Saturday, July 9, 2011
Today's essay is a bit disjointed. Normally, I try my best to talk about some part of finance I'm fairly certain most of our readers don't understand. But today, I want to talk about the structure of the world's monetary system.
The system has been under a lot of pressure since 2008. Cracks are beginning to form. And though the authorities are trying their best to "plaster over" these problems... I remain convinced their efforts will fail. These issues are the central financial questions of our time...
I'm not going to talk about complex economic theory today – at least not in great detail. All you really need to understand is this: by creating an incredible amount of credit around the world, the paper monetary system has financed decades of consumption that wasn't backed by production. Most western democratic nations have consumed far more than they've produced over the last 40 years. Their governments are trying to sustain this system because of its obvious political advantages: promising voters something for nothing is how to get elected in a modern democracy.
But... the system itself is beginning to fail because the amount of debt created over the decades can no longer be financed with accounting gimmicks or phony insurance schemes. Greece, for example, isn't facing a liquidity crisis. The nation is insolvent. That's why last year's bailout didn't work and why I don't believe the new 30-year debt extension in the news this week will work either.
So what will happen now?
Let me start by telling you about Andy Beal.
Andy Beal is a real person. He's made more than $1 billion over the last decade by simply exploiting the paper-money banking system. As you'll see... the fact that he's a billionaire suggests something is terribly wrong with our money. The ironic part? Beal would be the first one to tell you all about what's wrong with the system.
Andy Beal is a banker... on paper, anyway. But he's not really a banker at all, at least not in the way most people think of bankers. Beal doesn't offer people checking accounts or provide much in the way of retail branches. He garners most of his deposits through brokers by offering much higher interest rates than you could normally find in an FDIC-protected account. Beal Bank pays 1% annually for annual certificates of deposit, instead of 0.5% like Bank of America offers.
Beal can easily afford to pay for his deposits because he boasts a 27% annual return on equity, which is unheard of among commercial banks. This is where the story gets interesting. You see, Beal's returns would be impossible in a stable banking system.
How does he make his money? Is it with extreme leverage? Nope. His Nevada bank, for example, has 35% of its assets in cash right now. Beal uses the government (through its Federal Home Loan Banks) to get money for next to nothing. Then, he invests capital into distressed assets...
For example, after the 9/11 terrorist attacks, Beal bought up distressed airplane loans, which were fully collateralized by working aircraft. He bought some of this paper for as little as $0.38 on the dollar – and then collected at par ($1). He has made money by lending to companies in bankruptcy, so called "debtor-in-possession" loans that are always fully collateralized and essentially subordinate to other bondholders. His best year ever was 2008-2009, when he bought $5 billion of distressed mortgage securities. As he told Bloomberg: "I wish we'd done twice as much. The sky was falling."
But as you know, the sky didn't fall. Instead, the Fed and the European Central Bank pumped the world full of bailout money and manipulated interest rates so the big banks could make plenty of money. That "reflated" the system. It prevented asset prices from falling, as they would have if we lived in a world of sound money, where consumption would always balance out with production over time. That Beal always makes money and generates such huge returns shows how flawed the system has become...
Beal takes advantage of the system in two ways. First, he gets all the super-cheap funding he can get, at the lowest possible price, by using brokers to get FDIC-insured deposits and then borrowing additional capital, for next to nothing, from the Federal Home Loan Bank in Dallas. That's the easy part: Beal knows when there's a crisis, the Feds will always make sure he has access to plenty of capital.
The next part is tougher and shows you how well Beal understands the game... He only puts this capital to work when he can buy things that are distressed – when the price he's paying is far less than the underlying collateral is worth. That's exactly the same technique we've stressed (over and over and over) when it comes to buying corporate bonds.
Beal knows he can't lose money on these operations for one simple reason: the monetary authorities cannot afford for asset prices to fall. If they do fall, the entire system will collapse. After all, they're on the hook for all of Beal's deposits. Beal knows there's not ever going to be a real debt liquidation. The central banks will never allow consumption to decline to meet production. Instead, government deficit spending, manipulated demand (cash for clunkers), or bailouts (TARP, the new Greek 30-year debt, etc.) will push asset prices higher and higher. Money supply will grow. Credit will be expanded.
In this global paper standard, you can always count on the government to keep defaults from spreading too far. To make a fortune, all you need is guaranteed access to capital (the Federal Home Loan Bank line of credit and brokered deposits) and the discipline to build enough cash equity during the boom phases to load up on distressed assets during the busts.
Today, Beal's banks have shareholder equity of $3.2 billion. And he's not buying anything.
"Today's markets are being supported by a flood of money," he told Bloomberg. "There are so many lenders in a race to the bottom when things are good. We don't participate in that."
Beal knows he's gaming the system. And ironically, he despises the government. "I hate big government," he says. "I don't like the government-issued paper currency rules or the laws that require its use. But those are the rules, and I live by them."
The end game will be inflation. The whole premise of the question makes me chuckle. Show me an example in history where a paper currency gained in purchasing power as the issuing country went broke. It doesn't happen. What will happen, sooner or later, is a massive run on the U.S. dollar. I can't tell you exactly when it will happen, but I can tell you the signs of approaching trouble...
We're looking at many of them right now: Trading partners have begun avoiding the dollar for bilateral trade (Russia and China). The prices of gold and silver are soaring as central banks try to escape the U.S. dollar. Debt loads that can't be financed (in Europe, and U.S. banking system, U.S. homeowners) are creating massive economic problems. Prices for strategic commodities (copper and oil), foodstuffs, and farmland are soaring.
In the past (1979-1980, 1994), runs on the U.S. dollar were contained by increasing interest rates and reducing the growth of the Fed's balance sheet. This, in turn, reduced the money supply while increasing demand for dollars (thanks to high interest rates). While I believe such policies would work again, I wonder how we could afford them today, given the total debt in the U.S. And that's a big problem.
We might not be able to stop a run on the dollar, simply because we're broke.
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Date Range:6/30/2011 to 7/7/2011
Date Range:6/30/2011 to 7/7/2011