Fat Cats and the $700 bn bailout

Last week in summary

United States:

- Last week, we saw the Dow Jones fall over 7% on Monday 30 September on news the US$700 billion bailout bill had not passed the lower house of congress.

- Wednesday, a revised US$700 billionn bailout bill passes the upper house of Congress (Senate).

- Saturday (Aust time), the US bailout bill passes the lower house of congress. The reception to the bailout was not joy and elation. The Dow Jones ended up loosing 7.3% last week and the Nasdaq 10.8%, the worst week for the sharemarkets since 9/11.

Other countries:

- Germany's Hypo Real Estate Bank received a €35 billion (US$51.2 billion) bailout, Germany's No. 2 commercial property lender, and first German bluechip company to be rocked by the global credit crisis.

- Iceland in trouble (see below).

- Commodities (soft and hard) fell over 9% last week, the largest drop since at least 1956.

This world is currently experiencing: deflation.


US$700 billion bail out

The bail out plan was largely smoke and mirrors driven by election year politics.

The Federal Reserve has injected hundreds of billions of dollars into the system – which did not require congress approval. Henry Paulson, the US Treasury secretary is a former CEO of Goldman Sachs. There was no doubt he talked up the seriousness of the situation to President and congress to help his former banking colleagues. Warren Buffets US$5 billion investment (bet) into Goldman would have largely been on the expectation that Paulson would get his way. No doubt Buffet would have factored this in when looking at Goldman's fundamentals. However, a bail out is a bandaid and offers no long-term solution. The bankers will be back later to ask for more money.

Fat Cats

In the days leading up to the bail out plan passing congress, the world media was harpy on about the "fat cats" on Wall St. This commentary had good reasoning, with investment bankers, in particular, enjoying overly lavish salaries and bonuses in the last decade by simple marrying over priced assets (such roads, ports, power stations etc) with debt, and skimming nice profits off the top through management fees. The current liquidity/debt crisis shows that these assets are now grossly overvalued, because debt has become expensive, and even equity raising is becoming difficult.

Government

However, the global credit crisis is not just the fault of the fat cats. If there is any entity to finger point – its Government. It is Government which has encouraged business and individuals to use Keynesian economics. The economic structure which encourages devaluation of the currency, inflation and debt. The root causes, in particular, goes back to 1913 (when Federal Reserve was created) and 1971 (when bretton woods monetary system broke down). The Federal Reserve is nothing short of a market manipulator. It encourages people to spend more when they shouldn't! When looking for the root cause of sub-prime or the current credit crisis, most media commentators only look back about 10 years, to when the Clinton Administration encouraged Fannie Mae to ease credit requirements on loans to low-income earners. Others finger point Alan Greenspan who pumped the US economy with cheap credit by lowering interest rates. Both these instances are true, but no one is looking at the structure of the monetary system itself. Today's monetary system is no longer accountable without a link to gold.

Individuals

It's not just Government which is at fault. It's also individuals. Individuals who signed the dotted line for sub-prime mortgages, are as much to blame then the fat cats on Wall Street. At the end of the day, there needs to be individual responsibility for investment decisions. When there is a crisis, people always need someone to blame, a scapegoat. If people max out on their credit card, the bank with cut it up in front of you. Money has to be accountable. Individuals have to be accountable for their decisions. Unfortunately, individuals are once again, collectively looking to Government to resolve the global credit crisis through increased regulation. This will be detrimental to the free market which would clean out the bad money by itself, but now the US Government is leading the charge by throwing more bad money into the system through the bail out plan, and through the Federal Reserve injecting money into the system. The RBA is doing the same in Australia.

Why sell for pennies, when the Government will pay in dollars

Some commentators argue that the reason the market is so illiquid at the moment (with many banks going under or merging) is because they are holding onto bad assets which they should be selling to the market for 20c or 30c in the dollar. But because they have been expecting government to bail them out and buy the bad assets, they could sell these bad assets for 50c or 80c in the dollar to the US Government. Banks and companies do not go completely bankrupt. Left over assets are sold to the nearest buyer. This is how Macquarie has built a lot of its empire, by buying badly managed assets and better manage them.

$700 Billion vs. $600 billion

Lastly, the irony of the now failed $700 billion bail out is that the US Senate last week passed a $600 billion "stop gap" package including: $25 billion loan to the auto industry (for General Motors and Ford), $24 billion fro disaster relief for the recent Hurricanes... and other things such as ending the ban on oil drilling off the Atlantic and Pacific coasts. Really what's the big difference between lots of spending items that add up to $600 billion one week, and the $700 billionn bailout package the next?

Iceland?

In the last couple of days, Iceland's Prime Minister has warned that their country was threatened with national bankruptcy due to the global credit crisis. Aparently, Iceland's banks went on a debt binge, much like the investment banks in the United States. It's banking assets soared to nine times the annual GDP of Iceland. Now the repercussions: a collapsing currency and soaring inflation. With the banks on the verge of collapse, the Icelandic Government would be unable to bail them out, effectively bankrupting the nation. The Government did however provide an unlimited guarantee of bank deposits held by individuals. But covering this will be very inflationary.

It may be worrying to see a small country on its knees, but this is just the start. As I keep alluding to, the United States will fall on its knees too… its just a matter of timing. Like Bear Sterns going under, or AIG, or WaMu – Iceland should be seen as a wake up call to other countries that they could be next.