Fall 2012 – Newsletter

I had only one superstition. I made sure to touch all the bases when I hit a home run – Babe RuthMy parents never took my sister and me to Macy’s for the iconic pictures of excited children sitting on Santa’s lap. As only my father could describe it, he didn’t want his children to think somebody broke into their house to give them free stuff, concerned that handouts from Machiavellian strangers handicapped the able. Perhaps a bit extreme, but everyone knew where the toys came from, exactly how they got there and few families enjoyed Christmas more than we did.

A lot of what we’ve come to believe as adults have been disproven or marginalized altogether. The notion that sports reflect fair competition and large banks would refrain from manipulating interest rates gives folklore a bad name. Remember when developed nations called themselves civilized and the rest of the world thought it to be gospel? Now the gospel is sold at Wal-Mart with bibles made in China.

Our world has been turned upside down, or reinvented so often, depending on whom you might ask, that we have become stronger, more resilient. The ubiquity of untenable sovereign debts, reckless monetary policy and increasing global competition doesn’t even frighten us anymore; we’re far too exhausted to become overly consumed with horror, likely because we know that reasonable sacrifices and long-term strategies would solve the problem.

Even as we learn that the European Central Bank is more leveraged than either Bear Stearns or Lehman Brothers were in 2007 , we yawn with indifference, either a consequence of fortitude or an impromptu pause to weigh the gravity of our circumstances. Fortunately we live in a zero sum economy where wealth never disappears, it just shifts. Sure, a rising tide might lift all of the ships, but to pretend that everyone has access to a life raft, or that one might be offered to you, seems quite the risky proposition.

Countries accounting for 60 percent of European Union economies, for example, are stagnant or contracting and the unemployment rate for the 17 European countries using the euro as its currency was 11.2 percent in June . Lo and behold, an austerity program that includes less government spending and higher taxes on the working class actually slows the economy down, and as a consequence, reduces government revenue required to pay down the debt.

To be more exact, Spain and Italy have 2.8 trillion euros ($3.6 trillion) of government debt , four times the total of Greece, Portugal and Ireland, with 1 trillion euros in principal and interest payments on their debts coming due between now and 2014. Europe’s third and fourth largest economies, representing a quarter of the European Union’s overall economy, has no reasonable means by which to satisfy these obligations, as evidenced by spiking interest rates on Spanish bonds in a market increasingly resistant to lending them money.

Germany, having educated their workforce and maintained its manufacturing base, is in somewhat of a pickle, charged with backstopping weaker nations (and undermining its own creditworthiness) or watching the Euro disintegrate, and with it their export dependent economy. Nobody should be shocked by this development, except maybe the German public who came late to the beer party and will be stuck with the entire bill.

Inebriated citizens notwithstanding, the United States, bless her heart, has been kicking a can with remarkable resemblance down a very similar road. Congress, heaving under the invisible weight of a $16 trillion tab, spent decades ostracizing anyone who would challenge their math. Quirky Ron Paul of the congressional back bench and idiosyncratic Ross Perot became caricatures of noble street preachers passionately warning passersby of the massive debt wave headed in our direction. As to be expected, their concerns were publicly dismissed by top economists and budget chairmen with a congenial disregard usually reserved for less formal settings.

And yet the Fiscal Cliff appears before us.

The debt ceiling debate transformed an administrative procedure into a manufactured default defying struggle between Republicans and Democrats, one demanding more spending cuts and the other intent on taxing the rich. With neither side willing to trigger an economic catastrophe, they reached a compromise to immediately increase the debt ceiling by $400 billion, permit another $500 billion increase in the ensuing months and reduce spending by another $1.2 trillion over ten years .

To illustrate their resolve, both sides agreed that if the latter cuts were not ratified by December 23, 2011, a date that has since been extended, automatic cuts would be triggered. America’s cherished grab bag of goodies on the chopping block include the expiration of all Bush tax cuts, $55 billion in military spending, $55 billion in non-defense spending, the elimination of the payroll tax holiday, the alternative minimum tax adjustment, marriage penalty relief and the tax credit to help pay for college and raise children .

Should these cuts go into effect on January 2, 2013, the economy is projected to contract at an annualized rate of 2.9 percent in the first half of 2013 and by 0.5 percent over the entire year . Moreover, the unemployment rate would rise to 9.1 percent at the end of the year from 8.3 percent today, and with that, the legend of a Fiscal Cliff grows. Unfortunately, a sluggish economy would mitigate government revenue required to service the debt, while taking no action at all would increase the nation’s burden by $7.5 trillion .

And like our friends across the pond, nobody has any interest taking the government’s footprint off the gas. Which of the above cuts would be popular? Military spending is five percent of our GDP, creating jobs in Democratic as well as Republican districts. Increasing federal and FICA taxes that account for 83 percent of government revenue is even less popular, not to mention a dangerous proposition for anyone interested in reelection. Hurry up and bake the cookies; we need Santa Claus to give us more free stuff.

Nevertheless, if something looks too good to be true, the Federal Reserve probably had something to do with it. According to a report from the Federal Reserve Bank of New York, “the bulk of equity returns for more than a decade may be due to actions by the US central bank” . It turns out that the market is inclined to rise in the 24-hour period before the release of the Fed’s statement on interest rates and the economy, anticipating a stimulus policy that might inflate the price of securities.

The Federal Reserve, however, is in the minor leagues of market manipulation when compared to the large banks. The Libor rate reflects the cost of money and is the basis for everything from car loans to mortgages. The rate is determined by a daily poll carried out on behalf of the British Bankers’ Association that asks banks to estimate how much it would cost to borrow from each other for different periods and in different currencies.

Amazingly, the same financial institutions that duped us in the housing bubble allegedly ignored the honor system. According to Bloomberg, “By making a submission too high to be included in the average, a single lender was able push a previously excluded rate back into the pack to send the average higher. By submitting a rate that falls too low to be included, the average could be nudged down as a previously excluded rate re-enters the pack”.

What would be the point of manipulating interest rates? Because banks are allowed to trade derivatives for profit, and on an $80 billion portfolio of swaps, a 1-basis-point move on the U.S. dollar Libor could benefit a trader by about $667,000 . On the flip side of the coin, unsuspecting investors (as in cities and pension funds) were cheated out of returns on bonds with artificially low rates, bitten once again by complicated financial contracts, making them targets to be squeezed by traders who allegedly colluded with one another.

Early estimates are that banks face potential legal liability of about $176 billion based on the assumption that Libor was understated by 0.4 percentage points in 2008 and 2009 . Small potatoes if you ask me: thanks to lax international tax rules, the world’s super rich have siphoned at least $21 trillion into secretive tax-free havens . Still believe in Santa? The justice department settled with Morgan Stanley over accusations of price fixing in the electricity market, using derivatives to help clients violate federal antitrust laws and reaping $21.6 million in profit as an intermediary.

This litany of moral turpitude, gross incompetence and unabated greed isn’t particularly eye opening. After all, this is the year when the statue of an iconic football coach addicted to the drunken allegiance of half a million alumni became endangered. A time when America, having witnessed its own central bank create $3 trillion of fake money out of thin air, accuses China of manipulating their currency.

Any good baseball player knows exactly where to throw the ball if it is hit to his position in the field. In fact, that decision is made before the pitcher even winds up and delivers to the plate. Some investors are reluctant to acknowledge that we’re being ripped off one low CD rate at a time, but I’d prefer to know the truth – it gives me a fighter’s chance to find a suitable hiding place and profitable opportunities. After all, this is the world we live in, and it cannot be rigged if everyone knows, or at least should know, that the dealer regularly slips the best cards up his sleeve.

Securities offered through LPL Financial, Member FINRA/SIPC (http://brokercheck.finra.org/). Investment advice offered through Delancey Wealth Management, LLC, A registered investment advisor and separate entity from LPL Financial.

1. European Central Bank Leveraged Like Lehman: Author; CNBC; 5/10/12
2. Euro-Zone Rot Keeps Spreading; Wall Street Journal; 8/12/12
3. Euro-Area Unemployment Rate Reaches Record 11.2%: Economy, BusinessWeek; 7/31/12
4. Italy, Spain Head For Bailouts, Fidelity’s Stuttard Says; Bloomberg; 6/21/12
5. A summary of the debt ceiling compromise; CBS News; 8/1/11
6. Fiscal cliff: What’s really in it; CNN Money; 8/6/12
7. ‘Fiscal Cliff’ Has Many Perils; Wall Street Journal; 8/22/12
8. Fiscal cliff fight: Missing the big picture; CNN Money; 7/17/12
9. Market Savior? Stocks Might Be 50% Lower Without Fed; CNBC; 7/12/12
10. Libor Flaws Allowed Banks To Rig Rates Without Conspiracy; Bloomberg; 7/16/12
11. Suits Mount in Rate Scandal; Wall Street Journal; 8/26/12
12. A money ‘black hole’: rich hide at least $21 trillion in tax havens, study shows; MSNBC; 7/23/12
13. Federal Judge Grudgingly Approves Morgan Stanley Price-Fixing Case; New York Times; 8/7/12