A Mild Application Of Common Sense

Oh to have been a fly on the wall when the two old bulls, Paul Volker and Larry Summers, locked horns preceding President Obama's unveiling of his latest finance reform plan. Hopefully, little Timmy Geithner was taking notes. Volker, the ex Fed Chief and the only contrarian advisor the the president, has been pounding the table for months about the looting rampage the banks have been on. It appears he's had some effect.

Quickly dubbed "The Volker Rule", the plan's main function is to re-separate hedge funds, investment banks, and mortgage banks. The idea is to prevent mortgages from being used as collateral by anyone contemplating a night at the Wall St. Bordello.

Reaction in the press has been all over the map, reflecting factional differences in both political partys. Among the economically inclined, the point is made that the plan does nothing to halt CDO's and default swaps from happening. True, but I think irrelevant. The market for such things is in the mud and likely to stay there. No regulation required.

The consensus seems to be that it was a political move to stabilize the president's sinking poll numbers. But, isn't it any politician's duty to at least give passing thought to the will of the people? It would appear the people want a refund. The people don't much appreciate having their future earnings hand delivered to a pack of gold plated jackasses from New York.

There is a simple rule of investing that can be applied to any situation. Whenever investing in anything, one should consider the exit point, both on the upside and the downside. Once invested, it's good to ask yourself, 'If I didn't already own this, would I still want to buy it?' If the answer is no, it's time to sell.

When we bought the idea of banking deregulation in 1999, it seemed like a winner, and for a while it was. A lot of people made a lot of money, only to hang on too long and lose it. Knowing what we know now, would we buy today? Our investment in financial Frankensteins has gone south. We are a little poorer and a little wiser. The evidence is in. It's time to sell.

Finance Magic

In an article about the Obama Administration's problems in staffing the Treasury Department, Stephan Green, the Vodkapundit points out an interesting phenomenon:

According to a recent Reuters story, Blackstone Group CEO Stephen Schwarzman estimates that “Between 40 and 45 percent of the world’s wealth has been destroyed in little less than a year and a half.” Think about that. There was no 9/11 in New York, no nuclear bomb going off in London or Beijing, no fleets of bombers destroying factories — there has not been any physical destruction of capital whatsoever. Yet in the last 18 months, nearly half the wealth in the world has vanished into thin air.

Well, as every mother has said, at least once in her life, "Things don't just disappear, it has to be somewhere". So, where did nearly half the world’s wealth go? The answer depends on your view of reality. If the wealth was real, then it ended up in somebody’s pocket. If wealth is only a promise for future work, then it is not real. It can appear and disappear as easily as any other promise.

We are all familiar with optical illusions. Magicians make their living with them. Is there such a thing as a financial illusion?

You've worked and saved, and you're ready to buy a house. The work you have done is real. The money that was exchanged for your work is real; it is equal to the work you have done. So you plunk down 20%, and the bank covers the other 80%. Except, the bank doesn't have the 80%, they only have 2% on deposit with the Federal Reserve. The remaining 78% of the value of your house doesn't exist, not yet. But in the eyes of the banker, he has a note; a tradable commodity. He uses that commodity as a down payment on a bigger promise, and that commodity on an even bigger promise still.

All it takes to end the illusion is one broken promise; one call for a show of real wealth within a group of people who have none. When the illusion is over, what have we lost? You still have your house, your work, and you're keeping your promise. The banker still has houses and no real wealth. He's right back where he started.

I've heard we have lost our trust. Well, no kidding. Who would trust a magician?

Real Trust Requires Real Capitalists

Plowing through the hyperbole that the financial sections have become, one can sometimes find a little perspective. Rob Kirby writing in Financial Sense looks back on the road we have traveled:

Banks in the 19th century were owned by real capitalists and the equity capital of banks was about 60–80% of their balance sheets: bankers were lending or investing their own money, so they were responsible and did not accept excessive risks.

The 19th century also had what were called "wildcat" banks. These were often owned and operated by thieves and counterfeiters. They were located throughout the country, but were especially prevalent in the territories. They were characterized by the fact that they only had enough money to convince the locals that they had more. Today, we call that "a low reserve ratio".

Following a succession of bank panics, the central banking system was created in 1913 and called the Federal Reserve. And here is where it gets really interesting. The reserve ratio was set at 3%-12% depending on the size of the bank. What only a year before had been considered dishonest at best and criminal at worst, was now institutionalized as the norm. Shortly after this, the honest banker disappeared. The gold standard became a political football, before being phased out. With no cultural pressures, and no system of measurement, the wildcats could run free.

The required reserve ratio at the Fed is currently 10% on transaction deposits (checking and savings), and zero on everything else. Homes, cars, credit cards, entire businesses, have all been financed with nothing. And what of those savings accounts? Of course, there are plenty of exemptions and waiver rules included for favored political donors. Mr. Kirby continues:

...an accurate and logical accounting of where we are would amount to a confessional by the powers-that-be, punishable by law.

I don't see that anything is punishable by law. Inaccuracy and illogical accounting is the law. The lack of trust we see today is only the widespread realization that the money center banks are insolvent. They have been for a very long time. The banks are broke and everybody knows it. If the banks had been built on real wealth, regaining trust would be quick and easy. As it stands, what's to trust?