Hell, Meet Handbasket, Part II

When capital is allocated in a free market, it moves toward the productive, and the economy tends to prosper. By the same token, when it is misallocated, an economy can hit the skids.

We’ve had decades of misallocated capital in the U.S. Instead of saving, we’ve been spending… way beyond our means. Rather than investing in something productive, we’ve been gambling, taking on ever greater risks in the hope of the big payoff. Instead of creating the clean balance sheets that support stability – at all levels, personal, corporate, and governmental – we’ve piled up mountains of unsustainable debt.

The tragedy is that the prudent will suffer right along with the reckless. Misallocations of capital must be unwound, one way or another, before an economy can get back on its feet. It will be no simple task, and it’s made even more difficult by those who put themselves in charge of the clean-up: certain residents of Washington, D.C.

At the center of the storm are two men who propose to save the nation, and they could hardly be more different.

Secretary of the Treasury Henry Paulson is the Street’s guy. The former CEO of Goldman Sachs, the most powerful and successful investment bank, he brings a Wall Street insider’s perspective to the table. However committed to public service he may be, he cannot be expected to act against the interests of his friends in the banking community.

And then there’s Fed Chairman Ben Bernanke, a pure academician. For better or worse, Bernanke’s specialty is America’s Great Depression, and he considers himself an expert on the subject. Above all else, he wants to be remembered as the guy who understood how to steer the country away from the shoals of a Second Great Depression.

There is no question that Big Ben and Hammerin’ Hank are trying to navigate in unfamiliar waters. Today’s economy hardly mirrors that of a decade ago, much less the conditions of the 1930s.

Back in the spring of 2007, as the initial cracks in the structure began to appear, few were expecting the broken-levee crisis that has since unfolded. Savants such as our own Doug Casey and Bud Conrad saw it coming and said so, but no one in the mainstream was listening.

What was actually happening was that the first dominoes – subprime borrowers who should never have been approved – had begun to fall. In and of themselves, they would have been little more than straws in the wind. But because of the multiplier effect of the derivatives market, their influence reached far beyond a few blown mortgages. As more and more debtors were unable to pay, mortgage-backed securities lost value. And then the securities based on the MBSs lost value. And then…

Here’s where CDSs were supposed to ride to the rescue. They didn’t, for the simple reason that they had long since strayed far from their original insurance intent and become primarily an instrument that gave derivatives market players access to an asset class (mortgages) without having to actually own the asset.

As MBS values were hammered by defaults on the underlying loans, buyers of CDS protection began trying to collect. That hit CDS sellers, who were being drained of cash. Further out, derivatives speculators who had bet the wrong way defaulted or went bankrupt, sending shockwaves back down the line. Slowly at first, and then with increasing speed, the capital necessary to keep the system alive started drying up.

Everyone is familiar by now with the institutions that have collapsed or been bought out or taken over by the government. The list of names is stunning: Bear Stearns, Countrywide Credit, MBIA, Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Washington Mutual, Merrill Lynch, Wachovia. Wall Street has undergone a transformation unimaginable a year ago. The big investment banks are gone – bankrupted or swallowed up by someone else. Even the two that remain standing, Goldman and JP Morgan, have had to reinvent themselves as bank holding companies to save their own hides.

The movement of capital among financial institutions is based not only on integrity but on confidence. Right now, that confidence has evaporated. Banks are carrying so much paper of indeterminate value that it’s impossible to price in the risk of making a loan. So they aren’t lending to each other, out of fear that they’ll never get their money back.

The credit market, upon which our economy depends, has seized up.

When the government finally got around to admitting that there was a problem, it was already too late for any simple fix. So Washington had only two options: stand back and let the market sort things out or take drastic, emergency action.

No one knows quite what to make of Washington’s response to the credit crisis. Some are howling that it’s socialism, others that it’s fascism or, at best, corporatism, an unholy alliance of private enterprise and the state.

Whatever the name, there is no question that the government is boldly going where none has gone before, helping to bail out some financial institutions and seizing control of others.

The Treasury Department now has $700 billion – albeit with some strings attached – with which it can buy up toxic waste paper through the Troubled Asset Relief Program (TARP). Taking this direction, instead of making direct loans, allows the “assets” they buy to be resold somewhere down the road. And perhaps, the plan’s defenders say, even at a profit. Like that’s gonna happen.

Proceeding in ways never before tried, in early October the Fed announced it was opening the Commercial Paper Funding Facility. For the first time, it will buy unsecured paper. To facilitate this and to cover potential losses, the Treasury will deposit an unspecified amount at the Fed. This is in addition to the Treasury’s own buying spree, and the Fannie Freddie conservatorship, and the expansion of the FDIC to cover deposits up to $250,000, a move likely to send that agency back to the Treasury for another fill-up.

All the government’s actions to date have accomplished… well, precious little. For the time being, credit remains frozen. Banks are still making overnight loans to other banks, but only very selectively. The stock market, despite coming off its lows, is extremely volatile after enduring its worst crash ever. Commodities have sold off. States and municipalities are facing severe budget cuts and, in some cases, bankruptcy. Money markets are in trouble. Pensions and retirement funds are at risk. And recession, or worse, looms increasingly large on the horizon.

Nor is the crisis purely an American problem. Much of the U.S. bad paper was sold to gullible Europeans, and world economies and markets are so interconnected that if one sneezes, someone else catches a cold. Already there have been big bailouts in Germany and England. The Irish government recently announced it was guaranteeing all bank deposits, which attracted a flood of money from elsewhere in the European Union, enraged other members of the EU, and raised questions of how long that shaky confederation can endure as each country charts its own path through the economic minefield.

This is a once-in-a-lifetime event, a train to nowhere, and it will cause no end of suffering.

Since we can’t stop it, we’ll do the next best thing, which is to protect ourselves. That means assessing the likely fallout from the government’s meddling in the market, and developing guidelines for the best way to ride out the hurricane.

Some consequences are already baked in the cake. Casey Research Chief Economist Bud Conrad has been studying the unfolding crisis for years. Based on his work, this is what we foresee:

  • More financial institutions will collapse. So will many hedge funds. Money market funds are also shaky; although the government will do all it can to keep them solvent, those that invest in anything but Treasury bills are at risk.
  • The economy will fall into recession. By most lights, it’s already here. It won’t be brief, and there is even a chance that despite all the Fed’s pump priming, we could drop into a depression. For however long credit remains tight, business will be unable to function normally, and the consumer-driven economy will grind to a halt.
  • The whole structured finance model under which we’ve been operating is broken. The packaging of mortgages and other forms of consumer debt is impossible when no one will buy the packages. The trillions of dollars of outstanding mortgage derivatives will have to be unwound somehow.
  • Without debt leverage, private equity financing is dead. Raising money for business start-ups or expansion will be extremely challenging. IPOs will be few and far between. Leveraged buyouts are gone. Mergers and acquisitions will mostly be limited to distress sales.
  • At best, the government will succeed at what it’s trying to do, i.e., stave off a depression, by sacrificing the dollar and allowing a fairly high level of inflation. If we’re lucky, it won’t turn into hyperinflation.
  • Interest rates are going up. On the day of the coordinated, worldwide rate cut, the Fed lowered its discount rate by 50 basis points, yet the yield on the 10-year Treasuries rose from 3.5 to 3.7%. The Fed’s credibility is about shot, as it has debased its own balance sheet by swapping good debt for bad. With more than half of its reserves gone, it could itself become the subject of a Treasury Department bailout.
  • It is highly likely that the era of U.S. economic dominance, when the almighty dollar served as the reserve currency of the world, is drawing to a close.

But on the bright side… Well, there is no bright side. The hole that we’ve dug for ourselves will take a while to climb out of, and it won’t be easy. But at least you can protect yourself.

Doug Hornig
Doug Hornig is a senior editor for Casey Research, publishers of Doug Casey's International Speculator... for over 27 years providing investors with unbiased and carefully researched recommendations for high-quality gold and other natural resource stocks with the very real opportunity for a 100% or better gain within a 12-month horizon. Hornig also writes the Daily Resource, a daily column that appears on the KitcoCasey and Casey Research web sites.
Doug Hornig

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