Stress Testing the Banks

It's Labour Day in Victoria, but here in Auckland, the great wealth destruction of our time marches on. New Zealand house prices fell nearly 9% in the last year, the latest statistics show. Rising unemployment is now a big factor in the housing market. Mortgage payments are even harder to make when you don't have a job.

One thing you notice walking around Auckland's CBD is just how many students and tourists there are from Japan, China, and other countries on the Pacific Rim. It reminds you a little of Vancouver and even Melbourne. It also makes you wonder if large cities in Australia and New Zealand will become holiday playgrounds for the rich of Asia.

Of course that's jumping the gun a bit! We still have a massive global financial crisis to get through before a new global economic paradigm emerges. First the destruction, then the creation!

Henry Kaufman tells the New York Times that the whole model of "quantitative risk analysis...didn't save anybody or anything." He says investors will need to lower their expectations for equities to around 4-5% per year. Barton Biggs predicts that social unrest could come from the destruction of household wealth and that people ought to consider buying shot guns.

We're not sure if he was kidding. Probably not.

From an investment angle, the men interviewed in the article like the look of corporate bonds. And they also point out that markets outside the U.S. have crashed even harder than U.S. equities. It's also noted that despite humongous fiscal deficits in the U.S., the market for U.S. bonds and notes has plenty of buyers (even though supply is growing so rapidly).

You wonder, at least we do, if this rush of what's left of risk capital into the U.S. bond market will lead to a sovereign bond default somewhere else in the world this year. Repudiating un-payable debt is probably going to be a winning political strategy in counties with liabilities denominated in foreign currencies (Swiss francs, euros, yen, or dollars). Unlike the U.S., other countries can't print more of the currency. If they borrow in dollars, they have to repay in dollars, which means they have to buy them or trade for them.

By the way, if you are on holiday today, or just have some time to read an article by the best financial writer going today, check out this Vanity Fair piece by Michael Lewis. It's a gem. Lewis is a great writer. But he has the talent to get to the heart of any financial story.

Last week we repeated John Robb's idea that while the regulators are stress testing the banks (something the market has already done, if you look at the price of bank stocks) the regulators themselves are being stress tested. Or, more to the point, if GM and Citibank and AIG are failing because they are too large, complex, and poorly managed, then what about even larger organisations with even poorer structural finances like, say, the United States government?

Dan Denning
for The Daily Reckoning Australia

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