|Inflate or die. That’s the Federal Reserve’s mantra since the sub-prime credit crisis first hit the investment scene last August. Since then, this crisis has taken a destructive path and pummeled global equity and bond markets along the way. Global banks have also lost a combined US$1.6 trillion worth of stock market capitalization since last August. That makes this past year the worst year-over-year loss in history.
Before it’s all over, Americans, Sovereign Wealth Funds (SWFs) and other investors will pay an astronomical price to rescue the battered U.S. financial system.
The Death of a 24-Year-Old Bull Market
The bull market for financial services stocks first began in 1982. And this bull market hit a crushing dead-end in August 2007. It will be years before this sector fully recovers.
Let’s start with banks. Right now, large and small banks are desperate to recapitalize their smashed-out balance sheets. They continue to dilute shareholder equity through massive rights offerings and new issues. Dividends have been sliced and diced.
Since last August, banks have written off or lost a cumulative US$476 billion during the worst credit crisis in a generation.
We’re Postponing, NOT Avoiding Systemic Risk
Over the last 12 months, the Federal Reserve and the U.S. Treasury have dreamed up and orchestrated spectacular bailouts to preserve the financial system and avoid systemic risk.
But what are they really achieving? Long-term the consequences of the Fed’s actions will be horrendous. In the not-too-distant future, you’ll see existing and future generations of Americans paying dearly for our leaders rescuing one financial institution after another.
There is no “avoiding” systemic risk. The final consequence of Morale Hazard is a larger, more threatening financial panic down the road.
When the government bails out institutions and nationalizes failed enterprises, they only increase long-term inflation. For starters, they have to pay for those bailouts. So the government ultimately turns to taxpayers to fund the expansion of credit. By interfering with capitalism’s natural progression, the government delays its own financial reckoning.
In my opinion, an insolvent institution must be allowed to fail.
Morale hazard has played a major role on Wall Street and at the Bernanke Fed since March. Investors and analysts have seriously questioned the Fed’s unorthodox role as lender of last resort.
What business does the central bank have to collateralize a failed institution’s almost worthless debt with Treasury securities? That’s what the Fed did with Bear Stearns Cos. in March. The Fed did the same thing for other troubled but unnamed investment banks and banks over the same period.
Is Morale Hazard Justified?
Is a bailout justified if that institution mismanaged its business model? More importantly, should the government rescue a financial firm in the interest of deterring systemic risk?
It’s true that the Bear Stearns bailout deflected a major financial panic. But what really happened there? Contrary to most financial news reports in March, several large hedge funds were in the process of liquidating their accounts at Bear Stearns (Bear Stearns was a leading prime broker for hedge funds).
One of the largest hedge funds in the world actually sparked a run by other hedge funds to get out of Bear Stearns. The entire gamut of players scrambled to get their assets out before it was too late. There’s no doubt a major global financial panic would have ensued on March 17 without some sort of rescue.
In July, the government officially assured investors that Uncle Sam would guarantee GSEs or Government Sponsored Enterprises, Fannie Mae and Freddie Mac. Prior to Secretary Treasury Paulson’s assurances in mid-July, markets were reeling at the prospects of a Fannie and Freddie collapse.
Again, a failure of both mortgage giants would have caused sheer panic in global markets because of the significant role they play in mortgage financing, debt issuance, and liquidity to banks. So some will argue it was a good short-term solution…but at what cost?
The Piper Will Come Calling – Eventually
Bailouts and Morale Hazard have been highly subjective topics among investors and policymakers since March.
In the end, the United States will have to finance these and future financial bailouts with enormous amounts of credit, mostly from taxpayers. It’s inevitable that all this credit will eventually drain on the economy, American capital markets, and ultimately the dollar.
The United States is already losing its financial supremacy to London, Frankfurt, Hong Kong, Singapore, and Dubai this decade.
Capital flows to safe, tax-efficient shores. We’re likely to see new regulations in the U.S. as a consequence of the sub-prime mortgage debacle and other banking oversights. As a result, the United States will increasingly lose more market share to other international financial capitals.
Eventually, other financial systems will also feel strained by America’s slow but progressive financial dilution.
The United States still plays a vital role in global finance. So it would be naïve to think Dubai or Singapore won’t be affected by another major U.S. financial crisis in the future. That’s why I continue to buy gold. All governments are tied in one form or another to each other as global trade and capital flows have grown increasingly inter-connected. There’s no safe-haven overseas ahead of the next major crisis.
The dollar and other mismanaged currencies are just a bunch of drinks shaken and stirred by a warped bartender. Fiat paper is a poor store of absolute value compared to gold and other tangible assets like oil and gas.
Hedge your future with gold and other hard assets – paper money won’t protect your purchasing power from the upcoming inflationary storm in the United States and eventually, everywhere else.
ERIC ROSEMAN, Investment Director