Part III of a March 31 Interview

By Kevin Michael Grace

Q: I just watched the movie Inside Job. Do you think that if its message [bankers gaming the bailouts to line their pockets] spreads, there will be a collapse of confidence in the ability of governments to run the economy?

A: I think we are now in a bit of a financial bailout fatigue state. Will there be another crisis of confidence? Yeah, if we have another financial crisis, and I certainly think we will. We’re now at the pretend stage. We pretend all these second-lien mortgages sitting on the books of the banks are worth their stated market value, when they’re much lower. We pretend there’s nothing wrong with the housing market, when there are signs it’s starting to double-dip again.

I hope that when the next crisis comes the political response will be more robust than it was post-2008, when the Bush and Obama administrations and the European governments were absolutely disgraceful. There was no coherence and no attempt to get at the root causes. I think governments can deal with it. We had a much more severe situation in the 1930s, and we dealt with it then. If you look at the Swedish and Norwegian banking crises in the early 1990s, they claim their playbook was Jesse Jones’ memoir, Fifty Billion Dollars: My Thirteen Years With the Reconstruction Finance Corporation. I believe that in the banking crisis you want to punish the shareholders and protect the depositors. We could have achieved that through FDIC-style reorganization: nationalizing the banks, breaking them up and then selling them off to the private sector. It’s not some socialist plot to assume the commanding heights of the economy but a standard reorganization that’s undertaken all the time with smaller banks. We should have extended it to the big five US banks.

Q: The American housing market is truly dire and getting more so. In Canada, the price-to-income ratio is increasingly out of control. It’s now 13:1 in Vancouver. Yet we are told “it’s different here” in Canada, and the bubble won’t pop. What do you think?

A: My understanding is that the Canadian banking system is not a fragile as the American system. You don’t have the same degree of sub-prime penetration, and these Frankenstein-type derivative products are not as prevalent. Which is not to say that you couldn’t have a significant housing bust; you’ve had them before. But I don’t think this would necessarily pose the same systemic threat to the economy as the American housing crisis posed there.

Q: Recently I saw a report that Mainland Chinese are buying million-dollar houses in Richmond, just outside Vancouver, and knocking them down, so they can build new ones. This seems borderline insane.

A: Yeah, it is. And it becomes unsustainable when the ability to service debt becomes acutely difficult relative to the incomes involved. If these buyers still have lots of cash flow or they’ve got regular income payments to sustain their interest payments, then we’re OK. How are these Chinese investors funding their houses? If it’s through debt, how much are they getting from Canadian banks and how much from Chinese banks? If it’s the latter, then it really turns on what’s going on in China. It could be that the Canadian housing market becomes subject to the vagaries of the Chinese economy, which looks to me more vulnerable now than it has been in a while.

Q: We spoke about Europe in December. Has the situation there gotten better or worse since then?

A: Worse. The European Central Bank continues to backstop the bonds of the so-called PIGS, but they’re doing so while insisting on continued fiscal austerity, which is starting to play havoc with their economies.

Q: What happens if there are popular rebellions against the conditions of the bailouts?

A: I think that’s a real possibility. I suspect that when push comes to shove, and the ECB is threatened with the Euro at the abyss again, they will backstop the bonds and prevent a fully-fledged crisis, but they are unlikely to do it proactively. Meanwhile, things will get worse. There are certain countries, like Ireland, where the guarantees offered to foreign bond holders are accelerating unemployment. Ireland has a 15% unemployment rate. If they continue on the austerity path, it could be 20% to 25% in a few years. What country will stand for that? They might just say they’re withdrawing from the Euro. Right now, the Euro is falling without a net.

Q: The traditional IMF remedy is to insist upon greatly increased taxes and a slashing of government spending. Doesn’t this guarantee economic devastation?

A: Yes. The IMF are economic quacks. Their cure just accelerates the disease. The notion that somehow budget deficits per se are bad once they get past a certain level is absurd. Criticizing a large budget deficit without paying heed to the economic context is like blaming a thermometer because it records a sick person’s high temperature.

Part I of the interview.
Part II of the interview.

Marshall Auerback is Director of and Corporate Spokesperson for Pinetree Capital Ltd, a Toronto-headquartered diversified investment, financial advisory and merchant banking firm focused on investing in early stage micro and small-cap resource companies. Pinetree, which has a market cap of $439 million, is invested primarily in Uranium and Coal, Oil & Gas, Precious Metals, Potash, Lithium and Rare Earths and Base Metals. Mr Auerback was previously an advisor to a number of fund management organizations, such as PIMCO, the world’s largest bond fund management group, RAB Capital and David W Tice & Associates. He has a BA from Queen’s University and a law degree from Corpus Christi College, Oxford.