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 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 3-Aug-2008
Alan Greenspan calls this a "once in a century" liquidity crisis.

Web Log - August, 2008

Alan Greenspan calls this a "once in a century" liquidity crisis.

Says that the "big surprise" is the "impressive" American economy holding up rather well.

Here's the first part of Alan Greenspan's interview, when he appeared on CNBC on Thursday:

"Well, I think the big surprise at the moment is, given the extraordinary pressures coming from the financial sector, that the American economy is holding up rather well, actually. And indeed if you look in a global context, it's even more impressive.

Former Fed chairman Alan Greenspan <font face=Arial size=-2>(Source: CNBC)</font>
Former Fed chairman Alan Greenspan (Source: CNBC)

One of the reasons, of course, is that fact that when the crisis began, just about a year ago, the non-financial corporate sector was in exceptionally good shape.

The balance sheets were such that borrowing requirements were minimal, and indeed they've weathered, very significantly, much of what has created huge problems in the financial system, and only recently are they beginning to feel the pressures.

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The problem, unfortunately, is that the financial system has gone a whole year now -- we've had huge amounts of liquidity engendered by central banks, and it's getting increasingly evident that this is a once in a century type of phenomenon.

It is not the standard liquidity crises that we have seen in the past. It's verging on the issue of solvency, and the reason we know this is basically we have seen that only when -- For example in Britain, when Northern Rock was bailed out with sovereign credit that the system stabilized. And we had a very major problem prior to the Bear Stearns bailout, but once sovereign credit was substituted for their credit, that too stabilized.

But, it's very clear from the spreads that we see in Libor, OIS and credit default swaps for the financials, that we have not gotten closure yet. And it's going to take a while.

It's essentially, fundamentally the price of homes in the United States which are of course determining what the equity is in homes here, and therefore, what the ultimate collateral of the mortgage-backed securities is, pretty much around the world.

And we're still no where near the bottom of the home price thing, and we're looking for that as the critical statistic that will create a balance fundamentally in the economy.

And until then, I hope we can get a sufficiently stable stock market because there is the fundamental source of capital from which we get the ability to recapitalize a goodly part of the financial system, which surely needs it."

At this point, CNBC anchor Maria Bartiromo made a typically CNBC-like airhead remark: "And that's built on confidence." Like so many other people, including supposedly brilliant Nobel prize winning economists and central bankers, Bartiromo believes that fundamentals are irrelevant to the stock market, and all that matters is that investors have to just BELIEVE that everything's ok, and thing's will be ok.

Greenspan understands that the problem is much more serious. We're in a massive deflationary spiral that leaves less money in the world each day than there was the day before.

And by saying that "this is a once in a century type of phenomenon," he's acknowledging that it's comparable to the 1930s Great Depression, though it's unclear to me whether or not he yet understands that it's WORSE than the Great Depression.

However, he provides an explanation for one thing that's been puzzling me: Why has the deflationary spiral affected only financial services firms? It's true that investment banks and hedge funds were most heavily invested in near-worthless CDOs and other mortgage backed securities, but there should have at least a few casualties in other industries.

He says that non-financial firms have solid balance sheets, and didn't need to borrow. That's still puzzling, because financial firms also had solid balance sheets prior to the credit crisis that began a year ago.

At any rate, he expects other firms to be hit hard now, and we only have to look at General Motors, whose stock is at 1950s levels and which is close to bankruptcy, to see what he means.

Second quarter corporate earnings

Every week or two I post the table of S&P 500 average corporate earnings growth estimates, based on figures from CNBC Earnings Central supplied by Thomson Reuters.

Here's the latest table for second quarter earnings:

  Date    2Q Earnings growth estimate as of that date
  ------- -------------------------------------------
  Jan  1:              +4.7%
  Feb  6:              +3.5%
  Apr  1:              -2.0%   Start of quarter
  Jun  6:              -7.3%
  Jun 13:              -8.1%
  Jun 20:              -9.0%
  Jun 27:             -11.3%   End of quarter
  Jul  3:             -12.4%
  Jul  8:             -13.0%
  Jul 11:             -14.7%
  Jul 18:             -17.1%
  Jul 25:             -17.9%
  Aug  1:             -20.4%

As you can see, earnings estimates have taken another big hit in the last week,

A fall in earnings estimates means an increase of price/earnings ratios estimates. Here's the Friday's version of the graphic that appears on the bottom of the home page of this web site:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 1-Aug-2008. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>
S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 1-Aug-2008. (Source: MarketGauge ® by DataView, LLC)

It now looks as if a new trend has been established. For two years, investors had been tuning their buy/sell algorithms to maintain price/earnings ratios (also called "valuations") of almost exactly 18. But now they've re-tuned their computer software to target valuations around 21.

This is a startling development, since it means investors are really brain-dead about what's going on.

But it also means that the stock market is (21/18)-1 = 17% higher than it would have been if investors hadn't made that algorithmic adjustment. That is, the Dow Industrials would have been around 9700 if it hadn't been for this adjustment.

I'd have to guess that investors are VERY nervous about this situation. After living with P/E = 18 for two years, being at P/E = 21 in the current environment would have to be considered very high risk even by the most oblivious investors.

Fraud accusations for UBS and Citibank

New York Attorney General Andrew Cuomo is about to charge Citibank (actually, Citigroup Inc.) with fraud related to auction rate securities.

Cuomo has already brought the same charges against UBS AG, and as I wrote last month, there's a "smoking gun" memo that provides solid evidence.

The banks are charged with having "repeatedly and persistently committed fraud" by falsely representing to customers that auction-rate debt was safe, liquid and the equivalent of cash.

(For a discussion of the hare-brained auction rate securities scheme, see "Investment bank UBS is now 'writing down' clients' auction rate securities.")

As I've said many times, there's no doubt that massive fraud has occurred on Wall Street because of the circumstantial evidence.

The banks, ratings agencies and bond insurers who all colluded to give AAA ratings to near-worthless CDOs and other mortgage-backed securities might claim that they didn't realize what would happen in 2002, or 2003, or 2004, or 2005, or perhaps even 2006. But there can be no question that they knew, or should have known, in 2007 that their valuation models were broken. And yet, the rate of abuses actually INCREASED in 2007.

In fact, I would argue that by the time 2007 came around, financial professionals no longer even cared about their investors or about honesty or about who got screwed. If you look at all the actions and statements by financial executives in 2007, vastly many of which have turned out to be disastrously wrong, you can see that they all had one and only one purpose: Preserving their fat bonuses, fees and commissions, irrespective of honesty or professionalism.

The accusations of fraud directed at Citi and UBS are related to auction rate securities, but we should expect to see many more such accusations, related to ARSs and also to mortgage-backed CDOs and other securities.

Accounting rule postponed a year

Banks accused of fraud may have the perfect defense: "The regulators told me to commit fraud."

That's the gist of a a rule change by the Financial Accounting Standards Board that would postpone for one year a rule that would require banks to declare worthless assets more quickly.

As we discussed recently with regard to the latest of Merrill Lynch's repeated asset writedowns, financial institutions have been postponing as long as possible having to admit that they have near-worthless assets in their portfolios. Not admitting it is fraud, because investors in the bank are fooled into thinking that the bank is worth more than it actually is worth.

But fraud should be perfectly ok if everyone is doing it, and if government officials tell you to do it, shouldn't it?

The FASB rule change says that it's perfectly ok to continue perpetrating fraud for another year.

That should give Citi and UBS a perfect defense - the regulators are urging banks to continue committing fraud. Quite honestly, I don't see what possible justification Cuomo has for charging Citi and UBS with fraud, when fraud is the current standard. Why should they be singled out for selective prosecution when everybody's doing the same thing and regulators are encouraging everyone to do the same thing.

It's especially ironic that Cuomo is the attorney general of New York.

It was New York Insurance Superintendent Eric Dinallo who spent several months earlier this year helping the banks and "monoline" bond insurance to collude to commit fraud. One of the major banks involved was Citi.

Now how on earth could Citi possibly be guilty in New York of any similar fraud, if the New York Insurance Superintendent was openly and publicly helping Citi to conspire to commit fraud. Shouldn't Dinallo himself be charged with conspiring to commit fraud? There's hardly any doubt that he did it -- just read any business newspaper in February or March and see for yourself.

And, not surprisingly, Citi was the major proponent of postponing the FASB rule, so that they could continue to mislead investors about the value of their portfolio.

And the people on CNBC wonder why bankers no longer have any credibility!

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (3-Aug-2008) Permanent Link
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