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Precious Metals' Short-Term Outlook Is Bearish


Long-term investors, however, have a bullish forecast.


President Barack Obama's administration hasn't been aggressive enough in fixing the root causes that led to the near economic collapse. In a recent speech, Federal Reserve Chairman Ben Bernanke said that it was regulatory failure, not low interest rates, that was responsible for the housing bubble and subsequent financial crisis.

Bernanke denied any Fed culpability for inflating the housing bubble and blamed the "under-regulated" financial sector, which had designed and sold unconventional and exotic mortgage products that later turned out to be toxic.

One may ask why the Fed didn't do anything to limit the use of these mortgages if they were so dangerous. In addition, the biggest issuers of these mortgages were Fannie Mae (FNM) and Freddie Mac (FRE), both government-sponsored entities.

Bernanke conveniently ignores the relationship between the popularity of these mortgages and the low, short-term interest rates that made them possible in the first place. It can be argued that without the ultra-low interest rates provided by the Fed, the vast majority of these problem mortgages would never have been issued.

Regulatory reform to curb the banks' voracious appetite for risk-taking is moving through Congress at a snail's pace. While the Treasury has forced banks to raise capital, many still remain thinly capitalized and vulnerable.

Banks have been unwilling to sell bad assets and take a loss. They're stuffed with risky commercial and residential mortgages and consumer debt. While returns for investors last year were 0% at best, hundreds of thousands of bankers paid themselves hefty bonuses profiting from the taxpayers' largess. For the bankers its "heads" they win, "tails" you lose.

The dose of medicine that the American economy received this past year may have soothed some of the symptoms, but didn't treat the root disease. That would mean taking a long-term view, and politicians want short-term results. A major opportunity to make far-reaching changes is being wasted. It was Rahm Emanuel, White House chief of staff, who famously said, "You never want a serious crisis to go to waste." Although he was criticized for being flippant, he was certainly on to something.

As Nobel Prize winning economist Paul Krugman wrote in his New York Times column last week, reform will probably not be able to prevent bad loans or bubbles. But it can go a long way in making sure that when the bubbles burst they don't take down the entire financial system with them. The stock bubble in the 1990s, for example, didn't rouse a financial crisis because the risk was widely distributed across the economy. Here's how Krugman explains it:

By contrast, the risks created by the housing bubble were strongly concentrated in the financial sector. As a result, the collapse of the housing bubble threatened to bring down the nation's banks. And banks play a special role in the economy. If they can't function, the wheels of commerce as a whole grind to a halt.

Why did the bankers take on so much risk, Krugman asks. Simple. It was in their self-interest to do so.

By increasing leverage -- that is, by making risky investments with borrowed money -- banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn't the bankers' problem.

It's precisely because of that conflict of interest that we have bank regulation, but rules were relaxed and weren't expanded to cover what Krugman calls the "shadow" banking system, such as Lehman Brothers which had begun to perform bank-like functions.

Everything was fine as long as housing prices were going up, with finance accounting for more than one-third of total US profits as the bubble was inflating. When it collapsed, it was government aid on an unprecedented scale that pulled the financial industry back from the brink of disaster.

Many commentators argue that unless the Obama administration changes the rules, the incentives for bankers to continue doing business as usual will still be there. Like we said, it's "heads" they win, "tails" we lose.

Krugman argues that banks must be transparent about how much risk they're taking. And finally, reform should limit the financial industry's compensation practices.

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