who control monetary policy have decided that the solution is to knock interest rates down to zero, buy our government’s own debt to drive down long-term interest rates even further and to purchase worthless, or near worthless, mortgage backed securities (MBS) from those who created the mortgage mess in the first place. Again, there are many consequences to these ill-fated policies, but one of the most obvious impacts is on those who rely on interest rates of fixed income instruments (e.g. treasuries) to fund future obligations. Our Federal Reserve has artificially lowered interest rates to encourage more borrowing (indebtedness) and to discourage savings. The 10-year treasury is now returning only about 2 percent.

We need to question how the heck institutional investors, like CalPERS, are supposed to overcome this overt manipulation of the bond markets. We should also closely examine the long term affects of our current monetary policy. Those responsible for monetary policy seem to be reinforcing the very behavior, leverage and risk-taking that caused our economic problems in the first place with little or no concern for the victims. While world leaders advocate for austerity measures, at the very same time they embark on the biggest social welfare give-away in the world’s history in the form of bankrolling large financial institutions.

So, how have we reached the point where the world’s financial future seems to depend on the small country of Greece being bailed out by many? The short answer is that our financial institutions taught the Greek banks and government securitization and how to take future revenue streams and assets as collateral for increasing current debt… right up to the point of insolvency. It fascinates me that all of the government’s various stimulus and bailout programs combined with the Federal Reserve’s record infusion of liquidity continues to be the answers to our economic ills, even though they seem clearly to have failed over the last three years. But just the mere mention of more rescues and accommodative monetary policy and the world’s equity markets get giddy. Why? Because the assurance of more liquidity means more opportunity for profits, at least in the short term.

The (brief) long answer to why the world’s fate depends on Greece is that our financial markets are hopelessly intertwined with instruments like the $700 trillion derivative market. Have you heard the term “contagion” thrown around aplenty since the 2008 meltdown? First, everyone owns everyone else’s debt. Why? Mainly because there is so much of it. But in addition to the tentacles of debt winding its way throughout the world’s financial system, bets on whether those debt obligations will be paid off hugely outstrip the debt itself. Not unlike our mortgage meltdown, Credit Default Swaps (CDS), or derivative bets against mortgage holders was the real culprit behind our 2008 financial fiasco. The total CDS market was about $60 trillion, or less than 10 percent of the derivatives market. How much in derivatives is being bet against foreign nations paying off their debt? I don’t know, but I assume it will have much more of an effect than any of the original sovereign defaults that might trigger the derivative bets.

If you say to yourself that this is all too difficult to understand, I agree and that is one of my main points. How in today’s rigged casino markets do you invest pension funds with any sense of security or understanding? Markets have become excessively complicated because the supply side of investments has been overfed. What is the supply side of financial markets? It is easy money through artificially low interest rates and ever increasing liquidity. We must understand that we are in the biggest liquidity bubble in our world’s history, the biggest government spending and intervention in our world’s history, the biggest monetary experiment by our world’s central banks and the most leveraged and most complex investment instruments in our world’s history. All off this unprecedented financial activity can offer an illusion of a recovery, but for it to last (and be real), there seems to be an infinite number of stars that must come into and remain in alignment.

You might say I sound a little harsh. It stems from years of watching financial markets grow more and more complicated and nonsensical. Hence watching it all makes me wonder out loud, “Is this real or is this one of those crazy reality TV shows?” It is just my observation that the more financially responsible you are these days the more likely you will discover that the system works against you. That system, through large financial institutions, central banks and world governments control the game. It’s just too bad that they refuse to look down the field to see what awaits them. It reminds me of the training every CHP cadet receives at the academy; when operating a vehicle you must maintain a high visual horizon. This is to allow the operator to take early evasive action for dangers or situations that lie ahead. Imagine driving never looking at anything but the steering wheel — you just got a picture of how economic policy is being established these days. At best we are guilty of economic DUI. The problem with someone who drives looking at the steering wheel — or intoxicated — is that they are likely to take out other drivers no matter how defensive those other drivers are while operating their own vehicles.

I was asked what my purpose was in writing this article. Certainly, it was partly to blow off steam. Hopefully it is to educate you, the reader. But mostly it is to begin a dialogue that recognizes that we cannot begin to build remedies for funding future pension obligations until we have repaired the foundation upon which we are supposed to build. That foundation is to return to fundamentally sound and responsible investment practices. The starting place should be to boycott complex investment instruments that significantly enrich the money handler while bankrupting the pension plan.

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