We are currently caught up in the day to day gyrations of the stock, bond or foreign exchange markets. Politicians tell us that we are recovering, but we just need more stimulus packages and investment tax credits. The Federal Reserve proudly takes credit for “the recovery.” They maintain we have avoided a depression, but at the same time report monthly that we need interest rates at zero indefinitely. Members of the Federal Reserve and the financial press strongly hint that we need a second round of quantitative easing (the monetizing of debt), even though this program ended in March 2010.
This highly unstable financial system threatens to wreck the economy, deplete retirement savings and imperil democracy. This is not hyperbole. Let’s examine the indicia of instability:
- A Failing Banking System – So far this year, 120 banks have failed. This is well ahead of last year’s failure rate. As of August, 829 of a total of 7800 FDIC supervised banks were on a watch list. A watch list indicates a high probability of bank failure. The prior year 416 banks were on this list. See FDIC Finds 829 U.S. Banks at Risk
- Foreclosure-Gate – Poor documentation during the foreclosure process, ranging from false affidavits to improper notarizations to suspected forgeries, looms as the next big scandal. All this will lead to the real issue of violation or representations of representations and warranties during the securitization process. It has already led to financial participants attempting to return mortgage backed securities to their originating banks. See Pimco, Blackrock and New York Fed Seek Bank of America Mortgage Putbacks. Other money center banks face similar demands. For just Bank of America, Goldman Sachs analysts predict the put back liability could be as much as $25b. Foreclosure-gate and the “put back wars” will tie banks up in expensive litigation for years with the prospect of large losses. See Goldman on Total BofA Putback Losses:$25 Billion Which Apparently is a Good Thing
- High Frequency Trading – Lightening fast computer trading now dominates daily stock exchange activity. Trades are based on small pricing differentials rather than stock fundamentals. On May 7th, the Dow Jones Industrial Average plunged 700 points in 5 minutes. The SEC investigation attributed the crash to high frequency trading. See Speed-Addicted Traders Dominate Today’s Stock Market
- QE2 and Government Manipulation of Asset Prices – Brian Sack of the New York Federal Reserve has openly stated that the goal of the Federal Reserve is to put a floor under asset prices. Thus, the government is deliberately targeting and manipulating stock prices. Moreover QE2, which is the Federal Reserve openly buying government debt, has inflationary and even hyperinflationary potential. See Managing the Federal Reserve’s Balance Sheet
- Exodus of Retail Investors – Government manipulation, high frequency trading, wild market gyrations and economic circumstances have driven the retail investor from the stock market. The Investment Company Institute reports the 24th consecutive weekly retail outflow from equity mutual funds. This year to date $81b has been withdrawn. See 24th Consecutive Outflow from Domestic Stock Mutual Funds is in the Books
- Currency Wars – Despite denials from Secretary Geithner, the Administration and the Federal Reserve have engineered a 10% decline in the dollar since June 2010. Import prices have skyrocketed for resources such as oil. This has triggered currency wars between nations. Foreign governments have responded with attempts to depreciate their own currencies and impose capital controls. See As Currency Declines, Currency Conflicts Arise
- OTC Derivatives – Various forms of derivatives (credit default, interest rate and foreign exchange instruments) were one of the culprits for the 2008 financial crisis. The Bank for International Settlements estimates that $600T of these instruments are currently outstanding. One expert estimates that losses could run from $12.5T to $20.5T in the next crisis, with many institutions defaulting higher losses.
- Zero Interest Rate Policy – This is a two-edged source of instability. Banks can borrow at zero percent and use the funds to speculate, confident that the government will cover their losses. Earning little in safe investments, prudent savers are encouraged to spend or speculate with their dwindling savings. See Why is Charles Schwab the Only One Concerned About Zero Interest Rates?
- Leverage – The Basel III agreements were intended to impose more stringent capital requirements. The agreement permits banks to leverage their deposits 20 times. In the past 12 times leverage was considered prudent. Said another way, a mere 5 percent decline in an investment position under Basel III would result in the entire position being negative. See Basel III Summary, and the Fed’s Endorsement of 20x+ Leverage
- Sovereign Default – Ireland is only the latest victim of an unstable international financial system. Initially forced to adopt austerity measures, the government recently had to bail out an Anglo-Irish bank that had just passed the EU stress test. See An Angry Ireland Calls Out Europe. The specter of sovereign default still remains in Europe and experts have questioned the soundness of US debt.
- Looming Bailouts – Underfunded pension plans and state and local governments’ running huge budget deficits are the next potential candidates for massive federal bailouts. See, e.g., Is a $1 Trillion Bailout Ahead of State Pension Funds?
Strange Brew
Lack of government regulation, poorly thought out government interventions, mercantilist government policies, greed, and a myriad of other factors have created a strange brew. Every day we witness violent swings in the fixed income, stock market and foreign exchange markets. These gyrations have consequences in the real world as markets soar and crash. Savers are also consumers and their incomes have been destroyed. Consumers are threatened with higher food and energy prices. There is no safe place to invest funds. The success of the domestic economy depends on the whim of one man, Ben Bernanke. It is no surprise that investors are fleeing financial markets, and that gold soars.
We are running headlong into Stein’s Law (named for Herbert Stein, Nixon and Ford’s chief economic adviser): “if something cannot go on forever, it will stop.” But when these gyrations stop, probably sooner rather than later, we will be headlong into the next great financial crisis.
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