Agora Financial’s Rude Awakening

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Laguna Beach, California

• High-brow acronymic solutions for every financial boo-boo,
• What the bailouts are costing you, a golden stupidity hedge,
• Home of the brave, land of the freebie, and plenty more…

Joel Bowman, introducing today’s Rude from Dubai…

Earlier this week, we briefly touched on the perils of confusing the concept
of “right” with that of “need.” In the longer-than-usual (but, we feel,
better-than-usual) column below, Eric Fry examines how this confusion plays
out in your financial markets. Oh, and he also uses the word “owy.” This is
vintage E. J. Fry. Enjoy…

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———————————————————-

Bail-Out Nation
By Eric J. Fry

Welcome to “Bail-Out Nation.”

The Land of the Free is quickly becoming the “Land of the Freebie,”
especially for members of the millionaire corporate elite who make multi-
billion dollar mistakes…with someone else’s money. This unfortunate state of
affairs is jeopardizing the dollar’s value, as well as its hard-won reserve-
currency status.

Once upon a time, American-style capitalism resembled a bare-knuckled
fistfight – a continuous “Ultimate Fighting” match in which competitors would
pummel one another until a victor emerged. But modern American-style
capitalism is more like “arts and crafts” time in one of Manhattan’s pricey
nursery schools. Every coddled kiddy’s “artistic” creation – no matter how
inept or ghastly it may be – elicits praise from the nursery school
instructors. Indeed, every grunt elicits praise…and every boo-boo finds a
Band-aid.

Outside the walls of the nursery school, capitalism is just as brutal and
Darwinian as it has always been, perhaps even more so. But on the inside, the
privileged kiddies never shed a tear without receiving an immediate hug and a
“There, there. It’s okay. It wasn’t your fault…and even if it was your fault,
Uncle Ben will make it all better.”

As for discipline; forget it. The coddled capitalists of America’s high
finance never receive a slap on the wrist for any misdeed whatsoever. That
would be child-abuse. Nor do they ever even receive a time-out for bad
behavior. Worst case, punishment arrives in the form of multi-million dollar
severance packages.

Who are these “nursery school” capitalists? They are the folks who receive
millions of dollars each year to preside over public corporations and/or to
speculate with the shareholders’ capital.

American corporations are crawling with these leeches. Using other people’s
money, they engage in moronic speculations, knowing that success will
multiply their net worth dramatically and that failure will produce
negligible negative consequences. And sometimes even failure produces
success, thanks to the Federal Reserve’s well-established penchant for
bailing out speculators.

Because Wall Street’s privileged speculators receive continuous coddling,
they never really learn to behave themselves. Thus, when the multi-
millionaire, Nobel-prize winning operators of Long Term Capital Management
fell down and got an “owy” in 1998, Alan Greenspan’s Federal Reserve rushed
to their sides with Band-aids aplenty and emergency doses of financial
Bactine. He slashed interest rates, while also cajoling Wall Street’s leading
banks to provide a multi-billion dollar bailout.

Everyone called it a rescue plan for the capital markets. But the capital
markets of 1998 required no rescuing. They had worked flawlessy; they had
separated fools from their money.

But because the fools in question hailed from leading Wall Street
institutions, and because the Wall Street institutions, themselves, stood to
lose billions of dollars, LTCM would not be allowed to fail. Thus, the
bailout of 1998 was nothing more than government-sponsored collusion to
rescue speculators from the consequences of their ill-conceived speculations.

But the bailout succeeded in sparking a robust year-end rally, which made
lots of people very happy…and Alan Greenspan very popular. Few folks cared
that the bailout would lead directly to the largest stock market bubble of
the preceding 60 years – a bubble that would produce an epic bust and erase
hundreds of billions of dollars from the savings accounts of unsuspecting
individual investors.

During the early years of the 21st century, the Fed continued coddling Wall
Street’s privileged few, by slashing short-term interest rates to
unnecessarily low levels. Who benefited? Lots of banks and lots of
speculators…and lots of speculating bankers.

The speculators devised numerous ways to capitalize upon ultra-cheap short-
term financing. The speculators become overnight investment geniuses by
borrowing short-term and speculating long-term. But the sort of genius that
relies on short-term financing often perishes at maturity. Only a complete
moron would borrow short-term and invest long-term, without preparing an
emergency back-up plan or exit strategy – only a complete moron…or a coddled
capitalist.

Fast-forward to the summer of 2007 – the financial “Summer of Love” – and we
find the same playpen of privileged kiddies making the same poopies in their
diapers. All the biggest banks and brokers on Wall Street found themselves on
the losing side of some kind of ill-conceived loan. They found themselves on
the hook for billions of dollars worth of loans that no individual of
moderate intelligence would have ever issued with his own money.

Not only did Wall Street’s genius bankers issue billions of dollars worth of
idiotic loans, they also packaged the loans into billions of dollars worth of
idiotic mortgage-backed securities (MBS). The bankers then sliced, diced and
reformulated various types of mortgages into various categories (tranches) of
collaterized debt obligations CDOs and other asset-backed exotica.

Why did the whiz kids go to such great lengths to repackage mortgage loans?
Because it was a great way to move these things off their own companies’
balance sheets, and onto someone else’s. By moving the loans elsewhere, the
bankers could originate new idiotic loans, create new idiotic mortgage-backed
securities for public consumption…and collect hefty fees along every step of
the process.

When the Wall Street bankers couldn’t find any real buyers for their idiotic
mortgages and MBS, they would create non-real buyers called structured
investment vehicles (SIVs). These SIVs would borrow money, just like a
corporation, then use the money to buy mortgage-backed securities from the
Wall Street bankers who created the SIVs. The process would be something like
setting up a shell company to buy your house from you.

As long as the shell company could obtain financing, it could easily buy your
house, and might not even quibble about the price (but that’s a topic for
another day). Unfortunately, if the shell company suddenly lost access to
financing, it would have no choice but to sell the house it bought from you
at whatever price it could obtain.

That’s exactly where we are today.

Typically, SIVs borrowed short-term money in the commercial paper market,
rolling over their obligations every few months. In essence, therefore, the
SIVs financed their long-term mortgage assets with short-term CPO
liabilities. The process worked brilliantly…until it didn’t.

In mid-August, the asset-backed commercial paper (ABCP) market tumbled into a
deep-freeze, thereby eliminating the SIVs’ primary source of funding. What
happens to an SIV that cannot borrow in the CP market, you may be wondering?
Option A) It liquidates its portfolio of mortgage securities at fire-sale
prices; Option B) It goes knocking on the door of its original underwriter
for emergency funding.

Unfortunately, “Option A” includes the distasteful side-effect of putting
real-world prices on the billions of dollars worth of illiquid securities
that still carry Wall Street’s fantasy prices. Replacing fantasy prices with
real-world prices would force many American financial institutions to fess up
to the billions of dollars of additional mark-to-market losses – losses that
the institutions are pretending they have not already incurred. “Option B,”
therefore, seems like the lesser of two evils, but only in small doses. Large
doses of “Option B” could cause serious indigestion on bank balance sheets.

Enter the beefy “Master Liquidity Enhancement Conduit,” or M-LEC to save the
day. This $80 billion fund-to-be, according to Bloomberg News, “will help
SIVs, which own $320 billion of assets, avoid selling their holdings at fire-
sale prices.”

Here’s how the whole thing is supposed to work: Citigroup, Bank of America,
JP Morgan and a few lending institutions to be named later will kick $80
billion into a fund. The fund will buy AA- or AAA-rated CDOs. Once these CDOs
become the M-LEC’s property, they cease to require financing from the
commercial paper market or, more importantly, from the lending institutions
who are providing the $80 billion bailout. In effect, the banks are bailing
out themselves.

To the skeptical observer, therefore, the M-LEC merely puts a happy face on a
grim inevitability. These banks would be on the hook for billions of dollars
worth of financing anyway. So while pretending to “provide liquidity to the
SIV market,” the M-LEC is merely a ruse…and not even a very good one.

For one thing, Goldman Sachs is conspicuously absent from the consortium of
participating banks, even though former Goldman CEO, and current Treasury
Secretary, Henry Paulson, brokered the deal. Presumably, Goldman demurred
because it has no interest whatsoever in stepping into the SIV tar pit that
has ensnared its competitors…and will continue to ensnare its competitors.

The second problem with the M-LEC ruse is that it will not commence
operations for 90 days. That’s an eternity in the commercial paper world
where the SIVs are fighting for their survival. The 90-day lead-time reveals
the insincerity – or incompetence – of the M-LEC proposal. Many, many SIVs
could implode over the next 90 days - many more, in fact, than an $80 billion
fund could hope to rescue.

The entire SIV market totals more than $320 billion in assets, most of which
relies on financing of less than 270 days. Do the math.

The third glaring problem with the M-LEC ruse is that it will buy only AAA-
or AA-rated CDOs, where the least of the problems reside. A genuine bailout
fund would buy the most toxic securities first, and leave the highly rated
stuff out in the marketplace to find real-world buyers. This curious aspect
of the M-LEC, therefore, elicits the thought, “Gosh, maybe the banks are
trying to support the prices of the highly rated stuff they haven’t marked to
market, rather than the lowly-rated stuff they don’t own.”

Net-net, the M-LEC is a joke – a very bad joke.

It is the kind of joke that attempts to rescue well-heeled speculators from
the consequences of their recklessness…without providing any benefit
whatsoever to the capital markets overall. The SIV world doesn’t need a
bailout; it needs a mark-to-market. If SIVs were reflecting their real-world
pricing, instead of Wall Street’s government-sponsored fantasy pricing, REAL
capitalists would be lining up to purchase them or to provide financing.

The American capital markets do not need M-LECs, they do not need bailouts;
they do not need rescuing…except from the “nursery school” capitalists who
consider their wealth an entitlement, and who believe that their failures and
their successes both deserve multi-million dollar paydays.

The “Bail-Out Nation” is costing us all dearly. Every bailout undermines the
dollar’s value and international prestige. That’s a very heavy price tag. If
the “Bail-Out Nation” does not allow its coddled capitalists to fail, the
U.S. dollar itself might fail.

To be continued…

[Joel's Note: The systemic lack of accountability for anything the dollar
touches – be they high-brow financial institutions or Congressional expense
tabs - has seen the greenback plummet to its lowest levels against almost
every other major currency in recent times. This drastic depreciation is not
necessarily a bad thing…unless you hold all your savings in shot dollars.

If you do choose to hedge yourself, you may wish to look into the World
Currency Options Alert. With bets on the Australian and Canadian dollars
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Click here for more: The World Currency Options Alert

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———————————————————–

Rude Endnote: Late yesterday evening, we received an email from Byron King,
editor of Outstanding Investments. Byron has been following the ghastly
trajectory of the once-almighty buck and the skyrocketing price of
commodities like gold and oil. So busy have these new highs and lows kept
Byron that this week he is issuing a special two-part investment update for
readers of his newsletter. Byron will be reviewing the wealth of companies in
the Outstanding Investments portfolio that are riding high on the wave of
these recent trends. In addition, readers can expect an in-depth discussion
on the emergence of nuclear energy and a surefire way you can get in on the
action.

These reports will be hitting reader’s inboxes over the next two days. If you
are not already one of Byron’s many happy subscribers, you may wish to take a
moment and grab a spot on that list. The following link, by way of an
Outstanding Investments report on Gold, will give you all the necessary
information. Byron King’s Outstanding Investments: Gold Report.

Cheers,

Joel Bowman
Rude Awakening