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					                                             sings &Perspectives
                                          Mu
    ORANGE COUNTY BUSINESS JOURNAL
                                                                                                                              Volume 1, Number 9


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                                                                October 27, 2008



                                    Fallout From “The Deal” Culture
                                                               By JP Gough1



“H           ow the world turns… The heroes
            of only a few years ago are today’s
          rogues or idiots. And conversely, the slow-
moving and dimwitted of a few years ago are today’s
                                                                                   Forget the facts that one-third of all American home-
                                                                                   owners own their homes with no mortgage and that the
                                                                                   US has the highest level of homeownership in the world.

sages of deep wisdom. Everyone’s position has been                                 All drama. No substance.
altered by current events – with shock to some.
                                                                                   Don’t confuse us with the facts. Out of a total of $1.25
Looking for “Easy Street” and Drama                                                trillion sub-prime mortgages, about $250 billion (21%)
                                                                                   are estimated to be delinquent.
It used to be that the American stock market was a beacon of
reasonable safety and security for the explicit purpose of long-          But delinquent does not mean 100% loss. Some are being re-
term savings and investment. But things began to change in                financed under easier terms, although current lower interest
the 1970’s across the entire spectrum of American society as              rates will save many of them (while sticking the rest of us with
we began our collective search for the “easy street.”                     the “hidden cost” of inflation). Regardless, the underlying
                                                                          homes are worth something, even if prices are lower.
The ‘easy street’ became embodied in the MBA, who was
trained in purely numeric approaches to decision making. This             Losses of 10% on a foreclosed mortgage are normal. If we
approach fortified the “deal culture” where fortunes are to be            assume a new, historical high of 40% loss on all delinquent
made through manipulation, timing and exit strategies rather              loans (not just the ones actually foreclosed), that would equal
than on making anything of true value. “Exit Strategy” became             $100 billion in losses (tops).
the normal focus for every investment decision. Who even
thinks long-term anymore?                                                 So if the US government is spending $700 billion on a $100 billion
                                                                          possible loss, what are they doing with the other $600 billion?
Everyone has evolved into a financial gamesman, playing asset
bubbles where ever they may occur, from stocks to collectibles            Additionally, the world’s biggest banks already wrote off $640
to homes to their own businesses. Our collective goal seems               billion. If this is all about sub-prime mortgages, the write-offs
to be focused on not working, just like the gold of Eldorado for          would exceed expected losses by over six times.
the Spanish conquistadores (most of who died young, poor
and hopeless).                                                            Combined – the write-offs and the bailout at $1.34 trillion –
                                                                          exceed the amount of every sub-prime mortgage ever granted.
Compounding the search for “easy street,” society has focused             …This crisis is about more than just sub-prime mortgages.
on trumpeting the “mighty of the moment.” The “drama” of
everything has become paramount – with substance being                    Easy money puffed up asset bubbles across the world, mostly
ignored. Recent events of the financial crisis support this view.         in real estate, but also across the spectrum of financial securi-
                                                                          ties as well. [See my article “The Origins of the Sub-Prime
No one really asked for justification of the $700 billion bailout – not   Bust” in the OCBJ in September 24, 2007; http://www.ocbusi-
in public anyway. The claims of impending Armageddon were                 nessbank.com/pdf/OCBJ_SubPrime.pdf]
enough to bully everyone into line. Everyone rolled over on the
simplistic contention that this crisis is all about mortgages and         A culture of speculation on asset prices (believing that to be the
saving the homes of common, victimized citizens.                          source of wealth), along with easy money and well-intended,
but very unwise changes in accounting here and abroad, have             To prove this contention – do you know anyone who has read
come together to create this perfect storm.                             the 1-inch thick mortgage agreement he/she has signed in 17
                                                                        different places? Or for that matter, who reads – and is able to
When Drama Intrudes On Reality                                          understand – the public proxy statements of publicly traded
                                                                        companies?
The explanations for this crisis have morphed over the last few
weeks, from “mortgages” to “liquidity.” What really happened            What the nation needs today, is transparency and regula-
is that everyone stopped trusting each other.                           tion of the “shadow-banking system” of hedge funds and
                                                                        other investment funds which are not regulated and which
That lack of trust was caused by unreliable accounting standards        do not report publicly. This should have been done in 1998,
– worldwide – where accountants make “estimates” that                   when the collapse of a hedge fund, Long Term Capital, caused
become stated values on balance sheets (as if we can depend             a worldwide financial panic.
on those numbers; the finance world knows better). As those
estimates changed (“Fair Market Value” accounting), over night the      Our history has shown that at the bottom of every national crisis,
net-worth of some firms and banks was wiped out (“bankrupt”).           there is a problem of concentration of power, especially when it
                                                                        is below the surface of public awareness.
This change in value was initially only on paper. But accounting
or regulation forced the Wall Street firms and global trading           In the 19th century, Americans learned the hard way that
banks to “monetize valuation differences” of assets because             “Money is Power” when the economy of the United States
people and accountants today confuse “value” and “price”                came under the control of a small number of people called the
thinking they mean the same thing.                                      “Robber Barons.” It was this experience with their unbridled
                                                                        power in a “jungle market” that led to the Sherman Anti-Trust
Just because your house has declined in value, would you sell           Act of 1890.
it? Of course not. But investment firms and banks do not have
that option of holding. Whether the “price” reflects “value” is         Even in those free-wheeling, libertarian days, Congress under-
not taken into consideration by accounting.                             stood that our society could not be prosperous, stable and free
                                                                        if a few individuals could wreak havoc in the national economy
A mere “suspicion” of bankruptcy became a self-fulfilling               as if in a playroom. The nation came to realize that some eco-
expectation for several large Wall Street firms and mortgage            nomic and financial concentrations are so large, that the free
lenders. In the end, rumors caused their normal daily sources           market fails to function.
of funding to disappear – creating a “liquidity crisis.” Without
normal daily liquidity, these firms could no longer function.           Today, a number of hedge funds are so large that they move
                                                                        markets. Abuse is to be expected when the exercise of power
So, a “solvency crisis” caused the “liquidity crisis” – ‘I can’t lend   is hidden from public scrutiny. Recent examples of abuse
to you because I do not have faith that you will be around to           include manipulation of petroleum prices and the relentless
pay me back.’                                                           attacks on the stocks of whole industries through “short selling.”

That is why the initial actions of The Fed and other worldwide          As soon as the US government began investigating the manip-
central banks failed to unfreeze the markets. Pumping money             ulation of the petroleum “futures market” to inflate the “spot mar-
into markets, but leaving lenders exposed to loss in bankruptcy,        ket,” speculators disappeared overnight (some funds rumored
does not change the unwillingness to lend. Which is why Ireland         to be fronting for foreign governments that export oil). Since then
became the first to issue a blanket guarantee on all its banks.         petroleum prices have been falling in both “spot” and “futures”
                                                                        markets.
So to ensure that our biggest banks did not become subject to
a “liquidity crisis” through rumors, the US government                  When the SEC first limited short-selling on the stocks of the
pre-empted the possibility of such crises by forcing our largest        nation’s largest banks and Wall Street firms in July 2008, the
banks to take on the US government as an investor and                   stocks of those “protected” companies experienced an imme-
partner. With the US government as shareholder, no one in the           diate jolt upward in price – once the constant downward pres-
world should doubt our determination to keep our banking                sure from the mega-short-sellers was removed. But that left
system healthy and functioning.                                         the other 8000 banks in America to defend themselves against
                                                                        intensified attacks from the powerful short-sellers.
Forces At Work Below the Surface
                                                                        The Systemic Damage of Short-Selling
The grand-standing and vague calls for “More Transparency” and
“More Regulation” of our banking system is horribly misguided           Many countries do not permit short-selling because of well-
because not every “financial” is a “bank.” Furthermore, when we         established codes of fairness; they have declared short-selling
strive for more transparency in banking and the corporate world,        contrary to the public interest. [There are other ways to gamble
we make financial reporting an avalanche of thick reports that no       on the anticipated decline of a stock, through options and futures.]
one reads or can understand.
The reason why muscular hedge funds like short-selling is that       Having decimated the prices of bank stocks in the last 2 years,
the weight and momentum of their positions can force the price       the short-sellers have ensured that most American banks are
down in the direction of their goal. They do not wait for declines   now largely unable to raise more capital to help their commu-
in the price of a stock – they make them happen.                     nities in this time of crisis. Only by increasing capital can banks
                                                                     lend more money into their communities. The hedge funds
Short-sellers play on small-investor psychology, whereby 15-         weakened our national banking system, making it susceptible
20% of every company’s shareholders are prone to panic sell-         to foreign control.
ing because they assume that the market has perfect
information that they do not. This is a predatory tactic used by     This is one of the big reasons that the US government bought
the big and sophisticated against those who cannot defend            stock in our nation’s largest banks. Until the government did
themselves.                                                          that, the only available (but smart!) investors for the large banks
                                                                     were foreigners – resulting in almost a wholesale transfer of our
There are only two ways to “short-sell”:                             nation’s big banks to foreign governments (until last week).

(1) “Naked” short-selling increases the number of shares out-        Time For Serious Changes
standing beyond what the company has authorized. This is
like counterfeiting money.                                           The most pressing need is to protect the average American’s
                                                                     investment in the stock market from the predatory practices of
Someone trades a share of stock they do not possess, which           big hedge funds. Long ago, we heavily restricted our banks
increases the entire supply of “shares” in the marketplace. This     in order to protect the public from that concentration of power.
is what counterfeiters do when they print fake money – they          Now we need to address the threat from the shadow-banking
increase the money supply so as to effectively cause a deval-        system.
uation of the currency and an undermining of faith in the issuer
as well as the general economy.                                      Today, many investment and hedge funds are individually
                                                                     bigger than the majority of the nation’s banks; 90% of all banks
(2) “Covered” short-selling is when a speculator borrows             are under $1 billion in size! Unlike investment and hedge funds,
shares from custodians or fiduciaries (aka your stock broker)        all banks are heavily regulated to protect the public welfare.
that are holding the stock for you “in trust.”
                                                                     Taking those imperatives into consideration, Congress should:
The goal of the short-seller is to destroy as much of the
share value as possible so that when the short-seller buys           • Outlaw short-selling.
back the stock, the stock is cheaper. He then returns the same       • Require registration and reporting by all investment and
number of shares he borrowed (plus a fee) to the broker, who           hedge funds with bank regulators – not the SEC.
doesn’t care what the price of the stock is, as long as the bro-
ker can account for the proper number of shares.                     Investment and hedge funds have been operating as a
                                                                     shadow-banking system. So when these funds and their
Why would anyone lend their own asset to another person              money market funds started failing, only the bank regulators
whose sole intent is to destroy it? Would you lend someone           (FDIC, The Fed) could bail them out to keep a full-blown
your brand new, uninsured Porsche if you knew he would push          national panic from happening.
it off of a tall cliff into the ocean? [Ask your personal broker
how to prohibit the use of your stock portfolio for lending to       With these badly needed changes, we can begin a serious
short-sellers.]                                                      process of repairing the current damage and working toward
                                                                     preventing our never-ending lurch from crisis to mega-crisis.
In the last few years, hedge funds have found that they can          Let’s learn from history and push back the jungle.
shoot fish in a barrel. They use programmed formulas to select
and hit as many small companies and small banks in one day
                                                                     1
as possible. While each trade is small, the profit margins are         JP Gough is Chairman/CEO of Orange County Business Bank.
frequently large – and computer power today is cheap. So             His experience includes Wall Street, global finance and development
                                                                     finance, international banking and community banking. He also has
each fund can fleece millions of small investors in one day –
                                                                     an MBA and has done post-graduate work in futures, options and
legally.                                                             derivatives.




             Long ago, we heavily restricted our banks in order to protect the public from
                that concentration of power. Now we need to address the threat from
                    the shadow-banking system…of investment and hedge funds.
CONTACT US
Orange County Business Bank is committed to providing high quality personal service to
our clients. The members of our team are available to answer your questions and to be of
assistance.

DIRECTIONS
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buildings, comprises the complex known as MacArthur Court.

MacArthur Court is located on MacArthur Blvd. between Campus and Birch Avenues across
from the Orange County Airport with easy freeway access from the San Diego Freeway
(405) and Newport Freeway (55)




4675 MacArthur Court, Suite 100 • Newport Beach, California 92660
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