Regular readers of this blog know that I have been increasingly concerned about the credit crisis, and have maintained for some time that this crisis has the potential to bring down the global financial system. I have also stressed that there has been a very low probability of this happening. More recent posts, though, have been picking out specific indicators of rising risks, and, much to my dismay, I must say that the risks have risen once again.
Using the legendary Four Horsemen of the Apocalypse as a metaphor for the problems of the financial system, the first horseman was the initial revelations of the horrible mis-management of credit in the U.S. housing market, which came to light in August of 2007. The second horseman was the run on investment banker Bear Sterns in March of this year, which shook the foundations of Wall Street. We have now seen the third horseman with the U.S. Federal Reserve (the “Fed”) Bank’s bailout of insurer AIG, and cracks are starting to appear in the foundations of the global financial system.
There are two primary reasons why the bailout of AIG is so significant. First, the Fed allowed Lehman Brothers to go broke, and stood by while Merrill Lynch was bought out at fire sale prices by the Bank of America, yet jumped in to save AIG. Since Lehman and Merrill Lynch were two of the largest, most respected, and historic investment houses on Wall Street, yet were allowed to go to the wall, it raised questions about how bad things must be for the Fed to then jump in and save AIG. The bailout of AIG actually eroded confidence in the financial system rather than shoring it up.
Even Worse…
Worse – much worse – is it raises questions about the financial strength of the government of the United States, and its ability to survive this crisis. This breaks into two parts. First, the massively irresponsible U.S. fiscal deficit created by the incompetent and brain-dead Bush administration, coupled with the shaky financial position and profligate spending of the U.S. consumer, which produced an enormous trade deficit, are well known. With the Fed now flinging hundreds of billions of dollars at wobbly financial institutions, these problems raise questions of how many billions the U.S. government has left, and how many financial institutions it will need to save. In other words, does the U.S. government have the capacity to save the system? And if not, then what happens? If the markets lose their belief that the Fed can stem the crisis, then all hell breaks lose, and the system crashes. And the second part makes this even worse: will there be a run on the U.S. dollar and the U.S. government? Do the markets lose their faith in U.S. government debt? You are already starting to hear rumbles that the rating agencies are considering lowering the credit rating of U.S. government debt – which is precisely what I meant when I said cracks are starting to appear in the foundations of the financial system.
Catastrophic disaster is still not the most likely scenario. All central banks will come to the aid of the Fed out of their own self-interest, including the Bank of China, which has well over a trillion dollars in reserves. But the cost to the system, and the length of time it would take for the financial system – and the global economy – to recover would be measured in years, not months, and would mean years of pain, high unemployment, and slow growth.
This is not a happy story, and one I wish I didn’t have to tell, but to paraphrase Gandi, my commitment is to truth, not to comfort. Stay alert – important things are happening that could change the world at frightening speeds. And, as I’ve said before, I’m a firm believer in scenario planning and having contingency plans in your back pocket. This is the time for such planning, for such contingencies.
The Need for a Plan B
What’s your best strategy for getting through this hazardous period? In my opinion, you should be both cautious and forward-looking. Be cautious by not overextending yourself, minimizing your debts, and making sure you have liquid money available in the most secure of places, even if that means minimal rates of return in the short run. And be forward-looking, for even though there are risks out there right now, the biggest probability is that we will come through this period, as we have before. Then, when the situation looks as if it’s stabilizing, start spooning investment money into depressed blue chip stocks of solid companies, especially those with significant dividends. When the economy comes back, people are going to look back at this period, and wonder why they didn’t grab all the great bargains. We are approaching a major buying opportunity, the kind that comes once in a decade, or perhaps once in a lifetime. Don’t miss it.
Now is the time to be prepared, as any good Boy Scout will tell you, so what’s your “Plan B”?
