`Despite the pleas from bankers and politicians, mortgages are not plagued by a lack of liquidity but a lack of value. If sellers would be more negotiable, there would be plenty of liquidity. Who knows, at the right price I might even buy a few. The problem is that putting a market price on these assets would render most financial institutions insolvent, which is precisely why they do not want to let that happen. Simply pretending that all these mortgages will be repaid does not solve the underlying problems. It may keep some banks alive longer, but when they ultimately do fail, the losses will be that much greater. In the meantime, solvent institutions are deprived of capital as more funds are funneled into insolvent "too big to fail" institutions - hiding their toxic assets behind rosy assumptions and phony marks.” Peter Schiff, Let's Play Pretend!
As we have discussed last week in Expect A Different Inflationary Environment, we don’t believe that the US financial markets will see a renaissance during this inflationary episode nor do we believe it will lead the market out of the present bear market rut.
The stiff regulations to be imposed on the industry will be one major factor why. In addition, the G20 summit has equally accentuated the political demand to do so. Mass leverage from the system of 30 or 40 or 50 to 1 won’t be seeing the light.
Today’s leverage will mainly come from the global governments or if fortunate enough Emerging Markets or Asia whose credit system has been unimpaired from the recent crisis.
Moreover, as we discussed in Why Geither's Toxic Asset Program Won't Float spreading recessionary strains will further vitiate on the financial positions of banks, this percolating from the largest concentrated banks to regional banks.
While the recent changes in the FASB accounting standards may temporarily help alleviate the pressures to redress the balance sheets, it is unlikely for US banks to normalize the lending process in the possible understanding that gains from the overleveraged households and the financial sector may not be large enough to offset the risks of potential losses.
Next, there are regulatory concerns. The fact that the rules of the game are being changed daily and where a political backlash by the public on Wall Street has combined to turn off potential investors interests into participating in government sponsored programs.
Moreover there are major concerns like asset quality and the price discovery from the toxic assets which includes the gigantic credit default swap market and other forms of derivatives as the interest rate swap.
The issue of price discovery isn’t a figment of anyone’s imagination. The fact that bid and ask can’t meet into a voluntary exchange means that this isn’t a liquidity problem but a valuations problem. Why? To be sure, this isn’t a market failure for the simple fact that incentives driving the financial sector have been totally severely distorted by excessive government intervention, moral hazard issues, and or the bailout mentality.
Simon Nixon of Wall Street Journal hit the nail in the head with this poignant commentary (all bold highlights mine), ``In a capitalist system, prices are set in the free market and providers of capital bear responsibility for their losses. Neither of these characteristics hold true of the banking system. The price of credit, the basic commodity of the financial system, was distorted first by implicit government guarantees to depositors and other providers of capital, and second by the tendency of governments to cut interest rates at the first sign of financial trouble.
``Financial theory says the cost of capital to an enterprise should rise in line with risk. But banks during the boom were able to leverage themselves more than 50 times yet see their cost of funding fall.
``That is hardly the sign of a well-functioning free market. Those who provided funding to banks correctly gambled that governments would ride to their rescue…
``Indeed, it has been axiomatic of the policy-maker response that bondholders should be kept whole to avoid the threat that the banking system would seize up completely or that the insurance industry, with large bond portfolios, would become the next domino to fall. Most Western bank bonds are now issued with an explicit government guarantee. The result is a distorted global financial system in which the true cost of capital is obscured.
``In a fully capitalist system, there would be no guarantees. The market would ensure banks didn't become too big or too leveraged.
``At least the current crisis is sure to lead to higher common-equity buffers for all. But since removing the guarantees and breaking up the banks is outside the realm of political reality, an alternative solution is to charge banks explicitly and upfront for all guarantees. The charges would rise in line with leverage. That at least would raise the cost of funding, helping to generate a price signal to the market.
``Instead, global governments are taking the opposite tack. Unable to remove the guarantees and unwilling to properly charge for them because the banks remain too weak, they will try to limit the risks through more intrusive regulation.
``The results, if that goes too far, should be clear enough: lower bank profits, less capital generated, less credit created, lower economic growth and more bureaucratic control over the banks and the wider economy.”
In short the market cleansing process has been skewed by government’s intense efforts to camouflage real price values, which has led to lack of trust and confidence among the financial institutions. Without government lifeline all these structures are most likely to collapse.
The deflationary pressures will ensure that the US government will continue to inflate the system. And inflating the system means that it would need to accelerate the rate of inflation.
The likely scenario will be a tug-of-war between inflation and deflation. Although, inflationary pressures outside the ongoing debt deflation zone will probably take a firmer root or become more entrenched.
As we stated last week, inflation appears in stages and with the OECD real estate sector and the securitization backed structured finance out of play, the inflation process will be short circuited and likely be in rotation or in a feeback loop within the commodity sector and the world stock markets particularly in Asia and Emerging Markets.
The tug of war of inflation and deflation will ensure that debt deflation affected markets will underperform relative to those whom are least affected. Although the sheer magnitude from collaborative effort to stoke inflation may put a floor to these markets at the expense of the currency values.
While the G 20 summit declares that they “will put in place credible exit strategies from the measures”, it doesn’t say how they would do it. The tug of war between deflationary pressures and inflation suggest that they will lean towards more inflation than risks towards deflation. This would account for as the mainstream economic ideology in practice, whose results will likely mirror that of the 70s but at a far wider damage.
Moreover another dubious assertion is that they “will refrain from competitive devaluation of our currencies”. The fact that the degree of fiscal stimulus or monetary inflation will be applied differently means that the currencies involved in huge programs will obviously be ventilated through prices. Hence, refraining from competitive devaluation is an example of a fashionable political statement than to be seen in actual practice.
Finally as we appear to be seeing today, initially “boom conditions” will prevail. The next phase of will likely see a spillover of high commodity prices into consumer prices. And some central banks may apply brakes which may cause increased volatility, although such volatility may again prompt central bankers to lean towards inflation. Then we should see an acceleration of inflation.
If Emerging Markets and Asia succeeds to soak up the inflation to generate a boom in their national markets and economies then a future bust with these regions as the epicenter of the next crisis.
Otherwise, the other possible risk is one of hyperinflation where the aftermath would result to the end of the reign of the US dollar as the world’s de facto currency reserve.
