If It’s Too Good to Be True…

I wish I could say that it’s stunning how many victims have emerged in the Bernie Madoff Ponzi Scheme that resulted in the evaporation of more than $50 billion in assets. I wish I could say that it’s stunning who those victims are, among them some of the world’s largest banks, including RBS, HSBC, Natixis and BNP-Paribas, and some famous “small” investors, including the owners of the Mets, Dolphins and Eagles.

Alas. The only part of this that is stunning is that so many seemingly intelligent people allowed themselves to be drug into this pyramid fraud. The problem is that people believe in the concept of long-term profits that exceed the market return. It’s possible to outrun the market for a while, as I have done for the past few years holding a stake in Apple, but the extra risk inherent in a technology company, as well as a lack of diversification, that brought outsized returns in years past has served to erase those profits in a matter of months recently.

The same holds true- eventually- for everyone. No mutual fund, no individual investor, no algorithm, has ever successfully beat the average market return over a long-run timeframe. This isn’t meant to be a blog specifically about the finance industry or even the stock market, but rather economics in general. The fact that the market cannot be beat in the long-run is an economic absolute, not a financial absolute.

The reason is because it’s impossible for any algorithm or investor to account for the precise demands of every market consumer in the world, every potential news story or natural disaster, every political election, etc. Markets in general are priced, at least in theory, on every piece of data in the world (or at least every piece possibly relevant in the slightest to market values). This is the meaning of an “efficient” market. And where markets are even just generally efficient, not perfectly so, achieving an outsize profit in the long-run is unfeasible.

Those that were sucked into this scheme allowed themselves to be fooled by the trappings of finance. Financial wizards have concocted a variety of complicated instruments and investment schemes meant to perfectly shield from risk, provide excess returns consistently, or otherwise “break the rules”. We see their handiwork on display right now in the utter destruction of some of Wall Street’s oldest names. This particular story is no different and brings to mind an old adage: pigs get fat, hogs get slaughtered.

Even though Mr. Madoff was reporting returns well above those of the market year after year, without disclosing any type of pricing model or particular insight that could lead to exploiting market inefficiencies to such success, some of the world’s most respected banks apparently did not think to ask how this was possible. They were willing to believe, in effect, that two equaled five, and not just once, but on a continuous basis. Shame on them. Individual investors are more likely to get cheated into such a scheme because they don’t necessarily have the requisite knowledge to know that even the best investor couldn’t achieve these gains continuously. The financial institutions, though, should have known better.

This will eventually become the overriding narrative of this market tumult: the people in charge have no idea what they’re doing. To return to an economic description, one might say that 10% of the market is a reasonable portion to dedicate to those financial middle-men that handle all other transactions in the economy. Yet nearly 20% of the economy, when seen in terms of the S&P 500, was dedicated to the financial sector as recently as last year. Does anyone reasonably believe that one in five dollars should be allocated to transaction costs in our grand technological age? Even the federal government would be impressed by this level of bloat and inefficiency.

Welcome the current market convulsions. What we are witnessing is the grand economic reallocation of a full 10% (or more!) of our economy away from poor decisions to better avenues. It is clear that many of the people currently in charge of billions of dollars of other people’s money should not have that responsibility. Market forces will, we must hope, see to their demise.

This is why opposing government bailouts is important. This meddling in the market serves to reward those that have made poor decisions. As for saving those that were hurt by frauds perpetrated by men like Madoff, this too would be a mistake. The investors here are as guilty as Mr. Madoff. They participated in a willing suspension of disbelief in order to bring home profits that they knew had little to no grounding in reality.

The automakers (or more succinctly, the UAW) are facing their own reckoning. I believe that they will emerge stronger and more competitive in the end, or they will face ruin. GM will be drug by the government or by the market to friendlier waters. Ford has already properly vectored itself for success. Chrysler will die.

As I have said before, we face a unique opportunity here. The market will decide where all of this newly-freed capital will go, unless we intervene. I don’t support doing so, but the political realities seem to make this all but inevitable. If that is the case, we should do our best to be the market’s intercessor and be active in promoting those policies that will make us all more prosperous in the end.

Let the Market Liquidate

It’s incredible the lengths to which politicians on K Street and traders on Wall Street will go to in order to forget history. It must be truly difficult, especially for those old enough to have lived through similar scenarios in the past. There’s a wealth of knowledge that can be referenced in regards to this most recent “crisis” in the financial sector. The problem is that events never look quite the same twice, so all too many people either cannot or refuse to see the swinging pattern that we have been in for a long time now. Just as there seems to be a political pendulum that often swings from left to right- and back- a similar pendulum affects the American financial markets.

The two forces at battle here are interest rates and regulation. We are currently in a time of low interest rates and little regulation. This appears to be on the verge of changing, with Republicans and Democrats alike taking a populist stance against the “fat cats” on Wall Street, all while trying to figure out where to endorse a check that will increase the national debt by almost ten percent.

Look for regulation to make a strong comeback; following closely behind will be inflation. Regulatory measures serve only to squash free market efficiencies and add barriers and costs that make otherwise favorable investments no longer feasible. Regulation, in finance and elsewhere, serves to stunt growth. This is not exactly what the American and global economy needs at the moment, but don’t tell that to those dwelling within the Beltway, or executives looking for a way to personally escape their troubles at any cost to their shareholders and the American people.

The real problem is, and has been, and overabundance of money in the US financial system caused by incongruously low interest rates. Indeed, the current real interest rates offered by the Federal Reserve to banks is negative, once even very conservative inflation figures are taken into account! These low interest rates flooded the economy in the past few years with more new funds than were required to sustain normal growth. The excess money was left only to chase sub-standard investments. After all, money does not sit still for long. Indeed, it is this pattern of low interest rates that created the dot-com bubble in the late-90s, too. Fed Chairman Greenspan lowered rates dramatically to combat perceived weakness at that point, as well as to jump-start the economy following 9/11, after having taken them higher only for a very short amount of time. The housing bubble was given birth by these new low interest rates. After rates had increased slowly for a time, new Chairman of the Fed Ben Bernanke led the Reserve Board in lowering rates again to fight the outer bands of the current mortgage storm over the past two years. This series of rate-cuts undermined the US Dollar and resulted in the insane growth in commodity prices, including oil and gas, over the past year. The truth is that fiddling with interest rates almost never results in long-term good.

More concerning still, low interest rates combined with the Treasury’s plan to print C-notes continuously for months to come to bail out Wall Street will flood the market with ever more dollars. New regulations and the wounded nature of finance’s old titans will leave these dollars with no new direction in which to go. Given our current course, we face a short-term future where zero growth leaves new dollars only to chase existing goods, resulting in high levels of inflation. It’s the 1970s all over again.

And that’s my point. This is a cycle that the US is repeating for the umpteenth time. The economy boomed post-World War II largely because there was such a pent-up supply of money that simply couldn’t be spent during years of rationing. This newly-unleashed wealth resulted in explosive growth. The heavy, near-socialistic regulations on industry that existed during the war were torn down, and a relatively free-market emerged. Yet in the next two decades, regulation would creep back into American policy, again stunting the economy. Then, too, interest rates were kept at levels that put money into the marketplace at a faster rate than America’s GDP could digest. Cue the staggering inflationary period in the 1970s. Reagan broke the back of this inflation by taking dollars out of the market; Fed Chair Paul Volcker took the unpopular, yet necessary, steps to bring the monetary supply back in line with the true economy.

Inflation kills growth. If one expects a five percent yearly return for undertaking some sort of investment risk, yet sees that his money will be worth less the next year than now, he will instead require a return of five percent plus the anticipated rate of inflation. Only the very best projects are fully funded, and those nearer to the margin are either underfunded and forced to fail or never even are endeavoured upon. By breaking the back of inflation, Reagan and Volcker reset the economic environment and created the most important condition for growth to occur. Reagan then successfully sparked one of the most incredible periods of growth in the history of the world by lowering interest rates back to nominal- but not low- levels, decreasing the regulatory bondage faced by American enterprise and lowered taxes across the board. Lowering taxes simultaneously lowers the required rate of return for an investment and decreases regulatory (aka avoidance) costs that increase when taxes are high.

As Reagan proved, the recipe that sets the American economy on fire, rather than on firesale, is a nominal interest rate environment combined with low levels of regulation. Problems arise when politicians get greedy and try to meddle with the normal ebb and flow of capital in the free market. Meddling with interest rates corrupts the economic environment and results in mal-investment, such as the sub-prime housing debt now out in the market. Worse still, several Congressional measures have been passed in the past few decades that require banks to make a certain portion of their loans available to uncredible clients. Creating legal momentum and combining with it interest rates that spawn more money than the economy can normally absorb leaves nowhere for the money to go but to sub-prime debt. Indeed, although banks should have resisted the urge to make loans oftentimes bordering on crazy, blame for this should be shared by the monetary and fiscal policymakers in Washington.

Unfortunately, what comes up must come down. There are those out there that argue that the lack of a bailout will result in catastrophe. Yet we’ve already seen breathtaking changes in the composition of the financial sector in the last few weeks. The market will adapt on its own, as it should. Bad investments must fail, otherwise no true risk was taken. This creates a moral hazard equation where, in the future, people are ever more likely to make erratic investment decisions because they are confident that they will be able to keep the gain for themselves and share in any losses with the taxpayer.

The bailout must not occur. Instead, as is so often the case, economist Brian Wesburyoffers a better solution. The fact is that bad investments did occur, but the illiquid nature of the mortgage market means that just a few failures, or an immediate need for cash by just one or two small firms, creates a catostrophic accounting loss for all of the players in the market. As he says, the current accounting rules create a nonsensical mark-to-market necessity that is bringing even relatively well-capitalized firms to their knees:

Imagine if you had a $200,000 mortgage on a $300,000 house that you planned on living in for 20 years. But a neighbor, because of very special circumstances had to sell his house for $150,000. Then, imagine if your banker said you had to mark to this “new market” and give the bank $80,000 in cash immediately 9so that you would have 20% down), or lose your home. Would this reflect reality? Not at all. Would this create chaos? Absolutely.

Indeed, many mortgages may fail and not pay out. But the financial instruments these are wrapped up in were created with this largely in mind: by wrapping many mortgages together into some other type of product, risk is diversified and lessened.

The Congress needs to act to end this crisis, but a Publisher’s Clearinghouse check won’t do the trick. Instead, as Wesbury suggests, a suspension of mark-to-market requirements for certain instruments would allow banks to isolate these products until the real value of each can be more properly divined. In the meantime, the Federal Reserve needs to begin slowly cranking rates back up to a reasonable level (reasonable being defined as 2-3% after taking out inflation’s dithering effect). Investors that made particularly bad decisions will fail. But this is the risk that they took when they were tempted by astronomical gain. The stock market should not be in the same business as Little League baseball, handing out trophies to all participants.

It is not necessarily our fate to once again re-enter the stagflationary period of the 1970s, but that is the trajectory we currently follow. We must work together to slow down policymakers and to bring an end to the ready-fire-aim mentality that sweeps evermore heavily upon Washington in an election year of this magnitude.

Let the market liquidate. Rewrite the rules, though, so that the liquidation is fair and not frenzied. It won’t be pretty, but it won’t be another depression. $700 billion sounds like a lot of money, but it’s only five percent of annual GDP. If we took that whole hit this year alone, it would be the first thing large enough to actually cause a minor recession to an economy still silently growing at more than three percent. Next, set fair rates and resist the urges to let Washington arm-wrestle the invisible hand of the market with new regulations. Indeed, the answer here is less government meddling, not more.