Think the Gulf Spill Is Bad? Wait Until the Next Disaster

The world knows BP is a disaster, a monster of a disaster. BP’s disaster makes Hurricane Katrina look like a rain shower.

Every time a TV news station shows oil gushing from a broken pipe — one mile below the ocean’s surface — the world gets sick. Scenes of oil-soaked pelicans struggling for life both angers and saddens us. The financial losses endured by small businesses and fishermen cannot be imagined, let alone conveyed by the media interviews. BP is a disaster with a scope beyond comprehension.

I was in England when President Barack Obama blamed and criticized BP for this tragedy. His criticism sparked the anger of the British. Politicians wanted him to tone it down, to be more careful in his choice of words. British Prime Minister David Cameron told Obama not to “go after BP for the sake of it.” Virgin’s Richard Branson said he was “kicking a company while it was on its knees.” Their concern was not for the environment or those suffering the ravages of this disaster. Their concern was for the pensioners who are counting on BP for a secure retirement.

On June 17, London’s Daily Mail ran a headline screaming, “Obama Bullies BP into £13.5bn Fund for Oil Spill Victims… but British Pensioners will Pick Up the Bill.” The British are angry with Obama for pressuring BP to suspend dividend payments and set aside $20 billion for the cleanup. Obama’s strong-arm position has not only affected British pensioners, who own 40% of BP, but American pension funds, who own 39%, as well. In other words, the economic damage of the BP disaster goes far beyond the Gulf. The damage is spreading to pensions, pensioners, and portfolios all around the world.

An Atmosphere Changed

While in London, I decided to go to dinner at Canary Wharf, ground zero for the next BP. Only a few years ago, Canary Wharf was one of the centers of the financial universe. Condo prices were sky high, offices were packed, and high-paid bankers filled Canary Wharf with wealth and excitement. Today, Canary Wharf seems to be dying. It has lost its vibrancy. Many restaurants and offices were nearly empty and there were few lights to be seen in those once-high-priced condos.

And Canary Wharf’s ‘BP’ stands for Bomb Production. Canary Wharf is much like AIG, a factory for exotic financial products known as derivatives. The problem is that most people do not know what these murky and mysterious products are — and that includes the people who make them or buy them. It’s why Warren Buffett has called derivatives “financial weapons of mass destruction.” That is how powerful they are. During World War II, a ship exploded while loading bombs for transport at Port Chicago, California. The explosion flattened everything for miles. It is said that the ship’s anchor, which weighed tons, was found more than six miles away. Derivatives — financial bombs — have the same power if they accidently detonate inside a bank’s balance sheet.

The subprime disaster was a result of financial bombs — derivatives — exploding in financial institutions such as AIG and Lehman Brothers, as well as banks and financial institutions throughout the world. After the bombs AIG manufactured exploded, AIG received $181 billion in taxpayer funding and immediately sent $11.9 billion to France’s Société Générale, $11.8 billion to Deutsche Bank, and $8.5 billion to Barclays Bank of Britain. U.S. taxpayer money was going to bailout banks around the world. During the last three months of 2008, AIG was losing more than $27 million an hour. That is how powerful these derivatives can be. The problem I see is this: There are many more such bombs still sitting in balance sheets all over the world.

Financial Bombs All Over the World

Military bombs are classified by weight: 500-, 750-, and 1,000-pound bombs. Financial bombs have interesting labels such as CDO (collateralized debt obligations), ABS (asset backed securities), and CDS (credit default swaps). While they sound exotic and sophisticated, when put in everyday language, a CDO is simply debt sold as an asset. And CDS, or swaps, are simply a form of insurance.

Since the insurance industry is strictly regulated, and the bomb factories producing CDS did not want to comply with insurance industry regulations, they simply called them ‘swaps,’ rather than insurance.

To make matters worse, rating agencies such as Moody’s and S&P (and even Fed Chairman Alan Greenspan) blessed these financial bombs as safe, sound, and good for you. It was almost as good as the pope blessing these products. In 2007, the subprime boom busted, and we know what happened from there.

The problem is that approximately $700 trillion of these financial time bombs are still in the system. While people watch the BP disaster in the Gulf, few people are aware of the other BP, the financial bomb production that is still going on. If this derivative market begins to collapse, we will see another BP disaster.

Can’t Clean Up the Next Disaster

Most of us know there is not enough money in the world to clean up the Gulf. The same is true with the $700 trillion derivatives market. If just 1% of the $700 trillion derivatives market goes bust, that is a $7 trillion disaster. The entire U.S. economy is only $14 trillion annually. A 10% failure, equating to $70 trillion, would probably bring down the world economy. As with the BP Gulf disaster, there is not enough money in the world to clean up the next BP disaster.

Could such a financial disaster happen? The answer is “Yes.” In fact, just as President Obama pressured BP into doing the “right thing,” he is also pressuring the financial markets to do the right thing. The president and our congressional leaders are pushing through financial reform legislation. My concern is that, if not handled delicately, it is this financial reform that will set off the derivative time bomb… the next BP.

Currently, derivatives are traded over-the-counter, also known as off-exchange trading. This means derivatives are uncontrolled, unregulated, and unsupervised. The proposed financial reform legislation is pushing to have derivatives traded through an exchange. This will bring greater transparency and control. My concern is, when this happens, the reform will reveal fraud and failures we do not yet know about today. It will be like turning on the light and watching the cockroaches (bankers) run for cover.
While it is commendable that President Obama holds the rich and powerful accountable, I wonder what the price will be.

How many BPs can we afford?

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The economy is in trouble, but Richard Duncan has a solution. The chief economist at Black Horse Asset Management has also worked at the World Bank and served as the global Head of Investment Strategy of ABN AMRO Asset Management; his new book is The Corruption of Capitalism. Jack Otter spoke with him about the state of the economy, what we can learn from Japan’s mistakes, and what investors should do to protect themselves.

Back in 2008, everyone knew we were in big trouble. But right now the perception is things are turning around … and soon the world will be back to normal. In your book, you say that perception is actually just a pipe dream.

That’s right. Everyone needs to understand that we are being supported by government life support.

For example, last year the U.S. economy shrank by 2 percent, but the budget deficit was 10 percent of GDP — so had it not been for this … budget deficit, the economy wouldn’t have shrunk by only 2 percent. It would have been minus 2, plus minus 10 or minus 12, plus a multiplier: The economy would have contracted by 15 percent, unemployment would have gone above 20 percent, [and] it would have been a complete replay of the Great Depression. And this year’s the same. This year we’re looking at 11 percent of GDP budget deficit.

So we’re on government life support. This could remain like this for a number of years because the private sector is broken.

So what you’re saying is hundreds of billions of dollars are flowing from the government into the economy, and if it were not for that, the economy would be in deep trouble.

That’s right. In fact, $1.6 trillion this year.

And that’s all borrowed money?

That’s right.

Will we ever pay it back?

They will probably never pay it back.

You clearly think deficits are a big problem; you despise them. Yet in your book, you say we can’t live without one.

I think there are three important lessons that policy makers should learn from Japan’s … post-bubble experience. Their bubble popped in 1990 — 20 years ago.

The first lesson is when a giant bubble pops, it’s necessary for the government to support the economy with massive budget deficits for far longer than anyone thinks. Even now, the Congressional Budget Office is projecting $10 trillion worth of budget deficits over the next 10 years.

Point No. 2, though is that these budget deficits are much easier to finance than people currently realize. Japan has 200 percent government-debt-to-GDP [ratio], but the 10-year bond yield in Japan is only 1.4 percent — meaning that it’s very cheap to finance that government debt.

And the third and most important lesson we need to learn from Japan’s experience is not to waste all this money … building bridges to nowhere the way they did, but to spend the money wisely. [We need] to restructure the American economy, to actually make it viable again — because right now the U.S. economy is not viable. And that’s because wages in the manufacturing sector here are 40 times higher than they are in most of the rest of the world, where they are $5 a day.

Wow. That’s an interesting point in your book. You talk about how that money should be spent — and you say the government should invest in three 21-century industries. Can you explain that?

This money is going to be spent one way or the other. It’s just a matter of whether it’s wasted, frittered away, and stolen by special interest groups, or if we actually spend it wisely, restructuring the economy. … Instead of spending $10 trillion … over the next 10 years, I propose $13 trillion, an extra $3 trillion. The government should pump $1 trillion into solar energy, $1 trillion into the genetic engineering and biotechnology, and $1 trillion into nanotechnology. This would give us an unassailable lead in the 21st-century industries, and lock in another American century.

That’s a nice vision. But in Washington there’s not a whole lot of appetite for extra spending. Of course, as you say, it still goes on, but: Politically, how much of that is viable and how do you make it happen?

Politically it is difficult, because there are many special interests who do not want to see these things occur. You can imagine there’d be a lot of opposition from oil companies to trillion-dollar investments in solar energy. But still, at the very least, I hope this book provides a real clear analysis of what has gone wrong — not sugar-coat it, but with looking at the situation with our eyes wide open — and offers some solutions as to how we can get out of this. … I hope it provokes a discussion and a debate as to how we really could get out of this crisis. And if someone comes up with a much easier solution, I’d certainly support it.

You write that the financial industry has become a menace to society. Can you explain what you mean by that?

Right now, the three largest U.S. banks control most of this country’s deposits. And at the same time, these same banks are speculating in the derivatives market at the rate of trillions of dollars a day. This is a recipe for catastrophe. They blew up in 2008, had to be rescued, and now they still have not been reformed. They should be broken up into small, very tightly regulated utilities. Instead of being too big to fail, they should be made too regulated to fail.

Now what about these side activities, this proprietary trading: Would you stop that, or just let other companies do that that don’t have a government back up?

Banks should be banks and lend money, and that’s all they should do. Speculators and investment banks should be allowed whatever they want to do with their own money or their investors’ money. They shouldn’t be rescued by the government, they shouldn’t be allowed to be too big to fail — and they shouldn’t be able to use people’s deposits to speculate with.

A commercial bank should be a bank; an investment bank should be an investment bank. We need a return to the Glass-Steagall era, which provided 70 years of financial sector stability.

As an investor, looking at this somewhat uncertain future, what should I do?

Every investor is different, of course. Someone with a billion-dollar portfolio needs to do something in a different way than one who has $100,000 to invest.

Let’s consider that [$100,000] person …

… If their portfolio is large enough.

It’s important to have a broadly diversified portfolio.

I think gold is the surest bet. I believe that gold is likely to go up 10 percent a year, on average, for the rest of our lives. There may be some years when it drops 30 percent. But on average, gold seems to be the surest bet.

Still, no one should put his or her eggs all in one basket — not even a golden basket. So … I would also have in my portfolio blue chip stocks with a high dividend yield, in this country and other countries.

Also, government bonds: U.S. government bonds and German government bonds.

Next, I would recommend … buying a residential building to rent out.

And finally, I would recommend debt — fixed-interest-rate debt to finance your residential building.

And that way you’d be very broadly diversified.

The reason why it’s so diversified is because we’re on government life support; no one can be certain what the government’s going to do. If they spend too much money, we’re going to get very high rates of inflation. That would be bad for bonds and stocks, butwould be very good for commodities. Meanwhile, your debt would evaporate — and you still would have rental income.

On the other hand, if the government spends too little, we’re going to have deflation. That would be bad for commodities but good for bonds — and you’ll still have your rental income. The rents might go down, but so will the price of everything else.

So because we can’t be too sure what the government is going to do — and because the government is driving this economy now —diversification is the only way to have proper insurance.

That’s a very interesting. One more question: REITs. Is that for somebody who can’t afford a residential building? Can you invest in real estate through other implements?

I think no two REITs are the same. You’d have to look into at them very carefully.

And it might not provide that benefit, if your debt’s going down and rents are going up.

That’s true.

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The talk overall was quite interesting. Warren Buffett kept things light with his usual manner of funny and logical humour. His honest answers is one of the many reasons people admire him so much. For example, a woman in the audience asked what industry will be good to be in in future and Bill Gates named a few (IT, Healthcare, Energy…). But Warren said that she should do what she’s passionate about and what she cares about and not what the sectors are going to do well in future, as she’ll most probably do very well and she’ll be happier if she does what she’s passionate about.

More smart people have gone broke through leverage than to any other activity. A smart person can’t go broke unless they use leverage. As one of my friends says: If you’re smart, you don’t need it. And if you’re dumb you’ve got no business using it. So, it just doesn’t make sense.

-Warren Buffett

Investing isn’t gambling, there’s a real distinction. Basically, it’s subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of it’s revenue from corn, soya beans etc. and it cost me $600. I’m looking at the return from the farm itself. I’m not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that’s pure speculation.

-Warren Buffett

The video illustrates the relationship between the home-owners, banks, brokers, hedge funds, CDO’s, investment bankers, prime mortgages, sub-prime mortgages etc. and makes it easy for anybody to understand.

With all the government bailouts I was surprised to hear that the possible M3 (simple definition here), which the Fed stopped reporting. It is reported to be increasing to around 10% per month. That’s going to be quite a bit of inflation heading our way.

Marc Faber has some very interesting things to say, as always, and I’ve enjoyed the videos — especially part 2.

Part 1

Part 2

Some quotes from the weekend:

Warren Buffett:

• If you have a 150 I.Q., sell 30 points to someone else. You need to be smart, but not a genius.
• If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.
• [When asked why the conglomerate structure seemed to work so well for him] We’ve got this ability in terms of moving money around into various opportunities [without tax consequences]
• Leverage is what causes people real trouble in this world. You don’t want to be in a position where someone can pull the rug out from under you or, emotionally, where you pull it out from under yourself.
• There is so much that’s false and nutty in modern investing practice and modern investment banking, if you just reduced the nonsense, that’s a goal you should reasonably hope for.
• I think the most important lesson is the world needs a whole lot less leverage.
• In short, bad news is an investors best friend. It lets you buy a slice of America’s future at a marked- down price.
• I’m not worried at all about a run on the banks.
• In poker terms, the Treasury and Fed have gone ‘all in.’ Economic medicine that was previously meted out by the cupful (pumping dollars into the economy) has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.
• We’re certain, for example, that the economy will be in shambles throughout 2009—and, for that matter, probably well beyond—but that conclusion does not tell us whether the stock market will rise or fall.

Charlie Munger:

• Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you, but it doesn’t. They teach that in business schools because, well, they’ve got to do something.
• We do not need insane accounting that rewards people that can’t handle the temptation.
• In my case, I’m so nearly dead anyway that it’s a minor detail.
• Well, we still have a rising young man here named Warren Buffett.
• The stupidity in the management practices of the rest of the corporate world will likely be ample enough to give this company some comparative advantage in the future.
• In show business, they say something ‘has legs’ if it is going to last. I think Berkshire Hathaway’s system ‘has legs’.
• We’re going to have a hell of a time getting this fixed the way it should be fixed.
• This ‘one size fits all’ reasoning in the case of bank stress tests is very likely to be done poorly.
• I think you have to start with the idea that a lot of the current troubles are richly deserved.
• It’s a real privilege to be associated with a place like Berkshire, I think we have more fun doing what we do than practically anybody.

Peter Schiff is an American economic commentator, author and licensed stock broker who currently serves as president of Euro Pacific Capital Inc., a fully accredited brokerage firm based in Darien, Connecticut. Schiff was an economic adviser to Ron Paul‘s 2008 presidential campaign. Schiff is also a supporter of the Austrian School of Economics, along with Mark Faber.