Monthly Commentaries

Passing the torch and the risk “hot potato”. – October, 2005

This past month President Bush nominated Ben Bernanke to succeed Alan Greenspan as Chairman of the board of governors of the US central bank. While any successor to Greenspan will have a tough act to follow, Bernanke is a well-qualified activist who is on record as an ardent inflation fighter as well as a proponent of stimulating financial markets to promote economic growth. His immediate task will be tempering the rate of inflation – particularly in housing prices where consumers have depleted their savings and levered themselves inordinately to buy into the “American dream”. The risk of rising interest rates deflating the housing bubble is real. The proposed limitations on mortgage interest deductibility is another potential trigger for a drop in housing prices. Bernanke’s role will be to engineer a soft landing rather than a precipitous collapse. Greenspan himself has expressed some concern that the prolonged period of low interest rates has de-sensitized investors to the importance of demanding an adequate risk premium against unforeseen adverse economic circumstances. History is replete with credit crunches, proving that as consumers and investors demand greater choice in investment products and services, they focus on the immediate benefits and ignore the potential liabilities that might accompany future hard times. History also shows that these risks almost always return to haunt the financial institutions that originally provided the new products and services – real estate speculation in the late 1980’s caused the disappearance of the savings & loan industry in the US; consumer defaults on credit card purchases forced banks to charge 18% - 24% interest on outstanding balances to mitigate this exposure;

and the collapse of Long Term Capital Management hedge fund in the 1990’s threatened the survival of some large US financial institutions. The financial system has learned from these experiences and, realizing that there is no guarantee against future defaults, has rebuilt a sizeable capital base, has consolidated many of the smaller regional banks under larger umbrellas and has injected new rigour into the processes of credit evaluation and risk analysis. While no system is ever foolproof, the US banking system is better equipped now than ever before to assist Mr. Bernanke in unwinding what might otherwise be a potential disaster. Peter Sacks Managing Partner