Tuesday, March 24, 2009

John Hussman's Latest Market Commentary

In his market commentary yesterday ("Fed and Treasury - Putting off Hard Choices with Easy Money (and Probable Chaos)"), Dr. Hussman reiterated his call for the government to require bond holders in financial institutions to assume some losses in order to recapitalize those firms:

Make no mistake - we are selling off our future and the future of our children to prevent the bondholders of U.S. financial corporations from taking losses. We are using public funds to protect the bondholders of some of the most mismanaged companies in the history of capitalism, instead of allowing them to take losses that should have been their own. All our policy makers have done to date has been to squander public funds to protect the full interests of corporate bondholders. Even Bear Stearns' bondholders can expect to get 100% of their money back, thanks to the generosity of Bernanke, Geithner and other bureaucrats eager to hand out the money of ordinary Americans.

Though I believe that the consequences (via credit default swaps and the like) are overstated of letting bondholders take a haircut, and will ultimately be no worse than having the public take the losses, the fact is that we don't even need the bonds of major financial institutions to go into default. What we do need to do is offer those bondholders a choice:

1) The U.S. government takes receivership of the financial institution, changes the management, wipes out the stockholders and a chunk of the bondholders claims entirely, continues the operation of the institution in receivership, eventually reissues the company to private ownership, and leaves the bondholders with the residual. This is not “nationalization,” but receivership – a form of “pre-packaged bankruptcy” that protects the customers and allows the institution to continue to operate, followed by re-privatization. As I've previously noted, this would fully protect all of the customers and depositors at no probable expense to the public. Alternatively;

2) The bondholders voluntarily agree to move a portion of their claims lower down in the capital structure, swapping debt for equity (preferred or common), allowing the bank to have a larger cushion of Tier-1 capital, avoiding insolvency, and hopefully allowing the bank to recover by its own bootstraps, preferably assisted by debt restructuring on the borrower side (via property appreciation rights and the like). Similar debt/equity swaps would be an appropriate strategy toward failing U.S. automakers as well.

Hussman also added a note on inflation:

The reason we're not seeing inflation here and now is that despite a near doubling in the monetary base, we've seen a buildup in goods inventories combined with a surge in safe-haven demand for government liabilities. So investors have absorbed the increased supply of government liabilities without a collapse in their marginal utility. This will not persist indefinitely, so unfortunately, any nascent economic recovery in the next couple of years will be against the headwinds of both Alt-A mortgage defaults (coming to your neighborhood in 2010), and inflationary pressures as soon as safe haven demand for Treasuries eases back even moderately.

The graph above, of 4 year annual CPI growth versus 4 year annual growth in government spending, accompanied Hussman's column.

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