ASSET PROTECTION PLANNING—ITS NEW MEANING; AND THE CAUSES OF THE 2008 INTERNATIONAL CREDIT CRISIS–by Richard Duke

Excerpt from the books: International Trust Laws and Analysis, Kluwer Law 

https://lrus.wolterskluwer.com/store/products/international-trust-laws-analysis-company-laws-wealth-management-tax-planning-strategies-online-prod-9888002153/looseleaf-item-1-904119830x

[¶4000]           ASSET PROTECTION PLANNING—ITS NEW MEANING

Richard Duke     [WRITTEN IN 2008]

Duke Law Firm, P.C., Birmingham, Alabama

The international debt crisis has caused asset protection planning to focus more on avoiding losses with respect to wealth and secondly to avoiding loss of assets in future potential lawsuits. The focus now is on selecting proper jurisdictions to implement asset protection vehicles and selecting proper asset managers to manage assets. Asset managers must focus on investing in companies and industries that produce real items that consumers must purchase and less on companies and industries that produce discretionary items that consumers may not purchase. Asset managers must have knowledge, experience and expertise in selecting, maintaining and changing currencies in the ever-changing environment caused by actions of the central banks and the governments around the world.

Asset protection planning has taken on new meaning as a result of the international credit crisis. The proper focus of asset protection currently is to attempt to minimize value—even substantial loss in value—of assets, particularly invested assets. Diversifying one’s investments not only in asset allocations but also among currencies has taken on new meaning because of the potential problems with respect to the U.S. dollar, which is the world’s reserve currency. The U.S. is the largest debtor nation in the world and the largest debtor nation in history. The Federal Reserve continues to inflate the money supply by computer entry, which will eventually result in a substantial devaluation of the dollar as the world’s reserve currency. China proposed establishing a basket of currencies to replace the dollar as the world’s reserve currency. If or when China’s proposal will be implemented is unknown; however, it is an example of concerns about the U.S. dollar.

The Federal Reserve has worked itself into the uncomfortable position of being between a rock and a hard place. If it continues its policy of economic stimulation by increasing inflation, we risk hyper-inflation and eventual collapse. If it raises interest rates to bring inflation down, protect the dollar, and preserve foreign investment, it will cause deepening recession in a nation overextended with personal and government debt. It is a choice the incoming administration will have to face, but there is no alternative to sacrifice in one form or another.

However it plays out, the dollar’s decline will continue, and the only way to avoid serious loss is to make nondollar-denominated investments before that decline turns into a rout. Get out of cash and bonds right now …

Today, [the Federal Reserve] doesn’t have the option of raising rates significantly without triggering consumer debt defaults and mortgage foreclosures that would bring the economy to its knees.[1]

On May 28, 2009, The Wall Street Journal reported that Treasury yields and mortgage rates surged to their highest levels since November 2008 dealing a blow to the efforts of the Federal Reserve to stimulate the economy by keeping borrowing costs low. The article pointed out that Federal Reserve made low mortgage rates a priority in an attempt to curtail the U.S. recession by buying mortgage-backed securities and Treasury notes and bonds. But the winds turned against the Federal Reserve in recent days, the article points out, as investors are concerned that the government’s approach may lead to inflationary price rises.[2] On June 3, 2009, the New York Times reported that increased rates may translate into hundreds of billions of dollars more in government spending for countries like the U.S., Britain and Germany. But the New York Times further stated that each single percentage point increase could cost the U.S. Treasury an addition $50 billion annually over a few years and eventually an additional $170 billion annually.[3]

Causes of the International Credit Crisis of 2008

The causes of the international credit crisis are no mystery unless one listens to the news media, politicians, the chairmen and members of the board of directors of the Federal Reserve and mainstream economists that leave one completely confused. Thomas Jefferson wrote: “Nothing can now be believed which is seen in a newspaper. Truth itself becomes suspicious by being put into that polluted vehicle. The real extent of this state of misinformation is known only to those who are in situations to confront facts within their knowledge with the lies of the day…I will add, that the man who never looks into a newspaper is better informed than he who reads them; inasmuch as he who knows nothing is nearer to truth than he whose mind is filled with falsehoods and errors. He who reads nothing will still learn the great facts, and the details are all false.”[4]

Thomas Jefferson also wrote: “banking establishments are more dangerous than standing armies; and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.”[5] With Jefferson’s words about banking establishments, the following is a list of the substantial underlying causes of the international credit crisis:

1. The Federal Reserve and Credit Expansion. The Federal Reserve, a privately-owned organization, maintained and continues to maintain interest rates at lower-than-market rates. The low interest rates, along with easy access to borrowing and the belief that values of property (such as real estate) would continue to rise caused a credit-induced boom. The factors in the foregoing sentence caused malinvestments (sometimes referred to as over-investments or improper investments not based on reality but on the fact that cheap credit was easily accessible) that at some point had to be liquidated (as all malinvestments at some point in time must be liquidated). Speculative manias gather speed through expansion of money and credit. Most expansions of money and credit do not lead to a mania; there are many more economic expansions than there are manias. The subprime market is a current illustration of credit-driven mania (boom) followed by a bust.[6]

In general, the Austrian theory of the trade cycle (or the Mises theory of the trade cycle) is that loans at interest rates lower than market rates, and with loans not being made on the basis of real savings, result in a boom of malinvestments in the markets or certain aspects or areas of markets that are not made based on sound economics or forecasts. This boom, driven by credit and lower interest rates, cannot be sustained and some or all of these malinvestments will be liquidated. For a detailed discussion of the Austrian theory of the trade cycle, see http://mises.org/tradcycl/austcycl.asp.

[T]oday credit expansion is exclusively a government practice as far as private banks and bankers are instrumental in issuing fiduciary media, their role is merely ancillary and concerns only technicalities. The governments alone direct the course of affairs. The have attained full supremacy in all matters concerning the size of circulation credit. While the size of the credit expansion that private banks and bankers are able to engineer on an unhampered market is strictly limited, the government’s aim at the greatest possible amount of credit expansion. Credit expansion is the governments’ foremost tool in their struggle against the market economy. In their hands, it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, the finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.

The inescapable consequences of credit expansion are shown by the theory of the trade cycle.[7]

Some might ask “he’s the Fed Chairman; how could he have been wrong?” My response is: Greenspan erred by continually picking an interest rate that was too low, then he solved the turmoil that resulted from the decision with another period of interest rates that were again too low. The result was that, during his reign, the United States experienced a bubble in stocks and then in real estate. The two massive bubbles emerged within 10 years of each other. Prior to Greenspan’s arrival at the Fed, excluding the brief mania for commodities and precious metals from late 1979 to early 1980, the country had been bubble-free for over 50 years.[8]

The Japanese twin bubbles of stocks and real estate had only burst in 1989—just over a decade prior. It was a perfect example of what not to do, that is, wait too long to address the market imbalances. Meanwhile, it was simultaneously also a perfect reminder of the lesson that history books teach us over and over again: bubbles—and the enormous misallocation of capital that goes with them—should be avoided at all costs.[9]

History repeats itself with the housing mania … a dangerous credit bubble brought on by financial innovations advocated by Greenspan creates irresponsible lending practices … real estate becomes the country’s money pit.[10]

2. Fannie Mae and Freddie Mac.

Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) are government-sponsored enterprises (GSE) with a mandate to expand affordable housing in the U.S. and provide liquidity and stability to the U.S. housing and mortgage markets. Created in 1938 at the request of President Franklin Roosevelt, Fannie Mae was chartered by Congress in 1968 as a private, shareholder-owned company. Freddie Mac was chartered by Congress in 1970.

Neither Fannie Mae nor Freddie Mac lends funds directly to home buyers. Instead, the two organizations fulfill mandates and achieve objectives by operating in the U.S. secondary mortgage market. Both institutions work with bankers and brokers to ensure that funds are allocated for lending at affordable interest rates; they achieve this objective by buying mortgages.

Together, Fannie Mae and Freddie Mac own (or back) more than $5 trillion of U.S. mortgages in 2009. The two companies account for almost half of the $12 trillion U.S. mortgage market. But even the size of the companies could not prevent the two institutions from being engulfed by the global financial crisis of 2008 – the biggest since the Great Depression of the 1930s.

On September 7, 2008, amid mounting concerns about the solvency of the two GSEs, the Federal Housing Finance Agency (FHFA) – the regulator of Fannie Mae and Freddie Mac – determined that the two GSEs could not continue to operate safely and fulfill their public mission. This was deemed to pose an “unacceptable risk to the broader financial system” and the U.S. economy. Therefore, FHFA announced that it would place the companies under conservatorship, which is essentially the equivalent of a Chapter 11 bankruptcy, and appoint new leadership.

Fannie Mae and Freddie Mac’s problems had their beginnings in the U.S. real estate bubble of the early 2000s. Fueled by low interest rates and relaxed lending standards, U.S. home prices increased at rates that were well above the historical average in the 2001-2006 period.

Much of that housing boom was spurred by the disproportionate increase in subprime lending, whereas borrowers had spotty credit histories or less-than-pristine credit records. Such borrowers historically found it difficult to obtain a mortgage that would enable them to purchase a home. But in 2004, the U.S. Department of Housing and Urban Development (HUD) directed Fannie Mae and Freddie Mac to purchase more loans made to subprime borrowers. This would expand the market for subprime loans and also enable the two GSEs to fulfill their affordable housing mandate in the U.S.

From 2004-2006, Fannie Mae and Freddie Mac purchased $434 billion in securities backed by subprime loans, further fueling the boom in subprime lending. In 2004 alone, the two GSEs purchased $175 billion in subprime securities, accounting for 44% of the market and an increase of 116% from 2003, when they bought $81 billion in these securities. In 2005, Fannie Mae and Freddie Mac purchased $169 billion of subprime securities, accounting for 33% of the market, and in 2006, scaled their purchases back to $90 billion.

However, from 2007 onwards, as the correction in U.S. housing began gathering momentum, delinquencies and foreclosures began rising sharply. Rising defaults on subprime mortgages triggered a global credit crunch in August, 2007; the credit crisis eased up by the end of the year, but took a turn for the worse from March 2008.

Fannie Mae and Freddie Mac recorded $14.9 billion in combined net losses in 2007, depleting their capital and undermining their financial strength. With Fannie Mae already down 83% for the year and Freddie Mac down 88% on concerns about their solvency, Treasury Secretary Henry Paulson said federal regulators would back the two GSEs and asked Congress for the authority to inject unlimited amounts of capital into the two companies. These measures served to improve investor sentiment only briefly. By the last week of July, the stocks had resumed their slide amid escalating concerns about their survival.[11]

3. The Community Reinvestment Act (CRA), 1977. The CRA sought to address complaints from anti-poverty activists and housing advocates about banks allegedly discriminating against minority borrowers and “redlining” inner-city neighborhoods. The CRA decreed that banks had “an affirmative obligation to meet the credit needs of victims of discrimination in borrowing.” The CRA was largely ignored until Treasury Department’s 1995 regulations that made receiving a satisfactory CRA rating more difficult. The new regulations deemphasized subjective assessment measures in favor of strictly numerical ones. Bank examiners then used federal home-loan data, broken down by neighborhood, income group and race to rate banks on performance. The CRA is the underlying cause of loans to be made to individuals who could not repay those loans.

4. Portfolio Insurance—Black-Scholes. Professors Black and Scholes at the University of California at Berkley created a strategy known as portfolio insurance, which supposedly savvy investors used. The model is based on the assumption that a trader can suck all the risk out of the market. The valuation in the securitization process and the CDOs was based on an options-pricing model used by credit agencies called Black-Scholes. The model assumes that a trader can move all risk out of the market by taking a short position and increasing that position as the market falls, thus protecting against losses, no matter how deep the losses may be. The Black-Scholes glitch was discovered only after the market began crashing, leaving no buyers and the inability to sell short. As investors tried to unload stocks at the market fell, this created the very disaster that was attempted to be avoided. Because Black-Scholes failed, trillions of dollars of securities were mispriced without regard to the possibility of crashes and panics.[12]

The basis for the credit rating agencies’ process in valuing the securitization process and the CDOs came from using an options-pricing model called Black-Scholes. The model is based on the assumption that a trader can suck all the risk out of the market by taking a short position and increasing that position as the market falls thus protecting against losses, no matter how steep. The glitch in Black-Scholes was discovered only after the fact that a when a market is crashing and no one is willing to buy, it is not possible to sell short. If too many investors are trying to unload stocks as a market falls, they create the very disaster they are seeking to avoid. Black-Scholes didn’t work; trillions of dollars’ worth of securities were mispriced without regard to the possibility of crashes and panics.

Those who tried to attack or discredit Black-Scholes were attached as not understanding advanced math and theories. “But, it was like trying to replicate a fire-insurance policy by dynamically increasing or decreasing your coverage as fire conditions wax and wane. One day, bam, your house is on fire, and you call for more coverage.”[13]

5. Securitizations. Securitization is the process of taking an illiquid asset, or a group of assets, and through financial engineering, transforming them into a security. Structured finance is the repackaging of financial assets to allocate risk and obtain higher credit ratings. Structured finance generated great benefits for many institutions, enabling banks to repackage and apparently sell off their exposure to home mortgages, credit card loans and other assets. It is as though investors thought that somehow the securitization process had taken all the risk out of real estate financing. As the investments became more diverse, so did the pervasion of any problem into seemingly unrelated or unconnected portfolios. Investors were paid more for repackaged receivables than the amount the companies holding those receivables thought that they were worth. Why? The next two reasons for the debt crisis will answer this question.

Although dispersion of risk through securitization and globalization may be a good thing, market players fail to appreciate that dispersion also spreads exponentially the potential losses from that risk throughout the global capital market. With diverse investors crossing over from their traditional markets and their usual asset classes and using increasingly leverage to invest in new asset classes and in newly developed structured finance products, liquidity grew enormously; but like any fully integrated system, the actual risk of loss permeated and eventually overran the entire system. It is a two-way highway that is no longer limited to special classes of institutional or private investors but now includes hedge funds, opportunity funds, private equity investors, and sovereign wealth funds, among others.[14]

6. The collateralized debt obligations and credit rating agencies. The collateralized debt obligation (CDO) was developed for asset-backed securitization market. When a lender sells an asset, it does so to remove the asset from its balance sheet to free up capital and allow the institution to make a new loan, as well as to collect a new fee. Real estate lending went from being a portfolio business to a fee business—from a storage business to a moving business. Yet, by financing its purchaser in the sale of an asset, the loan seller is removing the asset from its balance sheet as owner but clearly reacquiring the risk of the newly pledged asset as lender. Investors misperceived and mispriced an otherwise obviously risky investment because the credit rating agencies rated the CDO transactions using the identical ratings granted to mortgage-backed security transactions and the long-standing “quality” residential and commercial mortgage-backed securities market. Continuing the discussion in the paragraph immediately above, investors misproceed and mispriced an otherwise obviously risky investment because the credit rating agencies rated the CDO transactions using the identical ratings granted to mortgage-backed security transactions and the long-standing “quality” residential and commercial mortgage-backed securities market.

With the componentization adjustment to the structured finance capital stack and the continuing historically low interest rate environment, the real estate finance market continued its enormous growth trajectory. The availability of capital continued to grow, spurred on by the appetite of capital market investors for more high-yield product. Yet most investors in these new capital market products were not cash buyers but looked to finance their investments as part of their strategy of maximizing their yields. Although the typical term warehouse, repo and reverse repo lines were available to finance acquisitions, these lines of credit were floating rate loans and subject to being marked to market and margin calls by the lenders.

There was, however, a new technology—the collateralized debt obligation (CDO), which had been developed originally for the asset-backed securitization market. See John C. Kelly, & An Introduction to Commercial Real Estate CDOs (Parts I and II), Prob. & Prop. 38 (Nov./Dec. 2007) & 55 (Jan./Feb. 2008). Wall Street adapted CDOs for use in the commercial real estate finance segment of the market. When a lender sells an asset, it does so to remove the asset from its balance sheet to free up capital and to allow the institution to make a loan as well as collect a new fee. Real estate lending went from being a portfolio business to a fee business—from a storage business to a moving business. Yet, by financing its purchaser in the sale of an asset, the loan seller is removing the asset from its balance sheet as owner but clearly reacquiring the risk of the newly pledged asset as lender. Therefore, the prospect of being able to remove assets from the seller’s portfolio without retaining the risk of the asset on its balance sheet was a very appealing structure for asset sellers; the fixed interest rate and lack of mark to market requirements and margin call risk were big selling points for asset buyers looking for financing.[15]

7. The incredible mispricing of risk.

The problem is not with securitization, but with securitizers’ and investors’ almost incredible mispricing of risk. It is as though investors thought that somehow the securitization process had taken all the risk out of the real estate financing. Definitely, a very wrong conclusion—ask any B-piece buyer who does due diligence on collateral. Too much capital, lower interest rates, increased leverage, increasing values, lower cap rates, and so on, have taken down booming real estate markets before. Securitized lending was not exception. The difference was that the risk was not being assessed for the term of the loan, but almost at the point of origination. Make it and sell it. Chain of fools: hard evidence that securitization encouraged lax mortgage lending in America, the economist, Feb. 9, 2008, available at:

www.economist.com/finance/displaystory.cfm?story_id=10641119

The pressure to compete with other lenders—lower rates, more proceeds—simply overwhelmed the process. Volume was emphasized over pricing of risk. Issuers viewed themselves as exporting the risk—it was someone else’s risk after it was securitized. But as has been seen, it does not always work out quite that way. Assets have a way of migrating back to an issuer’s balance sheet through a term financing of asset sales or an investment in an asset by a subsidiary such as a SIV [structured investment vehicle] or other alternative investment unit. Thus, the seeds of the current turmoil have been planted over the last several years.[16]

8. VaR—Value Added Risk.

There aren’t many widely told anecdotes about the current financial crisis, at least not yet, but there’s one that made the rounds in 2007, back when the big investment banks were first starting to write down billions of dollars in mortgage-backed derivatives and other so-called toxic securities. This was well before Bear Stearns collapsed, before Fannie Mae and Freddie Mac were taken over by the federal government, before Lehman fell and Merrill Lynch was sold and A.I.G. saved, before the $700 billion bailout bill was rushed into law. Before, that is, it became obvious that the risks taken by the largest banks and investment firms in the United States – and, indeed, in much of the Western world – were so excessive and foolhardy that they threatened to bring down the financial system itself. On the contrary: this was back when the major investment firms were still assuring investors that all was well, these little speed bumps notwithstanding – assurances based, in part, on their fantastically complex mathematical models for measuring the risk in their various portfolios.

There are many such models, but by far the most widely used is called VaR – Value at Risk. Built around statistical ideas and probability theories that have been around for centuries, VaR was developed and popularized in the early 1990s by a handful of scientists and mathematicians – “quants,” they’re called in the business – who went to work for JPMorgan. VaR’s great appeal, and its great selling point to people who do not happen to be quants, is that it expresses risk as a single number, a dollar figure, no less.

VaR isn’t one model but rather a group of related models that share a mathematical framework. In its most common form, it measures the boundaries of risk in a portfolio over short durations, assuming a “normal” market. For instance, if you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99 percent chance that your portfolio won’t lose more than $50 million. That portfolio could consist of equities, bonds, derivatives or all of the above; one reason VaR became so popular is that it is the only commonly used risk measure that can be applied to just about any asset class. And it takes into account a head-spinning variety of variables, including diversification, leverage and volatility, that make up the kind of market risk that traders and firms face every day.

Another reason VaR is so appealing is that it can measure both individual risks – the amoung of risk contained in a single trader’s portfolio, for instance – and firmwide risk, which it does by combining the VaRs of a given firm’s trading desks and coming up with a net number. Top executives usually know their firm’s daily VaR within minutes of the market’s close.[17]

The VaR led to widespread institutional reliance and failed to take into account a financial meltdown. As a result, it was useless as a risk-management tool and created a false sense of security among senior managers and watchdogs. Nassim Nicholas Taleb, the best-selling author of The Black Swan crusaded against the VaR for more than a decade and referred to it as a “fraud.” Anyone who questioned the VaR, however, was told they didn’t understand mathematics and did not know what they were talking about.

9. Credit Default Swap (CDS). The buyer of a credit swap receives credit protection where the seller (apparently, such as from AIG) of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller (such as AIG) of the swap. This gave a false sense of security to buyers of securitized instruments.

10. Derivatives. Derivatives are financial instruments that have no value of their own. That may sound weird, but it is the secret of what derivatives are all about. They are called “derivatives” because they derive their value from the value of some other asset, which is precisely why they serve so well to hedge the risk of unexpected price fluctuations. They hedge the risk in owning things like bushes of wheat, French francs, government bonds, and common stocks—in short, any asset whose price is volatile.

Frank Knight once remarked, “Every act of production is a speculation in the relative value of money and the goods produced.”[18] Derivatives cannot reduce the risks that go with owning volatile assets, but they can determine who takes on the speculation and who avoids it.

Today’s derivatives differ from their predecessors only in certain respects: they are valued mathematically instead of by seat-of-the-pants methods, the risks they are asked to respond to are more complex, they are designed and managed by computers, and they are put to novel purposes. None of these features is the root cause of the dramatic growth in the use of derivatives or the headlines they have grabbed.

Derivatives have value only in an environment of volatility; their proliferation is a commentary on our time. Over the past 20 years or so, volatility and uncertainty have emerged in areas long characterized by stability. Until the early 1970s, exchange rates were legally fixed, the price of oil varied over a narrow range, and the overall price level rose by no more than 3% or 4% a year. The abrupt appearance of new risks in areas so long considered stable has triggered a search for novel and more effective tools of risk management. Derivatives are symptomatic of the state of the economy and of the financial markets, not the cause of the volatility that is the focus of so much concern.[19]

Derivatives are financial instruments with no underlying value, and the secret is that they derive their value from the value of some other asset, which is precisely why they serve so well to hedge the risk of unexpected price fluctuations. “In 2003, there was a debate about financial WMDs (weapons of mass destruction)—derivatives … The debate was between two giants of American capitalism—Warren Buffett and Alan Greenspan.” In 2003, Buffett took aim at derivatives, calling them “financial weapons of mass destruction.” He was joined in this crusade by a few notable figures … The major defender of derivatives was Alan Greenspan, Chairman of the Federal Reserve Bank … The head of the central bank’s role as cheerleader of the derivatives lobby was curious.[20]

11. Greed. In the mid-to-late 1990s, major changes in financial markets took a new turn. The financial virus spreading through the markets, which previously involved primarily new risk, broke through a significant barrier and began to involve new methods of deceit.[21] Even Alan Greenspan told a Senate bank committee in 2002: “An infectious greed seemed to grip much of our business community. The executives would be consumed with their company’s appearance, and they would doubtless enlist a network of well-paid professionals—accountants, analysts, and even lawyers—to buttress the corporate image. Through praise as exemplars of shareholder value, these executives would in fact be single-mindedly obsessed with their own enrichment. They would be at first indifferent and, later, with the confidence wrought by success, arrogant about their disregard for legal and ethical norms.”[22]

12. Arrogant disregard for legal and ethical norms. The executives would be consumed with their company’s appearance, and they would doubtless enlist a network of well-paid professionals—accountants, analysts, and even lawyers—to buttress the corporate image. Through praise as exemplars of shareholder value, these executives would in fact be single-mindedly obsessed with their own enrichment. They would be at first indifferent and, later, with the confidence wrought by success, arrogant about their disregard for legal and ethical norms.[23]

Vinson & Elkins, the law firm, whose biggest client was Enron, took care of the paperwork in a mere forty-eight hours. Such eagerness was not atypical of lawyers, who had, in the ‘90s, come to identify quite closely with their executive clients … Lawyers spent many hours with executives; they knew them, often fraternized with them, and of course were paid by them. The shareholders were a mere abstraction. Yet it was to that group that the lawyers were ultimately responsible—it was their money that paid the bills.[24]

 13. Misunderstanding of the definition of inflation. The definition of inflation has been distorted, which results in focusing on the consequence, not the cause. Inflation is defined as the creation of money and credit out of thin air (modern times: computer entries). Inflation is “an increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices; it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures, as when the supply of goods fails to meet the demand.”[25] The consequence of inflation is a general rise in prices. It is not possible to have a general rise in prices without first inflating the money supply through increased money or credit. Focusing on the consequences of inflation is similar to going to a physician for an infection caused by a splinter and the physician gives you antibiotics to cure that infection; but the infection is caused by a splinter. Remove the splinter and the infection will go away. Remove the lower-than-market interest rates by the Federal Reserve and the credit-induced booms will either go away or are lessened.

[¶4002]     The Impact of the International Credit Crisis

The international credit crisis is real and the failure of governments to allow the value of assets, such as real estate, to return to the real value may have dire implications. Governments of most of the major countries are attempting to continue as in the past by making credit easily available at low interest rates while at the same time the Federal Reserve is creating more fiat money through computer entry. The use of bailouts and so-called stimulus programs (political pork spending) in order to continue as in the past most likely will be unsuccessful and delay the ability of assets to return to their true value allowing assets to reach real value so that buyers and sellers will return to the market. The U.S., and most of the world, is returning to reward those who are producing real goods and services as opposed to spinning paper, for example, in financial institutions. Those financial institutions have rewarded their key employees with substantial millions of dollars in salaries and bonuses in the past. This cannot be sustained as the market is beginning to reward those who are producing those real goods and services. For example, farming—one of the most real goods and services—is an area of growth in which asset managers and investors should consider as a growth investment. Government intervention, through bailouts, stimulus programs and fiat money is delaying assets returning to their real values so that buyers and sellers in the market will appear.

[¶4003]     Selecting Proper Asset Managers

It is imperative that asset managers understand the implications of the international credit crisis, the interventions by government and the creation of fiat money through computer entry by central banks around the world. For some period of time, increased job losses will occur in the U.S., as well as many parts or the world, while at the same time, prices continue to rise on various goods and services. The central banks that have created significant amounts of fiat money believe that they can contract the fiat money supply before the consequences of inflation (creation of money and credit) result, which is the general rise in prices. Due to the complicating factors and the inability of computer models to read future human actions and events, it is recommended that asset managers not rely on timings by central banks in contracting the money supply before a substantial rise in prices occurs. The potential consequences of inflationary price rises, with continuing job losses caused substantially from government intervention and not allowing money to flow to those who should be rewarded (such as those producing real goods and services) will delay recoveries in the market.

Asset managers must understand the implications of the U.S. being the largest debtor nation in the world, as well as the largest debtor nation in history. China, with its own problems unrelated to the subprimes, securitization and the use of derivatives, is the primary creditor of the U.S. In the past, China has loaned money to the U.S. Treasury by buying Treasury notes in order for its companies to sell products, goods and services to the U.S. Several other countries have done the same. The implications of any moves by China and other countries that are creditors of the U.S. Treasury as a debtor must be watched on a daily basis by asset managers. One of the investment world’s iconic figures, Jim Rogers, who also gained fame from traveling around the world first on a motorcycle and then by automobile and now lives in Singapore as a U.S. citizen, states the following: “Whatever the risks, this much is clear: its more scary to have all your savings in the U.S. stock market than it is to put a portion in China—whether investing in China’s growth or as a hedge against a potential U.S. slowdown.”[26]

Asset manager must consider that there may be a radical transformation in the American economy, as well as economies around the world.

The coming decade will witness a radical transformation of the American economy, marked by rising inflation, higher interest rates, and soaring commodity prices, coupled with a weakening dollar; declining markets in stocks, bonds, and real estate; and recession. Asset-based wealth creation and home equity, the cornerstone of the good times during the bubble years, have been revealed as shams, and the economy will have to return to its traditional roots of saving and producing rather than borrowing and consuming.[27]

When the “irrationally exuberant” stock market ran out of greater fools and finally broke in 2001, investors, acting characteristically, began shifting from paper to stuff—from claims to wealth, like stocks, which can become worthless, to physical things like commodities, which are always worth something.[28]

As Jim Rogers predicted, as the international debt crisis began to unfold, the stated that would exhibit the fastest growing would be Iowa, as well as other states that are engaged in agriculture. Why? Mr. Rogers’ reason is that consumers, as a result of the international debt crisis, are choosing to buy real things instead of financial assets and paper shuffling; therefore, companies that are producing real things will potentially flourish in this international debt crisis. Real things mean items that we must have in order to sustain life, such as food, water, transportation such as automobiles (at a cost that consumers can afford), etc. As Mr. Rogers further states, companies that produce discretionary items as opposed to items that must be purchased in order to sustain life will have a difficult time coming out of this international debt crisis.

[¶4004]     Investing During the International Debt Crisis

The authors of this book are not Registered Investment Advisors or financial planners, nor are they licensed to provide investment advice or make recommendations with respect to investments. However, the author of this Introduction has, over the years, followed certain individuals whose advice has been accurate primarily as a result of their own knowledge, research and analysis causing them not to listen to the mainstream economists or investment advisors, government officials and others.[29] The following are the recommendations made by individuals whom this author follows. These knowledgeable individuals make clear that we must understand the impact of the real inflationary price rises with respect to the real value of the assets in which investments are made.

  • Own stocks or interests in conservative producing companies, such as dividend-paying utility or commercial real estate companies benefiting by being vital to the economics of resource-rich countries.
  • Invest excess cash in non-dollar money market fund or foreign equity portfolios and unload bonds whose rates are artificially low and prices artificially high. Look at the real inflationary price rise figures, not the ones presented by governments.
  • Foreign equities
  • Identify undervalued U.S. companies destined to profit from the revival of the economy.
  • Select foreign stocks that are currently cheap because of the temporary market weakness but will be a part of the real economy.
  • Gold mining stocks and the direct ownership gold.
  • Understand that most asset managers are poorly prepared for what’s ahead: can no longer count on falling interest rates, accelerating inflation, and rising asset prices (especially the real value of assets taking into consideration inflationary price rises).
  • Diversify the portfolio into commodities by using commodity experts who have a good track and understand the implications of the creation of fiat money by the Federal Reserve and other central banks. The commodities experts must understand that as a pure Chinese Yuan and Indian Rupees are saved in U.S. dollars with more spent on real assets.

[1] Peter D. Schiff, The little Book of Bull Moves in Bear Markets: How to Keep Your Portfolio Up When the Market Is Down, 42, John Wiley & Sons, Inc. (2008).

2 Liz Rappaport, “Rise in Rates Jolts Markets,” Wall St. J. (May 28, 2009).

3 Nelson D. Schwartz  “Rising Interest on Nations’ Debts May Sap World Growth,” N. Y. Times (June 3, 2009).

4 Thomas Jefferson, The Life and Selected Writings of Thomas Jefferson, 673, Modern Library, Random House (Adrienne Koch & William Peden  Eds., 1944 and 1972).

5 Thomas Jefferson, The Life and Selected Writings of Thomas Jefferson, 673, Modern Library, Random House (Adrienne Koch & William Peden  Eds., 1944 and 1972).

6 See Charles P. Kindleberger and Robert Aliber, Manias, Panics and Crashes—A History of Financial Crisis, 55 (John Wiley & Sons, Inc., 2005).

7 Ludwig von Mises, Human Action-A Treatise on Economics, 794 (3rd Rev. Ed.) (1966).

8 Bill Fleckenstein, Fred Sheehan, William Fleckenstein, Greenspan’s Bubbles—The Age of Ignorance at the Federal Reserve, 3, McGraw-Hill Professional Publishing (2008).

9 Id. at 134.

10 Id. at 151.

11 “How Fannie Mae And Freddie Mac Were Saved” by Investopedia Staff, (Investopedia.com): http://www.investopedia.com/articles/economics/09/fannie-mae-and-freddie-mac-saved.asp.

12 Michael Lewis, Panic!—The Story of Modern Financial Insanity, W.W. Morton & Co. (2009).

13 Michael Lewis, Panic!—The Story of Modern Financial Insanity, W.W. Morton & Co. (2009).

14 Joseph Philip Forte, Disruption in the Capital Markets: What Happened? 13, Probate & Property, v. 22, n. 5, Real Property, Trust and Estate Law Section of the American Bar Association (Sept./Oct. 2008).

15 Joseph Philip Forte, Disruption in the Capital Markets: What Happened? 10, Probate & Property, v. 22, n. 5, Real Property, Trust and Estate Law Section of the American Bar Association (Sept./Oct. 2008).

16 Joseph Philip Forte, Disruption in the Capital Markets: What Happened? 13, Probate & Property, v. 22, n. 5, Real Property, Trust and Estate Law Section of the American Bar Association (Sept./Oct. 2008).

17oe Nocera, ‘Risk Mismanagement: Were the Measures Used to Evaluate Wall Street Trades Flawed? Or Was the Mistake Ignoring Them?” New York Times (Apr. 1, 2009); see also William D. Cohan, House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, Doubleday (2009).

18 Quoted in Unemployment and Mr. Keynes’s Revolution in Economic Thought, Canadian Journal of Economics and Political Science, Vol. 3 (1977), at 113.

19 Peter L. Bernstein, Against the Gods—The Remarkable Story of Risk, 304-305, John Wiley & Sons, Inc. (1996).

20 Satyajit Das, Traders, Guns & Money—Knowns and Unknowns in the Dazzling World of Derivatives, 19-20, Prentice Hall Financial Times (2006).

21 Frank Partnoy, Infectious Greed—How Deceit and Risk Corrupted the Financial Markets, 190 Henry Holt & Company, Incorporated (2004).

22 Roger Lowenstein, Origins of the Crash—The Great Bubble and Its Undoing, 127 (The Penguin Press) (2004).

23 Roger Lowenstein, Origins of the Crash—The Great Bubble and Its Undoing, 127 (The Penguin Press) (2004).

24 Id. at 136.

25 Simon and Schuster, Webster’s New Universal Unabridged Dictionary, 2nd Edition (1972).

26 Jim Rogers, A Bull in China, 60-61 (2007, Beeland Interests, Inc., Random House).

27 Peter D. Schiff, The little Book of Bull Moves in Bear Markets: How to Keep Your Portfolio Up When the Market Is Down, 19-20, John Wiley & Sons, Inc. (2008).

28 Peter D. Schiff, The little Book of Bull Moves in Bear Markets: How to Keep Your Portfolio Up When the Market Is Down, 86-87, John Wiley & Sons, Inc. (2008).

29 See, for example, Jim Rogers: http://www.jimrogers.com and Peter D. Schiff http://www.europac.net/.

 

 

 

 

 

 

 

 

 

 

[1] Peter D. Schiff, The little Book of Bull Moves in Bear Markets: How to Keep Your Portfolio Up When the Market Is Down, 42, John Wiley & Sons, Inc. (2008).

 

[2] Liz Rappaport, “Rise in Rates Jolts Markets,” Wall St. J. (May 28, 2009).

 

[3] Nelson D. Schwartz  “Rising Interest on Nations’ Debts May Sap World Growth,” N. Y. Times (June 3, 2009).

 

[4] Thomas Jefferson, The Life and Selected Writings of Thomas Jefferson, 673, Modern Library, Random House (Adrienne Koch & William Peden  Eds., 1944 and 1972).

 

[5] Thomas Jefferson, The Life and Selected Writings of Thomas Jefferson, 673, Modern Library, Random House (Adrienne Koch & William Peden  Eds., 1944 and 1972).

 

[6] Charles P. Kindleberger and Robert Aliber, Manias, Panics and Crashes—A History of Financial Crisis, 455 (John Wiley & Sons, Inc., 2005).

 

[7] Ludwig von Mises, Human Action-A Treatise on Economics, 794 (3rd Rev. Ed.) (1966).

 

[8] Bill Fleckenstein, Fred Sheehan, William Fleckenstein, Greenspan’s Bubbles—The Age of Ignorance at the Federal Reserve, 3, McGraw-Hill Professional Publishing (2008).

 

[9] Id. at 134.

 

[10] Id. at 151.

 

[11] “How Fannie Mae And Freddie Mac Were Saved” by Investopedia Staff, (Investopedia.com): http://www.investopedia.com/articles/economics/09/fannie-mae-and-freddie-mac-saved.asp.

 

[12] Michael Lewis, Panic!—The Story of Modern Financial Insanity, W.W. Morton & Co. (2009).

 

[13] Michael Lewis, Panic!—The Story of Modern Financial Insanity, W.W. Morton & Co. (2009).

 

[14] Joseph Philip Forte, Disruption in the Capital Markets: What Happened? 13, Probate & Property, v. 22, n. 5, Real Property, Trust and Estate Law Section of the American Bar Association (Sept./Oct. 2008).

 

[15] Joseph Philip Forte, Disruption in the Capital Markets: What Happened? 10, Probate & Property, v. 22, n. 5, Real Property, Trust and Estate Law Section of the American Bar Association (Sept./Oct. 2008).

 

[16] Joseph Philip Forte, Disruption in the Capital Markets: What Happened? 13, Probate & Property, v. 22, n. 5, Real Property, Trust and Estate Law Section of the American Bar Association (Sept./Oct. 2008).

 

[17] Joe Nocera, ‘Risk Mismanagement: Were the Measures Used to Evaluate Wall Street Trades Flawed? Or Was the Mistake Ignoring Them?” New York Times (Apr. 1, 2009).

 

[18] Quoted in Unemployment and Mr. Keynes’s Revolution in Economic Thought, Canadian Journal of Economics and Political Science, Vol. 3 (1977), at 113.

 

[19] Peter L. Bernstein, Against the Gods—The Remarkable Story of Risk, 304-305, John Wiley & Sons, Inc. (1996).

 

[20] Satyajit Das, Traders, Guns & Money—Knowns and Unknowns in the Dazzling World of Derivatives, 19-20, Prentice Hall Financial Times (2006).

 

[21] Frank Partnoy, Infectious Greed—How Deceit and Risk Corrupted the Financial Markets, 190 Henry Holt & Company, Incorporated (2004).

 

[22] Roger Lowenstein, Origins of the Crash—The Great Bubble and Its Undoing, 127 (The Penguin Press) (2004).

 

[23] Roger Lowenstein, Origins of the Crash—The Great Bubble and Its Undoing, 127 (The Penguin Press) (2004).

 

[24] Id. at 136.

 

[25] Simon and Schuster, Webster’s New Universal Unabridged Dictionary, 2nd Edition (1972).

 

[26] Jim Rogers, A Bull in China, 60-61 (2007, Beeland Interests, Inc., Random House).

 

[27] Peter D. Schiff, The little Book of Bull Moves in Bear Markets: How to Keep Your Portfolio Up When the Market Is Down, 19-20, John Wiley & Sons, Inc. (2008).

 

[28] Peter D. Schiff, The little Book of Bull Moves in Bear Markets: How to Keep Your Portfolio Up When the Market Is Down, 86-87, John Wiley & Sons, Inc. (2008).

 

[29] See, for example, Jim Rogers: http://www.jimrogers.com and Peter D. Schiff http://www.europac.net/.