Is Another Banking Crisis Brewing? Is it Time to Increase Gold Holdings?

"Risky debt may cause trouble for U.S. banks". That was the title of a front page article in this past Wednesday's "Financial Times." The article was based on a report by Wolfgang Hammes, a senior manager at McKinsey, a management consulting firm. Mr. Hammes, who specializes in the banking industry said, "There is a substantial amount of hidden credit risk at U.S. financial institutions that could potentially lead to serious loan losses. Most banks' risk management systems are not sufficient to identify and quantify these risks."

Mr. Hammes noted that in spite of a nine-year economic boom, U.S. consumers and companies are more indebted than ever. The borrowings of the average U.S. household now exceed a year's disposable income, according to Federal Reserve figures. At the same time, corporations are more leveraged than in the past. For example, the average debt to equity ratio for S&P companies has shot up to 116% compared with 84% in 1990 at the end of the 1980's junk bond boom.

The consultants are even more concerned about the rapid growth of riskier types of credit on bank balance sheets. As an ex-banker, I can tell you I have seen a number of these cycles. Toward the end of an economic boom, banks get very lax in their credit requirements as well as restrictive covenants they impose on borrowers. Bankers like everyone else, make the mistake of projecting the past indefinitely into the future. A good example of bankers getting carried away with trends of the past was in 1980 when major money center banks in the U.S. made loans to oil companies based on assumptions that oil prices would range upward to between $50 to $100 for the next decade. So, with such a long period of prosperity behind us, I do not find a report by Mr. Hammes that "sub-prime" lending (loans based on interest rate pricing at LIBOR rather than the prime rate), has grown by 80% a year to more than $100 billion since 1995 to be a bit surprising. Neither is it surprising that margin debt now exceeds $200 billion, given the longest and greatest bull the world has ever seen. A lack of fear and respect for the carnage bear markets leave in their tracks is always a characterization of the end of great bull markets. Other trouble signs noted by Mr. Hammes are the rapid growth in high-yield borrowing and a trend among individuals to take out new home equity loans to pay off credit card debts.

In addition to being afflicted with the general optimistic climate of the times, bankers also find themselves pressured to increase earnings by investors who demand higher and higher stock market returns in the late stages of a bull market. And, bank managers and lending officers are in fact rewarded with higher bonus payments when they do generate robust earnings growth. But to generate the returns demanded by investors, riskier and riskier loans must be made. The problem is, the bonus and salaries paid to bank executives do not take into account higher loan risk.

Nor do Wall Street analysts pay much attention to portfolio risk. Hammes found that only 5% of Wall Street bank analysts actually pay attention to the credit quality of bank loan portfolios. To do so would most likely make the job of selling bank stocks more difficult. So Wall Street analysts simply ignore the topic of loan risk. In other words, analysts feed investor fantasies of ever increasing stock market returns for the sake of their own bonuses. Nor would their bosses allow them to be objective since their rewards are also based on the short term profits of their firms.

SYSTEMIC RISK & GOLD

Mr. Hammes believes as do I, that an economic slowdown could threaten the financial health of many banks. But the concerns voiced by Mr. Hammes are far more serious than merely the potential losses for some of our banks. Given the interdependence of our fiat currency system, the demise of a few major banks could quickly lead to a financial disaster for our entire financial system. Actually, the notion of a systematic meltdown is nothing new for regular readers of "J Taylor's Gold & Technology Stocks" (www.miningstocks.com). Our good friend David Tice, whose firm Tice & Associates manages the Prudent Bear Fund, has been warning about the dangers of our "Credit Bubble" for quite some time. However, now that a main stream newspaper is providing front-page coverage on this topic, there may be a greater willingness on the part of more investors to begin taking cover in fixed income instruments like government paper.

With 50% of our Model Portfolio allocated to short term U.S. Treasury instruments, we have already made that move. However, what makes us different from most other investment advisors is that we also recognized that once the financial system breaks down, you need to own an asset outside of the system to help cushion the shock from a systemic collapse. When confidence is lost in the banking system, as it happened in the 1930's and during the 1970's, investors inevitably return to the only time proven money outside of our fiat monetary system, namely gold. As we have demonstrated in our "Homestake Study" (visit www.miningstocks.com), gold mining shares can provide an enormously effective insurance policy for investors when the system breaks down. Given the declining security of bank portfolios, that potential is beyond a doubt greater now than it has been since the 1970's. Consequently, we also have allocated 17% of our model portfolio to precious metals and precious metals mining stocks, and 5% to the Prudent Bear fund because we believe it is increasingly likely that another confidence shattering event will take place in the near future.

For those of you who are not familiar with the Prudent Bear Fund, I like to describe it as a small investor's hedge fund. You can begin investing in the fund for as little as $2,000 or $1,000 for your retirement plan. Most of the assets of the fund are used to short stocks that in the opinion of fund manager David Tice are overvalued and vulnerable to a market decline. The Prudent Bear fund also invests a considerable amount of its resources in gold mining shares. I know David Tice personally and have a very high regard for his ethics and talents. If you would like to know more about the Prudent Bear Fund, call 1-888-778-2327 or visit www.prudentbear.com.

Disclaimer: The prudent Bear Fund has been recommended in J Taylor's Gold & Technology Stocks newsletter and 5% of J Taylor's Gold & Technology Stocks Model Portfolio has been allocated to this fund. No compensation has been provided to Jay Taylor or his family in connection with this recommendation.