Last week we saw the government outline in sketchy detail a massive financial support package for the ailing US economy. Some have questioned why it took so long to come to the rescue. Critics don’t understand either the complexity of the problem or how Washington works. In order to get both Congressional leaders and foreign dollar buyers to accept these moves as the complete solution, the apparent size of the problem had to appear to shrink. Neither group will be able to grasp the full situation before the program begins to unravel. While the economic problem is housing prices, the financial problem is much bigger.
The timing and the positioning of these events were dictated by the political season. Let's hope that the smoke and mirrors work until the next administration is sworn in.
In all of the chatter about solutions, both the Treasury and the Fed pushed for the creation of a clearinghouse for derivatives. The notional value of all derivatives outstanding in the US markets is in the hundreds of trillion dollar range. (Where is Carl Sagan when we need him to go the next higher level?)
We are not only unclear about the absolute size of this liability, but also the identity of the owners, as most of these trades are private or over-the-counter.
A simple mortgage packaged as a structured note can be briefly owned by ten different entities, each of whom has hedged their perceived risks through the use of derivatives of different natures and maturities. In some cases the participants in the derivative trade have had each other as a counterparty on other trades and thus have reduced their net risk. However the market does not know the net amount that is owed to which party and when. If there is a central clearinghouse, the marketplace would be aware every moment in time which player had a debit or credit balance.
Until we can size the problem we don’t know large the needed potential bailout needs to be. At this time I am guessing it to be over one trillion dollars.
When the global markets learn more about the approved bailout program and its impact on perceived inflation, we should monitor the rates that central banks around the world sell their gold reserves. If they slow down further, watch out.
For Us the correct short term investment strategy now remains elusive. No matter who manages to get the control of the Senate, (which is what is really important in the November election), the next four years may not be very satisfying. The stage could be set however, along with other developments for real global growth which will carry us forward.
If you are a long term investor as an individual or as a fiduciary for an institution, I would recommend closely following the drama addressed above, but not to change fundamental investment strategy. My book, Money Wise, is for those who are looking to evolve their lifetime investment strategies and perhaps extend them to multiple generations.
We should not make our primary focus the markets even after the election, the end of year, the first term of the new administration or even the second term. Instead we should focus on periods of ten years or longer. In doing so, I submit the prospects for the prudent investor may well be better than any other time in our lifetime.