Dodgy Market and Dodgy Federal Reserve Chairman Candidate!

Is that sound we hear the sabres of war rattling, or the knocking together of wood as a bunch of Pinocchios gather in front of the media to justify their coming attack on Syria?

Both! Truth, as the saying goes, is the first casualty of war. These days, it’s the first casualty of a politician opening his or her mouth in the morning. Here’s the latest nose grower from UK Prime Minister David Cameron, courtesy of Bloomberg:

“This is not about wars in the Middle East; this is not even about the Syrian conflict,” Cameron said in televised remarks. “It’s about the use of chemical weapons and making sure as a world we deter their use”‘.

The three old imperialist cronies, the US, UK and France, are apparently getting together to organise a military strike. But don’t worry, it has nothing to do with Syria or the Middle East.

France has had a special interest in the region ever since Godfrey de Boullion led the first crusade to the ‘promised land’ around 1096. When the Ottoman Empire crumbled after the First World War Britain started carving the place up, and then the US got involved when the oil began to flow.

Ever since, these three Western powers have been moving pieces around the Middle Eastern chessboard. We’re not sure how good the moves have been though. And it’s hard to win a long strategic game when you’re running out of money.

Reuters reported recently that:

‘Treasury Secretary Jack Lew pressed Congress on Monday to allow the government to borrow more money, saying that it could default on its obligations if lawmakers do not act by mid-October.

“Congress should act as soon as possible to protect America’s good credit by extending normal borrowing authority well before any risk of default becomes imminent,” Lew said in a letter to congressional leaders’.

What better way to get Congress to open the purse strings once again than by starting a war! Or is that too cynical?

It pays to be cynical these days. To be a cynic is to be a realist. And the reality is that governments will do anything to get their hands on more cash if they need to.

Whatever the reality, markets don’t like it. The Dow Jones was down 170 points overnight. Gold rallied strongly into resistance around the US$1,420 area, before pulling back a bit.

But has the weakness really got anything to do with the looming war that is not about Syria or the Middle East? Or is it just an excuse to sell overvalued stocks that may not have the benefit of a Federal Reserve tailwind anymore?

We’ve been telling our subscribers for months that a major correction is coming. Gowdie Family Wealth editor Vern Gowdie has been telling anyone who’ll listen to get into cash and ride out the storm.

War isn’t a reason why Vern is expecting trouble and nor is it a reason for our concerns.

We just know the market is overvalued, propped up by liquidity rather than fundamentals, and is, in general, a farce.

In these environments, all it needs is an excuse to hit the sell button and turn the mood from bullish to bearish. War is one excuse…a new Federal Reserve Chairman is another.

According to CNBC, we’ll soon hear who the new Federal Reserve boss is.

‘A source from Team Obama told CNBC that Larry Summers will likely be named chairman of the Federal Reserve in a few weeks though he is “still being vetted”; so it might take a little longer.’

If Summers does get the job, it will be a triumph of PR over substance. Over the last few months we have been told relentlessly how ‘brilliant’ Summers is.

He was one of Harvard University’s youngest tenured professors at the age of 28; he left to become Chief Economist of the World Bank in the early 1990s before joining the Clinton Administration and taking over from Robert Rubin as Secretary of the Treasury.

He returned to Harvard as President from 2001 to 2006, before resigning under ignominious circumstances. In 2009, President Obama appointed Summers as a Director of the National Economic Council, where he became a key advisor to the President. He left in December 2010, returning to Harvard and the pursuit of private business interests, which among other things included consulting to large US investment banks.

What is often left out or glossed over in the ‘Summers for the Federal Reserve chief’ PR drive is the major role he played in losing the Harvard Endowment fund huge amounts of money in the global financial crisis.

During his Harvard Presidency, Summers made two big calls that ultimately cost the prestigious university billions of dollars. He argued that Harvard should manage its cash account more aggressively, in line with its long term endowment fund strategy. (The cash fund was for everyday operational expenses).

The head of Harvard’s endowment, legendary fund manager Jack Meyer and his successor Mohamed El-Erian, warned against the move but Summers ignored them.

As a result, 80% of the operating cash fund (only slightly lower than Summers’ recommended 100%) turned into a relatively illiquid, long term investment fund. That is, the cash fund was no longer ‘cash’.

Then in 2004, he hedged US$2.4 billion in Harvard’s future borrowing costs by entering into interest rate swap agreements with some of America’s largest investment banks. The idea was to protect the university from rising interest rates. They didn’t plan to issue bonds until 2008 and beyond, but Summers wanted to lock in the low interest rates that prevailed in 2004.

The swaps weren’t a new innovation for Harvard. What was new, and practically unprecedented, was the long duration of the agreements.

Swaps provide protection against rising interest rates but they lose value if rates fall. As it turned out, the US housing market collapse and subsequent financial crisis saw interest rates in the US fall — a lot. This meant Harvard’s interest rates swaps were quickly losing value, and their investment banking counterparties demanded cash collateral to offset these losses.

But Harvard was short of ‘cash’. Thanks to Larry Summers, it was nearly all invested in the endowment fund, an illiquid, long term vehicle whose value was plummeting due to the escalating credit crisis.

The Harvard board panicked. Instead of riding the storm, they just wanted out of the swaps. They issued bonds (ironically at a relatively high rate of interest) to raise enough cash so they could terminate the swap agreement – at the worst possible time. That is, when the cost of doing so was greatest.

According to data available from Bloomberg, Harvard paid their investment bank counterparties around US$600 million to exit most of the swaps immediately, and agreed to pay another US$425 million over 30 to 40 years to exit the remainder.

On top of all this, Harvard’s general operating ‘cash’ account reported a US$1.8 billion loss in the 12 months to 30 June 2009.

Larry Summers may not have been around when the proverbial hit the fan, but his fateful decisions from years earlier cost the University plenty.

And this guy is set to get his hands on the world’s biggest monetary lever. No wonder the market is selling off.


Greg Canavan+
for Markets and Money


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From the Archives…

Richard Fisher’s ‘Super Easy’ Fed
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US Stocks and the Timeless Wisdom of Izzy Stone
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A Bond Market Tantrum

20-08-2013 – Nick Hubble

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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