wealth preservation Archives - Page 2 of 2

Financial Price Discovery Postponed for the Duration

In the financial bust of just five to six short years ago, prices of financial assets across the board were in free-fall. Even when prices stabilized at bargain levels, liquid and solvent buyers were frozen in place, unable to bid.

This is because in a deleveraging-inspired selling panic, prices disconnect from the underlying understanding of value. It left potential investors yearning for price discovery.That is, they sought the comfort of believing that financial assets trading in the market were priced below what one could expect from investors attuned to both upside possibilities as well as downside risks.

Much the same is happening today — not that prices are falling relative to some traditional notion of value, but rather prices have thrust beyond what traditional metrics of value easily justify.

A further source of discomfort is not just the level of prices but the pricing inconsistency between bonds and stock. There now exists strong support simultaneously for both, which typically occurs in eras associated with greater efficiency in production, widening profit margins and strong economic growth, without inflation.

And that expectation is not widely held today.

Rather, there are a variety of worries still on the horizon, some near-term and some longer-term.

They include a continued respect for the Great Recession, the economic and financial implications of debt finance or taxation to pay the Baby Boomers’ entitlements, and the uneasiness that the central banks are setting markets up again for another asset bubble, among others.

Pick your economic poison and there are lots of candidates that impact investors’ assessment of profit realization and growth, sovereign debt risk, currency risk and inflation risk, all the things that investors pay attention to.

What creates the great pricing disconnection is that central banks indeed share many of those fears, as do investors — and as a result, they purchase financial assets as a nostrum for all those ills. The liquidity provided to investors from the sale of their assets to the central bank is then spent on other investments, which in turn drives prices upward across the board.

And more central bank fire power was added recently when the European Central Bank joined the other major central banks. In the case of Europe, there are multiple problems being addressed via large-scale asset purchases, including economic lethargy, commercial bank funding problems, government debt sustainability, and the fear of deflation.

Given that array of serious issues, the ECB one-upped the Fed’s zero interest rate policy with a negative interest rate policy, not just in real terms but in nominal terms (at least for bank deposits at the central bank).

Not to be outgunned, the Fed made another addition to the list of concerns that require large-scale asset purchases: The eradication of long-term unemployment among those short on job skills.

But moreover there is now a dynamic that is setting in among the major central banks. They can’t be outgunned in asset purchases or their currency will rise in value and create comparative advantage problems that would inhibit their exports and their economic recovery.

So the central banks are getting close to the interactive dynamic of having to respond with enough asset purchase intervention to offset the pressure for their currency to appreciate due to the intervention of others. We have entered a modern day beggar-thy-neighbor dueling of central banks that seek to lock in exchange rates with asset purchases. This of course elevates asset pricing across the board of investment categories and across countries.

The result is that perceived risks are not being translated into lower market prices by investors; they are being translated into higher market prices by central banks — which is equally true for bonds and stocks.

The irony is that we have one large financial segment buying because of their economic fears (central banks) and the fearful private investors are buying despite some of the same fears because they believe that central banks won’t quit supporting their assets.

The net result is very high bond prices and a bottoming out of yields and yield spreads, which in the case of the Euro Zone has taken some of the periphery bonds yields lower than U.S. bond yields.

And in the equities markets, the medium P/E ratio (shown below in red) is elevated unless one expects broad-based improvement in economic growth with rising profit margins.

As a result, financial prices do not reflect market expectations of anything but central bank willingness to participate in the asset buying fix.

And there are too few niches in the markets that will be unaffected or protected from the vulnerability of central bank restraint if it were to occur, but the search is on and is centering on “alternative” assets.

As long as this pricing disconnect continues, there are a lot of textbooks and mindsets that need to be revised as to what prices are trying to tell us about risk and opportunity.

At the moment, financial market prices float detached from the anxieties of market investors as long as the same anxieties drive the central banks into action.

Somewhere there are real market prices to be discovered when the central bank fog is lifted, but for an individual central bank to drop out of the fix requires all central banks to simultaneously back off of this modern day beggar-thy-neighbor interaction in concert, or else they would be at a relative disadvantage in foreign trade.

The Robin Hood Reflex Once Again Confronts Capitalism

Thomas Piketty, a name you are not likely familiar with, is a French economist who has given voice to the notion that there has been a growing concentration of wealth at the upper end of the spectrum both in Europe and the U.S. That is, the rich are getting richer at a faster rate than others. And of course, what follows is the Robin Hood reflex to redistribute.

Aside from Piketty’s work, another factor adding to the redistribution reflex is the relatively greater gain in corporate profit than in labor income over roughly the last 30 years.

Both facts taken together create a general sense that those who are getting rich are getting rich by manipulating labor income, an idea recently expressed by a former Secretary of Labor.

From this it becomes a small step to launch an assault on capitalism with Robin Hood redistributive policies, whether of wealth or income or both.

All these ideas are now in play and I anticipate that they will, in one way or another, be an important part of the discussion during the fall Congressional elections.

Americans’ propensity to accept Piketty’s facts, his theory and his policy implications has led to Beatlemania-like obsession with his celebrity — all based on a dry economic tome of 576 pages which made it to the top of the Amazon bestselling list within a month of its English translation and publication.

Now, as a blogger who attempts to never exceed 2,000 words so as not to the lose today’s time-stressed audience, I find it difficult to believe the book was actually devoured cover to cover, except by those wishing to prove him wrong and indeed, errors in data have already surfaced.

But who really cares about devouring the book or the data when you already have an opinion? Now all you need is the proof in your hands: It was a conclusion seeking confirmation.

What creates the environment for belief and acceptance is that the U.S. and European middle classes have indeed been dealt a setback. According to a Pew Mobility Project, men in their 30s in 2004 were earning 12 percent less than their father’s generation at the same point in their lives.

Furthermore, the U.S. real medium (middle of the distribution) family income is at the 1995 level — which makes a ripe audience to engage in income or wealth redistribution policies.

There are good and logical reasons for the setback in labor income and the increase in wealth values, and there are also reasons to believe that the unevenness of economic progress, however measured, has been due not to a fatal flaw in capitalism but rather to a lot of self-correcting special influences.

For one, the Great Recession is now on the mend. At first, it hit wealth levels harder than labor income, and the Fed’s QE has been more effective in resurrecting wealth values than employment and labor income so far.

But that all is now changing with trained and effective labor being in short supply and wages increasing. This is not just a transient bounce–back, but with the prospects for zero labor force growth over the next few decades, it will provide constant scarcity pressures to lift labor income more than the returns to wealth.

The relative growth of wealth story is also going to change with both stock and bond values teetering at levels that would be difficult to sustain when the Fed phases out its mega QE.

But the bigger cause of the retardation of labor income over the last 30 years has been globalism. That is, opening U.S. markets to emerging-nation suppliers that produce goods with hordes of low-wage labor caused the wages of similarly skilled U.S. workers to decline and emerging market (EM) wages to increase.

This is the natural economic phenomenon better known as factor price stabilization, which, for a time, worked against developed country labor income — and now its time is over. (Sorry Robert Reich, it had nothing to do with a corporate conspiracy.)

But the outsourcing of products from U.S. markets is now at ebb-tide with re-shoring replacing off-shoring. What adds to that thrust is the natural rebalancing that causes the currencies of those successful EM exporters to appreciate, making foreign goods even more expensive relative to U.S.-made goods. This is the natural see-sawing mechanism of global trade, where success sets you up for a correction ahead.

For example, China accepted the notion that it must allow its currency to float to the market rate, and indeed it did so by appreciating 30%. So now China is the one in trouble when it comes to exporting its way to continued growth. Its wages and currency have both gained relative to the developed world, making Chinese goods paid for with U.S. dollars considerably more expensive.

Another important factor that supports Piketty mania is that retarded U.S. wage and labor income growth to a segment of population is due more to a lack of skills, training and work ethic among the young. Be prepared for a discussion of the ill effects of a school system that produces trophies (or high grades, a trend that has now been extended to the university level) for all participants, whether they won or lost in whatever academic or athletic competition they are engaged in.

The readjustment process will take place via job training, and hopefully Americans will regain a sense that the trophy goes to only to the winner. This socialization readjustment might be the more difficult, as it covers not just skills but also things such as developing initiative and responsibility, which somehow fell from academic consideration.

Another source of wealth concentration buildup over the previous decades is the outsized windfall that financial sector participants accrued by connecting foreign savers to U.S. financial securities and markets leading to the housing boom (and bust). This too is over.

Capitalism has served humanity not just since the birth of the republic but for many centuries before. It took us out of the woods, onto the farms and into the cities — and then into suburbia and now back to concentrated urban growth in cities that tend to tax at lower rates and do not attempt to provide as much in the way of government services. This is the counterrevolution I wrote about called Plan B.

What is missing from the redistributionist discussion is the effect of monetary reward as an incentive to meet the market test. That — not some kneejerk robotic employer — is what provides the quantity and quality of goods we enjoy. Indeed, what keeps the redistribution discussion alive is that that economic theory has not incorporated the effect of monetary incentives to the willingness to produce, so that we would be able to calculate the loss in output if income or wealth were redistributed.

That is, at the current state of economic theory, we cannot put a number on what is lost when we lessen rewards via redistribution which places the redistribution discussion in the realm of philosophy, fairness and equality.

But those doubting that redistribution matters to output and product development can now take a trip to Cuba to view the frozen-in-place technology of the 1960s, when wealth was redistributed and capitalistic incentives were snubbed out. It made all equally poor, except for the political class. Or one can take a trip to China and marvel at the transformation that occurred when monetary reward was re-introduced to a communist economy.

Basically wealth growth and labor income are joined at the hip — in addition to incentives to produce more or different goods, entrepreneurial accumulated wealth is vital to finance the next generation of new ideas and next generation jobs via venture capital or private equity. Certainly government would not or could not do that.

In addition to the above concerns about reducing the size of the total pie if it were to be split evenly, redistributors should be aware of the difficulty of actually redistributing. It can be accomplished, say, via a negative income tax or the welfare state that Bill Clinton (yes, a Democrat) eliminated.

But somehow the redistributors have lost all faith in Adam Smith’s invisible hand of the markets incentives guiding what to produce efficiently. They prefer to let the government decide which goods and services are produced and at what price.

Take, for example, The Affordable Care Act. Through pricing via income level, it has produced significant income redistribution in such a way that the even the middle class has been seriously compromised. Indeed, all income deciles have suffered except the bottom two with a pretense that the medical services purchased are actually available.

Politicians who are seeking re-election are nervous about this fact.

That is, let us not fail to consider the scarcity of medical providers as they are compensated at rates below market. As for Medicare recipients, good luck finding a private practice physician willing to take you if payment is compensated at Medicare rates.

When all respect and understanding for the invisible hand is lost, there is always the government’s role in taking the provision of services in-house. That is the story of the Veterans Administration, and that will show you perversions of incentives to produce. We didn’t need the deaths at the VA from year-long waits to tell us that. The U.S. Post Office has long been training us to take a number and get in line.

In the case of letters or packages, we head to UPS or FedEx or e-mail at a higher price that the market seems to be happy to pay for efficient service. Heading for the private market if the government allows it, will also be the outcome of healthcare delivery.

All in all, redistribution or government production of goods buys nothing but shrinkage in which all are set back.

So, Thomas Piketty, it appears that you fall into the long list of French philosophers and economic tinkers who have had dubious effects on the economic benefits to man.

On Saving the Economy: Plan B

The antidote to a troubled macro environment since Keynes wrote the book in the 1930s has been the dual demand-side sledgehammers of government deficit spending and monetary expansion.

Both were thought to induce private spending with multipliers that would generate output and absorb the unemployed. Well, that’s how the theory went.

When it was first applied, it was not a theoretical experiment but rather the necessity of paying for and financing WWII.

At that time, the twin necessities of fiscal and monetary policy jolted the economy forward with such force that the unemployment rate was driven down to 1.2%. It appeared to provide validation of what fiscal and monetary policy could do, and economists and policymakers around the globe embraced it (and they still do).

After all, it simply required legislation for spending, raising the debt ceiling, and the Fed’s Open Market Committee’s agreement to go along with it. Basically, it was Bureau of Engraving and Printing policy that printed both the Treasury securities to pay for the deficit spending and the dollars to purchase them.

It was the easy way out, which became Plan Ain times of economic distress, whether they’re related to shortfalls of income or jobs. And now it’s also intended to rebuild wealth, save banks, and cheapen the dollar as well.

But for these macroeconomic sledgehammers to work, they are not cheap. US Government debt to GDP has increased from 62.7% to 101.6% in the last eight years. The relative size of the Fed’s wartime quantitative easing was a 50% expansion of its balance sheet — as opposed to a 300% expansion in the modern day reincarnation of QE. But alas, unemployment has been driven down to but a narrowly measured 6.7%.

So it’s obvious that something else is afoot, and it has to do with the question of why the twin sledgehammers are not working as well anymore. And furthermore, what is the “something else” that policy makers are now turning to? That is to say, what is Plan B?

The basic answer to why the sledgehammers are not working is that both monetary policy and fiscal policy are debt-financed spending, either by the government or the private economy. The problem is that it works as a cyclical remedy, as long as the debt doesn’t accumulate — which implies that in the prosperities that follow, debt reduction should take place. That is what George W. did not do, but Bill Clinton did.

The need to avoid accumulating debt was forgotten as the economic high just induced a greater desire for prosperity with mindless expansion of the debt-to-income ratio.

Basically, debt-driven spending — whether public or private — is a cyclical policy that is not meant to be a long-term secular fix. If a government and the Fed keep at it as a secular fix, it has offsetting effects when a greater share of income is required to service debt.

This is not lost on the private economy, as consumer debt relative to income has been worked down since it peak in 2007, which in turn continues to slow the economy today. Nor was it lost on Keynes himself. But governments didn’t get the memo, and they keep on piling up debt, which restricts the economy by creating a need for more revenues to service that debt.

The twin forces of stimulus from debt-financed spending and the subsequent need to service or retire debt is becoming evident today. As an example, in Japan since the last election, Abonomics has employed the macro sledgehammers with great force but has followed up with a national consumption tax that offsets Plan A. Much the same is happening in Europe and in the U.S. with QE tapering and fiscal sequester reining in the expansion of Plan A.

So what becomes Plan B when Plan A is being made to face the facts — specifically that secular debt accumulation is ultimately counterproductive?

Politicians are now doing what is pragmatic to attract business to their geographical location without the benefit of Ivy League economic theory. This is being done city against city, state against state, and now country against country. Plan B at the country level was the subject of the recent G-20 meetings as a response to the Fed’s tapering of QE, so it’s going global.

Plan B takes the form of reducing taxes as compared to your competitor, enacting less costly and burdensome regulations, and even underwriting business start-up expenses. It also takes the form of job training and infrastructure development. Those and other efforts are supply-side efforts to be relatively more competitive.

Some of them are outliers by historical example. That would include Michigan, which became a right-to-work state in 2012, and others in the Midwest are following.

There is a significant difference in the public perception of Plan B as compared to Plan A. In B there is little accompanying press and no photo opps for the politicians or the Fed Chairman, and hence fewer images to drive Wall Street expectations. But these low-profile policies are relentless, albeit slow. On the surface they appear to be policies that do more in totality than merely change the location of business. The benefits come in the form of greater efficiency (measured by output per worker) and less debt accumulation, either public or private.

Are they enough to offset the unintended debt consequences of previous demand stimulus? That we shall see, but at least this is a move in the right direction toward offsetting the ill effects of secular debt accumulation.

A major question is: Can these policies that are associated with the Right Wing be implemented by Left Wing majorities in many places? Well, if Liberals are in political control, they are also responsible for economic outcomes. So they will find ways to implement typical conservative platforms packaged as inspired liberal genius.

The Vulnerability of Private Wealth to Government Financial Stress

The Slow-Moving Train Wreck Has Picked up Speed: Foreign Depositors in European Banks Will Be Outed

In a recent Texas Enterprise presentation, I described how losses to Cyprus depositors could occur elsewhere. Moreover, I suggested that this was not a one-time aberration of our understanding of normal. Rather, this is the new normal, better described by a Texas Enterprise reporter as “a slow-moving train wreck.”

Since his phrasing was more eloquent than mine, let’s go with that as a title to this month’s blog. Except in the short time since that title was conceived, the impending train wreck has just picked up speed.

The notion of a train wreck for an economy is of course in sharp contrast to our notion of “old normal,” in which an economy chugs along spewing off the multiple gifts of jobs, income and wealth all by itself, even without much need for government locomotion or correction.

That is the way it was for a long time. Yes, there were occasional interruptions in that steady progress, most of which proved to be no more than minor and short-lived recessions. But the train kept chugging along, because economies do have natural self-correction mechanisms to keep the train on the tracks and moving at a normal speed. This is the notion of an equilibrium growth path.

Primary among the natural economic mechanisms are prices of inputs and currencies. In recessions, unemployment creates low wages, and low demand for capital causes yields to diminish. With capital outflows, currencies decline, and goods become cheaper to produce and eventually become attractive to foreign buyers. Hence the economy’s engine turns around all by itself and keeps on chugging. In an economy’s boom episodes, those same resources become expensive — which is a self-moderation mechanism that slows sales and production.

During booms, interest rates increase due to scarcity and the inflation premiums that markets price into debt contracts. This means that in that economic environment, there is relatively little need for the Federal Reserve to further raise interest rates.

However, after WWII, self-correction gave way to statutory imperatives to not allow prices to reflect scarcity, which somewhat deterred the self-correction mechanism. Minimum wages prevented the unemployed from offering their services at a lower market rate, and reserve currency prices had a built-in upward bias so exports would not pick up. Hence the self-correcting market mechanisms were somewhat compromised.

For the most part, following WWII, monetary policy and contra-cyclical fiscal policy added to demand so as to keep the locomotive running at the highest maintainable speed, never mind a little inflation. In addition, the Fed’s routine fine- tuning required flexibility and timely policy to keep the engine’s mechanisms in working order — the locomotive would lurch forward when policymakers gave it some gas, and it would slow down when they applied the brakes.

But now, what was considered “normal” back then is almost unachievable: Not only is the engine in sad repair, but the ground under the tracks is giving way.

One reason for this is that we are now facing what the Fed calls “headwinds” — when they push the accelerator to the floor, there is no acceleration, but it’s not due to lack of trying. Same is the case in Europe and Japan: They are trying but getting no traction.

But now the old locomotive has sprung several more disconnects. For one, it suffered through The Great Recession just as old age caught up with both machinery and the work force. The aging population also requires fiscal resources to make good on government entitlements. That process tends to slow the old locomotive, as the government finances entitlements by diverting private resources.

Another slowdown occurs when the government foists its entitlement debt on first banks, financial institutions and, most recently, on central banks across the world — making them weaker and compromising the engine’s traction even further.

But now in a new bold move to come up with the funding for entitlements, European governments have chosen to cannibalize depositors in their own banks (and, in turn, the banks themselves) by forcing them to reveal the identities of foreign depositors to their home governments.

The end to Euro bank secrecy has already given rise to witch hunts for depositors, basically requiring them prove to their government that they paid taxes on funds in their foreign bank accounts. But since the truth will not be revealed until the end of the year, depositors have ample time to seek new ports for their holdings — which will no doubt be outside of the EU. The total amount of the deposits that are likely seeking a new home is estimated at about $21 trillion, or about twice the amount of U.S. commercial banking system deposits.

If that were not enough incentive for depositors to flee Europe’s banks or seek other alternatives, the EU has also made it clear that the ad hoc Cyprus bank formula for large bank resolution — in which depositors and other debtors take a hit when the bank goes insolvent — will be applied across all future EU bank insolvencies.

Needless to say, holding government bonds as assets is a leading cause of bank insolvency — if the government can’t service its debt, it certainly can’t rescue the bank’s supposedly insured depositors.

To add to the risks that Euro depositors face, the IMF has indicated a new policy for assisting financially strapped governments that rationalizes not assisting them. The IMF wisely decided that it will not rush in and be a lender to distressed sovereigns an act which often provides the funding needed to save banks.

Instead, it will wait until after the sovereign defaults on its existing debt as it wants no part of being written down with the rest of the bond holders. This no doubt removes an important source of emergency funding for the sovereign and the bank depositor, which the IMF has come to realize simply enables the sovereign to keep on spending at its expense.

With support for bank deposits being removed, the conclusion is Euro depositors are at risk without much in the way of government back-up whether or not deposit accounts are anonymous. So Cyprus is the new rule and not the exception.

Banking and moreover, financial globalism — a system in which capital is free to flow toward the best use that promotes economic growth — is being sacrificed to support state deficits. But the sacrifice will not be confined to Europe, as the U.S. and the Euro zone are placing maximum pressures on all haven countries to do the same so as not to lose competitive advantage.

So with Europe in the sixth consecutive quarter of recession, the slow moving train wreck has just picked up speed, no matter how much gas the monetary authority gives the aging locomotive.

Is the Cyprus Bank Fiasco the Template for the Future?

We are living in profound times. The Great Recession, followed by epic levels of deficit spending sustained by monetary policy, is now having short-term remedial effects on the U.S. economy.

But before we declare victory, we need to be clear that the real battle lies ahead. Over the next four decades, the government will be under unrelenting pressure to finance the commitments of the developed world governments and pay interest on its accumulated debt.

Even if the political miracle of balanced budgets were adopted (along with ultra-pro-growth policies), that wouldn’t eliminate the interest expense on the debt that has already been accumulated. Governments will need to marshal the political will shortly, if it’s not already too late.

If they don’t, what lies ahead are more Cyprus-type events in which bank deposit cram-down is, in effect, a tax on private wealth — the result of government pressures to sell debt.

Here’s how this occurs: Governments delude themselves and their constituencies to think there is no sovereign debt finance problem and hence no need to stop spending. A favorite tactic in this self-delusion has been to force-feed government debt onto the balance sheets of the country’s private banks and non-bank financial institutions.

Within the EU, that tactic went pan-European. This means Greek debt (remember that?) is sprinkled onto the balance sheets of institutions across Europe — especially the Cyprus banks, as it turned out. Financial regulation encourages this sprinkling of debt by declaring government debt to be safe and sound, pushing private institutions to expose themselves to government debt risk.

This is typically done before governments turn to their central banks to support their bonds, an outcome that has only occurred recently.

Basically, the regulated financial institutions were made into piggy banks to finance their government’s deficits and allow them to keep on spending. In piggybanks economics, governments pilfer the funds and leave a confessional note, which in this case are their government’s bonds. After all, who would criticize the banks for being a party to the pilfering when the government’s debt is classified by regulators and rating agencies to be Tier 1, or riskless?

This is not a solution — it is merely an enabling device that allows the government to avoid short-term pain and financial embarrassment from not being able to sell their bonds to market investors at reasonably low yields. But it builds on itself and blossoms into later and greater pain.

It’s an attempt to cure cancer with aspirin, covering up the underlying financing discomfort of the government debt overload. But with the advance of time, the aspirin has worn off and the cancer has spread. It took down the banks in Cyprus, which had purchased a large helping of Greek government debt that subsequently took a 74% haircut.

To add to the government’s financial problems, piggybank finance in turn triggers deposit insurance payouts, typically by the same government whose bonds were written down. When government bonds depreciate due to market risk valuations, there is a multiplier effect on fiscal demands, accelerating the decline and fall of both governments and banks.

Since European governments only recently took up pan-European bank supervision and joint responsibility for bank losses, it was too late to prevent the crisis in Cyprus, as there was no time to build up a deposit insurance trust fund. That requires many years of banks paying a deposit insurance fee that actually goes into a lock box, so bank bailout assistance needed to be pay- as-you-go.

When the German and Dutch voters contracted a well-deserved case of assistance fatigue for southern European banks, this ushered in the era of private wealth meltdown in the form of depositor haircuts.

In the words of the Dutch finance minister, what you just saw in Cyprus is the template for future insolvent banks. In an interview with reporters in Brussels after the Cyprus plan, he indicated:

“What we’ve done last night is what I call pushing back the risks (onto depositors).…If we want to have a healthy, sound financial sector, the only way is to say, Look, where you (depositors) take on the risks, you must deal with them, and if you can’t deal with them, then you shouldn’t have taken them on … that is an approach that I think … now we should take.”

What has abruptly occurred is a shifting of the burden and responsibility to the private wealth owner, and an end to the pretense of government responsibility for financial stability, safety and soundness.

This is the end of the post-Depression era in practice since the bank runs of the 1930s, in which governments sought to preserve, protect and defend private wealth owners — and had some ability to do so.

Heretofore in the saga of Euro sovereign financial strains (now in its fourth year), all revisions and reinterpretations of the underlying treaties, laws, collateral agreements, benchmarks, and other policies that formed an understanding of the rule of law were protective of the individual in times of extreme stress. That is, hastily assembled Euro country bailout funds and the ECB’s extraordinary LTRO financing of banks and its support of various government bonds was in violation the rules but for the benefit of private wealth owners.

This has been replaced by reinterpreting the rule of law to benefit governments at the expense of private wealth owners, pushing depositors to the front of the line to take losses in order to protect the government.

This is a tectonic shift. It raises questions about the future costs and changes that could stem from the loss of confidence in government protection of wealth, especially among bank depositors.

This loss of confidence will drive risk premiums on bank deposits of both insured and uninsured deposits. This natural financing response by depositors implies a higher deposit rate commensurate with the perceived risks before depositing, resulting in shrinkage in banks’ spreads between the yields earned on assets and paid for funding.

As it happens I was involved, along with co-author Doug Cook, in a study of the size of the risk premiums depositors required when confidence in deposit insurance protection was in question in the U.S. during the Savings and Loan crisis of the 1980s. Even with deposit insurance pledges by the government (but with a yet to be recapitalized deposit insurance fund), the market assessed on average 370 basis points to the bank’s cost of funding due to the insurance risk (as apart from the bank’s risk) in the geographic areas where it was thought the banks’ assets were weak.

This represents an enormous shrinkage of the banks’ underlying profitability even in the absence of further asset write-downs. And moreover, banks have become especially vulnerable when central banks drive down asset yields to a floor of zero and the market forces its funding costs upward. There is no margin left in the middle, which is a banking disaster in the making.

To give you an idea of where we may be heading, the net impact of government guarantee risk on the U.S. Savings and Loan industry is that the industry no longer exists. This raises the question of where Euro banking will migrate, as there is a large demand for riskless transaction assets.

No doubt some Euro bank funding will find the U.S. shores, but the same underlying softness exists in U.S. deposit insurance guarantees, as the FDIC is barely solvent and the U.S. government is central-bank dependent. Hence, the U.S. suffers from the same cancer, albeit at an earlier stage.

The Cyprus fiasco was well more than a reorganization for the Bank of Cyprus. It is a revelation that developed-world banking is not anchored on terra firma for those with claims on the piggy banks, whether they are bank deposits, annuities or private pension funds. They are all at risk now and are no longer government supportable.

The bottom line, as stated by the Dutch Finance Minister, is that investors now need to examine carefully their chosen private financial institution’s balance sheets and their wealth holdings with a new understanding of risk in this new millenium.

The Spellman Report

The Spellman Report, Where the Economy and Markets Meet

Tag Archives: wealth preservation