More Gasoline On The Fire

This week's announcement by the Fed that it will create a new mechanism to provide funding for credit challenged banks has been lauded by Wall Street as an innovative approach to solving the credit crisis. In truth, it is really just the same response the Fed has had for all problems great and small: crank up the printing presses, shower money on the problem, and hope that financial pain can be obscured by the balm of inflation. Both the Fed and Washington politicians are completely clueless regarding the ill effects of the plan, and are simply acting in desperation to keep a ticking time bomb from exploding before the next election.

The Fed and other foreign central banks will provide this liquidity by auctioning low interest rate loans to holders of U.S. mortgaged-backed securities. The loans will be made under the same terms currently in use at the Fed's "discount window", with the added benefits of even lower interest rates and anonymity (borrowers wish to avoid the public stigma that comes from utilizing the discount window). Since the loans can be collateralized by mortgage-backed securities, the Fed will be on the hook should these loans not be repaid. In other words, the losses will simply be monetized, or more precisely socialized, as they are passed to the public in the form of inflation.

To get a sense of the losses that potentially await the public, in a recent transaction, E-Trade Financial liquidated its entire portfolio of subprime mortgaged-backed securities for a mere 27 cents on the dollar!

The hope that this additional credit will somehow alleviate the problems in the U.S. housing market is extremely naïve. Virtually none of this newly created credit will find its way back into the domestic mortgage market. With our real estate prices still too high, the gathering potential for lenders to be forced to assume liability for "unsophisticated" borrowers, the added uncertainty regarding mortgage terms, and the persistent weakness in the U.S. dollar, such loans will be far too risky for most foreign lenders to consider. Instead, these banks will take this cheap Fed money and invest it in higher yielding assets overseas. Off-loading risky U.S. mortgages to the Fed in exchange for cheap loans that can be used to finance better yielding foreign investments could well develop into the next carry-trade of choice.

The real losers will be ordinary Americans, who do not get the benefit of the newly created money, but merely suffer the consequences of rising domestic prices and a falling standard of living. With this new plan, the Fed is laying its cards on the table and its hand is a loser. If mortgage losses are socialized through inflation, this new cure will be even worse for the economy than the "housing bubble disease" the Fed infected us with in the first place.

Now that the Fed has upped the inflation ante it's time to press our bets on gold. About two weeks ago Goldman Sachs predicted that shorting gold will be the best trade of 2008. Call me cynical, but knowing Goldman Sachs, my hunch is this shrewd investment bank, recently criticized for shorting the very subprime loans it was touting to its customers, may be perusing a similar strategy with gold. Perhaps Goldman has a current short position it needs to cover or wants to buy a lot more gold, but needs to convince others to sell it to them.

Maybe Goldman will be right after all. Shorting gold could turn out to be the best trade of 2008, but not for those who short it, but for Goldman Sachs as it takes the other side of the trades. Recent moves by Paulson and Bernanke virtually guarantee that gold will rise. It's good to be the king.

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