A Witches’ Brew

Equities have had a better seven days, but the witches’ brew of the global debt markets continues to bubble away, and get murkier.

Consider the following debt-related stories, all from this week.

  • The Fed gives loans to “systemically important countries” by establishing swap lines with Brazil, South Korea, Mexico and Singapore.
  • The Fed lends directly to corporates via its new commercial paper programme (incidentally allowing AIG to arbitrage the punitive rate it was paying on its previous loan facility).
  • Russia, not to be outdone, bails out its own oligarchs with state bank loans.
  • The Royal Bank of Scotland delays its capital-raising prospectus to take advantage of laxer accounting standards and reduce the amount of bad debts it reports. Incidentally, this sends its shares down.
  • Italian and Greek government bonds trade at their highest yield spreads to German Bunds since the introduction of the Euro.
  • And – I’m still struggling to think through the implications of this one if it gets passed – an “alliance of financial industry interests and consumer advocates” is seeking a 40% write-off of credit card debts in the US.

The last story, in particular, suggests that all the bailout plans will come to nothing if the willingness of debtors to repay is being eroded, as a loss of confidence in the whole system would surely overwhelm efforts to prop it all up.  Why should the average citizen feel he has to pay his debts if he sees those at the top and bottom of the pile being forgiven?

What we are seeing is the obfuscation of who owes what to whom, the massive transfer of private sector liabilities to taxpayers, inconsistencies in who gets the money and who doesn’t (Lehman, Morgan Stanley, Goldman Sachs), and, at the bottom of the pyramid, increasing signs that debts will not be repaid.   Can we avoid further blow-ups?  I doubt it.

In physics, the second law of thermodynamics basically tells us that you can’t build a perpetual motion machine.  But that doesn’t stop our political and financial sector leaders from trying.  All these bailouts and accounting tricks disguise the fact that the bad debts in the system cannot be reduced (although they probably can be made worse!) – the associated risks can only be transferred.

So while bank A gets its liabilities reduced, country B sees its creditworthiness worsen because government debts are rising and taxpayers are shouldering a heavier and heavier burden.

As one astute observer recently put it, “Back when this whole mess started I quipped that no plan was the best plan. After mocking Paulson’s first plan I said plans d, e and f would be where the real fun starts. Here we are (with the loans to emerging market governments). The Greenspan put now is worldwide. But there is no reason to get bored. There are a lot of plans to come before we get to z!”

Who knows – maybe the recent liquidity injections can rally the markets for a quarter, six months, even a year?  And we as journalists and reporters have plans g-z to look forward to.  But what has happened over the last few months has clearly weakened the whole debt-based system, creating dangerous new linkages and making a systemic collapse (via massive private and public sector defaults) much more likely.

How to view this as investors?  Ironically we may now be better off in equities than in bonds (but only in those companies that are unleveraged and that have tangible assets on the balance sheet).  And I can’t see this whole mess as anything but bullish for the precious metals, and probably other commodities too.

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