The End of Gold, Part Three

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Includes: DGZ, DZZ, FXE, GLD, IAU, UDN, UUP
by: David Bailey

When there was a lot of response to my last posting, I felt I should devote some extra time to the opposing view. I want to be fair and thorough and I always find it useful to try and look at a question from different vantage points.

I only found one argument for the pro-gold case that holds any “promise”. As of this writing, nobody knows all the details, but I have to admit that - potentially - it's a real doozy. Despite days of wading knee-deep in strict, “Austrian School” screeds and wild, Hyper-Monetarist predictions of crumbling currencies, I still believe that gold shows every sign of being in an anti-bubble, deflation is still the predominant economic threat, and the structural place of gold in a fiat money world has not changed and is not likely to. But I sure saw a reason somebody might want to bet on gold. I'll bet you saw it, too.

It all hinges on whether or not President Obama has indeed found for his Treasury Secretary the only man in the world who thinks the main flaws with the original Paulson Plan were that it was not expensive enough, not ineffective enough, and that it created too little moral hazard. You will bet on gold – and be wise to - if you really think the Administration will ultimately create the $2 trillion nightmare, the GSE From Hell, the hideous government golem some propose to call the “Aggregator Bank”.

Call her: “Aggie Mac”

If you hate Fannie (FNM) and despise Freddie (FRE), you'll absolutely loathe Aggie. If you think the GSEs we have are market-distorting monstrosities run by criminals, I'm guessing you won't like a new GSE that's a market-spiting money-murderer run for the benefit of criminals. After all, Fannie and Freddie only bought loans and mortgage-backeds that were possibly fraudulent. That's disgusting enough. Aggie Mac would buy the stuff everybody already knows is fraudulent. I'm pro-stimulus. I even agree with George Soros when he says that “The government ought to take the GSEs out of limbo and use them more actively to stabilise the housing market.” But this is ridiculous.

Aggie Mac is the half-baked, half-witted answer from people who say the challenge in this “bank rescue” business is pricing the “toxic” mortgage-backed garbage. Of course that's nonsense. The market has told us very clearly what the fair price for these "assets" is: effectively nothing. There are plenty of world-class experts in distressed assets. They will not touch this junk with a ten-foot pole. Rightly so. The market in private-label RMBS is frozen because these bogus securities are so shot-through with malfeasance they can't be priced. A “no-trade equilibrium” obtains in this markets for a very logical, very sound, very well-understood economic reason. Some guys got a Nobel Prize for figuring it out, but it's just plain common sense: Fraud drives prices to zero.

But I guess some yahoos over at the Super GSE Think-Tank believe they can wave a magic money-wand at “the market” (to whom, exactly, do they refer?) and some little elves and fairies will appear, bearing a desperate need to buy phony bonds and hundreds of billions of dollars with which to do it. Where these geniuses learned their “economic theory”, I don't know, but I wonder if I can sell them a few hundred metric tons of Chinese powdered milk. I'll bet I can still get it cheap. Maybe they'll think that if they buy it, people will suddenly think it's safe. I also know of some folks who'd like to sell them some peanut butter – lots and lots and lots of peanut butter. Can we have a “bad bank” for peanut butter? How about an E. coli ground beef aggregator?

Supporters of the Aggie Mac concept point to the Swedish plan. They start by ignoring the first, most-crucial step. I saw PBS's resident economics "genius" Paul Solman describing it the other night. [I have to admit it worries me a little when the "liberal" media latches naively onto the idea of giving big, nasty corporations almost unimaginable amounts of taxpayer money]. Mr. Solman had on a Swedish economist who explained the first step which Mr. Solman of course completely ignored. Therefore, let me quote the wise Swede:

    "What Sweden did was first, to make sure that they know all the losses in the banks."

Emphasis his. Still it was apparently too nice and understated a Swedish way of saying something very, very important for American “economists” to note. Translated it means: "First, we went behind closed doors and very politely got the banks to admit all their fraud to us." Of course nobody used the word “fraud”. That's not the European way. But if the Swedes are subtle, they're not stupid. What they did not do was go to the banks and say: “Just tell us what assets you'd like us to take off your hands.” To have done that would have been to take on an unmanageable nightmare you could never sell to anyone. That would have been idiocy, or, Aggie Mac.

Without significant truth-telling, a “bad bank” plan is just plain bad. Really bad, because of course the Swedish plan also involved this second little step called “nationalization”. This gave the Swedish buyers of the now-transparent fraudulent debt a great deal of control over the remaining, clean institutions. How anyone thinks he can emulate a plan while ignoring these two, huge components is beyond me. Well actually not. It's called “mark-to-model”. It worked so great the first time, Aggie Mac figures she'll try it again – with government models this time.

That should be fun.

Professionals (albeit undercapitalized professionals) have already modeled these bonds. They are called “bond insurance companies”. Yet banks are not making bond insurance claims and potential buyers clearly don't feel the bond insurance will protect them. Why? Well, you can't collect a bond insurance claim on a fraudulent bond. Nobody should even have to say this, but all the Aggie Macs in the world won't make mortgages and MBS buyable so long as folks know there may be fictitious borrowers, fictitious collateral, phony property assessments, phony FICO scores, phony loan agreements, phony syndication agreements, phony securitization agreements creating phony corporations, tax-cheating in their tax-havens, their phony bonds, with their phony structuring, getting phony ratings from corrupt rating agencies, insured by uncollectable bond insurance and “hedged” by phony CDS written by the insolvent or near-insolvent. Have I missed anything? Again, a fraudulent good or service is designed to deceive. People don't want to be deceived. Therefore they won't buy. It's just that simple.

We won't get a market until we can produce an assurance that the fraud has been wrung out. That takes hard accounting work, transparency and rock-solid guarantees. Nobody with any common sense thinks it works any other way. For that reason, I doubt that this awful Aggie Mac nonsense will ultimately get much traction. We don't yet know the plan. Apparently Secretary Geithner doesn't even know the plan. But even if it turns out that Geithner is nothing more than a toy of the banks, I think President Obama is too smart to ask the taxpayers to be suckers for such a blatant rip-off. Harry Reid? Maybe. Barack Obama? I don't think so.

But for the sake of looking at how Aggie Mac could make the goldbugs' day, let's look at how bad is the bad version of the “bad bank” that's been kicking around – the no-truth, no-nationalization, mark-to-model bastardization of the Swedish plan. The economic theory here is really quite astonishingly bad. The Administration wants to stimulate the economy. In fact, it wants to stimulate inflation. If one concludes - as many economists have - that the threat to the economy is deflation, this is highly reasonable. Yet even in theory Aggie Mac fails to be stimulative and fails even to be inflationary. Instead, it makes the jump straight to hyperinflationary. But how could awful Aggie Mac do such a terrible trick?

It's not easy. Hyperinflation has been ubiquitous throughout the third world, but it's very hard to create in a major currency and has never been created in a major, international currency. Small country currencies sometimes fall under the control of a crooked elite using their nation's banking system as a personal printing press. When that happens, the easy availability of larger, “harder” currencies mean the small currency is quickly undermined and pretty soon a bottle of beer costs folks what used to be three months' salary. The U.S. dollar, on the other hand, is both the currency of the largest economy on earth *and* used to buy and save by people across the world. The immense and fast-growing "Eurodollar" economy has been an inflationary America's saving grace, in my view. Americans may act as though the value of our currency is completely unimportant to us, but foreigners have decided that the dollar is really important to *them*. We may even be have helped them accept the dollar by printing so darn many. Pretty sweet deal.

How do you screw it up? Just throwing huge piles of new money at a world currency won't produce hyperinflation, but it is almost always stimulative. With such a huge amount of money involved, theory tells us that a plan will only fail to be stimulative if the immense cash-dump is on a group of unregulated people who have shown a really extraordinary talent for useless speculation and no motivation to produce solid credit or growth, no matter what the inducement. That's our banks. So far, so good.

But certainly huge piles of money are at least always inflationary? Theory tells us no, not absolutely always. Look at that double-size monetary base we already handed the banks and the way it just sits there at the Federal Reserve, inflating nothing. As an economic matter, the paying of huge amounts of money for nothing is highly deflationary. Paying huge amounts of money for nothing – like over-valued real estate and loans to under-qualified borrowers – is how we got our deflation threat in the first place. And now we propose to pay a huge amount of money for an unmanageable, unsaleable loan portfolio full of fraud with a fair market price of zero. Wow, that is special.

But to produce a dollar-based hyperinflation, you still have to create an international plan to undermine trust in the currency worldwide. To do that, you would have to create a sort of “Crooked International Bank Reinvestment Act”, specifically rewarding mismanaging malfeasants who had printed trillions in counterfeit loans and sold them across the globe. You would have to simultaneously:

  1. Give a bunch of huge, crooked, dollar-based, international, financial institution some truly enormous amounts of cash.
  2. Free them from the consequences of fraudulent loans.
  3. Put no meaningful structures in place to assure the cash into good loans rather than crazy loans and wild speculation.

The Aggie Mac plan would, of course, do all three. It would give these banks a “get out of jail free” card, a printing press, plenty of paper and say: "please print real money this time." This is not generally a good plan with international loan counterfeiters who almost crashed the dollar as recently as this summer.

Without rooting out the mechanisms for fraud and putting the remaining system under tight-enough control to be trusted again, a "bad bank" Aggie Mac would be an economic failure and, possibly, hyperinflationary suicide. As I say, I suspect President Obama is too smart to fall for this brazen scam, and I'm even more confident the American people won't have it. But, if not and some huge Aggie Mac monster really does rise from the inky depths of idiocracy, swim the stinking swamp of stupidity and cross that broad plain of pecuniary perversion that is America in the 21st century, I have this piece of financial advice for you at which you may already have guessed:

Buy gold, buy buy buy, and buy some more. Buy banks and real estate and when they spike, sell and pile your profits into even more gold. Then move that gold – and yourself - to another country.

I very seriously doubt the Aggie Mac idiocy will come to pass, but if it does, I'll see you at gold $5000.

Disclosure: no positions - yet.