By J.D. Seagraves, on March 18th, 2009
The conventional wisdom is that the year 2009 will be a tough one. We’ll all have to cut back on spending, get our debts under control, skip the annual family vacation, and clip coupons, but by 2010, we’ll have a “return to normalcy.” Unfortunately, this just isn’t in the cards. The era of Permanent Prosperity has turned out to be not-so permanent, and in ’09, the bills are finally coming due. Sure, we’d like to hunker down and pay them, but the president, the Congress, and most importantly, the Federal Reserve, aren’t going to let us. As bad as 2008 was, we’ll one day look back on it as The Last Good Year.
The Political-Media-Banking Complex
Even though they’re the ones who will be taking us off the deep end, we can’t blame Obama and the Democrats for our sorry state of affairs. Clearly, the Bush administration bears the bulk of the responsibility, and the Reagan and Nixon-Ford administrations played their parts as well. In fact, it’s the hole that Nixon began digging for us with the closing of the gold window in 1971 that will ultimately burry the U.S. dollar.
Under the gold standard, every $35 represented an ounce of gold in the Federal Reserve’s coffers. Of course the Fed played tricks with accounting and created far more paper dollars than it had ounces of gold backing them, but there was at least some limit to the extravagance of their monetary machinations. All this changed on August 15, 1971 when President Nixon unilaterally reneged on America’s promise to redeem Federal Reserve Notes (a.k.a. U.S. dollars) in gold. Since then, the Fed’s ability to create money out of thin air has been entirely limitless.
The Fed’s rampant inflation has become so commonplace that the vast majority of financial journalists don’t even take notice of it. The federal government is deeply in debt, so where does it get the money to fund all of these bailouts? Few bother to even consider the question, and those that do assume the bailouts will be paid for with tax revenue. Pundits who are a little more on the ball might understand that the bailouts and “stimulus” won’t be paid for with taxes, but by issuing new government debt, but even this misses the point. That debt is largely “monetized” by the Fed, which is just a fancy way of saying the Fed creates new money out of thin air to pay the government’s bills. So how much money has the Fed created in this manner in the past three months? The answer is quite shocking.
How Money is Measured
M0 is the measure of the nation’s monetary base. It includes all physical currency such as notes and coins, as well as accounts at the central bank that can be exchanged for physical currency. This is the strictest of monetary measures, and the one least susceptible to rapid increases. M1, by contrast, adds bank reserves and checking accounts to the money supply, while M2 also tags on savings accounts, money market accounts, and CDs under $100,000. M3, which the Fed stopped tracking because the increases were too large to explain, is the most liberal measure of money supply, as it includes all CDs as well as institutional money market accounts, Eurodollars, and repo agreements.
The important takeaway from the monetary lesson above is that M0 is the most conservative measure of the money supply available and is completely indisputable: it is the physical currency in circulation or in the coffers of the Fed. It exists in reality, not electronically. And here’s the scary reality: for the period ending December 3, the Fed had increased the M0 money supply by as much in thirty days as it had in the previous eighty-three years! The amount of money in circulation was 74% higher on December 3, 2008 than it was on September 3, 2008. And here’s where it gets even scarier: each one of those $268 billion new dollars in print can turn into ten new dollars via the process of fractional-reserve lending.
This is not a conspiracy theory, but the cold hard facts. Many ancient civilizations met their doom by holding on to superstitions the likes of which we think our society is somehow above. But the truth of the matter is that all but a tiny fraction of Americans hold fast to the most absurdly false religion imaginable: the notion that prosperity can be created at the printing press. In 2009, this myth will be shattered once and for all.
By Ajay Shah, on March 18th, 2009
Lok Housing & Constructions made the following disclosure during the just concluded Dec’08 quarter:
The global economy in general and the real estate industry in particular is passing through recessionary scenario, which has resulted in to financial melt down of un-precedential scale. From time to time the Company had entered several agreements for sale of plots, properties, development rights and constructed units held by it as stock in trade. In accordance with the consistently followed accounting policy of the Company, sales revenue and profit thereon were recognised at the time of entering in to such agreements to sell. Due to the financial meltdown and Severe economic recession, some of the parties with whom the Company had entered in to agreement to sell have failed to meet their commitments and considering the overall interest of the Company, the agreement for sale entered in to in the past financial years and in respect of which revenues already recognized have been mutually terminated / cancelled. The Company has been legally advised that though the agreements for cancellation of sales have been entered in to during this quarter (being October to December 2008), but since cancellation of sales pertains to sales recognised earlier, the financial statements of the period during which sales and profits were recognised needs re-construction / amendment, on the doctrine of “Relation back”. The Company shall amend the financial statements of earlier years and get the same approved in the next general body meeting. Accordingly no effect in respect of cancellation of sale agreements has been given in the financial statements of this quarter. During the quarter under review the Company has entered in to 53 agreements for cancellation of sales made in the earlier financial years, the sale value of which is Rs 282.14 crores and the resulting loss / reversal of profit recognized earlier being Rs 225.01 crores”
How big is this restatement, compared with the size of the firm?
It is huge. In the last three years (FY06, ‘07, & ‘08), Lok Housing Constructions reported cumulative revenues of Rs.578 crore and cumulative net profit of Rs.226.4 crore. The revenues were taken in the income statement based on the Company signing sales agreement with potential buyers (as mentioned in the explanation provided by the Company).
Now they say those contracts have been mutually terminated/cancelled, which means it will have to restate earlier numbers, ie. sales by Rs.282 crore (50% of total sales of the last three years) and net profit by Rs.225 crore (almost 100% of all profits earned during the last three years). Prior to FY2006, the company did not even make profits.
Using the CMIE standardised definition of PAT net of P&E, the profits ever made by the company are: Rs.14.55 crore (’06), Rs.79.07 crore (’07) and Rs.109.78 crore (’08). Compared with these more modest values, a restatement of Rs.226.4 crore is even more massive.
How did this happen?
In its accounting policies section of the Annual Report for FY07 and FY08, the Company states the following:
- The Company follows completed contract method of accounting in respect of its construction activity. Under this method profit in respect of units sold is recognized only when the work in respect of the relevant units are completed or substantially completed, which is determined on technical estimates.
- The construction and development cost for completion relating to the sold units, which are considered for profit are estimated on the basis of technical evaluation.
- Revenue recognition in respect of property sale transactions is on the basis of agreement to sale and are subject to execution of conveyance and compliance of applicable legal formalities.
The first and second statement is clearly not in sync with what the Company describes in its Note to Accounts for the Dec’08 quarter. Thus, it has to be the third point which states that it recognizes sales in respect of property sale transactions on the basis of “agreement to sale”. However, according to Accounting Standard 9, the Company can book revenues only if the following two are fulfilled:
- The seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and
- No significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.
This means, revenues can be booked only upon delivery of the said property, which clearly was not the case for Lok Housing, else it would not have to restate sales and profits. So how is Lok Housing able to book revenues and profits and yet not deliver the property to the purchaser with whom it has an agreement to sale in place for more than 2-3 years?
Could it be because of the following Guidance note by the ICAI on Recognition of Revenue by Real Estate Developers?
Revenue in case of real estate sales should be recognized when all the following conditions are satisfied:
- The seller has transferred to the buyer all significant risks and rewards of ownership and the seller retains no effective control of the real estate to a degree usually associated with ownership;
- no significant uncertainty exists regarding the amount of the consideration that will be derived from the real estate sales; and
- it is not unreasonable to expect ultimate collection.
7. The determination of point of time when all significant risks and rewards of ownership are transferred depends on the facts and circumstances of each case considering the terms and conditions of the agreement. In case of real estate sales, all significant risks and rewards of ownership are normally considered to be transferred when legal title passes to the buyer (e.g., at the time of the registration, with the relevant authorities, of the real estate in the name of the buyer) or when the seller enters into an agreement for sale and gives possession of the real estate to the buyer under the agreement. All significant risks and rewards of ownership are also considered to be transferred, if the seller has entered into a legally enforceable agreement for sale with the buyer and all the following conditions are satisfied even though the legal title is not passed or the possession of the real estate is not given to the buyer:
- The significant risks related to real estate have been transferred to the buyer. In case of real estate, price risk is generally considered to be one of the most significant risks.
- The buyer has a legal right to sell or transfer his interest in the property, without any condition or subject to only such conditions which do not materially affect his right to benefits in the property.
8. When the seller has transferred to the buyer all significant risks and rewards of ownership, it would be appropriate to recognize revenue at that stage subject to fulfillment of other conditions specified in paragraph 6 above, provided the seller has no further substantial acts to complete under the contract. However, in case the seller is obliged to perform any substantial acts after the transfer of all significant risks and rewards of ownership, revenue should be recognized on proportionate basis as the acts are performed, i.e., by applying the percentage of completion method in the manner explained in Accounting Standard (AS) 7, Construction Contracts. An example is a building or other facility on which construction has not been completed though all significant risks and rewards of ownership have been transferred pursuant to the fulfillment of conditions stated in paragraph 7 above. Another example is of a land which is yet to be developed though the seller has transferred all significant risks and rewards of ownership of the land to the buyer through an agreement for sale as per paragraph 7 above.”
I think this means that having once sold the rights to the buyer, the seller is merely a contractor and can therefore start booking revenues based on the work completed, i.e. even if a building is still under construction, the builder can start booking revenues and profits on it.
I am no expert on the accounting standards that are practiced by real estate companies in India, and after looking at the Notes to Accounting Policies in the Annual Report and in the most recent quarterly result for Lok Housing, my doubts have only increased. However, there have been some insightful articles in the press in recent times, which touch upon this topic:
- An article in the Hindu Business Line by Dolphy D’Souza of E&Y [link].
- An article in the Business Standard [link]
An unsatisfactory situation
This raises two questions:
- How can a Company be allowed to book sales and profits for transactions never completed and allowed to carry it for 2-3 years? Surprisingly, there are no provisions for bad debts in any of the years during 2006-08, the maximum sundry debtors (outstanding for more than six months that the Company reported by Rs.147 crore in FY08, half of what was due to Lok Housing and that they belonged to previous years?
- Even if our Accounting Standards do allow companies to book sales and profits without delivering the underlying consideration because there is an ‘agreement to sale’ in place, why is Lok Housing mutually terminating/cancelling these contracts and not going to the Court of Law and make those involved pay for the agreements entered into? How can a company benignly view cancellation of the agreements that are supposed to have earned it all the profits it reported in the last three years?
Disclosure: I have no shares of any Indian real estate company, and never have. I may never even invest in them in future too, unless there is more transparency in the way they operate, report their financials and the way the entire real estate market in India operates.
What can we do better?
I think the government would do well to:
- Make it compulsory for all the local municipalities (such as the BMC) across India to provide all information pertaining to real estate projects (the clearances/objections, blue prints of plans applied for by developers and thereafter approved by the municipal authorities, and other related and important documents), on the Internet.
- Ask every builder to a) Create a website, b) Make the entire plan as approved by the local authorities, the various clearances (CC, OC, etc.), and the flats/offices (including the ones currently on sale/already sold) available on the site with daily updates.
- Clarify guidelines on financial reporting, or else more episodes like Lok Housing will come about, particularly given the softness in real estate prices.
By Trace Mayer, on March 17th, 2009
Obamanomics are an Obamanation.
Robin Hood. President Obama. Are they the same persona? Based on TV and Obama’s news conferences both he and the media seem to think so. “Rob from the rich; give to the poor.” Of course, he uses the words “you should give more, because you have more”. But the reality of Obama’s accomplishments remain the same.
I do not see the likeness between this man and Robin Hood. While Robin Hood is a great folklore hero, I contend that Obama has nothing in common with the man. Let us review some of the finer points of the story. A tale with which I hope you are already somewhat familiar.
Robin Hood lived in feudal times. Kings, Lords and Barons ruled the country as the sole land owners. King Richard departed the country to fight in the crusades leaving Prince John to rule in his stead. Prince John and the Sheriff of Nottingham decided that they would claim the throne for themselves but they needed the support of the Lords, Barons and similar figures in the surrounding countries.
Their plan required many goods – Gold, Silver, Wine, and Food in order to bribe these leaders to join their cause. In acquiring this stuff to buy the allegiance of the lords and barons they began taxing the people heavily if not outright stealing their possessions.
Enter a man with the courage and skill to fight such tyranny, Robin Hood. As a loyal and patriotic man he fought to protect the people and the throne of the king. He would steal the money/taxes back from Prince John and return it to the poor from whom it was wrongfully taken; establishing the mantra “rob from the rich; give to the poor”. In doing so he protected both the people and the crown until King Richard’s return.
So I ask you; how in any conceivable way could President Obama be likened to this man? Recently Obama began to push sweeping legislation to steal (*ahem, sorry tax) from the rich of this country. One assumes he is doing this to give to the poor; yet somehow all of the money ends up in the hands of banks and automakers.
President Obama performs this redistribution in broad daylight. The more I stare at his policies; the more I liken the man to Prince John. He is trying to steal the very life out of people to buy the right allegiances, also known as votes, in order to keep the throne he is guarding. After all, large portions of bailout money will be distributed in 2011.
Obamanomics, my unoriginal pet name for the “New” new deal, scares me to death. Recent polls suggest that FDR should be considered one of the top 3 presidents in the United States history. While history books have been favorable I do not understand.
Why is it that no one remembers the perpetual unemployment FDR created with his policies? How can anyone in today’s time acknowledge ponzi schemes, like Madoff or Social Security, as good ideas? Eventually FDR did successfully reduce unemployment in this country but it took a war and the loss of a few million good men.
Is this really the direction we want to head? It is Obamanable to think that World War II was a good thing and that FDR should be praised. Yet the whole nation is looking to resurrect FDR’s policies.
This time which future generation will be burdened? Are there even any left unburdened? We are staring at the greatest redistribution of wealth in our era. Unless theft is considered “earning” the wealth is going to the people who did nothing to earn it. By the way, theft income is required to be claimed on your income tax return unless you are a tax eater for the government and are not required to report it.
The hardest part is trying to be Robin Hood in this story. The Prince has a larger army and superior guns. Government propaganda attempts to paint tax evaders, like Treasury Secretary Geithner, Senator Daschle, etc. as leeches on society and unpatriotic. But how does one protect their own country when the nanny state government is attempting to steal it from them?
I anxiously await the return of the king and President Obama is not him either.
By Bhagwad Jal Park, on March 17th, 2009
I’m a big fan of TV series like “24″ and “Lost”. My wife and I eagerly watch episode after episode and get completely involved in the characters and the storyline. In fact, we begin to identify with each character and their mannerisms to the extent that we “latch” onto the main figures. We would give way to howls of outrage if say Kiefer Sutherland who plays “Jack Bauer” were to be replaced by someone else!
Image Credit: TCM Hitchhiker
My greedy Game Theory mind immediately latches onto this scenario as a means to extort money out of Television Series producers. In my earlier article on the benefits of holding back patents, we discussed the problem of holdups. Holdups are situations where party A has the potential to cause massive damage to party B after the initial assessment has been made and work set in motion.
In the case of patents, this meant that if you have invested millions in making a factory, then I can hold you up by acquiring a patent on a crucial process that is mandatory with your current setup. In the case of the TV series, this means that an actor like Kiefer Sutherland who has already been ingrained into the hearts and minds of millions of fans, has the ability to hold up FOX networks. Each series has 24 episodes. Suppose after the 10th episode, Sutherland demands a 300% raise from FOX, he would be holding up the network.
The key element here is that Sutherland is irreplaceable as “Jack Bauer” and that after airing 10 episodes, a substantial investment has already been made. These two factors are critical for any holdup and not just with TV Series.
It’s useless to say that FOX has a contract with Sutherland, and that Sutherland will forced to continue acting at a pre-arranged rate. Acting is an art, and Sutherland’s “performance” can just drop, he can lose the special way in which he says “You gotta trust me on this!”, or he can just come down with an inexplicable fever. There are many ways in which he could execute a holdup without breaking his contract.
So why doesn’t he? I guess there are two reasons. One, Sutherland may be a “good guy” and not greedy. Fortunately, as we say earlier, all humans are not rational. After all, he’s an actor and not a game theorist! Second, his reputation will suffer irreparable damage if he were to indulge in this kind of behavior. Assuming that Sutherland wants to pursue an acting career after the series gets over, it’s in his best interests to be a “good guy” and stick to the contract. In other words, a “repeat game” ensues.
But if Sutherland wanted to just amass one time wealth and live out the rest of his life in luxury, there would be nothing to stop him from holding FOX to ransom for huge sums of money. This means that TV networks should also be careful of actors who are getting old and are thinking of retirement. These actors have nothing to lose by their reputation being damaged, and can capitalize on their years of being decent by one massive holdup were they to ever get a chance! It short, never trust an old fart.
I can imagine that in the future, virtual actors will eventually replace real ones, and not just because they’re cheap, but because holdup problems can be averted. After all, virtual actors are your slaves and don’t have an agenda of their own. Given this inevitable future, I would be very worried if I were an actor just starting out, since my future is at stake. If everyone thought like this, then there would be a shortage of young actors and the asking price for young actors would go up…….
But no one thinks that far. Not young actors anyway. So don’t expect a shortage anytime soon. But the future of the TV industry is definitely set for a change. You can bet on that.
By Bron Suchecki, on March 16th, 2009
When the economic crisis becomes acute, when the rate of profit sinks towards zero, the bourgeoisie can see only one way to restore its profits: it empties the pockets of the people down to the last centime. It resorts to what M. Caillaux, once finance minister of France, expressively calls “the great penance”: brutal slashing of wages and social expenditures, raising of tariff duties at the expense of the consumer, etc.
The state, furthermore, rescues business enterprises on the brink of bankruptcy, forcing the masses to foot the bill. Such enterprises are kept alive with subsidies, tax exemptions, orders for public works and armaments. In short, the state thrusts itself into the breach left by the vanishing private customers. …
In richer, more fortunate countries, the bourgeoisie seems to have succeeded, not in escaping the crisis permanently, but at least in extricating itself for the time being from its difficulties. They have been able to start up again, after a fashion, the mechanism of profit, resorting to expedients which at least have not required the substitution of dictatorship for democracy. But they used basically the same methods in both cases: the state refloated private capitalism, revived it with great public works and huge “defense contracts.”
Guerin, Daniel. Fascism and big business. 2nd ed. 1973.
Originally published in 1939 by a French journalist and scholar. I found this in a used bookshop many years ago and had never got around to reading it (there are a number of books in a similar state of limbo in my library). It title on its spine caught my eye tonight and I thought the chapter titled “Big business finances fascism” might yield something relevant to our current situation. Didn’t take long to find the paragraphs above. History repeating? Question is: if the “bourgeoisie” can’t start capitalism back up, are we headed for fascism? Some may say that the fact that the President/Prime Minister changes every now and then just distracts us from the fact that we are already there!
By Ajay Shah, on March 16th, 2009
Governments running large welfare states have long resented tax havens, which reduce their tax take. In recent weeks, some people have managed to sell the idea that in response to the global financial crisis, governments need to crack down on tax havens. I, for one, don’t see any link between tax havens and the problems of the global financial system.
Writing in Financial Express a few weeks ago, Avinash Persaud had an eloquent argument about the critical role that tax havens play in enabling multinational corporations and thus globalisation. His description of the tax haven as a tax-efficient `junction box’ for a multinational corporation reminded me of the role of securitisation SPVs as junction boxes for financial contracts.
By Dan McLaughlin, on March 16th, 2009
Life is full of uncertainty. A plane might fall on your house. You may total your car. The value of your investments may crash. But, then again, you may find valuable mineral deposits on your land. You may inherit lots of money. You may find that the old trinket you bought at a flea market is worth thousands of dollars.
People make decisions based on their assumptions about the present circumstances and expectations for the future, whether that future is the next second or decades away. People act only because they expect to be better off, in some way, emotionally or physically, by acting. Those expectations may not hold up to reality, however, because, as we have seen, life is not a sure thing. Some people win and some lose.
There seems to have been a lot of losers these days. Investors, business owners, home owners and mortgage holders are taking a collective hit in the pocketbook. It is difficult in times like this to step back and see the overall picture, which is actually a quite wonderful thing, in spite of the mess created by monetary authorities. In societies where property rights are secure and people are protected from fraud, coercion and violence, including that by politicians, free trade leads to an amazing phenomenon. Whenever two people enter into voluntary trade, both sides win. Both sides to the transaction expect to be better off. If that were not the case, the transaction would not have taken place.
At the store, the customer values the shirt more than the money used to buy it. Conversely, the seller values the money more than the shirt. At work, the employer, the buyer of labor services, values the efforts of the employee more than the money he pays. The employee, the seller of labor services, values the money more than the time and effort given up to obtain it.
Because people create value by the things they do, they can give value for value received. That is the basis for the advancement of any society. Those societies that honor property rights and voluntary trade advance at a much quicker pace than those that don’t. The expectation of gain, and the ability to benefit from it, is a powerful incentive for people to create value. The expectation of ownership encourages people to invest in processes and equipment to create value more efficiently, thus benefiting everyone.
Some see the market process as systematic exploitation, a situation where every transaction has a winner and loser. They may point to the housing market or the stock market and explain that if someone buys at a high price and sells at a low price, that seller loses and the buyer wins. In this case it is important to identify what the loss actually arises from.
Using the stock market as an example, if someone bought at the peak of the bubble, they may indeed lose half of their investment if they sell today. The decision to sell is based on present circumstances of the seller and expectations for the future. There is a risk that the market can go lower. Neither seller nor buyer can predict the unknown future. If someone buys from the seller who’s stock lost value, the buyer assumes that the market will go up. He is willing to assume the risk of the unknown, which the seller is no longer willing to bear. The loss came only from the decline in the market prices, not from the selling. The decision to sell cannot affect what happened already. The seller benefits from being relieved of the risk of further decline. The buyer benefits from assuming the possibility of turnaround and future gains. In the transaction, both sides must necessarily feel they are better off by consummating the deal. They may regret their decision afterward, but that is because of events independent of the sale.
It is similar to totaling your car. The collision with the tree was the loss. If you make a deal with someone to buy your car, the person will pay the price of a wreck, not the price of a new car. The accident with the tree changed the present situation. Given the present reality, the decision can only be whether you are better off with the wreck than you would be with the money the buyer offers you.
The recent economic meltdown is like running into the tree. It arose from various factors, but chief among them is the inflationary credit expansion, and the inevitable collapse that results. Responsibility for the bubble and collapse rests squarely on the shoulders of the central banks and the fractional reserve system. Given that the loss in market prices is a fact of life, however, trade can only benefit the participants, as it did with the owner of the wrecked car.
In every voluntary trade, if you decide to sell your car or your stock or anything else, you win. You are better off after the trade, even if it is just because you don’t have to worry about any more losses. If the buyer decides to buy, he is also better off. Subsequent events might turn him into a loser also, but at the time of the deal, he was a winner. Both sides necessarily win with honest, un-coerced, voluntary trade.
By Trace Mayer, on March 13th, 2009
WHAT ARE TIPS
While perusing the internet scrounging for investment vehicles I stumbled across an article suggesting Treasury Inflation Protected Securities (TIPS). With TIPS the government agrees to borrow FRN$’s at a specified interest rate. The creditor receives interest payments based upon the invested principal. Also, the government promises to adjust the principal periodically throughout the year to reflect the loss of purchasing power resulting from inflation during the period.
On its face, this appears like a safe and secure investment. The creditor receives modest interest income by lending capital to the government and are compensated for it and therefore do not bear the downside risk of devaluation through inflation. Surely many retirees must feel warm and fuzzy with this instrument that performs like a stock that pays both a cash and stock dividend. As the instruments are guaranteed by the venerable United States government surely any investment advisor could recommend TIPS to anyone.
SNEAKY TRICKY GOVERNMENT
A deeper review reveals a dirty little government trick. But first a question. Assume 0% interest. If you invest $100,000 in TIPS for a year and the government declares the inflation rate to be 3% and after a year you redeem at $103,000; did you make an economic profit? Did you have a gain on your investment? Technically the government’s own decree is that you have not had economic profit. The TIPS principal is in the exact same economic position as a year earlier.
This is fine until you file your tax return and the government attributes to you $3,000 of taxable income. The less astute may not bat an eye as the government is simply doing what it does best, taxing you. The government concedes no economic profit because of inflation but still assesses a taxable gain.
If you assume a 25% tax rate, that would mean the government has managed to rob almost 1% of your purchasing power in just 1 year. Yet, no one complains because the amount of FRN$’s increased overall. Over 15 years the loss of purchasing power would be a slightly over 10% by investing in the very instrument the government asserts is designed to protect you.
NOT LIMITED TO TIPS
This scenario plays out in hundreds of examples where there is a taxable gain but an economic loss or loss of purchasing power. Real estate, stocks, bonds and commodities are all affected by inflation and investors get taxed through inflation without representation or due process of law. Have a 3% gain on real estate? Pay tax and end up behind. An 8% return on a stock portfolio? Well, 3% was courtesy of the government and now “the people” have the audacity to force you to give a share back.
Many assert that inflation is a tax. I partially agree. Theoretically in a predictable inflationary environment all assets rise together. Real estate, stocks, bonds and commodities all rise as the illusory currency evaporates. I am unaware of any government that permits concessions for currency debasement when taxing businesses and citizens.
This reveals the perniciousness of the inflation tax which results when there is either no economic gain or an economic loss yet taxation still results, it is unavoidable and pervasive. Even worse, the poor are most affected as they have no assets to rise with the illusory tide.
A gold ounce is an excellent example. In 2001 a gold ounce is purchased for $275. In 2008 the gold is traded for either $975 FRN$s or the equivalent amount of goods or services. The gain would be $700 even though the useless gold ounce did not change, grow or become scarcer in the world. Now the government demands a $200 share. Why?!?
Well, the government assert there is a gain and they want their cut whether they deserve it or not and are willing to use force to get it. Gold is especially painful because of the automatically higher tax rate which is instituted to make it less competitive as a currency in ordinary daily transactions. This is an splendid reason to support sound money legislation like the Indiana Honest Money Act.
CONCLUSION
I am not among the gold bugs that assert gold is a perfect inflation indicator because I find that with the random volatility, or lack thereof in the 90’s, gold is too volatile in the short run. Nevertheless, in the long run gold has been a great indicator of a competing currency’s value and is signaling that almost all are eroding fast. Even worse; all the governments are taxing businesses and citizens the entire way down during the great credit contraction.
This is a wonderful example of why businesses and individuals play tax games to reduce their exposure. But they are not the only ones. Who decrees the inflation rate used in the TIPS calculation? Yep, that same government that promised to adjust the TIPS so the investor would remain whole … before the taxes of course. There is surely no conflict of interest and people like John Williams of ShadowStats must be loony to assert that the inflation rate is understated. For these reasons TIPS are almost always an invitation, not that they care to ask, from the government to steal from holders of capital.
By Thersites, on March 12th, 2009
First let me state a few qualifiers when it comes to the Mets’ now infamous Citi Field. Citi Field is gorgeous. The team that will inhabit it is not as gorgeous. It is outrageous that the taxpayers are backstopping the bank which made the naming deal with the team. It is embarrassing to an organization that has already suffered epic collapses the last two seasons to be going into a new stadium dealing with this kind of headache. With this in mind, let me proceed to the broader controversy regarding the naming deal.
Today in the New York Times, representative Dennis Kucinich argues regarding naming deals that “Treasury has the power under TARP to make broad changes, They have to. It’s not whether they can or should; they have to. The legal issues are very easy to maneuver.” According to Kucinich, Citi Field represents “an egregious example. But we have a list of other banks we’re working our way through. We’ll hold hearings.” I do agree with Kucinich that naming deals such as Citi’s with the Mets represent extravagent, and probably poor expenditures. I don’t know how Citi projected that it would recoup their $400 million investment in the naming rights to the stadium, but investment banks made all sorts of investments far more ridiculous over the last decade to be sure.
Further, given that taxpayers are the ones who are responsible for propping up the company responsible for this deal, it should anger all of us. But what Congress (Mr. Kucinich excluded given his populist rhetoric against the bank bailouts) fails to realize is that were it not for the government’s decision to bail out these institutions, these types of issues would not exist. As Citi unwound its assets during its bankruptcy, the naming rights deal could be nixed and purchased by another company. Where were Kucinich’s angry colleagues when it came to bailing out Citi in the first place?
The outrage amongst politicians when it comes to naming deals not only masks their lack of appreciation that this would not be an issue were it not for propping up failing ventures, but also masks the greater implications of their intervention. Since we all are now shareholders in these institutions, the government will tinker with their management. This begins with caps on executive pay, but who is to say that it will end there?
As poorly as some of these institutions were managed, and granting that a lot of their poor management was due to incentives created by government intervention, I would guarantee that government control of the banks will be even worse. Do you think that Nancy Pelosi knows how to create a DCF model in Excel? Does Barney Frank know how the market for CDO^2’s works, let alone what a CDO^2 is?
Much as I think that President Obama could give a hell of a pitch to investors on the virtues of a closed-end real estate fund, there is no way that the government can ever run these businesses properly. Command economies have always failed. The government lacks the profit motive and the knowledge to successfully manage these companies. Putting the firms under the purview of government represents the greatest moral hazard of them all.
Remember, these are only the direct effects of strict government regulation of the banking sector. There would also be a great effect on the markets. If the government is to have say over the operating activities of the major banks, what kind of implications will this have for retail and institutional investors? Will money flood out to less-regulated private equity and hedge funds? Will those shops then become as regulated as the (remaining) big banks? What kind of confidence will exist in the markets when the biggest broker-dealers are being managed by politicians? Will people not recall what happened to all of the other GSE’s?
There are a plethora of problems with these institutions being managed by the government. The Citi Field naming rights deal is very small relative to the big picture, but it exemplifies the direction the government is going. I am just as angry as everyone else that we are responsible for keeping the Citi naming deal alive, but we must remember that it was because of government intervention that we got ourselves into this mess in the first place. As if it wasn’t bad enough that the Mets aren’t going to pursue Manny Ramirez, now us tortured fans have to deal with this pathetic situation.
By Trace Mayer, on March 12th, 2009
In December I published A Problem With GLD and SLV ETFs where I briefly perused the GLD prospectus. It concluded, “For these reasons including (1) the quality of the gold is at issue, (2) no audit of the physical metal is permitted, (3) counter-party risk impregnates the investment vehicle and (4) there are strong conflicts of interest with complicit players in the central bank gold price suppression scheme; GLD and SLV appear impotent in reducing inflation or counter-party risk.”
QUALITY OF GOLD
From the original article, “Page 12 “In issuing Baskets, the Trustee relies on certain information received from the Custodian which is subject to confirmation after the Trustee has relied on the information. If such information turns out to be incorrect, Baskets may be issued in exchange for an amount of gold which is more or less than the amount of gold which is required to be deposited with the Trust.” On page 11 “In addition, the ability of the Trustee to monitor the performance of the Custodian may be limited because under the Custody Agreement the Trustee has only limited rights to visit the premises of the Custodian for the purpose of examining the Trust’s gold”. Therefore, it appears that an audit of the actual physical gold is precluded (Update: See comments 25 & 26).”
READER COMMENT RAISES AN ISSUE
A perceptive reader commented (#25):
But I’m not sure how you get to “an audit of the actual physical gold is precluded” from “the Trustee has only limited rights to visit the premises of the Custodian for the purpose of examining the Trust’s gold”. “Limited rights” is not “no rights”.”
If Deloitte’s statement of 21 November in the 10-K is to be believed, they have “audited the … statements of condition … [and] such financial statements present fairly, in all material respects, the financial position of the Trust”. Now I am quite ready to be sceptical about the lengths DT went to check the gold was there. But, on the face of it, they have effectively stated that the $20bn worth of gold as per the balance sheet really exists and really belongs to GLD. And it’s hard to imagine they didn’t at least send someone to the premises of the Custodian to have a quick peep, though of course in this crazy world of mediocratic financial services it is probably unwise to have 100% faith even in that. [emphasis added]
TRUST AUDIT RIGHTS OF THE CUSTODIAN OR SUBCUSTODIAN
The latest 10-K (Commission File Number 000-32356) on pages 26 and 18 respectively: ” Gold held by the Custodian’s currently selected subcustodians and by subcustodians of subcustodians may be held in vaults located in England or in other locations.” and “In addition, the Trustee has no right to visit the premises of any subcustodian for the purposes of examining the Trust’s gold or any records maintained by the subcustodian, and no subcustodian is obligated to cooperate in any review the Trustee may wish to conduct of the facilities, procedures, records or creditworthiness of such subcustodian.”
The audit test was performed to the standard of ‘reasonable assurance’. Piecing these assertions together it could be possible for subcustodians to provide incorrect information, either negligently or willfully, to the Custodian concerning the physical gold quantity or quality. If the incorrect information came to the knowledge of the Custodian then they would issue Baskets. Regardless the Trust is unable to visit the premises and examine the Trust’s gold or any records maintained by the subcustodians. As a result, the paper instrument would inaccurately represent the represented underlying physical bullion and the error would most likely not be discoverable.
INVESTMENT IN GOLD VERSUS GOLD
In the 10-K on page F-3 SPDR Gold Trust asserts an “Investment in Gold, at cost” of $16,878,554,000. The term ‘investment in gold’ is used in multiple places throughout the 10-K. This is contrasted with other terms such as ‘Proceeds from sales of gold’. This raises the issue of whether gold and investment in gold are synonymous terms?
In accordance with International Accounting Standard 1, The Bank for International Settlement’s Annual Report, under Accounting policies footnote 14, treats Gold as a financial instrument. Under Notes to the financial statements part 5 the Bank is extremely careful to distinguish ‘total gold holdings’ as being comprised of ‘gold investment assets’ and ‘gold and gold deposit banking assets’.
In GLD’s case, the financial statements make a significant distinction between ‘investment in gold’ and ‘gold’. This is odd considering most companies do not make such a distinction between similar financial instruments such as ‘dollars’ and ‘investment in dollars’ or ‘euros’ and ‘investments in euros’.
Also odd is the lack of transparency over what GLD’s ‘investment in gold’ is comprised of. Is the phrase ‘investment in gold’ broader, narrower or completely different from the term ‘gold’? For example, can a COMEX futures contract, warehouse receipt or other similar OTC derivative fall under ‘investment in gold’? The term gold is well defined as a chemical element with the symbol Au and atomic number 79. Obviously, a warehouse receipt for gold is not gold unless the receipt is made of the chemical element of atomic number 79.
 Mr. Turk addressed this particular issue and concluded, “If GLD declared its asset to be “Gold”, the fund’s auditor would have to substantiate that the gold really exists, which GLD of course cannot do because of the inability to audit or even inspect gold stored in subcustodians and sub-subcustodians, which is a risk noted in the prospectus.”
Because the Trust does have some gold in their vault the auditors are most likely satisfied to a ‘reasonable assurance’ concerning the rest of the gold.
CONCLUSION
GLD ETF Trust supposedly holds more than 1,000 tons of gold. That amount is surpassed only by the United States, Germany, IMF, France, Italy and Switzerland; assuming they have the gold they claim. Under the GLD prospectus and latest 10-K it appears that the Trust neither needs to own actual physical gold that constitutes atomic number 79 nor allow their auditors to see and touch the undefined ‘investment in gold’. I agree with the reader who asserted that ‘it’s hard to imagine they [auditors] didn’t at least send someone to the premises of the Custodian to have a quick peep’. In other words, ‘Just trust us, the gold is there.’ But why believe them?
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