What seems to be continuing its long-term strength is gold. Now, I for one, have always felt that investing in gold is like shooting craps, because gold has no intrinsic value. It is only worth what people are willing to pay at the moment, and this can change for many reasons. I’ve been reading those who are gold bulls for years, and for the most part ignoring their counsel. Now, I’m feeling that gold may be a reasonable place to put some of one’s money. The primary reason for this is that the US and other countries have “printed” so much money (in their efforts to prevent the financial collapse) that the future value of currency relative to gold seems likely to continue to fall (so the price of gold in currency terms will rise).

Aside from this argument, gold has quite steadily risen in the last year (as well as previous years) even when events would argue that it should be declining. This suggests growing underlying demand.

David Rosenberg, who is a great skeptic about equities and the economy, puts the case for gold well:

GOLD GLITTERS

While the gold purchase by India’s central bank is widely viewed as the trigger point for the latest jump in the gold price, there are good reasons why bullion is in bull mode. It comes down to a fiscal policy in the U.S.A. that will stop at nothing to ensure that the economy embarks on an uptrend. Even with a fiscal deficit north of 10% of GDP, the article from yesterday’s WSJ that was titled Job-Creation Panel Leery of Spending really resonated. To wit:

“So far, the White House and Congress have been weighing a range of short-term tax ideas to spur job growth, such as expanded refunds for big companies that suffered losses; extension of a first-time homebuyer tax credit; and a new tax credit for hiring.”

So the strategy remains on “short-term” tactics as opposed to any long-run measures to improve the capital stock, enhance skills and training, bolster education and enhance productivity growth. If Milton Friedman taught us anything from the permanent income hypothesis, it was that changes to income or wealth that are perceived to be permanent have a much more beneficial and enduring effect than measures that are only transitory. But of course the other problem is who will pay for this fiscal largesse, and the answer is that nobody —the Fed will simply monetize the debt. More dollars will be printed and that is bullish for gold whose production is in secular decline.

Then we saw this article on the WSJ yesterday too, titled Labor Gets Boost In Skies, on Rails. Anyone involved in the markets, has to read this article and understand the differences between what is happening now and when the secular bull market began under Reagan administration in the early 1980s. To wit:

“Organized labor appears to be gaining the upper hand in the skies and on the rails, as labor and business battle for influence under the Obama administration.

Another reason for our bullish stance on gold is that we are not seeing the onset of a secular bull market in equities like the one we saw in the early 1980s.

The National Mediation Board wants to make it easier for thousands of airline and railway workers to unionize under the Railway Labor Act by seeking to junk a 75-year old election rule, according to a proposal published Monday in the Federal register. The move comes after a White House appointment shifted the balance of the government agency’s three-person board. Linda Puchala, a former flight attendant union leader, was selected to replace Read Van de Water, a former Northwest Airlines lobbyist, earlier this year.”

To reiterate, this is not the onset of a sustainable secular bull market in equities as we had coming off the fundamental lows of prior bear phases, such as August 1982, when:

• Dividend yields were 6%, not sub 2% currently
• Price-to-earnings multiples were 8x, not 26x
• The market traded at book value, not over two times book
• Inflation and bond yields were in double digits and headed down in the future, not near-zero and only headed higher
• The stock market competed with 18% cash rates, not zero, and as such had a much higher hurdle to clear
• Sentiment was universally bearish; hardly the case today
• Global trade flows were in the process of accelerating as barriers were taken down; today, we are seeing trade flows recede as frictions, disputes and tariffs become the order of the day
• Unionization rates were on a secular decline; today labor power is clearly on the rise
• A Reagan-led movement was afoot to reduce the role of government with attendant productivity gains in the future; as opposed to the infiltration by the public sector into the capital markets, union sector, economy and of course, the realm of CEO compensation

FINAL WORD ON GOLD

Gold broke out to a new high yesterday of $1,084/oz (and continues to rally today). It did this despite the S&P 500 managing to tick up two points and despite the DXY index actually eking out an 8bps rise to 76.3. This is NOT just a U.S. dollar story — have a look at what bullion is doing in Euro terms. Very impressive. This is a broadly based breakout and that means a durable secular bull market.
Looking at the growth rates in fiat currency that central banks are creating to stimulate their economies and the amount of bullion that would be necessary to back up this massive global monetary infusion suggests that gold can at least double if not triple from here. If you missed the first 4x runup from the $250/oz lows a decade ago, don’t worry about it. It’s like worrying about how you would have missed the first half of the rally in the S&P 500 from 1982 to 1992 when the index was at 400 and still had 300% to go before finally peaking out and sputtering at the 1500+ highs eight years later. In other words, the cup is still half full — and still can be filled with gold eagle coins.

Another investment source, Prieur du Plessis, who I respect, makes the case for gold from another perspective:

Gold bullion surging in all currencies

I argued the bull case for gold in my posts over the past few months (see “Gold bullion – regaining its shine?“, “Gold bullion glitters bright” and “Gold bullion – challenging $1,000“. With the gold price scaling fresh peaks and closing in on $1,100, it would certainly seem as if renewed interest in the yellow metal is being stirred up, especially subsequent to the purchase by India’s central bank of 200 metric tons of gold from the International Monetary Fund.

As printing presses are running at full speed to produce ever-increasing quantities of fiat money as governments engineer the greatest asset price reflation in human history – and the US greenback is heading South – the longer-term fundamental case for the yellow metal is arguably positive.

“The gold bug has caught several big hedge fund managers this year including John Paulson of Paulson & Company, Kyle Bass of Hayman Advisors and David Einhorn of Greenlight Capital, who believe enormous monetary and fiscal stimulus that has been injected into the global economy will eventually result in hyperinflation,” said The New York Times.

The gold price is not only making headway in US dollar terms, but also in most major (and minor) currencies as illustrated by the table and graph below. This is a manifestation of increased investment demand, whereas the initial rise in the gold price from its low in 2001 ($250) was mostly a reflection of US dollar weakness.

…

The shorter-term technical picture is also looking interesting. This is explained by Adam Hewison of INO.com who prepared a short technical analysis of gold’s most likely direction and key chart levels. Click here to access the video presentation.

Seasonally, the period from November to December has traditional been good for gold, with average gains ranging from more than 1% to almost 2.5% since 1970.

Source: Plexus Asset Management

I remain bullish on gold in the medium term, especially as I believe the vast money printing by central banks could set off strong inflation pressures down the road. I will not be surprised to see bullion remaining in a secular uptrend in the medium term. Add bullion to your portfolios, but given the notorious volatility of the metal only do so on pullbacks. (Emphasis added.)

Full Article

I stress the last sentence in Mr. Plessis’s article, because even thought the trend is strongly upward, there is a lot of volatility in price. Buying now, after such a sharp rise entails the risk of a fall. On the other hand, gold fever seems to be spreading quite broadly, which could lead to near-term sharp rises.

The simplest way to invest in gold is the buy GLD through a stock broker. This is an exchange traded fund that holds physical gold equal to the value of the outstanding shares; so it is relatively secure, and it is very actively traded.

A final warning: my timing has been less than sterling in the last year; so my coming to feel gold is a reasonable investment (among a set of relatively bleak choices) could be a good contrary sign.

If we were to continue the path of the Great Depression, real economic activity would have still a lot further to fall, and the stock market, though it has fallen a lot this time, would still have another 50% decline to go. Still, if the Great Depression is a guide, the stock market now is well below the level it was at the same relative point in time.

To me, the real question that these charts raise relates to the effectiveness of the fiscal and monetary measures that have been taken this time. Here are some comparison charts:

Clearly, short-term interest rates were lower initially and have since been pushed down to unprecedented levels.

The money supply, which is another indicator of monetary policy, is shown starting 4 years before the downturn (unlike the prior charts):

The authors comment on this chart:

Figure 5 shows money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases. Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.

Fiscal policy, as represented by government surpluses or deficits, is shown again starting 4 years before the downturn.

While monetary policy is wildly different than following 1929, fiscal policy is much less radically different. If we look at year 5 (2009), the fiscal deficit is about 2% of GDP. In 1930, it was zero; but 2% of GDP is not very significant. In 2010, the deficit is projected to be much larger, over 5%, compared to still zero in 1931.

The burning question is whether these differences are enough to push the world economy onto a different, more positive path than occurred in the 1930’s. There are certainly skeptics, especially followers of the Austrian school of economics. The current prevailing view, though, is that these measures, plus more that will be tried if these seem inadequate, will succeed. This seems overly sanguine to me. Rather, I think it is best to view us as in the midst of a grand economic experiment on the largest scale ever tried. Experiments, by their very nature, have uncertain outcomes.

We have already seen one part of the policy armada begin to come apart: the pushing down of long-term interest rates in order to make mortgages cheaper and house purchases more affordable. In the last month, the market has turned sour on US Treasuries. Yields on ten-year Treasuries have risen remarkably this year. The yield on the benchmark 10-year Treasury due May 2019 ended last week at 3.83 percent, up from the low this year of 2.14 percent on Jan. 15 (Bloomberg). Rising long term Treasury yields have pushed up mortgage rates from a low of 4.75% just a little over a month ago to a current 5.45%.

The rise in Treasury yields is being attributed to the massive deficits (the flip side of the economic stimulus). The federal government is going to need to sell $2 trillion of bonds to cover the deficit. There is skepticism in the market that this amount will be saleable at current yields, especially given the concern that all of the monetary measure will lead to inflation. Clearly, not everything is under the control of central government policy makers.

I would hesitate now to rush to implement his investment recommendations (see Will the Rally Ever End). His analysis is best viewed as a basis for long-term strategy, not for short-term trading. In general, by the time that big investors publicly announce their strategies, they and their colleagues have already acted on them.

Investment Outlook

Bill Gross | June 2009

Staying Rich in the New Normal

…

The current annual deficit of $1.5 trillion does not even address the “pig in the python,” baby boomer, demographic squeeze on resources that looms straight ahead. Private think tanks such as The Blackstone Group and even studies by government agencies, such as the Congressional Budget Office, promise that Federal spending for Social Security, Medicare, and Medicaid will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these three programs represent an approximate $40 trillion liability that will have to be paid. If not, you can add that present value figure to the current $10 trillion deficit and reach a 300% of GDP figure – a number that resembles Latin American economies such as Argentina and Brazil over the past century.

So the rather conservative U.S. government debt ratio shown in Table 1 will likely be anything but in less than a decade’s time. The immediate question is who is going to buy all of this debt? Estimates suggest gross Treasury issuance of up to $3 trillion this calendar year and net offerings close to $2 trillion – almost four times last year’s supply. Prior to 2009, it was enough to count on the recycling of the U.S. trade/current account deficit to fund Treasury borrowing requirements. Now, however, with that amount approximating only $500 billion, it is obvious that the Chinese and other surplus nations cannot fund the deficit even if they were fully on board – which they are not. Someone else has got to write checks for up to $1.5 trillion additional Treasury notes and bonds. Well, you’ve got the banks and even individual investors to sponge up some of the excess, but a huge, difficult to estimate marginal supply will have to be bought. The concern is that this can be accomplished in only two ways – both of which have serious consequences for U.S. and global financial markets. The first and most recent development is the steepening of the U.S. Treasury yield curve and the rise of intermediate and long-term bond yields. While the Treasury can easily afford the higher interest expense in the short term, the pressure it puts on mortgage and corporate rates represents a serious threat to the fragile “greenshoots” recovery now underway. Secondly, the buyer of last resort in recent months has become the Federal Reserve, with its publically announced and near daily purchases of Treasuries and Agencies at a $400 billion annual rate. That in combination with a buy ticket for over $1 trillion of Agency mortgages has been the primary reason why capital markets – both corporate bonds and stocks – are behaving so well. But the Fed must tread carefully here. These purchases result in an expansion of the Fed’s balance sheet, which ultimately could have inflationary implications. In turn, nervous holders of dollar obligations are beginning to look for diversification in other currencies, selling Treasury bonds in the process.

The obvious solution to both dollar weakness and higher yields is to move quickly towards a more balanced budget once a sustained recovery is assured, but don’t count on the former or the latter. It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect “new normal” GDP growth rates of 1%-2% not 3%+ as we used to have. Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets. Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. Staying rich in the “new normal” may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn’t as much concerned about the return on his money as the return of his money.

William H. Gross
Managing Director

In a wide-ranging interview recorded by Bloomberg Television, Mr. Faber touched on a wide variety of subjects. Below is a link to the video. Note that although the headline emphasizes the downside of his remarks, it is out of context. In context, he says the correction would be a prelude to a further rally.

Play video

This is a major shift in outlook from a person who has an admirable track record.

George Soros was an early and avid supporter of Barack Obama, so it’s probably no surprise he gives the President high marks for his handling of international affairs, the stimulus package, the budget (the famed financier calls it "very courageous") and for "stabilizing" the financial crisis.

But President Obama "lost a great opportunity" by not taking a more radical approach in dealing with the banks, Soros says. "There’s too much continuity with the bumbling and mishandling by the previous administration. Not enough discontinuity."

Specifically, Soros wanted Obama to "come out of the gate with a well considered plan" to recapitalize the banks, rather than continuing with the TARP and related bailouts. But the President may have been hampered by his desire to create consensus, Soros says. "The nature of far from equilibrium situations is that public understanding is always lagging behind events. If you’re guided by desire to have consensus, you’ll always be a little bit slow."

Mr. Soros focuses less than I on the inequity of taxpayers bailing out bank investors. His concern is more on the ineffectiveness of propping up Zombie banks, instead of forcing recapitalization. He is not, however, any happier than I at the lost opportunity.

Below are links to all of the interviews, with the last in the series listed first:

 

• Americans Were "Living in a Fool’s Paradise" That’s Gone Forever, Soros Says
• Soros: Obama "Lost a Great Opportunity" to Fix the Banks
• Soros Says Fed in a Bind: Beware Stagflation, Bursting of Bond Bubble
• Soros: Dollar’s Strength a Measure of System’s "Sickness"; Euro Will Remain Viable
• Soros: "Danger of Collapse Has Passed," But Stock Rally Not Sustainable
• Soros "Very Concerned" About Global Unrest, But Sees Positive Signs in Russia

Reuters

Wed Dec 17, 2008 7:08am EST  — John Kemp is a Reuters columnist. The views expressed are his own —

Fed unleashes greatest bubble of all

By John Kemp

Like the sorcerer’s apprentice, Federal Reserve Chairman Ben Bernanke and his predecessor Alan Greenspan have unleashed a series of ever-larger asset bubbles they cannot control.

Now the Fed’s decision to cut interest rates to between zero and 0.25 percent, coupled with a promise to  keep them there for an extended period, and the threat to conduct even more unconventional operations in the longer-dated Treasury market risks the biggest bubble of all, this time in the U.S. government debt.

THE ASYMMETRIC EXPERIMENT

Bubble mania is no accident. It is the direct consequence of the Fed’s asymmetric response to shifts in asset prices. Pressed to "lean against the wind" and adopt counter-cyclical interest rate and credit policies in the asset market, senior Fed policymakers have repeatedly demurred.

Led by Bernanke and Greenspan, officials have argued it is too hard and subjective to identify bubbles until afterwards, and not the Fed’s job to second-guess asset allocation decisions of professional investors.

Even if bubbles could be identified, they argue, pricking them would require swinging rate rises that would inflict widespread damage on the rest of the economy.

Far less damaging to allow asset markets to follow their natural cycle and stand by to cut interest rates sharply, supply liquidity and contain the fallout when the bubble bursts.

But the Fed’s asymmetric policy response to rising and falling asset prices (colloquially known as the "Greenspan/Bernanke put") directly led to much of the excessive risk-taking which has humbled the financial system over the last eighteen months.

More importantly, the Fed’s decision to respond to the collapse of the technology and stock market bubble by lowering rates to 1 percent and holding them there for an extended period is now widely accepted as a mistake that contributed to the bond bubble and subsequent housing market boom in the middle of the decade.

If the low-rate strategy was a mistake, it was a conscious one. In testimony to the UK Parliament last year, former Bank of England Governor Eddie George admitted the bank had deliberately sought to stimulate the housing market and house prices to support consumption during the downturn. Greenspan, Bernanke and Co seem to have adopted a similar approach in the United States.

The real mistake, however, was not creating one bubble to offset the collapse of another, but believing they could control what they had wrought.

When the Fed did eventually start to raise short-term interest rates in 2004, long rates remained stubbornly low for a year, and then rose much more slowly than anticipated, a development the puzzled Fed chairman and his able assistant Dr Bernanke described as "the Great Conundrum."

Even as rates eventually rose, the alchemy of securitization ensured the real cost of credit remained far too low until the subprime bubble finally burst in late 2007.

The second mistake is a basic design flaw in the Fed’s "risk-management" approach to setting monetary policy. Risk management is a nice idea, but not terribly useful. As engineer will explain, risk management involves trade offs and is not cost-free.

The Fed has struggled to formulate a response to "low probability, high impact" events such as the threat of deflation in the early 2000s. Its response has been to cut rates aggressively to ward off the danger of extreme downside events, a strategy officials liken to taking out an insurance policy.

That’s fine, but when these low risk events have not in fact occurred, as was never statistically likely, the resulting policy settings have proved far too loose, and the central bank much too slow to change it.

Concentrating on theoretical but small risks such as deflation has too often blinded the Fed to much larger risks near at hand of bubbles and asset inflation.

INTO THE UNKNOWN

Even as officials recognize policy has played a role stimulating an endless series of bubbles, the Fed finds itself trapped with no way out. Following the collapse of much of the modern banking system, the risk of pernicious deflation is now very real–more so than in the early 2000s.

So like the sorcerer’s apprentice, the Fed has cranked up the Great Bubble Machine for what policymakers hope will be one final time.

The Fed’s "unconventional" monetary strategy comes in four parts:

(1) Cutting interest rates to near-zero to lower the cost of borrowing.

(2) Injecting short-term liquidity into the financial system in the form of bank reserves (quantitative easing).

(3) Trying to pull down yields on longer-dated Treasury bonds through a combination of the jawbone (promising to keep short rates low for an extended period) and the threat to intervene in the market directly by buying longer-dated paper.

(4) Trying to reduce credit spreads above the Treasury yield for other borrowers, and increase the quantity of credit available, by buying mortgage-backed agency bonds for its own account, and financing other market participants to buy securities backed by other consumer credits, auto loans and student loans.

Most attention has focused on the zero-rate policy and quantitative easing at the short end of the curve. But the real significance lies in the unconventional operations targeting Treasury yields and eventually credit spreads at the long end.

Operations at the short end are designed to bolster the banking system and restart lending. But the Fed knows the banking system is not large enough to replace the much more important sources of credit from securities markets.

Operations at the long end are designed to get bond finance and securitized credit flowing. Short-end interest rates and quantitative operations are significant because they help shape the whole term structure of interest rates embedded in the curve.

ONE LAST SUPER-BUBBLE

The strategy has already succeeded in halving yields from over 4 percent in mid October to just 2.25 percent now.

By convincing investors interest rates will remain ultra low for a long period, the Fed has made them willing to lend to the U.S. government for up to ten years for what is a paltry return.

There are two risks. First, the massive rise in bond prices and compression of yields has come in the secondary market. The U.S. Treasury has not yet succeeded in placing much of its massively expanded debt and new requirements for next year at such low levels. But given the panic-driven demand for default-free assets, officials should not have too much difficulty.

The bigger one is that the Fed is misleading investors into the biggest bubble of all time. Bernanke is making what learned economists call a "time-inconsistent" promise to hold interest rates at ultra low levels for an extended period.

The problem is that if the unconventional monetary policy works, and the economy picks up, the Fed will come under pressure to "normalize" rates and reduce excess liquidity to prevent a rise in inflation. The resulting rate rises will inflict massive losses on anyone who bought bonds at today 2.25 percent rate.

Bizarrely, Bernanke and Co are in fact inviting investors to bet the policy will fail, the economy will remain mired in slump for a long period, deflation will occur and interest rates will remain on the floor, as Japan’s have done since the 1990s.

Buyers of real estate and subprime securities have recently been lampooned for foolishly overpaying at the top of the market. Bernanke and Co are gambling memories will prove short and investors will prove just as eager to pay top prices for long-term government and private debt even though the downside is large.

Let us have one last bubble, and when it collapses, we promise not to do any more in future…honest.

© Thomson Reuters 2009 All rights reserved

"Why should I care?" would be an understandable response to this topic. Inflation/deflation seems pretty far removed from concerns about economic and/or financial collapse. In truth, though, they are very central to the policies being pursued by the Federal Reserve. As you are likely to be aware, Mr. Bernanke has been anything but restrained in expanding the debt of the Federal Reserve and taking other measures aimed at expanding the money supply and keeping interest rates low. He has been explicit that much of his motivation is to avoid deflation, a falling off of prices. In his view, deflation is a specter so fearsome as to be avoided at all costs.

Why, you may wonder, is deflation such a bad thing? I have wondered the same thing myself. The underlying reason, it turns out, is the same reason that we are having a financial/economic crisis — the huge over-expansion of debt. As the economy contracts, many of those debt holders become hard pressed to pay back their debts. If prices decline, the burden of debt becomes even larger, because one needs to pay back with dollars that are harder to earn. Conversely, inflation has the opposite effect.

Consider, if inflation goes on at 3% per year, each year, one’s profits will increase by 3% per year just as a result of the inflation (leaving aside possible real effects on profits). In 10 years, due to compounding interest, $1 million of debt today will be able to be paid back in ten years for $750,000 of today’s dollars (which will increase due to inflation to the $1 million owed). Conversely, if prices decline by 3% per year, $1 million of debt today will take $1.34 million of today’s dollars to pay back ten year’s hence.

If deflation sets in, it makes outstanding debt burdens more onerous, and it also discourages taking on new debt for investment because the deflation effectively raises the interest rate. The Federal Reserve can’t lower interest rates below zero; so monetary policy is limited in its scope. Less investment will contribute to pushing the economy downward, which can then contribute to further deflation — and so on.

Mr. Bernanke believes that the deflation cycle was one of the major contributors to making the 1930′s depression so severe, explaining why he is so dedicated to preventing its recurrence.

Not everyone is so sure Mr. Bernanke is right or that he will achieve his goal of preventing deflation. Perhaps an even larger number believe that even if he is able to prevent deflation, he is doing so only at the cost of creating an unavoidable much larger inflation in the future. Mr. Bernanke answers such critics by saying that when the time comes, when the economy begins to expand, he will "mop up" all of the excess money in the system so that inflation won’t occur.

Who is right about this is not just an academic question. The huge increase in Federal Reserve debt, plus the huge increase in Treasury debt to finance the big federal deficits, are not matters of debate. They are fact. These create pressures toward higher interest rates for government bonds. However, the Federal Reserve to date has succeeded (or had "good fortune") to have very low interest rates for Treasury bonds.

If we have deflation, Treasury interests rates, although low, may persist or fall further, making Treasury bonds a good investment. Conversely, if serious inflation occurs, interest rates will follow suit and the price of such bonds will fall substantially. Whether bond prices will rise or fall in the future is a key question for all of those who now own the $6 trillion of publicly held U.S. debt.

As The Federal Reserve’s policies are official policy, they receive a great deal of media coverage of the rationale for them. Less coverage is provided to opposing views. I, therefore, concentrate on providing space for opposing, and to me very credible, critiques.

The first one in the series is from Reuters’ columnist John Kemp on the inherent contradiction of the Federal Reserve’s current efforts to push down and keep down long-term government bond interest rates.

[I hoped that] Obama would bring a fresh perspective to managing our economy, one that would provide for rebalancing the economy as well as the distribution of income. It is not just who get the money (although this needs to change), but what as a nation we choose to produce and consume. To make changes in the latter, we need to redistribute political and economic power. In Obama’s actions on the financial crisis, there is no evidence that he saw it as an opportunity to accomplish some of this redistribution. This is not encouraging for the future.

Since writing this, I watched Obama on the Jay Leno Show and on 60 Minutes. If you haven’t watched these, and have the time to spare, both of these provided very worthwhile insights into Obama’s understanding and approach toward addressing the financial economic plight.

What stood out for me were the following:

Obama spent most of his time on educating viewers about the origins and magnitudes of the crisis — and on the constraints and limitations the administration faces in attempting to resolve them. He made a good case for the approach taken in the Geithner-Obama plan — though he never really explained why the failing banks were not allowed to go into a restructuring process that would have lessened taxpayer risks.

Obama stated very directly that the bloated financial sector size and profits are not good for America.

He mentioned the unreasonable compensation of top people in the financial companies. He noted how in 1980, they earned 20 times average compensation, not the 200 times of recent years. The higher number is clearly unreasonable, he said. He said that the problem goes beyond the bonuses paid but to the excessive level of compensation in general (and perhaps, though I don’t recall exactly, he extended this beyond financial firms to corporations in general).

Further, it is not in our long-term interest to have all of the brightest people training for Wall Street. It would be better if they trained to become scientists, engineers, and others who would help the "real" economy.

He specifically mentioned that the financial sector didn’t produce "real" goods that people need, such as housing, automobiles, etc., and that we need to rebalance the economy away from the financial sector.

Obama’s understanding of the situation and his statement of values about what counts were reassuring. Though I still have issues with the latest bailout plan, I am more optimistic that he will address the problems of the disproportionate influence of the financial sector, and that he will work to move our economy toward types of production that will be to the long-term benefit of the people.

Even more redemption occurred when Geithner addressed Congress and laid out the regulatory reform requests of the Administration. This will be a major, fundamental reform in regulation of financial firms. For the first time, the government would have strong powers over firms such as AIG and other insurance firms. Hedge funds will no longer be able to operate in obscurity. The infamous unregulated derivatives will be regulated. Financial tax havens, such as the Cayman Islands, where big financial firms have operated outside of public scrutiny and government oversight, will no longer be exempt from government efforts to gain control.

In his appearance before the Banking and Oversight Committee, Geithner was strong and direct. He first summarized and acknowledged the failure to prevent the financial crisis. He then said,

To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game…

We need much stronger standards for openness, transparency, and plain, common sense language throughout the financial system. And we need strong and uniform supervision for all financial products marketed to consumers and investors, and tough enforcement of the rules to ensure full accountability for those who violate the public trust.

Financial products and institutions should be regulated for the economic function they provide and the risks they present, not the legal form they take. We can’t allow institutions to cherry pick among competing regulators, and shift risk to where it faces the lowest standards and constraints. [This is a major, current regulatory failure, where financial institutions incorporate in states or countries with minimal regulation. Roylat]

And we need to recognize that risk does not respect national borders. We need to prevent national competition to reduce standards and encourage a race to higher standards. Markets are global and high standards at home need to be complemented by strong international standards enforced more evenly and fairly. These are global markets and challenges. Building on these principles, we want to work with Congress to put in place fundamental reforms that create a stronger, more stable system, with much stronger protections for consumers and investors, and a more streamlined, consolidated, and simple oversight framework.

Geithner went into detail in each of these areas. His entire testimony reinforces the messages of the summary.

Taken together, Obama’s communications and the proposed regulatory reforms, demonstrate that the financial companies are not going to simply be re-inflated and allowed to return to their predatory ways — at least until memories of 2008 and 2009 fade away. Let’s hope that is a very long time in the future. At least for the near future, the prospect seems good that the power of the financial sector is going to be seriously downsized.

The Wall Street Journal story goes into depth. For those that can follow it, it provides a fascinating education on how these supposedly sophisticated organizations badly mispriced risk, and how other predatory financial concerns took advantage to reap billions in profits (which would not be realized if the government had not stepped in with taxpayer money to make the bets good).

I can see no public justification for making whole gigantic gambles on the failure of the U.S. economy. When gamblers are dealing with gamblers, caveat emptor should certainly apply. Bailing out the losers so they can pay the winners provides no public benefit.

Here is the article in full. It is worth trying to work your way through it.

Hedge Funds May Get AIG Cash

Some Bailout Money Is Set Aside to Pay Firms That Bet Housing Market Would Crater

By SERENA NG

Some of the billions of dollars that the U.S. government paid to bail out American International Group Inc. stand to benefit hedge funds that bet on a falling housing market, according to people familiar with the matter and documents reviewed by The Wall Street Journal.

The documents show how Wall Street banks were middlemen in trades with hedge funds and AIG that left the giant insurer holding the bag on billions of dollars of assets tied to souring mortgages. AIG has put in escrow some money for at least one major bank, Deutsche Bank AG, whose hedge-fund clients made bets against the housing market, according to a person familiar with the matter. The money will be released to the bank if mortgage defaults rise above a certain level.

In essence, while the U.S. government is busy trying to prop up the housing market — by trying to limit foreclosures, among other things — it is simultaneously putting up cash that could be used to pay off investors who bet housing prices would tumble and many mortgage holders would default.

It’s unclear how much government money might eventually flow to hedge-fund investors. Overall, the government has committed up to $173.3 billion to bail out AIG. Of that amount, AIG’s housing-related bets have cost U.S. taxpayers some $52 billion.

The investment strategies involved are perfectly legal maneuvers. Still, the losses show how AIG strayed from its core business: selling standard insurance policies to businesses and individuals to protect against everything from fires to lawsuits. "AIG’s financial-products division went heavily into the business of speculation, and its gambling debts are what taxpayers are paying off right now," said Martin Weiss of Weiss Research, an investment consultant in Jupiter, Fla.

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An AIG spokeswoman declined to comment, as did a spokesman for the Federal Reserve Bank of New York.

The transactions worked like this: Investment banks such as Goldman Sachs Group Inc. and Deutsche Bank sold financial instruments to hedge funds letting them bet that mortgage defaults would rise. These instruments were credit default swaps, a form of insurance that pays out in the event of a debt default.

It is not known which hedge funds made those bets with specific banks. However, several large funds made big, ultimately profitable, wagers that mortgage defaults would increase.

Many of the assets AIG insured were tied to subprime mortgages. The deterioration of those high-risk mortgages, along with AIG’s own financial woes, forced the insurer to put up billions of dollars in collateral, mostly to the banks that were its trading partners. AIG sold protection on securities backed by physical assets, as well as on positions almost entirely backed by other financial bets.

Some of the U.S.-government exposure traces back to the hedge funds that spotted problems in the U.S. housing market in 2005. They wanted to "sell short" — or bet against — securities backed by mortgages to questionable borrowers. These hedge funds entered into trades with investment banks. The banks then used a complex set of financial maneuvers to pass on some of the risk of those trades to AIG and other insurers.

The transactions meant that AIG was wagering that the U.S. housing market would remain robust. With housing markets now in free fall, the hedge funds stand to collect money from their bank counterparties. AIG is, in turn, compensating the banks.

The banks that had sold credit default swaps to the hedge funds wanted to turn around and hedge their own risks. But finding that protection wasn’t easy.

So at Deutsche, the German bank’s securities arm created a handful of offshore companies known as collateralized debt obligations, or CDOs. These companies carried a series of exotic names, according to securities filings, mostly based around the moniker "START," short for STAtic ResidenTial CDO. They allowed Deutsche to neutralize its exposure to the hedge funds’ bets by buying swaps from START on the same securities its clients were betting against.

START held assets from a hit parade of lenders closely linked to the subprime crisis, including Bear Stearns, Countrywide Financial and New Century Financial, according to documents reviewed by the Journal.

In 2005, Deutsche found a willing taker for a chunk of the mortgage risks held by START: AIG Financial Products. The derivatives arm of AIG agreed to pay out up to $1 billion under two of the START vehicles, if underlying assets deteriorated or the insurer’s own credit rating fell below a certain threshold. AIG stood to earn a fraction of a penny each year for every dollar of protection it sold, according to securities filings, meaning it made less than $10 million annually on the $1 billion in insurance.

Up until AIG exited the market in 2006, "AIG was by far the single largest ultimate taker of risk in the [subprime mortgage] CDO space," says a senior investment banker whose firm bought credit protection from the insurer.

Last fall, after AIG’s credit rating was cut, the insurer paid roughly $800 million to START, according to two people familiar with the matter. Much of the money is being held in escrow and will be used to pay off Deutsche’s swap contracts if mortgage defaults in the portfolio rise above a certain level. Some of that money could go through Deutsche to its hedge-fund clients.

 

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If the housing market improves, AIG could recover some or much of the cash it transferred to START. But that outcome won’t be known for years. The portions of START to which AIG is exposed were originally rated triple-A by Standard & Poor’s. They’ve since been downgraded to "junk" status by the ratings firm.

The START CDOs share some similarities with mortgage pools created by Goldman named "Abacus" and also insured by AIG Financial Products, according to people familiar with the matter.

These pools were made up of credit-default swaps tied to individual mortgage securities. AIG had to post collateral to Goldman when the assets dropped in value. Some of this money, too, could go to hedge-fund clients of Goldman.

From mid-September to the end of last year, AIG and the government paid $5.4 billion to Deutsche and $8.1 billion to Goldman under credit default swap contracts the insurer had written.

A spokesman for the German bank said, "Our exposure to AIG was well-collateralized and hedged." A Goldman spokesman also said his firm’s exposure was collateralized and hedged.

Write to Serena Ng at serena.ng@wsj.com

Printed in The Wall Street Journal, page A1

Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved

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It is striking how well the returns of various asset classes march downward along the line of increasing risk or volatility, as measured by the time-variance (standard deviation) of the prices of the assets. The market does a pretty good job of pricing the risk of different assets.