Op-Ed: The Illusion of Wealth

By Minyanville Staff  NOV 24, 2008 1:45 PM

The last eight years were a fantasy, created by massive debt, manipulation and deceit.


Editor's Note: James Quinn is a senior director of strategic planning for a major university. James has held high level financial positions with a retailer, homebuilder and a university in his 22-year career.

"I'd gladly pay you Tuesday for a hamburger today."
- J. Wellington Wimpy

If you're old enough to remember the Popeye cartoons, you'll remember Wimpy and his promise to pay at a later date for a hamburger today. As Congress listens to the latest pleas for $25 billion from GM (GM), Ford (F) and Chrysler, I can’t help but think of Wimpy’s promise. The entire $700 billion bailout (plus the $150 billion of pork used to buy votes) is based on the Wimpy motto. Give me what I want today and I’ll pay you at some future date. This has become the motto of government and corporate and consumer America.

The most amusing part of CEOs begging Congressmen for $25 billion is the assumption that there's $25 billion to give. The United States has no money. It's broke. It already spent $10.6 trillion more than it has. That's a lot of hamburgers. Uncle Sam, the personification of America, may need to step aside for the new personification of America, Wimpy.

Citigroup (C) has overshadowed the automaker’s “miniscule” request of $25 billion with today’s taxpayer bailout of over $300 billion. Over the weekend, when the Federal Reserve and Treasury do their best work, Vikram “Wimpy” Pandit asked Ben “Popeye” Bernanke for $300 billion - and promised that his worthless derivatives would be worth something next Tuesday. Somewhere, Charlie Prince is still dancing.

TARP: I Thought Turkeys Could Fly

"As God is my witness, I thought turkeys could fly!!!"
- Arthur Carlson,
WKRP in Cincinnati

Arthur Carlson was the clueless station manager on WKRP in Cincinnati, a sitcom from the late 70s. His idea for a Thanksgiving promotion was based on his belief that turkeys could fly. Treasury Secretary Hank Paulson is the Arthur Carlson of our generation. Instead of dropping turkeys from a helicopter, he dropped $179 billion in bailout money. It had the same impact. 

As detailed in the following chart, the first $125 billion was forced on the 9 largest financial institutions by Paulson on October 28th. Since that force-feeding, 21 other financial institutions have applied for -- and received -- an additional $34 billion from the $700 billion trough. AIG is a bottomless pit that has sucked $40 billion more into its vortex. Every company in America is trying to figure out how to get a piece of the action. American Express (AXP) and GMAC are converting to banks so they can get bailed out by taxpayers for loaning money to people who couldn't repay them. GMAC generated all of GM’s false demand over the last 5 years by providing financing to anyone who could generate fog on a mirror and sign their name  on a loan document.

By any reasonable assessment, the Troubled Asset Relief Program (TARP) has been a miserable failure and a complete waste of taxpayer money. The basis used to ram the bill through Congress was the purchase of the toxic assets off of bank’s book, but not $1 has been used for this purpose.

Furthermore, the banks who have received the $179 billion have not made any loans with the money. Some are using the money to buy other banks. Their goal is to become too big to fail. Others, like Citigroup, have used the money to buy back bad assets they created to mislead investors.

Michael Lewis, author of the classic Liars Poker captured the absurdity of TARP in a letter to Secretary Paulson last week:

As much as I admire all of your decisions I can’t help but notice that the main qualification of the bankers to whom you have been giving money, so that they might make smart loans, is that they have gone almost bankrupt by making stupid loans.

As your mind is subtle, I can only assume that you secretly believe that the American economy right now needs not smart loans, but more stupid ones - and thus that you have targeted the bankers who have proven they can make them.

I, unfortunately, have not flirted with bankruptcy, or made any stupid loans. But here’s my point: I haven’t been given the chance! Allow me to prove my financial ineptitude to you. I swear to you that when I return for my second round of assistance I will have proven myself fully qualified to receive it.

By giving money to bankers who have made many stupid loans you have made life harder for bankers who have never made stupid loans. By aiding the dumb banks you prevent the smart ones from replacing them. It may be that just now smart bankers are the last thing we need - but one day they may come in handy, and so we should do what we can to keep them from getting discouraged

Paulson has indicated that he's done dropping turkeys from the helicopter. He's counting the days until January 20th, so he can get out of town and relax with his $700 million fortune. At least he’ll enjoy a comfortable retirement, whereas many Americans won't.

Federal Reserve Gone Wild

As of May 15th, 2008 the Federal Reserve Bank of the United States had $881 billion of assets, $840 billion of liabilities, leaving $41 billion of capital. Federal Reserve Chairman Ben Bernanke has fired up the printing presses and helicopters since then.

Bernanke has created the Term Auction Facility, Term Securities Lending Facility, Primary Dealer Credit Facility, Commercial Paper Funding Facility and Money Market Investor Funding Facility, among others in the last 8 months. He also started paying interest to banks on reserves. The goal of unfreezing the system has been a wretched failure. Banks are finding it easier and safer to borrow from the Federal Reserve, earn interest on their TARP capital and not make any loans. All of the facilities and programs are a crutch that discourages banks from doing business. Why would a rational banker make loans to businesses and consumers as we're entering the deepest recession since the 1930s? This is where our country and government have become warped and dysfunctional. The Government is now encouraging reckless lending as the solution to previous reckless lending.

In the space of 2 months, Chairman Bernanke has doubled the balance sheet of the Federal Reserve. When he and Secretary Paulson were selling their rescue plan in front of Congress in September, they stressed transparency, oversight and openness. Yet the chairman has since withheld the names of all financial institutions that have borrowed from the Fed - and will not reveal the collateral that they have put up for those loans. 

Bloomberg News has sued the Fed under the Freedom of Information Act to force it to reveal where $2.2 trillion of taxpayer money has gone. The Bloomberg lawsuit argues that the collateral lists ``are central to understanding and assessing the government's response to the most cataclysmic financial crisis in America since the Great Depression.'' Investment Manager Ted Forstmann was correct when he said, “It’s your money; it’s not the Fed’s money. Of course there should be transparency.”

Click to enlarge

Contrast openness and transparency with the words of Chairman Bernanke in talking to the House Financial Services Committee:

"Some have asked us to reveal the names of the banks that are borrowing, how much they are borrowing, what collateral they are posting. We think that's counterproductive."

Or those of Congressman Barney Frank, as quoted in Bloomberg:

"I talk to (president of the New York Federal Reserve BanK) Timothy Geithner and he was pretty sure that they're OK. If the risk is that the Fed takes a little bit of a haircut, well that's regrettable."

Now, my local paper lists the people who were arrested for DUI on a weekly basis. The idea is that if you know that your neighbors will see this, you won't drink and drive. Bernanke is encouraging banks to drink and drive. How does complete secrecy restore confidence in the system?

Not that I feel any more secure with Barney Frank leading Congress on all financial issues. I wonder what a Washington insider like Frank’s definition of “a little bit of a haircut” amounts to. A 5% haircut on $2 trillion would be a mere $100 billion. Chump change in Washington.

Negative Wealth Affect

As the bureaucrats, professional lifetime politicians, corporate lobbyists and media spin doctors figure out how to waste our tax dollars, real people in America are suffering dramatic declines in their net worth. The chart below shows consistent growth in American household net worth since 1945, with only a slight drop during the dot-com Crash. The net worth of US households peaked at $58.7 trillion in 2007. We're now in the midst of the greatest decline in the history of the United States.

The balance sheet of American households tells an interesting story. Americans experienced a dual boom in stocks and real estate between 2002 and 2007. Real estate assets grew by 51% and financial assets by 55% over this period. These increases gave rise to a positive wealth effect. When people perceive themselves to be richer due to the increase in the value of their home and actual increases in investments, they're more likely to spend. This perception, along with a strong employment market led Americans to make dreadful financial decisions.

Even though real estate rose by 51%, mortgage debt rose by 75%. What Americans are learning is that real estate can decline, but debt lasts forever. Much of that extra mortgage debt was used to buy TVs, cars, kitchens, bathrooms and vacations. None of these luxuries have the potential to appreciate. Based on the decline in housing and the stock market, I have produced an estimate of the current national household net worth. By my conservative estimation, household net worth has declined by over $10 trillion since the beginning of the year and is now back to 2003 levels. By the time this recession is over, we will have eliminated all of the net worth created during the entire Bush reign. It was all an illusion, created by humungous amounts of debt, fraud, manipulation and deceit.

Source: Federal Reserve

American consumers are under intense stress. Now that there's no equity left to borrow against their houses, they're doing what they do best: Whipping out one of their 30 credit cards. The credit card writeoffs will be the next tsunami that hits our banking system and will be subsidized by more taxpayer funds. According to John Mauldin, credit card debt has exploded in the last few months:

Commercial bank exposure via the total amount of credit card loans outstanding has risen more in the last 10 weeks than it did in the previous 10 months cobined. Moreover, the growth in the last 10 weeks -- $32.3 billion, or roughly $600 million per shopping day -- represents nominal growth of 9.3%, or 48.3% annualized over the last 10 weeks. According to American Express, delinquencies on credit payments rose to 4.1% of all credit outstanding in the third quarter, up from 2.5% in 2007, with Bank of America's rate rising even more steeply - to 5.9% for the period. Moreover, the pool of loans deemed uncollectable rose to a high 6.7% in the third quarter, soaring from 3.6% last September. What consumer spending there is has been fueled in part by credit card: The second-largest merchant-vendor for credit card use is now McDonalds. This suggests that many consumers are in serious distress if they need to get their $4 Big Mac and fries with a credit card.

The unemployment rate is currently 6.5%, according to U-3 government figures. The broadest U-6 measure, which includes discouraged and marginally attached workers, is 11.8%. If you're still discouraged and jobless after 1 year, the government ignores you in its calculation. How convenient. If these workers were to be included, the unemployment rate is currently 16%. When someone tells you our current situation isn’t close to the Great Depression because unemployment was 25% in the 30s, keep this chart in mind. We've lost 1.2 million jobs in 10 months. The U-3 rate will reach 9% by late 2009. That would be another 3.6 million job losses. These are the kind of numbers that could lead to social unrest. Our social services system and food banks will be pushed to the breaking point.

The S&P 500 has declined by 44% in 2008. It provided an average real return of -17.65% over the last 10 years and an average real return of 83.6% over the last 15 years. These aren’t the returns that the Wall Street PR machine has been promising you. They have convinced people that stocks always go up over the long run. I guess it depends on your definition of "long run." Pension funds, endowment funds and financial advisors use annual returns of 8% to 10% in their models and assumptions. This shortfall in return will have devastating impacts on states, counties and companies with traditional pension plans, along with the average 401(k) investor.

So far, 2008 is shaping up to be the worst year for the stock market in history. When someone had $10 million and now has $5 million, it’s a shame. When a 64-year-old guy who worked hard his whole life and followed the rules loses half the value of his 401(k)months before his planned retirement, it's a tragedy. People who thought they could retire will now have to work for many more years. Millions are losing their jobs just as their home value declines and their mutual fund holdings are cut in half. This is the negative wealth effect in full bloom. People are scared to death and won't spend anywhere near the level they did over the last 20 years. Forced frugality is here. Embrace it. Young people should be happy with the dramatic pullback in the stock market and housing market. Many valuation and sentiment measures now point to solid long-term returns from this point onwards.

Click to enlarge

Source: Barry Ritholtz

Creeping Corporate Fascism

For the last 2 weeks I’ve heard the normal fear mongering and rhetoric about imminent disaster if the incompetent leaders of US automakers don't get a bailout. I've heard that if the Big 3 were to fail, 1 in 10 workers in America would lose their jobs. According to the Bureau of Labor Statistics, there were 145 million employed Americans in October 2008. According to their own information, the US carmakers employ the following number of workers worldwide:

General Motors 266,000
Ford Motor 87,700
Chrysler 132,130

Total Workers 485,830

Approximately 377,000 of these jobs are in the US - that's 1 in every 385 American jobs. The Center for Automotive Research, which is financed by the Big 3, issued a report just before General Motors, Ford and Chrysler's CEOs went before Congress that said 2.95 million direct and indirect jobs would be lost if the Big 3 ceased operation. Even this exceedingly broad interpretation of lost jobs comes to only 1 in 49 jobs.

This is a far cry from the 1 in 10 figure many Democratic congressmen have been spouting But the bigger the lie, the more likely people will believe it.

General Motors will burn through its remaining cash is less than two months. Ford has a little longer. Many politicians warn of the imminent collapse of society if these automakers declare bankruptcy. Again, the big lie is more likely to be believed by the masses. 

Chapter 11 bankruptcy will allow these companies to close unprofitable plants, shutter dealerships, rid itself of awful management and renegotiate union contracts. They will come out of bankruptcy with a leaner cost structure that will allow them to compete with Honda, Nissan and Toyota. If Congress bails them out with taxpayer funds, they will continue to pay workers $70 per hour versus the $42 per hour paid by the Japanese automakers.

We are heading down a path toward corporatism, where government merges with corporate interests. It's already taken root within the defense and healthcare industries. It's also taking place at the state government level. In Pennsylvania, a poorly run retailer named Boscov’s should be liquidating and getting ready to join Montgomery Ward on the scrap heap of retail history. Instead, Governor Ed Rendell is using taxpayer money to prop up it up.

No Easy Way Out

The incoming Obama administration is now floating the idea of a $500 billion to $700 billion stimulus package. The story which will be sold to the American public by his well- oiled PR machine is that we must do this to save the country. Haven't we heard this story before? The country's going through a necessary deleveraging that will take years to complete. There's no stimulus package that will stop this process. There's no easy way out.

Obama will convince the American people that once we save the country with the stimulus program, he’ll then address our long-term fiscal problems. He’ll convince the Republicans to support the stimulus package by delaying the tax increases on the rich. Democrats have never seen a spending plan they wouldn’t support. Republicans have never seen a tax that they didn’t want to cut. This is the kind of cooperation that will quickly lead to a $13 trillion national debt.

Tax cuts for the middle class sound great, except that a tax cut today is just a tax increase on our grandchildren. Former comptroller of the US, David Walker, describes the use of debt in the America thusly:

Individuals go into debt, and when they pass away, the debts go with them. But government debts stay, and they have to be assumed by our children and grandchildren. That’s not only fiscally irresponsible; it’s morally reprehensible.”

There are no easy answers to a problem that built up over a 25-year period. Americans will need to spend less, save more and live within their means. The next 25 years will not be as fun and carefree as the past 25 years. Government must address the $53 trillion of unfunded liabilities, develop a cohesive and ealistic energy policy, enact a simpler tax policy, create a plan to repair our crumbling infrastructure and encourage ideas that work for improving our educational system.

Many problems confront the US. They need to be met promptly and unflinchingly. Otherwise, the great American Republic will surely enter a period of long, slow decline. Next Tuesday has arrived.

No positions in stocks mentioned.

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