The administration’s 88-page “white paper,” released last Wednesday (June 17), goes a long way in identifying most of the weak links in the regulatory chain that was supposed to protect America from a financial freefall. But, as always, the devil is in the details.

In 85 of those 88 pages, extensive fixes are put forth in an attempt to create additional financial institution transparency, to bolster consumer protections and to enhance supervisory oversight. But, in fewer than four of those pages, without any detail, the white paper calls for a  “regime” to “provide for the ability to stabilize a failing institution by providing loans, purchasing assets from the firm, guaranteeing the liabilities of the firm, or making equity investments in the firm.”

The blind spot in the need to create such a “regime” if it isn’t intentional – is the missed assumption that all of the reforms supposed to constitute “A New Foundation” will still not be enough to arrest the failure of systemically important firms. The black spot on the administration and legislators’ records may ultimately be their complicity in not breaking up so-called “too-big-to-fail” institutions, Instead, the current and past administrations and elected officials coddled these firms and allowed them to continue to grow in both size and influence, to the point that they became large enough and important enough – as well as frail enough – to end up as assets in an American-style, taxpayer-funded sovereign wealth fund.

A Threat to the Economy’s Free-Market Foundation

Democratic capitalism – the foundation of our economic system – has two inherent characteristics that, if left unimpeded by government interference, result in almost-certain economic success. The first is the ideal of free markets and the other is the notion, popularized by Austrian economist Joseph Schumpeter, of creative destruction. Building from the foundation is a straightforward process: Free markets will themselves engender creative destruction, maximizing the ability of innovative entrepreneurs to destroy the hegemony of existing companies by creating and delivering new and better products and services to a free-to-choose public. Government coddling or the takeover of failing institutions destroys both of these foundational principles.

Keeping our eyes on the prize necessitates not impeding free markets or the process of creative destruction. And while prudent regulation is absolutely necessary to check and arrest the ever-present bad seeds from choking our field of dreams, allowing the pendulum to swing too far in the direction of government control subjects the democratic capitalist model to attack by socialist influences. And that assault is already underway.

In the face of financial devastation in America and throughout the world, government intervention has been a welcome intrusion meant to lessen the pain of lost savings, foreclosed homes, violated security, broken dreams and the horrendous fear that many of us will never rise out of the hole created by the implosion of trusted systems we rely upon for our way of life.

The danger now is that welcoming the seeming suave of government intervention may embolden some misguided politicians and the vested-interest big-government/big-money crowd to permanently corrupt our once free markets. Government intervention has the potential of destroying the creative processes by undermining entrepreneurs and small businesses to protect an emerging and quickly growing portfolio of government-controlled assets.

If it’s not intentional, why does the administration’s regulatory reform package lead us directly down this path?  By leaving in place discredited supervisory bodies and the failed regime of ineffective regulatory officers and soldiers, does the assured future failure of protected and coddled firms signal a policy paradigm shift towards more government intervention, control and ownership of giant, systemically important firms? Are we headed towards a more socialist economic model?

I brought these concerns to Bill Singer of BrokeAnd Broker.com, a partner at powerhouse law firm Stark & Stark, a veteran regulatory lawyer, staunch advocate for the rights of smaller broker-dealer firms, registered persons and defrauded investors, and a regular commentator on television and Forbes.com panelist.

“Look, I’d love to rail against creeping socialism and state capitalism, and you may well be right – that may be the sad legacy,” Singer said. “While it would be expedient to say that I don’t like it (and, frankly, I truly don’t), I like the concept that someone, somewhere has a cord to pull in the event of an emergency – the problem is whether there is anything at the end of that line when it’s pulled, or whether it merely sets off a series of contingency steps that will only reach some final stage long after the harm is done.”

When Too-Big-To-Fail Becomes Too-Big-To-Succeed

Whether it is an intentional shift towards a more socialist economic model, or the drift from the fallout of well-intended government assistance to save jobs, firms or industries, there’s an easier, more familiar and well-proven path that should be cleared and undertaken. Start by looking backwards. If too-big-to-fail firms constitute systemic threats, don’t allow firms to get too big. It really is that simple. There is no need and no place for socialist tendencies in this country if we already know that free markets create a level playing field for all willing participants and then take steps to make sure that they are not crowed out by vested interests that are backed and protected by the government.

Regulatory reforms must ensure that free markets remain free. Part of what’s necessary is to reform the tendencies of firms to overdo the concept of economies of scale. Bigger isn’t always better if it crowds out the processes of creative destruction, the drain in the tub that can overflow and undermine the floor and foundation of democratic capitalism.

It was big banks, big super-regional banks, big investment banks and big mortgage originators that deposited us into the economic sinkhole in which we’re presently mired. Community banks and small loan originators didn’t conceive of the weapons of mass destruction, but they were forced to compete with the big brothers of business by engaging in many of the same practices and investments as a way to remain competitive or be destroyed by the sprawl of bigger, bolder, and badder brethren. Why not disallow firms to get so big they swallow or destroy all competition?

To those that argue that larger and better-capitalized foreign firms will command the high ground, I say nonsense. If we want to compete with outsized international firms, we already have a mechanism to do that. For example, banks already syndicate large loans. By having even more banks participate in syndicated loans, it spreads the credit risk across a wider array of institutions. And maybe if our automotive industry hadn’t been allowed to get so large and cumbersome, we’d have more auto firms offering more innovative products and supporting a more robust industry of manufacturers, dealers and suppliers.

There’s a Way, But is There the Will?

Of course, without being overly protectionist, prudent legislation and regulation could easily control the sprawl of overly ambitious monster foreign interests. As politicians look at the power and potential of sovereign wealth funds, there may well be an inclination to compete with them by facilitating America’s own version of such a fund. Without enunciated exit plans from the asset control and ownership now enjoyed by the U.S. government, we’re going to move in that direction. A U.S. sovereign wealth fund can carry another name – state capitalism.

By keeping the old guard on duty and only giving them new binoculars, we may well see the next set of failures on the horizon – but will be powerless to stop them. Whether intended or unintended, the result will be the destruction of free markets and entrepreneurship.

We would do well to express our outrage at the prospects of such an outcome long before the debate goes behind closed doors and we end up with an oligopoly run by a cadre of self-serving officers.

Or, as best put by Singer, the veteran regulatory attorney: “Unless we are prepared to clean house – to purge ourselves of the majority of politicians now in power and to substantively overhaul the boards of directors of most public companies into meaningful, hands-on overseers, then we’re just deluding ourselves,” he said. “This isn’t merely a battle to re-start American capitalism; it is a battle for the heart and soul of our way of life.  While it would be popular to suggest that we still have a fighting chance, I think we also need to wonder whether we have the political will to implement the wholesale changes that are necessary.”

Source: Is the Obama Administration’s Financial System Overhaul Pushing Us Toward State Capitalism?

Unfortunately, the facts prove otherwise.  Three months before the recession was officially declared, Paulson and Bernanke have embarked on the largest bailout program ever conceived with the blessing of a lame-duck president and a complicit Congress – a program which so far will cost taxpayers $8.5 trillion. This staggering sum encompasses:  loans backed by worthless assets ($2.3T), equity investments in bankrupt companies with negative net worth ($3.0T), and guarantees on crumbling derivatives and other hollow collateral ($3.2T).

Back in September I was stunned that Paulson was able to make his case and win the support of Congress for a $700 billion bailout package (more than the total war spending in Iraq to date).

How could Americans (or more accurately, their representatives) agree to give such a broad mandate with so few checks and balances?  Have we become completely numb?

While I realize that many of our compatriots have been running large credit card balances and interest-only mortgages with little thought as to how they would repay their debt, one would expect a little more restraint when dealing with the financial future of the largest economy in the world.

Operating under the assumption that our largest financial institutions are “too big to fail”, in the span of a few weeks we went from pledging to spend $1 trillion to $3 trillion – a commitment which then grew to $5 trillion before ballooning to a staggering $8.5 trillion.

At the rate we are going, we will be dealing with double digits – in trillions- before the end of the year.
And while all off that money is not yet spent, make no mistake – these are real commitments with serious liabilities attached to them.

I have heard the argument that an equity infusion is not the same as spending money.  While I would agree that in an arms-length transaction this might actually be the case, our government is definitely paying a large premium.  What is the real value of Citicorp or AIG?  Since they are quasi-bankrupt (and would be totally bankrupt without massive injections from the Fed), a reasonable businessperson might pay a token price for their equity and the assumption of their enormous liabilities.  Before doing so however, a buyer would have to see some significant value in buying these entities as a continuing business.  In most cases, a buyer would not want to assume the company’s liabilities but would prefer to buy selective unencumbered assets in a bankruptcy proceeding.  Any money our government pays above what a reasonable person would pay in an arms-length transaction is real spending and should more accurately be called a grant.

While defenders of the too-big-to-fail policies argue that providing guarantees is not the same as granting money, the reality is that these guarantees are necessary to prevent the collapse of financial institutions currently lacking the necessary collateral to meet their loan covenants.  Should their loans be called, we could actually find out the real value of their assets.  The fact is that in-spite of Paulson’s and Bernanke’s efforts, deleveraging is already happening.  Although at a slower pace, one asset class after another is being adjusted down towards its intrinsic value, which is usually not much.  Make no mistake; many of these guarantees will eventually be called in by lenders.  In due time, unless our government is able to inflates its way out of this bottomless pit, it will have to honor most of these guarantees.

So how does $8.5 trillion dollars compare with the cost of some of the major conflicts and programs initiated by the US government since its inception?  To try and grasp the enormity of this figure, let’s look at some other financial commitments undertaken by our government in the past:

As illustrated above, one can see that in today’s dollar, we have already committed to spending levels that surpass the cumulative cost of all of the major wars and government initiatives since the American Revolution.

Recently, the Congressional Research Service estimated the cost of all of the major wars our country has fought in 2008 dollars.  The chart above shows that the entire cost of WWII over four to five years was less than half the current pledges made by Paulson and Bernanke in the last three months!

In spite of years of conflict, the Vietnam and the Iraq wars have each cost less than the bailout package that was approved by Congress in two weeks.   The Civil War that devastated our country had a total price tag (for both the Union and Confederacy) of $60.4 billion, while the Revolutionary War was fought for a mere $1.8 billion.

In its fifty or so years of existence, NASA has only managed to spend $885 billion – a figure which got us to the moon and beyond.

The New Deal had a price tag of only $500 billion.  The Marshall Plan that enabled the reconstruction of Europe following WWII for $13 billion, comes out to approximately $125 billion in 2008 dollars.  The cost of fixing the S&L crisis was $235 billion.

The best deal ever for a government program was the Louisiana Purchase, a deal with the French that gave us 23% of the surface of today’s US for only $15 million ($284 million in today’s dollars).  Why couldn’t Paulson and Bernanke display the financial acumen of a Thomas Jefferson?

How will our country repay its debts?   The current bailout represents 62% of our GDP.  Our current deficit of almost $11 trillion may exceed our GDP next year.

Recently the Treasury has been able to place new debt; investors have liquidated equities and bonds and sought refuge in the relative safety of the dollar and government bonds.

As we move forward however, our government will need to attract trillions of dollars annually to fund its programs and commitments.  The foreigners who have financed our irresponsible spending for many years will no longer be able to afford it, let alone finance more of our reckless behavior.

As a matter of fact, several countries have already announced their own bailout packages to prop up their domestic economy.  And, unlike during WWII, when Americans invested their savings to support the war effort and fund our government’s deficit, our citizens are in debt themselves with no savings left to invest.

In the near future, the Fed will have no choice but to turn on the printing presses and start operating them around the clock to create the money that can’t be raised in the capital market.

These actions will lead to a significant debasement of the dollar and a major appreciation of gold and all commodities (real assets).

Once this inflationary cycle starts, foreigners will realize that their investments in T-bills are depreciating rapidly.  There will be a massive exodus that will put more pressure on the dollar and on interest rates.  Our weakened US economy will be faced with the rising cost of capital and a painful period of stagflation.  Trillions of dollars will have been wasted.  Our government will have mortgaged America and the ensuing debt will have to be paid by future generations.

Not a very bright picture, to be sure, but the Casey Research team strongly believes that there are opportunities in every crisis. Preserving your assets and even profiting in times of crisis by making the trend your friend is the focus of Casey’s flagship publication, The Casey Report. We have helped subscribers get positioned in commodities in the late ‘90s, buy grains in 2006, and short financial stocks 18 months ago… resulting in double- and often triple-digit returns.

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Source: The Real Cost of the Recession

But let’s start with the financial news first. Macquarie Group (ASX:MQG) told investors yesterday that its profit fell by 43%, thanks to write downs in assets. It was the first time since going public twelve years ago the “Millionaire Factory” has reported an earnings decline. Still, the $604 million profit number was higher than what analysts were expecting ($594 million) and the stock finished up over 16.5% on the day.

In the revenue results and write downs you can see how the decline and fall of the investment banking model has hit Australian shores. MQG reported a 13% decline in fee and commission income (to a paltry $2.2 billion). Trading income fell by 14% to $722 million. The big one was the 43% decline in income from asset and equity investments.

There were some strange assets in the back rooms of the Factory. The company took over a billion dollars in write downs on its Italian mortgages and fund management assets. It did not, however, take any write downs on Macquarie Airports or Macquarie Infrastructure Group. Hmmn.

Picture the good ship Macquarie Group as something like a Noah’s Ark/Pirate Ship full of a menagerie of debt-financed assets. Under Captain Allan Moss as CEO, Australia’s version of Goldman Sachs sailed the high-seas of global finance, buying assets with borrowed money, bundling them into funds, and then charging retail investors fees to invest in the funds. It’s the sort of business those Somali pirates who hijack oil tankers should look into. Far more lucrative.

Twelve years of collective booty and swag gave the Factory quite a collection of eccentric and fee-generating assets. Some of those assets are not ageing so well. But you’ll note the company chose not to mark down the value of its infrastructure or airport funds, the two big ones.

It claims the current market value of those assets isn’t what they are really worth. The book value is more accurate. In the meantime, it is throwing other less attractive assets overboard. Deck chairs…Italian mortgages…extra chickens…everything must go!

There’s no doubt that asset values are likely to fall more next year and that revenues will continue to fall too. Still, the company says it will sell $15 billion in assets and then set sail, on the lookout for more acquisitions again. Garn!

It’s looking to sell its margin lending book. And new CEO Nick Moore said it will securitise its motor vehicle loan book, move it off the balance sheet, and sell it off. Thus the liquidation continues in the financial world. Loss-making assets are written down or thrown overboard at…er…fire sale prices.

What’s really happening, mixed metaphors aside, is that the Millionaire Factory model is giving way to deleveraging reality. In a world with falling asset values and tighter bank credit, it’s harder (and much less profitable) to build a cleverly constructed portfolio of assets and generate fee income from operating them.

In the post-credit crunch world (or post-Deluvian, if you accept the nautical metaphor), you have to focus on cash, not debt. One example would be Cash Converters, a sort of Main Street Macquarie, without the debt, and substituting Italian loafers for Italian mortgages. Cash Converters buys low and sells high. It’s the perfect business for the first world depression.

Cash Converters helps people turn lazy assets (guitars, mobiles, stereos, old harmonicas) into cash. And what is that but the liquidation of the consumer spending boom? Of course, most stuff isn’t worth as much people think it is. When you own something, you tend to think it’s worth more than everyone else.

Then you try and auction it on eBay or take it to a pawn shop or Cash Converters. There, you find that it’s worth a lot less than you believed in your heart. Such is life, as Ben Cousins and Ned Kelly might say. Kris Sayce at the Australian Small Cap Investigator (whom we often call the Ned Kelly of the Old Hat Factory) has been looking at Cash Converters as an example of what he calls “Main Street Stocks.”

We’ll let you know what he’s up to…but we think it has something to do with companies that actually do more business in a recession and increase both revenues and earnings-without relying on debt. If you have your own suggestions for “Main Street Stocks,” let us know at dr@dailyreckoning.com.au

Dan Denning

Source: Macquarie Group (ASX:MQG) Profits Fall By 43%