My first post of 2010 was The End of the China Decade, but it focused more on the rise of India.

The New York Times published Contrarian Investor Sees Economic Crash in China by David Barboza seven days later.

The prospect of a crash in China is real.  The banking system is closed and may be covering up severe flaws.  They may be hiding very high non performing loan rates. Some of our brightest bureaucrats failed to foresee the vulnerability of our own financial system and we have substantial disclosure. Any growth rate as strong as China’s is subject to a bubble scenario.

While it is difficult to predict how such a crash would impact us it could have severe consequences. China is way too big for any group of nations to bring financial support to it. Our currency could strengthen relatively as theirs weakens, but we could also be in big trouble if they need to liquidate their holdings of US bonds.

One possible benefit is the final proper alignment of their currency; an objective that has frustrated trade politics for decades. This could make American manufactured goods more competitive and jump start re-employment.

The biggest potential problem is the difference in political culture. High unemployment in America causes big deficits because of our social support networks. High unemployment in China may cause starvation on a large scale and much more dangerous political instability.

The biggest worry the current state of global financial instability renders is that such situations foster belingerencies.

From Financial Fiasco

by John Norberg

“The financial strategist George Cooper, who wants to rehabilitate a Keynesian analysis of the financial market, sees similarities between interventionist economist John Maynard Keynes’s desire to stimulate demand in times of crisis and the behavior of the serial rate-cutters at the Fed-interestingly, however, he thinks the latter are more Catholic than the Pope in this respect.  Keynes believed that an economy should be stimulated to escape from a deep depression.  The Fed and the politicians of today have systematically stimulated the economy to keep it from ending up in a recession in the first place.”

“This is what Cooper terms “preemptive Keynesianism.”  The difference is subtle but important.  Recessions send important messages to market players, telling them that their investments have failed and that they have borrowed too much.  That forces them to give up bad projects and get out of bad investment positions, moving the money to more productive parts of the economy.”

“If the central bank and politicians step in every time to save the economy from a recession, it will lull borrowers and lenders into a false sense of security that will make them take ever-greater risks.  They will be pushing a growing mountain of debt in front of them, and eventually the stimuli will not be a large enough to prevent a collapse.”

HKO Comments:

While many consider the meltdown a failure of capitalism and the free market, it would be more correct to see it as a failure to let the free market function.  The Fed appeared infallible under Greenspan because he avoided so many small crisis by pushing liquidity into the system. But by not allowing the excesses to correct themselves, it only made the underlying problem and the eventual reckoning worse.

Jim Cramer shows a correlation between Obama’s rising disapproval ratings and the rise in the S&P 500.  While correlation is not necessarily causation it is worth noting.

From James Grant’s “Mr. Market Miscalculates. “

“ I urge the regulatory bodies of the U.S. to incorporate an IQ test into their security licensing. No minimum passing grade would be mandated, but no one with an IQ of over 115 would be allowed to work in the financial markets.”

“Finance is too important to be left to smart people.”

TARP is often FORCED onto banks and then used as a means of control. It is a disturbing act to say the least.

In “Obama Wants to Control the Banks” by Stuart Varney in the Wall Street Journal Online describes the process and I also heard the story from Nepolitano on Fox that he describes.

excerpt:

Here’s a true story first reported by my Fox News colleague Andrew Napolitano (with the names and some details obscured to prevent retaliation). Under the Bush team a prominent and profitable bank, under threat of a damaging public audit, was forced to accept less than $1 billion of TARP money. The government insisted on buying a new class of preferred stock which gave it a tiny, minority position. The money flowed to the bank. Arguably, back then, the Bush administration was acting for purely economic reasons. It wanted to recapitalize the banks to halt a financial panic.

Fast forward to today, and that same bank is begging to give the money back. The chairman offers to write a check, now, with interest. He’s been sitting on the cash for months and has felt the dead hand of government threatening to run his business and dictate pay scales. He sees the writing on the wall and he wants out. But the Obama team says no, since unlike the smaller banks that gave their TARP money back, this bank is far more prominent. The bank has also been threatened with “adverse” consequences if its chairman persists. That’s politics talking, not economics.

HKO comment- what investor in their right mind would want to invest in a bank subject to such political extortion.

My seven speculative stock picks with sector and price as of 4/1/09 opening.

China Medical Technologies - medical- 13.77- CMED

Nucor- steel- 38.17- NUE

Tata Motors- auto- 4.93- TTM

Diamond Foods- foods products- 27.93- DMND

Suntrust Bank- banking- 11.74- STI

Adobe Software- software- 21.39- ADBE

Chesapeake Energy- energy- 17.06- CHK

No guarantees, just my picks for a group that is diversified among sectors. I will keep you posted.

Some of my employees have started to panic because of the losses in their 401k. While I am precluded from advising specifically, I do advise that they consider a 20/ 20 rule.

If they have less than $20,000 in their account or if they are at least 20 years from retirement, do not worry. Those with little money may see a sharp percentage drop but it will matter little in actual dollars. It will be more than offset by the continuous flow of dollars into their account buying stocks while the market is cheap.

If fact I contend that the best scenario that could happen to a young investor with only a few thousand dollars in his or her account is a sharp drop in the market and a gradual recovery allowing them to buy on the cheap.

The worst possible action would be to stop participating in the 401k plan or reduce the funding of the account. Such a course would not reverse the current loss and would eliminate the chance of participating in a recovery.

Your 401k is the best place to have fixed income investments since the interest is tax protected. Stocks should generate long term capital gains and already have a preferable income treatment that is largely wasted in the structure of a 401k. It would likewise be foolish to buy a tax free municipal bond to put in a 401k.

If your account is all equities I would recommend some portion in fixed income. The current financial meltdown has humbled many accounts that relied too much on equities.

by Henry Oliner

The history of Fannie Mae and Freddie Mac dates back to FDR and LBJ. Their mission was to provide mortgage loans to middle and lower income citizens. But like so many popular government programs (including health care) they want to provide more benefits than they are willing to pay for.

Mortgage lending like any other lending is relatively simple. You will loan based either on the value of the asset or based on the ability of the borrower to pay it back. To guard against the drop in the price of the asset, you will protect yourself by asking the borrower to put up a down payment. In the 1960’s and 70’s you generally expected to put down 20% of the price of the home in order to borrow the remaining 80%. You had to prove yourself a dependable income source with a good credit history and a good personal history from either education or job recommendation.

As housing prices grew the 20% down payment became onerous and the politicians wanted to help the poorer realize the American dream of home ownership. Down payments slipped to 10% or even less, often with a higher accompanying interest rate.

Under Reagan the interest on consumer loans such as credit cards was no longer deductable. People discovered, and banks pushed equity lines of credit. Simply borrow from the asset value of your home and pay off your credit cards with tax deductable interest.

Mortgage lenders started making loans of 100% or 110% or even 125% of the asset. This was the beginning of the end. When this many people believe that appreciation of homes is inevitable the top must be near. When home owners lost their jobs they would just walk away from the home and leave it to the bank. Having no equity they had nothing to lose. This was common in Houston during the oil bust of the 1980’s.

As local loans became commoditized, the security of the loan weakened considerably. Banks no longer kept the local loan on their books and profited from the cash flow of a quality loans of their own choosing that they owned; they were now paid fees to originate loans that were then sold and resold to Wall Street firms who marketed them as mortgage backed obligations.

The banks became distant from their loans, the fees became generous, and the quality suffered. Ridiculous incentives were paid to generate new loans with no penalty left for making poor loans. Short term pleasure for possible long term pain- the junkie’s dilemma.

To help people qualify for loans the financial institutions, with the blessings of the government regulators and oversight committees, invented ARMS, interest only, and then they just fudged appraisals and income qualifications. Creativity and rationalizations abounded to support popular delusions.

But at the core of this problem is that the government wanted to give something for nothing. By making loans available for people who could not afford them they ignored the long term risk, basically giving away risk coverage for free. This is like an insurance company offering you free insurance for your car and still expecting you to drive safe. Would you want to buy their shares?

The rest of the story is a story of fraud, cover up and politics designed to hide the basic and obvious truth. They distributed fashion awards (bonuses) to naked emperors.

Many of us have term policies to insure a specific period; for instance until the kids graduate college or until the house is paid for. Typically we let the polices lapse when we no longer need them.

According to Mark Skousen (Forecasts and Strategies- highly recomended!), these policies have value that you can realize rather than just letting them lapse. In his example a 73 year old man had a $3,000,000 term policy. Rather than let it expire he had a top Wall Street Bank pay $400,000 for his policy.

This will likely only work for people well over 65, but it is a secret well worth knowing.