The Consequence of Complacency Is Catastrophe

Yes, the stock market is going up, and our editors are helping to make sure you don’t miss the opportunity.

Yes, the U.S. economy is finally improving, and we’re among the first to recognize its current strength.

But if investors around the world think it’s suddenly OK to forget about the fundamental diseases that afflict the global economy, the consequences could be catastrophic.

In fact, it’s precisely because of rising stock markets — and the accompanying complacency — that we have the most to be concerned about for the long-term future.

Stock market euphoria is a powerful drug.

It’s an artificial stimulant for the economy, an antidepressant for investors who’ve suffered big losses, and a memory-blocker for bankers who helped cause the great debt crisis.

Moreover, it does nothing to resolve the continuing — and growing — threats. So before the great forgettery of 2014 sets in, let me remind you about just the main ones …

Threat #1
The U.S. Debt Monster

According to the Federal Reserve’s latest release of its Financial Accounts of the United States, the total interest-bearing debt in the United States has grown to $58.1 trillion, the largest in history. That includes:

• $19.5 trillion in U.S. Treasury debt, government agency debt, or government-sponsored debt (the TRUE national debt),

• $13.2 trillion in corporate debt,

• $16.2 trillion in mortgage debt and consumer debt, plus

• $9.2 trillion in other debts.

All told, even with the recent bull market in stocks, that’s still $27 trillion more than the total value of all U.S. stocks traded on all U.S. exchanges.

Sure, as long as interest rates remain low, this debt monster is not a crippling burden for the economy. But as soon as rates rise, it will inevitably return to haunt nearly all borrowers — especially those who have tried to skimp on interest costs by raising mostly short-term money.

And mind you — so far, I’ve been talking strictly debts that pay interest. But that’s just the tip of the iceberg. The U.S. government also has other massive commitments and obligations — for Social Security and Medicare, to veterans and others.

How much?

Based on the government’s own data, these hidden debts add up to over $70 trillion. And based on private estimates, they could be more than double that figure!

Threat #2
Rampant Speculation by America’s Largest Banks

After the 2008 debt crisis, there was much talk about reining in the unbridled speculation among U.S. megabanks, and for good reason: It was precisely that kind of speculation that brought the global financial system to the brink of Armageddon.

But despite some minor rule changes, virtually nothing has changed. In fact, according to the latest Quarterly Report on Bank Trading and Derivatives Activities by the Office of the Comptroller of the Currency (OCC), U.S. banks still control $240 trillion of the most highly leveraged speculative vehicle — derivatives.

That’s more than four times the size of the entire U.S. debt monster I mentioned a moment ago.

But if you think that’s shocking, consider these facts revealed in the same OCC report:

1. The largest four U.S. megabanks still control a whopping 93.2 percent of the bank-traded derivatives in the United States — a concentration of power (and risk!) that’s mind-boggling and unprecedented. The table below shows this inconvenient truth in black and white …

   

   JPMorgan alone holds $71.8 trillion in derivatives positions, or nearly 30 percent of the entire market. Plus, Citibank, Goldman Sachs and Bank of America control $63 trillion, $47.5 trillion and $41.4 trillion, respectively.

   Just among these four megabanks, that’s a total of $223.6 trillion, or 93.2 percent of the total market share!

   Or consider the same shocking phenomenon as illustrated by the pie chart to the right.

   The four banking giants — JPMorgan, Citi, Goldman and BofA — have so dominated the U.S. derivatives arena that they’ve literally shoved every other bank in the country out of the market.

   In fact, that tiny “other” category (black area in chart) controls only 6.8 percent of all U.S. derivatives but includes 99.9 percent of the institutions — 6,887 other U.S. banks, among which 1,143 do actively seek to participate in the market when they can.

   That’s over a thousand banks scrambling for the crumbs while the Big Four control almost the entire pie! It’s easily the greatest concentrations of financial clout of all time.

2. The credit risk of the Big Four, although down somewhat since the 2008 debt crisis, remains off the charts: For each SINGLE DOLLAR of capital that they’ve got on their balance sheets …
   • Bank of America’s total credit exposure to derivatives is $1.25.
   • Citibank’s exposure is $1.67.
   • JPMorgan Chase Bank’s is $2.17. And, worst of all …
   • Goldman Sachs’ exposure is a whopping $6.93 per dollar of capital. In other words, all it would take is a 14.4 percent loss in its derivatives and Goldman Sachs’ ENTIRE capital would be wiped out.

   And I’m talking strictly about losses related to credit defaults! Trading losses — due to bad calls about the market or underestimating the coming rise in interest rates — could potentially cause even more losses.

3. A whopping 81 percent of the derivatives are bets on the one sector in the market that could harbor some of the biggest surprises over the next couple of years — interest rates. That means any unexpectedly sharp move in rates could cause heavy damage to bank solvency.

Threat #3
Central Bankers Gone Wild

The U.S. Fed and other central bankers are vividly aware of these risks.

They witnessed it first hand in 2008 when the failure of one single company, Lehman Brothers (not even a particularly big player in the derivatives area at the time!), nearly ended the financial world as we know it.

This is the least-mentioned — but probably most powerful — reason  why, on the day of the Lehman bust, central bankers began printing so much money in such a big hurry … and why they haven’t stopped printing ever since.

In his recent webinar, Mike Larson explained it this way:

“We have a Federal Reserve balance sheet that has QUINTUPLED in size — from $880 billion just a few years ago to more than $4 TRILLION today.

“And it’s not just in the U.S. We’ve seen the biggest money-printing program EVER in Japan, the biggest rate-cutting program EVER in the euro’s 15-year existence, and the biggest easy money program EVER in the U.K.”

“DESPITE all those herculean efforts, long-term interest rates have STILL moved sharply higher. 10-year Treasury yields have already almost doubled to around 3 percent from 1.6 percent before the bubble began to burst.”

Agreed!

Now, after the wildest money-printing spree in the history of the world, the Fed says it is “tapering” the program.

But tapering doesn’t mean taking some of that money back out of the economy. It doesn’t even mean ending the outpouring of new funny money.

All the tapering does is to slow the pace of funny money that’s being injected into the economy every month — by a meager $10 billion.

And even that small course correction is enough to drive interest rates still higher. Imagine what will happen when the Fed is ultimately forced to truly end — or reverse — its money-printing madness!

WHEN might that happen? The answer leads us to …

Threat #4
Asset Bubbles and Inflation

The nation’s leading economists and politicians must have very short memories about history and even shorter time horizons when they peer into the future.

If not, they’d know that it always takes time for money printing to generate a surge in prices.

They’d also know that consumer prices are often the last to rise.

First, the money infusions drive up prices on select assets — such as stocks, real estate and collectibles. Then, the inflation spreads to things like rents, college tuition, health care, gas and food.

Right now — and for the near future — consumer price inflation is still in a long incubation stage. But history proves that, once the first symptoms appear in the form of major price hikes on consumer goods, it will be far too late to reverse.

Threat #5
Marginalized Populations

A poorly understood side effect of money printing is lopsided growth.

In nearly every country where central banks are pouring money into their economy, we see the same phenomenon:

Favored elites that are closest to — or most familiar with — the money spigots are the ones who make out like bandits.  Meanwhile, small businesses, middle-class citizens are left out. And the poor, already marginalized, are shoved into the dumpsters of society.

But if you think this is just a third-world syndrome, think again!

In the United States, 2012 brought the widest gap between the richest 1 percent of America and the remaining 99 percent since the 1920s. Incomes of the wealthiest 1 percent rose by nearly 20 percent, whereas the incomes of everyone else rose by only 1 percent.

In the BRIC countries — Brazil, Russia, India and China — where growth has been far more rapid, the income disparities are more extreme, and over two trillion people have been left behind in the dust.

I know. I’ve seen it with my own eyes — children with easily treatable diseases dying in makeshift triage outside Brazilian hospitals, surging homeless populations on the streets of Moscow, beggars swarming China’s largest cities and more.

What’s having the most immediate impact right now, however, is the extreme income imbalances in the Middle East and North Africa.

Why? Because that’s where we currently see the most obvious overlaps between income disparity and nearly every other social force that drives desperate individuals to desperate action: Political disenfranchisement. Religious hatred. Plus rampant violence by the people and by the state.

Threat #6
Chaos and Revolution

You know this story. It’s all over the news. And it’s been the lead topic of my Money and Markets for the past two weeks:

In Winds of War (Part I), I showed you how Larry Edelson was right: The winds of war are here. The storm is spreading. It’s growing rapidly in intensity. And it’s bound to directly or indirectly affect virtually every asset class on the face of the planet.

In Winds of War, Part II, I made the all-important point: If our leaders and allies still think they have the power to impose their brand of peace and freedom on the Middle East, they need to check into an insane asylum. Just in the past five years, wars have spread (or returned) to at least four countries in the region; several more states have collapsed and all have lost any semblance of stability.

The big concern: This could be just the beginning of a broader regional war and global conflict.

Threat #7
Dictatorships and Big Brother Societies

China is rounding up dissidents at an accelerating pace.

Egypt is throwing local and foreign journalists into prison.

Governments from Turkey to Bangladesh are cracking down on their opposition with growing impunity.

And alas, although the tools and lies used in those countries are far more extreme, the trend in America is not fundamentally different — a topic we will address broadly and deeply in coming weeks.

For now, suffice it to repeat my warning: The consequence of complacency is catastrophe. It’s never too soon to be safe.

Good luck and God bless!

Martin