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The Daily Reckoning | Monday, August 30, 2010 China downgrades US debt, let the ratings wars begin, Ben Bernanke's remaining options and why they won't work, Plus, Bill Bonner on the end of the vacation, the end of the "recovery" and plenty more... Economic Sandcastles Why Bernanke’s attempts to fix the economy are only a façade Eric Fry Reporting from Laguna Beach, California... America has an economy that produces about $13 trillion of activity each year. America also has a Federal Reserve Chairman that produces about 13 trillion raised eyebrows each year. Last week, in Jackson Hole, Wyoming, Bernanke raised a few more eyebrows by asserting that the Federal Reserve remains in control - more or less - of economic conditions here in the United States. Like a guy who falls down a flight of stairs, then stands up and says, "I meant to do that," Bernanke insisted the economy's dismal trajectory is neither particularly surprising nor particularly worrisome. "The preconditions for a pickup in growth in 2011 appear to remain in place," the Chairman declared. And even if economic growth continues to disappoint, the Chairman claims he's still got lots more gadgets in his bag of tricks. "Should further action prove necessary," he remarked, "policy options are available." The list of potential "further actions" include: 1) Further purchases of securities; 2) a change in the Fed's policy statement and; 3) a reduction of the interest rate it pays on banks' excess reserves. In other words: 1) Printing money; 2) Issuing comforting words and; 3) Encouraging leveraged risk-taking. "The FOMC will do all that it can to ensure continuation of the economic recovery," Bernanke added. "The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do." Here's our question: Do the words or deeds of a Federal Reserve Chairman - even an intelligent, well-intentioned Federal Reserve Chairman like Ben Bernanke - possess any real power to counteract the natural forces of economic entropy? Or to rephrase the question, can one man really change the course of a $13 trillion economy? Your editor is skeptical. Isn't Ben Bernanke just building sandcastles? For a while the sandy walls will redirect the whitewater. But at the end of the day, the ocean will have its way and little Ben will have a sunburn. Last Friday, investors seemed to believe that the Fed's sandy walls could actually repel the forces of debt liquidation and creative destruction. They seemed to believe that an "FOMC statement" here or a "policy measure" there could actually prevent doomed businesses from failing, or underwater homeowners from defaulting. And so for one day the stock market rallied, bond prices slumped...and investors entertained happy thoughts. But the truth of the matter is that the economy was just as feeble on Friday as it was on Thursday. Stocks did not rally because Ben Bernanke is back in control. Stocks rallied because the time for a rally had arrived. Nothing more; nothing less. Numerous measures of investor sentiment had tumbled to extreme negative readings. And as every seasoned investor understands, whenever sentiment reaches an extreme, share prices usually head in the opposite direction...at least for a while. "A good market bottom seems at hand," options pro, Jay Shartsis, observed last Wednesday near the close of trading. "The 'peak' open interest in the S&P 500 Index ETF (NYSE:SPY) is in the Sept 100 puts with an open interest of 435,578. In contrast, the largest call open interest is only 145,869 in the SPY Sep 115 call. Way too many bears- this is a bullish indication for the broad market." In other words, for those readers who do not "speak option," bearish trades outnumbered bullish trades by about three to one. Such lopsided bearish trading is very unusual, and usually indicates a short-term change in the market trend - from down to up. But do not forget that such indicators tend to be very short-term. Longer-term, the song remains the same. Notwithstanding Chairman Bernanke's optimism, the US economy continues to produce a dreary drumbeat of negative economic reports. Accordingly, the Commerce Department lowered its estimate for gross domestic product in the second quarter to an annual pace of 1.6 percent from an initially reported 2.4 percent. The economy's funk is no great surprise. Prosperity does not usually proceed from the interaction of government intervention and private sector chicanery. The US economy has endured way too much of both. Sustainable growth emerges from the interaction of investment, innovation and industry. Unfortunately, Bernanke's remarks in Jackson Hole remind us that delusions die slowly. Even after the crisis of 2008, a nation of investors still places its faith in the words and deeds of a Federal Reserve Chairman. At the same time, a nation of investors still places its faith in the words and misdeeds of the American credit rating agencies. Addison Wiggin provides the troubling details in the column below... New Presentation: If This Iran News Leaked, There'd Be Panic in the Streets Nobody in the Pentagon knows how to handle this. Nobody in the White House has a clue what to do. This epic, 1,354-year old conflict could be about to boil over - bringing suffering on par with what Europe experienced during the 1930s. Watch this new presentation before it's too late, right here. The Daily Reckoning Presents AAA Ratings: A Grim Fairy Tale AddisonWiggin How the ratings agencies have managed to emerge from the credit crisis unscathed and unregulated is a mystery...and a sham. "Nothing is ever clear or certain in public," we wrote in The New Empire of Debt. "Every error is someone else's fault. That is why so many men prefer it. The public world is so surrounded in fog that he thinks he sees half-naked nymphs behind every tree and $100 bills under every cushion." If Wall Street is a foggy valley of shadows where wise bankers pick the pockets of the wandering masses, then rating agencies act as the surrounding hilltops. No - not the pillars of transparency and relief from the villains below. Rather, they're the unscaleable, daunting cliffs that trap and thicken the fog. (This is the case almost literally, in fact. Moody's, Standard and Poor's and Fitch Ratings' major offices surround the lowest tip of Manhattan eerily... Moody's to the west, S&P at east and Fitch at the southernmost point of the island.) While it is the duty of ratings agencies to assess investment risk and provide a clear playing field for investors of every kind, we all know that they have done just the opposite. From mortgage-backed securities to municipal bonds, sovereign debt to CDOs, ratings agencies have notoriously mispriced risk over the last decade, and nearly all of us have paid the consequence. Yet they not only remain, but prosper. They're still used by every major firm in America (if not the world). And they're left largely untouched by regulators and investigators. Why? Last month, a long-running Senate study determined that over 91% of the AAA mortgage-backed securities issued from 2006-2007 have since been downgraded to "junk" - BB or lower. Surely, a screw-up this gigantic can only be attributed to some extremely smart people. A man off the street would have better odds just flipping a coin. Only geniuses can be so, so wrong. In fact, that's the best explanation for what happened to the "big three" ratings agencies. They were run by brilliant quantitative economists, with models derived from statistics dating back decades. Whether the housing statistics from the Great Depression were lost, or if the raters willfully left them out of their models, we don't know. But there was no model in use that took into account a generational crisis - one where home prices might drop 20% in one year. So investment bankers were able to stuff securities full of bad loans and still get their precious AAA ratings. "Their quantitative models appeared to have a Mensa-like IQ of at least 160," bond legend Bill Gross sums up nicely, "but their common-sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them." "It's easier to be smart than good," we also wrote in Empire of Debt. "Smart men get elected to high office. They run major corporations... "But it is virtue, not brainpower, that pays off." Of course, all the raters and bankers were more than just too smart for their own good. Their lack of virtue exposed a conflict of interest obvious to any functional adult; Investors want AAA-rated securities Investment banks deliver whatever their clients want Investment banks pay ratings agencies for their services The service of a ratings agency is to rate securities. You can pick your metaphor. It's like a student who pays his teacher to grade his papers. Or a plaintiff paying the judge's salary. Cultural differences only exacerbated the problem. Investment bankers might pay the ratings agencies, but it's the bankers - by selling those securities the agencies rate - who make the big bucks. It's quite common for a junior man at a ratings agency to one day work for Goldman Sachs or JP Morgan (though not the other way around). Thus, there is further incentive, though widely unspoken, for raters to play ball. After all, what's the Wall Street life expectancy of an S&P analyst with a ball-busting, no-games reputation? (This same relationship, by the way, is also a real issue with the SEC.) And so the game was played. Together, the rater and banker would decide what combination of loans garnered what rating. Of course, the banker wanted AAA notes to sell to the Icelandic government or a Fidelity retirement fund, and the rater wanted the banker's business...if not to become a banker himself one day. The models played along, too, having never known a crisis like the one that was around the corner. Even when things got really crazy - when there were just way too many bad loans to make a AAA security - bankers and raters found a solution. They split the security into different partitions of risk, each with separate yields, but all under the same rating. They called these "tranches," as if it weren't complicated enough - a French word for a "slice" or "portion." Shareholders and taxpayers, of course, paid the biggest price for the subprime fallout. Bankers have taken a few jabs, too...sort of. But ratings agencies managed to emerge largely unscathed. The big three, Moody's, Fitch and S&P, are not only still in business, but they remain highly relevant. Even as we write, traders are waiting to hear from them with bated breath...the fates of debt-strapped euro-nations, Greece in particular, is in their hands. S&P likes to boast that they insist on sending not one, but two ratings analysts to every country to help determine its credit sovereignty. "It's been our practice, and it's worked well," said S&P's John Chambers. S&P rated Iceland "A+" in March 2008, about six months before its currency collapsed. Late last month, Chambers helped knock Spain down to AA, a "bold" move, defying Moody's and Fitch's AAA rating on Spanish debt. "Here's a country," Bill Gross continues, "with 20% unemployment, a recent current account deficit of 10%, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels and whose fate is increasingly dependent on the kindness of the EU and IMF to bail them out. Some AAA!" That's the biggest bond investor in the world calling agencies out with a crystal-clear example of their inability to function. Yet global credit still lives and dies by their ratings. Despite all the obvious, common-sense issues - incompetence, conflict of interest, past performance - Congress is turning a blind eye to this tawdry corner of the financial services industry. Even the free market seems to have failed in this instance. There are more than just three ratings agencies in this world, after all. Some of them even managed to do their jobs. "Second tier" agency Egan Jones comes to mind. Its analysts are paid by the buyers of the securities it rates, not the issuers. What a novel idea! Yet Egan Jones is not the No. 1 agency in the world, for reasons we can't explain. Even if American investors are content to continue this charade, the Chinese are not. An upstart Chinese ratings agency, Dagong Global, has begun to offer a competing perspective. (Check out the rating on lucky nation #13 in the chart below!) There's one easy takeaway: You still can't trust Wall Street. The same players and the same rules that created this mess - largely for their own benefit - are still a part of the game. The other pill is a little harder to swallow. In the current market environment, the individual, independent investor has the best chances of long-term capital appreciation when he invests outside of "The Wall Street Fandango." When it comes to the truly important investments in life, leave the indexes, blue chip stocks, sovereign bonds and super funds to lower Manhattan. Ratings agencies and their banker clients do not bother with small companies, commodities, smaller funds and other securities that have little potential to make them large amounts of money. What's more, they have no stake whatsoever in the status of your small- to medium-sized business, your family, your education or your local under-the-radar investments. It's in these arenas, where Wall Street has no dice to roll and no purses to snatch, where your failure or success is determined by little more than willpower, wit and some luck. That's the best a good investor could ask for. Addison Wiggin, for The Daily Reckoning Joel's Note: Of course, you can increase the odds of making winning bets by hiring a red-hot, independent research team to scour the markets for you, delivering the best investment ideas under any political or economic conditions. Or, for a fraction of the price, you can take a trial subscription to Addison's Apogee Advisory, where he and his team breakdown all the trends that matter with actionable advice on how best to play them.Get on their "beta-test" list today, right here. Presentation Reveals - Government Retirement About to Belly-Flop Government-sponsored retirement is a myth. It's a great, big magic trick. Starting September 30, the government "safety net" officially begins to shrink. The smartest folks are getting ready now... For details - watch this shocking new presentation. Inside, you'll also learn how to collect thousands of dollars each year in "pension checks" from the government's "other" retirement program. You owe it to your future to watch this new presentation. To do so, simply turn on your speakers and click here. Bill Bonner The Summer the Recovery Went Missing Bill Bonner Reckoning from Paris, France... Well, the vacation is over. We came back to the city on Saturday. On Sunday, cars rolled in all day long - piled with bicycles, beach towels, and all the paraphernalia of summer. Walking to work, we saw a mother on a bicycle with her daughter behind her. The little girl was probably about 3 years old, still sucking her thumb. The mother had come to a stop in front of a nursery. We read the whole story in the little girl's face. She looked as though she was about to cry. Big eyes rolled up towards her mother...still sucking her thumb. Her mother reassuring it. She had spent the vacation with her family. But now it was time for her mother to go back to work...and the little girl to go back to the nursery. Poor little thing... More below... And so, here we are, too, back at our own nursery...with its computer screens, desks and telephones... Let's see, what happened this summer? Easy question. The recovery went missing. Ben Bernanke said so last week...or almost. He noted that the economy wasn't quite as spiffy as he had hoped and that the Fed stands ready, willing, and able to provide more help. The stock market liked the news. After falling for many days, it rallied 164 points on Friday. Gold was flat. The New York Times reports: THE American economy is once again tilting toward danger. Despite an aggressive regimen of treatments from the conventional to the exotic - more than $800 billion in federal spending, and trillions of dollars worth of credit from the Federal Reserve - fears of a second recession are growing, along with worries that the country may face several more years of lean prospects. On Friday, Ben Bernanke, chairman of the Fed, speaking in the measured tones of a man whose word choices can cause billions of dollars to move, acknowledged that the economy was weaker than hoped, while promising to consider new policies to invigorate it, should conditions worsen. Yet even as vital signs weaken - plunging home sales, a bleak job market and, on Friday, confirmation that the quarterly rate of economic growth had slowed, to 1.6 percent - a sense has taken hold that government policy makers cannot deliver meaningful intervention. That is because nearly any proposed curative could risk adding to the national debt - a political nonstarter. The situation has left American fortunes pinned to an uncertain remedy: hoping that things somehow get better. This is where the Great Recession has taken the world's largest economy, to a Great Ambiguity over what lies ahead, and what can be done now. Economists debate the benefits of previous policy prescriptions, but in the political realm a rare consensus has emerged: The future is now so colored in red ink that running up the debt seems politically risky in the months before the Congressional elections, even in the name of creating jobs and generating economic growth. The result is that Democrats and Republicans have foresworn virtually any course that involves spending serious money. "There are many ways in which you can see us almost surely being in a Japan-style malaise," said the Nobel-laureate economist Joseph Stiglitz, who has accused the Obama administration of underestimating the dangers weighing on the economy. "It's just really hard to see what will bring us out." Japan's years of pain were made worse by deflation - falling prices - an affliction that assailed the United States during the Great Depression and may be gathering force again. While falling prices can be good news for people in need of cars, housing and other wares, a sustained, broad drop discourages businesses from investing and hiring. Less work and lower wages translates into less spending power, which reinforces a predilection against hiring and investing - a downward spiral. What kind of help can the Fed give? Well, the only kind it has left. Team Bernanke has already given the economy as much conventional, monetary medicine as he could. Rates are at zero. They've been at zero for two years. What more can you do? The Fed has also used its unconventional tool - quantitative easing - to add $1.4 trillion to the Fed's own balance sheet. It buys bonds with money it creates - out of thin air - especially for that purpose. We wish we could do that. When the Fed wants to buy something it just snaps its fingers. Presto! New money. Money that didn't exist before. How neat is that? You want a new car? You don't draw on savings. You don't wait until you've got enough money. You don't sit down meekly in front of the credit desk to see if you qualify for financing. You just write a check and tell the bank to cover it. The Fed has already done quite a bit of quantitative easing. Normally, when it buys a bond with money it invented, the new money goes away automatically when the bond matures. So, the Fed has already said it would turn over its bond holdings, rather than let them mature and expire. And now Bernanke says he is ready to go further - by buying more bonds. But the Fed is hesitating. It knows it can increase the potential money supply by buying more bonds. But it doesn't know how much good it will do. So far, the banking system is not lending...and not converting this monetary base into the kind of consumer and business loans that boost consumer prices. The Fed knows, too, that investors may begin to worry about inflation. Bond buyers may begin to worry about a crash. At some point, these nagging worries could turn into a raging panic. But the Fed doesn't know where that point is. Neither does anyone else. And nobody knows whether or not it is possible to transmit just a little bit of inflation - enough to avoid deflation and persuade consumers to shop - by means of quantitative easing. It might be like a runaway train. Once you've lost control...it's too late. Markets now seem to anticipate lower inflation rates. The threat of higher levels could incite investors, consumers and business to get rid of dollars. This would nudge inflation rates up...and build momentum towards even higher price hikes. Every little increase in inflation rates could intensify the desire to exit dollars and US bonds... Who knows where the train would stop? Meanwhile, President Obama says he's not happy with the level of growth in the US economy. Which just goes to show how preposterous and absurd the whole discussion has become. Economic growth is a function of what people choose to do with their money. Sometimes they pursue growth. Sometimes they want safety. At present, they seem to prefer to play it safe. Households save. Banks stockpile cash. Businesses put expansion plans on hold and refuse to hire. What sense does it make for an elected president to take issue with the express, legitimate and sensible desires of the people he is supposed to represent? And more thoughts... We watched "la rentree" from a sidewalk café, where we sat down to compose our thoughts. Families came back to town, pulled up in front of their apartment houses and unloaded children, bags, bikes, baskets, grandmothers, dogs, and surfboards. Young men came up out of the subway, still wearing shorts, flip flops and t-shirts - unwilling to give up their summer garb until they absolutely had to. Couples began gathering at bars and restaurants to tell each other where they had gone and what they had done. "That's part of what I like about France," said Elizabeth. "It's the structure. Everybody goes on vacation. Then everybody comes back. You know what you're supposed to do and when you're supposed to do it." "Well, you certainly don't want to do it at the same time everyone else does," we protested. "There are traffic jams 50 miles long outside Paris." "Yes, but even that gives people a sense of shared adventure and hardship... I guess I should say, also, that I like the structure itself. Taking a month off. Spending the time reconnecting with friends and family. And you all know that that's what the time is for." A young man came into our apartment Saturday afternoon - taller, tanner, more mature, confident and fashionable than we had ever seen him. His collar turned up...his hair brushed back...we scarcely recognized him. It was our youngest son, Edward, 16, who had been with a friend at the beach. "Wow...what happened to you..." his father wanted to know. "I've been sailing. Hanging out at clubs. And I met some girls..." And then a young woman came to the door. She too was tanned...but she looked tired. "I haven't slept in 4 days," said daughter Maria, after returning from a trip to Mykonos. "It's completely wild there. It's not a place you would like, Dad...partly because it's all clubs, bars, and nightlife...and its 80% gays. Not that you have anything against gays...but you wouldn't fit in at all. "I loved it...but then, I was in 'work mode.' I mean, I was surrounded by fashion photographers, designers... The beautiful people. But these are the people I work with. Agents. Actors. Producers. We went out to bars and danced all night. "I feel sorry for some of them... Who was it who said, 'parties are a waste of time?' A lot of it seemed pointless to me. But I still had a good time. And now I need to go to sleep. I'll see you tomorrow..." Regards, Bill Bonner, for The Daily Reckoning