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Prediction: The day the bailout of the auto industry fails in the Senate, the DJIA drops more than 700 points.

Why do I suggest this?  It’s fairly simple.  Today, Congress has agreed a bipartisan plan, provided the industry can present a “viable” and compelling business plan by December 2 — 12 days away.  So if the Big Three can’t make their case, why such a big blow?  Afterall, there are many arguments, particularly from the conservatives, that make an equally compelling case: Chapter 11 bankruptcy would be a more draconian means of forcing these companies to abandon their pithy ways.  Even Michael Moore concedes that the although the ripple effect of letting the auto industry fail would be intensive, Americans are equally angry in their response to bailing out failed institutions.

There’s reasonable cause for concern for these bailouts and without presenting the viability, the sustainability, and some forecast of measurable success, bridge loans to nowhere are a waste of taxpayers’ dollars.  In the 1990s, the Japanese government spent billions of yen propping up corporations that were otherwise inevitably doomed to failure.  As a result, the “zombie corporations” took the Japanese economy more than a decade to start recovery.  At a certain point, there should be institutions that are too big to fail; what is the rationale behind the sacred cows (p.s., it is no longer what is good for GM is good for the US… it is what is good for Google is good for the US).

So why would the Dow drop more than 500 points if an entire industry is thrown into bankruptcy?  Simple.  The field of behavioural finance looks at the various human, social, and emotional factors that form the basis of investment decisions.  It is often this herd mentality that drives a flight, en masse, to quality.  Or the same mentality that drives speculators to raise the high point of oil to near $150.  Behavioral finance was what caught the attention of investors when Lehman Brothers failed, raising the prospect of the $700bn bailout.

These psychological lines in the sand are always being drawn and it’s my belief that as Lehman Brothers was the straw that broke the financial camel’s back, the automakers will be the straw that break the manufacturing camel’s back.  The rescue of the financial industry was not a panacea and in the short run, confidence in the American financial system has been shot.  I suspect the same will happen if there is no rescue of the auto industry.  Not only will consumer confidance start to collapse as a result of the ripple effect of involved counterparties (don’t forget, Detroit’s problems stem from poor financing of auto loans *ahem GMAC Financing* and the subsequent seizure of the credit markets, brought on by Bear Stearns and Lehman’s collapses), but also, investor confidence will start to shrink.  For whatever it’s worth, Detroit represents a significant amount of American R&D.  Without sufficent investment, that R&D will be lost to other countries.

The fact is, the American visa process for qualified individuals is already cumbersome.  Attracting qualified candidates is not the problem — getting expedited paperwork for them to research here is.  Yet without sufficent R&D to speed innovation and swing the economic downturn in reverse, America loses its final vestigages of greatness.

What’s a shame is that these events are unfolding so rapidly that there is almost no time to focus on macro-level solutions.   The seizure of credit markets means too much attention is paid to patchwork, micro-solutions-as-bailouts.  Yes, American taxpayers have a right to be upset about the bailouts.  But doing nothing is equally as extremely detrimental.  Finding the pragmatic solution is what will salve the healing until the housing and healthcare problems (which are the fundamental, root causes of any of the entire crisis) can be stablized.

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Hillary Clinton a contender for secretary of state - FT.com

Around six months ago, when I was still supporting Hillary’s presidential bid, but conceding that it was falling short, I proposed that Obama would take the nomination.  Though many were riding high on the change they could believe in, my concession was based on the speculation that any presumptive Obama administration would likely not feature Ms. Clinton in the vice-presidency, but rather another high role.  Since she would not be vice-president, I envisioned her assuming one of two roles: 1) Secretary of State, or; 2) Senate Majority Leader.

Suffice to say, the emergence of Hillary as a contender for this position comes as little surprise to me, though I also see valid experience in gentlemen such as Bill Richardson and Chuck Hagel.  What I think I would find surprising, is the fact that nobody would have thought of Clinton as a potential pick for the position.  I mean, talk about rupture from current foreign policy; Ms. Clinton would make a phenomenal pick even just to engage in re-igniting the Israeli-Palestinian peace process (which, if moved forward, could put a fundamental crimp in Iranian nuclear ambitions).

But here on this small blog that is read by probably five people every two months, my words go unheeded.  These are the same words that, in August 2007, predicted the financial crisis to become a house of cards, waiting to fall in on itself.  Failure to acknowledge that asset-backed securities trading on non-existing liquidity would cause a ripple effect through the financial markets has caused the current economic crisis, and placed me back on the job market.  When the issue of the $700bn “bailout package” arose in September, many believed that “Wall Street and Main Street don’t cross paths” (further fodder for a discussion on a potential bailout of the American automotive industry).  Now, my former company has had nearly 20% of its assets under management wiped out in one quarter alone.  It is no surprise they had to eliminate positions.

Now, I’m no Nouriel Roubini, with the economic modeling to make these types of predictions.  However I’d consider myself well-read enough to start looking at the world in an interdisciplinary fashion and start piecing pieces of the puzzle together.  This hasn’t yet bottomed out and on a near daily basis, re-invents its black swan tendencies.  Whether I’m John Paulson (also, n.b.– exhibit 1D) or not, the models don’t always work right.

In my opinion,  the only country to correctly take action on the crisis is China; its stimulus package acknowledges the slowdown’s domestic impact, and re-invests in domestic infrastructure.  It is exactly what America needs and what types of steps the next president should take once in office.

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Yet again, I’m managing to neglect my blog here - everything from whether or not the economy is in a recession (and if so, for how long), to my absentee vote for John Edwards being mailed on the day he drops out of the race, to the New York Giants (a team I cared about when I was about 10 years old) winning the Super Bowl, to “le Rogue Trader,” Jérôme Kerviel, of Société Generale, or even to wedding plans (which I’m going to have to have Judi start putting some updates on that part of the site)…

But instead, I’m somehow managing to update on Chinese news.  In an effort to better educate myself to globalisation, I recently started to sporadically read the English version of Xinhua online (Xinhua being the official news agency of the People’s Republic of China).  Now, when you consider the fact that the site is the government’s “mouthpiece,” it’s easy to read it with the proverbial grain of salt. But that also presents an interesting conundrum.

See, I’m looking at two different stories from three different news sources here:

1.  ”In China, many greet New Year in dark” - from CNN.com
2. “Snow-hit China welcomes New Year” -from BBC.co.uk
3. “Chinese leaders visit disaster-hit regions on holiday eve” - from Chinaview.cn (Xinhuanet)

What is interesting is how these three major news stations are reporting the breaking events in the snowstorm in Asia. The first two articles assess the actual picture of health caused by the snowstorms, often times interspersing human interest stories to demonstrate the severity of the situation.  The third article plays into the morale boosting by President Hu Jintao and Premier Wen Jiabao, replete with photo ops of Mr Hu and Mr Wen meeting with “ordinary Chinese on Lunar New Year’s Eve.”  Accompanying pictures in a photo gallery show the urban city of Hangzhou looking much like Boston, Massachusetts might during a Nor’easter.

Thus, the same story is really represented two different ways.  Yet due to government censorship of some foreign media, its leaders still come out ahead.  With the proliferation of the internet to all aspects of the world however, this changes the way we view events as well as history.  Propaganda is not new, nor is it necessarily exclusive to Communist countries.  Yet the outsider is more sensitized to these differences in stories (if not the inaccuracies themselves), even when the stories are apolitical.  So the question still remains, which messenger of the news does one trust?

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A few years back, I read the book, Ponzi’s Scheme: The True Story of a Financial Legend, by Mitchell Zuckoff. The book detailed the life of the ubiquitous Charles Ponzi, inventor of the first successful pyramid scheme. This scheme enabled Mr. Ponzi to get rich quick through what would be tantamount today to currency arbitrage. The crux of the scheme involved buying and selling International Postal Coupons (IPC) at a low price in Italy, taking the coupons to the U.S., selling them in the U.S. for a greater price, and re-investing in more of these coupons.

Ponzi attracted these investors by promising them 50% return on investment in 45 days or double their money in 90 days. In order to get even more people involved in the scheme (thus creating higher payouts for himself), Ponzi ended up buying so many IPCs that the object itself became devalued. As people became self-aware of the relative uselessness of so many IPCs, they demanded their money back. Unfortunately, the outpacing moneyback demand caused the base of the pyramid to crumble and eventually collapse. Ponzi’s complex scheme of arbitrage created an atmosphere of trading that was so euphoric, it lost its grounding.

Ever since I read this book and started to read more about the global financial marketplace and stock markets, I’ve been trying to pose a theory of my own: the financial system is nothing less than a Ponzi scheme that we’re all buying into. This past week, the subprime mortgage crisis seemed to validate my theory. Replete with a breakdown of my basic understanding of financial markets, here’s how I see it:

When I was in London, I started to broach the idea to my Ruskin roommate, Charles (not Ponzi). His response was that the marketplace is filled with such complex financial instruments that it would be difficult for one industry to bring down the market. This complexity meant that risk was spread out even farther with less direct impact on markets as a whole. What would happen in one industry would be less likely to touch another industry. Even though this conversation was only three months ago, it was an answer I was willing to buy into, since it was the only one that seemed to show that my theory wasn’t entirely developed. However, the past week seemed to disprove his answer, instead highlighting the poignancy of my own theory.

Subprime mortgages are mortgages that are offered with introductory interest rates that are lower than the prime rate — usually 300 basis points above the Federal Reserve rate. Typically after the first six months to a year (depending on the terms of mortgage), the interest rate skyrockets to exorbitant percentages that are often variable and much larger than to those offered to regular borrowers. But who would be taken advantage of like this?

Some subprime mortgages can often be described as a type of ninja loan (No Income, No Job, no Assets). After all, we all need some place to live, no?  Typically, the subprime borrower has a lower credit rating and is given a “second chance” by the lending bank.  In the eyes of the bank, there is a trade off by lending to people with unverifiable income or poor credit: the high-yield interest return on the lending risk.

What happens though, when even some of these borrowers can’t afford to pay when the interest rates rise to well above prime?  As the chart shows, with almost $600bn of subprime loans (35% of total mortgages) originated in the U.S. last year alone — when the mortgages aren’t paid and they go into default, the bank gets left with a house and no return.

Let’s switch tracks for a second and introduce another financial concept here: the idea of Asset-Backed Securities (ABS) or Mortgage-Backed Securities (MBS). For a financial institution, debt is viewed as an asset. Not only is it getting back the principal investment, but it is also getting a return on investment (interest). When a bank loans money for a mortgage, it knows that it will be receiving these monies back or else, based on the stipulations of the mortgage agreement, the homeowner will foreclose on the house. Rather than keep these mortgages on the balance sheets, the Financial Institutions repackage all the mortgages into MBS, where these securities can be freely traded on the open market. It’s a simple, yet very complex financial instrument that, once traded, starts to make the mortgages themselves seem useless.

The problem is, the mortgages are not useless. Much like with Ponzi’s IPCs, there has to be some sort of value underneath the derivative. If people cannot pay these subprime mortgages (or any mortgages, for that matter), there is no true backing to the instrument. Thus, unless paid for, the hedge funds and banks that trade MBS are really trading something without much value. When it is admitted that there is no actual money backing the securities - no liquidity - everything starts to catch up and the pyramid falls.

This became most obvious last week when several hedge funds - including some from large investment banks such as BNP Paribas, Bear Stearns, and Goldman Sachs - admitted to large losses stemming from the subprime mortgage crisis. The liquidity backing these securities just wasn’t there. The complex scheme of ABS and MBS created an atmosphere of trading that was so euphoric, it lost its grounding. The trading of billions of dollars of these securities even infiltrated other market exchanges.

Unlike the Ponzi investors however, the Federal Reserve Board (as well as Bank of Japan, Bank of England, and European Central Bank) was able to attempt loss-stabilisation by directly injecting this “lost” liquidity into the market. However, with an interest in maintaining interest-rates and inflation targeting, the Fed’s choice to flood the market with billions of dollars of liquidity raises the question of What happens next? Government didn’t offer bailouts to Ponzi investors.

So… is the financial system just a Ponzi scheme that we’re all buying into?

I’m not a financial analyst, but my critical analysis would seem to suggest that it is. The level of complexity that financial instruments starts to devalue liquidity, however it is liquidity that drives the entire world markets. Inability to back assets with liquidity makes them even more susceptible to risk. Risk isn’t merely spread out because of complexity, but is ultimately intertwined with everything else that drives the markets (lower overall investor confidence, for instance). When everyone wants their money doubled in 90 days and finds the money isn’t there, everyone gets burnt. I don’t think there’s anything complex about it: if my theory is even partially correct, when the full extent of damage is revealed, this whole crisis could be bigger than we all thought. They might as well have been selling IPCs.

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The battle is over, Rupert Murdoch has won.  Not only has Mr Murdoch won, he has also done it with little effort.  His efforts to buy the revered American financial newspaper, the Wall Street Journal have ended with a family realizing its destiny and mismanagement of its own firm.  As Louis Ureneck was quoted in yesterday’s Financial Times, “The irony of The Wall Street Journal is that it’s such a great journalistic institution and yet it’s been so poorly managed.  The double irony is that it’s a newspaper about business.”

Now I must admit that I am biased, as I read the Financial Times on a daily basis, and find the conservative leanings of the WSJ editorial board too much for my tastes.  However, I can only see two logically possible outcomes from the $5 billion takeover of Dow Jones by News Corporation:

The first outcome would be that Mr Murdoch ignores the agreement with Dow Jones’ Bancroft family and injects his meddlesome influence beyond into just operations but into the editorial content as well.  As anyone who knows media has already written, Mr Murdoch is known for his conservative touch on all his media outlets, from Sky Television to Fox News.  His tabloid sensationalism and penchant for selling product often comes with an ideological slant.  Were this to be the case, Mr Murdoch could alienate a large portion of his financial readers and convert them to subscribing to rival newspapers such as the global leader, Financial Times.

This gives me reason to believe that the second possible outcome would be more likely:  Rupert Murdoch would rather enhance his competitive stance and win people into switching to his paper.  By tampering with the current format, Mr Murdoch has nothing to gain from purchasing the Journal, particularly at the 65% price premium offered.  It is true that buying the newspaper will serve News Corporation’s agenda in promoting a Fox financial channel to rival CNBC.  But if Mr Murdoch doesn’t stay on the mark, the newspaper’s reputation gets cut on the spot.  Though my ideologies differ from Mr Murdoch, I recognize that changing the format makes little business sense.  If you buy a broken valuable and it ain’t fixed, don’t keep breaking it.

Ultimately, businesspeople are looking for accurate, balanced, and in-depth information.  Afterall, the markets depend entirely on information.  By skewing the news agenda and information of the Wall Street Journal and by creating a sense of distrust amongst its readers, Rupert Murdoch will lose out.  Smart business dictates Murdoch won’t choose to lose out.

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