Something's wrong with the sausage machine.
In the good old days of the Soviet Union, there were two markets for consumer goods: The G.Y.M. (pronounced Goom, because it's Russian) and the Black Market. The G.Y.M. was the government-run Glorious People's Wal-Mart, where the comrades went to do their shopping. Usually the shelves were more or less empty, but if they had anything in stock, the government-set prices were cheap. Which was why there usually wasn't much to buy at G.Y.M.; the commissars fixed the prices at rates below actual production costs.
Gasoline was heavily subsidized, so shortages were constant; the government sold most of the fuel the U.S.S.R. produced outside the country for operating cash. Bread was a few kopeks a loaf, and while bread was usually available, the subsidized price was so low that kids used the round loaves for soccer balls. Despite the vast tracts of wheat planted by the kolkhozniks, the Soviets had to import U.S. and Canadian wheat year after year. The Glorious Revolution had a few kinks in it.
Now, back to our two markets. When the shelves were empty at the G.Y.M., there was an alternative. The Black Market was out back, in the alleyway. You went there when you really needed something, like a pair of Levi's or a fuel pump for the Lada. You kept your wits about you, because it was a serious business to get caught dealing in the black market. Why? Because the black market was the real market, the honest venue for un-rigged transactions, and its existence exposed the "official marketplace" for the sham it really was. If you had the rubles, or better yet the greenbacks, you could get most anything you needed in the Soviet black market, but you paid a price. There was a "Lubyanka Surcharge" tacked on to compensate the seller for the risk of jail time.
Markets are supposed to work that way. They're supposed to factor in all the inputs including supply and demand, quality, and all known risks including risks to future supply and even the risks of long-term ownership. Like, say, holding a T-Bond that yields 4% through 30 years of inflation. Then, with all known factors weighed, buyer and seller get together and set the price between them.
Our markets are no longer operating that way. Big, shadowy realities are looming over the marketplace, distorting transactions and preventing normalization of prices. What has gone wrong?
At its root, the problem is that they're no longer honest, genuine markets. In a real marketplace, buyers and sellers transact freely. An honest price is the point where the highest bid price meets the lowest offer to sell. Everybody knows that, right? Apparently not. The Federal Reserve is out of the loop, and dancing its own tango.
By interfering in the markets, the Fed has set in motion a chain of events that will create outcomes that no one can predict. The markets for equities, fixed-income assets, and even real estate have been knocked way out of kilter by central bank interventions. Instead of buyers and sellers agreeing on a price, the market now has a third shadow participant in the form of the Federal Reserve saying, "You win, but you lose" and "You're too big to fail, but you we can manage without."
Like the ancient chart of the world with big blank spaces, the Fed's new course leads off the financial map into terra incognita. The production-based economy became the asset-based economy, which is now turning into the intervention-based economy. Wall Street has joined the Moral Hazard Club, but you and I are not invited. See for yourself:
http://www.minyanville.com/articles/index.php?a=16812
Now, instead of authentic markets, we have a giant constipated sausage machine that should have been left alone to process the meat at its own pace. But the pace of output wasn't good enough for the Fed. Back in the 1990's they pushed the input lever to High with cheap credit until stock prices burst out of their skins and went bad. Alarmed at the smell of decay, the Fed pushed the lever to Higher Still and made sausage out of the real estate markets. They didn't foresee the bankers grinding up sausage to make bigger sausages, and now the output side of the machine is plugged up with smelly stuff nobody wants to buy. It's been said, if you like sausage, better not to see how it's made. It holds true for financial sausage.
The Fed is now in a panic. The sausage machine is clanging and wheezing, and so the Fed is pushing the lever all the way to Maximum Overdrive with credit facilities never before envisioned. TAF's, TSLFs, Broker Lending Facilities--even the U.S. Treasury Dept. has jumped in with Free Money Disguised as a Tax Rebate. Never mind that Americans' 2007 tax dollars were all spent back in 1994. Never mind that those "tax rebates" are just more money borrowed from future wages. The feds assume you're too happy to get your hands on a few bucks to question where it came from, or else you're too stupid to even connect the dots. Spend that money wisely, because you haven't earned it yet.
In their rush to cancel out the bankers' losses, the Fed has triggered fresh implosions. It seems that the latest area of credit derivatives to post huge, mostly unrealized losses is the CDS market. It's estimated that more than $50 trillion in credit-default swaps were issued as insurance policies against wobbly mortgage bonds and other obligations built on consumer and commercial debt. Now the value of those default swaps is plunging:
http://www.nytimes.com/2008/03/23/business/23gret.html?em&
ex=1206417600&en=7426961ba18ad235&ei=5087%0A
What's going on here? In simple terms, the Fed has rigged the market. When the Fed persuaded JPM (NYSE: JPM, Bullboard) to take over the failed Bear Stearns (NYSE: BSC, Bullboard), they threw in $30 billion in insurance against losses on those Bear liabilities. The Fed has effectively guaranteed that Bear's assets will not fail, and rendered the credit insurance taken out against them unnecessary and thus basically worthless. Think about what the Fed's actions mean for anyone who bought credit default swaps, either as insurance against loss or merely as speculations on the failure of paper they never held. The Fed is saying, "You won't be needing that credit insurance, boys. We're backstopping the paper markets through our Term Securities Lending Facilities." Result: the CDS market is in freefall.
It's a whole new universe of moral hazard. The guys who were prudent and bought insurance have wasted their money. The speculators who were smart (when they figured that subprime mortgage derivatives were doomed) have been cheated of their profits. The most reckless and irresponsible have their backs covered by Ben Bernanke and his monetary magic.
In this new era, the Fed is attempting to rig the credit, currency and commodities markets. The Federal Reserve Board is not willing to allow interest rates to find their own level. The Fed exists to "fix" the price of money through its open market operations, to try to sustain a high rate of growth in the economy. Likewise, the Fed is not willing for the U.S. dollar to find its proper price level, nor are central bankers willing to let the gold price run free. The price of gold is just beginning to reflect the size of the money supply and the rate of its growth. If allowed to run free, the gold price will be like the Soviet Union's black market: A flashing red light on the dashboard, warning that the system isn't working.
The capital markets are neither casino nor playground. Ditto the credit markets. Both are critical to the functioning of our complex society, with all its economies of scale and finely balanced mechanisms of finance and production. The Fed's reckless button-pushing and lever-pulling will have unintended consequences, and the odds are, the consequences will be serious. And since we've never been down this road before, it's virtually impossible to know how markets will react to Fed manipulations, and equally impossible to prepare prudently for the reaction.
The Fed has become the ultimate Black Swan, an utterly unpredictable Mad Magician of the Markets. No one can foresee what tape-twisting card trick the Fed may play, or what market-moving creature they'll pull out of a hat the next time the urge to intervene strikes them. With an incantation the Fed can magically turn losers into winners, or pull an entire sector out of line and push a different one in its place. Fundamentals no longer matter; technicals don't matter; even market psychology doesn't matter any more. Only the Fed matters.
This loose-cannon Fed makes investing a game of blind-man's bluff. It makes gold a risky trade, despite the sabotage of the dollar. It makes short-selling the dollar a wild gamble. How can you play Pin the Tail on the Donkey if it turns out you're the donkey?
The Twin Crises of credit and derivatives were not Black Swans: They were foreseeable, and were in fact predicted by many, including Warren Buffet and George Soros. Smart traders and prudent investors took out insurance by betting against bank stocks and taking out credit-default hedges. Seeing this, the Fed took off its Police badge, put on a hoodie and proceeded to knock those prudent people down and snatch their purses.
Prudent and responsible people didn't buy overpriced houses with mortgages they didn't qualify for; instead, they saved money in bank accounts and bought Treasury bonds, only to find the Fed has pulled the plug on their dollars to rescue the bankers who took huge risks with lending capital and borrowed money.
This Fed is now a street thug on Wall Street, a Robin Hood in reverse--it steals from the poor to give to the rich. If and when the prudent folks with the government bonds and the savings accounts figure this out, the Fed will have a whole new set of problems.
At that point, card tricks and magic hats probably won't cut it.
