COMMENT No bottom for flailing financials
By John Browne
In recent months, even the most blindly optimistic forecasters have come to
grips with how United States commercial and investment banks took wildly
imprudent risks that will result in horrific losses. The resulting sell-off in
financial shares has tempted many investors to scoop up these companies at
apparently fire-sale prices. Wise investors should resist the temptation, as
the pain for financials is just getting started.
Although voices of prudence were dismissed at the time, these banks' risks were
leveraged largely through "off-balance sheet" mechanisms that generated massive
financial rewards for the financials while keeping the losses supposedly at
arm’s length. The resulting windfall yielded US$26 billion in bonuses for Wall
Street in 2007.
The tolerance for the risks and leverage was based upon the
widespread belief that real estate prices were set to rise without correction.
We now know that this was a fairy tale.
Soon, gullibility gave way to greed, which soon led to fraud, and the subprime
world was born. It was camouflaged by means of securitization, in the form of
collateralized debt obligations (CDOs), sometimes packaged within triple "A"
bundles. This so-called "toxic waste" was passed on to unsuspecting financial
institutions around the world. The hidden virus infected the entire vast
international financial system. Soon, the credit markets tightened, threatening
first their own financial crisis and then, with their reduced lending ability,
an economic recession.
When the Treasury-Federal Reserve team moved to rescue Bear Stearns and, more
recently, Fannie Mae and Freddy Mac, the $5 trillion-plus burden of risk was
neatly transferred to the American citizen. This week, the Wall Street Journal
commented on Nouriel Roubini, the New York University economist. He aptly
observed that it was "the price of a system that privatizes profit and
socializes losses". People could be excused for protesting strongly against
such political policies as outrageously un-American.
The rescue of Fannie Mae and Freddy Mac, in particular, generated a wave of
buying among the so-called "bargain basement" financial stocks, off some 80%
from their highs. This optimism was based largely on the belief that the
taxpayer would be forced to rescue the banks. But the banks are not the only
financial institutions in trouble. The home lending and credit boom provided a
feast for all manner of other speculations. Credit cards lenders became very
aggressive as did auto lenders and lenders to students. Even businesses
borrowed in order to participate in the great consumer credit boom.
These categories of lending are vast, in sum, amounting to several trillion
dollars. All financials are exposed, but the degree of infection is not yet
fully understood. Soon, even the government must wonder how much more taxpayer
"rescue" the $14 trillion US economy can afford?
As the recession takes hold, borrowers are heading for stringent times,
especially those with large, high-cost credit card debts. Likewise, their
lenders, including many regional banks, are likely to experience massive loan
defaults. Then, there are the insurance companies who have invested much of
their own reserve funds in real estate.
In short, investors should become urgently aware that banks are not the only
financial institutions that will be adversely affected by the severe economic
conditions now looming ahead.
Before being tempted back into buying financial stocks as "bargains", investors
should assess carefully whether or not the government will be able, either
financially or even politically, to extend taxpayer obligations to underwrite
the entire financial industry.
Finally, investors should estimate what the long-term cost of government
support will be in terms of higher taxes and the hyperinflation that will cause
the further debasement of the US dollar. How will they further inhibit future
economic recovery?
While the true extent of the problem is hard to estimate, it is a certainty
that the US dollar is likely to remain under downward pressure. Gold is likely
to experience strong upward pressure as high inflation leads into
hyperinflation and systemic financial risks become increasingly manifest,
offsetting the downward pressures of recession.
John Browne is senior market strategist, Euro Pacific Capital.
(Euro Pacific Capital commentary and market news is available at
http://www.europac.net. It has a free on-line investment newsletter.)
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