Financial Literacy

Large banks and companies borrow money amongst themselves for overnight cash flow planning and reserve requirements by their treasury departments. This is called the overnight repo market and is a trillion-dollar market (repo refers to repurchasing government treasury debts). There was such a shortage of available money last week, that overnight interest rates spiked from 2% to 10%. This spike was so high that the U.S. Federal Reserve injected billions to stop the overnight market from freezing up.

What is going on? Since the 2008 financial crisis, the U.S. Federal Reserve has put trillions into the U.S. financial markets by purchasing all kinds of bonds. This provided liquidity to all of the large U.S. money-center banks that were insolvent at the time, and boosted the economy. Over a decade later, in order to draw some of that extra trillions back out of the economy, the Federal Reserve has been selling bonds and allowing some to mature, pulling billions out of the financial system for about the past two years. This contraction of money will slow the economy, and banks hitting cash shortages resulted in last week’s overnight spike.

When a bank cannot get money in the overnight repo market from other lenders, then the lender of last resort is the U.S. Federal Reserve’s ‘Discount window.’ For several nights in a row the Federal Reserve had to buy $75 billion worth of bank assets to support the banks. Granted, it was not a normal day (corporate tax payments were made plus U.S. debt auction settlements – both of which sucked money out of the banking system), but all of this was known well in advance.

There are two views of this event:

1) The Fed now knows that they need to provide a much higher level of liquidity in the repo market, and they are doing that, so everything is operating normally.

2) This highlights that the banking system is so fragile that it could collapse any moment! The repo market is the canary in the coal mine for the rest of the banking system. (The average treasury security is re-collateralized 2.2 times so 3 people can believe that they each own the same asset. It is a game of musical chairs that isn’t well tracked.)

My view is that opinion #1 is correct in the short-term, that this was no big deal to the banks or the economy. However, it is still a colossal amount of money and I expect the Fed will have to lend around a half a trillion over a 3 week period. The size of this repo problem is unsettling, which leads to opinion #2: it may also be correct in the very-long term. As money manager Mitch Feierstien says, “You cannot taper a Ponzi scheme” and the Federal Reserve has been kicking this can down the road since its founding in 1913. They ramped up money printing in 1971 (when the U.S. went off the gold standard), and supercharged the money printing in 2008 with over $4 trillion. Just retracting a little of that extra money sloshing around the economy nearly seized up the overnight lending market. It appears that permanent money printing (called quantitative easing by the Fed) may not be reversed without adverse consequences. We all know how Ponzi schemes end, but I do not see signs that it will happen soon. (Although JP Morgan just informed their wealthiest retail banking clients that the U.S. dollar is losing it’s world reserve status so they should begin diversifying their assets into gold and Swiss Francs). Prudent risk management of your money is always important. Planning for unfavorable economic scenarios, even during these current times of high employment, is highly advised.

What will a financial crisis look like? The same as they usually do:

• Liquidity will freeze in a specific market (buyers will step away from making a price in an industry that is in a speculative bubble at the time, and those asset prices will fall).
• That liquidity crisis will begin a credit crisis (lenders will withdraw from making loans, it could begin in junk bonds, overnight repos, real estate loans, corporate bonds, or loans in industries in a speculative bubble like student loans or small oil frackers).
• The lack of lending will begin loan defaults from companies relying too heavily upon them.
• Those defaults will begin a cascade of secondary and tertiary defaults as solid loans are called-in by banks to be paid off immediately.
• The expectation of further defaults will cause the stock market and bond market to fall.
• The cascade of defaults will begin a currency crisis as demand for the dollar will fall.
• Jobs are quickly reduced, financial markets fall, businesses retreat, and a recession begins.

Much of this volatility will occur simultaneously, over hours and months, as government officials get in front of any camera, repeating that, “The problem is contained, there is absolutely nothing to worry about,” (exactly as they did throughout 2007-2009).

The U.S. stock market fell 5% this week when the Chinese currency, the yuan, hit a record low. What is going on in this trade dispute?

China was approved into the World Trade Organization (WTO) in 2001, allowing them access to free trade with the largest economies in the world. At the time, U.S. President Bill Clinton claimed that, “now we will be able to sell cars, have distribution there, open up telecommunications, lower their tariffs, and a hundred other favorable deals for us. Plus, it will make them more democratic and capitalist.” None of this occurred. Instead, China has stolen intellectual property, illegally dumped goods in the U.S., and the communist leaders still control their economy. The net result has been 4.5 million jobs leaving the U.S. for China, along with zillions of dollars in trade deficits.

Since 2001, not a single country or U.S. President has pushed back on China’s illegal and damaging behavior. That is, until President Trump. Trump has slowly been ratcheting up rhetoric and tariffs against China to level the playing field and force them into a fair and accountable trade agreement. Since China hasn’t been forced to back down in the last 18 years, they are not inclined to now, setting an unfavorable precedent. China is using every negotiating trick in their book in return – walking out of meetings, increasing tariffs on U.S. goods, and this week, lowering the yuan. This currency manipulation (which is also illegal) meant that China has more economic weapons they are willing to employ to avoid a Trump trade deal. Lowering the yuan could be a repeat of 2015 when other Asian countries were forced to lower their currency as well to keep their economic growth on track.

It is impossible to predict whether there will be some kind of trade deal and how that will impact Americans. For example, someone may have to pay an extra $2 tariff for a Chinese made shirt, however, the drop in the yuan may be $2 so the net effect may be zero on some items. (Although today for example, one of the U.S. tariffs is 25% and is only offset by a 5% drop in the yuan).The largest impact could be a reduction in the relentless intellectual property theft and counterfeiting out of China, boosting the economy of the U.S., Europe, India, etc. What is important to keep in mind is that any trade deal is a long-term game and worth any short-term volatility to get to a fair trade deal, for the first time, with China. While some business pundits whine over a Trump tweet during stock market trading hours that results in a few million temporarily lost, they should instead focus upon the result of the trade deal which will impact trillions of dollars and millions of jobs for generations.

Economics is simply the supply and demand for goods and services, along with the price discovery where people agree to transact. Anything that artificially caps or supports price above or below the free-market amount makes everyone worse off. Normally, it is the government creating false prices that backfire with unintended consequences (as with every socialist effort). In spite of rent control disasters and not a single economist in favor of them, “free” and “cheap” never goes out of style with politicians to buy votes. The latest price control becoming popular again is rent control. Although rent control for limited buildings has been around forever to create welfare housing, two states just passed state-wide rent control programs: Oregon and Illinois.

Before I get to those two states, let me mention Detroit. Detroit began intervening in the rental market 6 months ago and it is having a big impact. The city wanted to address the small number of horrible slumlords renting junkers with a new government bureaucracy. Officials decided that rentals must have a certification, and part of the application, is that the property must have passed a physical inspection with a long list of requirements. Now, Detroit is very poor where 32% of households live below the poverty line. Where people are poor, rents are low, and where there are low rents – there is very little money for a high level of maintenance and repairs. So far, Detroit rentals have a 97% failure rate to meet the inspection requirements. To sustain all of the required elements is far too expensive to be supported by the average affordable rent to Detroit tenants. So landlords can either operate without a certification or they abandon their rental properties. Both of these are occurring in a big way: only a tiny percentage are applying for certification, and property managers across the city say owners are abandoning huge swaths of rentals; creating more blight for Detroit. I have also spoken with landlords selling their Detroit properties to buy rentals outside the city limits. Instead of improving a tiny number of rentals, Detroit is actively destroying their rental stock. Plus, the added bonus of raising rents for the niche neighborhoods that can support a higher rates.

This same phenomenon occurs every time government intervenes in a heavy-handed manner into the rental market:

1. The number of available rentals plummets (converted to other uses, new development slows).
2. Quality of rentals plummets as profits are reduced due to lower revenue.
3. Rents increase far more than normal before the caps are introduced, and even after the caps over time because landlords will be eager to maximize any rent increase windows.
4. Rental homes fall in relative value from the drop in potential profit, reducing income to the county from property taxes.
5. Trailer park rent rates near these cities has been going up by 15% for the last two years.
6. The outcome of the government intervention is usually the opposite of the policy intent of the politicians.

This year, rent control is being tried at the state level in Oregon and Illinois (using 6 regional rent control boards across the state). Oregon is suffering from self-inflicted governance. When the government forbids housing development to keep up with the influx of people (exactly like Seattle), then rent and housing prices soar. Now to “solve” the housing problem that the government created, they need more government interference in the form of rent control. In Oregon’s case, they are limiting rent increases to 7% per year. Sounds reasonable, but this rule basically applies solely to Portland where rent and home prices have been increasing far more than that rate from the growing population. I predict that all of Oregon rents will be increasing. Why? A landlord may keep rent low for many reasons, and due to new costs or regulations, need to raise them quite a bit in one year. But this is no longer allowed with rent control. Since landlords are now forbidden from “catching up on rent increases,” they are highly likely to make certain they get an increase each year to stay ahead of possible cost increases instead of being behind after they actually occur. Going forward, it is nearly certain that rent inflation across the state of Oregon and Illinois will be higher than their neighboring states.

*Oh, I nearly forgot to mention the corruption. Anytime you have rent control, you also get politicians, bureaucrats, and inspectors ripe for bribes, kickbacks, extortion scams, and more. Sadly, all of this tempting corruption is an ongoing issue that never goes away: higher rent rate increases, special exemptions, bribes for certifications and inspections, etc.

Each country has a Central Bank (or entity that acts like one) that is responsible for their monetary system. This includes increasing or decreasing the money supply to: stabilize the economy, the inflation rate, the currency, and sometimes other goals such as the unemployment rate. There is another institution located in Basel, Switzerland called the Bank for International Settlements (BIS). This is the Central Bank for all Central Banks at the global level. The purpose of the BIS is to support central bankers with payment processing, their monetary policy, and the stability of the world’s banks.

You may have heard of Basel Agreements (or enumerated versions of them like Basel III Guidelines), referring to the BIS setting of voluntary regulations for the banking industry. Well, you may not have heard that the latest agreement for the end of March, 2019 is that gold will become a Tier I capital asset for banks. This hasn’t been the case for decades, bringing back a quasi-gold standard that President Nixon eliminated in 1971.

Gold bullion is currently considered Tier 3 capital for banks and there has been an international debate since 2012 on elevating gold to Tier 1 status. Each bank must have a minimum level ratio of capital to loans and this capital ratio is based upon approved tiers of asset classes. Tier 1 is the most valued and conservative type of capital. Although changing gold to Tier I has been delayed several times, it may actually come to pass in a of couple weeks. This may help explain why so many central banks have been on a gold-buying spree for the last three years: China, Russia, India, Turkey, Hong Kong, Egypt, Indonesia, Mongolia, Kazakhstan, and others.  This elevation in the status of gold for banks may make it more important to investors and speculators. Will this increase the price? Normally, it would. However, the systemic rigging of the price of gold (and silver) from opaque bullion vaults, dealers, and central banks makes this impossible to predict. But if the Central Bank to the world’s central bankers is making gold more important to bank’s balance sheets for stability, then it may be time to make it more important to your own personal balance sheet as well. Do the insiders know something about upcoming financial changes that will affect Tier I assets? The BIS (who swaps gold by-the-ton between central banks all the time) are the people who would most likely know. If the BIS is shifting gold’s position it may be prudent to consider examining or copying that shift.

While some companies slowly march toward obvious bankruptcy (Blockbuster Video, Kodak, Sears, etc.), others are technically insolvent but still able to lope along for years. Let’s examine three current large ones that, in my opinion, are The Walking Dead still loping along.

General Electric

GE has been a manufacturing powerhouse for over 100 years, and at one point was the 4^th largest company in the world. GE once had a AAA credit rating and today their bonds sell at junk-rated levels (GE Capital will need a $20 billion cash infusion to last the next 2 years alone). While their jet engines and power generation turbines are great, the company leadership ran it off the cliff with moronic forays into lending businesses. For example, instead of selling a jet engine, and perhaps lending the money to purchase most of that engine – GE would lend the money for the entire plane, many multiples of the value of their engine. So if there is an industry downturn, loan losses would subsume all profit and then some. GE also made mistakes in commercial real estate loans and even poor-credit consumer loans in Europe. The result of all these loans going bad during 2007-2009 is GE became a zombie company. In 2000, the stock price peaked at $60.50 in 2000 and as I write this the price is under $9, a capital loss of 85%. If GE survives enough decades to take profits from their manufacturing operations to shovel at their loan losses, perhaps it could survive without going through bankruptcy.

Deutsche Bank

Deutsche Bank (DB), is another company that is over 100 years old, a German bank that grew to become one of the top 20 banks in the world. Unfortunately, they made 2 critical errors. First, they loaded up on U.S. subprime mortgages before the U.S. real estate bust in 2008. Second, they went really big into all kinds of derivative contracts that created several financially unfeasible risks that it did not understand. These mistakes resulted in losses so large that the European Union had to bail them out, and their risk exposure is still many multiples larger than the entire European economy. The next recession may force Deutsche Bank into bankruptcy because it still fails “stress tests.” Deutsche Bank’s liabilities are so enormous (tens of trillions of dollars) that if it declares bankruptcy, the European Union itself may collapse just like the U.S.S.R. did in 1991.

Adding to these risks are fines and penalties. Like nearly every big bank, Deutsche Bank also periodically gets caught engaging in systemic fraud: rigging the gold market, rigging Libor interest rates, rigging foreign exchange rates, tax evasion, suspicious trading in Russia, violating UN economic sanctions to half a dozen countries, and money laundering for criminal cartels.

While Deutsche Bank’s stock price peaked in 2007 at $159.76, as I write this it is under $10 per share, a capital loss of 94%.

The Japanese Yen

If GE went through bankruptcy, the failure would be negligible to the world’s economy. DB’s failure would be a storm across all of Europe. But the big zombie nearing collapse is the Japanese Yen which would impact the whole world.

The Bank of Japan (their Central Bank) has been propping up the Japanese economy since the late 1990s. By suppressing the value of their currency for cheap exports, combined with propping up insolvent banks still wasn’t enough to help their economy. So the Bank of Japan continued printing more and more money to: pay unaffordable public pensions; prop up their bond market; and finally, propping up their stock market. The Bank of Japan just hit a new record on November 10^th. The Bank of Japan has a balance sheet as large as the country’s annual GDP, 552.8 trillion yen. This means Japan’s central bank has printed so much extra money it has been able to purchase a year of the country’s output. The Japanese central bank’s debt to GDP ratio is an unheard of 253% (as a comparison, the U.S. is 20%). The central bank has been taking this extra money printing and not only buying bonds with it (to reduce interest rates), but buying Japanese Stocks (through exchange-traded funds). The Bank of Japan has bought so much stock that it now owns 55% of the outstanding shares of Japanese public companies!

Some call this a Ponzi scheme or counterfeiting money to confiscate assets. No matter, because the Japanese money-printing game will end once it hits some type of insolvency event. This event may be needing to borrow foreign money or the Japanese Yen falling in value so far that the Bank of Japan cannot provide it any support. Then Japanese inflation would explode, foreign debts could no longer be paid back, and the Central Banker’s money printing scheme will have run its course.

While many financial experts claim that silver-as-money is a barbaric relic from 150 years ago, JP Morgan has amassed a stockpile of at least 700 million ounces (according to silver researcher Ted Butler) that is worth over $10 billion. This stockpile began in 2011 when JP Morgan opened their own silver warehouse, starting with no silver. Although JP Morgan is the largest commercial stockpiler of silver, there are 7 other large financial institutions (Such as Scotia Bank, Goldman Sachs, Citigroup, Deutsche Bank, HSBC, Bank of Japan, etc.) that are also involved in silver trading on a massive scale. Why is this?

Are these investment houses/bullion banks just sitting on vaults of commodities like crude oil, wheat, copper, and silver? JP Morgan is the custodian for the giant silver ETF (ticker symbol SLV), however, they have around 8 times the amount of silver necessary for SLV and are steadily increasing their stockpile. Less than 5% of their silver holdings are registered for trade on the COMEX exchange. Unless JP Morgan is holding all of these ounces for customers (highly unlikely), then JP Morgan may be holding all of this silver as a speculation. Be aware that stockpiling silver isn’t cheap – there are expenses such as facilities, security, utilities, tracking, physically moving it (the 1,000 oz. bars weigh 62.5 pounds each), physical audits, and more. These banks operate for a profit, so where is the profit to cover the cost of holding this stockpile coming from?

JP Morgan also holds the largest short position in silver on the COMEX futures exchange where the price of silver is set. Again, there are 12 other giant financial firms also shorting silver (betting on a price drop). Silver’s open interest in futures contracts divided by the days-of-production is larger than the open interest/daily production for crude oil, wheat, corn, soybean, copper, and sugar – combined. Since these other industries are larger than silver, then why is open futures contracts on silver/daily production the highest, by far?

The largest financial firms in the world are increasing their stockpiles of silver while simultaneously shorting the price of silver in the futures market; and doing all of this in unison. Why is this?

A few theories to explain this mystery by silver analysts include:

1. These bullion banks have been suppressing the price of precious metals to hide true inflation since the U.S. went off the gold standard in 1971. When excessive money printing and true inflation can no longer be controlled, silver is expected to soar, far more than gold, and they are preparing for what they believe is an eventuality.
2. These bullion banks are expecting silver to skyrocket in anticipation of the U.S. dollar beginning to lose its standing as the world’s reserve currency. Then the banks will cover their short positions, stand aside, and let the price of silver rise to create a giant capital gain.
3. These bullion banks are just making money on the pendulum swings in price. Their model is to increase their short silver position to drive the silver price down, then increase their stockpile at a cheaper price and reduce their short positions. After which they allow the price to drift back up again for a profit before throwing on a giant new short position; making profits on these price swings, over and over.
4. JP Morgan’s physical stockpiles are fake, they really just have paper silver contracts to help them manipulate the price of silver.
5. Today, most non-Western central banks are adding to their gold reserves as fast as they possibly can (China, Russia, India, Turkey, Hong Kong, Egypt, Indonesia, Mongolia, Kazakhstan, and others) leaving the other precious metal, silver, to be controlled and cornered by the relative little guys, the large banks.

For more investment bank silver history, in 2008 Bear Stearns went bankrupt, partially from losses on their giant naked-short position in silver; which was forced to merge with JP Morgan for $2 per share. Canada’s Scotia Bank lost between $500-600 million on their naked-short position in silver in 2011 on a price spike. Shorting silver by banks has been around a long time, but at this time many are also holding physical silver.

Can anything be inferred or deduced from all of this? In my opinion, it is still too much of a mystery for a retail investor to follow with any confidence:

• A dozen Central Banks in “Emerging Market Countries” are loading up on physical gold. This is so their country can offer a stronger and more competitive currency in anticipation of the next world’s reserve currency structure. Whatever that structure may be, they are assuming that physical gold holdings will be part of the formula.
• Many of the world’s largest banks have stockpiled physical silver and a few are aggressively adding to their stockpile with a long-term time horizon of years or decades. But they are also actively trying to keep the price of silver artificially low by shorting large amounts of futures contracts.
• The price of an ounce of gold today is $1,207 and an ounce of silver is $14. For as long as I can remember, gold bugs have been claiming the fair price for gold is $10,000-$25,000 and silver bugs have been claiming the fair price for silver is somewhere between $100-$500 per ounce. Well, I’ve been hearing these claims for over 45 years and nothing like that has yet occurred.
• There is a large community of “silver stackers” who buy more physical silver on a regular basis, as some or all of their savings. They add to their silver stack in anticipation of the next major fiat currency collapse, hoping that precious metals will soar in value. Some silver stackers have been doing this since the end of WWII, other stackers have been doing this since the U.S. took the world off of the gold standard in 1971. Although there have been a couple bull markets in precious metals since then, I wouldn’t expect the colossal payoff the stackers have been hoping for anytime soon.

Today’s modern economy rests upon a foundation of 3 industries. These most critical industries are:

1. Commercial farming (the last +400 years).
2. Mining (the last 5,000 years for metals, stone products, and energy like coal and uranium).
3. Crude oil (for the last 150 years).

Everything currently manufactured, constructed, or transported consumes products from these 3 industries. If there is impairment to any of these industries, it raises prices, reduces efficiency, lowers functionality, and reduces the overall standard of living across the globe. While there are some substitutions available for some of the specific mining and oil distillate products, they are far more expensive and less functional. Other mining products have no substitutions at all. And while no one wants their home next to a mine, rendering plant, or oil drilling operation, the lifestyle enjoyed by the world relies upon them operating somewhere convenient for their usage.

Whatever new methods and technologies are developed to potentially replace these 3 industries, they must provide reduced cost and improved functionality. Otherwise, it is highly unlikely they’ll be successful in the long term. I attended a dinner with two educated professionals older than me, who wanted to immediately stop fossil fuel usage. They were shocked when I told them that all of the wind and solar power in the world amounts to barely 1% of the electricity generation. Going forward, that number is very likely to drop as government subsidies are drying up for additional wind and solar installations, let alone their ongoing repairs and maintenance. When that occurs, most of those structures will likely go fallow (there are already over 14,000 abandoned wind turbines in the U.S.). This is what happened in the last “sustainable energy” bubble under President Carter 40 years ago, and anywhere the subsidies run out, like Spain in 2010.

Whatever your attitude about these 3 industries, we rely upon them. (For example, swapping a gasoline-powered car for a lithium battery car means a whole lot more lithium strip mining must be done somewhere plus the coal to charge it). Which is why it is disappointing that U.S. government regulations effectively prohibit: building new oil refineries, nuclear power plants, new coal mining, and new technologies for farming or producing food. Not everyone has an economics background, which is fine. But when forceful opinions, from a state of ignorance, prompt legislators to make policy, then we’re all left worse off.