Saturday, December 22, 2007

Connecting the Dots on the Subprime Mortgage Freeze and the Global Liquidity Bubble

22 December 2007

In reading today’s print version of the Wall Street Journal, I happened to take in the primary front-page story, “Banks Abandon Effort to Set Up Big Rescue Fund” (sorry, I have no online link for this story).

In brief, the story explains that the large US commercial banks no longer require a Federal Government Structured Investment Vehicle (SIV) to rescue their off-balance-sheet toxic mortgage debt, due to the intervention of offshore sovereign funds (the most recent case being Singapore’s $5 billion reinvestment of US funds in Merrill Lynch – in this case an investment bank).

OK, let’s deconstruct this. What is taking place here?

First, Asian and Middle Eastern governments are holding more US dollars than they know what to do with, so seeming fire-sale prices on US banks in trouble may be at least a temporarily attractive place to unload excess US dollars (the current most-favoured option being short-term US government bonds, the rush to which in recent weeks has caused the interest rate on these short-term money market vehicles to fall on the order of 2%).

This latest development has pulled the banks out of the hottest water, at least for now. The script being played is that of past rescue efforts, such as the Asian currency collapse of 1987, and the LTCM rescue of 1998. The idea is that the problem may not be as bad as it now seems, so these international cash infusions may pay off handsomely in the long term, and perhaps even in the short term.

Second, the government-sponsored fund was only going to buy the best slices of the “toxic” mortgage debt, leaving the banks still holding the least desirable and most unmarketable tranches. Thus, the rescue would only relieve the banks of the best part of their worst commercial paper. Therefore, the banks are biting the bullet, returning the questionable stuff to their balance sheets, and declaring so far only moderate losses.

Here, the assumption is that the subprime contagion won't get worse, for example, spreading to Alt-A mortgages, or even to supposedly higher quality mortgage paper taken out by higher-income real estate holders who may have over-leveraged themselves in response to low interest rates and the only recently-ended climate of relentlessly gushing liquidity.

However, news article after news article continues to reference the fact that bank-to-bank liquidity is still “frozen,” as the banks are now “on” to each other’s game – that is, the maneuver of selling high-interest debt as a “premium” investment vehicle.

So long as it remains difficult to pry new money loose from the mortgage originators, the possibility remains that the mortgage contagion could spread far further than is presently being discussed. This looming development could potentially undermine the quality of mortgage-backed securities at all levels, including those that are presently considered most marketable.

So now we come to the third issue, which so far I have not seen covered in the mainstream financial press.

This is the place where we will attempt to connect a few additional dots.

So far, the only solution being discussed to the liquidity freeze at the consumer mortgage level is to freeze interest rates as well.

Now, tell me if I'm misunderstanding something about how the financial system works here, but….

Let’s just say that the problem is a little bit bigger than unrecoverable subprime mortgage payments, which it almost certainly is. And let’s surmise that continued solution-thinking may not extend too far beyond the current rate freeze idea (which doesn't apply to all mortgage servicers in the first place, anyway).

What again was the main idea of originating this toxic financial waste in the first place?

Yes, you’ve got it. The idea was to sell a product that would generate higher interest rates for end-market investors.

And, why was that necessary?

Again, because liquidity-addicted governments and financial markets have created a long-term financial climate in which saving money at market interest rates is a losing game.

Interest rates are held artificially low due to a continuous stream of central bank money creation. Inflation statistics are massaged to the point of unrecognizability in order to keep the game going, and dividends and interest payments have diminished to a mere fragment of their past importance, punishing savers and citizens on fixed incomes.

For many years, the only way to create increased wealth has been through the appreciation of asset values. This is based on the idea that the next purchaser will pay more for the assets you hold than you paid at the time that you acquired them.

This is the game that is drawing into its final chapter, at least in the current phase of the multi-decade (post-World War II) liquidity-creation game.

Yes, this is the environment where investors and savers have been forced to take on ever-increasing risk in order to stay ahead of the government and central bank liquidity game. So the recently-popular, low-quality, nominally high-interest mortgage products resulting from so-called “financial innovation” are now going to have their interest rates frozen. Mortgage payers will no longer be required to increase their monthly payments to service their planned “post-teaser” higher interest rates.

What then happens to the end-market investors who are holding these supposedly higher-interest-paying investment products?

Well, the most obvious outcome is that no matter what happens, these investors will now no longer be compensated for the increased risk that they have taken on in return for expected higher interest incomes. That is, the fix for the strapped borrowers will once again punish the somewhat desperate investors who parted with their own savings in order to finance these supposedly higher-interest products.

That is, strapped savers and investors now have one less option to recover interest rates high enough to compensate them for the raging inflation in asset prices that has been created in the most recent chapter of the international liquidity game.

The current government and central bank-sponsored rescue plan comes to the aid of the irresponsible and the unforesightful, and once again punishes the group who have already been receiving most of the punishment administered by the liquidity creators – even their premium (higher) interest rate investments are being taken away from them as the US government casts out a lifebuoy to irresponsible or unwary borrowers at their expense.

In fact, this so-called rescue effort doesn't really aid the strapped borrowers (who will face rising debt obligations against declining asset values), or the lenders (who once again will be unable to secure returns on savings and investments sufficient to compensate them for the mounting ravages of inflation).

The rescue effort does, however, pull the commercial and investment banks and other low-quality mortgage originators out of their current jam – at least for now.

So now, what do we foresee?

Borrowers with mounting debts and with payments now set at the maximum they can afford are unlikely to be big spenders in the consumer marketplace.

Further, lenders (savers and investors) who cannot obtain sufficient income to compensate them for elevated risk or raging inflation will remain in a very tight corner. They will certainly have no surplus funds to pass on to the consumer marketplace.

If this is how it is now, then how can there have been a US-led economic boom over the past 4-5 years?

This question isn't too difficult to answer, even for a thinker so naïve as myself (I am certainly not a financial professional, just a saver/investor trying to figure out how to set aside sufficient funds for a secure retirement, as are most of my compatriots in this global liquidity “game”).

The major flow of “free” funds into the financial marketplace has resulted from the various fees that are charged by investment managers (in particular the big investment banks) to create the so-called “financially innovative products” (an
Alan Greenspan phrase) which have driven the financial asset bubble of the past two decades or more.

With every mortgage-backed security, collateralized debt obligation, structured investment vehicle, corporate acquisition, corporate bond issue, reprivatisation, corporate takeover, share buyback and corporate consolidation, the professional investment community has been able to create a new vehicle for increased income flow. (By the way,
John Mauldin has explained this all very well in a series of articles on

From the internet bubble of the 1990s through the real estate bubble of the 2000s, the professional investment community has been able to generate massive and ever-increasing fee income. This source of (entirely unproductive but absolutely massive and perhaps ultimately incomprehensible) revenue has fuelled the consumer-driven boom of the past 2 or more decades – particularly at the luxury end, accounting both for the widening disparity between the rich and the poor in the so-called capitalistic economies (this phenomenon has nothing whatsoever to do with free-market capitalism by the way, but with short-sighted and self-centred central bank, government and financial industry collusion), and the boom in the creation, sale and value of assets at the luxury end of the spectrum in particular (read any issue of the
Robb Report to get a taste of where this trend has taken us).

As I have mentioned previously,
Austrian economics makes clear that excess financial liquidity, generated by escalating government spending and irresponsible central bank practices, inevitably results in capital misallocation – that is – the excess flow of money always goes to the “wrong” places – to locations where less and less value is created while more and more “paper” wealth evanescently explodes outwards in inevitable financial booms, followed by ineluctable financial collapses.

The basic rule is, the bigger the bubble, the bigger the crash.

But remember, the primary point of my blog today is this – the new government/central bank/commercial bank/investment bank-sponsored rescue scheme is just one more manifestation of the inevitable punishment of savers and investors in the
largest financial bubble in world history, of which the main beneficiaries have so far been those who can charge fees for the rearrangement of financial assets.

Let me make clear, this development, which has grown to previously unimagined proportions over the past decade, is not capitalism. It is a manifestation of a partnership of big (financial) business and government to manipulate and exploit the flexibility of free markets.

It will only be the collapse of this massive financial bubble which will return true freedom to our markets. At this point, the piper will be paid, and today’s winners will become tomorrow’s (over-extended) losers.

If you are a small player in this global liquidity game, how can you enter the game so as not to be punished?

There is literally only one safe course I know of.

When financial assets deteriorate in quality, as is most transparently the case today, precious metals in all cases return to favour.

Interestingly, the one secure investment which resolves a game in which reasonable interest premiums on conservative investments are nowhere to be found is the oldest investment product, and the ultimate non-interest-paying investment: gold, silver and other precious metals.

Can’t get sufficient interest or dividends on your savings?

I've got an answer for you.

Take no interest or dividends at all.

Buy and hold gold, silver, precious metals generally, and shares in the mining companies that produce them.

In today’s savings and investment environment, precious metals are the only investment product that offer a secure store of value. And, paradoxically, even with gold presently stable at a near-record high $800 US per ounce, this ultimate store of value remains dramatically undervalued.

Why is that?

The past two decades have created a climate in which financial paper and other forms of financial assets have been accorded excessive value, on the assumption that continued government and central bank-originated liquidity flows would fix “every” financial problem.

Well, today's financial problem is that liquidity (read “easily-available loaned money”) has simply stopped working to repair the widening financial damage resulting from the relentless punishment of savings for 2 decades or longer.

The tables have already turned.

If you think $800 gold is pricey, think again.

Gold will be worth thousands of dollars per ounce before the last chapter of the current global liquidity game has been played out.

Gold has been a great investment since 2001. It is a great investment at today’s prices. And it will be a great investment for years and perhaps decades to come (if finding long-term value is your true investment interest).

There is a millennia-old answer to the complex financial problems created by today’s so-called “innovative” and ever more complex financial products. Simply stop playing the game of financial innovation, and return to holding a secure and tangible asset which never loses value in times of financial insecurity.

Don't think in terms of interest, dividends, or even capital appreciation. Consider one factor only – value.

Gold works now, has worked for thousands of years, and will continue to work for thousands of years to come. It is not an archaic relic but the ultimate store of value.

Value is not easily found.

My advice, take value where and when you can. Take gold as your guide, companion and friend through the global liquidity game.

1 comment:

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