And The Prudent Shall Survive

And The Prudent Shall Survive

By John Browne | 6 September 2008

Though few may have noticed, the past few weeks may be regarded as a global economic turning point. Evidence is mounting that the United States is entering a recession, with increasing signs that it could morph into a depression. While the George W Bush administration appears resigned to bail out or nationalize large tracts of American commerce, the presidential candidates drift towards Great Society era spending proposals. At the same time, America's principal economic rivals appear to be charting courses that are not in line with US interests. The Russian invasion of Georgia has revived tensions that have not been seen since the most frigid periods of the Cold War. With the Olympic Games over, China can relax and now exert its muscle without risking any politically motivated boycotts. Between them, these global players hold well over US$1 trillion, or 10%, of US government debt, which they can use as leverage in any strategic, economic or political confrontation with the US. There is also evidence that America's economic power is waning even in our own back yard. This week, Honduras, a traditional US ally in Central America, announced that it was throwing its lot in with a Latin American trade bloc dominated by Venezuela and Cuba.

For two years I have warned readers of a severe, real-estate led recession and encouraged extreme asset allocations to cash, particularly short-term, hard currency government bonds, and gold. Last year, I urged short positions in financials and US stock markets. Some ridiculed me. The financials are currently down some 84%. Apparently, the real-estate crash is biting deeper than just about any market "expert" had imagined.

The size of the problem is enormous. A fall of just 20% in US house values, (which is confirmed by the latest Case-Shiller data release) wipes almost $5 trillion from the wealth of American consumers and businesses. This amounts to more than one third of America's GDP and half of the total US government debt! How could the fallout be anything less than systemic?

Imprudent lending behavior, inspired by the housing boom, placed the security of banks depositors and shareholders at undisclosed and unprecedented risk. The banking problem is so large that failures cannot be allowed. The government has bent rules regarding financial reporting and the Fed's lending criteria to keep the financial ship afloat.

The main focus for now is on government sponsored lenders Fannie Mae and Freddie Mac, who are now understood to be hopelessly undercapitalized. Despite the complete predictability of this outcome, even conservative investors, including many banks, had been persuaded that securities issued by both Fanny Mae and Freddie Mac were risk free. And although shareholders for both entities are likely to be wiped out, corporate bond holders and those individuals and financial institutions who hold mortgages backed by both the government-sponsored enterprises correctly assume that the government will back their assets. However, hundreds of billions, perhaps trillions, of federal dollars will be needed to make whole all who foolishly loaded up on Fannie and Freddie debt. Unfortunately, the Federal cupboards are bare.

This week, the Federal Deposit Insurance Corporation (FDIC) announced that its problem list had increased to 117 banks from 90. Worse still, the FDIC announced that its fund had fallen below its legal deposit ratio, forcing it to increase its levy on member banks. This, just when the net income of its member banks, in desperate need of retained earnings, has fallen by some 86%. As more banks begin to fail, the ultimate cost to the Federal balance sheet is hard to imagine.

But, as the old saying goes, "What's good for the goose is good for the gander". So, if government financial favors are granted to reckless investment firms (Bear Stearns) and now mortgage borrowers, what about other economically vital "multiplier" industries such as automakers, airlines, credit card and insurance companies and even corporate real-estate lenders? The logical conclusion for this current drift is hyperinflation. In order to make good on its promises the federal government will have to resort to the printing press ... with a vengeance.

With America facing severe recession, many regions around the world will suffer. So who will suffer least? Nations that have run relatively prudent economic policies and those who produce goods required even in an economically depressed world will continue to prosper increasingly, relative to the US. The differential may become magnified as America's government hyperinflates. Investors will then increasingly dump dollar paper assets and buy hard currencies, government bonds of producer nations and gold. Investors ahead of this depression curve will likely suffer least.

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Normxxx    
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