The Great Baby Boom Unwind

I am asked often about who is to blame and who I am voted for. Believe me, there is enough blame to go around to both political parties. So I won’t even touch that subject. These are just my thoughts and you are free to debate them or prove them wrong. I will not be offended. I know I am often wrong and that is why I use stop losses on all trades…

The Glass-Steagall Act was designed to separate the guys who create capital (via leverage) from the guys who create risk. Because what ends up happening is greed takes over as you realize that the more leverage you create, the more profits you make. So the people who are responsible for managing risk get thrown out of the room, because anything they do to impede risk creation costs the bank money.

The Baby Boom
This all starts with the Baby Boom. 30 years ago, the government started enacting policies to prepare the country for the inevitable costs of the Baby Boomers retiring. The costs would be massive increases in entitlements and a substantial decline in consumption. So the government needed to formulate strategies to mitigate the cost of the retirement of the Baby Boom generation.

Replace diminishing Baby Boom Consumption
One goal was to add enough consumers to make up for the declining consumption of a retiring Baby Boom.

On the home front, they did this by opening up the border. How many illegals have received amnesty from Reagan, Bush, Clinton and Bush? Adding 30 or 40 million new consumers is a lot easier than having 30 to 40 million new kids, or outlawing abortion…

On the international front, they wanted to create millions of new middle class consumers in emerging markets. This was done by turning America into a hyper-consumer for the products made in these countries.

Companies move to countries with cheap labor and build manufacturing facilities (the focus is on China, India and the Philippines). Foreign workers have massive savings rates and their surplus savings is recycled back to us via the purchase of US Government debt (more on this later) as foreign governments buy US Treasuries to finance the debt needed to pay for all this excess consumption.

Diminish Entitlement Costs Via Inflation
This was a tricky play initiated under Clinton (Bush has continued it, so don’t get all politicky on this one).

In 1997, the government changed how inflation was calculated so that it could keep the annual Cost of Living Adjustments (COLA) on benefits artificially low. By definition, this decreases the real cost of entitlement programs versus inflation each year.

COLA is running at about 5% less per year than it should be. Check the chart titled “Alternate CPI Measures” here. Notice how annual difference between the “Pre-Clinton Era CPI” and the “Official CPI” –

http://www.shadowstats.com/charts_republish#cpi

Think about what this allows the government to do. It allows them to effectively CUT inflation-adjusted future Social Security benefits, without having to admit it or be forced to vote on it. Sneaky, but needed…

Bubbles
Credit driven asset bubbles were the engine to drive the consumption train.

Y2K
The first big effort to drive the expansion of the middle class in emerging markets was the Tech Bubble. The Tech Bubble was financed by the government under the pretext of getting everybody prepared for Y2K. Cheap money was provided to companies, leading to lots of unprofitable businesses and massive over-capacity to be created.
In early 2000, the cheap money stopped flowing and you saw a massive implosion in the pricing of all things technology because of all the excess production capacity created during the Tech Boom.
Scores of US Investors got ravaged, but the foundation was laid for the creation of the new Middle Class in the Emerging Markets

Real Estate
As the Tech Bubble was collapsing, the US Government needed to create a new bubble to stave off a Depression (yes I used the “D” word). The goal was to drive up the price of another asset class to full consumption via the “Wealth Effect”. The asset chosen was of course Real Estate.

In order to drive housing prices up, you need to increase demand. You increase demand by lowering the cost of money. You lower the cost of money in the following ways –

Cut Interest Rates
In late 2001 – 2002, Greenspan (appointed by a Republican and also used by a Democrat) gutted interest rates for historically low levels (1%). As rates fall, people refinance and their monthly payments go down.

Lower Lending Standards
You can also increase demand by lowering lending standards. The more people who can buy a house, the higher the prices go, so the US Government decided to allow people to lie on their loan applications and allowed the lenders to take those applications without checking the “facts” presented by the lenders.

Create Exotic New Ways to Finance
Banks started to create such things as 40 and 50-year mortgages. They created mortgages where you didn’t have to pay interest or principal until some future date. They created mortgages where your interest rate was artificially low for a set number of years.

People got greedy and used these new types of mortgages to buy homes they knew they couldn’t afford. Investors hoped that the price of their houses would go up and they could refinance in a few years.

Securitization
It used to be that when you needed a loan, you would go down to the bank and if they loaned you money, the bank would keep the loan on their books until you paid the loan off. They knew they were taking the risk, so they were smart about how they loaned it out.

Then some smart guy came along and told the banks that they could take the loans they made and lump them all together into a security and that security could be sold to private investors anywhere in the world. The idea would be that you would have “Ratings Agencies” tell you how much risk was in a security, that risk rating would determine the yield the security paid and also determine the interest paid by the initial borrow of the funds.

The Rating Agencies
If these guys do their job, then the system works. Because if you have bad credit, then the interest rate you would get on your loan would be so high, that you couldn’t afford to take the loan. If you have bad credit and don’t take the loan, then the bank doesn’t take on any risk.

But what really happened? The “Rating Agencies” failed to rate based on credit quality and instead got into a practice where they gave virtually ever security the same highest rating of “AAA”. This allowed banks to keep interest rates artificially low and allowed borrowers with bad credit to buy houses they couldn’t afford. There is absolutely no chance that this could occur without the explicit consent of the regulators and the US Government!

Oh, and did I mention that the banks who needed the highest credit rating on the securities they created were the same banks who paid the Rating Agencies to rate their securities? The Rating Agencies are now admitting before Congress that they would have rated dog sh*t AAA if a bank paid them enough money.

This is the Cliff Note version. I could go into a lot more detail, but I’ll spare you the outrage.

Implied Government Guarantee
Here is where all this stuff costs the taxpayers.
Again, foreign governments were the primary buyers of the securitized mortgages. They bought a lot of these issues from Freddie Mac and Fannie Mae. Freddie and Fannie are/were agencies of the US Government, which meant that the securities they backed had the “implied” backing of the US Government. Foreigners understood “implied” to mean “explicit”, just like the securities of Ginnie Mae and TVA have.

You remember the testimony before Congress in July where Paulson wanted the “Bazooka” to help him prevent Freddie and Fannie from failing? Did you know that at the time he was begging Congress for money, he was spending his evenings assuring Asian Central Banks that the securities banked by Freddie and Fannie had the “explicit” backing of the US Government?

Freddie and Fannie back about $4.5 trillion of mortgage debt. The US Taxpayer is now responsible for ALL OF IT!!!!!!!!! We are bailing out the Central Banks of Asia who knew damn well what they were buying. Moreover, the directly benefited not only from buying this crap, but the very creation of this crap, because it fueled the consumption in the US for the products manufactured in places like Japan and China and India…

Leverage
It just gets better!

Enron, Sarbanes-Oxley and You
You remember how the fall guy for the last bubble was carted off to jail and Congress had their hearings and the Sarbanes-Oxley Act was passed with great fanfare?
Do you remember what Enron did and Arthur Andersen signed off on? They did something called “off balance sheet accounting”. They basically took all of their losses and hid them in off-shore limited partnerships. When the news got out about what they were doing, Enron imploded and Arthur Andersen went under.

Why do I bring this up? Have you ever heard of a SIV? A “Structured Investment Vehicle”. Do you remember Paulson calling for a “Super SIV” earlier this year? A SIV is just an Enronesque off-balance sheet accounting trick used by banks. The Fed allowed banks to take the accounting trickery of Enron to a whole new level. They did so, so that banks could write a lot of bad mortgages and drive housing prices to ridiculously high levels.

Take Citigroup as an example. They have “assets” of $1.327 trillion. Did you know that they have off-balance sheet assets of another $1.2 trillion? Right now, Citigroup has a net worth of $67 billion. They are levered 37.7 to 1! That means the prices of the bonds that they hold only need to fall another 2.65% and Citi is out of business!!

The US Government allowed all this to happen and the taxpayer is now stuck paying the bill.

I’m tired of writing about this stuff. It goes so deep and it is so pervasive that I could write a book about it.

The bottom line is that this game has been going on for decades and the endgame is massive inflation to get rid of the real value of the debt.