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 [1]) 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 [2] and the budgetary deficit – excluding supplement spending for the war – is estimated at $400 billion. The Congressional Budget Office (CBO [3]) 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 [4] 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 [5] 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 [6] 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 [7] 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 [8]