Please, click here to read this article in pdf format: january-26-2010

Yesterday was the third consecutive day with the S&P500 below its previous support of 1,020pts, validating my view on risk. We may need to see more water running under the bridge until we can confirm a trend here. However, reviewing market commentaries, I found that all those who still stay on the bullish side have one thing in common: They see the higher regulation on the world’s banking system as a positive factor for economic growth. In particular, they believe that stronger capitalization and focus on lending, as sought by President Obama’s administration, will be meaningful in withstanding future volatility, and will also drive spreads tighter in the long term. This is a strong assumption I disagree with.

Below are the reasons of my disagreement, which were EXTENSIVELY ELABORATED in the LAST TWO CENTURIES by others wiser than I:

“…Confidence in the capacity of circulation of fiduciary media is not an individual phenomenon; either it is shared by everybody, or it does not exist at all. Fiduciary media can fulfill their function only on the condition that they are fully equivalent to the sums of money to which they refer. They cease to be equivalent to these sums of money as soon as confidence in the issuer is shaken even if only among a part of the community. The yokel who presents his note for redemption in order to convince himself of the bank’s capacity to pay, which nobody else doubts, is only a comic figure that the bank has no need to fear. It need not make any special arrangements or take any special precautions on his account. But any bank that issues fiduciary media is forced to suspend payments if everybody begins to present notes for redemption or to withdraw deposits. Any such bank is powerless against a panic; no system and no policy can help it then. This follows necessarily from the very nature of fiduciary media, which imposes upon those who issue them the obligation to pay a sum of money which they cannot command…” Cp. David Ricardo (http://en.wikipedia.org/wiki/David_Ricardo ), “Proposals”, op. cit., p. 406; Walras (http://en.wikipedia.org/wiki/Leon_Walras ), Etudes d’economie politique appliquee, Lausanne 1898, pp. 365 f.

“…The history of the last two centuries contains more than one example of such catastrophes. Those banks that have succumbed to the onslaughts of note-holders and depositors have been reproached with bringing about the collapse by granting credit imprudently, by tying up their capital, or by advancing loans to the State; extremely serious charges have been brought against their directors. Where the State itself has been the issuer of the fiduciary media, the impossibility of maintaining their redeemability has usually been ascribed to their having been issued in defiance of precepts based on banking experience. It is obvious that this attitude is due to a misunderstanding. Even if the banks had put all their assets in short-term investments, i.e. in investments that could have been realized in a relatively short time, they would not have been able to meet the demands of their creditors. This follows merely from the fact that the banks’ claims fall due only after notice has been given, whilst those of their creditors are payable on demand. Thus there lies an irresolvable contradiction in the nature of fiduciary media. Their equivalence to money depends on the promise that they will at any time be converted into money at the demand of the person entitled to them and on the fact that proper precautions are taken to make this promise effective. But - and this is likewise involved in the nature of fiduciary media - what is promised is an impossibility in so far as the bank is never able to keep its loans perfectly liquid. Whether the fiduciary media are issued in the course of banking operations or not, immediate redemption is always impracticable if the confidence of the holders has been lost…” L. Von Mises (http://en.wikipedia.org/wiki/Ludwig_von_Mises ), “The Theory of Money and Credit”, Chapter IV, p. 321-2, Yale, 1953.

As you can see, blaming banks has been fashionable since immemorial times and financial systems will never be stronger by making their operations more expensive. Therefore, the idea that credit spreads will eventually tighten because of better capitalized banks is absurd. And if credit spreads do not continue to tighten, the rally cannot continue. Moreover, why would banks seek to be better capitalized and pay for all the embedded costs? This is why their stock prices are off their highs.

Please, note that I am not bearish here, but neutral. As I write above, we need to see more water running under the bridge until we can confirm a trend.

Martin Sibileau