Feldkamp: The Macroeconomics of Crises and Fraud

Great comment from my friend and mentor Fred Feldkamp. Happy holidays.  -- Chris

The Macroeconomics of Crises and Fraud 

By Fred Feldkamp

A terrific NYC business writer wrote an article on Friday explaining the alleged fraud of Martin Shkreli.  It seems Shkreli is a young "master" at a VERY old game.

In macroeconomics, financial fraud is any method by which deception or duplicity induces those with money to "invest" in a scheme where they would, absent fraud, be less likely to invest.  

As long as the fraud goes undetected, it reduces the otherwise applicable "risk premium" investors demand in exchange for their money.  When fraud is detected, "risk premia" (also known as "credit spreads," the "cost of credit intermediation" or "CCI") rise as duped investors demand recovery.  Over time, that rise subsides and reverts to its pre-fraud level, as investors realize that no "gain" comes from burdening "good" transactions by demanding CCI that is above the ability of borrowers to pay.

Since low CCI causes macroeconomic growth and rising CCI is associated with economic stagnation, schemers and scammers regularly "praise" effective defrauders and criticize those who successfully expose fraud.  The schemers well-know that hidden fraud is the primary "cause" of investment "bubbles," but scammers of the world are often so thoroughly convinced that "their fraud" is "good" (or that their "special knowledge" will let them escape while others suffer), that they blame the "whistleblowers" for being effective at exposing duplicity.

This, more than anything, seems to support the saying that:  "No good deed shall go unpunished."

Examples of these trends are rampant.  The Great Depression began within five years after the US Supreme Court famously labeled any less-than-complete separation of ownership or security as imputing fraud "conclusively."  As a result, hidden frauds of "common law pledges" and pyramid schemes of "unconsolidated" corporate speculation (that had supported the creation of speculative bubbles throughout the "Gilded Age" of US "Robber Barons") were exposed.  

It took the Great Depression, World War II and seventy years of nationwide legal reform to overcome the sources of fraud and allow a massive speculative "unwind."  The reform process was finally complete in 2008, just in time to allow the US Fed (and, by imitation, other central bankers) to far more rapidly unwind the new forms of fraud that developed in the post-depression era of "banking de-regulation" (and were exposed when the US "housing bubble" burst in 2007-9).

The largest fraud of the de-regulation era, by far, created the housing bubble.  The fraud began in 1968 with de-recognition of the assets and liabilities associated with a US government supported housing program.  1968 is when Pres. Johnson decided to "de-recognize" the growing debt of "FNMA" by "privatizing" the government sponsored company.  To avoid exposure of rising US deficits, Johnson sponsored a plan to place FNMA "off balance sheet" by selling stock to the public, but continuing to induce investors to lend FNMA more and more money by retaining the firm as an "agency" of the US gov.

The notion that this scheme should allow the government to ignore the liability that its guaranty gave to support mortgage investments was always laughable.  It became absurd when GSEs convinced accountants and lawyers that the GSEs could "deal" in their own liabilities without re-booking them.

With the federal government effectively guarantying FNMA's obligations, how could the sale of stock possibly justify excluding FNMA's debt from calculation of the aggregate US debt load?  It was equivalent to a corporation saying that when it "sold" debt to underwriters, the corporation was no longer liable for the debt.  

The move allowed Johnson to pretend that his gigantic expenditures for the Vietnam war and domestic programs were being funded while the total US debt was "shrinking."  That's not "accounting," it's plain and simple FRAUD.

To seal this scam as a "bipartisan" political issue, when Johnson lost to Nixon in 1968, Nixon's team went "double or nothing" on the FNMA scam by "privatizing" the other US mortgage GSE, FHLMC.  So, as more and more of the world's "trade surplus" nations sought ever-increasing US capital investments (to prevent their local currencies from rising in value), it was ever-easier for the US GSE's to make ever-riskier investments in US housing. The fraudulent scam just kept building (and encouraging similar speculations in other asset classes) with no disclosure of the ultimate impact to expand the total US debt. 

With hindsight, the whole mess was simply stupid.  As long as everyone caught in the scam was making money, however, nobody had an interest to expose it.


Wisely (and thankfully), Ben Bernanke exposed the aggregate international imbalance liability for which all participating nations are liable in a September 2007 speech in Berlin. Since the world is not in debt to extraterrestrial life forms, of course, Bernanke's exposure of the fraud led to the only real solution--reduction of the interest cost associated with carrying liabilities to a point where tax revenues can be balanced to carry the exposed debt.

In 2007-8, Hank Paulson sought, on several occasions, to evade exposure of the US role in this debacle.  Each such attempt, however, backfired as investors kept driving CCI up to a point where Paulson's effort at manipulation was exposed, necessitating a change of course. 

When Paulson decided to "end" the GSE scheme by "conserving" the entities under government control, he blew up the whole scheme by pretending the accumulated deficits remained "off balance sheet" because the US government "ONLY" claimed 79.9% control (using a loophole that the government need only "consolidate" entities that are more than 80% owned--an even MORE obvious accounting fraud).

It was this "final fraud" of Hank's that caused the fall of Lehman a week later.  Paulson's approval was required to do anything for Lehman and, since he had both a son and a brother that worked at Lehman, he could not approve anything because he was conflicted.  As a result, there was nothing that could be done to "re-scam" the Lehman debt.  In short, Paulson was trapped (albeit in a different form) by a legal barrier not unlike the ones that barred Eugene Meyer and the Hoover-era Federal Reserve Board from "saving the world" in 1930.  

Once the world's central bankers did what was needed to fix the horrendous 2008 mess, we've only seen "mini-crises" of fraud as it is exposed and resolved.

In 2011, GOP "Tea Party" half-wits sought to force the US government to "default" on its all too obvious hidden liabilities.  That led CCI to skyrocket until the lunatics were forced to shut up.  Similarly, when governments in Europe sought to impose losses on peripheral nations that could not absorb the cost of liabilities that arose by a similar process in Europe, CCI rose rapidly.  CCI fell again when the ECB accepted its role to liquefy the market sufficiently to absorb the problems.

When the Tea Party gained "control" of the US GOP agenda in 1913, investors protested and forced Speaker Boehner to call the Tea Party's bluff.  As the reality of the calamity that would be generated if the US actually reneged on ANY of its liabilities became crystal clear, the loonies again blinked and CCI responded favorably.

Since June of 2014, CCI has risen dramatically as several problems have converged to sour the investment environment.  Europe seems hell-bent to find means for evading its responsibilities.  Theocratic dictatorships of the Middle East and Africa, being utterly incapable of "leap-frogging" to meaningful modernization, are now failing at an alarming rate and encouraging frustrated citizens and supporters to commit murder/suicide and other acts of terrorism.  

In some areas of the world, shortages of necessities like water and medicine are causing enormous harm and loss of life.  Among resource-rich emerging nations, falling commodity prices, led by the break-up of OPEC and new extraction technology, are causing still more hardship.  As wealth increasingly follows technologically savvy people and education becomes more expensive to acquire, wealth distribution imbalances are generating further economic hardships.

Ultimately (and ironically) it may only be the instinct for human survival that will generate the kind of "demand" needed to lift the world from another rising CCI "depression."   The world needs to address all these issues as the problems of "climate change" grow.  These matters "can" be resolved if we are all bound, by empathy, to "deal" with them artfully and intelligently.  Since the alternative is a "war" that nobody can win, spending "whatever it takes" to address the problems is now the world's ONLY choice.

In the past week, I watched one of America's most conservative financial experts explain to his assembled clients that "debt," properly managed, is "good."  It is only by intelligent leverage that the world benefits from the accelerated growth of "good" ideas, while the losses of "dumb" ideas are borne by those fooled into investing in them.

This applies equally to sound government-funded infrastructure investments as to privately-sponsored growth firms.  Ironically, it is during the upcoming US election year that many choices will need to be made.  The attached data appendix shows that there is little time for wasted debate.  At current CCI levels, government and private investment both need smart support.

The alternative is a crisis that nobody wants and that we can ill-afford.


December 20, 2015