Where Are the Bodies Buried?

Whatever your views on yesterday’s Fed action might be, a disturbing question is emerging that few seem to be paying much attention to – How long does it take for the financial system to identify who owes what to whom?

CDOs of CDOs of CDOs of CDOs cannot stand unaccounted for indefinitely. Knowing where the bodies are buried is a vital component to putting an end to the uncertainty risk premium that has elevated the fear factor among many investors, which, in the process, has sucked the Fed into reverting to the Greenspan playbook of more liquidity. But will more liquidity alone do the trick?

The Bank Credit Analyst’s thesis, “The Debt Supercycle”, says liquidity will work its magic, provided inflation remains relatively tame. Massive amounts of money can be pumped into the system to help reflate assets and preemptively avoid a severe economic downturn. All well and good, but a reflating system that contains untold amounts of hidden toxic paper may end up producing unintended and unforeseen consequences. A true manifestation of the expression, “You don’t know what you don’t know”.

Therefore, as we approach the six-month anniversary of the great awakening, the moment when complacent investors woke up from their Goldilocks stupor and came to recognize that all was not kosher, the question of who owes what to whom still remains unresolved.

The longer it takes bankers to identify the toxic paper on and off the books, the more damage to the global economy they will incur as trust erodes both within and without the core of the financial system thereby exacerbating an already tenuous credit situation.

With bankers still unable (unwilling?) to identify where the bodies lie and horde their precious capital, the far less than transparent New Power Brokers (Petrodollars, Asian Central Banks and their Sovereign Wealth Funds, Hedge Funds, and Private Equity) have stepped into the breach to save the day. However, their rescue efforts come with a price – opacity. And opacity is precisely what is not needed at a time when so much remains unknown and trust hangs in the balance.

Investment Strategy Implications

Equities are undervalued and yesterday’s Fed action certainly helps improve everyone’s valuation model. Equities are undervalued in a scenario that overstates the downside risks to global growth and corporate profitability (see “Here Comes the Global Depression”). Equities are not undervalued, however, in a world of endless undisclosed toxic paper and new capital opacity.

It’s high time we all learned where the bodies are buried.