'Good Vibes' Have Appeared Again

Signs of the Times:

"Sandy Weill, whose creation of Citigroup ushered in the era of U.S. banking conglomerates a decade before the financial crisis, said it is time to dismantle the nation's largest lenders."

This is Bloomberg's July 25th article, and the Wall Street Journal had the headline: "Sandy Weill Regrets Breaking Glass".

Weill is quoted "What we should do is go and split up investment banking from banking."

He was instrumental in the 1998 merger of Citicorp and Travelers Group, which was the deal that required the repeal of Glass-Steagall. And, as the saying goes "The rest was history", as Citi stock collapsed from 515 in 2007 to 9.70, repeat 9.70, in 2009. The best on the rebound was 51.50 in January 2011.

It is always fascinating to see examples of how the culture of finance changes from the habits of probity learned in the previous depression to "anything goes" in a new financial era. And, eventually, back to probity, for which Weill seems to be an agent.

It should be emphasized that in the early 1930s most in the establishment understood that the depression was caused by the financial collapse inevitable to a bubble. Since the 1950s too many academics believe that the post-1929 crash was due to the policy error of raising the discount rate from 5 percent to 6 percent in early August of that fateful year.

On the certain knowledge that the boom caused the bust, Glass-Steagall split ordinary banking from Wall Street banking. It made sense, as did the formation of the SEC with the mandate to prevent a repeat of the "Roaring Twenties". Well, with 2007 recording most of the features of a great bubble the SEC failed on its mandate. Also, one of the promoters of the SEC Act boasted that it "would put a cop on the corner of Wall and Broad Streets".

The Madoff fraud had a number of whistle-blowers and the SEC did not act on the biggest Pozni Scheme in history.

Glass-Steagall was thrown out in 1998 as part of another cultural change to reckless financial speculation. Now one of the key agents of change is exploring remorse and repentance.

Perhaps, the SEC will try to assume the mantle of responsibility and accountability that it was originally charged with.

Attached is a copy of our "Book Report" of September 7, 2007. The Ropespinner Conspiracy is a satire published in 1987 on the corruption of banking by "modern" concepts, otherwise known as borrowing short and lending long.

"The European Central Bank is edging toward a bond-buying program that investors say could end up printing money, echoing efforts by the Federal Reserve and other central banks to fix a credit crisis nearing its sixth year."

- Bloomberg, August 3

The article did not include that the Bank of Japan has been similarly aggressive since around 1991. Some of this summer's interns in the BoJ's research department could have been born after their Great Depression began.

Perspective

Fortunately, the "good vibes" have appeared again. Stock market action has been "choppy" and the latest rush has moved the S&P to 1407. This compares to the natural high of 1422 at the end of March and the test of that high at 1415 at the beginning of May. Unfortunately, trading breadth is deteriorating. We are watching for some ending action - seasonally and dynamically.

This has been supported by similar swings in commodities that are beginning to look tired. Other support has been provided by continued narrowing of the Ted Spread. The weekly RSI has traded from very overbought with last fall's financial pressures to rather oversold this week. The swing is big enough to be significant.

Longer-dated corporate spreads have narrowed significantly since early July.

Credit Markets

Since the high on July 26 the long bond has set a downtrend to 147.5. While declining with the joy of risk elsewhere, the key thing is that the top has been made.

Since the first of the month, investment grade corps (LQD) have rolled over, and the emerging market bonds (EMB) have declined a little.

The point is that long treasuries have been leading the action as lower-grade issues continued to party. Over the past week, the yield for Baa has increased from 3.54% to 3.63% as junk declined from 11.46% to 11.23%. Such divergences are typically found at important tops for the whole bond market.

And really in the party mode, sub-prime mortgage bonds have soared to new highs for the move. The one we monitor set a low of 38 in October and rallied to 52.6 in February. After slumping to 48 in early June, it rallied to 54 three weeks ago. The set back was to 52.5 and now it is at 56. The latest surge is getting compulsive.

This celebration of risk could expire within a few weeks.

The reversal could lead to serious dislocations in bond sectors that have yet to be hammered by the great global contraction.

Currencies

Today is interesting. The dollar and most commodities have been firm. The stock market has been firm to steady.

On the near term, the DX could rise for a few trading days and that would stall out the rally in orthodox investments.

This could be brief as the good vibes could run for up to a couple of weeks.

Otherwise, the Dollar Index is in a solid uptrend. As troubles appear in the fall the dollar could take out resistance at the 89 level. That was set with high momentum as the financial crash completed in March 2009.

Using a different model, the ChartWorks has had a target of 90.

September 2007
The Ropespinner Conspiracy

The Ropespinner Conspiracy is a novel by Michael M. Thomas, a former investment banker who writes enjoyable novels about high finance.

The title relates to Lenin's observation the "Capitalism will sell us the rope with which we hang it". Published in 1987 the story is about a brilliant but insidious Soviet conspiracy to infiltrate the U.S. banking system and corrupt it to its own destruction.

The attempt starts in the late 1930s with a brilliant young economist who fell for Keynes' persuasions in more ways than one. Waldo Chamberlain becomes a Harvard economics professor and rises to pre-eminence. He is also KGB controlled. The plan is implemented through his bright and presentable nephew, Mallory, whose successful career takes him to the top of a big New York bank. Altogether, the trio introduce a number of "new" concepts to banking.

The KGB controller is knowledgeable and quotes Bagehot in describing the scheme -

"But error is far more formidable than fraud: the mistakes of a sanguine manager are far more to be dreaded than theft by a dishonest manager."

The young protégé, Mallory, rises with his bank until -

"There was no question that he and CertBank had been the pathfinders. Man and institution had combined to transform the face and nature of banking and, with it, the face and nature of whole economies, of nations. Mallory and CertBank had perceived markets and opportunities . . . and had grasped the business of banking might be redirected, its nature irrevocably, irresistibly altered."

The Ropespinner plan was to take the banks, then set midway between Main Street and Wall Street, and return them to Wall Street.

The Glass-Steagall Act of 1933 separated commercial banking from investment banking. Beyond that, it was another example of post-bubble recriminatory legislation. The anti-bubble act (England) with the South Sea disaster of 1720 was taken off the books just in time for the bubble that blew out in 1772.

Glass-Steagall was passed in 1933 and repealed in 1999, which belatedly acknowledged that commercial banking had already embraced Wall Street.

"The problems were to legally find a way around the Fed's grip: How to "dehabituate" the relationship between banks and their depositors: how to engineer a massive increase in money supply (almost impossible to have a financial cataclysm otherwise); how to destabilize exchange rates, perhaps eliminate the gold standard; how to ignite a commodity-driven inflation, each was so rich in possibility."

This was to be implemented by Certbank's rising star, Mallory, who would -

"Then set the Cert's shoulder to the shiny new wheel and proclaim and propagate the new gospel from the podium of the bank's eminence, other banks would follow the lead, frequently hasty, since reflection and competitiveness were ill-matched bedfellows, and within weeks the new gimmick would be as accepted and widespread in American banking as if it had been proven over the years and certified from heaven by Morgan himself."

Preston marveled, 'The lad's the best talker of claptrap I ever heard, better than FDR!' "

The novelist develops the "new" banking ideas in a readable manner. Starting with negotiable CDs, EuroDollars, banks as a "growth" industry leading to the struggle for "market share", and total commitment to "total return", all the major changes in banking are placed in perspective.

Waldo plants the idea of negotiable CDs and, as the market for them developed, a traditional banker wonders:

"If a short-term obligation could successfully be renewed time after time, should it not be viewed as truly long-term capital and as a legitimate source for funding longer-term loans?

Waldo listened to these arguments and nodded sagely, and smiled inwardly. If ever there was a surefire recipe for banking disaster, it was to borrow short and lend long."

A book reviewer at the New York Times described "Ropespinner" as "a sophisticated piece of work - the story generates plenty of tension, and it is anchored in a series of well-documented and well-described settings."

It is a parable of our era and a more timely read now than in 1987. As far as plausibility goes, it's not too far off the mark.

Innovative banking always seems to go with experiments in currency. It's fascinating that there are two different views on arbitrary expansion of currency. Orthodoxy claims that it is an essential tool of policy making but military intelligence has used it for destructive purposes.

The Brits have been masters of "war by other than gentlemanly means". In order to destabilize the colonial economy, the British, during the American War of Independence, invidiously introduced huge amounts of counterfeit colonial currency. American inflation was sufficient to raise short interest rates to 10,000%.

At other times inordinate amounts of currency were clandestinely introduced into an enemy's country with hopes of destabilizing their economy and ability to fund their war effort.

It was done during World War II as well as to Argentina during the Falklands War in 1982.

In the post-bubble contraction of the early 1980's two Wall Street economists, nicknamed by the street as "Dr. Death" and "Dr. Doom", were pleading that the Fed should "open the taps" or something worse would happen.

Obviously the understanding of credit/currency expansion by spooks in intelligence is vastly different to that of academics and Wall Street economists.

The fictional Waldo, Mallory, and the KGB controller would be pleased with today's "new" banking practices.

Bob Hoye

Institutional Advisors

The opinions in this report are solely those of the author. The information herein was obtained from various sources; however we do not guarantee its accuracy or completeness. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance.

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