SPEAKING FREELY False signs of the end
By Ronald Solberg
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The big news in July was the taxpayer bailout of Fannie and Freddie. This is
meant to help the US housing market since, in the past several months, these
two institutions have essentially single-handedly kept any semblance of a
normal mortgage origination market operating. In and of itself, this is a good
thing. However, it remains debatable whether these institutions perform
an ongoing useful purpose in a normal market, not to mention the moral issue of
privatizing gains and nationalizing losses.
While this bailout has stemmed the horrible prospect of their imminent
illiquidity and default, they remain technically insolvent and will need to be
re-capitalized. Will this too be the taxpayer or the hapless foreign investor;
the two chronic bag holders? Treasury Secretary Henry Paulsen claims only US$25
billion of taxpayer money may be needed, if that, but the ultimate bill is
likely to exceed four or more times that amount .
Ultimately, were the US federal government forced to explicitly guarantee their
debt (as a matter of foreign policy since a huge portion is owned by foreign
governments and banks), the United States ratio of debt to GDP would virtually
double overnight, likely putting pressure on the spreads of US credit default
swaps and perhaps even lowering the country's sovereign AAA rating.
Even if this worst-case scenario for Fannie and Freddie is avoided, this
bailout means ever more US dollars awash in the global financial system that
increasingly investors are loath to hold (setting up prospects for further US
dollar weakness) and commodity price inflation.
The bailout of these now essentially public institutions helped ignite a rally
in US equities that now has held these gains through month end. Optimism waxes
eternal. Of course, other events have helped to buoy the market, including the
extension of the expiry date of the special Fed credit window through January
2009, the Securities and Exchange Commission's prohibition of naked short
selling of major financial institutions, and the $20 per barrel decline in oil
Outperforming sectors included financials, airlines, consumer discretionary, IT
and health care. Taking this price action at face value would suggest investors
believe the worst is over and that the economy (and stocks) are re-establishing
their foundation. But do not believe it. Here's why.
Merrill Lynch recently announced a second-quarter loss of nearly $5 billion,
involving an asset write-down of nearly twice that, with the chief executive
stating on July 17, "Right now we believe we are in a very comfortable spot in
terms of our capital". Although senior management claimed they had aggressively
marked down assets, reserved against bad loans and taken sufficient write-offs
in the second quarter, this shocking earnings report was followed a mere two
weeks later with the news that Merrill will be taking another huge write-down -
US$5.7 billion for the third quarter as it unloads huge amounts of risky debt,
and will also raise $8.5 billion by selling new stock. Can the CEO's statements
hold any credibility?
Globally, banks have written off somewhere between $450 billion and $500
billion in bad assets over the past year or so. The ultimate problem could be
twice that size, if not more. Moreover, bank capital will need to be
replenished over and over again. Which investors repeatedly will step up to do
this? Singapore's Temasek replenished Merrill Lynch in January only to see
their investment halve in value. They stumped up again for the banks this month
on the provision that Merrill made good on the first loss. There is unlikely to
be unlimited goodwill from global investors to re-capitalize global banking
without more transparency of asset quality.
Moreover, the current situation is not static. There are three aspects to this
evolving scenario, each involving feedback loops (harmonic frequencies) of
varying levels of intensity and time frames: financial stress; economic
consequences to the real economy, including the potential for policy errors;
and the erosion of business contracts amongst private stakeholders and even
more gravely to the undermining of the Social Contract.
US mortgage asset quality continues to deteriorate not least of which due to
monthly mortgage interest rate resets continuing to accelerate through year-end
2008. They are scheduled to continue to increase into 2009 but, by then, at a
decelerating pace. US housing prices on average have fallen nearly 16% year on
year and show no sign of abating. The Fannie/Freddie bailout is unlikely to
keep house price deflation at bay.
The dire condition of the banks suggests that their willingness and ability to
lend will constrict further, putting even greater pressure on the economy. As
the economy slows and consumers increasingly retrench on spending due to the
imminent need to save, asset quality problems for banks will spread to other
products, including credit card delinquencies, auto loans, home equity loans,
student loans and commercial real estate.
It is also likely that there will be a substantial up-tick in delinquencies on
corporate, municipal and state bonds as companies, cities and states alike find
that large and growing deficits cannot be solved merely by expenditure
reduction and tax hikes. We are in the midst of a profound, secular debt
de-leveraging cycle for which cyclical policy adjustments will struggle to
Paulsen and Federal Reserve chairman Ben Bernanke have clearly shown their
hand: they will throw as much money as needed to support any major financial
institution (or perhaps even markets themselves). However, their balance sheets
are not limitless either and debt monetization may ultimately occur. This
policy response would have enormous consequences, ranging from huge moral
hazard risks, incipient inflation, increasing regulation, misallocation of
resources and higher taxation.
The woeful American middle-class will have a steep price to pay for these
largely unquestioned and autonomously imposed policies that bailout the fallout
from Wall Street's greed, avarice and the gross regulatory mis-management by
the Federal Reserve over the past two decades. A secular decline in the
standard of living of the American middle class is a very likely prospect
resulting from increased taxation, inflation and perhaps even the loss of
seniorage from the diminished prospects for the US dollar as the world's
reserve currency. Will anyone be held accountable? Not if circus, obfuscation
and deflection continue to prevail.
Of course, it remains plausible that policymakers could be bailed out by a
resurgence of animal spirits. Benchmark securities such as ABX and CDX indices
may be oversold, and to the extent all level-3 (or mark to model) assets are
based off of these, there exists the possibility of a sharp short-covering
(sustainable) rally with risky assets experiencing explosive appreciation. This
dynamic would be further supported if cash on the sidelines (such as sovereign
wealth funds) gets involved. In this scenario, those investors with access to
high return to expertise (those organizations that can identify "real value")
will profit handsomely. Newly launched funds with no legacy problems would be
best positioned for success.
Nevertheless, it seems more probable, likely sooner rather than later, that US
bonds, equity and currency markets will react badly to this indiscriminate use
of liquidity to bail out the past excesses of Wall Street and the Fed's prior
neglect of mortgage fraud and loan pushing. The US Treasury curve is likely to
steepen much more than the current 140 basis point spread between two-year and
10-year US Treasuries.
As investors balk at the copious new supply of long-term US Treasury notes and
bonds, the 10-year yield is likely to approach double digits. Despite higher
rates, it remains plausible that the US dollar would continue to decline under
the weight of falling US asset markets, foreign-investor portfolios sated with
US-denominated assets and the final capitulation of foreign governments on
their exchange-rate regimes as they abandon their US dollar pegs to ease
All of this suggests a long and painful US recession that we are only just
beginning. Of course, America will survive this and ultimately begin another
expansion several years out. However, she will likely do so as a smaller
economy with a reduced role in the global financial and commercial markets.
Note 1. Thanks to John P Hussman, president, Hussman Investment
Trust for this analysis. Please refer to Bagehot's Rule and the Cost of Being
"Technically Insolvent" on his website http://www.hussmanfunds.com/ for more
Dr Ronald Solberg is vice chairman and lead portfolio manager of Armored
Wolf, an alternative real assets hedge fund and principal at Viking Asset
Management, a California-based Registered Investment Advisor.