It was about four years ago when I wrote how blissful ignorance was a portent of sharply increased market volatility, three years ago when I argued for dramatic action to clean up bank balance sheets by making equity and debt holders pay for their mis-pricing of risk, two years ago when I wrote about the rise of alternative trading venues and only last year when I got sick of all the Wall Street talk and focused on interesting trends in Big Data technology. Sadly, I’m back with some updated thoughts on gross financial mismanagement and our propensity to keep deferring pain until, well, the pain is enough to almost kill you. As screamed by the boggled Howard Beale in the film Network: “I’m mad as hell and I’m not going to take it any more.” Now it’s my turn: if words could scream you’d be deafened.
Banks in both the US and Europe are loaded up with lousy mortgage debt and the obligations of tottering sovereigns. The EU was a fantastic and wildly impractical idea that threatens to bring Western Europe to its fiscal knees. These were problems that could have been addressed proactively, but instead have been treated as political footballs and avoided at all costs. When the US went through its very homegrown crisis in 2007-09, the Fed, the Treasury and Congress could have acted in concert and forced banks to restructure, wiping out equity and unsecured debt holders, hiving off the healthy deposit-gathering institutions from the busted illiquid asset pools and capitalising each through the private markets. The healthy “good banks” with clean balance sheets could have been bridged by an RTC-type vehicle and then floated as quickly as possible, while the segregated bad asset pools could have been priced to move and taken up by the vast amounts of private capital waiting on the sidelines for prices to reflect real market risk premia. The problem is, the US Government never let this happen. As my friend Paul Kedrosky referenced this week, “The US doesn’t do pain.” Equity holders were allowed to reap the benefits of dirt-cheap credit from the Fed and debt holders were preserved as well. Mark-to-market rules weren’t strictly enforced, ostensibly buying the banks time for the mortgage markets to recover and organically repair their balance sheets. Of course, who was extending this timing option to the banks’ equity holders? The US taxpayer, of course! Well, if the markets don’t cooperate the whole plan kind of unravels, right? Please join me in Q3 2011, when the markets called bullshit on our mamby-pamby policy-markers who were simply too cowed by the prospect of doing the right thing and instead did the expedient thing. In essence, short-term gain for long-term pain. It’s not too late to implement my recommendation to force transparent mark-to-market accounting and clean up US banks ASAP. It would have a salutary impact on both debt and equity markets as it would show investors that the US Government will not stand for illusions of financial health. Do this, and maybe the overarching problem of entitlements can actually be addressed. Maybe…
The EU is no better. Flimsy “hard money” guidelines in order to support geographic and political expansion has been nothing short of a disaster. Now we have a massive economic and political entity being simultaneously dragged down by a subset of its constituents and breaking its banks in the process. Walt Wriston once uttered the words “Countries don’t go bankrupt.” Well, Mr. Wriston, they do and they should. Think about what a European sovereign default would mean, e.g., Greece, Spain, etc. Cleaning up busted balance sheets once and for all. Bringing transparency to those hidden European bank balance sheets. Re-establishing confidence in the continent’s largest banks. There is simply nowhere to hide. The market has it nailed. All one need look at is the price of gold over the past three years to know that even as stock markets rallied, storm clouds lurked over the horizon. Well, the storm is here, and it’s a bad one. Whether this means a painful unravelling of the EU and the ECB I don’t know, but one thing is for sure: some serious hits to equity need to be taken – now – if we are to establish a strong and healthy capital base off which to grow.
The funny thing is that once Western governments grow a spine, force hard decisions in the face of withering public criticism and actually allow a healthy and transparent capital markets to emerge, I really do think there would be a better shot at dealing with the generational problem of entitlement spending. This could serve as training wheels for our lawmakers, teaching them that extreme pain might actually be worth it if it were approached in a bipartisan way with the goal of putting the US on a healthy course for the balance of this century. As it stands today, our macro prospects look bleak.
Paradoxically, there is so much good going on as well. Breakthroughs in technology are making businesses more efficient, delivering greater value and choice to consumers and helping to solve global health issues on a massive scale. And this trend is just beginning. The spirit of innovation and risk-taking is out there, but it needs a healthy environment in which to thrive. Technology investment has been facing strong headwinds due to challenging economic conditions and the high level of risk perceived by global corporations. When countries are on the verge of default, banks are crumbling yet corporations are sitting on historically high levels of cash, something is amiss. Corporations need to be incentivized to spend that cash on growth. This requires customers willing to spend. Spending happens when incomes are stable or rising and confidence is moderate to high. These conditions require policies that support stable prices and the perception that the Government is reasonably effective and growth-oriented. Well, this is where we have a problem. Prices up. Real incomes down. Confidence in government at both absolutely and relative low levels. Something needs to give.
Our leaders can either continue to kick the ball down the field, keep interest rates near zero, prop up our banks and those of our Western allies and perpetuate the myth of financial leadership and soundness, or actually address our embedded problems honestly, quickly and effectively. I’m guessing our leaders are going to choose Door #1 because getting re-elected is just too important relative to being distracted by the truth. Pardon my cynicism. It’s only that I’ve got history on my side.
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