Ben Bernanke's doctoral thesis at Princeton was about the Great Depression and he concluded that the Fed acted too slowly and did too little to stop the Depression.
I thought he reacted too slowly when the credit crisis first began in July 2007. In the November 2006 issue of the Acamar Journal, I predicted a recession and called for investors to be defensive.
Bernanke did not seem to realise quickly enough that he needed to be aggressive. He does now, and has taken bold and unprecedented steps recently.
In recent days, he has injected $ 200 billion into the economy, and accepted housing debt as collateral in order to inject another $ 200 billion. He had worked with the major Central Banks to provide a coordinated policy response.
Regardless, the credit crisis is beyond the ability of the Federal Reserve or the US Government to control. The US is in recession and the US dollar will continue to fall as interest rates are cut. We already have negative real interest rates in the US.
It remains to be seen if Europe and Asia can continue their growth in the face of a US recession, but we are in for increasingly turbulent times. That is now apparent to all.
The crisis has been called a sub-prime crisis, which led to a liquidity crunch. But it is really a debt crisis involving the entire mortgage industry, bond re-insurers, credit card debt, corporate debt, etc.
Total credit market debt in the US has reached all-time highs. While the US economy is about $ 14 trillion, total outstanding derivatives total $ 516 trillion (Warren Buffett has called derivatives "weapons of mass destruction"). The prosperity created in recent years was simply not real or sustainable, it was financial engineering run amok. Real work was shipped to China and India while investment bankers in the West created wealth out of thin air, using leverage like a magician uses sleight of hand during magic tricks to dazzle the audience. Well, the party is over and the effects of de-leveraging will be very painful.
Ironically, after the great housing bubble in the US, the percentage of homeowner equity is at its lowest level since 1945, millions stand to lose their homes and the global economy has been put at risk.
This era of prosperity was driven largely by debt creation and unrealistic asset inflation, stimulated by Alan Greenspan's Fed. Greenspan is attributing the current crisis to everyone but his own actions, but history will not judge him kindly.
At a speech to the Independent Community Bankers of America last week, Bernanke asked the bankers to consider reducing the principal on mortgages where the homeowner can't make payments.
His argument: the bank would lose a large part of the principal anyway in foreclosure situations, which are bad for the economy as foreclosures lead to declining housing prices.
I must admit I was stunned by this. The $ 160 billion economic stimulus package announced earlier was already a travesty of free market economics. This involves the mailing out of free cheques to households (including non-taxpayers) in order to get people to spend money on consumption. The fact that this stimulus would have to be debt-financed by the US government (i.e. foreign lenders are paying for this bailout) is ironic but irrelevant under the circumstances.
But asking banks to voluntarily reduce loan amounts? What about people who'd acted responsibly and paid their debts on time? What about the likelihood of a mass of class action lawsuits from investors who had funded these mortgages?
But Bernanke has had his hand forced. 60% of the $6 trillion US housing market is underwritten by Government Sponsored Enterprises (GSEs or Chartered Agencies), primarily the Federal Home Loan and Mortgage Corporation and the Federal National Mortgage Association (wholesomely known as Freddie Mac and Fannie Mae).
While these are listed companies operating under a Federal Charter, there is an implicit government guarantee underlying their balance sheets. As at Dec end, Fannie Mae had core capital of $45.4 billion, or $3.9 billion more than the minimum required, while Freddie Mac's core capital of $37.9 billion, $3.5 billion over its minimum.
However, Freddie Mac's share price dropped 19% in a single day on Monday, March 10 on rumours of capital inadequacy.
Were either of these behemoths to go under, the US government would end up having to underwrite hundreds of billions (or more) in housing debt defaults and new loans, not to mention a systemic financial crisis. Better to coax the private banks to do it on its behalf!
These steps by Bernanke show that the financial system is under severe duress. The Fed is now growing money supply at an estimated rate of over 15% per annum.
It is risking the destruction of the US dollar and serious inflation in coming years in order to save the economy now.
How did it come to this?
Largely, it is the result of Alan Greenspan creating too much easy money (having sent interest rates to their lowest levels in 45 years following 9/11 and holding them there for too long) and as a result of risk being transferred from traditional players to newcomers (hedge funds) with a voracious appetite for higher yields.
Firstly, all of the investment banks on Wall Street (which used to be partnerships) went public over the last decade or so.
In a partnership, all losses are the responsibility of the partners. So, the partners in a business are very careful not to assume undue risk and act prudently when considering risk-reward tradeoffs.
But, when the Wall Street banks went public, the partners cashed out big-time and risk shifted to shareholders. As a result, Wall Street's business model changed. The investment banks began to assume more risk through proprietary trading and structured finance.
Transference of risks in the mortgage industry changed as well. In the old days, someone who wanted to buy a house would apply to his local bank for a loan. As the bank was lending its own money, it prudently checked the borrower's credit rating, income and ensured that the borrower had the capacity to make regular mortgage payments.
With the repeal of the Glass-Steagall Act in 1999, Wall Street was able to get into the act. Now, commercial banks and mortgage companies simply wrote mortgages for an origination fee and sold them to Wall Street banks.
Since the banks were selling the mortgages to Wall Street, they were not assuming any risk. To move volume, traditional lending standards were abandoned and, for high risk ('sub-prime') lenders, banks provided no-documentation loans, which meant they made no effort to verify the lenders' income or ability to repay the loans!
Innovative, high-risk products designed to increase mortgage volumes at all costs were introduced, which included no money down loans and reverse amortization loans (which meant that if your mortgage payment was more than you could pay, the balance was added to your original loan amount, steadily increasing your principal!!).
Wall Street bought bundles of loans, ranging in credit quality from AAA to sub-prime. Then financial engineering came into play. They took the worst quality loans to bond re-insurers, like ACA and Ambac, and for a fee, got them to guarantee repayment of the bond in the case of a default (sexily known as a "credit default swap").
This was simply a scam. Monoline insurer, Ambac, at its peak, had a capital of only $ 5.7 billion but it issued loan guarantees to the tune of $ 550 billion!
The credit agencies (such as Moody's) then blessed such sub-prime junk debt as AAA or BBB, based on the credit ratings of the bond insurers. The credit agencies were being paid by Wall Street, and so they played ball
All pension and many hedge funds are not allowed by mandate to buy debt rated as less than A.
But, with these dubious guarantees in place, Wall Street was able to peddle sub-prime junk dressed up as A+ quality debt to pension and hedge funds. This was simply a disaster waiting to happen.
With mortgage default rates now rising sharply, the value of the mortgaged backed securities has plunged. Turns out that the bond re-insurers have only a fraction of the capital actually needed to have genuinely guaranteed the bonds and their own credit ratings are being revised downwards.
The similar story applies for other securitised debt (credit cards, car loans, etc.).
The net result of all this risk-transference: Global banks will probably have to write-down in excess of $ 1 trillion in assets, Wall Streets banks have reported gigantic losses (Morgan Stanley had its first loss in 93 years), home foreclosures are at record levels, stock and real estate markets are falling and a nasty recession lies ahead as jobs are being lost.
Read the story about a Hong Kong based investment bank projecting a gold price of $ 3,400 per ounce in a recent issue of the Acamar Journal at www.AcamarOnline.com!
In January 2006, when gold was around $ 550, French investment bank Cheuvreux came out with a research report projecting a mid-cycle price of gold of $ 900 by 2009. I reported this in the March 2006 issue of the Acamar Journal.
The report was barely noticed and people I talked with did not really believe gold could reach such lofty targets. One guy I know, who used to be a gold trader in Saudi Arabia, was very skeptical and told me he was warning people about gold going back down to $ 250.
Well, gold got to $ 988 in February 2008, a year before Cheuvreux's prediction.
This is an all-time high for gold, breaking its earlier high of $ 875, set in Jan 1980.
Interestingly, CLSA, an investment bank based in Hong Kong, issued a research report from its Chief Strategist, Christopher Wood, calling for gold to rise up to $ 3,400 in 3 years.
This is, of course, a high in nominal price terms. If we adjust for inflation, gold would have to be above $ 2,200 to have reached its all-time high in real terms.
Nevertheless, the game has now changed. The Fed had a very unusual, large interest rate cut between its normal meetings as it desperately tries to keep equity markets from melting down and to prevent a recession (now forecast by Morgan Stanley, Merrill Lynch and Goldman Sachs). This will continue to hammer the US $ downwards, which has also broken below its multi-decade low of 78.20 on the US Dollar Index. There is now no obvious long-term support that the US dollar can rely on.
The weakness in the US$ undercuts its status as a reserve asset, and with gold having been money for at least 3,500 years, its status as de facto money is growing. Demand for gold is growing dramatically because it is seen as:
Gold is now effectively the world's third most prominent currency, after the US$ and the Euro.
It has been investment demand for gold that has taken it from $ 750 to over $ 980 in three months.
What has been interesting to see is how the largest gold Exchange Traded Fund (ETF), the StreetTracks Gold Shares (Symbol: GLD) has performed since the sub-prime crisis began.
What is remarkable is the GLD began in November 2004, and held no gold at inception. In just over 3 years, it has become the 8th largest holder of physical gold in the world (ahead of China and the European Central Bank!).
The chart below plots the US Dollar Index (blue line) against the actual holdings of gold in the gold ETF (green line) in the last few months:
A couple of things to note are:
China just launched its gold futures exchange, whose performance in the first few days has wildly exceeded expectations. ETFs are now being launched in Dubai and India. Demand for physical gold in India is up 72% from last year, despite muted jewelry sales due to high gold prices
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