| 11 May 2010
Devil Take The Hindmost
For now, our government is being very kind to the companies and participants that make up our financial markets. At least if you are a speculator. The Federal Reserve is exhorting us to speculate, and as long as you are big you can speculate with borrowed money for free, and market participants are enthusiastically going right ahead. Many are telling themselves sweet lies about being chaste investors, not disreputable speculators. We are trying to be a bit of both, but we do not pretend to be blushing innocents.
You prudent savers however are not so lucky, as our overlords at the Federal Reserve are robbing you of hundreds of billions in interest payments. Many are succumbing to the stick of low interest rates for the carrot of seemingly high returns that are likely to be transitory at best. I hope that it will not be disastrous.
I just listened to a commentator on CNBC (it is typically useless to listen) call savers the unintended victim of the low interest policy. Oh contraire! The struggles of savers and pensioners is not a bug, but a feature!
Bernanke’s goal is to punish savers and turn them into speculators and investors, no matter the folly, no matter the cost. We have embarked on a grand experiment in socialism of a peculiar nature.
“From each according to his thrift and prudence, to each according to his role as a banker and speculator.”
-Ben Bernanke’s Inner Marx
Marx was a clever fellow, and while we should avoid his solutions to the problems of his, or any era, we should give credit where credit is due. Marx believed that we capitalists would hang ourselves with rope made up of financial crises. Yep, the grouchy old whiskered one felt that banks (of various stripes) and speculators would game the system until it blew up. His analysis of this was rather spot on and well done.
As pointed out earlier by Mr. Byrd, the problem banks that have “recovered” have only done so by “extending and pretending.” They pretend that problem loans are money good; we pretend not to notice that they are not. The plan? Hope they can earn enough money to pay down the problem loans and only admit they exist when they have enough money to survive. That only works if things do not get bad quickly again. “Works” being a euphemism for allowing the bondholders at these banks to avoid large losses. Whether it “works” for the rest of us is another matter.
By the way, notice I said bank bondholders. Sure, because of the bailout bank executives, traders and others have been able to earn huge bonuses, and shareholders have recovered some of their losses. The real beneficiaries have been bondholders. Had bondholders been forced to take losses, or convert a portion of their bonds to equity, the banks could now be healthy. Therefore, the government penalizes your savings and commits your tax dollars, to make sure that bondholders of large banks do not have to recognize their losses. Please stay away from your pitchforks.
So how does the low interest strategy work? Pay you little, encourage you to speculate and raise the price of stocks and corporate debt. Meanwhile, banks borrow from the fed essentially free, and then lend that amount to our gov-ernment at 3% to 4%. Since banks can borrow and lend out at approximately 10 to 1, they are able to make a huge profit with no risk (10 X 3 = 30 % and so on.) Notice that means they are not lending to people and companies, but the government. Why lend to a small business and take on any risk when you can lend to the government and make huge profits? For this “trade” banks can then reward people huge bonuses for …well not much. Nice work if you can get it.
I however have a question that I have not heard discussed a lot, much less answered. With banks having bought huge amounts of government debt at low interest rates, what happens if interest rates rise? For you and me, if we buy a bond and interest rates rise we suffer losses. So, whither banks?
This has been part of the issue in Japan, and has led to deflation. Every time growth picks up and interest rates start to rise, and possibly inflation, credit dries up because banks and other financial institutions stuffed with low yielding government bonds feel stress, snuffing out growth in the cradle. Thus massive government spending leads not to price inflation, but deflation (for about 20 years and counting.) That is, until it does not. If the inflation genie ever does get out of the bottle, Japan risks hyperinflation. If Japanese bondholders decide not to hold bonds that yield less than 2% the game will be up.
We are a long way from Japan at this point, and I do not mean to imply that is our fate (though I would not totally discount it either.) I bring this up to point out that buying bonds instead of making loans does carry risks for banks and our economy at some point besides the obvious problem of lack of credit for smaller businesses. I do not know the endgame here, if there is one. The economic community as a whole does not seem to know either, the operative policy response seems to be kicking the issues down the road and work through it. That may be best, but it hardly provides any real basis for optimism.
Who cares? Markets are up, profits are rising, Gentleman Ben will keep the monetary floodgates open.
Whether it makes sense is another matter. Markets are overpriced. Even if the economy grows smartly and inflation (or deflation) avoided, we are likely to have another ten years of low returns. As usual, the economy may help us identify risks, but the ultimate driver is still the price you pay.
That is not a surprise. The great secular (long-term) bear markets started from strenuously overvalued markets and lasted about 16 years on average. Given the last decade (and the current secular bear market) started from the most expensive height in market history, to expect we would get off any better than that is probably asking too much. I briefly thought we might get there in 2009. Just a little further down, followed by fits and starts for about a year and we might have gotten cheap enough and stayed down long enough for a sustainable bull market to begin. No such luck. We got down to pretty darn cheap, but nothing spectacular, followed by a flashy rally that brought us right back to overvalued, though not spectacularly so. So close, but no dice.
Nope, Bernanke is determined to live up to the markets notion that every time we crash and burn the Federal Reserve (and now the EU has joined the party big time) will be there to bail us out with a stunning recovery where the more speculative you are the more money you make. From investing legend Jeremy Grantham (pdf):
Still, it does seem inefficient for the Fed to help us up and then lead us off the cliff again. And to do it twice seems like sadism. And for us to play the game once more seems like lining up behind hot stoves and begging, “Please, can I burn my hand a third time?” Investors used to be more pain averse. It used to be “once bitten, twice shy.” This time, surely it should be “twice bitten, once bloody shy!” The key shift seems to be the confidence we now have in Bernanke’s soldiering on with low rates and moral hazard to the bitter end, if necessary, cliff or no cliff. The concept of moral hazard has changed. It used to be a vague expression of intent: “If anything goes wrong, I will help you if I can.” It seems to have been transmuted into a cast-iron commitment. The Fed seems to be pledging that it will bail us out after every flood. All that is lacking is a rainbow!
We expect the market has further to run, though the risks are many. We expect inflation for now to remain subdued, though longer term is another matter. The longer-term outlook for the various stock markets is awfully boring and dis-appointing, though it is likely not going to be boring in getting us there.
