Wednesday, October 01, 2008

Just a flesh wound

BLACK KNIGHT: Have at you!
ARTHUR: You are indeed brave, Sir knight, but the fight is mine.
BLACK KNIGHT: Oh, had enough, eh?
ARTHUR: Look, you stupid bastard, you've got no arms left.
BLACK KNIGHT: Just a flesh wound.
Try Youtube if you haven't seen it.

The US financial sector reminds me of the Black Knight in Monty Python's Holy Grail, with "reality" in the role of King Arthur. The bail-out, retaining the metaphor, is akin to sewing the Black Knight's arms back on so he can fight (and lose) again.

It seems a bit odd for me to argue against the bail-out. I expected something of the sort, and base my continued long position in Gold on its effects. The more non-performing debt that gets shifted from the private to the public sector, freeing the private financial sector to continue what they have been doing, the weaker will the US$ become, thus driving the price of Gold higher.

Yet, I think the bail-out will merely delay the inevitable- a massive crash of the major financial firms (clearing the field for new players) or nationalization. The party is, it seems to me, over.

Sadly, the US financial sector, like the Black Knight, just can't admit it has lost. Unregulated finance conducted under the umbrella of presumed safety of a lender of last resort- the Fed- combined with golden parachutes for senior management regardless of performance, tends to self-immolation.

The checks and balances of finance that you, I, or any small business work within are non-operative on that level. The attitude of "get the stock price up as high as we can, any way we can, so we can get bonuses, and if we fail, no biggie, the Fed cleans up the mess and we parachute down in safety," is a poor mind-set for making the vitally important decisions of capital allocation in an economy. It also hasn't helped that a few foreign Central Banks have bet heavily on perpetuation of the system and are loathe to take the hit if it falls.

I have previously bemoaned the shift in markets from price discovery to price enforcement vehicles. Price discovery is difficult enough without a bunch of big players with (almost) unlimited access to capital driving (or maintaining) prices to (at) certain levels. It has become a Sisyphusian task, the perpetuation of which, is seems to me, risks losing some of the open markets' great benefits.

The problems in the credit markets, in my view, are not due to a lack of liquidity per se, but a lack of liquidity at the enforced prices. If the powers that be wished to improve liquidity they could let interest rates rise, as LIBOR does when lenders are skittish.

Please note, I wrote, "let interest rates rise," not "drive them higher." The widening spreads between T-Bills and Eurodollars and LIBOR and Treasuries are signs that the price of credit is too low. If the Fed stood aside, interest rates would jump, and credit would be rationed by price.

In the not so distant past, one sure way to improve demand for credit securities was to raise the interest rate. When the last real estate mess was being cleaned up in the US, the RTC Bonds needed to carry a hefty interest rate. When Germany reunified, Bund rates jumped without dissent from the BBK as they were aware that capital wouldn't be easily found at the then current rates.

Of course, a jump in interest rates would have disastrous effects on the financial behemoths (and the common man). Trillions of dollars of derivatives would be repriced in a flash, in an environment where hedging would be difficult if not impossible.

It is the financial sector's apparent inability to allow price to act as credit rationing mechanism which leads me to the view that it is already dead. If a Bank can't deal with rising rates, it isn't, it seems to me, much of a bank.

The bail-out is just a way to keep rates low for a bit longer. At least until the next refunding, that is.