The real subprime issue

The real subprime issue
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First Published: Mon, Nov 12 2007. 11 14 PM IST
Updated: Mon, Nov 12 2007. 11 14 PM IST
Bare Talk had done some plain speaking on the dismal fortunes that awaited the US dollar and on the likely good times for gold, in the past. So far, this is playing out as expected. There are sceptics still there on the misfortunes of the US dollar and on the attractiveness of gold. That is healthy. If there are no converts to be won over, then the bull market in any asset class is history.
Sceptics point to the performance of gold during May-June 2006 when most emerging market stocks fell. The Morgan Stanley index of Asia (ex-Japan) stocks fell just a shade under 30% in those months. The price of gold per ounce dropped 21% in US dollar terms. However, the flip side is this. During July-August 2007, when there were severe doubts about the stability of financial institutions in the US and in Europe, the same Morgan Stanley index of Asian stocks dropped 18%, whereas gold price in dollar terms fell a meagre 4%. There is a lesson in this.
It is true that financial liquidity has distorted the price of all assets in the world, including that of wine, art and horses. Gold and crude oil are no exception. The reason the price of gold fell hard in the summer of 2006 was due to the fear of monetary policy tightening in the US in an environment of strong growth and moderate inflation pressures. Liquidity tightened. The US dollar gained in value. This year, it was fear for the financial system. Liquidity tightened and yet gold barely flinched.
Hence, withdrawal of liquidity alone is not going to upset the attractiveness of gold as a store of value. If anything, the cause of the credit and liquidity contraction coming from the lack of confidence in the integrity of financial institutions, and by extension in the financial system, enhances its attractiveness as a store of value.
Ben Bernanke, chairman of the US Federal Reserve Board, told the Congress last week that he expected the recent developments to lead to a healthier financial system in the medium to long term.?He?is?being?optimistic.
Late on Friday night, it appears that the three major banks—Bank of America, JP Morgan and Citigroup—have agreed on the modalities of creating a fund to park the assets that they hold so that they could improve in value over time. This is evasive. It also happens to be in contrast to the admonitions that Asians, including Japan, received from Americans in the 1990s. Asian governments and banks were asked to come clean forthwith, take the hit to their capital and restructure or privatize.
In contrast, American banks are releasing truth in instalments. Transparency is at a premium. One thing they have successfully done is to browbeat the Federal Reserve to lower interest rates, perhaps, against its own convictions. That is the diet that they had feasted on and which has caused indigestion. Yet, they clamour for more of the same. It is because the industry has long forgotten classical banking based on assumption of risk. Risk was not unbundled, but assumed away. It is coming back into the balance sheets of banks with a vengeance.
Yet, when the reward for 10-digit losses (billions) is nine-digit compensation, the result is a weaker dollar in spite of improving trade and current account deficits. The deficit is in morality and credibility, as practice at home differs from preaching abroad. With home prices dropping, foreclosures rising and consumers losing confidence rapidly, America continues to report strong labour markets and GDP growth. Further, it is hard to reconcile benign consumer price inflation figures with soaring energy and food prices. Perhaps, it is not just the banks that rely on mark-to-model reporting.
The problems plaguing and caused by the financial sector have been deliberately lumped together as the “subprime issue” for they turn the spotlight on the defaults in mortgage loans by borrowers whose credit worthiness is subprime. That is unfair and misleading. The financial sector with its superior knowledge and information mostly exploited them and, egged on by greed, added more layers of leverage to mortgage debt. The enforcement director of the Securities and Exchange Commission laments the “rampant” insider trading among Wall Street professionals. It is American capitalism that is subprime. It has lost its moral compass.
Economist and arch-critic of the Bush administration Paul Krugman is not sure that the Democrats will provide the answer, free from the influence of the lobbying power of the world of finance. In his column in The New York Times on 5 November, he hedged his bets and said the answer would be revealed in due course.
It is this context that provides the backdrop for further correction in the US dollar and the bull market in gold. However, developments in the coming years might prove that holding gold is small consolation, if at all.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at baretalk@livemint.com
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First Published: Mon, Nov 12 2007. 11 14 PM IST