Banks operated with less capital because of an assumption they would be rescued by the government, he said. Lehman Brothers Holdings Inc. wouldn’t have failed with adequate capital, he said. “Rampant fraud” was also an issue, he said. Lack of Trust “Fraud creates very considerable instability in competitive markets,” Greenspan said. “If you cannot trust your counterparties, it would not work.”

“The Fed … has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible.” So even though the Fed has flooded the credit markets with cash, spreads haven’t budged because banks don’t know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is “the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue.” *** Today, the banks have a problem on the asset side of their ledgers — “all these exotic securities that the market does not know how to value.” “Why are they ‘toxic’?” Ms. Schwartz asks. “They’re toxic because you cannot sell them, you don’t know what they’re worth, your balance sheet is not credible and the whole market freezes up. We don’t know whom to lend to because we don’t know who is sound. So if you could get rid of them, that would be an improvement.”

The underlying problem isn’t a liquidity problem. As I’ve noted elsewhere, the problem is that lenders and investors don’t trust they’ll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years — the derivatives, credit default swaps, collateralized debt instruments, and so on — has undermined all notion of true value. Many of these fancy instruments became popular over recent years precisely because they circumvented financial regulations, especially rules on banks’ capital adequacy. Big banks created all these off-balance-sheet vehicles because they allowed the big banks to carry less capital.

Alan Greenspan didn’t think regulators should even pay any attention to fraud:

He didn’t believe that fraud was something that needed to be enforced or was something that regulators should worry about, and he assumed she [Brooksley Born] probably did. And of course she did. I’ve never met a financial regulator who didn’t feel that fraud was part of their mission, but that was her introduction to Alan Greenspan.”

Indeed, as Born pointed out last year, Greenspan told her:

I don’t think there is any need for a law against fraud.

The FOMC announcement was widely anticipated, but while it was largely priced into the US TIPS market, it was not priced into the gold market. As we discussed in our last report, 10-year US TIPS yields had fallen to under 50 bps off the growing prospect of another round of quantitative easing. While speculative long positions had been building from arguably “oversold” levels, they were not building rapidly enough given the sharp decline in US TIPS yields, leaving the gold market arguably “under-bought.”We expect that the post-FOMC announcement rally that has carried gold prices close to our 3-month $1400/toz target has been driven by a sharp increase in net speculative positions, and we expect that ultimately, net speculative long positions will rise to a record 37 million toz given that US TIPS yields are below 50 bps.

Consumers: We expect gold prices to continue to rise from current levels as real interest rates should remain low on a continuation of quantitative easing in the United States. As a result, we believe that current gold prices provide an opportunity for consumers to layer in upside protection. However, longer term we continue to see considerable downside risk should the US Federal Reserve tighten monetary policy earlier than expected. Consequently, we recommend near-dated consumer hedges in gold, but more so in platinum where recovering global automobile demand will likely continue to put upward pressure on auto-catalyst demand and therefore on platinum and palladium prices.

Producers: While we expect gold prices to increase in 2010 and 2011, the rising risk of declining gold prices once the US Federal Reserve begins tightening monetary policy suggests this is a good time for gold producers to begin scaled up hedging of forward production, particularly for calendar 2012 and beyond.