Bloody Streets and Flying Pigs

“Buy when you see blood in the streets,” the old-timers used to tell us, before I became an old-timer. The streets are looking pretty bloody.

The biggest one-day drop in the stock market since the financial crisis got the headlines yesterday. But the real indicator of how bad things are getting, or at least how bad people think things are getting, came in a letter from the Bank of New York to some of its biggest depositors. Beginning next week, the bank is going to charge them interest, rather than pay them interest, for keeping their money on deposit. This is the banking world’s equivalent of a flying pig.

There is no sugar-coating the fact that this is a strange and scary moment in global finance. The United States of America says it deserves to keep its AAA credit rating because it has just agreed with itself to borrow more money so it can pay its debts. The wealthier countries of the euro zone are realizing that they made a lot of their money selling goods to less-wealthy countries, which borrowed from banks all over the euro zone in order to live as though they were wealthy. Nations like China that actually have cash to put away are having all sorts of trouble finding safe places to put it.

Memo to China: Don’t bother calling the Bank of New York.

Strange as it is, this is not the end of days. It is not even 2008, which felt like the end of days to a lot of people. There is a world of difference between what is happening now and what happened those nightmarish weeks three years ago when Lehman collapsed, AIG, Fannie and Freddie became wards of the state, and the entire financial system came very close to cardiac arrest.

Back then, banks could not get the money they needed to stay in business from normal channels. Nobody knew which banks were solvent and which were not, so nobody was willing to do business with anybody. The Federal Reserve literally had to force-feed cash to big banks, whether they needed it or not, so the ones in bad shape could blend into a crowd while being kept on life support long enough for regulators to restore order.

Now we have the opposite problem. U.S. banks are so flooded with the cash that is running away from Europe that our banks are trying to slam the doors. Banks have stopped being workhouses where you send your money so it can support you. Right now, banks are garages, where you pay to park your cash so nobody steals it; meanwhile, you hope it does not get dinged enough, by taxes and inflation, to ruin its trade-in value.

The solvency of America’s big banks is considered a sure thing. We had credible stress tests in 2009. Weak banks like Washington Mutual and Wachovia have been folded into stronger institutions. If all else fails, we are quite certain that despite all the rhetoric about no bank being “too big to fail,” our major institutions are, in fact, too big to fail – and nobody in Washington is going to make the Lehman mistake again.

Europe did not learn the lessons it should have learned from our experience. Two rounds of stress tests have failed to reassure anybody about European banks. The tests are too widely seen as a whitewash that did not honestly address the banks’ exposure to the debts of those struggling weaker nations in the euro zone. Europe has a central bank, but it does not have a strong central government that can step up and say, convincingly, that the continent’s banking system is going to be preserved at any cost – even though this is true.

Germany is not going to let Europe’s banks go under because Greece, or Spain, or even Italy cannot service their debts. Neither is France or the Netherlands. It is true that the existing bailout mechanisms are much too small to actually keep Italy or Spain afloat, especially if they both take on water at the same time. But the reality is that those countries and the banks that hold their debt are too big to be allowed to fail.

Just as our own Congress did with the debt ceiling, the Europeans may wrangle until the 11th hour. They may utter all sorts of oaths about private sector haircuts and moral hazard. They may refuse to make further bailouts. But when the theatrics are done, Germany and its fellows will work out some arrangement between the big European governments and the big banks, because they will have no other choice.

The underlying problems are real. A lot of money, represented today by those mountains of debt on both sides of the Atlantic, was economically wasted – it did not create assets that would have generated the income needed to repay the debts. Governments on both sides of the pond continue to spend more than they take in, and thus require still more loans. Cash-rich countries like China keep making these loans because they need to put their cash somewhere, and because cutting off the borrowers would mean cutting off their own customers. Eventually, though, someone is going to have to pay the bills.

Who will that be? All of us, to an extent, because a lot of these debts will be inflated away. Just yesterday, Japan and Switzerland tried to push down the value of their currencies. They want to make their own money worth less so that their products will look cheaper to foreign buyers, even though it means less buying power for Japanese and Swiss consumers. They want inflation. The United States, Europe and China are all involved in a three-way game of trying to keep their currencies cheap compared to one another, even though they don’t admit it. Brazil desperately wants to cheapen its currency.

But a lot of the bill will be paid by lenders, because a lot of current and future loans are not going to be repaid in full or on time. Borrowers will get a better deal than they bargained for; lenders will suffer.

One thing is the same as in 2008: The smart money is not following the crowd. Maybe the economy will slow into another recession, and maybe stock prices will fall further. But companies are making a lot of money, and managers know how to cut costs to get through a slowdown. Stock prices are going to eventually come back. In the long run, stocks are likely to outperform inflation and bonds, as they always have. Bond prices, on the other hand, have virtually nowhere to go except down. This is especially true for U.S. Treasuries, where the world is flocking for safety even as we await a downgrade in that AAA rating.

Things might even turn around in a hurry. The Federal Reserve will probably try to ride to the rescue next week with a third round of stimulus, dubbed QE3 (for “quantitative easing,” which is what a central bank does when it can’t cut interest rates that are already at zero). The Europeans might get their act together and make it clear that their national governments, their banks and their currency are going to be propped up at whatever cost is necessary. Investors will remember that when you own a stock, you care mostly about how much money that company makes, not what happens to some government bonds that the company does not own.

Take it from this old-timer: Buy when you see blood in the streets. Avoid buying flying pigs, however. They have to come back to earth eventually.

About Larry M. Elkin 534 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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