Generally, stock prices are a reflection of corporate profitability. Sometimes rising stock prices lead economic activity and sometimes price appreciation trails economic growth. But historically, stock prices don’t rise if the economy isn’t growing.

This time around, however, there was a “trickle-down” benefit that boosted stocks, but bypassed the economy.

The monetary stimulus trickled down from banks, where it was initially injected, onto corporate balance sheets. From there, thanks to a weakened U.S. dollar, the stimulus enhanced export-driven corporate profitability.

Lest you think this occurred by happenstance, let me assure you: This all happened by design.

The Ugly Truth About the American Banking System

Most U.S. banks were in dire straights and all of the too-big-to-fail banks (the largest banks in the U.S.) were insolvent as a result of the credit crisis that hit in 2008. Both the U.S. Treasury Department and the Federal Reserve (which is run by bankers, essentially for banks) recognized that they had to save the banks at any and all costs – otherwise the U.S. economy and the global economy would collapse into a depression of catastrophic proportions.

Money was pumped into the financial system by means of several government and Federal Reserve programs. Interest rates were kept so low that the overnight rate that banks charge each other, which is engineered by the Federal Reserve Bank of New York, was, and still is, at historic lows in the range of 0.00% to 0.25%.

With money borrowed at essentially no cost, banks bought risk-free U.S. Treasuries. The banks used the Treasuries they bought as collateral to borrow more money in the short-term “repo” markets. And with those additional borrowed funds, the banks bought even more Treasuries.

The interest that the banks collect on the Treasuries (which you and I as taxpayers are essentially paying) created a profitable “interest-rate spread” – the difference between the interest they earned on the bonds they held and the almost-interest-free “loans” they took out in order to leverage their balance sheets.

Banks play a key role in the U.S. economy. By lending money to the private sector, they make it possible for new companies to be formed and existing ones to grow – all of which creates jobs and helps the economy grow.

But banks aren’t lending to the public. Why should they? They make good, safe money on a risk-free basis running the Treasury-spread trade.

Besides, U.S. credit demand has been anemic.

Corporate America Joins the Party

Because interest rates are being held down at artificially low levels, corporations also turned to the bond market to borrow cheaply. In such a low-rate environment, fixed-income investors were forced to scramble for any additional yield they could get above that of U.S. Treasuries – meaning they were only too happy to oblige corporations by lending them money.

Corporate America was able to quickly retool its collective balance sheet, and now sits on about $2 trillion in “cash equivalents” – Treasury bills that companies use to make sure that they collect at least a tiny bit of interest.

The key direct consequence of this massive monetary stimulus has been a weak U.S. dollar. As the dollar falls in value, it makes U.S. exports cheaper on global markets.

That’s why corporations with healthy balance sheets and substantial overseas sales have been reporting great earnings. And it’s also why these corporate heavyweights – and many mid-sized companies, besides – have enjoyed a nice run-up in their share prices.

It doesn’t end there, either. When such strong stock-price gains are posted in a couple of sectors, investors turn to “underperforming” sectors to ferret out bargains, hoping to get in ahead of the inevitable share-price rebounds that result from the money that floods in after investors “rotate” out of fully priced stocks into their undervalued brethren.

One Long Stock-Market Sell-Off?

The bottom line is that the stock and bond markets have been big beneficiaries of the trickle-down policies of the Fed and the Treasury. This is exactly what Fed Chairman Ben S. Bernanke said he wanted to see happen in order to stem the threat of deflation. It has been an articulated policy (except for any admission that they wanted to knock the dollar down – which, of course, they knew would happen).

That brings us to the state of the U.S. economy.

By this time you’ve no doubt heard the term “The New Normal.”

The New Normal – as espoused by PIMCO‘s Mohamed A. El-Erian – is pictured as an American economy with a chronically anemic growth rate of 1.0% to 2.5%, and structural unemployment in the 8% to 9% range.

It’s not a pretty picture.

Already this year, first-quarter gross-domestic-product (GDP) growth was adjusted from an initial estimate of 1.9% all the way down to 0.4%. The second-quarter number just came in at 1.3% -well below the 1.9% rate analysts had been expecting.

It’s not just the GDP numbers that have been all over the place and slipping dangerously. Many other economic indicators and data points are turning down.

Investor sentiment and consumer confidence are at multiyear lows. Unemployment remains stubbornly high and is likely to rise. Private-sector employment has been horrible and new deficit-reduction plans will lead to reductions in government spending and layoffs in the historically stable government-jobs sector.

It’s no wonder, then, that when the Purchasing Manager’s Index came out on Tuesday at 50.9% (its lowest level since October 2008, and its first contraction since June 2009), already-skittish markets plunged. And they’ve continued to fall – as we saw with yesterday’s 4.78% plunge in the Standard & Poor’s 500 Index and 4.31% dive in the Dow.

Just like last August, if the economy continues to falter, the markets will pay more attention to economic reports than to company-earnings reports – no matter how good those earnings reports might be.

And unless we get another round of stimulus – in whatever form we’re able to get it – the aborted stock-market sell-off of last August will come home to roost today.

As this week’s stock-market sell-off underscores, last summer’s QE2 rescue mission has only postponed the inevitable.

Investors better be defensive. The financial markets have been long overdue for a major correction. And without some new stimulus that actually makes sense for the economy – and doesn’t just pump up asset prices – the protracted stock-market sell-off that will carry us through autumn will forever be remembered as “The Fall.”

News and Related Story Links:

• CNNMoney.com:

  Is this finally the economic collapse?

• Money Morning News Analysis:
  U.S. Credit Growth: Is Anemic Lending an Early Indicator of a Double-Dip American Downturn?
• Wikipedia:
  American Recovery and Reinvestment Act of 2009.
• Institute for Supply Management:
  Official Website.
• Wikipedia:
  Too Big To Fail.
• Investopedia:
  Interest-Rate Spread.
• Money Morning:
  The Debt-Ceiling Debate: The Death of the “Risk-Free” Investment.
• Investopedia:
  Deflation.
• Pacific Investment Management Co. (PIMCO):
  Official Website.
• Mohamed A. El-Erian:
  Official Bio.

In the event of a U.S. default, a downgrade, or a combination of the two, the Frankenstein-like facelift that will change markets for years to come is going to start with a “haircut” that trims the collateral value of U.S. Treasury debt.

Lately, the word “haircut” has been transformed to mean a loss – as in “my stocks went down in the bear market … man, I took a real haircut.”

But that’s not the technical definition.

A “haircut” is actually a securities-industry term that pertains to the U.S. Securities and Exchange Commission (SEC) Uniform Net Capital Rule 15c3-1. Securities broker-dealers, regulated by the SEC, have to maintain a minimum amount of “net capital” – or enough of a capital cushion to remain solvent.

When calculating their net capital, securities firms weigh their liabilities against their assets.

But not all assets are treated equally.

In some cases, such factors as credit risk, market risk and even its maturity can bring about an increase in uncertainty for certain assets. If that happens, the SEC can demand that firms “haircut” that asset – marking down its cash value using general formulas that discounts its “present value.”

The more an asset has to be haircut, the less its collateral value becomes.

The Collateral Calamity

Because U.S. Treasuries are U.S. government obligations and have traditionally been considered to be essentially risk-free, they typically haven’t had to suffer much in the way of haircuts.

In fact, short-term Treasury bills aren’t haircut and the longest-dated Treasury securities are only haircut by 6%. For the most part, haircuts on government securities are based on weekly yield volatility measures calculated by the Federal Reserve Bank of New York.

But since traders have used those Treasury securities to borrow more money to buy more government bonds and other (more-speculative) investments, a bigger-than-normal haircut on federal debt obligations will cause lenders to demand additional security on the loans they’ve made to leveraged trading desks around the world.

Leverage is all fine and good, as long as one of the following two things don’t happen to you.

The first thing that’s bad news for leveraged trader is if prices fall. If you’re leveraged enough, and the prices of the assets you’re loaded up with start to decline, you can quickly start eating into your capital base.

For example, if you are leveraged 10-to-1, meaning you have $1 of capital and a $10 asset position, the price of your position only has to fall by 10% to completely wipe out your capital. In the current market environment, a 10% move in just about any asset class can happen in a day or two – if not in a matter of hours or minutes.

The second thing that wreaks havoc with leveraged trades is if the collateral that’s been posted to borrow money (with which the leverage is accomplished) falls in value, then lenders will demand additional collateral, usually in the form of cash.

Of course, the double whammy occurs if the value of your collateral (in our present scenario, that means U.S. Treasury securities) falls at the same time that the securities you’re leveraged up with (we’re once again referring to U.S. Treasuries) also fall in value … well, you’re toast.

And the fallout won’t end with you.

The Ultimate Debt-Ceiling Debacle

This could actually result in a kind of “global margin call” – kicking off a worldwide de-leveraging scenario that could sink global markets and torpedo world economies. That’s the Frankenstein-like facelift I referred to earlier.

Here’s why.

The credit-ratings downgrade and an outright default play a big role in this, too. You see, while a ratings downgrade would affect America’s perceived credit quality, an actual default would change the market’s fundamental consideration of cashflow rights and the degree of certainty held about future payments regarding government obligations. Such a radical change in the quality and market-risk features of government securities would mean that they would be subject to deeper haircuts.

There’s the debt-ceiling-debacle “trigger” I’ve been talking about.

As leveraged institutions have to take deeper haircuts on the Treasuries they’ve put up as collateral for their loans, they’ll have to come up with additional collateral. If at the same time they are required to post additional collateral their leveraged positions are being marked down, there’s likely to be a sell-off of multiple asset classes as cash has to be raised.

Default is a game-changer.

Government securities will no longer be pure-interest-rate instruments. They will immediately assume the risk profile and characteristics of lesser-credit products and not be the baseline against which all other credits are measured, but demand new measures of their own default probabilities.

It’s bad enough that the U.S. government securities market is the largest securities market in the world. What’s even worse is that the derivatives market – which is at least 100 times as large as the U.S. government securities market – principally uses Treasury securities as collateral for their “private contracts.”

If you don’t think this is a real scenario, think again: Monday’s move by the CME shows that it’s already started.

It’s only a matter of time before the effects of building margin calls weigh on asset classes around the globe.

To be forewarned is to be forearmed: Let’s just hope that Washington resolves this whole debt-ceiling debacle before this global-margin-call cycle gets started.

News and Related Story Links:

• Money Morning:
  The Debt-Ceiling Debate: The Death of the “Risk-Free” Investment.
• FoxNews:
  If No Deal, U.S. Will Lay Out Plan.
• Money Morning:
  U.S. Debt Default Would Be Worse Than Lehman Brothers Collapse.
• Federal Reserve Bank of New York:
  Official Website.
• Money Morning:
  A Sovereign-Debt-Default Survival Kit: The Four Countries That Will Keep Their AAA Ratings.
• Securities and Exchange Commission:
  Official Website.

Beating the Wrap

The clearest manifestation of the financial industry’s power is its ability to consistently avoid criminal charges for egregious acts and barter its way out of serious harm by accepting civil charges and paying off its keepers so this sector’s players can continue to run free.

The numbers are staggering when you consider:

• The hundreds of millions of dollars that banks were fined for their dot-com-bubble “pump-and-dump” scheming back in 2000.
• The $550 million that Goldman Sachs Group Inc. (NYSE: GS) paid to settle allegations that it defrauded its own client in a single deal that came to light last year.
• The $100 million Citigroup Inc. (NYSE: C) had to pay to settle allegations of misconduct stemming from its sale of auction-rate securities.
• And the hundreds of millions in fines JPMorgan Chase & Co. (NYSE: JPM) paid to settle allegations that it defrauded investors in a single collateralized debt obligation (CDO) sale, for bribing public officials in Jefferson County, AL, over a muni-bond scandal, and for bid-rigging to win business in 31 states.

That’s a pretty dramatic list. And, yet, I’m not even scratching the surface.

There’s not enough space in this story to list all the fines that every major bank in the United States has had to pay to settle “allegations” of wrongdoing.

But rather than subjecting the institutions and their executives to criminal charges and trial for engaging in patently illegal activities, the very system that is supposed to be policing this activity and protecting taxpayers is letting clever lawyers dance over our justice and regulatory systems – with a wink and a nod from their partners at the U.S. Department of Justice (DOJ) and U.S. Securities and Exchange Commission (SEC).

It’s all about “deferred prosecution agreements.”

Years ago, the Justice Department devised this idea for dealing with juvenile offenders and those involved in minor drug offenses: If the defendants kept their noses clean and adhered to agreements stipulating good behavior for a specified period of time, the prosecution would be deferred.

Of course, it didn’t take long for clever lawyers to lean on the DOJ, and eventually the SEC and other judicial and regulatory agencies, to give their clients – big banks – deferred prosecutions.

“The corporate crime defense bar has this down to a science,” Russell Mokhiber, editor of the Corporate Crime Reporter, told The New York Times. “I interview them all the time, and they boast about how they’ve gamed the system.”

Deferred-prosecution agreements are secret. The internal investigations are “private” and there’s no transparent “discovery” process that can be checked by outsiders or used by other claimants who want to sue these banks and their executives.

Without admitting or denying wrongdoing, it’s hard for any other aggrieved parties to use the levied fines as evidence that criminal activity took place, even though it’s a given.

How and why the DOJ, federal courts, the SEC, and Congress are protecting these crooked moneymaking machines needs to be addressed openly and honestly.

If it isn’t addressed, the situation will only deteriorate from here.

And where we are now isn’t pretty.

The Quiet Coup

If you want to get an idea of how financial services, and in particular the banking industry, have hijacked the U.S. economy, just look at how they’ve grown.

Take a look at “The Quiet Coup,” an article by Simon Johnson, a professor at MIT’s Sloan School of Management and former chief economist at the International Monetary Fund (IMF), that was published in The Atlantic Monthly.

In that article, Johnson points out that from 1973 to 1985 the financial sector never earned more than 16% of domestic corporate profits. But in the 2000s, that figure rose to 41%.

Compensation in the financial sector during that period surged just as appallingly. That is, from 1948 to 1982, average compensation in the financial sector ranged between 99% and 108% of the average for all domestic private industries. Starting in 1983, however, it began to shoot drastically higher – and reached 181% in 2007.

Bankers enjoy extraordinary rich personal compensation. But more importantly, the money their institutions make is spread across the political spectrum, greasing the wheels that grind out favorable legislation crafted by both Democrats and Republicans.

The Final Word … Until Next Time

The amount of money that banks have spent on lobbying and campaign contributions, to elevate political hacks to positions of power in Congress (and later to pay off these same hacks by hiring them as private-sector consultants, investment bankers, and board members) would fill volumes, turn stomachs, and prove once and for all that America is run by bankers.

Simon’s article clearly defines the ramifications of the banking industry’s power – especially when he says that:

“The crash has laid bare many unpleasant truths about the United States. One of the most alarming is that the finance industry has effectively captured our government – a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.”

We started by examining the Bank of America settlement, and have concluded with this final word. The message we come away with is clear: If we continue to let banks run amok – and allow them to avoid any consequences – it won’t be long before the next financial crisis hits.

And when it does, it will be even bigger than the one that we continue to suffer through.

News and Related Story Links:

• The Atlantic:
  The Quiet Coup
• The New York Times:
  As Wall St. Polices Itself, Prosecutors Use Softer Approach
• Money Morning:
  The Next Global Credit Crisis: Why U.S. Banks and Greek Debt Will be the Toxic Trigger.
• Cornell University Law School:
  Criminal Enterprise.
• Money Morning:
  Don’t be Fooled: U.S. Banks Aren’t as Strong as They Look.
• Money Morning:
  Avoid Financials: Bank Earnings Are Set to Slide
• Wikipedia:
  The Gettysburg Address.
• Money Morning:
  Why Inflation in China Could Lead to Another Global Recession.
• Google News:
  Bank of America Settlement.
• The New York Times:
  Bank of America’s Mortgage Deal Questioned.
• MIT Sloan School of Management:
  Official Website.
• International Monetary Fund:
  Official Website.

The Stock Market Volatility Index: What’s at Work?

I’m often asked this question: If there’s fear in the marketplace – and traders are buying puts and their prices are increasing, and they are selling calls and their prices are decreasing – why don’t the two cancel each other out and the VIX react less dramatically?

That’s a great question.

And the answer comes in two parts.

First, “selling calls” is a hedge against falling stock prices. But when you sell calls against a position you hold, you only collect the “premium” or payment that you sold the calls for. No matter how far the stock falls, your downside protection is limited to the money that you collected for selling the calls, meaning this hedge has limited value.

On the other hand, by “buying puts,” you can hedge or profit from a steep-and-lengthy drop in the price of the underlying stock. Even more important, in a sell-off or outright panic, investors and traders are more inclined to buy puts as protection or as a speculative position without too much concern for the prices they have to pay. That’s why volatility spikes in fearful markets.

That brings us to the current situation. I think we’d all agree that there’s been an awful lot of fear in the markets of late. And yet the stock market volatility index – the VIX – has remained stubbornly below (often well below) its historical norm of about 21.

So just what’s going on here?

Going by these low VIX readings, investors and traders have been shrugging off a whole host of negatives that are hanging over the stock market. Bullish investors would have us believe that stock prices are very effectively climbing the proverbial “wall of worry,” meaning “the market” sees good times ahead for stocks.

That may be true. But there’s also more to the story.

The Rest of the Story

Before the markets reached recent highs this past spring, investors and traders began protecting accumulated profits by selling calls against their holdings. I’m not just talking about individual investors; I’m talking about institutional players, too.

At the time, all sorts of potential market “headwinds” were grabbing headlines – everything from the twin tragedies (earthquake/tsunami and nuclear disaster) in Japan, inflationary fears and the approaching end to QE2 here in the United States, soaring oil and commodity prices, and the convulsions in the Middle East, to name just a few.

What we saw was that put buying was met head-on by even-more-robust call selling. So while the buying of protective puts should have lifted the VIX, a steady stream of call selling was offsetting what would otherwise have been generally widening premiums.

The more the markets digested the bad-news headwinds and the higher stocks edged, the less put-option prices were being bid up. What’s more, as things have quickly settled, call sellers have added to the downward direction of the stock market volatility index.

But there are larger, more-important structural dynamics working to keep the VIX low.

For one thing, the so-called “reach for yield” in a very-low-interest-rate environment is causing investors – and especially institutions – to sell calls against stock holdings in order to generate income.

Demographics are playing a role, too. Baby boomers have started to retire. As boomers age, they are switching from stocks to fixed-income investments, which reduces the demand for put protection as they unwind their equity holdings.

Hedging and Speculation Strategies

The real question to ask is: So where do we go from here?

It remains to be seen whether the selling of calls for income is a statement that investors believe the market has limited upside. If so, that would mean that they’re willing to trade away the small chance that there will be a substantial increase in stock prices in return for a boost in their income.

It also remains to be seen whether a low VIX means that the premium options sell for is lower, making it necessary to sell more options to garner additional income. If that’s the case, the lower level of this stock market volatility index would be structural, and thus self-sustaining.

But it’s also possible that a terrible danger is lurking behind these low VIX readings. And that’s something you need to beware of: Just because it appears as if the markets have adjusted to all these headwinds and haven’t corrected meaningfully doesn’t mean that they won’t.

That brings us to hedging and speculation strategies.

In terms of hedging, what I can tell you is this: The low VIX creates an excellent opportunity for you to buy put protection at reasonable prices. In the face of future unknowns, and as long as implied volatility is low, you should take advantage of cheap puts to add some portfolio protection … just in case.

For traders of the VIX, holding positions for big moves is out of fashion and foolish. Until the VIX stops trading in narrow bands, traders should take smaller profits and be quicker on the trigger when their trades are in the black. They can always keep a deep out-of-the-money position in calls if they want a longer-term, investment-type play.

Although the VIX is a stock market volatility index, traders and investors need to understand that it’s really no different than any other investment instrument – meaning that it, too, is vulnerable to structural changes and the dynamics of constantly moving market expectations. You should always understand what’s going on with the instruments you invest in and trade … and avoid at all costs getting blindsided by moves that you could have anticipated.

News and Related Story Links:

• Reuters:
  Bulls Ready to Charge into Wall of Worry.
• Money Morning News Archives:
  Articles by Shah Gilani.
• The Capital Wave Forecast:
  Official Website.
• Investopedia:
  Market Maker.
• Chicago Board Options Exchange:
  Official Website.
• Wikipedia:
  The VIX.
• The New York Times:
  Monchik-Weber Sales Talks?
• Wikipedia:
  Black-Scholes.
• Investopedia:
  Implied Volatility.
• The Chicago Sun-Times:
  The Sad Retirement Outlook For Midwest Baby Boomers.

The sometimes-violent demonstrations on Wednesday forced Greece’s Socialist Party Prime Minister George Papandreou to reach out to the opposition party in an effort to form a coalition government.

He was quickly rebuffed, is reshuffling his cabinet and will call for a vote of confidence. A no-confidence vote – pretty much a foregone conclusion at this point – would require new elections to be held quickly.

The Surprising Trigger for the Next Global Credit Crisis?

This kind of leadership chaos is unnerving to stock-and-bond investors around the world – especially since Greece needs an infusion of $85 billion (60 billion euros) by mid-July to remain solvent.

And Wednesday’s announcement by Moody’s isn’t helping. In addition to its warning that France’s three biggest banks may be downgraded, the U.S.-based credit-rating firm made it clear that there were other banks in France, Germany and the rest of Europe that could face the same treatment in the event of a Greek debt default.

All of this is widely known. But the largely untold “rest of the story” is this: If the European banking sector implodes, the U.S. financial system could take an unqualified beating.

B ig U.S. banks have been lending generously to banks across Europe. C lose to 29% of their lending books during the past two years have gone to their heavyweight European counterparts. While they have pulled back considerably as a result of recent turmoil, U.S. banks are widely believed to have $41 billion of direct exposure to Greece.

The amount of exposure to the rest of Europe is not easily quantifiable.
And this U.S. financial system link doesn’t end there: U.S. money-market funds have a hefty European exposure, too.

A recent report in The Wall Street Journal said that the three large banks Moody’s is threatening to downgrade – BNP Paribas SA, Credit Agricole SA, and Societe Generale SA (PINK ADR: SCGLY) – get a significant amount of their short-term funding from America’s money markets.

According to The Journal, about 12% of the loans made by our biggest money-market funds were made to those three banks.

The interconnectedness of U.S. banks and money-market funds to global banks, many of whom are now at risk from a Greek default, is a sobering revelation.

Even the European Central Bank won’t be immune.

Bad News for the ECB?

According to Open Europe, a U.K. think tank, the ECB will be close to insolvency if Greece defaults – or even “restructures” – its outstanding debts.

The ECB has $116 billion (82 billion euros) of equity capital against a balance sheet just shy of $2.84 trillion (2 trillion euros) of “assets” consisting of bonds, loans and “credits”. Of that amount, it holds $637 billion (444 billion euros) of debt paper from the so-called “PIIGS” countries of Portugal, Ireland, Italy, Greece and Spain.

Of that total, approximately $270 billion (190 billion euros) are Greece’s crumbled paper. Open Europe estimates that a 40% to 50% haircut on Greek debt would come close to wiping out the ECB’s capital base. And the spillover from the contagion – the next global credit crisis – would sink the central bank almost overnight.

Lorenzo Bini Smaghi, an ECB executive board member, doesn’t buy the conclusions reached in Open Europe’s rapidly circulating report – telling the WSJ.com blog that they are “fundamentally flawed.”

For instance, on the subject of the ECB’s holding bonds that might fall precipitously, Bini Smaghi said that “not being a liquidity-constrained institution, we can act as a buy-side counterparty in markets where sell-offs are taking place, and our investment in those markets can be held to maturity, so that only default risk could threaten our profit and loss accounts.”

In terms of collateral, the ECB board member said that “assets held as collateral only constitute a guarantee, not a direct exposure. Accordingly, related price decreases could only induce Euro system losses if those decreases took place after the default of the counterparty.”
But here’s what’s frightening: In dismissing claims that the ECB could fail, Bini Smaghi makes arguments that repeatedly rely on the premise that there won’t be any actual defaults.

When talking about the bonds the central bank holds, he opened up the proverbial can of worms by saying that “only default risk could threaten our profit and loss accounts.”

Doesn’t he realize that default is exactly what’s on the table?

It’s the “Euro system losses” that would take place as a result of a Greek default that has the global investing community frightened to death. European contagion spells global contagion.

French President Nicholas Sarkozy is in Germany today (Friday) to meet with German Chancellor Angela Merkel. Not surprisingly, the topic will be the Greek debt crisis. President Sarkozy will be pleading with the German Chancellor to back off Germany’s call for Greek debts to be “restructured.”

The rift between France and Germany, the strongest members of the European Union (EU), could be the straw that breaks the Union’s back. That could certainly mean that the next global credit crisis is fait accompli. And it would also represent a definite end to the global recovery.

News and Related Story Links:

• Reuters:
  Greek Unemployment Soars in March, Industry Slumps.
• The Guardian:
  Europe Warned of Financial Chaos Over Greek Debt Crisis.
• Time:
  As Austerity Anger Swells, Greece’s Government Struggles.
• Bloomberg News:
  Papandreou Reshuffle Fuels Dissent Among Allies as Financial Markets Slump.

Key Problems With the U.S. Housing Market

According to the feedback I received, many of these “root causes” are very clear. The list includes:

• Too much government manipulation and stimulation.
• A free market that’s not permitted to operate as such.
• Banker (Wall Street) greed that causes – and then perpetuates – wrenching boom-and-bust cycles.
• Too much easy money, which paved the way for too many easy loans.
• Too many (ineffective) regulations.
• Too few (effective) regulations.
• Too many houses on the market.
• Banks that have no incentive to lend.
• And a generally unhealthy economy.

I agree that all of those issues are root problems. But here’s the thing: To fix the housing market – and with it, the U.S. economy – we can’t just attack one, two or three of these.

We have to address all of them – and in a comprehensive fashion.

My plan proposes to do just that.

Try it on again. Only this time, when you comment, help me identify unintended consequences that could result from the plan, and let’s make it better together.

When Government Involvement is OK

Let me start by saying that my plan isn’t another government-manipulation scheme. It does require temporary government action (legislation) that is specifically designed to address these issues in a manner that will turn the market around. But it also puts a strict time limit on these initiatives, meaning the government intervention will eventually expire and allow the free market take over once and for all.

If you’re cynical, like me, you’re saying: “Yeah, but self-serving legislators pander to special interests to perpetuate government-controlled programs.”

You’re right, but that’s another problem for another time – and involves throwing the bums out of office.

In the meantime, my housing plan recognizes that special interests profited egregiously from the de facto government backing of the aptly named government-sponsored enterprises (GSEs) Fannie Mae (OTC: FNMA) and Freddie Mac.

They have to be killed off.

T he plan calls for them to be unwound – and buried.

But in our advanced economy, there is a need for a “mechanism” that is able to transfer risk to investors who are willing to accept it.

That mechanism is called “securitization.” That’s what securitization does. And that’s what Fannie and Freddie do.

GSEs such as Fannie and Freddie help increase the flow of mortgage money in the financial system. They amass a pool of money, which they can use to buy mortgages that they carry on their books as inventory, or that they repackage and sell. But there are a few things wrong with this model. And my plan fixes them all.

As I outlined last week, my plan creates a replacement pool of capital. But that money won’t come from investors who believe that the government will backstop their Fannie and Freddie bonds; it will be free money “donated” by all the banks that “we the taxpayers” bailed out so that they could live to rip us off another day.

Under my plan, the new mortgage pool:

• Won’t be government-backed.
• Will last for only 10 years.
• And will have to lend at prevailing rates based on its “cost of capital” (which will be zero).

Banks will be forced to lend on similar terms: In other words, in addition to the existence of the pool that banks will have to contribute to, banks will have to compete with one another and the pool by providing loans on the same basis as the pool offers.

And the pool will have risk-retention requirements – the same as banks. That should be 10%. This means the pool, and banks, will have to hold 10% of the value of their total loans as a reserve against possible future losses. After all, banks that overleveraged themselves without a substantial -enough cushion of capital reserves against crashing asset prices led to the credit crisis.

Because this is only a temporary liquidity pool – and because we aren’t a communist dictatorship (even so, the banks owe us something for all the trouble they caused, and the trillions of dollars of economic damage they’re responsible for) – banks should get a break on the taxes they pay on the profits they generate from the pool.

The public will be benefiting and banks need the profit motive to serve as an incentive. We want those banks to profit so that they can transparently rebuild their balance sheets and pay taxes again. (Another plan we need to talk about is breaking up all the too-big-to-fail banks).

The idea of “sunsetting” the pool is that it clears the way for other private-mortgage-money investors and syndicators to get into the business and compete profitably.

The ultimate objective here is clear: We want to get the U.S. government out of the mortgage-lending business, and let the free market take over after a transition period.

Save the Housing Market, Save the U.S. Economy

While we’re getting mortgage financing back on track, we need to stabilize the sinking U.S. housing market itself. With my plan, tax credits will get prospective buyers off the fences they’re currently seated on – and will spur them into action.

U.S. housing prices have fallen precipitously. S hould we just let them continue to freefall? No one knows what the natural equilibrium level should be in any town, county, region, state, or nationally.

What we can assume is that a housing-price bottom will eventually form. And if that “bottom” is significantly below where we are now, this country is in for a lot more economic pain.

That statement – more than any other – highlights what I said at the outset of this column: If we’re going to save the U.S. economy, we have to fix the U.S. housing market. It also attempts to speak to free -market advocates, of which I am one, by saying that sometimes an engineered soft landing is easier to bounce back from than a full-blown crash.

My plan to offer tax credits against depreciation and credits for appreciation doesn’t inordinately manipulate prices. It simply incentivizes people to test the waters sooner rather than later by subsidizing (yes, that’s what I’m suggesting) the very real risk that new homebuyers would be taking by making a purchase at this point in a soft-and-unsteady market.

Don’t be too quick to dismiss this part of the proposal: After all, we subsidize banks that take risks that are backstopped by taxpayers. Why not offer a small subsidy directly to U.S. taxpayers?

If the small tax credits (they could and should be limited to some range of home prices, if for no other reason than to avoid giving additional tax breaks to the uber-wealthy in this country) are enough to incentivize people to “bottom fish” for homes – and enough people decide that prices have come down to a level that justifies this investment or speculation – then we will have created a “floor” for housing-market prices that could hold.

It’s a relatively market-based solution to a market-based problem. And it recognizes that markets need risk-takers and sometimes risk-takers need an edge to play.

If you’re thinking that this tax-credit scheme is another government handout that’s going to come back to cost us, you’re right. And that’s another reason I like the plan.

Time to Act

By giving tax credits against future tax revenue, the federal government is trading revenue from tomorrow (which it wouldn’t be getting if the economy keeps sinking) for a chance to stabilize the housing market today. It will hopefully achieve that point of stability sooner rather than later – and will energize the U.S. economy at the same time.

What’s wrong with forcing more fiscal discipline on profligate government spenders? Eventually, we are going to have to address spending in a meaningful way. If my plan is enacted, it will add to the question of what future revenue will be available to spend if we are giving taxpayers much-needed tax credits to stabilize the housing market and the economy now. I know it’s fanciful, but part of my plan is designed to impose fiscal discipline on the federal government by repatriating taxpayer money back to taxpayers.

There are plenty of unintended consequences that will manifest themselves if my plan is enacted and implemented. I’m developing a list (it’s short right now) and I would welcome your help. If we can work together to shape this plan so that it is better positioned to deliver the hoped-for impact on the U.S. housing market and the U.S. economy, we just might be able to present Congress and the Obama administration with a deal they can’t refuse.

It’s our country, our future and our obligation to our democracy to be part of the solution to our collective problems and not part of those problems. If you’ve got constructive comments and ideas for making our plan better, I will do my part to stitch them together so we can do what needs to be done for our country.

News and Related Story Links:

• Money Morning News Archive:
  Columns by Shah Gilani.
• Investopedia:
  Government Sponsored Enterprise.
• Wikipedia:
  Subprime Mortgage Crisis.
• Investopedia:
  Securitization.

Phil Steinschneider commented that my plan was too complex. I don’t believe it is. There are a few “moving parts,” but the plan essentially supports a financing component and a price-stabilization mechanism based on tax credits. As for Phil’s insight that too much manipulation and stimulation caused the problem in the first place, I agree. It’s just that sometimes it takes a bit of counter-manipulation to swing the pendulum more to its center.

Juan and a few other commentators believe that promoting a sensible immigration policy would help better balance supply and demand. I agree with all of you. Unfortunately, as much as we would like to see our incomprehensible and exclusionary immigration policies addressed, the likelihood to tackling two seemingly intractable problems at the same time is probably impossible in our charged political theater.

There were several comments about letting the free market work and just letting housing prices fall to their lowest common denominator. Patrick, for one, wouldn’t mind seeing prices collapse. I am all for the free market. However, markets are never free. They can’t be in a complex econometric model like the one we’ve set up and live in. In theory, I’d like to see “freer” markets, just not so free that they become a “free-for all.” And with good reason: The truth is that by freeing up banks through deregulation, we fostered the greed factor, which ran unchecked and helped drive us over the cliff. Can we really afford to see a wholesale collapse of housing?

Even Charles Scouten, who thinks we should trust the free market to determine the mark-to-free-market” (my phrase, not Charles’… but, hope you like it) value of homes and mortgage-backed securities (MBS) by making banks sell some portion of their inventory into the real world to engender true price discovery, has a not-so-free component to his free market. Charles inherently saw the need for banks to be forced to sell (that’s not a free market) and have a “supervised” (by government) valuation methodology and process. Even in the hope that free markets are the answer, less-than-free-market oversight is almost always contemplated. It is either free, or it isn’t. But I do get where you’re coming from Charles.

Wayne Harper is absolutely right. Banks are not working with homeowners or buyers. You are right Wayne, starting a bank is a good “if-you-can’t-beat-‘em-join-‘em” solution. Let’s not waste any time. We need to open a branch soon and run hat-in-hand to the Fed.

Among the many comments there were also several great ideas that I will work into my plan to make it better. Verland Talbia Gillan has a novel idea (that banks will never allow, but someone might give it a try) to tinker with amortization scheduling to build equity as fast as you are paying interest. Chuck Rymal wants to address the impact of the housing collapse on credit scoring. Joe Ball sees advantages in making loans easily assumable and more “potable.”

I loved and wholeheartedly agreed with Ian Davies’ wishful thinking that the Fed’s privateering (my phrase) be ended once and for all: Hear! Hear!

And, perhaps best put by Roger Wickes, who has been living the housing nightmare as have many others out there, the problem isn’t just housing: As he notes, it’s “the economy, stupid.” Specifically, as many of you said, it’s about jobs. You are right, of course.

But that said, and agreed with: Maybe by fixing the housing market we can actually save and create some jobs. Is that so stupid?

Follow the Money

So how do we attack this twin-tiered challenge of mounting inventories and falling prices?

First and foremost, we have to address the biggest thing that matters – money. Without the ability to finance home purchases, we’re only going to sink deeper and deeper into the black hole.

There’s no arguing the fact that bad financing – securitization – got us into this mess.

Forget all the arguments about how loan factories spun out no-doc “liar loans,” or how buyers were equally complicit in perpetrating mass fraud. Forget about the argument that the Community Reinvestment Act (CRA) forced banks to make bad loans to subprime borrowers (the academically derived statistics don’t support this assertion). Forget about how low interest rates were to blame (that’s partially true). And forget about the fact that deregulation greased the whole slippery slope (that’s definitely true).

At the end of the day, the truth that matters is that securitization financed the whole scheme.

Without the ability to offload the risks being packaged into mortgage-backed securities (MBS), very few of the millions of suspect mortgages made would have been originated in the first place.

And without such government-sponsored enterprises (GSEs) as Fannie Mae (OTC: FNMA) and Freddie Mac ultimately competing against private MBS syndicators, the doomed housing-market train would never have left the station – let alone achieved the long length and high velocity that exacerbated the crash damage.

That’s where we start. Unless the government is providing direct-and-transparent tax incentives to bolster homeownership (more on that later), it has no business being in the mortgage business – especially when that “business” ultimately puts taxpayers at risk.

Fannie Mae was a Depression-era program, as was the Federal Housing Administration (FHA). Fannie was nothing more than a “bad bank” that U.S. President Franklin D. Roosevelt established to take on the defaulting mortgages that were building up on the balance sheets of U.S. banks. The idea was to free up bank capital so that the banks could make loans elsewhere.

It worked so well that Fannie eventually grew to behemoth proportions and President Lyndon B. Johnson, in order to get Fannie’s debt portfolio off the government’s balance sheet, privatized it in 1968. In fact, Fannie was such a success as a monopoly that the U.S. government, in its infinite wisdom, decided to create a duopoly by forming Freddie Mac and privatizing it in 1970.

Because of the widespread belief that these institutions were backed by the federal government (technically they are not), Fannie and Freddie were cheaply and easily able to raise the money they would use to purchase mortgages. When the securitization business began in the 1980s – and especially after that business soared – those two GSEs were at the forefront of packaging and selling MBS instruments, as well as buying back many of them for their own bloated accounts.

Fannie and Freddie are both now under government conservatorship, which is another way of saying they became insolvent and taxpayers bailed them out. When they collapsed so did the private securitization market.

Here’s how to fix that market – and revive the U.S. housing market in the process.

Three Ways to Revive U.S. Housing Market Financing

To fix the securitization market, and resuscitate the American housing market in the bargain, the federal government must do three things.

First, the government must guarantee all of Fannie and Freddie’s existing notes and mortgages (they’re essentially doing that already), to make sure the market isn’t panicked. Once that’s done, announce a cutoff date – after which Fannie and Freddie will no longer be given a Treasury credit line and will be unwound.

Second, Washington must mandate that all the banks that got government help – on a pro-rata basis proportionate to their bailouts and their profits (calculate in bonuses and dividend increases) – will have to contribute to a private national pool of mortgage capital. That pool will replace Fannie and Freddie and will finance mortgage lending in competition with all banks and mortgage lenders. But it will have a single, 10-year lifespan. The government must decree that earnings and profits from this pooled capital are tax-free and must unwind the pool over the allotted 10 years. After all, Fannie and Freddie don’t pay state or local taxes, and never did.

Third, Washington must reinvigorate the private-securitization market by making a new federal ratings agency responsible for assessing creditworthiness and assigning ratings on mortgage pools. It should tax interest and profits on the pools (those not created out of the national mortgage pool outlined above) at a flat 10% for 10 years.

These moves will bring the securitization market back to life and new investor cash will flow into the mortgage business.

To establish a guarantee on individual mortgages the government should follow the FHA business model by having mortgage borrowers pay an up-front guarantee fee equal to 1% of the borrowed amount (the fee can be rolled into the loan, if desired). The borrowers can then pay an additional ½ of 1% of outstanding principal each year into the guarantee pool – and those payments can be spread out over the 12 months of each year.

Mortgage pool s yndicators should have a 10% retention requirement (5% is being proposed and banks are already balking at that), meaning that MBS bankers should have to keep 10% of what they originate on their books. But new regulations can give bankers a break on the set-aside haircut by reducing the reserves they are required to hold against these balance-sheet assets.

A Defibrillating Shock

If we’re to simultaneously arrest the U.S. housing market’s mounting inventories and falling prices, we need to create tax incentives for buyers to stimulate demand.

Banks have supposedly set aside loan-loss reserves against bad mortgages (in fact, they are already reversing a lot of those reserves as they see credit metrics improve). So these institutions are technically carrying inventory and MBS assets that have been marked-to-market, meaning they should be valued at today’s depressed prices.

Against that backdrop, any improvement in sales and prices from here would be good news.

To stimulate sales, and generate at least some tax revenue, Washington needs to start a tax credit program that begins on Jan. 1, 2012 and runs for the next five years. For the first full year the property is owned, the rules should allow 100% of capital appreciation on purchased residential property to be credited back to reduce the home’s cost basis. That cost- basis- reduction program should be permitted to run for five years, with a 20% annual diminishment in each subsequent year from the first full year of the program.

After this coming Jan. 1, in addition to a credit against appreciation that reduces the cost basis and increases the home’s potential profitability, the government should also allow homebuyers a tax credit equal to 50% of any depreciation in the value of their home for the next five years.

In addition to increasing homebuyer demand, these tax incentives will also stabilize the market. And that will help drive investor interest in mortgage-backed instruments, increasing available financing and lowering its cost.

These are not-so-modest proposals, but if we are going to do something about the depressed state of the U.S. housing market, there’s no time to waste being modest. Without these actions, the financial ugliness we’re experiencing right now could literally last for decades.

News and Related Story Links:

• The Money Map Report:
  Official Website.
• Money Morning News Archive:
  Columns by Shah Gilani.
• Hope Now:
  Official Web Site.
• U.S. Department of the Treasury:
  Official Web Site.
• U.S. Department of Housing and Urban Development:
  Official Web Site.
• RealtyTrac.com:
  Official Web Site.
• Wikipedia:
  Real Estate Owned (REO).
• Investopedia:
  Liar Loans.
• U.S. Federal Reserve:
  Community Reinvestment Act.
• Wikinvest:
  Residential Mortgage-Backed Securities.
• Wikinvest:
  Subprime Lending.
• Investopedia:
  Government Sponsored Enterprise.
• HUD.gov:
  Federal Housing Administration.
• WhiteHouse.gov:
  Franklin D. Roosevelt.
• WhiteHouse.gov:
  Lyndon B. Johnson.
• The Business Dictionary:
  Duopoly.

Don’t Be Fooled

There are 7,575 banks that hold an aggregate $7.2 trillion that’s insured by the FDIC. But the 10 largest U.S. banks hold more than half of the assets held by the entire banking industry.

The bottom line: Those 10 banks can skew the sector averages, hiding any trends, developments or problems at the smaller institutions that make up the rest of the industry.

Although the FDIC blithely reported that only four banks were added to its “problem list” in the current year’s quarter.

Here, too, a broader context is required.

For one thing, that “problem list” – which identifies banks that don’t have enough capital to protect them against risk – stands at 888. That means that nearly one in every nine (888 of the 7,575 FDIC-insured banks) U.S. banks is in trouble.

Those 888 banks have total assets of more than $397 billion.

And even though only four banks joined that list in the fourth quarter, the grand total of 888 is the most in 18 years.

Here’s the really scary part: Back in 2006 – we’re talking five short years ago – that list only had 50 banks on it.

There were 26 bank failures in the first quarter of 2011. That comes after last year’s total of 157 – which was the highest amount since 1992.

On its face, that seems to be an improving trend. But with 888 banks identified as “problems,” that’s a trend that could turn very quickly.

Here are two other disturbing trends – these, too, masked by the big-bank skew:

• First, while big banks continue to report earnings improvements, thanks to the ongoing reduction in loan-loss reserves, the FDIC says that banks with less than $1 billion in assets are doing just the opposite – and are continuing to add to their loan-loss-reserve pools.
• And, second, while overall profits were higher, this was yet another bit of big-bank sleight-of-hand: The profit improvement was driven by the decline in loan-loss-reserve set-asides; bank revenue for the first quarter of this year was actually down $5.5 billion, or 3.2%, on a year-over-year basis.

While that doesn’t sound like much, and it isn’t terribly bad, it is only the second time in the 27 years that the FDIC has been keeping such statistics that quarterly revenue actually fell. The only other time was the fourth quarter of 2008 – during the depth of the global credit crisis and the Great Recession.

Six of the 10 biggest banks over the period reported lower non-interest revenue, which fell 3.7% to $58.6 billion for the entire industry. Eight of the 10 largest banks reported lower net-interest income, which was down 3% to $106 billion on an industry-wide basis.

And banks reported tighter margins and a 17% drop in revenue from “service” charges and “fees,” which include such items as overdraft charges and late-fee charges on credit cards.

Total loan and lease balances for the quarter were down 1.7% from a year ago. Again, while that doesn’t sound so bad, it is actually the fifth-largest drop in loan book balances in the FDIC’s 27 years of keeping such records. Worse, loan balances have been falling for two straight years.

Beware of the Economic Fallout

It’s no secret that the U.S. economy is highly consumer driven. So while many of our multinational corporations are in great shape – thanks to strong overseas demand – domestic growth has been sluggish, partly as a result of weak loan demand, which is being increasingly reflected in banks’ metrics.

If we actually remove the nation’s 10 biggest banks from our field of vision, the domestic picture based on the rest of the banking industry looks anemic, at best. I say that based on the fact that big banks are making most of their net new loans to one or both of two places – to overseas borrowers, or to foreign banks. And that means the contribution they’ve made to the domestic economy has been much less than is needed to foster real growth.

Banks are facing increased U.S. regulatory oversight (which is a good thing in the long run) at the same time they’re facing heightened international standards based on pending Basel III requirements that will have to be met. But it’s not the addition of regulatory constraints that banks are suffering from (most of them under the Dodd-Frank Wall Street Reform and Consumer Protection Act have yet to be written and the Basel III requirements are to be phased in over several years yet to come), it’s sluggish loan demand partly resulting from their own more-stringent standards.

Going forward, investors must take special care to watch and see if banks are growing – and, if they are, how are they getting that growth?

If domestic loan demand improves, that’s a good sign that banks are getting back on track. If, however, loan books expand as a result of lowered standards, well, look out below. (The one particular scenario to beware of here goes like this: The market for the already-well-served, and highly creditworthy borrowers becomes even more saturated due to intense competition. Banks, in search of more growth, see no option but to chase after “subprime” borrowers who are once again viewed as viable customers. It happened once before…)

When it comes to U.S. banks, revenue, interest margins, fee revenue, loan-loss reserves, charge-offs and customer profiles are all important metrics to track, and to scrutinize, in order to gauge the health of the banking industry – and the outlook for U.S. gross-domestic-product (GDP) growth. But don’t let yourself be fooled by the-more superficial figures.

After all, with U.S. banks, we’ve now demonstrated just what to look for.

News and Related Story Links:

• Money Morning News Archive:
  Articles by Shah Gilani
• Answers.com:
  Capital Ratios.
• FDIC.gov:
  An Introduction to Asset Quality.
• The Boston Globe:
  Fewer Banks Joining FDIC “Problem” List.
• Wikipedia:
  The Dodd-Frank Wall Street Reform and Consumer Protection Act.
• Money Morning Special Report:
  U.S. Credit Growth: Is Anemic Lending an Early Sign of a Double-Dip American Downturn?
• Wikipedia:
  Basel III.
• XE.com/Reuters:
  U.S. bank earnings up but revenue falls in Q1.

A Profile of Glencore

When researching a difficult topic, the best place to start is usually right at the beginning.

So let’s do precisely that: What is Glencore and what does it do?

Based in Baar, Switzerland, Glencore is a private company that has 485 partners, and employs 54,800 people in 30 countries at its industrial subsidiaries, which consist of mines, farms, production, processing, milling, refining, and storage and distribution facilities. It also employs 2,700 commodities traders in 40 countries around the world.

Glencore owns 34% of mining giant Xstrata PLC. It trades crude oil, oil products, copper, zinc, lead, alumina and aluminum, ferroalloys, nickel, cobalt, coal, coke and agricultural commodities.

Rich, the billionaire founder of Glencore, was also one of the founders of spot-market oil trading. In the early 1980s, Rich was indicted for tax fraud, and for illegally trading with Iran during the 1979 hostage crisis. He was wanted by the United States, but remained beyond its grasp, and refused to return to this country – and ultimately was famously pardoned by Bill Clinton on the 42nd president’s last day in office. (The Website of the Marc Rich Group features a “frequently-asked question” (FAQ) section that notes that Rich “was never convicted, or even tried, for any criminal offense.”)

If the Glencore IPO is as successful as expected, the resultant public company will have a market capitalization of more than $61 billion. That means that Glencore – despite its freshly minted status – will be instantly bigger than Nestle SA (PINK ADR: NSRGY), Novartis AG (NYSE ADR: NVS) and UBS AG (NYSE: UBS). In fact, it will debut as one of the largest companies traded on the London Stock Exchange (PINK: LDNXF) and it will immediately be made part of the FTSE 100 Index, forcing institutional money managers and index funds to buy its shares as a component of the benchmarks they track.

In order to make Glencore’s debut as a publically traded giant a total home run, the company solicited the interest of “cornerstone” investors to commit to purchasing some of its shares. The rich crowd drawn into the Glencore IPO is reported to include:

• Aabar Investments, an Abu Dhabi sovereign wealth fund that says it will invest $850 million as a “cornerstone” investor, and $150 million besides – bringing its total Glencore outlay to a cool $1 billion.
• The Government of Singapore Investment Corp. Pte. Ltd. – Singapore’s sovereign wealth fund (SWF) that’s more commonly referred to as GIC.
• Hedge fund Highbridge Capital Management LLC (owned by JPMorgan Chase & Co. (NYSE: JPM)).
• And BlackRock Inc. (NYSE: BLK), the world’s largest money-management firm.

It seems that investors are lining up – and they weren’t doing so in order to read the 1,300-plus page prospectus that Glencore had to use to disclose all the risks that it faced. These investors were trying to get in on the commodities boom that Glencore has navigated for maximum profit – and in which it can be expected to have its corporate hands for many, many years to come.

But are those investors being lured into the ultimate trader’s “bear trap?”

Key Questions to Ask

First of all, the company has to come to market by its announced launch dates. If it fails to do so, Glencore will have to go back and crunch some more financials. Analysts and others seem to be ignoring the fact that the financials on which the company’s valuations are based were last updated on Dec. 31 – meaning the first quarter is a mystery.

Call me cautious, but wouldn’t it be more revealing to see how the company – which supposedly controls about 50% of the world’s copper trading, 60% of the zinc market and huge amounts of other commodities that have been, shall we say, somewhat volatile in the most recent quarter – has fared in the face of the bursting commodities bubble.

In other words, is Glencore cashing in at the top? Isn’t that what traders do? Sell high and buy low? Isn’t selling at the top of its market the same thing that a few other notable (change that to “exceptionally brilliant”) trading houses did not so long ago?

For instance:

• Didn’t Goldman Sachs Group Inc. (NYSE: GS) go public in 1999, right before the tech bubble popped? And isn’t Goldman’s stock price currently trading well below its high-water mark?
• Didn’t hedge fund giant Fortress Investment Group LLC (NYSE: FIG) go public at $18.50 a share back in February 2007 – right before the markets crashed? And isn’t that once-high-flying IPO stock now trading at less than $5.25 a share?
• And didn’t Stephen A. Schwarzman take private-equity giant Blackstone Group LP (NYSE: BX) public at $31 a share in 2007 – at the absolute apex of the LBO market cycle – and isn’t that stock now trading at less than $17.00? (In another interesting parallel to the Glencore deal, Blackstone also landed a major investment from a sovereign-wealth fund – a $3 billion infusion from the China Investment Corp. (CIC). China profited handsomely when the stock surged nearly 18% on its first day of trading. But at yesterday’s closing price of $16.87, Blackstone shares are down 43% from CIC’s purchase price of $29.605 a share – meaning China’s SWF is sitting on a loss of about $1.3 billion).

Given that “selling at the top” is what traders do best, the questions to ask here are clear: Does the Glencore IPO signal the top of the commodities bubble? Are the insiders selling out at a perfect time? And, as we saw with Blackstone and CIC, are the new Glencore shareholders coming aboard at the absolute worst moment?

You bet.

Glencore’s mystique (there’s that word again) and legendary status as a global powerbroker and master trader is part of what the company insiders are selling. Their sales pitch is based more on the past than it is on the future.

After all, Glencore’s past reads like a Hollywood script, if not a Tom Clancy novel.

It’s a long and fabulous story.

Here’s the short version.

Building the Mystique

A young Jewish émigré named Marc Rich escapes Belgium in 1940 – before Hitler’s panzer-headed blitzkriegs rolled through – and ends up in America. By 1954, Rich is earning $60 a week at Philipp Brothers (now the Phibro LLC unit of Occidental Petroleum Corp. (NYSE: LLC)), at the time a well-known commodity-trading house in New York.

Rich ends up trading oil, which isn’t much of a business when he first gets involved. As it turns out, however, he’s in the right place at the right time: By applying his unique genius, Rich basically creates the spot-trading market in crude oil.

In 1973, Rich “accidentally” bumps into his legendary Philipp Brothers boss, Ludwig “Jes” Jesselson, on the ski slopes of Switzerland. When Jesselson asks him what he’s doing there, Rich replies “skiing.” But in an exchange that’s now part of Wall Street lore, Rich mentions his upcoming bonus and suggests that he’s earned a $1 million payday. Jesselson reportedly retorted: “We’ve never paid a trader a million dollars and we never will.”

Within 48 hours, Marc Rich & Co. was doing business out of its new offices in New York’s swanky Piaget Building.

The timing couldn’t have been any better. The 1973 Arab oil embargo was an oil traders dream. Rich’s new company made millions. He had quite a run, too. But the fact that oil was the most precious commodity on the planet – coupled with the fact that the countries that controlled the biggest supplies were often at odds with the United States – forced Rich into a precarious high-wire act.

But he was game. Whether he was helping set up a secret oil pipeline that sent so much Iranian oil directly to Israel that the barren Jewish state actually became a net exporter of oil, or trading Iranian oil to apartheid-era South Africa for uranium, Rich wasn’t afraid to mix it up with “rogue” states or to do business with dangerous operatives.

It eventually tripped him up, and Rich got caught “daisy chaining” oil for illicit profits. He had allegedly devised a complicated process through which he was able to buy domestic U.S. oil that was controlled to sell at only $6 a barrel and move it around on tankers and reclassify it to sell at the then-hefty price of $40 a barrel.

Despite the American embargo against Iran, that country would ultimately become Rich’s key oil supplier for a decade and a half – and according to one source he reportedly earned billions of dollars selling oil for the Iranian ayatollahs.

Not only that, Rich was accused of tax evasion and of “trading with the enemy” by dealing extensively with the Ayatollah Khomeini’s Iran during the 444-day Iranian Hostage Crisis. In 1983, Rich was indicted for the illegal oil deals and for evading more than $48 million in taxes, and he was also charged with 51 counts of tax fraud, according to a Time report.

Rather than face charges, Marc Rich fled to Zug, Switzerland, where the Swiss, Spanish and Israeli governments defended and protected him. Commodities trading had made him a powerful man with connections that reached the highest offices in many of the world’s governments.

His wife Denise, heiress to the Florsheim fortune, divorced him in 1996 and collected a tidy $365 million. Denise and, it is rumored, former Israeli Prime Minister Ehud Barak, lobbied-then President Clinton to grant Rich a pardon. It was done on President Clinton’s last day in office – an act that Time has included as one of the 10 “most notorious” presidential pardons in U.S. history.

(President Clinton also pardoned his half-brother Roger Clinton, and former business partner Susan McDougal. But it was the Rich pardon that seemed to draw the greatest ire from Republicans and Democrats alike. In fact, the uproar over the pardon was so intense that authorities launched an investigation into whether it had been “purchased” by the generous donations that Denise Rich had made to the Clintons and to the Democratic Party. It must be noted here that investigators failed to find enough evidence to indict Clinton, and the matter was dropped.)

But Rich feared what might happen if he once again set foot on U.S. soil. So he’s never returned.

The Key Takeaway From the Glencore IPO

That controversial chapter also closed the book on his tenure at Marc Rich & Co. In 1994, Rich was bought out of his interests in what would become Glencore International by its then managers for a reported $600 million. The rumor is that his partners forced him out after a $200 million loss on a bad Zinc trade.

There’s little doubt that Glencore continued its secretive ways, while also maintaining the Central Intelligence Agency (CIA) and Mossad connections that Rich had always been famous for.

So, you have to ask yourself: Why would a giant secret society like Glencore, with a dark past, want to come into the light of day and relinquish the private, backroom-dealing business model that made its partners and founder fabulously wealthy?

I’ll tell you why. Because the old game is over and commodities prices are about to break down – and in a big way. By utilizing its newly tapped source of capital – its own stock – the partners will eventually be able to cash out (they have a lockup provision of four years to five years). Not only that, the company will also be able to withstand the coming crash in commodity prices and then be perfectly positioned to buy at the bottom, which is what it is planning to do.

The whole Glencore story is amazing. And when you understand the game that’s afoot, the story of the Glencore IPO is even more so.

As amazing as this tale is, however, I’m not touching the stock. I’m buying the timeframe the company insiders gave themselves – which is the four years it will take for commodities to fall and then to rise again.

That’s when commodity prices will peak again and the partners will cash out, once again at the top. That’s the prediction that the Glencore IPO is making for us: Use that insight to your own advantage.

News and Related Story Links:

• The Financial Times:
  Glencore narrows IPO price range to 520p-550p.
• The Telegraph:
  Glencore to price at top of range in flotation.
• Reuters:
  Glencore Set to be Priced at 530p or Above: Sources.
• The Marc Rich Group:
  Frequently Asked Questions.
• Wikipedia:
  Marc Rich.
• Daily Mail:
  Glencore is set to ignite stock flotations boom in New Year.
• WhiteHouse.gov:
  Bill Clinton.
• Fox Studios:
  Official Website.
• FTSE Index:
  Glencore International: Fast Entry/Expected Timetable For Changes in FTSE Indices.
• The Financial Times:
  
  Shrewd Glencore will skew FTSE 100 away from UK.
• Aabar Investments:
  Official Website.
• Aabar Investments:
  Press Release: Aabar Investments Intends to Invest a Total of $1.0 Billion in Glencore’s IPO.
• Government of Singapore Investment Corp. Pte. Ltd:
  Official Website.
• Highbridge Capital Management LLC:
  Official Website.
• Wikipedia:
  650 5th Avenue.
• Investopedia:
  Bear Trap.
• Wikipedia:
  Phibro.
• Wikipedia:
  Arab Oil Embargo.
• Time:
  The 10 Most Notorious Presidential Pardons.
• Bloomberg BusinessWeek:
  The Rich Boys: An ultra-secretive network rules independent oil trading. Its mentor: Marc Rich.