Bailout could boost inflation, sink dollar

Oil and gold surged Monday as investors worried that huge new debts will harm US Treasury's credit standing.

A spike in the price of gold and oil was matched Monday by a fall in the US dollar and in stocks – all signs of unease as investors take a sober look at a mammoth government bailout of financial institutions.

Two big questions are weighing on investors:

First, will this bailout cost so much that it affects the creditworthiness of the US Treasury?

Second, will the bailout succeed in calming credit chaos and restoring health to the banking system?

In Monday's trading:

•Oil rocketed to nearly $121 per barrel, up $15 in a single day.

•Gold surged past $900 per ounce, a one-day jump of $43.

•The Dow Jones Industrial Average lost nearly 400 points, giving up the gains it made last Friday on the bailout news.

Oh, and last but not least, the dollar tanked.

"You've seen a fall in the trade-weighted dollar of about 2.25 percent today," says Paul Kasriel, director of economic research at the Northern Trust Co. in Chicago. "The markets have rendered a verdict of some sort."

Investors aren't so much revolting against the bailout as wondering what it all means.

Some may be concluding that, with rising US Treasury debt could come higher interest rates or inflation in the future.

Gold and commodities such as oil are hard assets, seen as a hedge against such a threat. Meanwhile, investors tend to shun the dollar in such a scenario.

"Maybe they're saying, 'I want to hold something real here,' " Mr. Kasriel says. The American economy is swimming in debt, he says, and the bailout plan will simply shift some of the worst debts from weakened banks to the largest balance sheet around – that of US taxpayers.

The day's huge surge in oil prices also stemmed from a technical factor. The expiration of a monthly crude oil contract added to price swings as traders rushed to cover their contract positions.

But markets are clearly grappling with the implications of the world’s largest financial industry needing a taxpayer rescue.

Recent government interventions are beginning to pile up, as Alex Patelis, a London-based economist at Merrill Lynch, pointed out in a report Sunday headlined, “As the US printing press starts.”

The biggest tab so far is the Treasury’s still-emerging plan to buy $700 billion in mortgage-related debt, but it goes beyond that. Among the other Treasury costs Mr. Patelis cites: An $85 billion loan to insurance giant AIG, $10 billion for purchases of mortgage bonds from Fannie Mae and Freddie Mac this month, $100 billion to fortify the Federal Reserve’s balance sheet, $50 billion to insure money market mutual funds.

In all these cases, it’s not clear that this is money that taxpayers will ultimately have to pay. Much of the money to buy debts, for example, should be recouped when those assets are later sold.

But suddenly the risk on the government’s balance sheets seems to be widening every week. It’s not surprising that investors are asking some questions about the soundness of the dollar.

Meanwhile, many economists and investors are wondering if the $700 billion fund to buy shaky mortgage-related debts will achieve its objectives.

In the aftermath of the past year’s credit bust, the financial industry needs to undergo a massive consolidation, argues Richard Bernstein, chief US investment strategist at Merrill Lynch in New York.

He has said for several months that a government fund, like the Resolution Trust Corp. that dealt with failed savings-and-loan institutions nearly two decades ago, could help with this process. But in a report to clients Monday, he questioned whether the Treasury’s new plan will achieve that objective.

“Certainly, ridding the financial system of bad debt is an admirable and necessary goal,” he writes.
But whether it promotes consolidation may depend on details Congress is weighing now.

One key question: Will the Treasury buy the assets at a price that’s good for banks – helping them on the road to recovery, or at a price that minimizes costs to taxpayers?

“In a way, we view the eventual terms of the [fund] as a tug of war between taxpayers and equity shareholders of financial companies,” Mr. Bernstein writes. “Although in the long run, it is entirely possible that both taxpayers and equity shareholders win, it is difficult for us to envision such a win-win outcome in the shorter-term.”

If the Treasury drives a hard bargain on behalf of taxpayers, the result may do little to clean up bank balance sheets. One possible benefit: The removal of bad assets might remove uncertainty that has made it hard for banks to raise needed capital by issuing new stock to investors.

The bottom line of all the gyrations in Congress and in markets?

“There’s a real loss,” Kasriel says. “What we’re really arguing about is who’s going to bear the loss.”