The U.S. Credit Crisis: Major Paradigm Shift

 |  Includes: DBA, EEM, EFA, FXI, IEV, IFN, ILF, RSX, SPY
by: Mohammad Farooque

The credit crisis is getting worse and worse. The magic Wands (lowering interest rates and printing more dollars) which worked in the past several years have suddenly stopped working or working in the opposite direction, leading to higher commodities prices, including food and gas.

The US (government and public) has been used to the idea of "credit or financing" for everything from the birth of a baby, going to college, buying a house (or car), buying Chinese goods or to pay back-office workers in India or finance wars in Iraq and Afghanistan. It worked well for several years since there was strong demand overseas for dollars since everybody was doing business in the dollar. Technically this could have worked well indefinitely as long as the markets kept going up.

However some innovative people came with the idea to sell all that debt to investors in the form of complicated investment vehicles that not even their "inventors" or the CEOs of the companies which are holding them understand well. Financial institutions holding these investment vehicles borrowed heavily against them as they now become worthless.

On top of that these investment vehicles of uncertain value have been used as collateral against extensive borrowing. Now each investment dollar is covered with multiple layers of debt. According to some estimates, the US has debt obligations of over 265 trillion, almost 19 times the GDP (2007) of the country. For me it is amazing to notice how so many investors, central banks, and even the IMF and World Bank do not appear to realize the magnitude of the debt crisis.

Global investors are coming to realize that these levels of leverage are unsustainable and are becoming very defensive as a result. The US credit crisis is scaring investors everywhere from developed western markets to developing markets and frontier markets. This is evident from the synonymous and precipitous fall in stock markets from China to South America to Canada during the last several months. It is a matter of time before most of the investors will realize that it is not a global crisis, rather it is a credit crisis limited mostly to US and to some extent Western Europe and Japan. Now there are two questions facing the investor community. 1. How the credit crisis will be fixed? 2. How long is it going to last? Will the whole world's economic growth be hostage to the irresponsible investing practices of a few?

1. How this credit crisis will be fixed?

The best solution is, as some have been suggesting, to "let the markets take the pain and get cleared". This option will be good in the long run, however the majority of the big financial houses will go down as a result. This is the least likely possibility because of the politics involved (any president who will try to do this will be very unpopular) as well as consideration to protect the big banks.

The other option could have been that European, Asian and South American Federal banks and Sovereign wealth funds step up to the plate and salvage the problem. At the start of the subprime crisis when European central banks were not aware of the magnitude of the crisis they tried to help out by injecting substantial amounts of liquidity into the system. Similarly, Singapore and some Middle Eastern Sovereign Wealth funds stepped in, even individual investors like Saudi Prince Al-Walid bin Talal attempted to show solidarity by investing several billions in Citigroup (NYSE:C), though now it seems these players are staying away from this mess.

Therefore it seems that the possibility of world financial institutions making a concerted effort to thwart this crisis is least likely at this stage. The only viable option left is to continue printing more and more dollars without consideration of and keep accepting junky securities as loan collateral from troubled financial institutions. This may salvage some of the financial institutions but it could also bring unpredictable and unforeseen consequences for the economy.

2. How long is the crisis going to last and how it will end?

Now the main question is how long this downward slide is going to last? I believe it can not be predicted however, as I argued in my previous articles, that there is a big wealth transfer going on from traditionally rich countries to traditionally cash poor countries e.g. India, Russia, China, Brazil etc. At some time point an equilibrium will be reached, however this may be 5-15 years down the road.

Until now, world markets have been acting in a way that the whole world has been in an economic crisis due to credit related issues. Over time investors will realize that the credit issue is limited to those countries and segments of the economy which have been living beyond their means or have been too greedy while others are just fine, healthy and kicking. I believe the so-called third world countries of yesterday (emerging markets) will be the biggest winner from the credit crisis because a) the debt they owe to rich nations is in dollars and as the value of the dollar goes down their debt will reduce proportionality; b) investments in those countries will keep on increasing for some time; c) many developing counties have stashed huge piles of cash which they can use to their advantage.

On the other hand, in the long run, I believe agricultural based/natural resources based companies will do better in the USA. To me, debt crisis is a major paradigm sift in the history of mankind. As World Wars I and II resulted in a major paradigm shift since all the third world countries got out of physical occupations, though still remained economically dependent afterwards, the current paradigm shift due to the debt crisis will lead to economic independence and prosperity of third world countries in Asia, Africa and Latin America.

For the above reasons, I recommend investing in emerging markets and US companies in the agriculture sector, natural resources and energy.

Disclosure: None