This past weekend I saw an increase in the number of institutional investors or researchers that I consider to be smart, making forecasts that the 2008 bear market is either over or nearly over.
The arguments are either that a) the problem has become so grave that governments have been stirred into extreme monetary and fiscal action, and this stimulus will boost stock prices and narrow credit spreads very soon; or b) secular bear markets usually terminate when stocks are down 45% unless government makes a serious mistake or doesn’t act soon enough. People who lean on the latter point say that since the government has acted quickly and forcefully, and hasn’t made any grave mistakes, the current bear will halt now after the recent waterfall decline of October.
I sure hope they are right, but count me as doubtful. Here’s why: I think that the government actually has made a grave mistake, and continues to make that mistake, and actually thinks that what they did was a great idea. And it might be months or years before they recognize it. Moreover, the architect of that mistake, Tim Geithner, is being championed for a position as Treasury Secretary in a possible Obama administration.
The mistake is that the Federal Reserve and Treasury decided at some point this summer that they wanted to kill or seriously maim the hedge fund and private equity fund industry. They blamed bears in the hedge fund industry for short-selling shares of major financial institutions, and spreading negative rumors to boost the value of those short positions. They also seem to believe that hedge funds are inherently destabilizing.
Hey, big lender–
The problem is that the hedge funds had emerged in recent years as a sort of “shadow” banking system, one that was willing to take risks that banks, broker-dealers, and governments were not willing to take. Due to the passage of a variety of regulatory rule changes, they were allowed to dramatically leverage-up their ample balance sheets past the 10-1 level, and they used borrowed money to buy whole companies, and make big loans to many more. They not only were lending money to Big Company X to buy Big Company Y, and buying Company Z themselves, but were also providing mezzanine financing to smaller companies around the world. And moreover through their efforts to make money in the credit default swap business, these private partnerships were providing options to companies that wished to hedge out their debt risks worldwide.
The shadow banking system might have been a disaster waiting to happen, I’ll grant you that. But the decision to crush it by allowing leading prime broker Lehman Brothers go bankrupt, and then the decision to halt all short-selling in financial companies, provided a one-two punch that has led to massive, sudden, unexpected losses in the hedge fund industry.
It might be easy for us mere peons to shrug our shoulders, and not lose sleep over the ruined fortunes of billionaires, but this decision has affected us all. It’s not just rich people who were invested in the funds. Many pension funds and endowments were invested as well, and they’ve all lost tons of money in this mess. Plus the losses have kicked off a massive wave of redemptions, and that has required these heavily leveraged funds to sell tens of billions of dollars worth of commodities, stocks and loans into a market in which there are no buyers.
We’ll only be able to tell in a few years how important the obliteration of the shadow banking system has been. But my estimation at this point, while we’re directly astride a major historical event, is that it was critically important.
Now granted, it could well be that the elimination of the leverage employed by the shadow banking system turns out to be a positive in the long run. I don’t doubt that one bit. But right now I don’t think its impact has been fully gauged by the government or investors, and therefore I don’t think we can tell the extent to which it will continue to serve as a lid on demand for securities. Extinction-level event?
The key thing for investors to think about in this regard is the following: To what extent was the demand for goods for the past dozen years the result of some kind of excess leverage either in the manufacturing system or the financial system? In other words, how many things — houses, computers, televisions, wireless towers, loans — were sold because the shadow banking system helped the regular banking system make them irrationally cheap to finance, build and distribute?
If the right answer is a big number, then we’ve got a real problem. Exaggerating to make a point, we could call the demise of the shadow banking system as an extinction-level event for credit. Without the easy credit that made it easy for Brazilian ore owners to build massive new mines, or for global transportation firms to create new container or dry bulk ships, or for China to build new factories, then a lot of the great momentum forward of the past dozen years comes to a halt. And if these companies now have to pay back their loans without the benefit of cash flow from the expected numbers of paying customers, then the problem is even bigger.
If an asteroid has indeed hit the global credit markets, governments are going to try to plug the impact crater by printing money. But if you play out my “extinction” theme, then what happens next is the financial equivalent of the tsunamis, toxic dust clouds and acid rain that ultimately killed the dinosaurs. In other words, a wave of unstoppable repercussions may end up swamping governments’ ability to curb the crisis.
Some smart, veteran, objective observers believe that governments have never failed to come through with a rescue in these circumstances because they own printing presses and can inflate their way out of crisis. Let’s hope that is the case, but at the same time prepare for the grim alternative.
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This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.