Another One Bites The Dust

Another One Bites The Dust

Anyone who knows me or has read my articles and blog posts knows that I have a contentious relationship with the Wall Street Journal. Their editorial pages can be blatantly right-wing and their articles discussing various investment vehicles and their raison d’etre have been less than accurate. However, an editorial discussing the latest bubble to burst is completely accurate.

The editorial page in October 24, 2008 edition of the Wall Street Journal discusses the bursting of the “other” bubble. That bubble is the oil bubble. As I have been ranting about for approximately nine months, the run up on oil was due to a weak dollar caused by short-term rates, and speculators who used oil as a dollar hedge. Now that the dollar is strengthening (in spite of low rates), oil prices have fallen. Now that being long oil is not a viable speculation strategy, speculators have left the market. Even a decision by OPEC to cut production has had little effect on oil prices. The belief that the price in oil prices was completely due to fundamentals was fostered by pundits who were ill-informed, dishonest or both.

From where was this demand supposed to come? It was supposed to come from developing nations which had allegedly decoupled from the U.S. They allegedly decoupled even though they relied on the U.S. as the primary market for their goods. That is some feat not to be affected by the economy which purchases the majority of one’s goods. It was all bogus. The market was being manipulated by participants looking to foster a self-fulfilling prophecy.

The danger now is that, it appears that the government is trying to re-inflate the bubble, but it doesn’t know how to do it. I am fearful that it will be successful, but judging by recent policies, there is little chance of doing so in the near future. However, it could happen again a few years from now.

The Fed is expected to lower the Fed Funds target rate to 1.00% at next week’s FOMC meeting. I believe this is a desperate attempt to sooth nerves. It will have little economic effect. Why? The problem is that it is too expensive to borrow, but rather that banks are unwilling or (more accurately) unable to lend, at least not like before. Banks are hoarding cash because they know they will have billions more in writedowns. One only need look to Wachovia as evidence. Prior to it being acquired by Wells Fargo, Wachovia had written-down just over $20 billion. After Wachovia had to come clean for the merger, that number of writedowns rose to over $96 billion. That is quite a jump. One must wonder how much the larger players have yet to write-down. It is likely well over $100 billion.

Thus far, the government’s rescue plans have focused on banks not having to take large writedowns. This is like trying to live with cancer instead of removing the malignant growth. The balance sheet malignancies before the banking system can once again be healthy and investors come back to the markets to re-capitalize the banks.

The free market does work. Yesterday, existing home sales unexpectedly rise fueled by buyers purchasing foreclosed properties. This is a good thing. Once the market is permitted to seek its own level, the housing markets will stabilize and the recover can truly begin. If this is all that is needed, why doesn’t government permit this to happen?

There are two reasons, one social and one economic. The social reason is that Americans have been taught that they are entitled to own their own homes. The real estate industry used this belief to convince buyers that it is their right to own, not just a home, but “the” home. There is also a belief in this country that a bank is evil of it forecloses on home. Owning a home is a responsibility, not a right.

The economic reason is that if home foreclosures continue, home prices will continue to decline. Although the market dictates that home prices should decline, the result would be much damage to bank balance sheets and more failures (possibly including larger institutions) would occur. Banks unwisely loaned money to those who could not pay. Some of it was greed, but some of it was mandated by the government. Congress conveniently leaves itself off the list of guilty parties.

Congress is directly to blame for the deepening crisis. By permitting and (in the case of Barney Frank and Chris Dodd) encouraging Treasury Secretary Paulson to wipe out the GSE preferred holders (allegedly to protect taxpayers), the preferred market was killed. This has eliminated banks from raising Tier-1 capital (Tier-1 consists of preferred stock, common stock or deposits) from private investors. Banks have been raising CD rates to attract deposits and investment banks Morgan Stanley and Goldman Sachs have become bank holding companies is desperate attempts to stay afloat. Other banks have purchases their smaller and weaker brethren to gather deposits. It isn’t enough. This is why the government is buying preferred shares of large (and soon to be mid-size banks and insurance companies). If the government had simply backstopped Freddie and Fannie and purged management, without wiping out shareholders, investors and not taxpayers would be recapitalizing banks and the GSEs.

Where do we go from here? We probably go into a major global recession (we are probably already there). Without confidence in the banking system, investors will continue to flock to the safety of U.S treasuries. This will keep long-term rates low and the dollar relatively strong. This will help consumers by keeping food and every prices low. Of course, job losses will also result. Not until investors are willing to recapitalize banks and banks are willing to lend, we will remain in an economic fund or worse.

How is investor confidence to be restored? Banks must come clean as to their writedowns. If a bank will fail as the result, it should be auctioned-off to healthy banks. Home prices can then be permitted to correct. Yes, some home owners will lose their homes, but buyers who can better afford to own these homes will step up. How can banks obtain enough capital which to lend?

PNC’s acquisition of National City can be used as a blueprint. TARP funds can be used to facilitate purchases of weaker banks by stronger banks. That should be the extent of government involvement. Healthier banks, without government ownership, will attract investors. This will permit banks to recapitalize and lend. The government should also reinstate GSE dividends (as stated by former Fed Governor Wayne Angell). The government should admit its mistake and vow never to do so again. Investors would also recapitalize the GSEs, lessening the burden on taxpayers.

There is one problem with all of this. It requires an apolitical approach. Looks like we’re in for nasty weather, I see bad times today.