Who’s Really to Blame for the Crooked Financial System

By: Money_Morning

Martin Hutchinson writes: It’s been in the news the last couple of days. Goldman Sachs Group Inc. (NYSE: GS) bankers are headed for record bonuses. The Financial Times reports that bankers’ pay in the London market is already right back to 2007 levels and going higher. Banks are poaching each others’ best staff, and are offering huge pay packages to staffers willing to make the leap.

It’s enough to make you succumb to the Two Minutes’ Hate.

But let’s face the truth. As egregious as salary escalation seems - coming as it does on the tail of the worst U.S. banking crisis since the Great Depression - the reality is that this is the U.S. government’s fault. After all, it was the U.S. Federal Reserve and the Obama administration that created all the bailouts and the special-loan-subsidy schemes for banks that would otherwise have been on their last legs.

In a truly free market, ex-Citibankers (NYSE: C) would be on every street corner of Manhattan - selling apples - and that would properly hold down the pay of those bankers still lucky enough to have a job.

The sudden rebound in demand for bankers is a symptom of overall market conditions right now. The U.S. stock market is way up from its lows, there are three Chinese initial public offerings (IPOs) due to come to market this week (one of them for a company with no earnings), the volume of home mortgage refinancing has been running at record levels, the FHA index of home prices has dropped only 0.3% this year and the volume of new corporate debt issuance is also high. Commodity prices are well off their lows, and oil prices are again close to $70 a barrel, which would have been considered an excessively high level only three years ago. That’s not a picture of a financial market - or a global economy - in deep recession.

Far from it.

To some extent, this is good news. A revival of the financial system and its ability to finance businesses and home purchases is exactly what the huge monetary and fiscal stimulus was meant to produce. A modest revival in world trade, as inventories cease being wound down and Chinese production ramps up again, is also a necessary precondition for economic recovery.

As the banking bonus news suggests, however, much of the activity is coming in some pretty funny places, where the excesses of the past decade were concentrated and where you wouldn’t expect to see such a quick revival.

That gives us a clear indication of just what the problem is. Because bankruptcies weren’t allowed to happen back in September and October - as they would have in a free market - there are more institutions in the market than there should be, Citigroup and Merrill Lynch most notable among them.

Moreover, in a true free market, the entire credit-default-swap (CDS) business - a product that caused $180 billion of losses to the financial system through American International Group Inc. (NYSE: AIG) - would be nothing but a smoking ruin. But in the market we are living in, those $180 billion worth of losses have been transferred to the tab of the taxpayers of America.

With Citigroup and Merrill Lynch bankers mooching around on street corners, financial sector salaries would be forced down to a more reasonable level.  As it is, the few unemployed unfortunates who worked at Lehman Brothers are not enough to depress the market. Likewise, credit default swaps have caused huge pain to the unfortunate employees of Abitibi-Bowater Inc. (NYSE: ABH), General Growth Properties (OTC: GGWPQ), and Six Flags Inc. (OTC: SIXFQ), each of which went bust partly because their creditors were playing in the CDS market and had no incentive to find an alternative to bankruptcy. Had CDS caused the pain they should have to financiers, the product would no longer exist, to the considerable benefit of the rest of us.

Inevitably, we are going to have to pay the price for all the bailouts. The financial sector will eventually shrink to its proper size, as will its members’ earnings. CDS will eventually be sharply restricted, to prevent their holders from forcing random companies into Chapter 11. Interest rates will have to rise, to accommodate the huge debt-funding needs the government has incurred. Money will have to be kept tight, to pay for the indulgences that Fed Chairman Ben S. Bernanke granted during the bubble, as well as for the even greater-indulgences of the bust.

Which is probably why you don’t want to hold U.S. stocks right now. [Click here to check out a related Money Morning story on the salary increases some banks are offering in order to retain key employees.]

[Editor's Note: Longtime global investing expert Martin Hutchinson has made a specialty of evaluating banking profit plays, and in recent reports has warned investors away from "Zombie Banks" and devised his own "stress test" to highlight the best profit plays in the troubled U.S. financial-services sector. Hutchinson brings that same creative analysis to his The Permanent Wealth Investortrading service, which uses a combination of high-yielding dividend stocks, profit plays on gold and specially designated "Alpha Dog" stocks to create high-income portfolios for his subscribers. Hutchinson's strategy is tailor-made for uncertain periods such as this one, in which too many investors just sit on the sidelines and watch opportunity pass them by. Just click here to find out about this strategy - or Hutchinson's new service, The Permanent Wealth Investor.]

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