We're All Madoff

This is an uncomfortable reality, but it is reality.

Mr. Madoff stands accused of (in his own words) running "a Ponzi Scheme."

In fact, our entire economy over the last ten years, and really back to at least 1987, has been roughly equivalent to what Mr. Madoff was doing.

So has our government.

Let's go down the list of things that have been inflated beyond their natural boundaries, and look at how each and every one of them was destined to collapse - and why they're all collapsing at once:

• The Internet Bubble.  While there were companies that made a real pre-tax operating profit (and a real net profit), mine included, the vast majority of the firms in the Internet space did no such thing.  They reported "pro-forma" earnings, used EBIDTA (that's earnings before interest, depreciation, taxation and amortization, as if none of those things count) while levering up (meaning: interest was going to continue to rise!) as their primary profit gauge, and in fact operated with leverage ratios (total assets deployed to tangible equity - that is, value) that were in the stratosphere.  In short they borrowed to pay back their previous loans and make payroll, and when the lenders (which were in some cases equipment manufacturers) realized that they'd been had, the entire house of cards came tumbling down.
• The Housing Bubble.  Homes, as a place to live, must be able to be purchased for a reasonable percentage of one's income.  What's "reasonable"?  History says that this is 28% of your pretax income for all your direct household expenses (principal, interest, taxes and insurance plus mandatory spending such as utilities and a maintenance reserve) and 36% of your pretax income for all debt service including household and other.  Note that at the "maximum leverage" that is sustainable you have only 8% of your pretax income available for "other debt service"; how many people can meet that?  Think folks - if you have a $100,000 income, this means you have only eight thousand dollars for all payments on other debt.  Two modest car loans and their insurance will exceed this limit for someone who makes $100,000 - and we're talking Ford's here (small sedans too, not SUVs), not Benz's or Lexii.  As these ratios were exceeded in order to remain "affordable" increasingly exotic terms were required, starting back in 2001 when the car makers were cajoled by the Bush Administration to put forward their "Drive America" program with zero-percent interest for three years.  As this crept further and further into our economy mortgage programs that were in fact not mortgages (as there was absolutely no possibility of the borrower paying them off on the original terms) were pushed in order to keep property values climbing.  In 2007 the limit of this insanity was reached, the "last sucker" was found, and the pyramid collapsed as these so-called "mortgages" were exposed for what they really were - a serial-refinancing scheme designed to strip equity and transfer it to the bankers.  The entire scheme collapsed and along with it our markets and economy.
• The Stock and Credit Markets Generally.  The Internet Bubble and Housing Bubble were the externally-visible symptoms of what was going on behind the scenes.  The S&P 500 was posting "earnings" of more than $100 a share, but those "earnings" were a phantom.  "Private Equity" and "Hedge Funds" were buying companies and essentially flipping them using debt backed by bank credit that was, like in the housing and Internet markets, backed by nothing other than vapor.  Commercial Real Estate deals were being done at "cap rates" that were unbelievably optimistic, essentially not even paying the interest due, banking on the ability to roll the debt as "property values never go down."  Anyone remember "M&A Monday" on CNBC through all of 2006 and the spring and summer of 2007?  What was that all about, if not flipping companies like speculators flipped houses? 
• Our Government's Finances.  We put into place Social Security and Medicare, two schemes that have accumulated fifty three trillion dollars in forward liabilities with zero in assets behind them.  These liabilities are growing at a rate several times that of GDP.  Then, as if this wasn't enough, we passed "Medicare Part D" which has now added even more to the liability side of the balance sheet but which was and is totally unfunded by assets.  This both can and will collapse just as did the Housing and Internet bubbles.  Our government has been spending money it doesn't (and never will) have for a very long time, but we have now entered the phase (just like the Internet and Housing Bubbles) where debt is increasing at an exponential rate compared to assets.  We have, in the last year, nearly doubled the outstanding public debt commitments on the United States ($8 trillion added against a $10 trillion base), with the previous $10 trillion itself having doubled from $5 trillion in the space of just a bit more than a decade.

There are many who say that our government debt-bubble will not collapse, and they list a whole host of reasons.

Why would you believe that?

Can you show, through history, one speculative bubble that has not popped? 

Can you find one time - just once - that such a bubble was able to be grown without limit?

Simply put: No.

Americans have, as a nation, become fat, dumb, "entitled" and lazy.

Our Declaration of Independence lists the following rights that are endowed to us by our creator:

Life, Liberty and the pursuit of Happiness.

Note that nowhere in this list are:

• Free anything, including wealth, food, health care, shelter or even a job.
• Happiness itself (only the right to pursue, but not achieve, happiness is endowed)

America as a nation was founded by a group of rugged individuals who understood all of this.  They were not necessarily religious, although they believed in divine providence; that is, that "from somewhere more powerful than they their original seed was formed."  Some believed that source was a Christian God, some believed it to be the earth herself, some believed it to be some vague spiritual force. 

But all believed and understood that the fundamental rights that flowed from that original creation did not involve deceit, trickery or theft, irrespective of how it was accomplished.

Unfortunately deceit, trickery and theft all feed on themselves.  They are uniquely human vices; when they first appear they seem innocuous.  "Social Security" was originally called "OASDI"  (that is, Old Age, Survivors and Disability Insurance) and still legally is.  Think about that for a minute - two of the components were put into that bill to guarantee that children would not starve, and those who became permanently disabled (usually through work) would not be cast into the streets to die.  A noble cause to be sure, but what has Social Security become?  While the "SDI" portions still remain and are both important and, one would argue, necessary, that's not where all the money goes - it goes instead to the "Old Age" portion, where nearly everyone who receives it made choices during their working years to spend all, or nearly all, of their earnings.

There are many who argue that those who live "hand to mouth" don't have that choice.  Really?  Here are two statistics that make clear that this is simply false:

• In 2003 there were 159 million cell phone subscribers in the United States, and the average monthly bill was $49.91.  Penetration has since grown to approximately 70% of the population (from ~60% in 2003.)  Since 25% of all persons are under the age of 18, the majority of the non-subscribers to cellular services are in fact children under the age of 10.
• In 2002 58 percent of persons age 18 and over were overweight, and 23 percent were considered medically obese.

So in fact we have two "inconvenient facts" that contradict the claim that those who live "hand to mouth" and yet are working could not save for their retirement and old age if they decided to do so - the first being that they spend nearly $600 a year on cellular service - a luxury, and the second being that nearly 6 in 10 are consuming significantly more food (and paying for it) than their body demands for metabolic balance.

This sort of "self-deceit" is how it begins.  You're now considered "poor" if you live in a 1300 square foot house and don't have a cellphone. 

Yet in the 1960s and 70s, decidedly-middle-class Americans - myself included - grew up in homes like this that featured three small bedrooms, one bathroom, one living room of about 150 square feet and an eat-in kitchen.  We had one black and white television in the living room with rabbit ears on top and one telephone on the wall, and we could not afford to make long-distance phone calls with the exception of a couple of very short calls to relatives over the Holidays.  We did not have air conditioning nor all manner of electronics chewing at electricity day in and out and thus our electrical consumption was a fraction (in kilowatt-hours) of what people consume now.  McDonalds' was considered a luxury, as it was (and is) cheaper to cook up something at home - say much less other restaurants.

My father was a CPA for Howe-Martz Glass in Detroit during most of my youth - a decidedly middle-class, white-collar career.

Today, the way we lived would be mocked as "destitute."

Don't get me wrong - improving standards of living are not a bad thing.  In fact, they're a very good thing, and we have come a long way since 1776 in that regard.  Indoor plumbing, flush toilets, electrification of homes allowing lighting and machinery, telephones, personal computers, the Internet and the automobile (and its larger cousin the truck) all have brought great strides forward in our society. 

But somewhere along the line we decided that transparency in our financial dealings, both as a government and privately, were not essential elements of fair dealing and computation of risk.

And therein lies the problem.

See, evil requires secrecy.

Theoretically, banks are supposed to hold reserves of about 8% against their deposits, and therefore are limited to roughly 12:1 leverage against their asset base.  Investment banks had a similar limit explicitly codified in the law, because as non-depository institutions they had no deposits against which to measure these ratios.  In fact, up until 1998, all such "demand accounts" - that is, those in which you could walk into the bank and demand your money immediately (e.g. checking accounts and similar) were subject to these reserve requirements.  This put an effective cap on leverage and thus risk - and the otherwise-unbridled growth of commercial and bank credit.

But starting in 1998 this changed.  This Treasury Department OTS memorandum outlines a number of bills that were put forward by Senators and Representatives that, in many cases, still sit in our Congress.  Senators Shelby, Hagel and Reid are explicitly named, along with the infamous Representative Leach of Gramm-Leach-Bliley.  That memorandum also effectively eviscerated the reserve requirements that formerly kept our banking and thrift system safe and sound.

Between this change in policy, The Federal Reserve's intentional refusal to act to stop what amounted to infinite leverage, Treasury Secretary Paulson's (successful) entreaty to ease leverage limits on investment banks in 2004 (when he was running Goldman Sachs) and other similar actions taken by our government, we have in fact created the largest bubble ever blown in economic history throughout our banking and credit systems.

Now that bubble has popped.

In 2000, the damage done by the 1998 and 1999 decisions (which just happened to coincide with the final "blow off" top in the Nasdaq!) put our GDP approximately 10% "out of balance" with our actual productive capacity.

That is, the debt taken on during that bubble in excess of GDP growth represented about a 10% "premium" to a sustainable GDP level.  Were we to simply wave a wand and make that debt (credit) disappear, GDP would have been 10% below where it was in 2000. 

2000 GDP was approximately $10 trillion, so we would have suffered a $1 trillion contraction in GDP to bring the system back into balance, along with whatever business and banking failures which would have come along with that adjustment.  Those failures would have resulted in an "overshoot" of some amount - perhaps another $500 billion.

Note that a total "peak to trough" contraction of 10% is generally thought of as a Depression.  Not a "Great Depression", but an "ordinary" Depression.

Therefore, the economy in 2000 faced an economic Depression.  To put this in perspective, in the post-war era the worst Recession on record was the 1973-75 event which recorded a 4.9% contraction in real GDP.

George Bush, our Congress and Alan Greenspan, however, refused to accept their responsibility in 2000 and 2001 for the economic policies of this nation and its banking regulators that led to the final blow-off top in the Internet Bubble. 

In fact, Gramm-Leach-Bliley along with the sweep account changes were responsible for about half of the excess leverage of the Internet Bubble, and thus about half of the economic correction made necessary by its final blow-off top.

That's right - had those changes not been made we would have faced a 1973-74 style recession, but with those changes we were guaranteed a depression as the economic "just desserts" of the Internet Bubble era.

Being that this was deemed "unacceptable" Alan Greenspan along with Congress and the other regulatory bodies in Washington DC responsible for banking (and general credit system) safety and soundness undertook an intentional course of action to "paper over" the losses.

But wait!  How can you do that?

You can't - except through fraud.

That is, you cannot prevent a loss from appearing and being recognized unless you allow people to lie about the value of securities, place them off-balance-sheet in opaque containers where nobody can see what's inside (and thus how they're performing) and "lever up" to issue yet more debt (credit) to cover the cash flow that should be happening but isn't.

As the embedded (and fraudulently-concealed) debt continued to mount banks and other institutions found themselves performing a Madoff - that is, issuing new credit (debt) to be able to "show earnings" that in fact were a phantom.  Unlike Madoff they did not have to go find someone new to put money in to be able to issue the checks to existing investors, since a bank that can operate with no reserve requirements imposed on it is capable of issuing as much credit as it wants, effectively "printing money."

Regulations and leverage limits are supposed to prevent this, but they were systematically and intentionally dismantled in the name of "financial innovation."

In truth they were dismantled in the name of a massive financial fraud that permeated every corner of our credit system, from credit cards to student loans to automobiles to housing.

This ponzi scheme even extended to individual consumers - that is, you. 

If you HELOC'd out money and paid down your credit cards with it, then charged anew or cash-out refinanced, you were a Madoff.  If you bought a house with an Option ARM, knowing full well you could not make make a fully-amortized "recast" payment, you were a Madoff.  If you played the balance transfer game with your credit cards, rolling balances from one zero-interest offer to another, you were a Madoff.  Tens of millions of Americans did one or more of these things - and each and every one of them - if not you then someone you knew - was running a personal version of Madoff's scheme.

Every organ of our government and regulatory system was involved in this knowing deceit and the complicity required for it to occur - Congress, The White House, Treasury, The Federal Reserve - and still is.

So why did the bubble collapse, if these institutions are able to continue to literally "print money" and the regulators were intentionally ignoring all of it?

The fundamental problem with all Ponzi Schemes, even those in which the operator is able to issue credit at will, is that it relies on people not challenging the books. 

It requires "belief" - that is, confidence.

Thus the phrase "con game".

When Bear Stearns two hedge funds collapsed, the house of cards began to shake.  People started looking at balance sheets and asking lots of very inconvenient questions, including exactly how one can have a mortgage-backed security rated "AAA" when 40% of the loans in it are either delinquent or in foreclosure.  A few people started to listen to those who had analyzed the math, such as myself and Mish, and the light came on in their head - "Oh My God, they're right!"

See, while credit spends like money, it is not money. 

Money is in fact production; you gain it only three ways - by growing something, mining something or making something.  That is, by producing a thing (whether it be a car, apples, a barrel of oil or software) that did not exist before.  In the most-basic of terms, all money ultimately comes from the energy imparted upon the earth by the Sun.

Yet money backs all credit at some ratio, and the higher the ratio, the more that credit is subject to destruction if those people with money (that is, production) decide to take their ball and go home.

This, at its root, is why all schemes like this must and will fail.  It is a mathematical certainty that confidence will eventually be lost as the math and truth of what is going on will eventually become evident to a sufficient number of producers and they will "take their ball home"; once that happens the credit they are underwriting is no longer backed by production.  This leads to a rapidly-increasing leverage ratio which in turn leads even more people to "take their ball home" and the scheme thus must and does collapse.

You would think that Bernanke and Paulson would recognize what is going on - and that they are unable to stop the inevitable collapse.

Here's the problem - they do recognize it, but they are two of the architects of it, and admitting the truth means taking responsibility for what they have done.

That's not going to happen so long as they believe they can manage to keep the "con" going with someone.

The group of "someone's", however, is shrinking rapidly.  Commercial and Investment bank loans, then Fannie and Freddie, then commercial paper issuers, and now various sorts of consumer loan products such as credit cards, automobile financing and student loans are all being shunned by those with actual money as they start to peek under the kimono and find not a pleasant sight but rather something both ugly and hairy staring back at them.

Thus, the transfer of all of this "credit" (really bad debt) no longer backed by money (as the producers have taken their ball and left) from the institutions that created the ponzi scheme to "the sovereign" - the Government - in all of its forms, whether it be Treasury or The Fed directly.

The latest announcement came on Friday, when The Fed loosened the terms of the TALF (one of its alphabet soup programs) and effectively allowed hedge funds to borrow from it.

This, incidentally, is why Bloomberg has had to sue The Fed to try to get disclosure of the crap they have taken on their balance sheet, and why Fox News announced that it is suing Treasury to gain disclosure of what they have taken on.

It is also why Markit has announced that they're "postponing" the listing of performance data on "Prime" mortgages - they were pressured to do so (by their own admission) because a published price means no more lying about values, and that could mean immediate (and monstrous) new writedowns for banks which hold trillions of dollars of "Prime" mortgages yet are valuing them pretty much "however they want."

As I said before, evil requires secrecy. 

There is real (and justified) fear that should the truth of what is being held in these "Fed and Treasury programs" be disclosed in full that those with money (that is, producers) would flee United States Treasuries (and dollars.)

This is not an unjustified fear; it is, in fact, fear of exactly what has happened thus far and led to the collapse of AIG, Lehman, Bear Sterns and the near-collapse of Fannie and Freddie.

And what is The Fed using for its "credit grade"?  Ratings from the same agencies that graded as "AAA" toxic subprime debt that all blew up.

If this last gambit fails so does our government's ability to deficit spend.

There is a near-100% probability that it will fail - we are simply arguing about the "when", not the "if".

See, without evidence that the debt (not deficit) they are asked to back will be paid down at some date-reasonable in the future, eventually the people with money will flee. 

It is simply a matter of exactly when their confidence fails (that is, at what leverage ratio do they say "screw this!"), not if it will fail.

Removal of the ability to deficit spend, when the government will be running a $1 trillion+ deficit next year, would result in a roughly 25% instantaneous reduction in the government's budget - assuming tax receipts will be maintained.  The problem is that they won't - with unemployment skyrocketing and GDP collapsing, tax receipts are likely to fall 30% or more, meaning that in all probability the government will find itself having to cut its budget in half on an immediate basis.

Since a goodly part of that budget is in fact interest and it cannot be cut (without causing a general default) the consequence would be a requirement to slash all government programs immediately by approximately 60% - including Medicare, Social Security, the military, education, other social programs (e.g. Title I) and everything else.  In addition The Fed would be forced to immediately disgorge all of its bad assets into the market at whatever price they could be sold for, lest The Dollar become "de-currencied" almost instantaneously.

Think about Iceland and how quickly their situation unraveled.  It can - and may - happen here.

Now to the next question - how bad would it be if we were to take the proper steps today to bring our economy back into balance?  And how bad will it be if we wait a while longer, and/or are forced to do so by a confidence problem with our government debt and/or currency?

To bring our economy back into balance, as of August 2007, we would have required a 20% GDP correction as a direct consequence of the actions of the 2000-2007 time frame.  While this is "twice as bad as 2000" in terms of percentages, it is actually three times as bad in terms of dollars, since GDP went from $10 - $14 trillion during those years.

That is, as of August 2007, we would have had to suffer a $3 trillion contraction in GDP, essentially wiping out all of the gains since 2000.

In the last year we have spent - not committed, spent - another $2 trillion dollars we do not have.  That is another 10% GDP contraction, for a total of 30% - or roughly equivalent to the Great Depression.

This increase in the severity of the necessary re-balancing of the economy was brought about as a direct result of the actions of Ben Bernanke, Hank Paulson and Congress.  That's right - fully 1/3rd of the damage that now must be taken was voluntarily taken on and put on your head in the last year by the people who claim they are "protecting" the American economy.

If we allow the programs promised thus far - totaling $8 trillion - to be spent, plus Obama's expected $700 billion+ "stimulus" package to be put into the mix, we will get very close to and may exceed 50% GDP contraction required to bring the economy back into balance.  That is, the total damage will be five times that which was necessary in 2000 and more than twice that necessary in August of 2007, and all of that increase will be due to the intentional acts of our government officials.

I have high confidence that we won't get to that level of destruction simply because the producers with money won't allow it to go that far before they pull the rug out from under us.

I rate the odds of a forced cessation of these programs, either via a bond market dislocation or a currency crisis somewhere before that $8+ trillion number is realized in excess of 80%.

The important thing to keep in mind is that the sooner we stop this idiocy the less damage we will take. 

That the damage will be serious, that unemployment will be rampant, that our economy will contract dramatically - this is now all assured and cannot be avoided.

But the more money we spend that we do not have, and the more risk we transfer to our nation's balance sheet (instead of leaving it where it is and allowing it to sink the imprudent) the worse the inevitable will become. 

We are buying rapidly-decreasing amounts of time before the dislocation and dramatically increasing the amount of damage that will occur with our present policies.

This is mathematics, not conjecture, and irrespective of the government's attempt to claim otherwise 2 + 2 still equals 4.

Finally, before one says that "FDR did this and it helped" in the 1930s note that the "Great Depression" was actually two separate events, with the first (1929 - 1933) being a contraction of about 33%, and the second, from 1937 to 1938 where GDP declined by 18.2%.

The second contraction was entirely caused by the government's response to The Depression (and The Depression itself was caused by government's refusal to perform its regulatory role!), and it was only WWII that truly put a stop to it by killing off competition for jobs and destroying huge amounts of capital equipment that then had to be replaced.

Unless you're rooting for several million of our young people to be killed in the next World War, this lunacy must stop now.

Specifically:

• President Obama must not try to stop the unwind.  In fact, quite to the contrary - we must cease taking on more debt (that is, funding more bailout and "stimulus" programs) because they simply make the matter worse.  In short President Obama must force the unwind to take place by withdrawing the artificial support.  I'm well-aware that from a political popularity point of view this may well be impossible - nonetheless, if we are to avoid catastrophe it must be done as the damage now is much smaller than the damage that will occur if we don't stop the insanity.
• The Fed must be told to either place back into full force and effect all leverage and reserve requirements and police them or the US Government will act to force them to do so.  This must happen right now.
• Full, 100% transparency for all - including Treasury and The Fed - must occur immediately and be maintained in perpetuity.  We must not lose the confidence of those who fund our debt and to do so we must prove on an immediate and continuing basis that we have changed.
• We must accept the contraction in our GDP that will and must occur.  In short, we must stop lying and papering over the inevitable which has done nothing but make what is to come worse.  There will be massive numbers of bankruptcies, including large banks and other institutions, that will come from this.  We have no choice but to accept this reality as it is far less damaging than the alternative.
• The human suffering that is and will occur will be tremendous no matter what we do.  The one place we can and should spend is on essential human needs; that is, food, shelter and clothing.  We can provide barracks-style shelter, cafeteria-style food, basic medical care and donation-based clothing for millions of Americans for a song compared to these "bailouts" and we both can and must.  Every state should have these centers established in major cities and at least one at or near its geographic center (or the closest reasonable place to it) in which all United States Citizens (but no illegal aliens) can come, reside, eat and obtain basic clothing and medical care at no cost to them.  This can be done at a cost of single-digit dollars per day per person, and we must.  This is a social imperative and we simply have to be prepared to provide it.

We can rebuild our economy, but we must do so from a stable base.  The GDP contraction that is to come must be accepted, and we can no longer fund false GDP "growth" with an ever-increasing debt load.

Our choice is to accept this now or have it forced upon us in the future, with that future date approaching at a rapid rate and the amount of damage increasing with every day we delay.