Sep 26 2008 1:46PM

There has been some very plain spoken language bandied about lately on the economic times we live in. This is a nice change from the multi-page-disclaimed, leveraged-to-the-hilt, overlain-by-derivatives paper that had built up in the system. Is there some inevitable conclusion to capitalism’s folly in this? No. Capitalism is about the owners of capital making decisions about how it is employed. The layers of paper that have clogged up the system are about lessening the burden of decision making as capital is entrusted to people who take some off the top as it is sent off in a new direction. Too much of this paper has been of the “never-really-explained and certainly-not-understood” variety. This is a big part of the problem, and both capital-owners and capital-brokers have had a hand in making the mess. The seizing up of debt markets that an overbuilt US (and elsewhere) housing market created has resulted from both owners and brokers deciding, finally, it is time to “never get fooled again”. Now a massive bailout of the banking system by governments is at hand. This move has been initially praised on the simple basis that it is necessary to keep the system from coming unglued.

Usually we would be high on the on the list of critics of any government bail out, but in this case a step back is needed to properly gauge what is going on not just in the US, but elsewhere. Russia has announced it will pump $170 billion into its banking system, China that it will pump a yet to be decided amount into its, and other emerging economies are making similar noises. Is this a shaky start to a capital driven market system in these economies? Yes, if it were only that. These funds will also be a fitting end to state driven allocation systems in which decades of mismanaged funding by government has not yet been dealt with.

China, the world’s main growth engine, has a very large store of “under performing” (read “unredeemable”) loans in its “commercial” banking system. Almost all of these were loans to government-owned companies made in the aftermath of the failed socialist experiment. Now that China has funds to move in and “save” its banks, it is well worth bearing in mind that it is actually making up for its own past foibles in doing so. It will be dealing with billions that continued to fund bad businesses that hold layers of party stalwarts in place while a real market, based on the decision making of capital owners, was being built. The country can afford the bill, and properly handled this process will help clean up past mistakes by allowing government-run businesses to fail. We reiterate that last point since we’re in the midst of haggling over a bailout by the US government (read: the creditors of the US government). China can afford to do this; it has almost two trillion in reserves and won’t need to go cap in hand to the market, a la Paulson and Bernanke.

In Russia the old system simply fell apart before a parallel economy could be established. During that process, small bits of capital materialized from nowhere to buy up the choicest enterprises for a song, many of which are in the resource extraction fields. The oligarchs then leveraged the capital needed to rejuvenate these businesses the old fashioned way, by taking it where they could. Government stamped out any paperwork needed to see this done, and took back the bits it decided should fund its own dachas. Russia recently deciding to expand, again the old fashioned way in places like Georgia, has without question added to the scent of panic that has recently filled the air - and just as the oligarchs are legitimizing themselves, on the back of the secular commodities bull. Russia will have to bail out its banks with postponed dacha refits, and a reluctant recognition that beggaring the export markets that have paid for its growth is a mugs game if those same markets turn off the money tap. Less panic would be nice, but if saner (and more reasonable) heads come of this it will seem worth the price. We won’t come to the defense of that gang of KGB retirees but would note, again, that Moscow has the cash to just cut a cheque to grease the wheels of its sputtering capital markets.

China and Russia represent the extremes of how to leave behind socialism. Others who have been growing themselves out of bad government allocation systems will similarly be able to deal with this debt crisis, and should for the most part be able to better their own systems as part of the bargain. They are after all growing and saving, and so have the capital with which to move on. Some fiscal realignment is needed, but that is largely catching-up at any rate. The biggest issue right now, however, is still in the US and some other parts of the developed world banking system, were most feel government bail-out is a shift that seems to somehow reward those who caused the problem. The 100s of thousands of jobs being lost in Wall Street firms aside, chastising government for a bail out ignores the reality that the real problems in the West are as much monetary as fiscal and the idea of living on credit didn’t stop at the shores of Manhattan Island. If only.

In the US both government and market have been living off funding from growth elsewhere, and they have been doing so for decades. Also, government adjusts the money supply through the commercial banking system by tinkering with interest rates – lower rates equal, more or less, more money supply via higher borrowing. The big issue is that so much borrowed capital has been used to do this that leverage created a gross oversupply and overvaluation of the American dream’s hallmark item, a “home of one’s own.” Those unpaid for houses essentially became part of the US money supply, even to the point of re-leveraging them (over and over) to pay for stuff like furniture and cars. When the housing cycle peaked, the rest of the world suddenly realized too much of its collateral was actually paper of questionable value rather than tangible assets, and stopped its funding altogether. US housing prices have since tumbled by about 20%, and the bottom of this spiral is not yet recognizable. This is an indirect decrease in the US money supply, but not one you are going to see in anyone’s ledger. After bailing out or buying up a number of the overleveraged firms that were being destroyed by this downward spiral, the US government has finally said in essence that it will backstop the whole mess. There will be hue and cry that this is saving the wealthy who created the problem (partially true), but in reality everyone who is living on future income has had a hand in this. And in no small measure the US government is really going to be resupplying a money system gone awry by allowing “investment banks” to function as though they were actual commercial banks that have far stricter rules on how they leverage funds.

Because the global banking system has become so interconnected, this mess had also frozen funding to many other things in the world, and that has been the cause of the global panic. Interestingly, this pushed massive flows of capital towards US T-Bills, so the US government should be able to keep its funding promise, and at low rates, for now. This appears to have stemmed the panic. There will be more pain coming for some, and Wall Street will not be able to function as it has. This will be a righting of past mistakes, including the screwball accounting that was created to deal with the mess from the last bubble, a rating system little short of fraudulent and the end of big spending US investment banks as the centre of commerce.

A long, and long overdue, process of paying its bills will have to begin in the US. The greenback should fall further. It has to in order to continue generating the export economy the US needs to have since this is the only bright spot in the US right now. It should also fall if the scale of borrowing required is anything like the trillion plus numbers being bandied about now. The truth is that the current plan is another version of “other people’s money” with Washington rather than Wall St as the center of leverage. The rest of the world will start to pick up the pieces and move on, and happily buy American made goods as they become priced to market. That will include US financial services, though with smaller fees and with more people representing the sources of capital actually being in the room. That makes a lot more sense than writing and overwriting ponderous rules and strategies to govern (or hide) risk – the system will become much more about capital-owners deciding the form and function of investment. We don’t see how it can be otherwise unless financiers and sovereign wealth managers the world over learn nothing from this whole episode. Washington and Wall St will try and paper it over, literally and figuratively, but the fact is they have stiffed a lot of international capital pools in the past year. They can only hope for short memories on the part of those they lost trillions for but we don’t think they will get their wish this time.

Once US housing finally finds its bottom and that will take a while yet, we will know the actual costs of this debacle. Our take continues to be that, two years after the peak of the US housing market, the balanced supply-demand picture for materials bodes well for the resource economy still trying to get on top of the broader growth in the global economy. In fact, we doubt the sector has any way of being ready for the up-tick in demand that the housing bottom is going to cause, but more on that can wait for another time.

While the quest goes on for someone to blame for this mess, we think it important to remind that the title of this piece is a reference to unwieldy and poorly understood systems. It is however also worth pointing out that kleptomaniacs are a lot who are driven to take, and who do so with little regard to the intrinsic value of what they pocket. It was way past time to stop the spiral of one-upping in the leverage game that has caused this damage, and some degree of justice should be coming down the pike to deal with the worst abuses of it. But many played a part in this. What are being dismantled now are mainly castles in the sky that had been created by, and for use of, the most driven. Stop looking up and you will find most of the world around you has not been badly damaged.

Progress, including the shift of economic power from the West to the rest of the planet, continues apace. We maintain our focus on precious metals for the moment, since they will be part of seeking out new forms of investment and security. The centre of this problem, unlike much previous debt driven crisis, is quite separate from the sources of both capital and growth even in this increasingly interdependent world. As the greenback weakens on oversupply of new Treasuries dumped into a calming market, we expect Asian buying power to put the legs back under the balance of the resource sector sooner than most currently fear. We don’t like the bailout, but anything that feels “final” enough for the rest of the world to move on will be a boon to all, even if the healing process for the US takes longer than America itself hopes.

David Coffin and Eric Coffin
From the August 2008 HRA Dispatch

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David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery publications focused on metals exploration, development and production stocks. They were among the first to draw attention to the current commodities super cycle and have generated one of the best track records in the business thanks to decades of experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at www.hardrockanalyst.com for more information.

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