Defensive Interpretation on GD?

[Gordo]

So does anyone else think customer accounts at brokerage firms are in jeopardy NOT because of investment returns, but from actual accounts just disappearing? This is the twilight zone prediction John has written. He also thinks the FDIC will run out of money (which is quite literally impossible). I'd just like to know if anyone else believes this nonsense and why?

John has repeatedly confused brokerage funds with customer funds. Customer funds remain in the customer's account, it is invested into whatever the customer wants to invest it in. These funds are also typically covered by SIPC in the event of fraud.

The only way customer funds are at risk is if the brokerage is stealing them. This does happen from time to time, and it is punished, and SIPC member firms have coverage for the customers' loss. I'd expect to see that sort of thing only at very small firms. I would be shocked if it happened at a big firm like Schwab, and even at a troubled firm like E*Trade. E*Trade can go bankrupt without any losses to customer accounts, same thing happened with Bear Sterns. I know what you are thinking - Bear Stearns required a massive government bailout, which isn't going to happen in future situations of that kind - true, however the bailout was essentially for Bear Stearns bond holders and counterparties (and shareholders to a lesser extent). If you do some searching, not one article mentions that the bailout was for brokerage account customers. The brokerage accounts were transferred to JP Morgan, it was perhaps the most (only?) valuable part left from the failed Bear Sterns company.

When a brokerage firm goes bankrupt, customer accounts are transferred to a firm that isn't bankrupt. This process usually doesn't even take much time and there is little if any disruption to the customer. Through all of the bank failures to date, NO BROKERAGE CUSTOMER ACCOUNTS HAVE EVER BEEN IN JEOPARDY. Not a single person has lost any money in FDIC insured bank accounts either, and none will.

A new great depression might happen, but I can absolutely guarantee it won't look anything like the last one.

[Higgenbotham]

John has repeatedly confused brokerage funds with customer funds. Customer funds remain in the customer's account, it is invested into whatever the customer wants to invest it in. These funds are also typically covered by SIPC in the event of fraud.

The only way customer funds are at risk is if the brokerage is stealing them. This does happen from time to time, and it is punished, and SIPC member firms have coverage for the customers' loss. I'd expect to see that sort of thing only at very small firms. I would be shocked if it happened at a big firm like Schwab, and even at a troubled firm like E*Trade. E*Trade can go bankrupt without any losses to customer accounts, same thing happened with Bear Sterns. I know what you are thinking - Bear Stearns required a massive government bailout, which isn't going to happen in future situations of that kind - true, however the bailout was essentially for Bear Stearns bond holders and counterparties (and shareholders to a lesser extent). If you do some searching, not one article mentions that the bailout was for brokerage account customers. The brokerage accounts were transferred to JP Morgan, it was perhaps the most (only?) valuable part left from the failed Bear Sterns company.

When a brokerage firm goes bankrupt, customer accounts are transferred to a firm that isn't bankrupt. This process usually doesn't even take much time and there is little if any disruption to the customer. Though all the bank failures to date, NO CUSTOMER FUNDS HAVE EVER BEEN IN JEOPARDY. Not a single person has lost any money in FDIC insured bank accounts either, and none will.

I didn't want to give the impression in that last post that John and I discuss details in blog posts and things like that on a routine basis. Our points of disagreement have been mostly along theoretical lines like mean reversion. For example, I disagree that the 3% average growth rate over the last 120 years is sustainable.

Having said that, we did discuss this subject of customer money. I am more intimately familiar with the futures business and mentioned that in the case of futures accounts customer funds are deposited in segregated accounts in banks like JP Morgan (that have no relationship to the futures firm). I said there is no risk to the customer deposits in futures accounts in the event of a meltdown, but that there could be counterparty risks on profits owed for a particular trading day if a meltdown is severe enough or if fraud is involved (like whoever was alleged to have dug into Refco for several hundred million because they didn't liquidate his losing positions--I can't remember all the details but they are out there) and the exchange can't cover it. In the case of stock brokerage accounts, I mentioned that money market accounts, which are also segregated customer funds as you mentioned, are only safe to the extent that the paper backing them is good. Recently the Fed has been backing the commercial paper markets for this reason (to keep the money market accounts above parity as some of them dropped below sometime in the last 2 months). I'm assuming they are using the bailout money to do that. But that's a separate issue from the brokerage.

There was a blog post within the past few months that discussed these issues and I remember not agreeing with some of it. It seemed like some of the post related to futures and some to stock brokerage accounts and some of the terms had been mixed up. I didn't write to John and point it out because I am more interested in the general theory and how it pertains to what he recommends the public do and the gist of the post was to stay out of stocks, which wasn't bad advice in my opinion, especially at the time it was given.

As far as the FDIC, hasn't John been saying to keep your accounts under the limit? That's all I can really remember reading. I think your opinion seems to be that the banks and the government will all collapse or all survive. That's true if the banks are essentially nationalized and we seem to be on that path, but I haven't thought it through to a great degree. I believe that if the US government stays on the path that it is on with the bailouts, and it seems like they will, that eventually the government and the banks will go under, but that's really too far off to predict at this point if the sole cause is financial problems. But if something like a severe pandemic or nuclear terror attack occurs and the country can't get back on its feet, then it won't be very far off in my opinion. Adding to the post, so, yes, somewhere in the recesses of my mind I have come up with scenarios where, due to a sudden threat outside the financial system, the government will abandon the bailout plans and sacrifice the banks to save itself so the country can put resources into dealing with the exogenous threat.

[Gordo]

I think your opinion seems to be that the banks and the government will all collapse or all survive.

No, why do you say that? I think there will be many more bank failures, but that's nothing new, its not like banks just started failing in 2008. As for the government, I don't see any realistic chance that it could collapse anytime in the next couple decades anyway. Maybe I'd give it 1 in 100 odds over the next 50 years, and 1 in 50 odds over the next 100 years, but that's just a wild guess. I don't know why so many doom and gloomers think a great depression, if we even have another one, would cause a government collapse. Didn't happen the last time, why should it happen this time? And part of it is that we can replace every single politician in any given 4 year period, so why do we need any OTHER form of government "overthrow"? Is the theory that we will need an "overthrow" to start a new currency and wipe out debt or something? Heck, I think we could conceivably do that without an overthrow. In the very least, massive dollar depreciation is absolutely inevitable at some point in time (which won't make our creditors very happy) - anytime from next week to 20 years from now.

[Higgenbotham]

I think your opinion seems to be that the banks and the government will all collapse or all survive.

No, why do you say that? I think there will be many more bank failures, but that's nothing new, its not like banks just started failing in 2008. As for the government, I don't see any realistic chance that it could collapse anytime in the next couple decades anyway. Maybe I'd give it 1 in 100 odds over the next 50 years, and 1 in 50 odds over the next 100 years, but that's just a wild guess. I don't know why so many doom and gloomers think a great depression, if we even have another one, would cause a government collapse. Didn't happen the last time, why should it happen this time? And part of it is that we can replace every single politician in any given 4 year period, so why do we need any OTHER form of government "overthrow"? Is the theory that we will need an "overthrow" to start a new currency and wipe out debt or something? Heck, I think we could conceivably do that without an overthrow, in the very least, as massive dollar depreciation is absolutely inevitable at some point in time (which won't make our creditors very happy).

By collapse, I meant a financial collapse where loss occurs to depositors and debt holders perhaps via a sudden dollar devaluation or debt repudiation, but not a political collapse. I used the word survive incorrectly because lack therof does imply a political collapse in the case of a government.

As far as how the government is structured, I can see changes coming out of this Fourth Turning. The government may become more decentralized. One thing I can see happening is that states or groups of states could have more autonomy and power relative to the federal government than they do now, and are likely to define themselves more versus other regions according to political and economic philosophies. We see that happening with the red states and blue states. There may not be a resolution to that except for the various regions to prove which philosophy is better according to some measure of performance. People could move into regions where they are in agreement and be governed by the philosophy they agree with. That could lead to more competition between states or regions and perhaps a system might be set up where regions would be forced to have balanced trade, and a region that can't maintain its balance of trade might lose population and resources to regions that are more efficient. But I don't see an overthrow of the government either.

[Gordo]

By collapse, I meant a financial collapse where loss occurs to depositors and debt holders perhaps via a sudden dollar devaluation or debt repudiation, but not a political collapse.

I think a sudden depreciation of the currency is highly likely, and if not sudden, then just steady, although it is almost politically easier to do it suddenly (like Roosevelt did). Its almost debatable if you can/should call this a "collapse" though, it is something that could be viewed as a very psychologically powerful tool - when the currency is rapidly depreciated, stocks go up (as they lose net value), and prices (CPI) probably will not reflect the change immediately (which would match what happened in the 30's). It is somehow more palatable to people when they lose money via stealth, ironically it can even make them more optimistic about the future, and of course it makes debt repayment easier (at the expense of savers).

[Higgenbotham]

I think a sudden depreciation of the currency is highly likely, and if not sudden, then just steady, although it is almost politically easier to do it suddenly (like Roosevelt did). Its almost debatable if you can/should call this a "collapse" though, it is something that could be viewed as a very psychologically powerful tool - when the currency is rapidly depreciated, stocks go up (as they lose net value), and prices (CPI) probably will not reflect the change immediately (which would match what happened in the 30's). It is somehow more palatable to people when they lose money via stealth, ironically it can even make them more optimistic about the future, and of course it makes debt repayment easier (at the expense of savers).

That gets back to the first post in the thread. If I understand the response to mosullivan, that person is saying that once the move into treasury bills (he says treasuries but I pointed out earlier that the 30 year has held steady for the last year) subsides (and he expects it to subside soon if I understand correctly) then there is enough money/imbalance/whatever in the system already to quickly ratchet the dollar lower. In other words, the market will take care of it. My conclusion, although I was never able to get to it in any of the other posts, is that the deflationary process likely has a long way to go, likely another 2 years at least, although nothing is absolutely certain. Since this is not a "pure deflation" (using a phrase from this thread) I am not advocating that the dollar has to get a lot stronger, just that it is not going to collapse (there's that word again--let's say that word means approximately that the dollar index goes from 85 to below 50 in less than a month) before the deflationary process runs its course. And it doesn't seem likely to me that any "New Bretton Woods" will be finalized within the next 2 years. When you say, "In the very least, massive dollar depreciation is absolutely inevitable at some point in time (which won't make our creditors very happy) - anytime from next week to 20 years from now." that to me could be the same idea, but not necessarily.

[Higgenbotham]

[I believe its possible that we will not even have one full year of deflation (as measured by CPI) but 1 or 2 would not surprise me, 3 would match the great depression, and would be totally unexpected by me.

OK, I found your specific estimate as to how long deflation might last on page 3 of this thread. My expectation is at least 2 years, close enough for now. We'll know more as time goes on.

[Gordo]

Sounds like we are pretty much on the same page. It's very difficult to predict the deflation cycle. All I know is that long term you should be more concerned with the INFLATION problem. Deflation is real and serious, but in the real grand scheme of things (20 year timeframe) it's almost irrelevant.

The following is what an analyst I respect had to say about this recently. The only thing I have doubts about in his analysis is that housing prices could rise in the face of sharply rising mortgage rates - this seems very unlikely and would depend on incomes keeping up with inflation (something that is unlikely if unemployment ticks up). But even if nominal home prices merely stabilized I think it would be viewed as a victory.

At any rate, his commentary is thought provoking to me...



"Today’s main topic is why inflation will rise sharply worldwide over the next several years, and will remain persistently high for several more years.

The main threat to the worldwide economy today is falling residential real-estate prices. Of course, slumping equities and commodities will periodically cause problems also, but a comparison of the collapse of the Nasdaq bubble in 2000-2002 with the collapse of the real-estate bubble is already showing the latter to be a far more serious threat to global prosperity—and we are only in the very early stages of the real-estate pullback.

Governments around the world would love to be able to prevent housing prices from declining further. That would be the single greatest contributing factor toward enabling them to maintain the status quo, and to minimize the threat of severe political instability or worse. However, they cannot repeal the law of supply and demand.

What they can do is to create the illusion that housing prices have stabilized. Here is the secret: high inflation.

Let’s assume that no matter what anyone does, real average housing prices worldwide will continue to decline 7% in real terms, every year, for each of the next ten years. This is probably very close to what is actually going to occur, although the decline is likely to be a lot less smooth in most regions.

If inflation is 2%, then a 7% real decline means a 5% drop for nominal prices. In other words, if a house sells for one hundred thousand dollars today, and it falls by seven percent in real terms over the next year, while inflation is two percent, then the house will be selling for ninety-five thousand dollars a year from now. Repeat this process each year over a ten-year period, and you will be sure to have billions of unhappy and increasingly angry homeowners around the world.

Now let’s assume that inflation, instead of running at 2%, has soared to 10%. The same $100,000 house today will be selling for $103,000 a year from now, since the rise in overall consumer inflation will be greater than the pullback which was caused by housing prices continuing to unwind from their historic bubble.

If inflation continues to run at a 10% clip, while housing prices keep dropping by 7%, then nominal housing prices will actually rise about 3% each year, rather than falling! The average person will be delighted that the government was able to “solve” the housing problem, and will remain fat, dumb, and happy. Only a few people will be smart enough to realize that the value of their house in terms of baskets of groceries, or gallons of gasoline, or any other real goods, will actually have fallen by more than half.

This, then, is the obvious “perfect solution” to the housing and the mortgage crises.

The only problem is getting there from here. If inflation is going to rise to 10%--or even to 8%--it will cause a huge surge in interest rates, including mortgage rates. A mortgage rate of 12% or 13% will initially be sharply negative for housing prices.

However, once rates reach that level, if they roughly stabilize, mom-and-pop homeowners will be delighted to see that housing prices are “moving in the right direction”.

Therefore, I believe that governments have already concluded that this step of major global reflation is the least of all possible evils. The recent deep cuts in federal-funds and other short-term borrowing rates by central banks around the world; recently announced heavy bailout packages in the trillions of dollars; policies which intentionally ignore potential reigniting of inflationary fires; and other government initiatives in recent months clearly indicate that there is a coordinated global effort to address the housing crisis primary through this means.

The only interesting question is how long it will take for most of the world to reach inflation of eight or ten percent.

I believe that inflation will rise so sharply and “unexpectedly” over the next several months that well-known measures of inflation will reach multi-year and possibly even multi-decade highs in 2009. TLT and long-dated U.S. Treasury debt will similarly slump to a multi-year and perhaps a multi-decade bottom—thus providing a fabulous buying opportunity several months from now when inflationary fears reach their zenith.

This initial reflation attempt will likely not persist beyond 2009, as the next global deflationary wave will arrive in one year or less and will reign supreme until 2010 or 2011. All thoughts of rising inflation will be drowned in the next major recession which begins a year or so from now.

However, once that passes and worldwide stock markets reach multi-decade bottoms, we will have a major reigniting of inflation that will make the next inflationary binge one for the record books. By 2013 or 2014, we should have inflation near 10% and mortgage rates above 12%--perhaps well above 12%. This will be true not only in emerging markets, but even in most or perhaps all developed countries.

Housing prices in nominal terms will therefore finally stop declining in perhaps 2013, after first slumping by an additional 40% worldwide due to the 2009-2011 recession and soaring mortgage rates, as well as a continued unwinding from their historic bubble. Housing prices will continue to decline substantially in real terms through 2018 or 2019, but almost no one will care since nominal prices will likely be moving higher after 2013.

Similarly, elevated inflation will cause the inflation-adjusted level of major equity indices such as the S&P 500 or the Nikkei to reach important lower lows in real terms in 2018 or 2019, even as their nominal price levels will be noticeably higher than their respective 2010 or 2011 nadirs. This will be analogous to the 1982 bottoms for worldwide equities that were far below their 1974 lows in real terms (i.e., after adjusting for inflation), but were meaningfully higher in nominal terms. In fact, the 1982 readings represented the lowest levels for many bourses (including the Dow Jones Industrial Average) since the 1920s and even earlier, if expressed in real terms.

In an environment of falling real prices, and especially when housing prices are slumping, it is politically far easier to tolerate above-average inflation than almost any other alternative. Therefore, politicians will take the easy way out this time just as their predecessors (and in some cases, the exact same folks) had done in the 1970s and early 1980s. The initial pain of mortgage rates doubling and related social grumbling will be eased by the illusion of nominal housing-price increases that will “happily” persist for many years.

Once housing prices finally become undervalued in real terms and begin to rise in real terms, politicians will figure out a way to bring down interest rates—which will further stimulate the economy. It’s such a “perfect solution” that this process will probably be repeated once every three to five decades to resolve whatever other foolish messes central bankers get themselves into over the next several centuries and beyond.

As an investor, don’t concern yourself with trying to prevent the inevitable. The future of the financial markets is already preordained. By correctly anticipating the next move for either rising or falling inflation, you will be able to profit handsomely by planning in advance for its next major trend change."

[mosullivan]

It still seems like for now we are losing more than we are creating and the net points to deflation. Dollars are disappearing faster than they are being put into the system and so the dollar rises. While there are many different interpretations on how this applies across (M1, 2 3) it seems like Central Banks are still plugging holes; but the market isn't listening.

It also seems like this can go on for a while, like the next 12-18 months. Beyond that, maybe we'll be closer to a bottom. I had to take a limb off the learning tree and admit my poor assumption that inflation (here and now) was a no brainer. Its called learning...and just when I think I understand, BOOM!

My primary reason for starting this discussion was how surprised I was at the defensive response I received when proposing this simple (above) deflationary explanation to gold bugs, inflationists or what have you.

I don't think banks can simply reflate when they desire. Do we need any more pizza shops, hair salons, home projects, strip malls or the latest "town center"? Would forcing banks to lend out make the inflation genie pop out of the bottle? I don't know. To me it seems like it would just be a bad investment now. I'm sure we'll have reflation at some point but I still have a hard time seeing it now.

I appreciate reading everyone's thoughts and TGIF (almost)

[John]

> My primary reason for starting this discussion was how surprised I
> was at the defensive response I received when proposing this
> simple (above) deflationary explanation to gold bugs,
> inflationists or what have you.

All I can tell you is that I've gotten extremely hostile reactions to
this subject myself.

Over the years, I've written about many subjects on my web site, many
times referring to ethnic groups, genocide, wars, atrocities, etc.
You'd think I would get hostile reactions to those subjects, but I
rarely do.

There are two subjects that have gotten me multiple extremely hostile
reactions:

• The food crisis, and that the population of the world grows
  faster than the food supply.
• The gold bubble -- that gold is in a bubble, and that when the
  bubble bursts, its price will fall to the $300-400 / ounce
  range.

I'm not completely certain why it's these two particular subjects
that arouse hostility, and accusations of being a psychopath, but they
do.

Sincerely,

John