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Systemic Risk Is Still on the Table

Systemic Risk Is Still on the Table
Dreamstime/Alain Lacroix

By    |   Saturday, 29 July 2017 12:28 PM

Nearly 10 years ago, the stock market hit its housing-boom-fueled top. Over a period of about 18 months, stocks would tumble over 30 percent on average, marking the biggest pullback since the Great Depression.

What happened? The simple answer is this: everyone got greedy.

To be specific, banks could make out increasingly risky loans, because they could sell those loans to Wall Street. Wall Street could make a bundle repackaging those loans. Credit rating agencies made money giving ratings on those loans. Institutions like insurance companies and pension funds could buy those highly-rated loans and get a slightly better return than investing in government bonds. The government was happy—as long as the economy was booming, so were tax receipts. Individuals could buy and flip homes, making more in a few months than they’d make in a year of corporate toil.

It was a perfect storm. Could it have been prevented? If banks had been required to keep their loans on the books, a lot of the greed could have been checked. Maybe not all, but enough to stop the financial crisis from becoming, well, a crisis.

But the original speculation occurred at a more fundamental level: The Federal Reserve.

The central bank kept interest rates artificially low. From the pre-Y2K Crisis that never materialized to the post-9/11 consumer spending binge to the start of the Iraq War, the Fed kept interest rates low.

As the leader of the global banking cartel, the Fed has a profound influence on global finance, starting with interest rates. Remember, interest rates are essentially the cost of money. Whether you want to buy a house or car or finance a business, you can offset some of your risks by borrowing money. In return, however, the borrower needs to be fairly compensated for taking on that risk.

Under a free market system of interest rates, borrowers and lenders would come to agreements on what to charge for borrowing money. Such a level would likely be higher in nearly all instances to account for the risks of things like business failures, real estate prices, and the like.

But because we centralized our banking 105 years ago, we no longer have this key check. Chances are interest rates wouldn’t have gotten so low in the first place, fueling the housing boom. And chances are lenders would have either raised their interest rates faster or would have required some other margin of safety like higher collateral levels. A free market might not completely prevent bubbles from forming—manias will happen as long as humans have emotions—but it can offer more checks and balances.

That’s the real trouble we’re in today. While things look rosy, our financial system still has systemic risk. The “too big to fail” banks are bigger today than they were a decade ago. And the Fed set a new precedent during the financial crisis: buying up toxic assets.

In the past, like during the Long-Term Capital Management crisis in 1998, the Fed acted as a broker and ensured that private interests had the funds needed to clean up the system. This was still a dangerous precedent to set, since it still encouraged a lot of risk-taking and created the sense that the government would eventually bail out any failure that was big enough to spook the system.

In short, rather than having a market of buyers and sellers reach an agreement, we have a one-size-fits-all, top-down approach. That sort of thing will ruin a country—just ask the Soviet Union. Oh, wait, you can’t. But as long as dangers emerge, governments will use it as an excuse to flex power. That’s true even if they’re the cause for the danger that was created in the first place!

As an investor, I want risk accounted for. But it’s difficult to fully appreciate the risk when it’s this systemic and when it gets more centralized after every crisis. Remember, the Nobel-Prize-winning geniuses behind LTCM found a strategy that worked great—until it didn’t.

Markets are responsive because there are multiple sources for buyers and sellers to go through. A top-down approach thus increases, rather than decreases risk.

It’s the same problem with health insurance right now. Many parts of the country only provide one insurer right now thanks to the imploding dumpster fire that is Obamacare. Are consumers better off when they only have one choice, or when they have dozens? If we’re talking a commodity, it might not matter. But for something where they can pick and choose, competition keeps markets more honest than government laws ever can.

How can an investor avoid systemic risk?

One idea is to simply try and “opt-out” by buying an asset like gold. Gold sits there, does nothing, earns no interest, and is otherwise boring. I do like gold—it’s been out of favor for far too long, and inflation is on the rise, which is good for the metal.

But the biggest holders of gold are central banks. While they’re net buyers now, there’s no telling when one or two of them may decide to make some large sales, which could easily tank the price of the metal in a short period of time. Gold is okay to try and avoid that risk, but beware its limitations.

For avoiding systemic risk, I’m a bigger fan of growing my wealth out of the problem. One area that looks enticing in that regard is technology stocks.

Think about it this way: the government can’t regulate it until it exists. And by the time something exists and is making enough money to get on the regulatory radar, there are probably only a few big players to begin with. What starts off as genuine competition will get locked into a pattern of crony capitalism. But as long as a company is continually innovating with new products and services, they can continue to stay one step ahead of the regulatory web.

In this area, innovation has been a boon to companies like Google (GOOG), Apple (AAPL), and even Amazon (AMZN). They’ve taken on established competitors and won in the marketplace. The only real downside to these tech plays is that they’re crowded. They’ve led the market higher year-to-date and are susceptible to a pullback as money rotates to relative value. But on a big enough pullback, industry-dominating tech companies are worth looking to buy for the long-haul.

Risk is unavoidable if you want to make a real return after inflation. Embrace it, but beware the dangers of increasingly centralized risks.

Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.

© 2021 Newsmax Finance. All rights reserved.

How can an investor avoid systemic risk? One idea is to simply try and “opt-out” by buying an asset like gold. Gold sits there, does nothing, earns no interest, and is otherwise boring. I do like gold—it’s been out of favor for far too long, and inflation is on the rise, which is good for the metal.
systemic, risk, investors, table
Saturday, 29 July 2017 12:28 PM
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