Paul Tustain says it was government action — slashing interest rates — that caused the crisis. Now they tell us slashing rates further and nationalizing banks is the way to ‘fix’ the economy.

This ‘fix’ will and lead to a protracted period of underperforming stocks and bonds… and create the perfect conditions for a bull market in gold.

This from Whiskey & Gunpowder:

It seems almost everyone — from both the right and the left of the political spectrum — agrees that the world needs more government intervention in the form of bailouts and increasing regulation. We’re getting it, too.

Yet once we have grasped that the underlying cause of this disaster was credit creation by government itself, we should perhaps be a bit wary of putting governments ever more in charge.

Governments operate a cheap credit policy in order to defer pain, stay popular, and get re-elected. The U.S., British, Australian, Russian and now pan-European bank rescues are intended to create and promote a higher volume of cheaper and easier credit than the market really wants. They aim to supply yet more of the wretched stuff which got us here in the first place.

Is that really so wise?

If we allow governments to control finance through regulation, we give them extraordinary power over the direction of the economy. Because they can (and will) deny finance to some projects and grant it to other, more politically appropriate ones. Such government control has repeatedly shown itself to be much worse than our imperfect marketplace at handling the power of economic direction — both in this case, where their efforts at economic stimulation are the root cause of the fiasco, as well as in recent history, particularly with communism.

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The new rush of bailouts, and their associated tighter regulation, pushes us further towards the socialized “command” we thought the world had abandoned in 1989. That is bad — and there is a better way to rapidly re-configure our economies in the right way:

More than ever we need to trust the market. Let interest rates rise (without government interference) and allow the market to kill off those institutions whose functioning depends on limitless supplies of cheap credit.

Yes, there would be pain, but it would right a long list of wrongs. It would make houses affordable for younger working people. It would make saving worthwhile again. It would make borrowing less attractive. It would increase the use of equity in the financing of enterprises, and significantly decrease their use of debt, making all of them much safer in future downturns.

Each of these moves in the right direction are, sadly, the moves which yet another dose of rescue money will now suppress. This won’t be understood by our politicians, however, so we will get yet more patched-up bailouts — and lots more regulation besides.

Did you notice? While the United States, Britain, the Netherlands and Australia were banning short selling on their local stock markets, the Chinese were relaxing restrictions on it. This is enormously telling. Asians — suppressed by the command economy for decades — aspire to a world of free enterprise. Unlike us they are now prepared to accept the costly consequences of those repeated errors which the free enterprise system allows people to make.

When we finally wake up under the yoke of our new, improved and over-sized government regulators, we will have lost the privilege of benefiting from free and highly profitable financial centers. It’s the turn of Hong Kong, Mumbai, Shanghai, and Singapore.

Oh well — it was nice while it lasted. And from an avowedly selfish point of view, I think it is almost certain that these tax-funded bailouts will be good for me personally, because they will be good news for BullionVault.

I believe we will now avoid the pain of a sharp correction. Instead we will get many years of miserable underperformance in shares, bonds and deposits — the classic backdrop to a strong bull market in Gold.

With no bailout, gold would probably rocket even faster than it has this week, and within a few months it would have fully appreciated. That would be time to exit gold and start buying bombed-out productive assets instead.

The speed of such an ascent in Gold Prices would be highly profitable for gold owners (including me), but it would probably prevent BullionVault from aggregating more than a few thousand new customers in total. My personal ambitions for the business would never be met.

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Instead, as all this bailout money seeps in, I anticipate some temporary relief for the stock market, followed by a long, slow, miserable slide in mainstream investment performance, accompanied by a steady rise in the value of Gold Bullion.

Every month, this on-going shift from paper to gold…from debt to hard assets…will cause a few thousand more people to join BullionVault, buying and selling solid gold bullion — safe and secure in their choice of Zurich, London or New York — at ever-higher live market prices.

So — entirely hypocritically — I believe one outcome is required, yet hope for another! Knowing governments won’t allow the incautious banks to fail, I can only look forward to helping more investors each day move a portion of their wealth into gold.

Source: Gold and the Flood of Cheap Government Money

Unfortunately, when a series of vicious insurance losses hit the world’s insurance market through the early ’90s, many Lloyds members lost absolutely everything – houses, furniture and indeed their lives. Many of today’s professional money managers engage in a similar practice when they sell credit default swaps (CDS).

CDSs, CDOs and all the other credit derivatives that populate the global financial markets present a new and uncertain risk for investors. Let’s dig a little deeper…

CDOs, as we explained in last Friday’s edition of the Rude Awakening, are new-fangled credit derivatives – i.e. they are bond-like instruments that are derived from pools of loans, usually mortgages. Through the wizardry of modern financial engineering, a pool of sub-prime mortgages, for example, can become an array of CDOs, some rated as high as AAA, others rated much lower. Industry insiders sometimes refer to the lower-rated CDOs as “toxic waste.”…

Institutional investors have been gobbling up these high-yielding – but very risky – CDOs because they are able to buy default insurance – otherwise known as a credit default swap (CDS).

For example, the buyer of a particular CDO could simultaneously buy a CDS to protect against a default. The investor would, effectively, pay an insurance premium to another investment institution for underwriting the risk of the underlying home-loans defaulting. Apart from a bit of legal drafting, that’s all there is to a Credit Default Swap. In return for a cash payment, you swap the risk of default.

These insurance premiums, paid to the underwriter of the CDS, appear to the receiver as income – just like the insurance premiums that any insurance company would receive. You are being paid for accepting risk, not for lending money.

So you see, the investment bankers have been very clever. They have said there are two components in a bond-interest payment: a fee for the use of your money, and a fee for the risk of default. The CDS simply separates out the [fee] for the risk of default.

The investment bank can have still more fun with this. Just like the boring mortgage streams that we started with, these CDS streams can be aggregated into a pool…then divided into tranches with different risk profiles…producing the magic of higher credit ratings for lower-risk tranches…plus concentrated risk in new toxic waste.

If you can get a credit rating agency to assess the tranches you have created, then you have something that looks like a CDO – and smells like a CDO – but which is not now based on cash flows deriving from borrowed money. Instead, it is based on cash flows deriving exclusively from insurance premiums that are paid to cover the risk of mortgage default.

That’s how CDSs get packaged into what is known as a “synthetic CDO,” and the investment banks can sell them for what appear to be fantastic yields. It’s a really neat deal…for the investment banks, which are selling to the highest bidder the right to receive their mortgage default insurance premiums in exchange for assuming the risks of default – so the buyer is just another “investment landfill”. He ends up with what’s called a “contingent liability.”

Why would any investment fund possibly fall for this scheme? The modern fund manager has a powerful short-term incentive to get a strong performance out of your invested savings. If he gets 2% more than the next guy he is a genius, and he will get more money under his management and much larger performance fees. As long as defaults occur rarely, synthetic CDOs can provide a pretty neat deal for the investors. They earn a steady income stream, simply by promising to stump up if there’s a default.

So you can see now how through the use of synthetic CDOs, fund managers can underwrite credit default risk and increase their income accordingly, without outlaying any fund capital. Importantly, however, they are placing their fund capital at risk. Your fund manager is a genius while there are no claims. But if it goes wrong, your fund gets hammered.

But the CDO story does not end here…

It was not long before the investment banking industry had a “Eureka” moment…They started insuring against the default of securities they didn’t even own! It’s like noticing your friend is looking a bit ragged and taking out insurance on his life for your benefit, without him having anything to do with it. And as long as there is demand for “easy income,” there’s no limit to how many of [CDS, the investment banks may create.]

When Delphi Corp (DPHIQ), a large motor parts spin-off from General Motors (GM) , got into serious trouble last year, its bonds fell into default. Incredibly, more than 10 times the nominal value of its bonds were then claimed from investment institution underwriters, by bankers who had insured against the default of bonds they didn’t own by issuing Delphi CDSs.

This isolated incident suggests that the mushrooming growth of credit-derivative issuance imparts an unknown and untested threat to the global financial system….

Long Term Capital Management failed in 1998. It was the last truly serious financial collapse which threatened the U.S. financial system. When LTCM went under, the bail-out fund required was $3.65 billion. The [LTCM] fund itself was leveraged to about $125 billion of assets…

Back in 1998 LTCM was plowing a lonely furrow. Its investment view was something to do with Russian bonds and the Japanese Yen. It was off the main investment spectrum, and there were few copy-cats putting the same market view into action in the same way.

That is where things are very different this time…Many banks and funds are involved…This makes the size of the problem potentially much larger, and of much greater risk to the whole financial system.

How large?…Depending upon who’s counting, the world’s investors now hold somewhere around $1 trillion worth of credit derivatives, at market value. But since the notional value of these arcane financial instruments exceeds $25 trillion, no one really knows how large the potential losses could become during a panic.

Now you can see the difference in scale between LTCM and the subprime bust. This may be 20 times worse than LTCM. And it’s getting worse – daily.

At a time like this, we should not underestimate the skill of people like Ben Bernanke at the US Federal Reserve in underpinning the financial system. They have been remarkably effective at organizing the lifeboats over many years and many crises….[But] Here at BullionVault we think the Bernankes of this world will one day fail.

The result will be a credit squeeze. Bond issues will be pulled, bank loans recalled, and business activity will sharply decline for lack of funding. The first two of these have certainly started – with a rash of failed issues at the end of June. Will these risks be contained? We don’t know…

Clearly we’re biased against excessive leverage, and against too much financial ingenuity, too. That’s why we’re in the physical gold bullion business. We believe that real physical gold is a sensible insurance against today’s increasingly weird financial system. It has been astonishingly reliable in that role in the past.

But this time, who knows?

Source: Investment Landfill, Revisited

Regulate in New York and finance goes to Toronto. Regulate in London, it goes to Frankfurt or Paris – and since Toronto, Frankfurt and Paris are run by the same nervous bureaucrat-types, we can reckon soon enough that the entire financial markets will be hosted out of Singapore and Shanghai.

There they will accept the risks as well as the rewards, to their very considerable long-term benefit.

You simply cannot enjoy being the financial center of the world but start bleating for government bailout whenever asset prices dip a few percent. As Paulson is demonstrating, the regulatory price for being bailed out is far too high. We must all grow up and take a full measure of punishment. The banks must take theirs.

Let the shareholders and depositors take theirs too. Just like natural organisms the financial system must have death to evolve into a better form.

Paulson’s plan is a dressed-up confiscation of the profits of the cautious, and a transfer of those profits straight back to unreconstructed gamblers in the worst offending banks. This is very unwise.

Caution must be rewarded

In these difficult times, profit (or more accurately the avoidance of loss) should be benefiting those who troubled to understand the risks in the system, and avoided them. But Paulson’s plan is currency creation, and a devaluation of the good quality assets owned by the cautious. He fails to understand that unless the system occasionally rewards caution there is no reason ever to be cautious again.

The market works better without these rescues. Only by appropriate economic reward to the cautious, when they are right and everyone else is wrong, will caution sit well beside risk-taking in the financial system. The real threat to New York’s and London’s continued dominance of the world’s future financial system is government regulation itself.

Mr. Paulson should read Hayek’s classic The Road to Serfdom, and he would understand the inevitable failure of his rescue plans. He would see how these top down rules remove society’s flexibility until one day we all wake up in a paralyzed “command” economy, where nothing can be done without official sanction.

Instead, he has forgotten what a command economy means. He should study the history of communism’s economic successes. It won’t take him long.

By Paul Tustain

There they will accept the risks as well as the rewards, to their very considerable long-term benefit.

You simply cannot enjoy being the financial center of the world but start bleating for government bailout whenever asset prices dip a few percent. As Paulson is demonstrating, the regulatory price for being bailed out is far too high. We must all grow up and take a full measure of punishment. The banks must take theirs.

Let the shareholders and depositors take theirs too. Just like natural organisms the financial system must have death to evolve into a better form.

Paulson’s plan is a dressed-up confiscation of the profits of the cautious, and a transfer of those profits straight back to unreconstructed gamblers in the worst offending banks. This is very unwise.

In these difficult times, profit (or more accurately the avoidance of loss) should be benefiting those who troubled to understand the risks in the system, and avoided them. But Paulson’s plan is currency creation, and a devaluation of the good quality assets owned by the cautious. He fails to understand that unless the system occasionally rewards caution there is no reason ever to be cautious again.

The market works better without these rescues. Only by appropriate economic reward to the cautious, when they are right and everyone else is wrong, will caution sit well beside risk-taking in the financial system. The real threat to New York’s and London’s continued dominance of the world’s future financial system is government regulation itself.

Mr. Paulson should read Hayek’s classic The Road to Serfdom, and he would understand the inevitable failure of his rescue plans. He would see how these top down rules remove society’s flexibility until one day we all wake up in a paralyzed “command” economy, where nothing can be done without official sanction.

Instead, he has forgotten what a command economy means. He should study the history of communism’s economic successes. It won’t take him long.

Paul Tustain
The Daily Reckoning Australia

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