Hedge manager Sprott sees trouble when easing ends

Date: Wednesday, October 21, 2009
Author: Alistair Barr, Market Watch.com

When so-called quantitative easing by central banks ends, the world economy may slip back into trouble, Canadian hedge fund manager Eric Sprott warned on Tuesday.

Toronto-based Sprott called Citigroup, Fannie Mae, Freddie Mac, and General Motors "dead men walking" in late 2007. On Tuesday, he said the U.S. government is the new dead man walking, partly because it may struggle to keep borrowing enough money if the Federal Reserve stops buying Treasury bonds.

Sprott's Canadian hedge fund, Sprott Hedge Fund LP, is up more than 400% since inception in 2000 as it rode a surge in gold prices and shares of gold miners and other raw materials companies.

Bank bailouts and other dramatic efforts by central banks have stopped the world "going into the abyss," Sprott said during a presentation at the Value Investing Congress in New York.

The "granddaddy" of all those bailout efforts is quantitative easing, in which central banks in the U.S. and the U.K. especially buy government bonds to keep interest rates low, Sprott said.

The U.S. government has raised roughly 200% more by selling bonds this year, versus last year, Sprott noted. Through the end of the second quarter of 2009, he said the only major buyers of these government bonds were central banks.

"When quantitative easing ends, what's going to happen?" he added, noting that there are already two clues to answer that question.

When the U.S. government's cash-for-clunkers program ended, car sales slumped. Meanwhile, as the end of the government's first-time homebuyer incentive approaches, recent data suggest weakness building again in the housing market, Sprott said.

Roughly 35% of all homes bought in the U.S. recently were purchased through the incentive program. If it is not extended, December home sales could slump 25%, Sprott estimated.

Sprott remains concerned about banks and other financial institutions in the U.S., because he thinks they remain too leveraged.

Banks leveraged roughly 20 to 1, have about 5% of equity supporting mostly paper assets. If those assets fall by more than 5%, the institutions are effectively bankrupt, Sprott said.

"The fundamental problem today is that the appropriate leverage ratio is certainly not 20 to 1," Sprott said, citing some of the bank failures this year in the U.S.

To be seized by the Federal Deposit Insurance Corp., these banks have already lost their 5% equity cushion. But some of the largest bank failures this year, including Colonial Bank, Guaranty Financial, and Corus, involved write-downs of between 11% and 25%, Sprott noted.