Friday, February 13, 2015


One of the endearing qualities we find in the fictional character Don Quixote is his innocent but delusional approach to life. Living in a fantasy world, Don Quixote's valiant adventures had him fighting evil and defending the helpless against mythical monsters. Unfortunately for the primary protagonist from Cervantes' Man of La Mancha (1604), the battles he waged  - though real to him - were against characters only he saw.

The bravery Don Quixote displayed against mythical monsters - like battling a row of windmills he believed were giant knights - makes him perhaps history's most famous errant knight of chivalry. 
Over the course of the story, battered by time and experience, Don Quixote abandons the well intended but delusional truths he pursued. Reality forced Don Quixote to see the world as it was, rather than as he wanted. 

I bring up Don Quixote because his story provides us with a nice backdrop for understanding the delusions market players in the financial sector experience today. It doesn't matter whether we're talking about the financial mandarins in our Too Big To Fail banks, or the self proclaimed wizards on Wall Street. They live and operate in a mythical world of their own creation. 

By now most of you know their world by heart. 

They tell us that they deserve big fees, large bonuses, and bigger salaries for managing and fighting in a mysterious market economy that's full of pitfalls and danger. According to them, they slay financial windmills and make us all better off because of how they keep the wheels of commerce moving. But they say nothing about how their decisions over the last 35 years have led to a string of bailouts orchestrated by the federal government, which have cost trillions of dollars (and will cost us trillions more in the future).

In spite of this reality, market players see themselves through Quixotic-like lenses, where they take on market monsters that are even bigger and more dangerous than the windmills that Don Quixote vanquished. And like Don Quixote, many of these market players want you and me to buy into their fantasies, and to view them as our valiant saviors. 

While they might believe we need to acknowledge their expertise the reality is most market players are delusional about the markets they operate in, and the financial windmills they slay.

The following helps illustrate the point. 

I recently got into a discussion with a retired investment adviser from Morgan Stanley. For the sake of this post let's call him Mr. Stanley. As it turns out Mr. Stanley didn't agree with a post from a mutual friend because the posted meme explained how President Obama wants to build more opportunities for the middle class by raising taxes on profitable investments (the capital gains tax), and by raising rates on the estate tax, which is assessed on estates worth more than $5 million when a family member dies and passes it on. 

In the eyes of Mr. Stanley raising taxes in these areas would ruin the economyHis argument was Quixotically simple.

Mr. Stanley argued that the proposed plan to raise taxes represented "class warfare" (I know, real original). To make his point he argued that people who inherited a family farm worth $10 million would have to sell their farm to pay the estate tax if taxes were raised, as President Obama proposed. 

It was the standard market talk of a market neanderthal: "Taxes bad. No taxes good. Drink free market grog."

Here's where Mr. Stanley - and almost everyone in his industry - gets it wrong. 

As I informed Mr. Stanley, he was using the same argument that the American Farm Bureau used when they bullied Congress into getting rid of the estate tax several years after 2001.*  I further explained that the American Farm Bureau - when pressed - could not come up with a single example of a family farm being lost to the estate tax, as he suggested would happen. 

I explained that because his example was not realistic neither were his assumptions. 

For example, when President Clinton raised the capital gains tax the economy took off. When Clinton left office (after raising taxes) our nation's economy was prosperous and generating over $200 billion a year in surpluses. 

To make my point to Mr. Stanley I made it clear that cutting the capital gains tax has never created enough growth or generated enough income to create Clinton-like surpluses (let alone eliminate the national debt) as Ronald Reagan promised when he introduced tax cuts for the rich - or "trickle down" economics - over 30 years ago

I went a step further and pointed out how Harvard economist Gregory Mankiw - the chair of the second President Bush's Council of Economic Advisers - went after Ronald Reagan's "trickle down" argument in his economics textbook. Mankiw called trickle down economics a "crank theory." 

Mr. Stanley became unglued. 

This is normal. People who live in fantasy world, where they believe they are masters of the market universe, don't like coming to terms with the knowledge that they're really not market gurus. Faced with an alternative reality, unlike Don Quixote who quit tilting at windmills once he saw the world as it was, people like Mr. Stanley dig in their heals and get ugly. 

It's actually fun to watch, and egg on, as the following makes clear.

After reading my response to his trickle down (supply-side) economic nonsense Mr. Stanley complained about my condescending tone. Worse, he started to whine about me being a bully. 

To be fair, it's hard not to feel belittled or threatened when you realize you have no clue what you're talking about. 

Frustrated because I also called him out on his jingoistic reference to "class warfare," Mr. Stanley then asked how people like me could dare to pit "one segment of the population against another" (ignoring how "trickle down" economics and their accompanying policies shifted massive amounts of money from the middle class to the richest Americans). This was especially irksome to Mr. Stanley because so many market players bravely put their "their capital" at risk. Specifically, Mr. Stanley wrote:  
Mark, there you go with the condescension, generalization and just plain BS. "Jingoism", Really!? What do you call pitting one segment of the population against another? What do you call attacking one segment that risks their capital and saves because that succeeded? As for the farm example, I don't care about what the Farm Bureau said, I used farms an example because we have some large farms here in Kern county. 
Mr. Stanley went on to explain how he was such a super economic adviser that he helped a little old lady cross the street (OK, I made that one up) as he made her a million dollars in the stock market.

Under different circumstances Mr. Stanley's achievements might be an impressive feat. But like Don Quixote, Mr. Stanley's story is based on his free market fantasies, which help him ignore how the real world actually works. To help Mr. Stanley out I reminded him that ever since the early 1980s the federal government has helped organize a succession of market bailouts for the financial sector and Wall Street. 

These bailout have not only kept our markets from collapsing, but have allowed people like Mr. Stanley to operate in a bubble-like environment. In this environment financial market players are insulated from having to deal with the worst aspects of their mistakes. Even better for market players like Mr. Stanley, with the federal government backstopping their bets when things go bad, they can make money as if market mistakes don't matter.

So, yeah, they're really not risking their capital if they're always getting bailed out.  

I offered four examples to illustrate my point.
1. I reminded Mr. Stanley of 1982, when our nation's biggest banks stupidly lent Latin American states over 50% of their assets, and in some cases over 100%. In part because Latin American nations at the time were run by military dictators and corrupt regimes, paying off their debts became a problem. The banks were in trouble, which ended up putting the entire financial system at risk. 
There were no worries on Wall Street, though. The federal government, under the direction of free market purist Ronald Reagan, orchestrated a bailout of Mexico (wink, wink), which actually saved the banks and America's financial system.
2. Then I reminded Mr. Stanley of 1987 & 1997, which saw the Long Term Capital Management threat (starting in 1997) and the start of the infamous Savings & Loan debacle. According to Alan Greenspan, "prosperity in our time" was threatened. The feds, acting on Ronald Reagan's and then George H.W. Bush's orders, reorganized and spent hundreds of billions fixing these messes too.
3. Then I brought up 1994, when Mexico was "bailed out" (again) so that America's financial sector could be saved (again) after making a lot of stupid bets (again).
4. Then we have 2008, the Mother of All Bailouts. Over $4.3 trillion is already out the gate, while another $11-14 trillion is waiting to be flushed into Wall Street at the next bailout party.

There are more bailouts I could list during this period, but you get the point. Market players risk nothing when the federal government (you and I) backstop their bets.

I ended our exchange by emphasizing to Mr. Stanley that the financial sector's successes - going back at least 30 years - have depended on regular bailouts and government props (favorable legislation, the Greenspan Put, Quantitative Easing, favorable legislation, etc.). 

With trillions of dollars dumped into the market I made it clear to Mr. Stanley that the industry, and those who work in the industry, have effectively become wards of the state. 

End of story.

Again, there are more bailout stories than those listed above. Still, what happened in 1982, 1987 & 1997, 1994 and 2008 make it clear that we haven't had a functioning market system for some time now. We still don't.

Put more bluntly, whatever successes market players like Mr. Stanley have had in "the market" have been state sponsored. Like the kid who goes bowling and has the bumpers put up to make sure they don't get discouraged by the gutter balls, the successes of market players over the past 35 years have been made possible by government bumpers (amounting to trillions of dollars in bailouts) that people like Mr. Stanley like to believe were never there.

This is why I asked Mr. Stanley one simple question at the end of our exchange: What happens to the little old lady's million dollar stock market bonanza that "he created" if the feds had never stepped in to bailout and clean up the financial sector's messes in 1982, 1994, 1987 & 1997, and 2008? 

I asked the question because Mr. Stanley, like many who operate in the financial sector, willingly ignore the impact that a succession of market bailouts have had on our market environment, and on their clients' portfolio performance over time. How do you ignore the cumulative effect of a series of bailouts that have dumped trillions of dollars into our markets?

You can't unless you choose to ignore it. This is Mr. Stanley's reality. 

Like Don Quixote, Mr. Stanley didn't really slay any financial windmills. The federal government has been guaranteeing the markets success for years now. Put more simply, market players like Mr. Stanley, who believe their clients have successful portfolios because of their market acumen alone, are fools. 

- Mark

* The federal estate tax was not applicable from 2001 through 2004. According to the IRS, you need to inherit an estate worth more than $5,430,000 before you begin paying an estate tax. What this means is that 99.85% of all estates owe no estate tax when it passes from a deceased family member to another. There are very few state governments - which includes California - that apply an inheritance tax
Note: In the original version I failed to list 1997 as the beginning date of the Fed organized LTCM rescue.

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