The Panic of 2011 will come from the sovereign debt crisis in Europe.  It will spread to the US, because the Dodd-Frank Wall Street Reform and Consumer Protection Act financial guarantees another financial collapse.  In the next bank crisis, there will be many more regulators involved in breaking up failing megabanks.  Sheila Bair, the departed head of the FDIC, was correct: the big banks may as well be broken up now, not in the midst of a financial
collapse.  If done now, it will be much more orderly.

In the US, the government is crowding out borrowing.  Bankers want a two-point spread.  They can make that by taking money at 0% interest from the Fed and putting it — risk-free — in 2.3% 10-year US Treasury bonds.

Hurricane Irene will be hitting the East Coast in a few hours and I think of how people misperceive risk. When I taught in the New York City area, I used a hurricane as an example of how people misperceive risk. I would ask them what they thought the chances were that a Category 3 hurricane would hit New York City. No answer. Students today have not taken any history and are bored with history anyway, so they can’t imagine questions that are outside the experiences they have had in the last few weeks.

“Okay,” I say, “let’s do it by order of magnitude. How many think it is one in 10?” One or two hands. I will write that on the board.

“One in 100?” More hands.

“One in 1,000?” One hand.

“One in 10,000?” Usually none.

Then I ask the ones who said one in 10. “How do you know this? Was there a hurricane here when you were a child?” Then I ask the one who said one in 1,000. “How do you know it is one in 1,000? There is only 400 years of recorded history for New York City.”

The real answer is 1 in 133, based on three category 3 hurricanes that hit New York. The last was in the late 1800s and the water went to Canal St., where Chinatown and Little Italy are today. That was before the subway was built. I would draw out the conclusion that consequences are more important than probabilities. I write that in block letters on the board, CONSEQUENCES ARE MORE IMPORTANT THAN PROBABILITIES.

I tell the class “Again, people misperceive risk. They think one in 1000 is the same as zero.” I write “.001” and “.000” on the board and say, “These are not the same numbers.”

Insurance is for catastrophes. I tell students to be sure that they insure for the worst possible outcome, not for what they think will happen. I mention that reading Peter Bernstein’s Against the Gods.

I wonder if any of the students that I taught in New York and New Jersey remember what I said about NYC, hurricanes and risk today, as Hurricane Irene bears down on them.

For many years, politicians have given generous retirement packages to government workers. In turn, the workers give generous political contributions to the politicians. The promised benefits were not funded when granted. Politicians may have calculated that when the bill comes due, they will be retired or dead. Well, at least in Costa Mesa, the bill has arrived and instead of raising taxes, current workers are fired so that previous workers’ pension checks and health care can be paid. A previous generation lived better than the current generation, and is now causing the current generation to have less police, fire, and other government services.

This will also happen eventually at the Federal level with Social Security Disability Insurance, Social Security, Medicare, Medicaid, and other unsustainable programs.

Meanwhile, the FDIC is vigorously enforcing the Community Reinvestment Act . In January, at least 50 banks will be examined for compliance with the CRA. The CRA ostensibly is to prevent banks from redlining neighborhoods. In practice, banks have quotas for low-income loans. This means that banks make lots of loans which they know will eventually go bad. The old American dream was to get an education, which led to a good job. With the income from that job, a worker could buy his or her own home. This was changed by Pres. Clinton in 1999: be poor and you are entitled to your own home. The New York Times forecast in 1999 that policy would end in disaster and it did, especially when ACORN encouraged fraud in loan applications. Unfortunately, the CRA is still the law.

There may be closures next Friday, but after that, given the holidays, I expect no closures.

Soon the third quarter report showing the number of problem banks will appear. Meanwhile, the complete list of failed banks is here.

ETFs are available to short the dollar (symbol UDN) or go long foreign currencies using WisdomTree Dreyfus Emerging Currency Fund (symbol CEW). I personally think it is hard to pick which currency will devalue faster if there is competitive devaluation. The only currency I am confident will appreciate is the yuan.

The yuan isn’t freely traded. Some suggest investing in Hong Kong banks which could profit from a change in value of the yuan. ideas on how to play a rise in the yuan by buying bank stocks that would benefit from a rise in the yuan.
I still think that commodities, especially gold and oil, are the best way to protect against the coming inflation.

[Full disclosure: no position in UDN, CEW or Hong Kong banks.]