Tuesday, September 23, 2008

In a Single Week America Sails into Uncharted Moral Territory

Today's comment is by Jack Crooks, Currency Analyst and editor of World Currency Options and The Money Trader.

Dear A-Letter Reader,

If you were lucky enough to make it through last week without any major losses, then I congratulate you.

Last week was a street fight in the markets, and I personally know plenty of traders who came out bloodied and bruised. Thanks to the active participation of central banks and the U.S. Treasury, it's now almost impossible to find your footing and stick to an investment strategy without being broadsided.

So instead of analyzing this unpredictable marketplace or trying to read Paulson's mind, we're going to review a week that will no doubt go down in history. In so doing, we'll develop a better understanding of the moral implications of the past week's events.

Week in Review: One for the History Books

If you have money on the line right now, then you know it's been a less-than-pleasant week of trading. We had one of the largest point losses in Dow history followed by a 200-point gain in the very next session. There have been more swings than you could find on the neighborhood playground. But there's also been a steady - if not growing - sense of worry.

At the heart of it all, there has been an equally steady stream of intervention hoping to relieve such concerns.

If you didn't have a chance to keep up with how things played out from day to day, let me do a quick and dirty recap:

Sunday: The Federal Reserve pumped a bunch of money into the system, increased how much it will provide in lending facilities and further liberalized the collateral it will accept in exchange for loans.

Monday: Lehman Brothers declared bankruptcy. Bank of America took control of Merrill Lynch. And AIG's fate hung in the balance.

Tuesday: The Federal Reserve denied the markets a much anticipated interest rate cut. Instead, it followed with a two-year, US$85 billion loan to bailout AIG.

Wednesday: The Treasury announced a finance program where it would auction off Treasuries, separate from what it already offers. The proceeds will go to the Federal Reserve to use for "initiatives."

Thursday: Central banks around the globe decided to join the party. They declared efforts to pump nearly US$250 billion into the global system to avert a financial train wreck.

Friday: We learned of a new initiative, spearheaded by Treasury Secretary Henry Paulson, to put together US$800 billion in a new-fangled institution and US$400 billion more at the FDIC. The money will be used to take crappy assets off troubled balance sheets and grease up money markets.

Sunday: We heard some of the nuts and bolts of Paulson's plan as he ran the talk-show circuit, and we waved goodbye to the Independent Investment Bank. That's right, Morgan Stanley and Goldman Sachs will play a pivotal role as "Bank Holding Companies" in Paulson's new plan.

Prior to this week, steps taken to stabilize the market were considered ineffective. By the looks of it, though, this week's actions tell me these guys don't want to fail in their efforts to restore order...again. But the condition of credit markets is far from cured.

Plus, there's another issue that the Fed and Treasury might have to wrestle with down the road...

Moral Hazard: Don't Worry, We're Too Big to Fail

"We cannot protect all risk in the market, and we should not do it at the risk of the taxpayer." — Richard Shelby, Alabama Senator

"Moral Hazard" is a pair of buzz words circling lunch tables, office cubicles and board rooms around the world. Why? Simply because the Fed and Treasury are taking matters into their own hands, trying to put an end to the losses wreaking havoc on the global financial system.

And in doing so, our government could be seen as endorsing the reckless lending that led us to this disaster in the first place.

However, what scares me most about these interventions is that some could create a humongous burden on the taxpayer.

The two-year US$85, billion loan from the Fed to AIG this week is an attempt to provide a controlled environment to deal with the pain, spare the financial system from the effects of extreme counterparty risk, protect the real economy and keep the bill off the taxpayer.

So what if the burden of this financial mess doesn't end up in the taxpayers' lap? Could there still be moral hazard?

Good question.

Because what kind of precedent are they setting? These are banks and institutions that took on toxic derivatives and securitized debt. They fattened up when times were good, but come crying for help now that the going has gotten tough. How many more will follow expecting the same treatment?

Perhaps this is the real issue.

JACK CROOKS, Editor of World Currency Options and The Money Trader

Let’s scribble on the back of our proverbial envelope for a moment:

$700 billion bailout package for Wall Street
$438 billion projected deficit in the federal budget for FY 2008
$200 billion for Fannie Mae and Freddie Mac
$150 billion in rebate checks under the guise of “stimulus”
$85 billion for AIG
$29 billion for Bear Stearns

Hmnn… $1,602 billion…. that’s quite a bill for the year… not to mention the nearly $1.6 trillion in Treasury swaps and short-term paper the Federal Reserve has lent out during its auction facilities.

Who’s going to pay for all this?

The national debt ceiling will have to be raised for the second time in as many months to accommodate the request… this time to $11.3 trillion… boosting the national debt to over 70% of GDP. The highest the national debt got during the Great Depression was 44% of GDP.

 

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