Big Danger: A Convenient Forgettery on a Mass Scale
Will the Ghosts of 2008 Return to Haunt Us?

It never ceases to amaze me how quickly and thoroughly our nation’s decision-makers and investors forget the lessons of history.

It’s a unique form of amnesia suffered by presidents, cabinet members, senators, congressmen, and Fed chairmen. It’s a disease on Wall Street, in Silicon Valley, Detroit and Hartford. And it’s highly contagious, spreading to American savers, investors and speculators.

My father used to call it “a convenient forgettery on a mass scale” — society’s psychological mechanism whereby certain traumatic events of the past are erased from the public consciousness.

It’s wrong. It’s foolhardy. It’s downright dangerous — both for the nation as a whole and for individual citizens.

And it’s particularly common in the one area that can have the most profound impact on our livelihoods — the erudite world of sophisticated financial transactions and policies. Where greed competes head-to-head with fear. Where trillions of dollars are at stake. Where even some of the most sophisticated investors are vulnerable to deception.

Case in point …

Yesterday was the 10-year anniversary of
a landmark event that changed history.
But no one seems to remember or care.

Can you guess what that landmark event was?

Here’s your first hint: It happened on April 2, 2007, as I said, ten years ago yesterday.

Hint #2: It was the first major financial collapse of the greatest debt crisis of our lifetime, leading to the worst market meltdown in one hundred years and the largest government rescues of all time.

Hint #3. The company that went under was one of America’s largest lenders of subprime mortgages.

Its name: New Century Financial, the second-largest originator of subprime mortgages in the United States. Its stock plunged from a high of $64 in 2004 to 10 cents per share on the pink sheets in 2007. Its investors lost billions of dollars. And it was just the first of many.

Here’s my diary of key events that followed …

July 31, 2007. Bear Stearns, one of America’s largest investment banks, has just liquidated two hedge funds that invested in high-risk securities backed by subprime mortgage loans. Fed Chairman Greenspan and virtually all of Wall Street are pooh-poohing the crisis, saying it’s “contained” exclusively to “a small niche” in the U.S. mortgage market. We warn our readers that it’s just the beginning.

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August 6, 2007. American Home Mortgage Investment, which specializes in adjustable-rate mortgages, has filed for bankruptcy protection. Still, government officials and Wall Street pundits insist the crisis is “easily containable.”

December 3, 2007. In today’s Money and Markets column, “Dangerously Close to a Money Panic,” I write that Bear Stearns has “sunk its balance sheet even deeper into the hole, with $20.2 billion in dead assets, or 155 percent of its equity; and is threatened with insolvency.” I warn that “Lehman Brothers is in a similar situation,” because of an even larger, $34.7 billion pileup of “risky, impossible-to-value assets,” representing 160% of its equity.

January 11, 2008. Bank of America has just announced that it will buy the bankrupt subprime lending giant Countrywide Financial for $4.1 billion in stock. This means America’s largest weak bank is absorbing the most rotten assets of the entire mortgage market. It’s obviously a huge mistake and a bad omen for all investors.

March 14, 2008. Bear Stearns failure. Exactly 102 days have passed since last December, when I warned that Bear Stearns was threatened with insolvency, and today it happened.

The Federal Reserve Bank of New York says it’s providing a $29 billion emergency loan, while Bear Stearns is signing a merger agreement with JPMorgan Chase in a stock swap worth $2 per share. That’s less than 10 percent of Bear Stearns’ most current market value and a staggering decline from a peak of $172 per share as late as January 2007.

March 17, 2008. “Huge financial failures ahead.” In today’s Money and Markets, “Closer to a Financial Meltdown,” we warn sternly about “The Containment Myth.”

Weiss Ratings analyst Mike Larson and I remind readers about the dangers we first stressed back in 2007 — in regard to subprime lending, the housing crisis, the broader financial crisis and the likelihood of an S&L-type meltdown.

Today, we’re stepping up those warnings. We write that “Bear Stearns is not alone; the crisis, not contained.”

Included on our short list of major financial firms among the most vulnerable to failure: Lehman Brothers, Merrill Lynch, Citibank and Bank of America.

August 6, 2008. “Big Banks on the Brink.” Our Money and Markets readers seem to be paying close attention to our warnings, but Wall Street remains oblivious and complacent. So we’ve decided to send out a press release announcing a live broadcast naming the nation’s weakest U.S. banks and thrifts.

Citibank is at the top of our list as the biggest and most vulnerable. More than 100,000 individuals view the broadcast or the recording. The transcript is distributed to over 400,000.

September 7, 2009. Fannie Mae and Freddie Mac have just been placed under “conservatorship” of the U.S. government, another one of those creative government euphemisms for outright bankruptcy.

But no words can disguise the enormity of collapse: The U.S. Treasury is committing to bailout funds of $100 billion for each, the largest bailout for any company in history. Common and preferred shareholders are wiped out. It seems the entire world is in shock.

Too bad they didn’t read what we wrote four years ago (in Safe Money Report of April 2005 and Money and Markets September 24, 2004): “Fannie Mae is already drowning in a sea of debt. It has $34 of debt for every $1 of shareholder equity. That’s big leverage and of the wrong kind. Plus, the company has only one one-hundredths of a penny in cash on hand for every $1 of current bills. Think Fannie Mae can’t go under? Think again.”

September 14, 2008. Merrill Lynch is bankrupt, and Bank of America is again stepping in to clean up the mess, much as it did for Countrywide Financial back in January.

That Bank of America would take such unprecedented risk with depositors’ funds is unbelievable. But what’s even harder to believe is the fact that the bank is paying a 70.1% premium for the shares. Something very fishy about this transaction!

(Later Congressional testimony by Bank of America CEO Kenneth Lewis and internal emails released by the House Oversight Committee reveal that the so-called “merger” was a shotgun marriage forced upon the bank by U.S. government regulators.)

The Big Bang

September 15, 2008. Lehman Brothers has filed for bankruptcy protection. Until now, virtually every government official and investor in the entire Western world has been assuming that ALL of America’s largest financial institutions are “too big to fail.” But today the government has effectively declared that Lehman Brothers, one of the biggest of them all, is too big to save. It’s the Big Bang of the financial crisis.

JPMorgan Chase, the nation’s single biggest player in the market for derivatives, puts up $138 billion to settle Lehman’s outstanding transactions. Nearly all of Lehman’s other assets go into immediate liquidation.

September 16, 2008. Financial weapons of mass destruction. What was once just a “contained problem in a small niche” has now exploded into a dark mushroom cloud over Wall Street and every major financial capital of the world.

The nuclear material: DERIVATIVES, the same kind of high-risk contracts and transactions that killed Lehman Brothers and now threaten to sink the capitalist system as we know it.

That’s why American International Group (AIG), the nation’s largest player in the derivatives markets among insurers, has also gone broke today. But unlike Lehman, it gets an instant $85 billion bailout from the Fed in exchange for an 80% interest in its shares.

Meanwhile, a large money fund, Reserve Primary Fund, has huge losses in its short-term loans to Lehman. So its share price, which is always supposed to be fixed at $1, has suddenly fallen below the all-important one-buck level.

September 18, 2008. “Money market meltdown ahead.” Reserve Primary Fund has been swamped with a half-trillion dollars in liquidation orders, and the contagion is beginning to spread to other money funds. We warn that the most-liquid financial markets in the world, called “money markets” – including trillions of dollars in short-term commercial paper, CDs, bank acceptances and other instruments — could soon become fatally illiquid for the first time in history.

September 19, 2008. Money fund bailout. In a desperate attempt to stem the panic in the money fund world, the U.S. Treasury has just announced the equivalent of federal deposit insurance for money market funds, transferring still more responsibility from the private to the public sector.

October 3, 2008. The “mother of all bailouts.” The Emergency Economic Stabilization Act of 2008 is passed with a 263-171 bipartisan vote in the House. Almost immediately, $700 billion in bailout funds start flowing from the U.S. Treasury Department straight into the coffers of giant U.S. banks on the brink of failure.

But it’s just the first of many actions around the world — in the United States, Western Europe and Japan — that help transfer more trillions of dollars in toxic assets from the books of bankrupt corporations to the books of federal governments.

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October 7, 2008. Money market meltdown. The global market for short-term corporate IOUs (commercial paper) has sunk into a sudden deep freeze. This market is the oil that lubricates the industrial and banking operations of the entire world. Without it, the engine of the global economy will grind to a screeching halt.

In response, the Federal Reserve has just announced a never-before-heard-of “Commercial Paper Funding Facility.” In other words, virtually any major company in the world that cannot roll over its short-term debts coming due is, in effect, invited to stop by the Fed’s offices in downtown Manhattan to pick up all the cash it needs.

October 8, 2008. Zero interest rates. It’s rate-cutting time, and it’s big: Almost every major central bank in the world — including the U.S. Fed, the Bank of England, the European Central Bank, plus smaller ones such as the Bank of Canada, Swedish Riksbank and the Swiss National Bank — are announcing simultaneous, coordinated interest-rate cuts of 0.5%.

For the Fed, it’s the first leg of a three-step move down to zero percent. But on the other side of the world, in Tokyo, it has left the Bank of Japan (BOJ) stranded, virtually alone. Why? Because the BOJ already cut its interest rates to zero long ago, and it has no more room to cut.

Ironically, for years, Japan’s zero-interest policy has been derided by every other self-respecting central banker in the West as “foolhardy” or “amateurish.” Now, they’re all moving swiftly through exactly the same gateway to the same “other world” — with no plan regarding when or how to get back to normalcy.

The immediate result is that, despite the rate cuts, global stock markets are plunging, and Japan is the biggest loser, down more than 9% today.

November 24, 2008. Citigroup bankruptcy. Today marks the 110^th day since a half-million investors received our list of prime bankruptcy candidates with Citibank at the top. And sure enough, today the bank has failed. By any definition known to CPAs, financial analysts or insolvency specialists, Citigroup is bankrupt. The government, however, is again trying to redefine when “a failed bank fails.” Even while the Treasury pumps in massive amounts of bailout funds, they’re swearing up and down that Citigroup has not “truly” failed.

Early 2009. Money-printing madness. It now looks like “the failure deniers” (folks who denied that individual institutions like Citigroup, Merrill Lynch or Bank of America actually failed) had a point. But only in this sense: It’s not just Citigroup and a growing list of other banks that have gone under. It’s virtually the entire financial system that has failed, and they are that system.

Moreover, as we’re discovering now, it’s not just one bank here and there that’s getting massive federal bailout funds. It’s the entire economy: The Fed’s releases reveal that, for the first time in U.S. history, the central bank has embarked on a massive money-printing spree.

Here are the facts: Before the Lehman collapse, it had taken the Fed 5,012 days — 13 years and 8 months — to double its balance sheet (a reliable measure of how much money it has printed). In contrast, after the Lehman Brothers collapse, it has taken Ben Bernanke only 112 days to do the same. In other words, he has accelerated the pace of money printing by a factor of 45-to-1.

Imagine an Interstate highway with a speed limit of 55 miles per hour. Suddenly, a new driver appears on the scene with a jet-powered engine that accelerates to a supersonic speed of 1,350 mph. That’s the same magnitude of change Fed Chairman Bernanke has presided over since Lehman went under.

But that’s not all. Bernanke & Co. have invented and deployed more weapons of mass monetary expansion than all prior Fed chairmen combined.

The list boggles the imagination: Term Discount Window Program, Term Auction Facility, Primary Dealer Credit Facility, Transitional Credit Extensions, Term Securities Lending Facility, ABCP Money Market Fund Liquidity Facility, Commercial Paper Funding Facility, Money Market Investing Funding Facility, Term Asset-Backed Securities Loan Facility, and Term Securities Lending Facility Options Program. None of these existed before. All are new experiments devised in response to the Debt Crisis.

Back to the Present

Where does all this leave us today, ten years after the first major collapse of that era? Some highlights:

1. We’ve had eight years of zero or near-zero interest rates. Now, the big question is: What happens as rates rise again?

2. We’ve seen round after round of money printing (QE1, QE2, QE3 plus a stealth QE4) that make the first few months of post-Lehman money printing seem puny by comparison. If the Fed begins to drain some of that money from the economy, then what?

3. Businesses and investors have enjoyed a seemingly risk-free Garden of Eden, sponsored by the Fed, driving global investors away from low-yielding safety toward higher-yielding risk assets. If old and new risks rise from the ashes, where will that take investors?

4. Plus, spurred by all of the above, we have witnessed the greatest speculative bubble in government bonds of all time. Will it bust? When?

5. Who has learned the lessons of history? And what will be the ultimate consequences for those who did not?

Stand by for my answers in the weeks and months ahead.

Good luck and God bless!

Martin