Commit Fraud, Get Free Money

Borrow at 0%, Lend at 3%, Make Billions

Is it customary, when someone is charged with fraud and awaiting trial, to leave them in possession of the victim's credit cards, and, indeed, to continue to allow them to spend and gamble the victim's money?

In the corporate arena, apparently the answer is "yes."

U.S. vs. Goldman Sachs

While the putative victims in the SEC's fraud case against Goldman Sachs are two institutional investors, the real victims are the millions of Americans who've lost their homes and jobs due to Wall Street's role in causing The Great Recession.

Yet Goldman Sachs, by virtue of its status as a "bank holding company," continues to have direct access to the Federal Reserve's discount window, where the cost of money is . . . . nothing (not coincidentally, what millions of thrifty Americans are currently earning on their hard-earned savings).

Goldman Sachs and other too big to fail banks can then take that free money and turn around and lend it back to the government -- taxpayers -- for a risk-free 3% (more if you add leverage).

How much of Goldman Sachs' just announced $3.5 billion quarterly profit was made in such a fashion?

How about, just for the sake of decorum, suspending Goldman Sachs' access to free Fed money, until it's cleared of the charges pending against it?

Benjamin Franklin, Strategic Default, and Economic Recovery

Strategic Defaults Driving Retail Sales?

A penny saved is a penny earned.

--Benjamin Franklin, circa 1780

A penny defaulted on is a penny earned.

--Benjamin Franklin, 2010??

No, I have no way of knowing whether a modern-day Benjamin Franklin would have uttered the second quote. In fact, he didn't even say the first one (that hasn't stopped him getting credit for it, though!).

But the sentiment is well-placed.

More and more economists now see a connection between rising strategic defaults -- the term for owners who walk away from their underwater homes to preserve their cash flow -- and recovering retail sales.

That link helps explain a conundrum -- namely, why are retail sales improving when hiring is anemic and unemployment is still high?

Strategic Default Economics

The (partial) answer appears to be that people who've ditched their expensive mortgages have more disposable income to spend at Target, Bed Bath & Beyond, restaurants, etc.

Sometimes, A LOT more.

So, somebody who bought a home at the peak in Las Vegas (or Southern Florida, or Phoenix) for, say, $600k and has seen prices subsequently drop 40% could easily rent for $2,500 a month, instead of paying their $4,500 monthly mortgage. And live in just as nice a place.

Voila! An extra $2,000 in monthly disposable income.

Multiply that phenomenon by a couple hundred thousand people, and suddenly it's no surprise to see retail sales pick up.

Here's what David Rosenberg, former chief economist at Merrill Lynch and now playing the same role at Canadian firm Gluskin Sheff, says in today's edition of his daily market analysis ("Breakfast with Dave"):

Speaking of the U.S. housing market, we are convinced that strategic defaults by various homeowners, along with double-digit growth in tax refunds, have spurred the jump in retail sales (Easter timing helped too) of late. The economy is growing, the bulls are in a great mood, apparently we are into a new phase of job creation, and yet somehow 320,000 mortgage loans that were current when 2010 began were at least 60 days past due in March. Interesting.

--David Rosenberg, "Breakfast with Dave" (4/19/2010)

Of course, more borrower defaults ultimately means more foreclosures, which translates into more housing market supply -- and more bank write-off's.

But thanks to the Federal Reserve's policy of zero percent interest rates, banks are now booking huge profits to help offset their mortgage and housing-related losses ("Citigroup Posts $4.4 Billion Profit" -- WSJ).

They also continue to benefit from the government's unofficial policy of "too big to fail," with the implicit promise of future bailouts, if and when needed.

It all sort of recalls the chorus from a classic rock 'n roll song:

Take a load off Annie, take a load for free;
Take a load off Annie, And (and) (and) you put the load right on me

--The Band; lyrics, "The Weight"

The (financial) weight, indeed.

The Gold Tax

The $64 Trillion Question

What do rational savers and investors do in an environment of zero percent interest rates, where the daily headlines speculate how long major currencies (like the U.S. dollar) will hold their value as national debts mount?

Switch (at least) a little of their holdings to gold.

Even if that amount is relatively small -- say, 5% of liquid assets -- the effect on global commerce could be huge.

That's because 5% of global liquidity is still a huge number, and it's magnified many times that by something called a "fractional reserve banking system."

"Fractional reserve what???"

If you're not an economics wonk, stop here; however, if you can handle a little bit of brain teasing . . . . read on.

Global Money Supply: How Much?

To figure out how much 5% of the world's money supply is, one first has to estimate . . . the world's money supply.

If you know, send me an email.

However, as best I can tell, a working estimate is about $30 trillion.

That consists of both coins and legal tender, as well as short-term banking deposits, money market funds, CD's, and the like.

While definitions vary, to be included in the foregoing number, the instrument must be liquid -- that is, easily converted to cash and spendable.

Bottom line, defensive savers reaching for financial insurance conceivably could switch something like $1 - $2 trillion of their former paper money reserves into gold.

Or already have.

That's against a backdrop of recession-anxious consumers already upping their "rainy day" funds in case of extended unemployment, unexpected (and uncovered) medical bills, etc.

Cash vs. Gold

What's the big deal if people effectively put a trillion (or two) in their mattress?

Due to something called "fractional reserve" banking -- the system in developed countries today -- $1 on deposit at a bank theoretically can support $20 of loans. That's because banks typically only need to keep $1 in reserve for every $20 they lend.

So, a $1 trillion withdrawal potentially has the effect of reducing lending activity by $20 trillion.

That, in an economy where assets like stocks and housing have already taken multi-trillion dollar hits the last two years or so.

Missing Drain Plug?

To combat this contractionary dynamic, the Federal Reserve and other central banks have been, shall we say, "aggressively" increasing liquidity -- printing money.

Unfortunately, as central bankers have poured money into the global currency "bath tub," they haven't seem to notice that there's a big hole in the drain plug -- if indeed there still is a drain plug.

Ironically, it may even be the case that the more "fiat" (paper) money central bankers create, the more people defensively convert that money to non-fiat forms -- like gold -- to protect themselves.

Addressing this vicious circle -- and removing the "gold tax" -- would seem to be the biggest imperative for today's monetary policy makers.

P.S.: economists have various terms for times -- like now -- when monetary policy seems to be impotent (or worse). They include "pushing on a string," "liquidity trap," etc.