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The Nationalization of Wall Street, by John Ing
Federal Reserve Chairman Ben Bernanke once said: “By increasing the number
of U.S. dollars in circulation, or even by credibly threatening to do so, the
U.S. government can also reduce the value of a dollar in terms of goods and
services, which is equivalent to raising the prices in dollars of those goods
and services. We conclude that, under a paper money system, a determined government
can always generate higher spending and hence positive inflation.”
The Fed slashed short-term interest rates six times in six months to 2.25 per
cent from 5.25 per cent despite the U.S. Department of Labor reporting that
consumer prices had jumped 4.3 per cent at an annual rate in January -- the
biggest rise in two years. As a result, the Fed's benchmark overnight lending
rate is about half the rate of inflation and real interest rates are now negative.
The last time interest rates were negative, housing exploded; the housing bubble
grew larger stoked by Wall Street's alchemy of mortgage backed securities that
are at the heart of the unfolding crisis.
Bernanke, a student of the Great Depression, believes that policymakers and
politicians then were too slow in countering the downturn, letting the resulting
panic sink the economy. Bernanke is right about the foot-dragging almost eight
decades ago. But by slashing interest rates and lending hundreds of billions
to Wall Street today, he risks creating yet another bubble. Already, Bernanke
has orchestrated the biggest bailout since the Great Depression in the wake
of the collapse of the mortgage industry. Even oil, gold and other commodities
retreated rapidly from record highs as traders flattened positions in a desperate
deleveraging process. The greatest fear is the fear of the unknown. The current
financial crisis is due to the lack of confidence and trust because of uncertainty
about the extent and breadth of the potential financial losses.
Counterparty Defaults
The credit market simply lacks credit. The subprime woes have spilled over
into dislocations in the overall credit markets – from municipal debt,
to corporate debt, to derivatives. Fears of a default by a counterparty is
threatening the global financial system and is believed to be one of the reasons
behind JP Morgan Chase’s bid for Bear Stearns. Banks are hoarding and
have stopped lending since their thin capital base (and solvency) is at risk
while their customers such as hedge funds, private equity and Corporate America
are forced to deleverage and dump the assets – like those owned by Bear
Stearns – in a no bid market. Lower rates will not unblock this logjam.
Unfortunately, lower interest rates are not the answer in warding off this
financial market crisis. The source of America’s problems is not interest
rates. The problem is simply too much debt and too much leverage. A great unwinding
is the answer.
Despite the dramatic drop in rates, there are still no signs of a pick-up in
the credit markets. Trust has evaporated. Banks are desperately trying to dump
billions of leveraged securities in an illiquid market. To date Wall Street
has taken only $200 billion of writedowns but has only raised about $100 billion,
leaving a shortfall. The Fed has extended loans to the investment banks, taking
on some of their illiquid paper as collateral. After failing to offload these
to a naive public, the game of "slicing and dicing" risk and dispersing
this risk is over. Now, that risk has come back to haunt them. And any sale
becomes a new benchmark for these dubious assets, leading to more price cuts
and, of course, further fire sales and bigger losses. The markets have yet
to reprice risk.
The Tip of the Iceberg
In the credit binge, the risk-rating agencies became more like principals rather
than advisors and helped spread the poor quality of debt by rating risk highly.
Today, AAA ratings mean nothing. With the closing of America's capital market,
the big Wall Street icons such as Citicorp, Merrill Lynch and Morgan Stanley
were forced to rebuild their balance sheets with the help of foreign buyers
such as foreign sovereign wealth funds from Singapore to Kuwait. America's
growing reliance on foreigners for funding its deficits has become its Achilles
heel. Already there is a controversy over the growth of sovereign wealth funds
(SWF), which manage between $2.5 trillion and $3 trillion, and to date more
than $100 billion has bailed out Wall Street's biggest investment banks. But
the United States can't accept this money without conditions. In the past,
the Asian or Middle Eastern buyers bought trophy buildings, recycling their
excess dollars back into the United States. As of last summer, foreigners owned
$ 6 trillion or 66 per cent of the entire $9 trillion U.S. federal debt load.
In order to keep their currencies competitive, the Asian central banks and
the petro powers of the Middle East ploughed their reserves into U.S. treasuries.
This is great while it lasts, but as Asia booms and Wall Street declines, the
big buyers of treasuries are growing disenchanted with some of their earlier
purchases. No one likes to lose money and the Fed must somehow maintain the
trust of foreigners. China's near-Bear experience and the promise of more taxpayer-assisted
bailouts will certainly cause foreigners to think twice about investing in
the United States. Wall Street's problems seem to be chronic and the Chinese
are looking at huge losses in their foray into Wall Street. It will get worse.
We believe there will be less Asian money available to finance America’s
trade deficits, which requires over $2 billion a day of outside funds.
Wall Street's Margin Call
The party is over on Wall Street. Carlyle Capital Corp., the publicly traded
investment fund affiliated with the powerful Carlyle Group, defaulted on $22
billion of mortgage securities on a flimsy capital base of less than $1 billion.
That is 22 times leverage, exceeding the leverage of bankrupt Long Term Capital
Management LLC. And venerable Bear Stearns was sold for about one third per
cent of its value the previous week. With almost $100 billion of liabilities
against book value of less than $12 billion, the investment bank was forced
to close its doors at liquidation value. Bear Stearns was the key prime financer/broker
for America's biggest hedge funds and its demise threatens a domino-like counterparty
chain reaction that could spread throughout Wall Street.
Bear’s key role in the web of financial players and counterparty risk
emerged as a major reason for the Fed’s bailout. Ironically, it was last
summer’s collapse of two Bear hedge funds that sparked the upheaval in
the markets. Bear simply was hoist upon its own petard. Most troubling is that
all investment banks are similarly highly leveraged. Bear Stearns borrowed
$30 for every $1 of capital. Yet Morgan Stanley has leverage of 32 to 1, Merrill
Lynch 28:1, Lehman Bros. 32:1 and Goldman Sachs 26:1. Worse still, not even
the Sheriff of Wall Street is around to witness the unraveling.
That Wall Street cannot fund itself has forced its major players to borrow
massive amounts of money from the Federal Reserve. The Fed has even taken to
accepting dubious assets as collateral to alleviate the financial stress in
the markets, which in essence makes the Fed "the garbage collector of
last resort." The Fed created a growing $200 billion lifeline available
to lend treasuries in exchange for unmarketable triple-A mortgage-backed securities.
Bear Stearns was the first recipient of this largesse and already the Fed is
on the hook for more than $30 billion of Bear's obligations that JP Morgan
does not want. This is not a crisis in liquidity but one of solvency.
In our view, the Fed’s solution is simply the beginning of the de
facto nationalization of Wall Street. What’s particularly worrisome is that
the Fed has started on the slippery slope of taking on the credit risk and
liabilities of Wall Street, similar to the Bank of England’s bailout
of Northern Rock, which ended in the nationalization of that sorry institution.
The Bank of England’s nationalization of Britain’s largest mortgage
company cost taxpayers more than $200 billion. The sobering message, however,
is that it’s far from over. Inevitably, politicians and regulators are
pressured to prevent more problems, but there is no point in closing the barn
door after the horse has left.
With the shadow of the Thirties looming, the Fed's orchestration of events
since August, from the decision to give Wall Street access to the discount
window, to the acceptance of Wall Street's inventory as collateral, to the
cronyism of the Plunge Protection Team (PPT)
to the $30 billion backstop of unwanted securities to the Bear Stearns' rescue,
to the relaxation of rules
governing quasi-government bodies such as money losing Fannie Mae and Freddie
Mac, all points to a role beyond that of a lender of last resort. In absorbing
the liabilities of Wall Street, the Fed is simply piling on debt on more debt.
No nation, even the United States, can borrow forever without facing up to
economic consequences. And no one is too big to fail.
Just Who Will Bail Out The Fed?
The U.S. dollar is among the sickest currencies in the world, giving up 50
per cent of its value since 2002 because the United States is deep in the financial
hole. The gap between spending and revenue grows ever wider. Today, foreigners
are not so eager to help. The problem is that America is a debtor country and
dependent on foreigners to finance its chronic deficits requiring an inflow
of $800 billion from foreign investors each year to finance the country's deficits.
Not surprisingly, America's creditors are losing confidence in the country's
solvency. Americans spend too much and save too little. America's trade deficit
is at seven percent of GDP and the budgetary deficit - excluding supplement
spending for the war - is estimated at $400 billion. The Congressional Budget
Office (CBO) estimated the costs of the wars in Iraq and Afghanistan so far
at $600 billion and Congress is to approve another $275 billion. The CBO estimates
the war might eventually cost between $1 trillion and $2 trillion by 2017.
Meantime, consumer spending accounts for more than 70 per cent of the U.S.
economy, but household debt is now at 140 per cent of consumers of after-tax
income. Debt on debt is not good.
There is no question that the bursting of the housing bubble and the cost of
the inevitable breakdown of the financial system has created huge dangers for
the global financial system. The vortex already has dragged down institutions
in the United Kingdom, Switzerland and New York. The United States is on a
path similar to Japan’s deflation in 1990s. While the savings and loan
bailout cost U.S. taxpayers “only” $200 billion, this time the
potential cost of the biggest bailout in history is estimated at more than
$1.2 trillion or enough to wipe out half of the global banking sector’s
capital. We believe that fears that U.S. taxpayers face even bigger bailouts
to save Wall Street will further undermine confidence in the dollar, boosting
gold’s allure. Gold is a good thing to have as a barometer of investor
anxiety.
Previous crises such as the stock market meltdown in October 1987, the S&L crisis in the early the 90s and the Asian contagion in 1997 or the bursting
of the tech bubble in 2000 had a common denominator – too much money
chasing too few markets. Warren Buffett warned that derivatives today are the
new ticking time bomb. Derivatives exploded to a whopping $516 trillion by
2007, according to the Bank of International Settlements. Yet it is not the
size of the market that concerns us. It is the growing risk of counterparty
failure since the capital position of the global banking system supporting
the $500 trillion plus of derivatives is estimated at only $2 trillion, insufficient
to handle even one per cent of potential losses.
Stagflation Now?
In January, U.S. farm prices had an annualized 7.4 percent increase, the biggest
yearly gain in more than 26 years. Beset by credit woes, the U.S. economy appears
to be entering a period of low growth and high inflation, just like the stagflation
of the 1970s. Rising food and energy prices are sopping up what is left of
consumers' discretionary income. The bad news is that central banks appear
to be providing the very fuel that will stoke inflation even further. The Fed's
dramatic lowering of interest rates has not helped domestic demand. Instead,
it has simply sped up the flood of capital away from the United States. There
is tight productive capacity from potash to steel to coal while the only surplus
seems to be in cars and condos. Of concern is that the rise in commodity prices
is not cyclical but structural, with huge supply shortages.
Inflation is the monetary flavour of the week and the month. Inflation is rising,
pushed upwards by high oil, food and commodity prices. Short-term government
yields are at lows only because of the Fed's panic to prop up Wall Street
and long rates are actually rising. More important, inflation is on the rise
in France, Japan and Saudi Arabia. Meantime, in China it is at the highest
level in a decade.
The Fed is worried more about the risk of a financial meltdown than rising
inflation. This time, central banks have not only flooded the system with money
but also loosened financial regulations for highly leveraged mortgage giants
Freddie Mac and Fannie Mae. Prices, of course, are rising because there is
too much money being created. The root cause of inflation is money creation.
Sadly, for the central banks and the financial markets, inflation is the obvious
solution to U.S. indebtedness, allowing money to depreciate even faster. For
creditors, this is not a solution.
The potent combination of a slowdown, the cost of Wall Street's bailouts and
skyrocketing commodities has investors justifiably worried about a repeat of
1970s stagflation. In the 1970s, two oil embargos doubled the price of oil
to $50 a barrel. The oil shocks were accompanied by a surge in 'soft' commodities
after the anchovy fishery off the coast of Peru almost disappeared. The need
to replace the anchovies caused the Japanese to switch to soybeans, which caused
a spike in prices. Indeed, the jump in commodities crippled the global economy.
Costs went up and wages were raised to compensate for increased prices in a
classic case of cost-push inflation. In 1980, the U.S. inflation rate reached
13 per cent and wage and price controls were imposed when inflation hit 4 percent,
the identical level today. Gold rose from $35 an ounce to more than $850. Interest
rates soared to double digits when the government realized that it had to fight
inflation, Fed Chairman Paul Volcker arrived on the scene, eventually snuffing
out inflation by sending interest rates to the sky, which ended in a decade
of stagflation.
Today, we have similar ingredients in place, now only monetary policy is much
easier. The parallels are most ominous. Recently, M2 money supply increased
a whopping $35 billion a week as the Fed provided both expansive monetary and
fiscal stimulus. With inflation picking up, investors should know that the
current monetary inflation is not just an increase in the monetary base. It
is the leverage impact of this monetary inflation, which creates bubbles. As
in the 1970s, food prices have now risen by more than 75 percent from the lows
of 2000. Meantime, China's growth and poor weather has intensified demand,
cutting into supplies at the same time. Ironically, the spike in the oil price
has encouraged the conversion of grain to bio-fuels, helping to trigger a dramatic
increase in food prices. This is controversial because Americans are actually
subsidizing crops for fuel instead of for food; making it seem more important
to drive an SUV in the United States than it is to eat.
Moreover, the news could be even worse than we think because the government's
inflation statistics are skewed. For example, the 'core" inflation rate excludes
energy and food prices because of a desire to 'even out' spikes. Thus, we
are told inflation rose only 2.7 per cent on an annualized basis in February.
The elimination of food and energy has relegated inflation to the back pages,
making historic rate comparisons meaningless. The bottom line, however, is
that energy and food prices are increasing and the core rate is on the move.
The CPI rate is actually 4.3 per cent, the same level that spurred wage and
price controls on Aug. 15, 1971.
When The Swamp Drains, The Ugly Frogs Are Exposed
For us, there is a sense of déjà vu because the
Bernanke reflation is similar to Alan Greenspan keeping interest rates too
low for too long causing
the housing bubble and, ultimately, the credit bubble. Now both have burst
and we have Bernanke pumping yet again. To avoid a systemic banking crisis,
the Fed has opened the monetary flood gates. Investors are concerned about
credit conditions. If Wall Street firms continue to lose money at current rates,
they will find themselves below capital requirements in less than six months.
Bernanke and Wall Street appear to think that the solution is to reduce interest
rates. And yet by relaxing borrowing requirements, they are in fact leveraging
the system even more.
America's solution is to devalue its currency further and monetize this mountain
of debt by inflating its way out of the problems, just as it did in the 1970s.
And the emphasis on more bailouts has prompted investors to seek refuge in
'hard assets' such as gold and oil as a hedge against future inflation and
currency depreciation. That is why gold hit $1,000 an ounce.
The U.S. dollar has fallen to a new low against the euro while gold recorded
new highs. Further rate cuts by the Fed have the effect 'pushing on a string'
and to date has not ended the downward spiral in housing. The Fed has cut rates
by 300 basis points but long-term yields have actually gone up, not down, further
reflecting investors' concern that inflation is the next big problem. Mortgage
rates have actually gone up. After the subprime mess came the CDO mess.
Then the investment banks fell and now the hedge funds are falling. All are
subject
to capital constraints, and in the deleveraging process, Wall Street's inadequacies
are surfacing just as a draining swamp exposes its ugliest frogs.
The Bottom Line?
We believe the piling on of more debt to rescue the financial system and the
U.S. economy is unlikely to work in the face of a surge in inflation. Nor will
driving interest rates to the floor work since it will debase the dollar further.
Americans have become too dependent on foreigners, who have become increasingly
uncomfortable with their enormous dollar holdings.
Reflation has created a new commodity bubble. The other driver is the emergence
of China and India, coupled with supply constraints caused by sustained underinvestment.
The aging infrastructure of the commodities producers has not kept pace with
the new demand. Thus, there is a need for the market to return to balance.
Unfortunately, greater money supply will neither cause a fall in demand nor
significant increases in supply, so prices are expected to remain at elevated
levels for some time to come. In mining, for example, it will take at least
five years before any new discoveries come on stream. In addition, power shortages
in South Africa have led the mining industry to both curtail expansion and
current production. Consequently, there will continue to be waves of consolidation
as the bigger mining companies look to economies of scale. Gold is a good commodity
to own.
What Do We Need?
Needed is the recapitalization and restructuring of Wall Street, which is bloated
from a decade of financial innovation. Needed is the repricing of risk. Needed
is a new way for the rating agencies to rate risk, in that they cannot be principals
but truly arms-length advisors. Needed is a restoration of faith in the U.S.
dollar, which requires a fundamental change of policy in the current and next
U.S. administrations. Needed is a boost in the U.S. savings rate, which now
sits at zero. Needed is a reduction in the twin U.S. deficits. Needed is more
candour from officials and policymakers. Needed is a deleveraging process.
Needed is for the Fed to allow the investment banks to take their losses, support
those in need of liquidity, but not assume those losses. While prices will
undoubtedly go lower, investors are really looking at a repricing of risk.
The markdowns are needed as a discipline. Needed is a change in the accounting
rules to reflect mark-to-market losses and the impact on the investment banks'
capital. Needed is a reversal of the accounting rules that allowed the banks
to leverage up and instead put an emphasis on capital building rather than
leverage. Needed are the changes in the impact of securitization that converted
illiquid debt into new instruments. Needed is a change in accounting rules
for off-balance sheet vehicles.
The United States must also address its continuing problem of too much consumption
and its reliance on debt. America’s credit woes come at a time when the
rest of world is no longer willing to finance its current account deficits.
After a quarter century of wealth creation, Americans have no choice but to
work harder, tighten their belts, retire later and save more.
The economic downturn has paved the way for a new sheriff in town. Among the
Democrats, one of them is an inspiring orator but both offer no solutions other
than hope. Both want a government to spend more, abrogate trade agreements,
bail out its institutions and use more government intervention. For a time,
Americans enjoyed a free ride on the stock market and housing market. Now they
need a leader to solve the country’s problems in new ways, not old ones.
And Finally, Needed is a Role For Gold
Gold cannot be created like fiat currencies or be printed like dollars. At
one time, the pound sterling was the world’s reserve currency. It, too,
failed. The monetary order is changing again and the dollar as a reserve currency
is losing value and influence. In our view, a basket based on gold’s
value will go a long way to restore needed liquidity in the markets. Gold is
simply the new old currency. Gold hit $1,000 an ounce because the world has
been losing confidence in the dollars issued by the Fed.
Gold reached new highs amid tight supply/demand fundamentals, U.S. dollar weakness,
investment buying and, equally important, the lack of faith in dollar assets.
Gold has doubled in euro and yen terms since 2005. Investor demand is at a
record, led by China, which has consumed more gold than India and United States
combined. Meantime, supplies have been constrained as South Africa, the second
largest producer, has curtailed its production due to a lack of power. China
holds only about 600 tons or less than one per cent of its total reserves in
gold. With reserves of $1.7 trillion, China will inevitably diversify part
of those holdings into gold.
But most important, gold is a global currency that will become the “go
to” asset class as the foundation for the global currency system falters
due to the protracted credit crisis. Gold will go higher as long as America’s
solution to its debt crisis is to pile more debt upon debt, further debasing
the dollar. America will, in effect, default on its obligations, either through
currency debasement or inflation. Gold has no counterparty risk and no risk
of default. This bull market has just begun. We see gold more than doubling
to $2,500 an ounce. Gold is the ultimate “currency” and the inevitable
store of value and medium of exchange. When George W. Bush was sworn in as
president, gold was at $265 an ounce. This month, gold traded at $1,030 an
ounce. In essence, the U.S. dollar has been devalued by more than 100 per cent
in almost eight years of his presidency. Will the next president do any better?
JWR Adds: For the second half of this article, including
John Ing's specific investing recommendations, see
Gold-Eagle.com
