The American Dream and the New Financial Regulatory Reforms - House and Senate Reconcile

* The American Dream, The Alger Hiss story, rags to riches, you get the idea, is one of the guiding principles which has made this country great, and drawn immigrants from all over the world. The American experience is one which has allowed many groups of immigrants to come to this country, work hard and through perseverance, become an integral part of this country’s fabric. My paternal grandfather came to the US from Russia as a teenager in the early 1900s. He got his first job by taking a broom from a business owner in lower Manhattan, and took over side-walk sweeping responsibilities. This merchant eventually found other things for my grandfather to do, and then offered him a place to stay in the buildings attic. My grandfather eventually went on to establish his own business in the same field. As they say, the rest is history. To my knowledge, the government did not give my grandfather welfare or subsidies. He had to work for everything he eventually gained.


It is with this back-drop, that I want to share comments from a couple of readers, in response to yesterday’s blog. On average, I agree with the next two readers:


1st readers comment: “I’ve gotta weigh in on this: as someone who grew up in the oil fields of West Texas, I’m very familiar with poor peo


“It’s certainly not fair that the rich get richer and that many of their get rich schemes are making money off the backs of the less fortunate – for instance, talking people like my cleaning man, who was duped into refinancing his house during the housing boom _”  


Ah, yes, us stupid little people need the guidance and protection of our moral and intellectual superiors.  Well, that’s sure not the way my friends and fellow-workers in the oil patch looked at it. Silly us; we figured we could look after our own interests.  And with regard to income inequality, it was huge.  A lot of ranchers make a lot of money – it took big ranches to run cows in semi-arid West Texas and a lot of land = a lot of oil wells = a lot of money.  And guess what?  We workers didn’t resent their wealth and felt that they owed us something; we congratulated them on their good fortune and went about our business.


With regard to your request “If you have any creative ideas to solve this problem, please send them in,”  I can tell you from experience it ain’t esoteric and complicated, but you have to work for it: go to school, make decent grades; go to college (but get a degree that has value – forget about majoring in Gender Studies or whatever); get a job and stick with it; save at least 10% of your income; don’t take out montages you can’t afford and, obviously, don’t run up credit card debt; and you’ll do fine.  You won’t be as rich as Bill Gates, but, hey, life isn’t fair.


So here’s a news-flash: this is “a place where all classes of citizens are given the opportunity to rise above the shackles of their position in society.”  And what’s this “shackles of their position in society”?  Groan.  What, exactly, are those “shackles”?  Is it grossly unfair that if you smoke dope and hang out on the corner and don’t do your school work, then you are not going to do as well as someone who does the things I described above?  I don’t think so.


America is not a class-bound society.  We are not “shackled” to our position in society at birth.  There is social mobility.  What our class warriors ignore when they cite the statics on income inequality is that the composition of the upper and lower quintiles changes over time.  Sure there are some stuck at the bottom who stay there and there are a fortunate few born who are born at the top and stay there (funny how class warriors never complain about, say, the Kennedy’s); but for most of the rest of us, we move up and down the income scale as we move through life: starting out low or relatively low when young, moving up until we reach our peak earning years, and then, perhaps, moving down-scale again during our retirement years.  


Forgive the lengthy rant.  You obviously touched on a sore spot.  To my mind, this pseudo-Marxist class warfare has a definite political component.  To our self-proclaimed elites, the idea that a little person like me, a West Texas red-neck, can have illusions of self-sufficiency is ludicrous.   Clearly, in their eyes, the likes of me need their help – in exchange for political power, of course.” (end of 1st readers comment)


2nd Readers comment: “Your readers comments today make me sick to my stomach. Anyone who has ever used the phrase “leveling the playing field” really means “rigging the game.” Not to mention the sheer disdain he or she has for capitalism in general. They give a couple of anecdotal examples of people who perpetrate fraud (which is illegal already, to have the playing field equal, so to speak), and then concludes that taxing the wealthy is the only fair conclusion. Do they really posit that the rich can only get rich by exploiting the poor? No one gets rich by adding value for their customers anymore? (This is) a very shameful way to think about capitalistic endeavors. Income inequality is not inherently a bad thing. Without it, the incentive to do better is completely eroded. I wouldn’t be here working 12 hour days in a high stress environment if I made the same kind of money as someone with a much less intense and difficult job. If you want to raise taxes in order to close the deficit gap, that’s one thing, but don’t ever pretend you’re doing something out of the sake of fairness. I found your view of income inequality a much more palatable view. Income mobility is the correct metric, not income inequality.” (end of 2nd readers comment)


I think the concept of being able to work hard, and advance ones cause is an integral part of the enterprising American fabric. The comments by yesterday’s reader did go a bit far, but it is also important to understand that people think like that. And while I do agree that some folks were tricked into taking out larger mortgages than they cannot afford, these same folks were also a participant in the “free money” syndrome which characterized the housing bubble in the early part of the 2000′s.


On the side of advocating a welfare state, another reader writes in with this comment:


“Dear Rick, I appreciate that it is possible to find fault with the administration’s policies, especially if no alternatives are proposed. I agree that the administration should be spending the stimulus on capital improvements to the nation’s infrastructure. However, these types of projects take a long time to get going (planning, acquisition of property, local government approval, contracting). The money needed to get into the system right away to stop the panic. I am not certain it would have been wise to allow AIG to fail. They were the underpinning to too much of the investment world’s capital and if they had collapsed the panic would have likely escalated to a point that it could not have been contained. Are you sure you would have done differently if given the power to make that call? In any event that was a Bush administration call. It is hard to pin that on Obama. 


A great deal of the stimulus went to the rich. Bail-outs, 0% interest, purchases of long term mortgage debt. Much of that money is being horded on bank balance sheets and not being lent. The poor and middle classes are paying for this bail out of the rich. They are paying their payroll taxes which is helping to stave off failure for many wealthy folks who have been given welfare for the rich. Even those who were not directly involved in companies like AIG and GM have been essentially given welfare. The money spent on the stimulus is the reason the panic subsided and the stock market grew to where it is today. With so much more wealth being transferred from the poor to the rich, why shouldn’t they pay a higher levy for playing in this system?” (end of readers comment)


Let me start off by asking, do you think 0 percent interest rates helps the rich? I would argue not. They have the most to invest, and are earning nothing on their money. And over half of all people pay no taxes! Listen, taxes are going up, that is not the debate. The debate will be over how the government gets the other $1.2 trillion they need, and if they raise taxes even further, then the underground economy will flourish, as it does everywhere with high tax rates. Look at Greece, where only 2 citizens reported income over 1 million euros.


Let move onto AIG. It would have been possible to strip AIG, the parent of all its operating subsidiaries, since the insurance subsidiaries were overseen by local insurance regulators. What would have been left is a bankrupt financial products group. The government could have allowed the various banks who would have taken losses from an AIG default some capital relief, instead of making everyone whole. The government let Lehman fail, but could not see its way around AIG, so I am not so sure what the difference is, other than “trust us, letting AIG fail would have been too big a problem”. In any event, what happened is now history, and the Obama administration will be judged on how the resolution of AIG turns out. Letting AIG walk away from the reduced bid for their Asian operations will turn out to be a stupid move. Maybe they know something we do not, but in my opinion, this is taking too much time. The US government should not be a majority shareholder of AIG. AIG needs to be wound down now!


Rescuing AIG was not a bailout for the rich. If you owned AIG stock, you lost almost all of your market value since 2007. The money spent on stimulus went predominately to fund extended unemployment benefits and to states, so they did not have to fire teachers; that is my simplified, yet incomplete summary, so I really do not see the stimulus as being rich friendly. And you cite the rising values of stocks over the last year. The rally which followed came out of a vacuum of such negativism, that the market had to rally some decent percentage from the low. And if you value stocks today, compared to their average price in 2007, stocks are still down 30%; the S&P is now at 1073, compared to an average of 1477 in 2007. I agree that 1073 is better than 666 at the low, and while stocks benefited from the government’s efforts, the plan did was never directed towards stocks. 


Additionally, the value of the rich’s real estate, while hard to value, is poised to drop more than the real estate of the average person. The government is still subsidizing mortgage rates via the GSE’s, who are buying or guaranteeing 90% of all mortgages made, and these mortgages are limited to a cap of $417,000, which effectively eliminates all properties over $600,000. Instead, these programs are supporting house values for the middle class, not the wealthy. In short, I have a hard time believing that the stimulus programs and budget deficits was meant for the rich, nor do I think the rich are benefiting from this more than the average person.


* Financial Regulatory Reform – the House and Senate conference committees came out with outlines of their compromise very early this morning. Bloomberg had a very well written, and lengthy description of the compromise on their top stories this morning. For those who are not Bloomberg subscribers, here is a link from Bloomberg’s website:


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Instead of recapping that story, I want to point out a few aspects which I think are noteworthy, and worth mentioning:


1>  Banks will have to spin their swap/derivative operations into separately capitalized units. My contention is that this will prove to be the biggest problem going forward. Additionally, the bill directs the regulators to move many of these derivative instruments onto exchanges, which will hold margin against these positions. The reason why derivatives have proliferated so much is because the banks have not had to capitalize their activities in a separate subsidiary. While the banks have 2 years to set this up, this will be a major impediment going forward.


2>  Banks will have to hold a 5% interest in securitizations when the loans being securitized are deemed to be high risk. This would have included much of the subprime universe, as such attributes as Interest Only loans and high LTV loans would have fallen into this category. Given how stringent new loan requirements have become, this will prevent the next subprime problems from occurring in another 70 years, but not likely to have much impact in today’s environment.


3>  The FDIC will have wind-down authority over all financial firms, which would have helped greatly in the case of Lehman, Bear, or AIG. This aspect of the law will come into play a lot quicker than most people think. Given my dire forecast for the next few months to few years, I believe the FDIC will be winding down a few very big institutions.


While financial stocks are doing better today, my prediction is that the wind-down authority will cause the ratings agencies to downgrade their debt, and having to capitalize their swap units will create additional strains on their capital. Read the Bloomberg article if you are interested in learning more. To me, this is a negative event for the financial firms.


* Trading points: I sent out the attached graph to the real time distribution last night. This depicts the S&P over the last 6 weeks, and shows how well the market has stayed within the trend channel, in each of the recent down trades. Here is my comment from last night:


“As most of you know, I make frequent use of trend channels, typically to alert me that a trend change is occurring, and to get out of a trending market position, when the trend shifts. This has been very reliable, as it relates to getting out of shorts. And it is with this in mind that I am presenting the the current down channel in yellow, and suggest that if we cannot continue the same rate of this slope, that it will be time to cover the shorts, or at least take defensive actions to preserve capital. Agreement on Fin-Reg between the House and Senate panels tomorrow could kick the market down, as most everyone has been trying to ignore what will happen to banks capital if the swaps groups need more capital. If the market takes out 1040, watch out below! We are close!”


I cannot emphasize how important the 1040 level is to the sustained welfare of the stock market. If the market follows the channel down to the 1040s today, then I will be very concerned that we could take that support level out next week. What concerns me the most is a free-fall which could happen if we break this level. An Elliott Wave interpretation of the charts leaves open a real possibility of a 3rd of a 3rd of a 3rd wave collapse. This wipe-out will be at least as vicious as the collapse in October of 2008, when we witnessed 2 collapses in close proximity to each other, with a 13% drop in 8 trading hours (1.2 days). From 1040, a 13% drop puts the S&P at 900, or the Dow below 9000. It would seem to me that some external event would have to occur to trigger such a move. If the Elliott wave interpretation is correct, then such a collapse is in the cards between now and October. This keeps me on alert for exactly what will cause such an event to occur, especially as we approach the technically important 1040 level.

   

Further lending fuel to the technically bearish picture is a “spiral calendar” date of October 10th, which Chris Carolan, who invented this method of time forecasting, is espousing. In fact, Chris has had the October date on his radar screen for years. Combining these two analytical methods gives me greater concern that we are near a precipice; if not next week, then sometime over the next few months.