Written
by Hank Brock, CPA, MBA, CLU,
ChFC
Last post, titled
What You Should Know About
Today's Economy, I shared an
email conversation with my
daughter, Andrea (this was
originally written in March
2008). In it I referred to some
of the problems in today’s
economy, and posed the question
if we are in 1977 all over
again. Every one of you for
whom we have prepared a written
Retirement, Tax, and Estate Plan
during the past four years have
read a section discussing our
current “socio-economic
environment.” Within that
section we made some generic
observations about interest
rates, the deficit, the falling
dollar, international trade,
each of the investment markets
including real estate, and many
other topics. But, throughout
those four years we have
included in every engagement the
following observation:
“
Corporate
and Personal borrowing is
at an all-time high. This is the
major chink in the armor of the
economy. Rising interest rates
may force defaults, causing a
domino effect on defaults – on
corporate debt and home
mortgages….The severity of
massive debt keeps the economy
in a more precarious condition
that it otherwise would be; more
critically, it keeps families
with debt more precarious, while
families with minimal debt will
be cushioned against economic
volatility...” Do you remember
reading this in your plan? It’s
been there for four years.
We may not be able to change the
economic problems of our nation,
but we can do things to insulate
ourselves against them.
I will say it again: the last
time we saw these economic
indicators was 1977-1979. Do
you remember 1979-1981? Let me
remind you: falling dollar (this
is the one to watch), 13%
inflation rate, 13% unemployment
rate, 21% Prime, 18% money
market funds, 17% mortgages,
$850 gold, $50 silver (remember
the Hunt brothers trying to
corner the silver market?),
skyrocketing deficits,
skyrocketing oil and food
prices, money supply growing far
faster than the economy,
plummeting stock market,
plummeting real estate, zero
building, “stagflation,” and on
and on.
We ask ourselves why? The
discussion of indicators is too
exhaustive to make meaningful
mention here, except to say that
the world has changed since
then. Some of the similar signs
are the falling dollar, which
has fallen almost 50% against
the Euro during the past few
years. That suggests a terrible
10-15% inflation rate; after
all, inflation is ultimately
defined as “the value of the
dollar.”
Some might ask, “Why has America
been able to spend and spend and
run such large deficits without
inflation? Without a day of
reckoning?” I’ll just mention
two reasons we’ve been spared:
(1) Free trade has allowed us to
buy goods and services while
keeping our costs down and enjoy
a higher standard of living
(incidentally, free-trade is
also the #1 foreign policy to
prevent war—people don’t go to
war with people with whom they
trade), and (2) Foreigners have
been willing to finance our
government deficit, allowing us
to spend and spend without a day
of reckoning. More on this in a
moment.
Who can veto Congress? Who can
veto the President? The Fed?
No. Who can veto the Fed? Hint:
Many are not even U.S. citizens.
Those that are buying U.S.
Government Bonds—China, Saudi
Arabia, and Japan, in that
order, because they are the
one’s financing our budget
deficit. They are why we have
not had a day of reckoning.
People can hate them all they
want, but they pay for our
Medicare, entitlement programs,
and wars.
Now, what’s the problem with all
this? The problem is that, with
the falling dollar, U.S.
interest rate must, I repeat
must, rise! Those
nations will not continue to
finance our deficits if they
can’t get their money returned
to them, adjusted for the
currency exchange rate! They’d
rather go finance the deficits
of Western Europe! Are our
friends in Western Europe
financing our deficits? No!
They’ve got their own deficits.
And will the U.S. Government pay
the higher rates, even if it
breaks the economy as it did in
1981? Or worse? Of course,
because who would finance
America’s deficit if it
defaulted on its debt?
The Fed can lower short-term
rates, but it has no control
over long-term rates. That’s
determined by the free market.
Inflation is, and interest rates
will, rise dramatically! What
does this do to a debt-ridden
nation? See 1979-1981. BUT,
perhaps worse this time. Far
worse.
A very wise and astute
businessman made some quiet but
urgent observations about our
economy. Members of the
predominate faith here in Utah
refer to him as “the Prophet.”
Whether you are of the faith or
not, he was a mature adult at
the time of the Great
Depression, and he has managed
the business of a large
multinational organization. He
passed away a couple months
ago. He commented, “the economy
is a fragile thing…there is a
portent of stormy weather
ahead.” (Gordon B. Hinckley, CR,
10/1998) Later he again
stressed the importance of
getting out of debt and the
shocks our economy could see
(CR, 10/2001). And again
recently (CR, 4/2007). Why don’t
we listen to those that have
been down the path before?
Why far worse? In 1991 then
Governor Bangerter appointed me
along with two others to serve
as three members of the Utah
Thrift Panel to arbitrate claims
brought by depositors against
five failed thrift
institutions. Do you remember
the S&L debacle of the late
1980s? And how it broke the
FSLIC, needing a congressional
bail-out? And caused a real
estate collapse of 50% in CA,
AZ, and elsewhere? Now the
banks are into mortgages, and
the FDIC is no stronger, and the
problem is many, many times
larger. Unlike then, today the
consuming public have been
cannibalizing their net worth
under the stupidity of home
equity loans, living high, going
to Tahiti, on equity that
sometimes took generations to
grow. The growth of the 1990’s
was phony growth, spurred by
spending that we did not have,
and which is exhausted now.
Why far worse? Maybe this is
the clincher: Derivatives. Ever
heard of them? Originally Fed
Chairman Greenspan was against
regulating them because they
were a means to “reduce risk.”
Derivatives are basically “bets”
that some risk will or will not
happen. Derivatives do not
“reduce risk,” they “transfer
risk,” in a zero-sum manner.
What’s the problem? Greedy
bankers figured they could get
rich off trading derivatives.
And they could do this without
regulation, without reporting it
to their shareholders on their
financial statements, and by
being highly leveraged, based on
the bank’s credit rating. Maybe
they only had to put-up $1 for
every $20 dollar bet, thus
leveraging themselves 20 to 1,
and as much as 100 to 1.
Get this.
Every major financial
collapse in the past 20 years
has been the result of
derivatives, starting with Black
Monday in 1987. Then the S&Ls.
Remember the 223-year-old
British Barings Bank brought
down by a reckless hotshot
27-year-old trader? Remember
Orange County going bankrupt due
to $1.5B loss in derivatives?
Remember the collapse of the
Asian markets in 1997? Remember
Enron getting caught in the
squeeze, too leveraged to hide
any longer? The collapse of
Argentina? Remember the LTCM
hedge fund collapse when the Fed
organized a $3.5B bailout? And
now the collapse of
Bear-Stearns. Why? Derivatives
on their mortgage portfolio
multiplying the impact of the
basic problem (sub-prime loans)
many-fold. It isn’t the
sub-prime loans—it’s the
derivatives.
How does all this happen? And
how does it affect you? This
happens when the bet is made,
and a financially strong
institution only has to put up,
say, 2¢ on the dollar as
collateral. But, if their
financial rating gets
downgraded, as happened to Ford
& GM a while back, those holding
the contract have to increase
their collateral to double or
triple. What assets do they sell
to cover their bet? Their bad
assets? The derivatives? No.
They have to sell their good
assets, their stocks. This puts
selling pressure on the market,
things worsen, and downward
spiral begins. So, this isn’t
just about derivatives. It is
about the banking industry, the
stock market, and real estate.
(Bonds would likely increase in
value, which is the major asset
backing the insurance industry.)
Two weeks ago, for the first
time in history, the Fed pumped
money into the ailing securities
markets to save the investment
bankers and brokerage houses
from collapse, to the tune of
$200 billion. Now the Fed says
they want to regulate not only
banking, but also the securities
industry, and virtually replace
the SEC. Will it happen? Of
course it will. “Them that’s got
the money make the rules.” The
Fed’s got to “protect their
investment.” And the Fed can
buy/dictate anything because
it’s got the printing press (at
the cost of our inflation).
How big is this
phantom economy where no
real goods or services are
produced? The U.S. economy is
almost $14 Trillion in total
output. The world economy is
about $50 Trillion in total
output. Current derivative
“bets” out there total
$516 Trillion
dollars—that’s 10 times the size
of the entire global economy!
And 37 times the size of the
entire U.S. economy! And
one-third of it is held by three
banks: JP Morgan Chase, Bank of
America, and Citigroup ($158T as
of 3Q07, John Pugsley, Sovereign
Individual, 3/08). “J.P. Morgan
Chase’s dabbling in derivatives
makes it too big for even the
Federal Reserve to bail out.”
(John Crudele, New York Post.)
“Derivatives the new ‘ticking
bomb’ … Buffett and Gross warn:
$516 trillion bubble is a
disaster waiting to happen.”
(Market Watch, 3/10/08) As
Warren Buffett said at his last
Berkshire Hathaway annual
meeting: “A world where huge
amounts of leverage have been
brought into the system is a
dangerous world.”
Banks and securities/brokerage
firms are into derivatives,
hence the $100 billion and $200
billion bail-outs, respectively,
two weeks ago. This isn’t pocket
change. We will all pay for it
in a higher inflation-tax. Same
with the mortgage industry. The
only financial industry that has
stayed away from derivatives is
the insurance industry, which
primarily holds 90%+ in bonds to
back its obligations.
I am not a doomsayer. I
simply say that we live in a
precarious economy with unknown
risks. I suggest we go
conservative by staying/getting
out of debt, and putting our
dollars into safe vehicles that
will weather most any financial
storm. I suggest that if we
prepare right, we have nothing
to fear. I believe the prices of
wheat and other commodities will
continue to rise, so get your
year-supply of food. And there
is a whole list of other actions
someone can take to protect
their families against days of
increasing commotion and
volatility ahead. I am not
saying anyone needs to panic and
run out and live off nature, or
sell everything and buy gold. I
am suggesting that we be
forewarned, forearmed, prepared,
and informed about what’s going
on in the world about us.
If you are already a client, we
invite you to call for a
periodic review. If you are not
already a client, we invite you
to talk with us. You can start
by attending one of our public
workshops. If not us, then talk
with somebody that understands
more than just a few annuity
products, but also a little bit
about tax strategies, and the
world economy. My sincerest
best wishes to you.
Hank Brock is president of
Brock and Associates, LLC, a
financial planning firm
specializing in retirement,
estate, and tax planning. Hank
Brock can be reached at
435-673-9599.
