This is an interesting op-ed in the morning edition of the WSJ:

We’re now in the 37th month of central government manipulation of the free-market system through the Federal Reserve’s near-zero interest rate policy. Is it working?

Business and consumer loan demand remains modest in part because there’s no hurry to borrow at today’s super-low rates when the Fed says rates will stay low for years to come. Why take the risk of borrowing today when low-cost money will be there tomorrow?

Why borrow at all, in the main?  Borrowing is the taking of leverage — “gearing.”  It magnifies both gains and losses, and it is the losses that turn into trouble, as often they wind up being borne by someone other than the borrower.

They’re supposed to be borne by the borrower and lender, incidentally.  But the lender rarely actually eats them, especially when things get “really bad” — then the taxpayer gets soaked, directly or indirectly, as we have seen.

Federal Reserve Chairman Ben Bernanke told lawmakers last week that fiscal policy should first “do no harm.” The same can be said of monetary policy. The Fed’s prolonged, “emergency” near-zero interest rate policy is now harming our economy.

It always was Charles.

The Fed policy has resulted in a huge infusion of capital into the system, creating a massive rise in liquidity but negligible movement of that money. It is sitting there, in banks all across America, unused.

No.  Capital and borrowing are not the same thing.  They spend the same, but they’re not the same.  Capital is economic surplus — that which you have after you earn and pay the necessities of life (or to run your business.)  Borrowing is leverage — “mechanical advantage” if you will, but it is always a negative-sum game as not only does it have to be paid back but the interest expense means you must earn even more to pay it with.

The multiplier effect that normally comes with a boost in liquidity remains at rock bottom. Sufficient capital is in the system to spur growth—it simply isn’t being put to work fast enough.

The paradox of debt is that due to the negative sum nature of it there is always less of a multiplier than the liquidity increase would suggest.  That is, mathematically it is a negative game for the borrower in every case.  This does not mean that a borrower cannot turn that disadvantage into advantage, but it does mean that the odds are against him or her in doing so.

The poker player in Vegas is at a similar disadvantage due to the house “rake.”  If six similarly-skilled players sit at a poker table in Vegas and play long enough they will all wind up broke, because the house rake will consume all their money.  It is a certainty if the game goes on for long enough, the skills are evenly-enough matched, and their luck is reasonably even.

The only way for such a player to win is to be better than the other people at the table by a sufficient amount to overcome the house rake.  He must also stop playing when he has amassed enough winnings and depart.  This means that for the player of superior skill he is incented to play at a higher level of wager, becasue he wants the fewest number of hands dealt to make his money to keep the rake’s “rape” of his stack to a reasonable level.

We’ve also seen a destructive run of capital out of Europe and into safe U.S. assets such as Treasury bonds, reflecting a world-wide aversion to risk. New business formation is at record lows, according to Census Bureau data. There is still insufficient confidence among business people and consumers to spark an investment and growth boom.

Business formation comes from capital formation which is the product of economic surplus.  That’s all.  Since capital formation is born of savings, that is, economic surplus, zero interest rates destroy the incentive to do so.  Low interest rates tend to cause people to borrow for uneconomic purpose, just as inflation provides incentive to buy things that aren’t really needed right now “because they’ll go up in price tomorrow.”  This is all malinvestment of one form or another and it’s destructive to the health of the economy.

Just look at SYSCO, which reported results this morning.  They showed that food inflation was 6.8% over the last year, contrary to the government lie that “inflation is non-existent.”  Uh huh.

What Mr. Schwab is missing here is that The Fed is hardly an “independent” central bank.  It is in fact beholden to Congress, which has pumped up $5 trillion in debt over the last three years.  That debt has a servicing cost, and it is the “ultra low” interest rates that make this temporarily affordable.

How is Congress going to service this debt when the rate of interest rises?  More to the point, where are the adults in the room in Washington DC?  We’ve had this on both sides of the aisle — “we must stimulate the economy!” — with borrowed money.

Outright bribery of the electorate both hasn’t and can’t work to lead to a durable recovery.  Instead, it has backed Bernanke and Congress into a corner.  When rates rise to just a blended 4% Congress will be facing a $600 billion annual interest bill.  From where will the money come?

This is the trap into which Japan fell and what we are facing today.  It is an extraordinarily destructive cycle that is very, very difficult to break, because it requires pulling the liquidity support at the same time Congress dramatically raises taxes, cuts spending (real cuts, not the imaginary cuts from “baseline” budgeting) or both.  In short it requires admitting that we took fiscal heroin to avoid pain and accepting the accumulated damage for a period of time, accepting the “deferred depression” that we all tried to hide.

Charles Schwab leaves this unsaid, of course, but then again he’s running a brokerage.  Were people to think this thing through they’d realize that the mathematical conundrum presented by Schwab has no resolution that doesn’t ultimately result in that contraction asserting itself.  There is always the matter of timing, but not outcome — that which is fueled by nothing other than fiscal methamphetamine either leads to a nasty crash when you stop taking or heart failure.  Pick one — both suck but while one is nasty the other is fatal.

Karl Denninger with  James J Puplava CFP

About the Author

 

Karl Denninger

Author at The Market Ticker http://market-ticker.org/

Countries around the world, particularly in the West, are hopelessly in the red, with debt rising every day. Even worse, politicians seem paralyzed, unable — or unwilling — to do anything about it. It is a global disaster that threatens the immediate future. But there might be a way out.

When Carlo Ponzi, a dishwasher from Parma, Italy, immigrated to the United States in 1903, he had $2.50 in his pocket and a million-dollar dream in his head. He was able to fulfill that dream, at least temporarily.

The scheme continued. Ten investors turned into 100, and 100 investors turned into 1,000, until the scam was discovered. Ponzi spent many years in prison, and he died a pauper in 1949. But his name remains important to every criminologist today — and every economist.

Economists use the term “Ponzi scheme” to describe a disastrous mechanism in which someone pays off old debt by constantly taking on new debt. The repayment of the debt — the most recent loans, plus interest — is deferred into the distant future, fueling an eternal process of debt refinancing.

It’s the classic pyramid, or snowball scheme, practiced by thousands of con artists after Ponzi. The most spectacular case was that of New York financier Bernard Madoff, who was responsible for losses of about $20 billion by 2008. Snowballs are set into motion, becoming bigger and bigger as they roll along. In the worst case, they end in an avalanche that takes everything else with it.

Western economies have not acted much differently than the fraudster Madoff. In 2011, they were virtually inundated with bad news and old sins. Almost everyone — in Europe and in the United States — has been living beyond their means, from consumers to politicians to entire countries. Governments have become servants to the markets upon which they have become dependent.

Bigger Snowballs

On an almost weekly basis, the reports have become more worrisome and the sums of money involved more staggering. Many are now concerned that, as 2012 begins, the snowballs will only get bigger — and roll faster:

• There are the banks in Europe, which will have to repay about €725 billion in combined debt in 2012, including €280 billion in the first quarter alone. With the private market largely off-limits to them, the banks have had to rely on the European Central Bank (ECB) to bail them out. The ECB is now lending them fresh money — as much as they want — at minimal interest rates.
• There is a country like Italy, which has an exorbitant amount of debt to service at the beginning of the year. About €160 billion in debt will mature between January and April; the total for the entire year is about €300 billion. The government in Rome is already having trouble finding buyers for its bonds.
• There is the ECB, which is creating billions essentially out of nothing. On an almost weekly basis, it is acquiring bonds that no one else would buy from Portugal, Spain and Italy and, in the process, it is turning into a reluctant financier of nations. This financial aid already amounts to €211 billion.
• There is the European Commission, whose president, José Manuel Barroso, supports the use of so-called euro bonds. These bonds, which would be issued jointly by the countries in the monetary union, would amount to an accumulation of collective debt on top of national debts.
• There is the €440-billion euro bailout fund, of which €150 billion are already promised to Greece, Ireland and Portugal. But because this amount is still not enough, the finance ministers have decided to “leverage” the fund, a seemingly harmless term for bringing in additional lenders, thereby multiplying the volume of credit.
• And then there is the United States, which only remains solvent because the Congress in Washington keeps raising the debt ceiling. The American government already owes its creditors about $15 trillion. Stay tuned for the next installment.

In other words, there are plenty of snowballs that have started rolling and getting larger with each rotation. Some aspects of the economic system in the industrialized countries resemble a gigantic Ponzi scheme. The difference is that this version is completely legal.

Living on Credit

Old debts are paid with new ones, with borrowers giving not the slightest thought to repayment. This has been going on for a long time, far too long, in fact. It was only with the eruption of the financial crisis in 2007 and the outrageously expensive bailouts of banks and economies that many people realized that the entire world is living on credit.

“Debt is rising to points that are above anything we have seen, except during major wars,” economists at the Bank for International Settlements (BIS) concluded in a recent study. “The debt problems facing advanced economies are even worse than we thought.”

This is even true of seemingly rock-solid Germany. In the third quarter of 2011, German public debt amounted to €2.028 trillion, an increase of €10.8 billion over the debt level just three months earlier. Germany’s public debt grew by about €120 million a day — or more than €80,000 a minute — between July and September.

To make matters worse, this increase occurred in a quarter marked by plentiful tax revenues and a significant decline in unemployment. But debts increase independently of whether times happen to be good or bad.

The End of the System

The same thing is happening almost everywhere. In the first decade of this century, which was by no means a weak period economically, countries more than doubled the level of debt — to an estimated grand total of $55 trillion by the end of 2011.

The United States leads the pack with its national debt of $15 trillion, followed by Japan with about $13 trillion. Germany’s €2 trillion looks almost paltry by comparison. Today, the three major rating agencies award their highest credit rating to only 14 countries in the world.

The fact that nations are continually spending more than they take in cannot turn out well in the long run. The word “credit” comes from the Latin “credere,” which means “to believe.” The system will only function as long as lenders believe in borrowers. Once the belief in the creditworthiness of borrowers is destroyed, hardly anyone will be willing to buy their securities.

When that happens, the system is finished.

This is precisely what happened with Carlo Ponzi’s scheme. And now entire countries are suffering suspiciously similar fates. They are no longer being taken seriously.

Meanwhile, it is also flaring up in the United States once again, with Democrats and Republicans blaming each other for the nation’s debts. Instead of taking responsibility and consolidating the budget, President Barack Obama prefers to rail against the Europeans’ approach to crisis management. They, in turn, refuse to tolerate any interference, especially from the United States, which they blame for being the source of the financial crisis in the first place.

In this fashion, the Old World and the New World are tossing the blame back and forth, while confidence in politics and its ability to avert collapse is dwindling on both sides of the Atlantic. Is there still a way to stop the avalanche, or at least to diminish is destructive force? Why do countries that collect taxes have to borrow money in the first place?

Part 2: Of Good Debt and Bad Debt

Alexander Jung – Spiegel

Can you hear that?  It almost sounds like a little bit of peace and quiet.  This year, the holiday season has been fairly uneventful, and for that we should be very grateful.  But it isn’t going to last long.  2012 is going to be a much more difficult year for the U.S. economy and the global financial system than 2011 has been.  So if things are going well for you right now, enjoy this little bubble of peace and tranquility while you can.  Because while things may look calm on the surface right now, the truth is that this is a very scary Christmas for financial professionals and world leaders.  Most of them know how fragile the global financial system is at the moment.  Most of them know that we are living in the greatest bubble of debt, leverage and financial risk that the world has ever seen.  As I wrote about the other day, world leaders would not be throwing huge bailouts around like crazy if everything was going to be just fine.  The truth is that we are rapidly approaching another financial crisis that may end up being even worse than the horrific crash of 2008.

Despite unprecedented efforts by the European Central Bank, the yield on 10 year Italian bonds is nearly up to 7 percent again.

Keep an eye on the yield on 10 year Italian bonds.  That is going to be one of the most important financial numbers in the world in the coming months.

But Italy is not the only problem.  The reality is that several European governments are teetering on the verge of default right now.  Meanwhile, confidence in the European financial system has been absolutely shattered and a devastating credit crunch has set in.  Nobody (other than the ECB) wants to loan money to the banks and the banks are massively cutting back on loans to businesses and consumers.  This is causing the money supply to fall.  The ECB is trying to hold things together with chicken wire and duct tape, but it isn’t going to work.

In major financial centers such as the City of London, this is a very scary Christmas and the outlook for the new year looks very frightening.  Because financial activity has dried up so dramatically, a number of firms are already shutting down.  The following comes from a recent Bloomberg article….

London’s stockbrokers are shrinking as Europe’s sovereign debt crisis and competition from international firms squeezes revenue and fees.

“This isn’t just a blip, this is much worse,” said Tim Linacre, who is stepping down as chief executive officer of Panmure (PMR) Gordon & Co., a 135-year-old brokerage. “It’s a desert for activity, which is why you are seeing some firms throw in the towel.”

In the past month, Altium Capital closed its securities unit. Evolution Group Plc (EVG), Merchant Securities Group Plc, Arbuthnot Securities Ltd. and Collins Stewart Hawkpoint Plc have all accepted takeover offers from larger competitors.

“It feels worse than any other time,” said Lorna Tilbian, an executive director at Numis Corp. who began her career in 1984. “All I hear about is people putting up a white flag.”

Many out there are wondering if we are about to face another crisis like the one we saw back in 2008.

Unfortunately, none of the underlying problems that caused that crisis were ever really fixed.

We did not learn from history so now we are in for another round of pain.

In fact, Chris Martenson believes that this next crisis will be even worse than 2008….

There are clear signs of a liquidity crunch in the asset markets right now, and the question I keep hearing is, Is this 2008 all over again?

No, it’s worse. Much worse.

In 2008 there was a lot more faith and optimism upon which to draw. But both have been squandered to significant degrees by feckless regulators and authorities who failed to properly address any of the root causes of the first crisis even as they slathered layer after layer of thin-air money over many of the symptoms.

Anyone who has paid attention knows that those “magic potions” proved to be anything but. Not only are the root causes still with us (too much debt, vast regional financial imbalances, and high energy prices), but they have actually grown worse the entire time.

Frightening stuff.

A couple of months ago, I wrote about the coming derivatives crisis that could potentially wipe out the entire global financial system.

When the next great financial crisis strikes, there is going to be a lot of focus on derivatives once again.

Top global financial authorities such as Ben Bernanke continue to insist that derivatives are perfectly safe.

But there are other voices in the financial world that are warning that we are heading for financial armageddon.  For example,just check out what Mark Faber is saying….

“I am convinced the whole derivatives market will cease to exit. Will become zero. And when it happens I don’t know: you can postpone the problems with monetary measures for a long time but you can’t solve them… Greece should have defaulted – it would have sent a message that not all derivatives are equal because it depends on the counterparty.”

That is very strong language.

Faber also believes that the stock market is going to get hit really, really hard during the coming crisis….

“I am ultra bearish. I think most people will be lucky if they still have 50% of their money in 5 years time. You have to have diversification – some real estate in the countryside, some gold and some equities because if you think it through, say Germany 1900 to today, we had WWI, we had hyperinflation, WWII, cash holders and bondholders they lost everything 3 times, but if you owned equities you’d be ok. In equities in general you will not lose it all, it may not be a good investment, unless you put it all in one company and it goes bankrupt.”

Some of the top financial officials in the entire world have also used some very scary language in recent weeks.

The head of the International Monetary Fund, Christian Lagarde, recently stated that we could soon see conditions “reminiscent of the 1930s depression” and that no country on earth “will be immune to the crisis”….

“There is no economy in the world, whether low-income countries, emerging markets, middle-income countries or super-advanced economies that will be immune to the crisis that we see not only unfolding but escalating”

But most people are so busy opening up the cheap plastic presents under their Christmas trees (that were mostly made overseas) that they aren’t even paying attention to these warnings.

Look, when the money supply falls significantly it is almost impossible to avoid a recession.  Just look at the historical numbers.

Unfortunately, money supply numbers all over Europe are falling dramatically right now as an article in the Telegraph recently noted….

All key measures of the money supply in the eurozone contracted in October with drastic falls across parts of southern Europe, raising the risk of severe recession over coming months.

Confidence in the banking system in Europe has never been this low in the post-World War II era.  Sadly, most people simply do not understand how bad things have gotten for major European banks.  One Australian news source recently put it this way….

“If anyone thinks things are getting better, they simply don’t understand how severe the problems are,” a London executive at a global bank said. “A major bank could fail within weeks.”

Others said many continental banks, including French, Italian and Spanish lenders, were close to running out of the acceptable forms of collateral, such as US Treasury bonds, that could be used to finance short-term loans.

Some have been forced to lend out their gold reserves to maintain access to US dollar funding.

The outlook is very ominous.

Financial professionals all over the globe are telling us what is coming if we are willing to listen.

The following comes from a report recently produced by Credit Suisse’s Fixed Income Research unit….

“We seem to have entered the last days of the euro as we currently know it. That doesn’t make a break-up very likely, but it does mean some extraordinary things will almost certainly need to happen – probably by mid-January – to prevent the progressive closure of all the euro zone sovereign bond markets, potentially accompanied by escalating runs on even the strongest banks.”

The first six months of 2012 are going to be a very key time.  National governments and big European banks are scheduled to roll over huge mountains of debt.  But if they can’t find any takers that could bring the global financial system to a moment of great crisis very quickly.

The following is how former hedge fund manager Bruce Krasting recently described the problem that Italy is facing….

At this point there is zero possibility that Italy can refinance any portion of its $300b of 2012 maturing debt. If there is anyone at the table who still thinks that Italy can pull off a miracle, they are wrong. I’m certain that the finance guys at the ECB and Italian CB understand this. I repeat, there is a zero chance for a market solution for Italy.

But even if we don’t see a formal default by a major European nation such a Italy, that doesn’t mean that major European banks are going to make it through the crippling recession that has now begun in Europe.

Charles Wyplosz, a professor of international economics at Geneva’s Graduate Institute, is absolutely convinced that we are going to see some major European banks collapse….

“Banks will collapse, including possibly a number of French banks that are very exposed to Greece, Portugal, Italy and Spain.”

Authorities in Europe are saying the “right things” publicly, but privately they are preparing for the worst.

As the Telegraph recently reported, the British government is now making plans based on the assumption that a collapse of the euro is only “just a matter of time”….

Yes, we are heading for a huge financial collapse and massive economic trouble.

So enjoy the good times while we still have them.

They are not going to last too much longer.

The Economic Collapse

As I opined rather quickly when MF Global collapsed, the real risk is not that a futures merchant went under.  Brokerages go under all the time — I went through two “consolidations” after 2000 and in both cases my assets and trading accounts were simply moved over to a new entity.  How “forced” those were is open to some question, but from my perspective I went to bed one day with an account at “X” and woke up with one at “Y”.  Nothing disappeared.

The problem occurs when you wake up and assets have disappeared.  This has become a disturbingly-common pattern of late, from Bernie Madoff to Stanford and now MF.  As Reuters reports:

(Business Law Currents) A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients. 

MF Global’s bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet. 

Yep.

What most people don’t understand is that when you open a brokerage account you allow your assets to be used to ”borrow, pledge, repledge, transfer, hypothecate, rehypothecate,loan, or invest any of the Collateral”

Absolutely standard  boilerplate language.

But here’s the problem — this is “in accordance with Applicable law.”

This use, incidentally, is why brokers scream that trades are “just $5!”

Well, yes.  But your money is being used by the brokerage, more or less, as collateral.

But there’s a difference between earning on your funds and securities (which brokerages do all the time) and stealing your assets.  The latter occurs when the law is circumvented — whether legal or not.

And it appears that it was — UK laws appear to contain no limits on the amount of hypothecation or re-hypothecation that can take place.  MF Global thus appears to have transferred client assets outside of US jurisdiction where they were then subject to much looser — effectively zero — in the way of risk controls!

But the underlying means by which this escaped surveillance is the same means by which both Lehman and Enron blew up — the use of off-balance-sheet vehicles to hide total risk exposure.

Specifically, these “repo to maturity” deals which our current law permits to be booked as “purchase and sale” agreements, thus realizing the expected coupon flows as “profit.”

The flaw in this reasoning is that a “true sale” must be just that — it must leave you with no obligation beyond the execution.  But that’s not true here — if the collateral declines in value either in the interim or at maturity the entity can be forced to make up that shortfall either through posting more margin or through an offsetting settling charge.

As such allowing this to be taken off the balance sheet is an outrage, as there is a continuing obligation and risk of loss that goes beyond the date when the agreement is consummated.  That is, it’s not a “true sale” despite being able to be counted as one under existing law.

The myth that is operative here is that lending to sovereigns is “zero risk” and thus the face value of a sovereign bond is the value at maturity.  This fiction leads to the accounting treatment.  But this is a factual lie — not only now, but always, because lending to a sovereign is nearly always, as a matter of both fact and law, unsecured.

As such there is nothing other than a bare promise standing behind these loans – and governments break promises all the time.

If you remember some of my earliest rants from 2007 they focused on the off-balance-sheet games that were being played at the time.  I called them nuclear financial weapons of mass destruction because they are — such vehicles are always a scam in some form, as the only reason to use them is to hide from customers, regulators and the common public the amount of risk you have on.

That is, they have as their essential purpose in each and every case the intentional hiding of the amount of leverage that the entity involved has taken on, and thus it serves to intentionally overstate the amount of loss that entity can absorb before it is rendered bankrupt.

In short, in each and every case the intent is to deceive and thus induce other parties to enter into transactions at terms they would not be willing to transact under were they to know the truth. 

THEY ARE THUS INHERENTLY FRAUDULENT CONSTRUCTS IN EACH AND EVERY CASE AND IF WE HAD AN ACTUAL JUSTICE SYSTEM IN THIS COUNTRY EACH AND EVERY INSTANCE OF THESE CONSTRUCTS WOULD BE TREATED AS A SERIOUS FELONY RESULTING IN ARREST, INDICTMENT, PROSECUTION AND IMPRISONMENT.

We learned this when ENRON blew up with their infamous “barge” transactions and then once again in 2008.  Yet despite these two stunning examples and absolute proof that the essence of these transactions is the intentional hiding of risk and deception of clients and counterparties we have refused to prosecute these “instruments” as unconditionally unlawful acts despite the fact that their essential purpose is in every case the deception of others.

And now we have farmers and others who did the right thing — who engaged in ordinary financial practices that have existed for centuries and which should have involved no execution risk of materiality at all – who once again got robbed through the intentional hiding of risk and this intentional deception.

The damage is to systemic liquidity and confidence.  The games are still being played this morning over in Europe in a furious attempt to “restore confidence” but in point of fact the underlying scam lies here — and until it is addressed and stopped there will be no resolution or stability.

The Agriculture Committee this morning is once again playing “dog and pony show” while Eric PlaceHolder refuses to indict and Obama says that “nobody did anything unlawful.”  This is a blatant and outrageous lie by all parties in the government — off-balance sheet acts are in each and every case an act undertaken with fraudulent intent as their entire purpose is to conceal the risk and size of a given transaction.

And finally, let me reiterate what I’ve said since this story broke: So long as there are off-balance-sheet liabilities and derivative contracts have preference over deposits — both of which are true in the present time — this very same risk is present for anyone with a BANK OR INVESTMENT ACCOUNT OF ANY TYPE in The United States.  If you believe otherwise you are wrong.

What do 1637, 1873, 1929, 2000 and 2007 have in common? Why has our economy refused to recover after the 2007 housing market implosion? Is there some sort of simple solution, or even a means of protecting oneself from the ongoing stress in the labor and financial markets when your neighbor loses half the value in his 401k and you receive a pink slip with your paycheck?

Throughout history it is the serial and intentional abuse of financial markets and the unholy alliances that are formed between banking and governments that lead to the worst economic catastrophes.

“Irrational exuberance” is often given the blame, but intentional distortion of factual information, such as the credit quality of a borrower, is not “irrational” — it is an active deception undertaken for profit.

Governments are driven by the same sort of mentality as are private businesses when it comes to willful blindness or outright false statements of fact. It is very convenient for a government to borrow and spend just a few more dollars than they manage to tax from their citizens, satiating their demand for services of all sorts, just as it is convenient for a household to borrow against alleged home equity so as to be able to live a lifestyle that is unsupported by its earnings power. Financial deceptions tend to start small and are justified as being temporary or trivial, especially when they support the holy grail of all economies — growth.

But arithmetic does not care about politics or the personal ethics of politicians, businesspeople or homeowners. The fundamental nature of compounding is often cited as the “most powerful factor working in your favor” when you save and invest, yet that same nature makes fiscal deficits, no matter where they exist, a dangerous drug that addicts with its siren song and then bites back with vicious yet unavoidable consequence.

“Throughout history it is the serial and intentional abuse of financial markets and the unholy alliances that are formed between banking and governments that lead to the worst economic catastrophes.”

Karl Denninger Author, “Leverage”

America has a 30 year record of addiction in this regard. From 1980 until the collapse in 2008 there was not one three month period where growth in GDP exceeded that in total systemic debt. We thus generated alleged growth in our economy that was factually false over a 30 year period and built into our economy false signals of demand. The mathematical laws governing exponential growth made certain the outcome of 2007, where we reached more than 6 dollars of additional debt for each dollar of added GDP, just before the subprime crisis led to the near-collapse of our banking and financial systems. Unfortunately rather than both allowing those who made imprudent bets to fail while holding the people who intentionally misled to account we bailed out the institutions that knowingly took dangerous bets under the rubric of systemic risk but left the market to ravage the common American.

“Leverage” is about these abuses and their impact on real people. It chronicles the abuse of debt financing and fiscal deficits while demonstrating the fundamental mathematical relationships that underlie all financial systems and cannot be avoided.

You can read dozens of books on the 2008 collapse and the incestuous interconnectivity between big business, finance and the political system, but most remain within their narrative focusing on the bad actors or try to provide a guide for personal protection of one’s assets from what appears to be certain economic calamity to come.

“Leverage”, however, spends half of its easily-understood pages in a different endeavor: Real solutions in the political and policy space that, while unable to prevent what is mathematically inevitable, will soften the blow while realigning our nation to restore the rule of law, render banking safe and sound into the indefinite future, address our unsustainable entitlement promises, return both capital and manufacturing to our nation and provide the underlying and necessary energy resources that America needs for a vibrant economy.

Karl Denninger founded The Market Ticker®, a blog dedicated to uncovering market mischievousness. He is also a columnist on SeekingAlpha.com and has appeared on MSNBC, CNBC, and is a frequent guest on WBAL talk radio in Baltimore. He produces a weekly Internet radio segment on BlogTalkRadio with real-time call-ins from listeners and occasional invited guests. Karl is also one of the original founders of the Tea Party movement, and, along with FedUpUSA, launched the first financial protests related to the bailout of banking institutions after the failure and forced takeover of Bear Stearns. Previously, he was CEO of Macro Computer Solutions, and is a self-made
entrepreneur and millionaire.

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A 3,000 to 1 shot, Wall St. took it, collected billions in
bonuses, blew it and you paid for it.

Before 2008, how Too Big to Fail Banks’ hidden
3,000 times leverage rigged the Real Estate market and defrauded EVERY mortgage
borrower and many others…

This article disabuses the notion that “deadbeat borrowers” caused the financial crisis.  And offers an  answer to the question that still lurks in the mind of every American; whether black, white, native American, asian or  Hispanic; whether educated or not; whether English, Spanish, or Mandarin speaking.

Taking a big step back, and looking at it like a business process:  “How could so many Americans ALL have made the same ill-advised mortgage borrowing decisions?”  The answer lies in what did they ALL have in common…

It was all about leverage

What is leverage?

Leverage is a way to control more of something when you can’t pay for it in full.  We do it all the time; when we buy a car – except few of us actually buy the car, we finance it or lease it.  We also do it when we buy a house – except almost no one pays cash for a house, we finance the purchase with a loan; it’s secured by a mortgage on the property.

Example of 5 times leverage:

When we buy a house and put 20% down, we buy a house worth 5 times as much as the down payment.  If we put $100 thousand down we can buy a house worth $500 thousand.  $500 thousand divided by the $100 thousand we put down equals 5 times leverage.

100 times leverage:

By the same calculation ZERO down mortgages were suffice it to say, 100 times leverage, it’s actually more but that’s a discussion for later.   Repeat after me, no money down mortgages equal 100 times
leverage.

(Click for Sharper Image)

Who controlled and approved EVERY leverage decision?

Leverage Approval #1 by:

TBTF Banks (ultimately) approved every one of these loans and bundled thousands of others like them initially into mortgage backed securities (MBS).

Leverage Approval #2 by: [the key, little known fact]

In the past, TBTF Banks used to sell them off (remember that word) to investors like mutual funds, insurance companies and pension plans.  In the 2000’s TBTF banks issued almost $17 Trillion of MBS, but did not sell all of them OFF to 3rd parties.  They held massive amounts of them to turbo-juice their bonus checks in a 2nd set of books (legally) in OFF balance sheet, special purpose entities.  As a refresher Enron did the same type of thing.

In the decades, make that for over 60 years before the 2000’s TBTF banks’ leverage was around 12 times; however when they concealed trillions worth of MBS – their leverage increased to over 30 times.

Remember 5 times leverage?  It was based on how much the house was worth right?

And when TBTF banks add more leverage on top of the borrower’s leverage we don’t just add it – we ______? You guessed it – we multiply it.

3,000 times leverage on house prices:

100 times leverage on the borrowers side times 30 times leverage on the TBTF banks’ side is 3,000 times leverage ON house prices.

Lather, rinse and repeat – 100 times 30 equals 3,000 times leverage.  Lather, rinse and repeat

100 times 30 equals 3,000 times leverage.

Remember what I first told you about leverage?

Leverage lets you (or TBTF bank) control something that you can’t fully pay for.  Well the TBTF
banks’ way of financing them in the Asset Backed Commercial Paper market began to dry up in August 2008, so they couldn’t pay for these assets.   This is the direct cause (but not the root) for the Fed and US Treasury to (have to) step in and pay CASH for them in the bailouts of 2008, and again in 2009, and again in 2010 and yet again 2011 via the Fed’s QE trifecta to the tune of over $20 Trillion dollars.

The interactive portion is about to begin:

Is it any surprise that the assets backing the commercial paper were ________? You may have guessed it – MBS.

Is it any surprise that the Fed created a new category to track ABCP in_______? You would be correct if you guessed 2006; just two swift months after Ben Bernanke was appointed chairman of the Federal Reserve by President Bush.

Is it just a random coincidence that almost $17 Trillion of Mortgage Securities were created by TBTF banks from 2001 to 2008?

What was that word I asked you to remember?

Oh, right it was OFF.

When TBTF banks’ CEOs, executives or prop traders got their year end bonus check did we hear reports that anyone said it was OFF (or that it was too much)?  Nope.

Yet even the erudite, indeed veritable student of the Great Depression, Chairman of the Federal Reserve, Ben Bernanke in October 2007 was unaware of (just a few days after the stock market peaked at 14,087 as measured by the Dow Jones Industrial Average) what the TBTF Banks were really up to when he entertained the NY Economic Club.  See “One year, One Trillion Dollars; the education of Ben Bernanke 2007 to 2008…” Fiduciary in thought and action: One year, one Trillion dollars; the education of Ben Bernanke from 2007 – 2008…(since there appeared no news report that any of the luminaries of the NY Economic Club questioned Mr Bernanke we assume they all understood and agreed with his distinguishing point.  I only wonder was that before or after they might have cashed a bonus check based on…LEVERAGE.)

Yup and we paid for it then and continue to pay their salaries, benefits like paid vacations, health care (non-taxable) even now – silly us.

The top 12 reasons + one

TBTF banks, before 2008 created a hidden, secret “market” for MBS:

1. As stated above TBTF banks changed from financial intermediaries into speculators via their proprietary (for the house only) trading desks;
2. Hiding (the FDIC used the word “concealed”) trillions of MBS off balance sheet;
3. Allowing their own internal prop traders to value #2  (legal under the SEC’s 2004 Consolidated Supervised Entity (CSE) program) despite the fact few if any, of #2 had EVER seen the light of any “market” trade as one between arms-length parties;
4. Why? To maximize same prop traders’, managers’ and CEOs’ cash bonus checks;
5. All based on the assumption (almost a religious belief) that national median home prices had NEVER gone down – true, as you may recall;
6. BUT the past was under a 60 times house finance, prudently underwritten leverage regime (20% down payments, verified job, income, assets and 12 times bank balance sheet leverage);
7. TBTF Banks’ single handedly created 3,000 times leverage on house prices, the underlying collateral of any MBS, CDO, etc.;
8. 3,000 times leverage is the product of Zero down loans; 100 times leverage for the borrower and 30 or more times TBTF bank on and off balance sheet leverage;
9. Mr Bass testified to the FCIC in January 2010 that TBTF banks’ leverage at the end of 2007 – yes end
   of 2007 (see page 13) shows almost all TBTF Banks were over 30 times, Citigroup at 68 times leverage; meant an adverse swing (in the value of the underlying collateral or obligations) of as little as 1.5% wiped them out completely – insolvent;
10. And we know that leverage worsened in 2008…and we know from Goldman Sach’s 2007 to 2008 collateral call dispute with AIG that MBS valuation marks (not even CDO’s) were south of 90;
11. It’s not about Fannie or Freddie either; they were downstream of information from the TBTF banks – again TBTF banks held trillions of MBS, in secret OFF balance sheet; I’m not saying it was necessarily illegal but it was fraudulent; as it was knowing, willful and intentional fraud upon the other side to the mortgage – the borrowers. And it only went on as long as it did – BECAUSE they were hidden;
12. And we know it’s not about CRA as home ownership peaked in 2004 nor can we blame it on the variant of “homeownership for all” as just a few too many houses were not primary residences but 2nd, 3rd, 4th and 5th homes and condos – each time the loan was approved (ultimately) by TBTF banks;
13. Last, 3,000 times leverage on home prices represents a 50 fold increase over the 60 times historical norm; more importantly shows that TBTF Banks’ violated requirements of their banking charters; i.e. to operate according to “safety and soundness”.

*Except borrowers who falsified their loan apps.

How could EVERY American mortgage borrower ALL have made the same mistake?

1)  Every mortgage loan was (ultimately) approved by?

2)  Every mortgage loan was securitized by?

3)  Massive amounts of securitized loans were held for speculation by?

4) Thousands of off balance sheet and or off shore entities were created by?

5)  Massive amounts of #3 were held off balance sheet by?

6)  The 2004 SEC CSE program was lobbied for by?

7)  Models, not markets were used to value off balance sheet holdings by?

8)  Hundreds of billions of customers’ money market funds  were diverted to affiliated banks known as industrial loan companies by certain?

9)  Massive dollar amounts of leverage were employed by?

10) Massive (greatly increased by hidden leverage) bonus checks were paid by?

11)  Assets held off balance sheet were not timely, fair valued by?

12)  Massive amounts of Fed and US Treasury aid were received by?

13)  LSD used by?

* TBTF Banks on LSD indeed; massive amounts of Leverage, Swaps and Derivatives.

A “Financial Crisis” approved, securitized one loan at time and brought to you by your friendly neighborhood TBTF Bank on LSD; one they prefer to still keep secret…

By the way, there was no need to create vast bodies of new laws except to require all securities and derivatives to trade on open, disclosed markets with independent clearing agents; just like stocks have traded on the NYSE for decades.

Chris McConnell AIFA®, Accredited Investment Fiduciary Analyst™ - is an expert on the securities industry and markets with over 28 years experience dealing with accounting, leverage and compensation issues.  He has an economics, accounting and fiduciary background.  McFid, BFD Expert™ since 2003.  To visit his website Fidiciary Forensics.

Author’s Note: 3,000 times leverage is an estimate as not all mortgages were zero down; just several million too many; not to mention “every app was approved” underwriting.  But we do know that 60 times leverage (on house price) was the norm for decades; also called safety and soundness; and we also know that TBTF banks’ leverage, assuming their year end 2007 marks were accurate, when the 2007 to 2008 Goldman AIG dispute timeline triangulated with Mr Blankfein’s 2010 testimony to the FCIC suggests otherwise, are understated – correct understated.  And we know that marks worsened (and caused leverage ratios to increase in 2008).  Again, the pressing need for CASH infusions from the Fed, UST in 2008/9, and kinder, gentler accounting treatment courtesy of the SEC/FASB

Discussion (registration required to post)

If so – IF this is really about “the 99%” – then you need to understand a few things. 

Some of you already do.  To those, this article is redundant.  To the rest, and to the majority of the people in this nation, it is not.

Last night I appeared on Dylan Ratigan’s show.  You can watch the segment, and should.  I used the word financialization, which a few people emailed me about and asked me to explain.

Thus, this Ticker.

So what is financialization anyway?  It is the process by which something very ordinary (say, a TV set) becomes financed. In doing so there is inherently created the use (and usually the abuse) of leverage.

What is leverage?  Leverage is simply the ability to act as though you have much more of something than you really do.  For example, you can use leverage to pry off the lid on a beer bottle.  Your raw strength is multiplied by the lever (the bottle opener) to lift the cap.

But note that there is no free lunch.  While the opener may multiply the force applied to the cap, the distance the opener moves is proportionally reduced compared to the movement of your hand.

In economics, leverage is the use of debt to pretend to have more economic surplus (that is, purchasing power) than you really have.

Let’s take a TV set.  If you save up the money to buy one, then go into the store and pay for it, you now own a TV set.  There is no leverage involved; you took your economic surplus form working (which you didn’t need for food, energy, shelter and clothing – thus, it’s a true surplus to you) and you expend it on a TV set.  The transaction is simple; once it is completed there are no residual effects.  If you lose your job the next day, you still have the TV set and will forever more until it either breaks, wears out or you dispose of it in some way.

But what if the TV set costs $500 and you only have $100?  Well, you could financialize your acquisition of the TV.  That is, you could borrow $400 by buying the TV on installment payments with a $100 down payment, and now you have a TV.

Or do you?

Actually, the bank (or the store) owns a TV.  You may have custody of a TV set, but you don’t own a TV set. You owe a debt.  You have promised to work tomorrow to cover the expense of the television. You don’t own the TV until you pay it off.

This is all fine and well up until you lose your job.  Now the bank comes after you and wants the TV back, plus whatever deficiency there is on reselling the TV set to cover your debt.  You suddenly discover, much to your chagrin, that you never owned it at all.

This all sounds pretty ordinary, except that the economic effect of financializing that transaction isn’t, in fact, ordinary at all.

See, in economics there is this thing called “supply and demand.”  The more demand there is for something with a given supply, the higher the price tends to be.  In ordinary times a gallon jug of drinking water in a store is a dollar, and from the tap it costs so little we don’t ordinarily put a price on it.  Yet if there was just a hurricane, and there is no fresh water available, what would the price of that same gallon be?  Ah, now we have much demand and very short supply, and as such the price will be quite dear.  Perhaps the price of that water might be several gallons of gasoline (for the seller’s generator, of course.)

So what has happened to our economy over the last three decades?

In short, things that never should have been became financialized. And as the goods and services became financialized, demand was shifted upward – people were made “able” to allegedly “buy” things they could not otherwise afford.  The expected response in the marketplace to such a thing, predicted by basis economics, was that prices would rise.

Prices, in fact, did exactly what you’d expect.

If you’re wondering why you can’t afford to pay for college by flipping burgers or pizzas in your off hours, this is the reason.  It was precisely the distortion of the government making student loan debt non-dischargeable, which made it available to almost everyone at a “low interest rate”, that drove up the price of college educations to the moon.  And to the moon they went – up 450% since the 1980s, more than five times as much as average salaries increased.

How about houses?  A middle-class house in 1960 sold for $12,000. It had three bedrooms, one bath, a living room and an eat-in kitchen. The walls were plaster (not drywall) and it was of generally-stout construction.  The average family income in 1960 was $6,691 or about 1/2 of the price of a house.  The average family size was just over 3 persons and about 32% of women were in the workforce; the remainder typically stayed home and raised the kids.  That wasn’t so hard to do when you could buy a house at twice the average income.

What happened when we financialized houses?  Prices went up.  A lot.  They went up much faster than did incomes.  First to 3x incomes, and in some parts of the nation in the 2000s they went to utterly ridiculous multiples, like 5, 6 even 10x.  How?  Nobody ever really actually owned the damn house; the bank owned it and you were turned into a financial slave!

How about cellphones?  Oh, they’re cheap; we didn’t financialize those, did we?  The really nice ones are $199 at the store.  Uh, no they’re not.  Ever notice that the price of the service is twice that of prepaid?  Why do you think that is?  That’s simple – the difference between $100/month and $50/month is, well, $600/year.  Oh, and that was a two-year contract you signed, so that $500 cell phone that you got such a “deal” on at $199 actually cost you nearly $1,500.  That’s right – that nice “smartphone” was financialized and you’re paying three times as much for it as a consequence, rather than buying it right now for cash on a prepaid plan..

How about medical care?  In the 1960s your parents wrote a check to the doctor.  If it was really serious they probably had insurance; they got billed and then filed a claim.  Bankruptcy due to medical costs was extremely rare, and you could almost always afford whatever you needed medical attention for by paying with the money in your wallet.

How about now?  Well gee, you’ve got copays and prescriptions are cheap, right?  The doctor costs $20 to see and the ‘script he writes is another $10, and you think this is great.  Uh, not so fast kemosabe.  Ever get laid off?  Ever hear of a thing called Cobra?  COBRA is a law that says that your employer has to allow you to continue your health insurance once you get fired or are laid off for a period of time.  There’s only one catch – you have to pay the entire amount of the health insurance premium yourself.  The employer is permitted a 1% (yes, really) mark-up for the service of handling your check.

I cannot tell you how many times someone quit or was fired at my company, got the COBRA paperwork and proceeded to call me and scream that I was screwing them because to keep their “health insurance” they were going to have to fork up $800 a month.  That’s $9,600 a year, incidentally, and this was in the 1990s.  They always accused me of ripping them off, never mind that it was black-letter law under penalty of prosecution that I could only charge 1% for handling the money and otherwise had to bill them at exactly what the insurance company billed us!  No, you don’t have “free” (or even reasonably-priced) health care folks.  It’s insanely expensive, and why?  Because again we financialized it.  Those who have a demand for health care now can (by law) always receive it – it’s effectively the ability to write your own infinite leverage on health services.  What has happened to the price?  It’s gone to the moon and as a consequence nobody can reasonably afford to show up in a hospital any more for even the most-routine emergency without being bankrupted if they do not have insurance.

Now it is absolutely true that we have treatments and other medical “miracles” that we didn’t 20 or 30 years ago.  But that we can do a thing on a technical basis doesn’t mean we can afford to do that thing.  We can put a man on the moon, but we can’t afford for everyone to take that flight.

By the way, you don’t happen to think that all this financialization was an accident, do you?  Of course not.  Shifting the supply and demand curve means there’s more money to be had from the transaction. 

Where do you think that money went?

Why, right in the pockets of JP Morgan, Goldman Sachs, Morgan Stanley, Citibank, Bank of America and yes, the bank on the corner.  I’m sure you’ve noticed that bank buildings tend to be quite nice.  Grand exteriors, high-rise buildings in the middle of cities (very, very expensive real estate), fabulous lobbies with marble floors and other similar visible elements of opulence.  Where do you think all the money came from to buy that stuff?  Why, from you – the rube standing there in the lobby!  Never mind the bankster’s bonuses!

Was this all the “free market” at work?  Absolutely not!  Student loan debt was given “special status” and cannot be discharged in bankruptcy.  Fannie Mae and Freddie Mac massively distorted the housing market.  Medical insurance companies are exempt from anti-trust laws, and drug makers were given the ability to legally prohibit you from doing what you’d like with what you own (specifically, reselling things you purchased and paid for.) 

All of this distortion in the market occurred due to the direct acts of government acting at the behest of fat cat banksters and industry insiders, using the threat of force to strip your wealth.

Every morning in the financial media we hear about how horrible it will be if we put a stop to this financial rape and the financial system’s size and influence shrink dramatically!

So let’s talk about the distortions and what removing them will do for a minute or two, shall we?

If we get rid of financialization in the above things, what happens?

Well, we’re told that if we cut out the student loan programs, for example, that nobody would be able to afford to go to college. 

Is this really true? 

Of course it’s not true.  You’re not dumb enough to believe that tripe out of the mouthpiece at your college or on CNBC, are you?  The college wants you to believe that, and so do the banks.  But what happens if tomorrow all the “free money” loans stop?  Now the college has empty classrooms because nobody comes any more.  Students can’t afford to attend, so they don’t.

What happens the next morning at that college?

Oh that’s simple: See, it doesn’t cost much to provide a few desks, chairs, and a roof over head along with a calculus book, does it?  Nor does an instructor cost that much when spread across a student body.  Let’s see how cheaply a college can educate you, if they’re unable to extract from you promises from the future and must instead talk you into providing them with economic surplus from your current efforts.

Let’s assume for a minute that there are 30 Calculus students in this college class and five instructional hours in a day, so we can serve 150 students in one room.  Figure the room is 1,000 square feet, which is more than sufficient (5×5 per student * 30 students plus room for the chalkboard, desk at the front and free space to move around; a 25×40 space should be more than sufficient.)  A buck-a-foot a month ($12/year/foot) is certainly doable in most areas if you’re looking for usable space, not gilded BS.  Four months is one term, so this is $4,000 for the space.  Figure another grand for the rental on the chairs and desks and we’re up to $5,000.

We have 150 students so the facility costs them $33 each for this class.  What’s the professor cost?  We’ll pay him $100,000 a year; we’re not pigs and this is Calculus, a typical “first year” college class, not a grad school thing.  He therefore makes $33,000 teaching class for this semester (four months.)  That’s $220.  We’re now at $250 per student for a four hour per week class, or about $60/credit hour.  Note that the professor is teaching four days in the classroom and has one for office work and grading; he works a five-day week of five hour days.  Not a bad gig if you ask me.

If the average student’s full load is 15 semester-hours tuition is $900 per semester to cover costs.

Guess what – in the late 1970s and early 1980s it wasn’t that much more than that. I remember paying it.

It doesn’t have to be today either.  It is because it can be.  Because you can pay due to the financialization, even though you’re not really paying — your promising to pay tomorrow – prices have gone to the moon.  Supply and demand were distorted, you got screwed and the banksters skimmed off the extra money, along with the college administrators.  Oh, and neither of them were honest with you about what happened either.

The important point here is that if we cut off the financialization of college you will still get an education.  The schools will scream and many will go bankrupt, but soon on the same ground where there was a bankrupt college there will be a new one, and this one will charge $2,000 a semester to attend instead of $10,000 or $20,000.  The difference?  You’ll have to pay cash, but you’ll be able to work a part-time job for the two grand and thus you’ll have no debt!

Who wins?  You do.  Who loses?  The fat cat college administrators with their half-million dollar salaries and the banksters who can’t hold your college loans over your head and threaten you with wage garnishments until you’re 80!

Houses are no different and neither is medical care.  The screaming about how “nobody will be able to go to the doctor” or “nobody will be able to buy a house” is a lie.  The doctor can set his fee at $100,000 for his services if he wants but if nobody can or will pay him $100,000 then he sells no service.  That doctor goes bankrupt immediately, soon there will be a different doctor (or maybe the same one after he goes through bankruptcy) and suddenly medical care will be much-more reasonably priced!  After all, if nobody can buy then the seller can’t make a living either, can he?  Prices will be forced down to what the ordinary person can afford to pay.

When it comes to drugs and devices its even worse.  Our government allows blatant price-fixing.  Viagra is 10% of the cost per pill in America just a few miles away in Canada.  It’s illegal, however, for you to re-import it from Canada back into the US.  Why?

Simple: Canada’s single-payer health system won’t pay more than $2 for the pill.  The manufacturer wants to sell them, so they do.  They make a profit.  But only on the “copy” of the pill – there’s no profit for the R&D in that price.  So who gets to pay for the R&D of virtually every drug and device in the medical world today?  You do, and it’s literally forced upon you at gunpoint because our government prohibits under penalty of law people from selling that which they first bought and paid for!

There is no way that such a price disparity would hold for more than 10 minutes were these laws to be dropped.  You get screwed on your prescriptions and devices you buy intentionally by our government through their protection of these industries.  You get financially raped so that everyone in the world can enjoy our medical technology at the mere reproduction cost and the banksters and drug companies can get rich.  It’s an outrage and again, it happens due to financialization of the medical industry and the force of government coercion, NOT the free market.

Here’s the question when you get down to it: Do you want to fix this or not?

If you do then the demand is not for “single-payer health care” or “free college educations” or “debt forgiveness.”

Those demands, if you succeed in obtaining them, will make the problem worse.  You will become more of a slave through those demands, not less.

The demand you must issue is that all the special protections that are currently afforded by government are to be dropped.  The government props under home lending are taken away.  The government mandates that people be treated medically irrespective of ability to pay and are able to cost-shift their care to others go away.  The non-dischargable nature of student loan debt goes away.  And government protection prohibiting the resale of anything someone owns that is legitimate (e.g. a truck load of Viagra) goes away.

Now, if you are a student with a lot of debt, you can file for bankruptcy.  Sure, your credit gets trashed if you file bankruptcy (and it should as you did foolishly take the loan) but the entity who loaned the money foolishly with not a care in the world if you could actually pay loses their money!  They will immediately, of course, stop making foolish loans — like lending kids $75,000 to study history.  The price of college educations will immediately fall back in line with ability to pay via a part-time job just as it was for more than a hundred years before we financialized college educations.

Without Fannie, Freddie, FHA and similar, along with demanding that before you foreclose you must be able to show actual transfer and ownership of the note house prices will collapse.  Yes, you’ll need a lot of money for a down payment in percentage terms, but this is good, not bad.  The average home price will be $100,000 or less against an average household income of $50,000, not $200,000, $300,000 or more.  You’ll have to save $20,000 before you can buy, but that’s ok too.  You’ll have immediate equity and you won’t be so far in debt.  If you want to buy a house you’d like prices to be low, not high, right?  House prices will return to where they were in relationship to incomes before we financialized them, and you will be able to buy a house!

Without the ability to cost-shift medical care, drugs and devices the price of this care will collapse.  Some advanced technologies will become rare and remain expensive, simply because they are technically very difficult and thus do have an actual high cost.  Most people will not be able to afford these medical technologies.  But routine and expected medical care will become much cheaper, simply because it has to in order for the doctor, hospital and drug company to remain in business!  You will still be able to go see the doctor, your broken leg will still get set, and most medical care and procedures will remain available for far less than is currently charged, simply because the firms and people involved in providing it want to continue to have jobs and as such they must charge what can be paid from your personal economic surplus, not your ability to demand that an “infinite source” of money cover the bill.

You can’t fix this any other way folks.  I am well-aware that this goes against the grain of “I need it right damn now” that has imbued our society, but mathematics simply doesn’t care about whether you agree or disagree.  It just is.

We can de-fang the banksters.  It’s not even particularly difficult to do.  The hard part is understanding that you’re not screwing yourself by taking this step and you won’t lose. Oh the banksters, the universities, the doctors and the Realtors will all lie to you and claim you’ll never go to college, you’ll never see a doctor and you’ll never own a house, but the fact is that they’re all lying.  The fact of the matter is that supply and demand governed the ramp in prices of all three of these categories of goods and services, and when demand collapses that very same economic law will govern the price collapse too!

You can bet the banksters, universities, medical societies and housing industry insiders know this, and they’re scared.  They know that if you figure it out their income is cut in half or more.  They are returned to middle-class working people rather than the fat cat status they enjoy today.  Doctors, college professors, home builders, bankers and Realtors used to be middle-class citizens, not gold-clad elites driving around in Lamborghinis and living in mansions!

What’s worse (to them) if you succeed in breaking the back of financialization, these people will lose the ability to enslave you.  You will have returned to yourself the power to choose when you work, how hard you work, and what you do with your own economic surplus, instead of having pledged it to the bank to buy the car, the bank to buy the house, and the insurance company in the event you get sick.

More importantly than your personal interest in this is that as a society we’ve reached the limits of the ability to financialize our lives.  That’s why the markets, housing and economy crashed in 2007.  We had used financial leverage to live beyond our means for the previous decade but in fact the imbalances and intentional distortions in the market date back to 1980.  There has not been one three month period where we have not abused leverage and financialization since that time.  Not one.

This is the choice we have before us.

We did not find ourselves here because of the “free market.”  We are here because the rich and powerful demanded special protections from government that allowed them to enslave you, they enticed you into taking that first hit off the crack pipe of cheap money, and then once you were hooked good they used the jackboot of the government to screw you through changes in the law and special protections for themselves so that you could not easily escape.

The solution is not to demand “free stuff” or “fairness.”

The only solution is to remove the excess leverage from the economy – to get rid of the debt that has been accumulated and force recognition of the fact that not only are many people bankrupt but the financial institutions are as well.  Only when the balance sheets on both sides are cleared can the economy recover.

This is the choice we face ladies and gentlemen.  We can either demand changes that are mathematically sustainable or we will fail at our goal and the spiral you’re seeing right now in Greece will come here.

“With all the mess going on at the moment, I thought it was worth while stepping back a little and trying to look at the bigger picture.” So begins Andy Lees’ latest must read letter to clients whch explains succinctly virtually the entire story of where we were, how we got to where are now, how the current trajectory is unsustainable, why due to decades of capital misallocation anything that the Fed does now is essentially irrelevant, why our untenable debt pile does nothing but perpetuate an unsustainable ponzi scheme which will result in an unseen explosion in the true cost of capital: gold, and why the bond market will eventually, and inevitably, force an epic repricing in the cost of non-gold capital absent the arrival of the deux ex machina of real, actionable innovation that the Fed, and all global central planners, keep hoping for. Because the longer we keep plugging away with that worthless substitute, financial innovation, which is anything but, the greater the final collapse.

Andy’s conclusion: “Until the debt is cleared and capital starts to be properly allocated, economic growth per unit of additional debt will continue to sour. Until we get some real breakthrough technology, requiring large amounts of capital to both innovate and then roll out, we have no chance of supporting the economy.” Too bad than that this absolutely spot on observation reflect precisely the opposite of what the Fed is pursuing. Which is why, all else equal, and it will be unless the Fed is finally eliminated from existence, America, and the entire western way of life, is doomed… But don’t take our word for it. Here is Andy.

Why are we here: simple – years of central planning resulting in the greatest experiment in capital misallocation in history.

We are in this mess because of excessive leverage and excessive consumption, financed by excessively cheap real capital – (not just Bernanke & Greenspan but further back to the end of the gold standard, and in fact even before that as it was this misallocation of capital that forced us off the gold standard in the first place). If capital had been allocated productively, then by definition debt would fall as a percentage of GDP. Total debt may rise, but efficient allocation of capital would always mean the economy would grow faster than the debt as it means you are making a positive rather than negative real return on that capital.

Whichever way you look at it, capital has been massively misallocated for years.

Corporate profits… or massive debt-funded ponzi scheme?

How can that be when corporates report massive profits? The profits are based on paying their workers a salary that meant they could only buy the goods they made by borrowing; in other words, a massive unsustainable ponzi scheme that could only ever end up with default.  Without the household debt accumulation, there would be no market to sell their products to, and without paying the workers sufficient, the debt would always have to default.

This required a massive increase in financial innovation to keep the illusion of corporate profitability alive – (household debt was a way of delaying putting the true costs through the corporate P&L account and recognising the costs). Financial sector innovation is itself another form of capital misallocation, taxing people away from real innovation – (to keep the illusion alive, an ever greater percentage of economic output had to be allocated to this illusion machine) – helping add to the resource constraint we are in today.

If financial innovation, which we have so much of is not needed, what is the right kind? And why is it so sorely missing.

A lot of what are described as efficiency gains have been just the removal of levels of safety and the removal of innovation in the system. Innovation and ongoing operations are always and inevitably in conflict, with the most readily apparent conflict between short and long term priorities. A second handicap to innovation is the way efficiency is achieved by breaking down things into small repeatable tasks. This specialisation and repeatability is a company’s greatest strength, but it is also its greatest weakness. Innovation is neither repeatable nor predictable. It is non-routine and uncertain. (Book: The Other Side of Innovation).

The culprit: none other than the great moderation, and, now, ZIRP4EVA:

Low real interest rates support excessive consumption, taking money away from innovation and balance sheets. When the US started suffering from its peak oil in 1970, rather than innovation it turned to globalisation to tax the broader global resource balance sheet, just as Britain and Europe had done 100 years earlier through colonialism, and recently accelerated that with the WTO. Globalisation has always been about accessing resources.

Which bring us to topic #1 here, and everywhere else where economics is involved: cash flows.

This has been a factor mobilisation story on unprecedented proportions, but appears to have reached its conclusion as resource constraint has meant the “cash flow” to grease the wheels has started to become more expensive and constrained. Profit without productivity can only carry on for a finite period; we are now clearly consuming down our balance sheet or putting it through the P&L account.

So we are left with a massive amount of debt, a massive amount of capital and labour that is unprofitable in the world we face, and a balance sheet of insufficient resources to keep the illusion alive. The only thing that will get us out of this in the long run is innovation which will expand the balance sheet, expand the pie and create the jobs that people want.

How do we get rid of the debt? Are we in a debt trap whereby any interest rate hike will kill the recovery? Clearly it is going to be incredibly difficult, but low real rates are the cause of the problem, not the solution. I don’t personally see a  zero rate trap, but we need to allocate capital far more productively than we are doing.

The cost of money itself is hugely important. How negative were real rates? When people talk of borrowing from the future, surely the same logic applies to the cost of capital. If we have had low or negative rates that supported excessive consumption, we now need to have high real rates to direct capital back to innovation and gradually repair the balance sheet. The real cost of capital has to go up. No matter how much fighting the Fed and Treasury do, the real cost of capital will rise. The bond markets have to be allowed to clear some of the debt and thereby remove some of this misallocation of capital.

It’s not “debt trap”, it is “Fed trap.”

Does that mean we are trapped in a position whereby the Fed cannot raise rates? Quite frankly it doesn’t really matter what the Fed does; real rates have to go up, are going up and will go up. The more the Fed and the government misallocate capital, the more the real cost of capital will have to rise higher to compensate. The only thing that will get real rates down is either a massive new discovery of incredibly cheap fossil fuels or the innovation that delivers cheap fusion. Otherwise it is a case of the cost of capital rising and causing demand destruction.

Getting the central banks monetary policy inline with the real cost of capital in the market must be the first step to rectifying the misallocation of capital. One obvious thing would be for economists to stop ignoring CPI of food and energy as irrelevant as it is the fastest growing part of the economy. By ignoring it, they are turning what should be a smooth and relatively painless transfer of capital into an occasional out-of control collapse and transfer. Getting both a proper monetary and fiscal policy framework in place, based off genuine data rather than smoke and mirrors and fiddles must be the first priority.

Which brings us to where we are now: a massive, unsustainable ponzi scheme:

Whilst politicians and investors acknowledge that excessive leverage created the asset and debt bubble, they do everything they can to prevent a rational deleveraging or efficient allocation of capital. For the moment the best measure of the cost of capital is gold. For years gold fell as fiat money was printed and this unsustainable ponzi scheme established, however as that ponzi scheme now unravels, gold must go up. The scale of both the ponzi scheme collapse and gold appreciation will be huge.

The problem is total credit market debt is still increasing.

As Fitch recently highlighted, Chinese on & off balance sheet debt has expanded by nearly 40% GDP in each of the last 3 years. In other words, the misallocation of capital is continuing making the ultimate problem that much worse. China is now getting almost no growth per unit of additional debt.

With each additional unit of debt, we are digging ourselves a deeper hole to get ourselves out of. Surely it is better to at least slow the digging? If we can allocate capital productively at the margin – (we know where we need to start making real returns) – then once we can start making a positive return on that marginal debt, then it becomes easier to support the residual debt we have.

If Andy is right, the framework of the next great class class conflict is set: it will be between the productive private economy and the “unproductive economy.” Yes: Marxist tensions are about to make a repeat appearance:

Private sector annuity rates will be tumbling and yet the unproductive public sector are still being given great pensions. We are taxing the productive private economy to give to the unproductive economy. This has to end. The idea of a European fiscal union fills me with dread as that would be locking this unproductive transfer into stone. Rather than keep kicking the can down the road, lets own up to our excesses and start putting the economy back on track. Don’t reward the rioters in London with yet another handout; force them to pay for the damage they have caused and the police time they have consumed.

Is Greenspan to blame for this dead end? Yes… but only so far. One can just as readily blame the traditional duel between short and long-termism, or what is known better as “it will be the other administration’s/generation’s issue.” In other words, Washington is just as guilty as Wall Street, and that infamous private bank.

Why have we misallocated capital for so long? We can blame it on democracy, but bigger than democracy is the culture that forces politicians to favour the immediate status quo over the longer term good of the country. That culture then presumably comes down to poor understanding which comes back to low levels of education. We need to address these route courses.

His conclusion:

The real cost of capital has to rise. That will happen through default in one way or another. Debt has to be cleared. Multiple contraction is inevitable.

Financial sector innovation has to be squeezed by engineering and scientific innovation. Until the debt is cleared and capital starts to be properly allocated, economic growth per unit of additional debt will continue to sour.

Energy is the cash flow in this story. Until we get some real breakthrough technology, requiring large amounts of capital to both innovate and then roll out, we have no chance of supporting the economy.

Nothing can be added to this.

ZeroHedge