Smells Like 1987

Its been over two weeks since my last posting, I have been off-island for work and for holiday and just got back in last night. Lots of developments in the markets over the last couple of weeks. We saw a slight panic in all asset markets as stocks, bonds and commodities all sold off in unison before recovering last week. We have also seen the Yield Curve threaten to invert once again, but I will spare everyone from another yield curve lecture (for the people more recently added to the list, I sent out a couple of commentaries a few months back which focused on the then-inverted yield curve and what it meant for the economy - if anyone is interested, I can send those commentaries to you).

Back to the markets, while I never really thought that this correction might be the beginning of the asset price crash that I have been calling for, the thought did cross my mind a couple of times. Most notably, while in New York, the managing partner of the fund manager that we were reviewing - by the way, this guy is a Wall Street legend - was heard saying that it "Smells like 1987". While I don't think he meant that he expected a market crash in the ensuing weeks (or maybe he did), I think he, along with many others, have noted that there a lot of similarties between today's market environment and that of 1987 (I was in 9th grade, so I will exclude myself from that group).

Most notably, in 1987:

1) There was a severe correction (crash?) in the USD - which actually required a concerted effort by the G-7 to stop - this is the key factor today as well
2) You had the rare concurrence of rising interest rates and rising equity markets - this also happened in 1994 with no market dislocation
3) The U.S. budget and trade deficits were increasing rapidly (some might say spiraling out of control) - much like today
4) You had a new Fed Chief - ok, this is more of a coincedence.

While I am sticking to my projection that there will be no dislocation in the near future, there are some worrisome signs that should not be ignored. And of course any event-driven problems (Iran?) could bring the mounting imbalances to a head.

While I get back into the flow, I thought I would throw in a few random thoughts from the last couple of weeks:

Most of the risk in the U.S. stock market has been due to inflation - For the past 80 years, the risk in the Dow Jones has barely outpaced the rise in the value of gold, which serves as a good proxy for the loss of purchasing power in the USD since it was taken off the gold standard in 1913.

Look at these numbers:
Gold
October 10, 1929 - $20.63
Today - $651
Gain - 3056%

Dow Jones
October 10, 1929 - 352.86
Today - 11,278
Gain - 3096%

Of course, the Dow Jones would pay dividends (avg over time around 3.5 - 4%, but that is pre-tax and tax rates for most of the past 80 years have been quite high - up to a max rate of 90% in the 1950s). However, this return does not factor in brokerage costs for the Dow stock strategy.

Also, as Bill Fleury pointed out, the Dow suffers from survivorship bias. Meaning that as companies begin to decline in market capital, it is removed from the Dow in place of a younger, higher growth company. Therefore, a buy and hold strategy on the old 1920s Dow stocks would have given you a MUCH lower return than the one noted above.

For the sake of curiosity, here is the original list of Dow companies from 1896, only GE remains today:

· American Cotton Oil Company, a predecessor of Bestfoods, now part of Unilever
· American Sugar Company, now Amstar Holdings
· American Tobacco Company, broken up in 1911
· Chicago Gas Company, bought by Peoples Gas Light & Coke Co. in 1897 (now Peoples Energy Corporation)
· Distilling & Cattle Feeding Company, now Millennium Chemicals
· General Electric
· Laclede Gas Light Company, still in operation as The Laclede Group
· National Lead Company, now NL Industries
· North American Company, broken up in the 1950s
· Tennessee Coal, Iron and Railroad Company, bought by U.S. Steel in 1907
· U.S. Leather Company, dissolved 1952
· United States Rubber Company, changed its name to Uniroyal in 1967, bought by Michelin in 1990


Fannie Mae report - Please read the following story about the Office of Federal Housing Enterprise Oversight report on Fannie Mae which was released last week. Why has this not hit the mainline news. This is a grossly scandalous story that has received almost no media attention. Tens of millions of dollars were paid in bonuses to executives of Fannie Mae based on fraudulent accounting records. Even more so, the report showed that the IT, risk management and internal control structure of this company were neglected.

Don't people realize the implication of this, as a Government-Sponsored Entity, Fannie Mae has an implicit guarantee from the government. Any disasters at this company and it would have to be bailed out by taxpayers. Even worse, Fannie Mae is so large and so entrenched in the U.S. structured mortgage market, a failure of this company could literally cause a global financial meltdown. I don't think I am exaggerating when I say that.

May 24:Operational Risk - Report Finds Fannie Mae Criticized for Earnings Manipulation
Author: Corinne Russell and Stefanie Mullin
Date: 2006-05-24

James B. Lockhart, Acting Director of the Office of Federal Housing Enterprise Oversight, yesterday released its Report of the Special Examination of Fannie Mae. The report details an arrogant and unethical corporate culture where Fannie Mae employees manipulated accounting and earnings to trigger bonuses for senior executives from 1998 to 2004.

James B. Lockhart, Acting Director of the Office of Federal Housing Enterprise Oversight (OFHEO), yesterday released its Report of the Special Examination of Fannie Mae.
The report details an arrogant and unethical corporate culture where Fannie Mae employees manipulated accounting and earnings to trigger bonuses for senior executives from 1998 to 2004.

The report also prescribes corrective actions to ensure the safety and soundness of the company.

“The image of Fannie Mae as one of the lowest-risk and ‘best in class’ institutions was a facade,” said Lockhart. “Our examination found an environment where the ends justified the means. Senior management manipulated accounting; reaped maximum, undeserved bonuses; and prevented the rest of the world from knowing. They co-opted their internal auditors. They stonewalled OFHEO,” Lockhart said.

“Fannie Mae’s executives were precisely managing earnings to the one-hundredth of a penny to maximize their bonuses while neglecting investments in systems internal controls and risk management,” Lockhart said. “The combination of earnings manipulation, mismanagement and unconstrained growth resulted in an estimated $10.6 billion of losses, well over a billion dollars in expenses to fix the problems, and ill-gotten bonuses in the hundreds of millions of dollars.”

The OFHEO report is the product of more than two years of in-depth review involving nearly 8 million pages of documents. The report includes the following key findings:
=> Fannie Mae senior management promoted an image of the Enterprise as one of the lowest-risk financial institutions in the world and as “best in class” in terms of risk management, financial reporting, internal control, and corporate governance. The findings in this report show that image was false.
=> A large number of Fannie Mae’s accounting policies and practices did not comply with Generally Accepted Accounting Principles (GAAP). The Enterprise also had serious problems of internal control, financial reporting, and corporate governance. Those errors resulted in Fannie Mae overstating reported income and capital by a currently estimated $10.6 billion.
=> During the period covered by this report—1998 to mid-2004—Fannie Mae reported extremely smooth profit growth and hit announced targets for earnings per share precisely each quarter. Those achievements were illusions deliberately and systematically created by the Enterprise’s senior management with the aid of inappropriate accounting and improper earnings management.
=> By deliberately and intentionally manipulating accounting to hit earnings targets, senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders. Earnings management made a significant contribution to the compensation of Fannie Mae Chairman and CEO Franklin Raines, which totaled over $90 million from 1998 through 2003. Of that total, over $52 million was directly tied to achieving earnings per share targets.
+> Fannie Mae’s Board of Directors contributed to those problems by failing to be sufficiently informed and to act independently of its chairman, Franklin Raines, and other senior executives, failing to exercise the requisite oversight over the Enterprise’s operations, and failing to discover or ensure the correction of a wide variety of unsafe and unsound practices, even after the Freddie Mac problems became apparent.
=> Senior management did not make investments in accounting systems, computer systems, other infrastructure, and staffing needed to support a sound internal control system, proper accounting, and GAAP-consistent financial reporting. Those failures came at a time when Fannie Mae faced many operational challenges related to its rapid growth and changing accounting and legal requirements.
=> Fannie Mae senior management sought to interfere with OFHEO’s special examination by directing the Enterprise’s lobbyists to use their ties to Congressional staff to improperly generate a Congressional request for the Inspector General of the Department of Housing and Urban Development (HUD) to investigate OFHEO’s conduct of that examination and to insert into an appropriations bill language that would punish the agency by reducing its appropriations until the Director of OFHEO was replaced.

“As a government-sponsored enterprise, Fannie Mae has a unique position among American corporations and an extremely important mission,” said Lockhart. “It is also the second largest borrower in the world, only behind the U.S. government. As such, Fannie Mae has a special mandate and position of public trust. The previous management team violated that trust and did serious harm to Fannie Mae,” Lockhart said.

The report ends with recommendations from OFHEO’s staff to the Acting Director, which he has accepted. Some of the key recommendations include:
=> Fannie Mae must meet all of its commitments for remediation and do so with an emphasis on implementation – with dates certain – of plans already presented to OFHEO.
=> Fannie Mae must review OFHEO’s report to determine additional steps to take to improve its controls, accounting systems, risk management practices and systems, external relations program, data quality, and corporate culture. Emphasis must be placed on implementation of those plans.
=> Fannie Mae must strengthen its Board of Directors procedures to enhance Board oversight of Fannie Mae’s management.
=> Fannie Mae must undertake a review of individuals currently with the Enterprise that are mentioned in OFHEO’s report.
=> Due to Fannie Mae’s current operational and internal control deficiencies and other risks, the Enterprise’s growth should be limited.
=> OFHEO should continue to support legislation to provide the powers essential to meeting its mission of assuring safe and sound operations at the Enterprises.

The Zombie Currency

Definition of a Zombie company: In Japan, one way that banks get around the problem of writing off bad loans is by providing troubled companies with debt waivers or swapping their debt for equity. This method has been used to help the country's largest supermarket chain Daiei Corp. Analysts say this type of support is risky because it simply disguises the problem by shifting it from the company to the bank, keeping dying companies alive on minimal nourishment, and ultimately hurting competitiveness. Companies like Daiei are called "zombie companies" as it muddles along without any vigor or aim.

Now all you have to do is substitute Daiei with the USD, debt waivers with foreign currency reserves and Japanese banks with the Bank of Japan (quite possible the least competant of all Central Banks - now that is saying something). The USD perfectly fits the definition of a zombie currency.

The price action on the USD over the past 4 years (temporarily interrupted in 2005 by the Fed's tightening campaign) shows that foreign investors are losing their appetite for USD holdings. The last couple of weeks with the skyrocketing price of gold and silver along with a quick deterioration in USD in the fx markets may be warning us of an impending market dislocation.

Due to the $800 billion annual U.S. trade deficit, the global investment community has to purchase a net $2 billion + per day, every day, just to keep the USD from falling. Therefore, a slow, downward drip in the USD simply means that foreign investors are simply accumulating USD assets more slowly. If they were to actually start selling USD, then look out.

So who are these "foreign investors" that come to the rescue of the USD each and every day? Since the demand for USD assets from private investors is clearly slowing, it leaves the foreign central banks and governments. In fact, a term has been coined for these public sector investors, called "Non-Economic Players" (NEPs) - which is a euphimism for currency manipulators. These are mainly China and Japan, but include many other countries in the Middle East along with Russia, Brazil, and South Africa; maybe even Canada, the U.K. and Europe in smaller amounts.

The theory goes something like this. If the USD were to fall precipitously causing inflation, higher interest rates, lower real estate prices and general financial carnage - American consumers would no longer be able to live above their means and buy "stuff" on credit from foreign companies. This "stuff" ranges from cars to flat-screen TVs, to t-shirts, to oil, to any other gadgets or conveniences/necessities in our daily life.

To avoid this scenario where people actually have to pay for the stuff they buy, the NEPs "lend" a huge chunk of their export earnings back to the U.S. in the form of bond, equity, and real estate purchases (amongst many other types of investments). By buying these USD denominated assets in such gargantuan numbers, they artificially prop up the fx value of the USD.

And thus a zombie currency was born and perhaps a zombie economy with it.

The problem is that they are interfering with the adjustment process of the foreign exchange markets and have created unsustainable bubbles - which show up in the form of burgeoning U.S. trade deficits and the foreign reserve holdings of the NEPs. The larger the manipulations, the larger the imbalances grow - which in turn require even more manipulation.

What is the endgame? We will now see if the NEPs are willing to continue throwing away the money earned from the blood, sweat and tears of their citizens to prop up the zombie USD currency.

Of course, I have GROSSLY oversimplified this story and have not even mentioned the FED's role in this scheme. But the point of this commentary is highlight the Asian practice of creating and maintaining Zombies - besides I have hammered on Big Al and Hellicopter Ben (Bobby) enough over the past few months.

By the way, last week's article generated an amazing response. I had 25 e-mails by the time I woke up in the morning, mostly about my comments re: the housing market. This is clearly an emotional topic for many people. For further discussion, here is an article written by Mike Shedlock(http://globaleconomicanalysis.blogspot.com/) :