Please, click here to read this article in pdf format: april-19-2010

Indeed, we can’t start the week without referring to the SEC’s securities fraud action vs. Goldman Sachs.  We will not comment on the case itself, but on what we think is its macro consequence. For those interested in the case in particular, please, click on the link: http://online.wsj.com/public/resources/documents/secgoldman2010-04-16.pdf

We agree with those who see this case as the start of a major move to press financial institutions in the US to accept tougher regulations on lending, derivatives, etc. We are concerned about the rhetoric used by politicians, who continue to blame Wall Street’s greed for all their credit expansion. Frankly, the comments made by certain US senators on Friday were no different than those one can hear from Hugo Chavez on his weekly TV show. But long term, we don’t think this should impact the compression in credit spreads or stocks valuations…The driver of the rally that started in March ‘09 has never been fundamentals, but quantitative easing policies. In Europe, the monetization of deficits is becoming increasingly more explicit. With sovereign risk on the rise, government debt is placed in the banking system, which in turn places it as collateral at the European Central Bank (ECB), to raise liquidity. In summary, the graph below shows the process taking place in Greece:

As you can see, in step 1, governments place debt at banks. Among other sources of funding, Banks use deposits (in Euro) to leverage their capital in this transaction. In step 2, banks may turn to the ECB to exchange the government debt for liquidity, at face value (at par). The final outcome is shown in step 3: Basically, the ECB has bought government bonds, in exchange of fresh money. This is an indirect monetization, which transfers wealth from all the holders of Euro notes to the taxpayers who enjoy the fiscal spending of governments that use the ECB. The size of this transfer equals the fall in purchasing power of the Euro vs. other currencies/commodities, multiplied by the amount of Euros in circulation. It is easy to see that soon, every government will compete to place its debt at the ECB, to win this game.

In the US, monetization is undergoing a change. It has temporarily stopped with the unwinding of the quantitative easing programs, but given the unbalanced nature of the federal, state and municipal budgets, it shall continue. Meanwhile, foreign investors (central banks) and increasingly banks buy US debt. The upcoming financial regulatory framework will be supportive of monetization. Hence, the need to press institutions, as we first glimpsed on Friday. As the issuance of Treasuries and rise in policy rates eventually increase the cost of capital, it will be evident that the sustainability of the recovery/valuations will be more fragile. The government will continue to blame Wall Street for not lending enough to Main Street, while it simultaneously generates a crowding-out effect on corporate credit with the implementation of Basel 3. Under Basel 3, regardless of its final shape, banks will be forced to hold government debt as liquid assets (vs. other corporates) and to issue more equity to raise capital. In countries like Argentina, we have seen this coercion take place already. How was the liquidity shortage circumvented? The government itself became the major lender (i.e. Banco Nación). Would the US not do the same through its Agencies? In our opinion, US financial institutions will be the losers in this game, while gold starts to look like the real winner. Fortunately, on Friday, gold sold off, as investors long financials needed to raise liquidity.

Martin Sibileau