When Trust is Lost
When a child is suddenly confronted with the fact that its parents have not been honest toward it, all its in-born trust in its parents will suffer beyond repair. When suspicion of infidelity arises between lovers, all mutual trust and love will vanish like snow under the sun. From there on, and the child, and the lovers will have to find their own way. Real trust, once hurt, never returns.
Financially, with all the scandals of late, people's trust in the integrity of business, financial institutions, brokers, markets, in the accounting profession, the impartiality of the media, and the belief that one's savings are safe, has gone out of the window.
Loss of trust is contagious. Once the flames of suspicion have been kindled everything connected is bound to come under scrutiny, from finance to justice and on to politics. From Wall Street to the Federal Reserve, the SEC, the Treasury, the judicial system, to the lobbyists, senators, congressmen and on to the White House itself.
When September 11th hit, the trust that America was safe inside its own borders, the trust that the CIA, the FBI and the Pentagon were the infallible protectors of America was shattered.
There is no difference in the consequences and irreversibility of loss of trust in a country and its institutions or in parents or a love. America has entered a deep crisis which cannot and will not be corrected in a day and which will need many years to correct and overcome. Deep cutting, fundamental changes in the rules, in the attitude of people and politics are needed to get the country back on the right footing. There is more to it than reassuring, make-believe, speeches by a President or laughable window dressing by Wall Street, where the wolves think they will get away by just changing into another set of sheep-clothes. Not this time! Once trust is lost, anything related comes into question.
In the beginning there were only sporadic scandals occasionally popping up here and there. Like the Funds of Funds, the BCCI, the LTCM. More recently however the happenings have begun speeding up and in accelerating succession mega-fraud after mega-fraud is coming to light: ENRON, Tyco, Anderson, World.Com, Xerox, Merck, to mention but a few.
Inquiries and investigations into the various scandals have gotten off to a start. Journalists who earlier had not dared to write anything, which might have cast doubt upon the integrity of Wall Street, are now seeing their revelations published over the back of the established interests of the media owners. Not any longer are the editors able to hold back the surging tide of criminal revelations. And in order to be covered, just in case, employees of all levels of the financial world, who once would have thought twice before revealing information of shady dealings going on, have begun to come forward with their side of the story. On a daily basis rumors and hints of further scandals are appearing on the underground and not so underground pages of the Web. Questions are being asked by the media, in the Senate and in Congress. Questions are raised inside boardrooms: "Are we at risk to be found out?" "And if, will our friends in government be able to protect us?", "Who can still be trusted inside this very board room?"
It must become clear that business on Wall Street can not stay business as usual any longer. Dog eats dog, and the more so when the pressure is on. Trust is evaporating fast on Wall Street. Balance sheets are coming under close scrutiny and are bound to show either less profits or greater losses in future. Business relationships are being redrawn. "With whom can we still do business?", "Where are our weak links?", "Which defaults could be trailed to us?" An atmosphere of uncertainty and suspicion has invaded Wall Street. Business will not be the same again for a long time to come!
Loss of trust inside Wall Street, loss of trust by the American investors and last but not least, loss of trust by foreign investors in the American financial markets and the dollar.
The hurdles of the financial crises in the last fifty years were all resolved in due time, because the people in charge were still trusted at the time. Problems were resolved or could at least be patched up. The death of the fixed exchange rates, the collapse of the London Gold Pool, the closing of the gold window by Nixon, the Carter Dollar crisis with its resulting violent spikes in the prices of gold and silver of early 1980, the run on the British Pound, the one day 23% percent fall of the Dow on October 87, the Tequila crisis, the S.E. Asia crisis, all were overcome, except yet for the lingering Japanese financial doldrums and the present Argentinean crisis.
Today's crisis however is different. Not only has trust in the viability of the financial institutions proper and the respective watch dogs suffered, but also all trust in the financial elite has collapsed. And what is worse: suspicion of widespread, outright, criminal behavior and corruption on the highest financial level is creeping in.
The dollar and dollar denominated paper assets, from stocks to corporate bonds, have come under severe pressure. The dollar is nose diving and so is Wall Street. The US treasuries have not yet been much effected, but if the current dollar slide does not reverse soon, even the colossal US government bonds will not be able to escape the general down-trend. That will be the day their natural anti-podes, the precious metals, will finally turn up decisively. Precious metals are the sublime hard assets, Contrary to general belief, stocks are not the counter-party to gold and silver. Stocks in principle are also assets, as long as the business stays a going concern, whereas government bonds are but debt papers and are void of any substance except politics and hollow promises.
There is no way the dollar can be held up through intervention. And, as we are bound to hear much more about such currency intervention in the next few months, it will be good to remember what intervention does mean and what it doesn't.
Exchange rates are a monetary phenomena. Only the effective reduction of the amount of dollars in circulation, making dollars scarce, is able to enhance or at least maintain the dollar's value. Dollars can only be taken out of global circulation, by selling yen, euros, pounds or gold in exchange for dollars on the FOREX markets. However such intervention works only if the FED does not re-enter the dollars, just bought back on the foreign exchange markets, by returning these into circulation through the repurchase of bonds, another type of assets. But the latter is exactly what the FED does in practice! So do not be fooled! The Big Bankers which own the FED, are not really interested in reducing the amount of dollars in circulation, it would shrink their credit empire.
Intervention, accompanied with lots of publicity, done the two step way, one step forward one backward, will only work as an effective scare-crow for a few days. With the FED's foreign exchange desk selling and its open market desk buying, the supply of dollars remains unchanged. Intervention this way does not work. And next people will asks whether the FED should better not raise interest rates to make the dollar more expensive for use.
In short: if the FED really wants to stop the descent of the dollar, it has only one unilateral recourse: reduce the supply of dollars. As we saw, this is not the same thing as "intervention" in the foreign exchange markets. Intervention means the FED is buying dollars and selling yen or euros, which does indeed reduce the supply of dollars as long as the FED doesn't re-circulate these dollars the next moment. To withdraw dollars, the FED will have to sell assets, like foreign exchange, gold(!) or bonds, to the private sector in order to get dollars out of circulation and stop at that.
Around 1994/95 the Clinton administration had gotten itself into the same kind of dilemma as happened during the Carter administration, when the US trade deficit went through the roof and caused a sharp increase in foreign held dollar denominated assets, in reality but IOUs or claims on the USA. At the time, seeing Carter as a weak, indecisive, president, the foreign US bond holders lost confidence and presented the bill. That brought on the Carter dollar crisis.
People like to invest where they see a strong hand and leadership. Whereas Carter was seen as shy and weak by the outside world, a big mouthed and determent Clinton bullied the impression of a healthy economy and a strong dollar. Even with the huge outflow of dollars under Clinton the world did not mind as long as the excess dollars could advantageously be reinvested in the ever exorbitant new economy, in Wall Street and in US treasuries.
In 1994 a situation arose whereby the ever growing dollar creation and outflow gorged unexpectedly. Even the image of a strong Clinton administration couldn't turn the tide when it became obvious to the world that the underlying US fundamentals were dangerously eroding. In 1994/95 the US current account balance with the outside world became unstable when an out of proportion growing US trade deficit couldn't be offset any longer by the willingness of foreign capital to keep on investing into Wall Street and US treasury papers. January 1995 the dollar dived, US treasuries wobbled, gold gave warning noises and silver shot up. The euro had been conceived and the euro launch plan drawn. The dollar empire was under threat! The usual strong arm financial policies to push the dollar into the lap of the world did not work any longer. The old backing strength of savings, precious metal reserves, industrial superiority and resources had eroded. The savings rate in the US had become negative, the precious metal reserves were in question, the US home industry had greatly been sacrificed for cheaper imports and the US was now importing over 50% of its oil needs.
More was needed, much more. Something new was needed. And in came Robert Rubin with leverage and creative accounting. The most sophisticated, obscure and powerful leverage system ever conceived, derivatives, became the game. The revitalized dollar flooded the world as never before and recycled back into the ever ballooning American stock and bond markets and the wonders of Silicon Valley. Rubin had brought it off, for the good of New York. He had invented Rococo finance with all its furry fancy designed to confuse the world. Now the euro, the yen and gold could be triple thrashed and the whole world made to dance to the tune of the dollar again.
Whereas LTCM, Long Term Credit Management, worked with a leverage of about 400 relative capital base, JP Morgan-Chase the world's biggest derivative holder, is being estimated to have a derivative leverage position of over 600 to one! ( see the JP Morgan essays written by Adam Hamilton) The world's total derivative holdings are estimated at well over 100 trillion dollars, 85 trillion mostly in interest rate and currency derivatives of which Morgan-Chase holds the lion share with Citi-Group the runner up.
JP Morgan might be holding a lot of leverage to keep the dollar strong and its competitors, inclusive gold, down, but do remember, every lever, how powerful it might be, needs a pivot to handle and the pivot is trust. Trust that the derivatives do posses underlying value, trust that the counter party can and will comply, and that the game will go on. The only trouble is that trust has been fatally damaged.
The Rococo period was the last stage of exorbitant extravagance which ended in the bloody French Revolution.
23 July 2002
Hans Schicht
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