September 2008 MARKETS AT A GLANCE Eric Sprott Sasha Solunac Sprott Asset Management Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 362 4928 Toll Free: 888 362 7172 www.sprott.com The Financial System Is A Farce: Part Two Last year at this time we wrote an article titled “The Financial System Is A Farce”. It’s now been a year hence and, as evidenced by recent events, not only is the financial system still a farce, but it has become exponentially more so. As Treasury/Federal Reserve bailouts in the financial sector become the rule rather than the exception, the issues we wrote about then (and, in fact, have been writing about for a number of years) are gaining relevance. Namely, by not allowing the free markets to decide the outcome of deleveraging, an environment is created ripe with moral hazard, abetting in the misallocation of resources, and sowing the seeds for a future financial crisis. It’s all part and parcel of the farce that is today’s financial system, and it all started six years ago when the Federal Reserve adopted unprecedented monetary extravagance, leading to what can only be described as the largest and most pervasive global financial bubble in history. The inevitable result, as is becoming increasingly clear, is that the cleanup in the aftermath of this bubble when all is said and done will have the largest price tag, indeed the largest destruction of wealth, in history. As we’ve long warned about, the bursting of a bubble always has disastrous consequences, as is painfully evident today. There is no greater testament to this carnage than the fact that major Wall Street institutions, many of which have been around for over a century (having even survived the Great Depression) are now falling like flies one after the other, almost overnight. In order to refresh our readers’ memories, here is a brief summary of what we wrote then. It was evident to us that the bubble spawned a proliferation of assets of highly dubious value, the vast majority of which were being valued on a ‘mark-to-model’ basis, which far surpassed the true realizable value of these toxic assets. Such accounting methods would be more accurately called ‘mark-to-myth’. It was financial gaming taken to the extreme, leading to an environment where the balance sheet of the entire financial system was a ruse, with far less capital, and thus far greater leverage, than was being reported. We also stated that the proliferation of derivatives (the notional value of which, by last count at the end of 2007, totaled almost $600 trillion according to the BIS – though there are those who believe that number now exceeds a quadrillion dollars!) as a means to ‘hedge’ the value of assets was also a ruse. We believe that in many cases both sides of a derivatives trade booked profits, because that is what their models told them to do – which in and of itself is an obvious ruse. But the biggest part of the derivatives ruse was the ill-conceived notion that it somehow protected everybody from risks. Financial engineers lavished praise on these instruments, claiming a new financial era of unending stability. We believe, and have always said, that the proliferation of derivatives, far from reducing risks, only magnified the incestuousness of the financial system, increasing its susceptibility to long-ignored counterparty risk. On this point we believe we’ve been proven correct. Clearly, derivatives failed to avoid the monumental crisis in the financial system today – quite the contrary. They’ve increased the likelihood that if one financial institution goes down, they all go down, just like the house of cards it was all built on. As we wrote last year: “We believe if banks were allowed to go bankrupt, and their assets liquidated, then the true extent of 1 the ruse would be revealed.” Indeed, as predicted, there came a day when the ruse was revealed. This has resulted in an unprecedented intervention on the part of the Treasury and the Federal Reserve, taking the role of buyers of last resort for just about any and all paper assets in an effort to ‘save’ the financial system. Lest market-based adjustments prove too onerous for the economy to endure, 1 “The Financial System Is A Farce”, Markets At A Glance, October 2007, p. 2. Sprott Asset Management p.1 of 3 government is now taking over the functioning of the free markets to a disturbingly great extent. Unfortunately, this only exposes the other half of the ruse; namely, the erroneous belief that central banks can ‘solve’ financial crises with the same ‘solution’ that caused the crisis in the first place: throwing money at the problem. Alas, contrary to what Wall Street would have us believe, the road to riches does not lie through central bank actions of this sort. As centuries of experience show, the wanton printing of money is not the way to wealth creation. If it were then Zimbabwe would be the richest country in the world instead of being one of the poorest. As a corollary, one could also claim that neither does the road to riches lie through burgeoning government spending, especially in the context of the massive financial sector bailouts currently being contemplated, for it would ultimately lead to the same thing: the wanton printing of money, the debasement of the currency (in terms of gold, if not other currencies whose central banks are adopting the same ruinous strategy), and in the longer term, the general instability of the financial system. How this general instability manifests in the long run is as yet unknown. Suffice it to say, if US government bonds (about the only financial asset that hasn’t taken a drubbing of late) were to head into a downturn because they were perceived in the marketplace as being toxic themselves, then the shockwaves that would permeate the financial system would be enormous. This is why we are quite skeptical of claims that a global recession will be deflationary. Ceterus paribus that may be true, but all bets are off when massive bailouts are in the works. We’ve believed, and continue to believe, that as long as central banks continue to do what they do best, print money, then the logical economic result will be stagflation. History shows that exchanging cash for paper is always inflationary. It means the money-dropping helicopters are in full flight. We continue to believe that the ultimate outcome, at least for the United States, will be much higher interest rates (and much lower bond prices) for US government debt. How can it be otherwise? It’s the inevitable outcome when a central bank loses credibility. We believe this credibility has been severely undermined by everything the Federal Reserve has done over the past decade, starting with the era of Greenspan. He has been praised as the central banker par excellence, elevating the stature of the Federal Reserve to an all-powerful institution able to solve any financial crisis that comes its way. This was perhaps the biggest farce of all. Central banks cannot create wealth. Nor can they avoid losses. They can only convert one financial problem into another. The Federal Reserve clearly failed in its main task: to maintain a stable currency and stable purchasing power. Instead it concentrated on pumping the financial sector of the US economy to bubble proportions, sending it into crisis when the party ended, and, ironically, is now being tasked with saving the financial system from ruin. Sprott Asset Management Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 362 4928 Toll Free: 888 362 7172 www.sprott.com In its efforts to do so, it has only succeeded in making the financial system more deeply mired in the muck. The laundry list of Federal Reserve actions taken over the past year, both conventional and unconventional, have failed miserably. Nothing they have done so far has worked. Not the 350 basis points of rate cuts. Not the hundreds of billions of dollars of liquidity provided through open market operations. Not the $200 billion spent on increasing the amount and frequency of Term Auction Facilities. Not the $200 billion expansion of the securities lending program. Not the hundreds of billions spent on repo operations. Not the $290 billion being made available by the Fed to other central banks through swap lines. Not the $300 billion made available to the Federal Housing Administration to refinance failing mortgages. Not the $29 billion lent to JP Morgan to bailout Bear Stearns. Not the $200-$300 billion to bailout Fannie Mae and Freddie Mac. Not the $85 billion to bailout AIG. Nothing has prevented the financial system from imploding. The Fed’s latest acts of desperation include allowing banks to exchange their equity holdings for Fed cash (a huge farce), the guaranteeing of money market funds, turning the last two standing Wall Street investment banks into bank holding companies, and last but not least, the $700 billion bailout package currently making the rounds of Congress to directly buy mortgage-backed securities and other toxic assets on banking balance sheets. The government, through the Fed and the Treasury, has clearly established itself as the buyer of last resort. In the process they have become a mortgage lender and guarantor, an investment bank, and an insurance company. In all likelihood, they will next become an automobile manufacturer. Where does it end? Sprott Asset Management p.2 of 3 All attempts to date to deal with the crisis by throwing money at it have been futile, and we don’t believe the latest desperate measures will prove to be any different. The greater the desperation, the more adverse tends to be the outcome. At best they are delaying tactics. At worst they make the ultimate crisis worse than it otherwise would have been. The price to be paid for bailouts and cheap liquidity will ultimately be a crisis in the currency, effectively trading one risk for another: default risk for purchasing power risk. This is not the road to riches for the economy. It’s the road to ruin… and it all began when an otherwise enviable and prosperous financial system turned into a farce. Sprott Asset Management Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 362 4928 Toll Free: 888 362 7172 www.sprott.com The information contained herein may not be reproduced, quoted, published, displayed or transmitted without the prior written consent of Sprott Asset Management Inc. (‘SAM’). The opinions expressed are solely those of the author. They are based on information obtained from sources believed to be reliable, but it is not guaranteed as being accurate. The report should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions expressed in this report are subject to change without any notice and SAM is not under any obligation to update or keep current the information contained herein. SAM accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this report. SAM is the investment manager of the Sprott Funds. Important information about these funds, including management fees, other charges and expenses is contained in its simplified prospectus and/or offering memorandum. Please read them carefully before investing. Mutual funds are not guaranteed; their unit values and investment returns will fluctuate. Performance data represents past performance and is not indicative of future performance. Performance comparisons are drawn from sources believed to be accurate. This is not a solicitation.v Sprott Asset Management p.3 of 3