Thursday, April 26, 2012

Faith and Fiat Money

By Bert Whitehead M.B.A, J.D. © 2012

"Fiat Money" is commonly defined as money that has no intrinsic value and cannot be redeemed for specie or any commodity, but is made legal tender through government decree.

I have heard "Faith" defined as the belief in the experience of others.

This sums up our long-term economic dilemma. Since Nixon ended the convertibility of dollars to gold to combat inflation, the U.S. has given up any pretense of backing the dollar with gold or any commodity. So the currency we carry in our wallets and purses is essentially only slips of paper with pictures of dead white guys.

U.S. dollars are nonetheless respected and used globally as the world reserve currency. This only persists because everyone believes the dollar has value and can be used by people to buy things. Thus, we have faith that we can spend dollars to buy what we want. So far, so good.

But what happens if people around the world stop believing this? How could this scenario unfold? What can you do to protect yourself? This is the scare tactic that gold advertisements trumpet to entice people to protect themselves by buying gold as an investment.

There are over a hundred instances throughout the centuries during which governments issued paper money and backed it by a commodity, usually gold. "Fiat" paper money has never, however, lasted more than a few generations. Gradually these rulers or their successors could not resist printing more money to increase their spending to finance wars, or cover desirable social objectives. By decree they declared an increase to the legal currency even though they did not add enough gold to their reserves. This became known as Fiat Money.

Once merchants realized that they couldn't convert their money and receive the amount of gold they expected, they raised their prices. Inflation results when too much money chases fewer goods and services. In the 1970's this global issue was addressed by allowing currency values of each country to 'float' against other countries.

Government overspending is a hotly debated topic. Some economists (Keynesians) insist that there are times when it is appropriate for governments to run a deficit. They argue that, unless the government 'primes the pump' by increasing national debt, the country's economy could spiral into depression. The other side provides evidence that a government can't be trusted to ever pay off its debt. Running annual deficits will gradually debase the money and the economy will inevitably be ravaged by inflation.

Both sides of the debate can point to situations as proof that their theory is correct. Take the Great Depression, for instance. Did FDR's social economic stimulus bring our economy back to life in the 1930's, or was it really our entry into World War II that rescued the economy? Was the inflation in the 70's a result of the oil cartel raising prices, or did it arise from Nixon printing more money?

In reality, economics is not, strictly speaking, a 'science.' We can never apply the scientific method to economics since we can’t suspend a complicated global economy in time and study the effect of controlling selected variables.

Modern economists insist that the soundness of a country's 'hard' currency is not determined by how it is “backed”, but rather by whether it is easily converted into other assets. Historically, gold facilitated this convertibility, but that has been replaced by a nation's productive capacity, or gross domestic product (GDP). This seems reasonable, though it can be argued that this is a purely academic paradigm. Alas, austerity is the only known antidote to runaway inflation: we never know when our money ceases to be convertible (or 'spendable') until we can't spend it any more!

Today, for example, people would surely be hesitant to accept Greek drachmas at whatever rates their government decrees. As Argentina nationalizes private property to support their government spending programs, they should expect that the rest of the world will increasingly distrust the value of their peso. All countries that ignore economic realities are eventually exposed as their 'soft' currency starts trading on an internal 'black market.' The 'black market' sets the true value of their currency, irrespective of what the government decrees.

The take-away of this blog is simple: Currencies today do fluctuate in value. Trying to guess which one will go up next is not investing: it is gambling. Gold can be comforting if you can't sleep, but don't bet your retirement on it.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY

Monday, April 9, 2012

Goldman Sachs Fiasco: What it Means to You

By Bert Whitehead M.B.A, J.D. © 2012

It is about time we called it like it is....The ethical standards of financiers across the board are notorious for being somewhere between lax and non-existent. This is so ingrained that most firms dealing don't even think that their behavior is errant.

Goldman Sachs is now the pimple getting squeezed by the feds. Their firm is notable in the acne scarred financial landscape only because their greed duped even their peers beyond prior boundaries. Their financial practices are held up as the cause of the current economic meltdown, but in fact Goldman's executives are not feigning surprise.

Looking back at who caused the current bubble is a charade of shady practices instilled in virtually all the players in the money game. The bubble was kicked off by the politicians in 1999 with the repeal of the Glass-Steagall act. This was pushed by Clinton and endorsed by the then-Republican congress to free banks to participate in the full smorgasbord of financial offerings. Instead of just providing savings accounts and direct lending, now they could offer brokerage services, securitize debts on the secondary market, act like venture capitalists, etc., just like the big wirehouses. It was expected that this would create more competition.

So our current tragedy was birthed by the best of political intentions which seemed like a good idea at the time. Instead, as often happens when the government tries to effectuate public policy, they accomplished the exact opposite of what was intended.

There was a strong social policy, backed by both parties (as well as Acorn), to make housing affordable to all Americans. The percentage of homeownership during the 90’s expanded to almost 70%, up from 62% in the 1980’s. Congress pressured Fannie May and Freddie Mac to loosen lending standards to accommodate the increased demand for families to own their own homes. These private mortgage companies had nothing to lose by taking more risk because they were essentially indemnified by the federal government.

Key to this was the bundling of mortgages to be sold on the secondary market. One problem, however, was there was no experience rating to judge the future performance of such an influx of sub-prime borrowers. Rating agencies over-rated these offerings using the inadequate information available, because they are paid by the folks selling these securities rather than the investors ultimately taking the risk.

This egregious conflict-of-interest has been an accepted practice for decades. Even when underwriters issuing stocks for companies were exposed, no meaningful changes were made. Instead, the brokerage companies (including not only Goldman Sachs, but Merrill Lynch, Smith Barney, etc.) simply started a new department within their firms for their ratings business. This was justified because these new departments would be insulated by a ‘Chinese Wall’ so that investors could rely on their ratings. This was not only proposed with straight faces, I’m convinced the financial executives really believed that it was ‘business as usual’ and it would still enable them to sell new offerings.

With their mortgage bundles now over-rated, it was a good time to become a mortgage broker serving sub-prime borrowers. To put it gently, most sub-prime customers are not very financially savvy. A predatory mortgage broker would befriend the customer and offer to turn their dreams into reality. The commissions earned on these mortgages typically ranged from 6% to 12% of the full amount of the mortgage. They were constructed so that they were affordable at first, and buyers were assured that they would be able to re-finance in a few years, and the home values would continue to skyrocket.

These over-valued securities started getting wobbly when investors realized that more than the expected 4-5% of sub-prime borrowers were defaulting; the actual default rate even at the beginning was 10-15%. Like a game of ‘hot potato’ financial firms rushed to offload their failing mortgage bundles, and sold them to one another, and any one else. It’s not that they actively mislead other firms, but they didn’t provide full disclosure as to the risks which were becoming evident.

But why should they have to disclose risks, or conflicts of interest? When you listen to a Goldman Sachs executive explain their innocence, it’s like listening to a life insurance or annuity salesperson explain their commissions:

“How much in commissions do you earn on this sale?”
“Why do you need to know that? It has no relevance as to whether this is a great investment for you. Letting me put your money to work will more than cover my commission!”

The real problem here is that the financial industry does not believe they owe a fiduciary duty to their clients. A fiduciary duty means they have to make full disclosure of their fees and compensation, any conflicts of interest involved, as well as all the risks involved.

Yes, I am very biased on this issue because I think financial professionals should be held to the same fiduciary standards as doctors and even lawyers. This has been proposed in recent financial reforms, but the lobbies of the institution as is see no need to change because ‘this is the way business is done!”

Good grief.

N.B. This blog was originally written two years ago. My colleagues cautioned that it was too vicious to send out, so I put it away. With Goldman Sachs back in the news in this context, I brushed it off and had some of my family, friends and clients review it again. They suggested I tone it down, but urged that it be published. So I am going ahead now.