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No Bottom Yet For Flailing Financial (By Peter Schiff)

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July 23, 2008 – Comments (0)

No Bottom Yet For Flailing Financial
In recent months, even the most blindly optimistic forecasters have come to grips with how our banks and investment banks took wildly imprudent risks that will result in horrific losses. The resulting sell-off in financial shares has tempted many investors to scoop up these companies at apparently fire sale prices. Wise investors should resist the temptation, as the pain for financials is just getting started.

Although voices of prudence were dismissed at the time, these banks’ risks were leveraged largely through “off-balance sheet” mechanisms that generated massive financial rewards for the financials while keeping the losses supposedly at arm’s length. The resulting windfall yielded $26 billion in bonuses for Wall Street in 2007.

The tolerance for the risks and leverage was based upon the widespread belief that real estate prices were set to rise without correction. We now know that this was a fairy tale.

Soon, gullibility gave way to greed, which soon led to fraud, and the sub-prime world was born. It was camouflaged by means of securitization, in the form of Collateralized Debt Obligations (CDO’s), sometimes packaged within triple “A” bundles. This so-called “toxic waste” was passed on to unsuspecting financial institutions around the world. The hidden virus infected the entire vast international financial system. Soon, the credit markets tightened, threatening first their own financial crisis and then, with their reduced lending ability, an economic recession.

When the Treasury/Fed team moved to rescue Bear Stearns and, more recently, Fannie Mae and Freddy Mac, the $5 trillion-plus burden of risk was neatly transferred to the American citizen. This week, the Wall Street Journal commented on Nouriel Roubini, the New York University economist. He aptly observed that it was “the price of a system that privatizes profit and socializes losses.” People could be excused for protesting strongly against such political policies as outrageously un-American.

The rescue of Fannie Mae and Freddy Mac, in particular, generated a wave of buying amongst the so-called “bargain basement” financial stocks, off some 80 percent from their highs. This optimism was based largely on the belief that the taxpayer would be forced to rescue the banks. But the banks are not the only financial institutions in trouble. The home lending and credit boom provided a feast for all manner of other speculations. Credit cards lenders became very aggressive as did auto lenders and lenders to students. Even businesses borrowed in order to participate in the great consumer credit boom.

These categories of lending are vast, in sum, amounting to several trillion dollars. All financials are exposed, but the degree of infection is not yet fully understood. Soon, even the government must wonder how much more taxpayer “rescue” the $14 trillion U.S. economy can afford?

As the recession takes hold, borrowers are heading for stringent times, especially those with large, high cost credit card debts. Likewise, their lenders, including many regional banks, are likely to experience massive loan defaults. Then, there are the insurance companies who have invested much of their own reserve funds in real estate.

In short, investors should become urgently aware that banks are not the only financial institutions that will be adversely affected by the severe economic conditions now looming ahead.

Before being tempted back into buying financial stocks as “bargains”, investors should assess carefully whether or not the government will be able, either financially or even politically, to extend taxpayer obligations to underwrite the entire financial industry.

Finally, investors should estimate what the long-term cost of government support will be in terms of higher taxes and the hyperinflation that will cause the further debasement of the U.S. dollar. How will they further inhibit future economic recovery?

While the true extent of the problem is hard to estimate, it is a certainty that the U.S. dollar is likely to remain under downward pressure. Gold is likely to experience strong upward pressure as high inflation leads into hyperinflation and systemic financial risks become increasingly manifest, offsetting the downward pressures of recession.

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