Does America realise they have changed the world?
James Vinall - Wednesday, September 24, 2008
The Fed and particularly Alan Greenspan is entirely to blame for this mess which goes beyond personal
and corporate debt and has significantly weakened America and changed its position in the world forever.
During the late 1990’s US corporates spent a fortune on management and supply chain software and ran
up huge debts which caused the “tech wreck” in 2000. The Fed responded by bring the Fed fund target
rate (Bloomberg FDFD ) down from 6.25% to 1% within 18 months.
The effect was to cause a massive consumer boom with easy money which transferred debt from
corporates to individuals. In 2004, Greenspan should have started raising rates as the crisis had been
averted and cool household spending. Greenspan kept rates low and households kept borrowing and
spending. Where it got interesting was US consumers were buying Asian (particularly Chinese goods)
and Beijing chose to keep the US $ in the US by buying US treasuries and print money at home. In the
same way that Japan kept it’s currency low over the late 1960’s, 70’s and middle 80’s until the Plaza
accord), China was keeping it’s exports cheap for US consumers and funding their spending habits at the
expense of their own population on low wages and long hours to fuel economic growth.
You cannot spend on borrowing forever and need to earn to pay off your debt. However, Greenspan
kept the consumer boom going for two years longer than he should have done (2004 to 2006) and
handed the poison chalice to Bernanke in Jan 2006 without having reverse his “over exuberance”.
The other Greenspan mistake along with the US Treasury was to allow credit derivatives to replace debt
provisioning. When banks lend money they are required to set aside funds in the event of default as part
of their capital adequacy. Central banks and regulators around the world led by the US and UK allowed
banks to take out credit default risk insurance on loans they had made that would pay out in a default so
they no longer needed to set the cash aside for capital adequacy. This allowed the banks to lend even
more in a house of cards effect and massively increased systemic banking risk as even the smallest
failure could bring down the whole system.
AIG was the largest writer of credit default risk insurance derivatives in the world, which the Fed was very
proud of. That is why AIG could not be allowed to fail as it would bring down the entire worlds
overleveraged lending markets. The problem was that the banks taking out the default risk insurance had
a much better and insightful relationship with the corporate borrowers than AIG and knew the risk they
were protecting was underpriced.
Couple this with the executives of the major banks are overtly incentivised to generate profits in their
division and drive up their company share price. These executives took long term systemic risk as they
would have collected their bonus and moved on before these term products came home to roost as they
are now. Chasing short term personal benefit at the expense of long term corporate survival is the bane
of Western investment banking and also wider industry.
This has all irrevocably weakened US and European banking system where the governments and
regulators have been hoodwinked by the short term profits and success to allow banks and accountants
to do whatever they want to disastrous effect. Warren Buffet warned of this in 2003.
The cash of the world now resides with Middle Eastern and Russian petro dollars and Asian
governments who have hoarded American consumers spending on borrowed money. Alan Greenspan
effectively sold the deeds to the White House to the Chinese.

This changes the world political landscape and unless America chooses to significantly devalue the US $
to reduce the spending power of their creditors they will have to play nice.
As the US consumer is no longer keeping up their part of the bargain by buying vast amounts of Asian
consumer goods there is no need for China to buy US treasuries. If America antagonises China and
Russia they could threaten to sell vast amounts of US Treasuries to fund domestic economic stimulus,
sending long rates soaring and the US $ crashing.
The world order has changed and the US will become more protectionist as its influence wanes. The
same is true of Western Europe and it means international banking system will see greater regulation.
The USA does not have an export orientated manufacturing economy to take advantage of a weak US$
and will therefore be hit with imported inflation.
Attached is the chart of the Nikkei 225 from December 1989 to December 1990
The index peaked at 38,915 on the December 1989 and fell to 28,953 (down 26%) in four months
through to April 1990.
The market then rallied 15% off this short term bottom to 33,344 over the next two months to June 1990.
The market then fell sharply to 20,671 (down 47% from the all time high) by Sept 1990 as the scale of
the economic malaise and the extent of the debt collateralising securities and land became clear.
The market stopped falling on October 1992 at 14,657 (down 62% from the all time high) when the
government used public money to support the stock market.
The market finally bottomed out at 7,603 (down 80% from the all time high) on April 2003.
The Nikkei 225 closed today at 12,115 (down 69% from the all time high) which is still down 69% from
the peak in December 1989.
By running up huge debt, Japan lost its dominant position in the world economy and has never
recovered.
The same analysis for the debt laden NASDAQ Comp in 2000 sees the peak at 4,698 on Feb 2000.
The first slide was 35% down 3,042 by May 2000.
The following bounce was up 38% to 4,208 by August 2000 from that short term May bottom.
The secondary slide was to 1,794 (down 62% from the Feb 2000 peak) by March 2001.
This is where America is now, like Japan in the 1990’s and tech stocks in 2000.
America is arrogant and still believes they are the “masters of the universe” that Wall Street has not
come to realise that the whole world has changed and that there could be a sustained capital flight from
the USA for many years to come.
The S&P500 peaked at 1,576 in October 2007.
Then fell 20% to 1,256 (down 20%) by March 2008.

There was a 15% relief rally to 1,440 by May 2008.
Then the second sharp fall to where we are now at 1,185 which is down 25% from the Oct 2007 peak,
which is unlikely to be the end.
If the debt situation, market flexibility and loss of dominant global trading position is as grave in the US
now as it was for Japan in the 1990’s, it is possible for the S&P500 to bottom out at around 835 (down
47% from the peak) in the short term thru’ to 2Q09.
Longer term the S&P500 may descend to 630 as a 60% drop from the Oct 2007 peak sometime around
2Q10 as the economy fails to respond, the US$ weakens and US loses global economic clout.
Those of us that have seen this type of overburdening excess of debt before know that this is not a good
time to be getting long equity, particularly in the US .
We have not yet seen any major European bank turmoil as we have in the US and UK . I recently spoke
with a friend who is head of operational risk and compliance for a major European bank and he said there
are more than a few major European banks that are \"in a whole heap of trouble\". When that news breaks
it will take the shine off any nascent US equity recovery.
Best regards
James Vinall