The Fed led by fearless Ben Bernanke has made it clear that since deflation is a significant risk and bank lending is depressed, it intends to help the banking system further by up to $1 trillion in further bond purchases. The rational investor’s response to this was clear all last week: sell banks, whose assets are denominated in funny money and buy mining companies, which own the rights to tangible and scarce resources.
For 25 years until 2007, the financial services industry seemed the wave of the future. Earnings and assets trended upwards, while the rewards available to practitioners moved from the moderately generous and affluence-producing to bonuses that would have supported Pharaoh Ramesses II’s lifestyle although their beneficiaries alas mostly lacked Ramesses II’s taste. From a staid business driven by corporate finance, it became a high-risk business driven by trading, leverage and the innovation of new products whose risks nobody really understood.
As we now know, the apparently inexorable growth of financial services came to an end with the crash of 2008. Except that it didn’t. The Fed dropped interest rates to zero. The Treasury bailed out most of the banks that needed bailing out – and made sure that nobody lost money on AIG’s credit default swaps, thus perpetuating that market. Only the unfortunate Bernard Madoff went to jail, while the rest of Wall Street, after a statutory year earning $1, went back more or less to its normal levels of opulence.
Indeed, since 2009’s Wall Street remuneration was a record and 2010’s is slated to be yet another record, the financial services sector got off remarkably lightly for plunging the rest of us into endless recession. (Make no mistake about it, without 2008’s financial crash this recession would have been mild and easily overcome.) For one thing, the immense wall of liquidity throughout global markets has made its favorite pastime of “fast trading” even more profitable, as stock prices rise and trading volumes ratchet up. The banks are by this activity engaging in “insider trading” on vast scale, as well as possibly committing fraud when they program their computers to “ping” markets with orders that are instantaneously retracted. However no bankers appear to lose sleep over this thought. What’s more the danger that appeared real earlier this year that the authorities would do something serious to curb this, by introducing a Tobin tax or otherwise, seems to have receded altogether.
The banks were also given a new game to play by the Fed’s prolonged zero interest rate policy, in borrowing short term at close to zero and investing at 3% in long-term Treasuries or at about 4.5% in mortgage bonds (now openly guaranteed by the federal government.) Theoretically, there was a risk that interest rates would rise and give the banks huge capital losses, but the Fed tipped them the wink that this would not happen, so they were able to sit back with their 3% spreads, leveraged 20 times to give a 60% gross return, and not attempt anything intellectually taxing like lending to small business.
Only the home mortgage foreclosure crisis is making the banks lose sleep. If you thought all those securitizations were done with watertight documentation, I have a bridge to sell you. Securitization was quite the most annoying product with which I was ever involved; it consisted of an unbelievable blizzard of documents, all of which had to be completed perfectly by the low level minions left to carry out the details once the big guys and the lawyers had taken their fees and left. It was never likely to be done properly, another reason why the Jimmy Stewart model of local mortgage lending should not have been abandoned.
If the foreclosures involved only the banks and the unfortunate subprime borrowers, the banks’ errors would no doubt be overlooked by a bank-friendly judiciary, but securitized mortgage buyers included many large institutions, domestic and foreign, which are now sitting on large losses and have the right to put faultily documented bad loans back to the originating banks. Being rich and fairly intelligent, they will of course put back only the worst loans and keep those with a decent chance of being serviced. The purpose of securitization, to shift risks from the banks to other investors, will thus go into reverse as the great majority of the risks revert to the banks.
It has often been said that “I’m from the government, and I’m here to help you” is the most threatening line in business, and the banks are now about to rediscover the truth of this. At its meeting November 3, the day after the election, the Fed appears poised to launch a second round of quantitative easing, purchasing $500 billion – $1 trillion of government and agency bonds.
Banks and financial institutions anticipate this activity with relish, as they anticipate yet more volume and additional security in their lucrative games. However in reality there will two unanticipated effects on the banks of the Fed’s quantitative easing. First, since short-term rates are already close to zero, they can’t go any lower, so the game played by banks in buying long-term Treasuries and agency bonds will become less profitable. This might make the banks start lending to small business again, but don’t hold your breath; it will certainly reduce their profitability and the cash available for bonuses.
Second, the Fed’s bond purchases, monetizing the national debt, will bring back inflation in a big way – not a gentle swelling to 3%, 4% or 5% but a massive and very rapid surge into double digits. We are already seeing this in the global commodity markets, of which more later. The attempt by the Fed and its fellow central banks to depress all currencies simultaneously, if not checked in time, will send the dollar the way of the 1946 Hungarian pengo. (While the new currency, the forint, was worth only 4×1029 paper pengos, real money, in the form of the 1931 gold pengo, was at its peak worth 130×1029 paper pengos.) This will at some point cause a crisis in the Treasury bond market, in which confidence is lost and yields soar – wiping out the banking system’s capital positions. The Fed will attempt to resist this by further quantitative easing, but the longer it continues this suicidal policy, the higher inflation will get.
If, in a world of quantitative easing, it becomes suicidal to invest in businesses that deal in financial assets, the most profitable investments will instead be those that use the Fed-provided cheap leverage to invest in hard assets – in other words, commodity-producing companies. Commodity prices are already approaching their 2008 highs, without having had 2008’s excuse of a topping-out economic boom. They are driven partly by the demand in emerging and rapidly self-enriching markets for the bulky machinery that formed the basis of 1950s and 1960s prosperity in the West. They are also of course driven by the flood of cheap money.
We are thus moving into a world in which the fashionable growth sectors will be neither the banks, nor the tech sector, but mining and extraction operations. In 1973, when I graduated from business school, I had the opportunity to work for a merchant bank or a mining finance house. I chose the merchant bank, even though the mining finance house offered more money, but felt myself eccentric for having done so.
In 1993, there was no comparison; banking was infinitely more lucrative and exciting than mining. However in 2013, the pendulum will once more have swung the other way. While Goldman Sachs will be undergoing repeated rounds of layoffs, gilded youth, far from heading to Wall Street, will don a hard hat and head for the mining camps, to prospect for the next infinitely lucrative mineral seam. This will be much better for its health, both physical and mental. It will also produce a society like that of California in the 1850s or South Africa in the 1890s, in which swindles will take the form of mining projects rather than derivatives transactions.
Already on Wall Street, the mining sector has been the great recovery story of 2009 and success story of 2010. Fed policy will perpetuate this, as activities meant to benefit the banks will instead reduce them to insignificance against the mining houses. The Fed will eventually find in this new world its most important asset is not Wall Street but Fort Knox. Its most important coadjutors will be not the financial centers of Britain and Hong Kong, but Australia, Canada and Chile, where the world’s mineral wealth is located.
In the long run this bubble too will burst, and the mining companies will return to the obscurity in which they have labored since the 1970s. It is to be hoped at that stage that enough will remain of the U.S. and western economies to restore a reasonable level of stability and living standards. If we are unlucky, the world’s currencies will have been reduced to the level of the 1946 pengo – and the world’s economy to barter.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)