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The Daily Reckoning | Monday, May 24, 2010 Goldman vs. Gold: The perils of risk and the virtue of caution, Markets grow more and more unsteady...just as you'd expect, Plus, Bill Bonner on First Class capitalism, all the way from Beijing to Paris... Debt-Financed Everything The truth behind California's pension shortfall Eric Fry Reporting from Laguna Beach, California... The forces that have been tormenting the financial markets were nowhere to be seen last Friday. Maybe they decided to take a long weekend. Whatever the case, the Dow Jones Industrial Average rebounded 125 points, several European markets produced modest gains and the euro advanced for the fourth straight trading session. The financial market tormentors might also take Monday off, but we would expect them to return to work very soon. Friday's upticks have a decidedly counter-trend feel to them. The problem, dear reader, is one of too much public debt and too little private capital. "The Greek situation," Bill Bonner remarked last week, "is not very different from the situation in dozens of other countries - including Portugal, Spain, Italy, Britain and the USA. "America is unique...and just the same," Bill continued. "It is already so deep in debt that even if you taxed 100% of Americans' income, the resulting take wouldn't be enough to cover the deficit...And if you cut the Pentagon budget by 100%, you'd still have a deficit too. It would take a remarkable act of political courage and discipline to put the US back on the path towards sound public finances. "It is probably too late already," Bill concludes. "We are probably past the point of no return, as economists Rogoff and Reinhart insist. In our view, the US could still save itself IF it could make an extraordinary commitment to budget cutting. But we won't hold our breath." Unfortunately, America's "official" national indebtedness in only one little atoll in the nation's vast debt archipelago. As of last September, total US federal debt outstanding totaled to $12.0 trillion - or 84% of GDP. Based on GAAP accounting however (which includes the present value of long-term liabilities like Social Security and Medicare), the debt number mushrooms to $70.7 trillion - or nearly 5 times GDP! "[Based on] the GAAP-based deficit from US Treasury reporting," observes John Williams on his very insightful website Shadowstats.com, "total federal obligations as of September 30, 2009, stood at $70.7 trillion, up from $65.6 trillion the year before... [These] numbers are not just unsustainable, they remain uncontainable. Taxes cannot be raised enough to put the annual results in the black, and the level of program slashing needed in Social Security, Medicare, etc. to reduce costs appears to be well beyond the scope of any foreseeable political will in Washington." Unfortunately, our woeful tale of unfunded liabilities does not end in Washington. Several state governments are also racking up large annual deficits and even larger unfunded pension liabilities. Right here at home, in the Golden State, government finances have rapidly slipped from "okay" to "abysmal." And once again, the official debt numbers tell only a small part of the story. According to a study by the Stanford Institute for Economic Policy Research, California's pension shortfall is nearly 10 times worse than the official estimate of $56 billion. The Stanford study examined the California Public Employees' Retirement System (CalPERS), the California State Teachers' Retirement System (CalSTRS) and the University of California's Retirement System (UCRS). According to the Stanford researchers, California's pension shortfall is not $56 billion; it is $535 billion. Why the $479 billion discrepancy between these two calculations? One number is pure fantasy; the other is a reasonable guess. When calculating their future liabilities, the California pension systems assume annualized investment returns of 7.5 to 8 percent. The Stanford team, by contrast, ratcheted down those return expectations to 4.14% - a number that much more closely resembles both current realities in the financial markets and the pension funds' recent, historic returns. Based on the 4.14% rate, the Stanford team calculated the combined funding shortfall of CalPERS, CalSTRS, and UCRS prior to the 2008/2009 recession to be $425.2 billion. However, the research team reported, "Due to the $109.7 billion loss the three funds collectively sustained [in the most recent fiscal year], we estimate the current shortfall at more than half a trillion dollars." What will become of these debts and liabilities? How can we Americans (and Californians) possibly finance them? Most politicians in the land still pretend that America's massive construct of debt-financed services and promises is viable. Your editors are not convinced. We think the American system of "debt-financed everything" has taken a bad idea and run too far with it. It is not a system at all. It is a fraud wrapped inside a mass deception. Deception and capital preservation don't mix very well. That's why your editors here at The Daily Reckoning continuously urge investors to seek opportunities that are straightforward...not complex...and where the chances of deception are very low. That's why your editor fears financial stocks. He has no personal grudge against the financial sector; he is simply not smart enough to invest in it successfully. He is not insightful enough to recognize a prudent banker, much less an honest, prudent banker. "Sell risk, buy caution. Sell complexity, buy simplicity," your editor advised in a July 2008 presentation to the Vancouver Investment Symposium. The events of the last two years have not altered his perspective one iota. Read on... Strategic Short Report Special $1 Offer Open For a Limited Time Can You Afford to Pass on Our Most Profitable Bear Market Research? Right Now You Can Grab The Strategic Short Report for $1. Act Now... It may well prove to be the most profitable investment you've made all year. But You Must Hurry, This Offer Won't Last... See Our Introduction Letter Here. The Daily Reckoning Presents Beauty is Truth, Part II Eric Fry Simplicity and honesty are essential investment attributes. Complexity and deception are fatal. Most publicly traded financial firms, for example, reside at the complex and deceptive end of the investment spectrum. They are complicated and highly leveraged...which means the chances of a costly deception (whether intentional or accidental) are very high. The corporate histories of Countrywide Financial, Washington Mutual, Lehman Bros. and Bear Stearns illustrate the point. But we do not gather here today to mourn the dead; rather to scorn the living. In this case, Goldman Sachs. Once upon a time, Goldman Sachs was a revered moneymaker - the can-do golden child of Wall Street. During the 1990s, Goldman was the American financial firm nonpareil. Its over-the-top success epitomized the feel- good vibe of the market. Accordingly, Robert Rubin, the former CEO of Goldman Sachs joined the Clinton Administration to become one of the most admired Treasury Secretaries of all time. But then things changed. The stock market slumped, the housing market tanked and the economy stumbled. Through it all, Goldman Sachs made money. Lots of it. This one fact angered politicians and average Americans alike. "How dare Goldman Sachs make so much money by betting against the housing market, while so many average Americans were losing their homes!" the hoi polloi exclaimed. But making money is no crime...unless you are committing crimes to make money, which is exactly what the SEC's suit against Goldman Sachs alleges. According to the SEC's complaint, Goldman failed to disclose material information about a security it sold to clients. The SEC calls that "fraud" - always has, always will. Berkshire Hathaway's Warren Buffett, along with other Goldman cheerleaders, assert that the company did no wrong. "Goldman is in the business of buying and selling securities for profit," the cheerleaders declare. "It has a duty to its shareholders." This argument misses the point. The only point that matters is this: Beauty is truth; truth beauty. It's true that Goldman Sachs not only possesses the right, but the obligation, to make money for its shareholders. But it's also true that this obligation is subordinate to Goldman's fiduciary obligation to its clients. In other words, clients first; shareholders (and options-laden management) second. As one of America's largest purveyors of toxic collateralized debt obligations (CDOs), Golden played the role of financial cigarette salesman. Nothing wrong with that...so far. But this particular cigarette salesman took out insurance policies on its biggest customers. Okay, so maybe that's a bit morally ambiguous, but it is still perfectly legal...as long as the cigarette salesman didn't lie to his customers about the potential consequences of smoking cigarettes. But Goldman did lie. To continue our metaphor, Goldman not only "whited out" the Surgeon General's warning on every pack it sold, it also substituted its own warning that read something like: "These cigarettes are full of sugar and spice and everything nice, just like little girls." Goldman informed its clients that John Paulson - the guy who secretly helped construct the Abacus CDO that is at the heart of the SEC's complaint - was a large buyer of this security, when in fact he was a large short-seller of the security. That was a lie. Importantly therefore, Paulson did not utilize his legendary expertise of the CDO market to select the securities that would succeed, he used his expertise to select the securities that would fail. Goldman's failure to disclose this very material fact was a fraud...big time. If Goldman had merely informed its customers that the "cigarettes" it sold were full of "frogs and snails and puppy dog tails" and/or that the guy who helped select the securities comprising this particular CBO was selling it short, Goldman could have purchased life insurance on its customers all day long in full compliance with every applicable securities law. Every seasoned investment advisor and securities lawyer - or investment bank - understands that the SEC's Everest of regulations and no-action letters would boil down to three words: "Disclose, disclose, disclose." Disclosure is the key component of almost every statute. And it would be impossible to be in a position of power and influence on Wall Street without understanding this fact. A failure to disclose is the essence of the SEC's complaint against Goldman Sachs. And if, as your editor suspects, additional SEC charges emerge, "Failure to disclose" will likely play a key role in those as well. No one is exempt from this obligation - least of all the only financial firm that is a major market maker in all of America's largest financial markets. The "remedy" to this problem is not complex. Enforce the laws that exist. Insist on disclosure. Prosecute those who don't disclose. The financial markets do not need "more regulation," they need the same old regulation they've already got...rigorously and blindly enforced. Justice possesses too much eyesight. She needs to put her blindfold back on - and ditch her "Goldman" golf cap - and let a dispassionate analysis of the facts lead wherever it may. Whatever the outcome of the Goldman prosecution/inquisition, we investors must insist on truth or stay away. The best investments are those that are easy to understand...and trustworthy. Both Goldman and Greece would fail this simple test. Our advice: stay away from both of them. "Sell risk, buy caution. Sell complexity, buy simplicity," your editor advised in a July 2008 presentation to the Vancouver Investment Symposium. "The Era of Peak Greed is over; the Era of Caution is upon us. That's not such a bad thing. Caution sounds boring, but it's not nearly as boring as it sounds. In fact, I think being cautious is kind of an uncelebrated virtue. It's a little bit like being free of venereal disease. You can't really brag about it at a cocktail party, but it's still a pretty darn good thing at the end of the day." Two months after this presentation, Lehman Brothers came crashing down, and the entire investment world learned to its chagrin about all the mortgage-backed detritus the nation's banks had been squirreling away on their balance sheets. Lots of risk; lots of complexity...amplified by lots of leverage. Share prices have improved dramatically since the lows of one year ago, but many of the deceptive structures that created the financial crisis remain in place. The financial sector remains a minefield of complexity, leverage and questionable pricing of balance sheet assets. In other words, the risks remain because the deceptions remain. Therefore, sell risk, buy caution. Sell complexity, buy simplicity. Place your hard-earned investment capital in the hands of individuals who will respect and reward it; not in the hands of individuals who will abuse it. Eric J. Fry, for The Daily Reckoning Joel's Note: There are few investments out there less complicated and less risky than plain, simple, boring old gold. The closer the global economy gets to self-destruction, the higher the price of the world's only real money ought to rise. It may not be sexy, at least not in conventional terms, but caution rarely is. If you'd like to get started protecting your wealth with gold, but are unsure as to how to proceed from here, we suggest you check out Byron King's Gold $2,000 primer. It shows you all you need to know about gold investing, including the 5 best ways to get your hands on some yellow metal today. Bill Bonner Emerging Markets vs. Submerging Economies Bill Bonner Reckoning from Paris, France... We're back in Paris. The flight on Air France was long, but not disagreeable. It was even better in the First Class cabin. Not that we were in it. But we were curious about the people who were. Usually, on the Air France flight from Washington to Paris, you see a few rich people. You also see some people you wonder about. Typically, there is an African diplomat...or a hack bureaucrat from an international agency. Sometimes you will see a hip-hop star...or a fashion model. Or just someone who lucked into an upgrade. But on the flight from Beijing, the people traveling in first class were almost all Chinese. We could not tell for sure, but they didn't have that dull, stuffed-shirt look of politicians and aparatchiks. Instead, they looked like real entrepreneurs...real business people...people who probably paid for their tickets themselves. Here in Paris, the weather is warm. Everywhere you look, people are out at sidewalk cafes. Life is very pleasant in Paris...refined...stylish... ..but where's the excitement? The novelty? The growth? The innovation? There's something missing... It feels a little old... A little depasse...a little like yesterday's news...a little stale... ..like, soooo 20th century... The buildings here are old. The money here is old too. In China, everything is new. New buildings. New roads. New money everywhere. We're always wondering how the world works. How can a nation of 1.3 billion people under control of the Communist Party become the most dynamic, most capitalistic, most success-oriented race in the world? How can they grow their capital wealth at 3 to 10 times the rate of the US - when America is supposed to be the "most flexible and most sophisticated" economy in the world? You'll remember that Wall Street claimed to be using its derivatives and other math-heavy, fancy-pants products to make the economy safer while speeding up the rate of growth. It claimed to be way ahead of the rest of the world in its ability to raise and allocate capital. To hear the nation's leading economists and Wall Street banks tell the story, allocating capital to its highest, most efficient uses is what makes an economy grow. That's capitalism right? Using capital to make people richer. So, who are the world's best capitalists? Surely the people with the most experience at it, right? And the people who got Nobel Prizes for describing how it works, right? And the people with the most capital...the most skills...the biggest market...and the greatest success record in history, right? So how is it possible that people who just discovered capitalism 20 years ago could do a better job of it than Harvard grads motivated by million-dollar bonuses? How could a smart guy, with the best financial education that money could buy, with hundreds of years of capitalism behind him, backed by a government that professes to want to help him and flanked by almost unlimited capital, technology, and expertise, fall right on his face? How did so many winners turn into losers? We'll have some ideas on the subject later in the week. Back to the markets... Stocks bounced on Friday. The Dow rose 125 points following a big drop on Thursday. Gold lost ground too - down $12. US stocks are now down about 3% for the year. The markets are deflating... Don't expect to find out by reading the market commentary in the mainstream press! Journalists, commentators and the financial authorities are busily misunderstanding everything. According to the weekend analyses, last week's downturn was a reaction to bad news from Europe. They claim it's all the fault of the dumbo Europeans, who can't get their act together. They created a jacked-up common currency - the euro - but never unified their economic and fiscal policies. So many of the member states got in trouble. And now the others are reluctant to bail them out. And the risk is that either the strong nations drop out of the euro, or the weak nations are kicked out. Either way, the whole thing could collapse in a heap. Europe has a problem. But at least it's out in the open. Everyone can see what is going on. But that's not why stocks fell. We don't know why they fell. But we know it wasn't just because investors were nervous about what is going on in Euroland. The commentators and financial authorities have misunderstood everything... ..from what caused the crisis of '07-'09... ..to what good the bailouts achieved... ..to what is happening in the markets today. Tim Geithner, for example, is quoted in the weekend press telling the whole world that the 'recovery will continue despite problems in Europe.' He does not seem to realize that the recovery is not real...and that problems in Europe are really no different from problems in the US... The problem is too much debt - in Europe, Japan and the US. The bailouts add trillions in new debt. This is not a way to solve the problem. It is a way to make it worse. There are emerging economies. And there are 'submerging economies,' says our old friend Jim Davidson. The economies of Japan, the US and Europe are sinking under debt. All the slick Wall Street products merely added more debt to the private economy. Now, central banks and central governments are adding more public debt, too. Markets will react to the fundamental problem - no matter what the pundits and politicos say. They will mark down asset prices in the debt-burdened economies... The Great Correction is at work. And more thoughts... An update from the Emerald Isle, from our own Irish gem, Ronan McMahon. Ireland has been leading Europe by pledging deep cuts in the public budget. With a much lower government debt than the US, Ireland could still save itself. So far, the Irish have gone along with the 'austerity' measures with good humor. That may be changing: "I really hope Ireland can hobble along (re below) but it seems to be looking more and more like a best case scenario. We ran the largest deficit in euro land last year. Tax revenues continue to tank this year. The banks need another 20-30bn, which could bring this year's deficit north of 30% if the cash is dished out this year. The government proudly told us when they started giving Anglo [a major Irish bank] cash that it was 'off book' so it was ok. Now Europe is insisting it's booked the year it's paid. That's why last year's deficit numbers were revised up in March of April. "We took our first doses of medicine but the mood is changing. There was a mini riot outside the Dail (parliament). The police held the line...ironic given that there have been quite militant murmurings of action from within their representative body. Another dose of medicine is due in the next budget. Another 3bn in cuts needs to be found (although the EU are now looking at our books to see if we need to shave more). This time it won't be so easy to find or to cut. "NAMA (our bad bank) seems to be insolvent from the get go, and may need to be recapitalized. Not even a single euro of interest is being paid on a huge chunk of the loans it has taken over. Our economy is completely out of whack. Big multinationals are doing well making chips to keep your computer running or stents to keep your heart running or little blue pills to keep other parts running. But, in total they only employ about 100,000 people. "The public sector is bloated and horrifically expensive. "Exporters to the UK, or retailers north of a line between Dublin and Galway have been living a nightmare with sterling weakness... Many have just disappeared. For the past 8 years the service sector was pretty much based on us selling houses to each other. Everyone had a ton of money...the bricklayer, the mortgage broker, the solicitor, the realtor, the BMW sales man, the stockbroker... That's all gone. "The residential real estate tidal wave hasn't hit yet. Banks are ratcheting up interest rates in line with their cost of money. People will start walking away from their homes as they loose their jobs. Emigration is back... "It's pretty bleak. Hopefully we can hobble until we find the bottom of the rainbow." Regards, Bill Bonner,