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August 28th, 2012

If Gold Rusts…

If gold rusts, what shall iron do? Geoffrey Chaucer raised this question several hundred years ago regarding the crisis of confidence resulting when presumably esteemed leaders are tarnished. Substituting large institutions for gold in Chaucer’s query frames the concerns of U.S. citizens. Banks, insurance companies, regulators, rating agencies and Congress have shown themselves to be incompetent or corrupt in the management of their affairs for many years. Thoughtful approaches to problems, like Bowles-Simpson, get kicked to the curb while satire becomes reality in financial regulations.

In the last week some remarkable actions have been taken pursuant to Dodd-Frank. As a reminder Dodd-Frank was concocted to prevent a future collapse of our large financial institutions. On consecutive days the SEC refused to place any capital requirements upon money market funds and their trillions of dollars of assets, but instead promulgated rules, which the SEC estimates will cost $4 Billion for U.S. companies to implement, requiring public disclosure whenever companies use certain metals, like tin or gold, produced in the Democratic Republic of the Congo. Remember this is part of legislation designed to prevent “Too big to fail”. Rather than ensure the safety of trillions of dollars of liquid assets the government has ranked gold diggers as a larger systemic risk than money market funds, on a risk measure that is too big to scale.

The illusion that regulation can eliminate or diminish bad behavior took several more hits this past quarter. The largest fraud was Peregrine Financial Group which has been regulated for over two decades. Officials discovered this fraud when they read Peregrine’s founder’s suicide note. Ironically, some of the stolen money was used to pay regulatory fines and fees. One of the businesses in which Peregrine engaged was selling gold bars and “Sponge Bob Square Pants” silver bullion coins, $259 for a set of four. Inspector Clouseau might have raised an eyebrow at this activity. The CEO used Adobe Photo Shop and Excel to create forged bank statements. He gave the auditor his personal P.O. Box as a mailing address to verify bank statements for the bank and only he opened mail from the banks. None of this was seen as suspicious by regulators.

In the great financial crumble of 2008, two factors were prominent: excessive leverage throughout the system and lending practices/policies and packaging for home loans that were the product of the seven deadly sins. One visible subset of the housing mess was the alchemy that transformed bundles of subprime loans into AAA rated securities structured as collateralized debt ogligations (CDOs). Setting aside the rating agencies’ inability to analyze risk, one of their and the CDO’s buyers beliefs about subprime loans was that the default rate would never rise above the historic 4% trend line. In fact it rose to above 40% as these securities were obliterated. A similar emperor’s new clothes treatment has been applied to the actuarial assumption for pension returns. Many public pension funds continue to use 8% or more as their assumed rate of return on assets as any lower figure would make the size of their underfunding politically unexplainable. In fact, in some of these locales, it requires a legislative vote to change the number no matter how much lower the actual investment return is. CALPERS’ recent twelve month return of 1% makes its 7.5% target seem dear. CALPERS performance gap persists over many years not just the most recent ones. Bankruptcies such as Stockton, CA and Central Falls, RI are going to continue unless the trifecta of benefits, contributions and investment returns gets intelligently recalibrated by the affected constituents. San Jose and San Diego just had city wide elections to codify benefit changes. In an era of closing libraries, rotating firehouse closures and laid off police, this situation needs addressing before anyone with a pension is seen as the new “1%”.

I’m Rob Morris and I approved this blog.

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