NEWS #79

From February 3, 2008 to March 24, 2008

March 24, 2008

Richard Kolon sent me the following note, which I pass along here.

"According to this chart, most mortgage rates have been RISING the last two months.

http://www.mortgagenewsdaily.com/mortgage_rates/

How is that going to help the consumer? Not one bit!

The government is bailing out the banks who made the irresponsible loans, but the banks want to charge higher rates to customers now, even though the Fed has reduced interest rates they charge BANKS by 3% from the peak in the Discount rates (in effect).

The Fed is subsidizing irresponsible lenders!

This is madness.

The Japanese did the same thing. They remained in trouble for nearly 2 decades, by trying to prevent failures on falling asset values.

A recession at least would allow interest rates to fall, and then maybe some people with adjustable rate mortgages might be able to afford their payments, Instead, the banks are using the bailouts to gouge their customers into paying more, while THEY PAY LESS for treasuries.

Consumer borrowing is going to dry up. The problem with subprime mortgages is going to worsen as more financial banks layoff their own people.

I will continue to SKF it."

Here is a link that Rich sent earlier:

'How Bad Can It Get?', by Hans Wagner of FinancialSense.Com.

Here is a link sent in by the Red and White D.

'Partying Like It's 1929', by Paul Krugman of the New York Times.

March 18, 2008

I got some reactions to my comments on the 16th. Here is what the Orange Section had to say:

"Bender, as always your comments were excellent.

I hope your readers understand that all that really matters is their real, liquid purchasing power. More importantly, government inflation numbers are an outright scam. What is worse, those are the numbers the brains at the Federal Reserve are using to make decisions. My opinion is they have built up a great deal of 'error' in the system. That error is getting ready to assert itself in the macro economy. We may be seeing the very beginning of a change in the rules of the game for the FED. Not in the sense of what they set out to do, but a shift in their policy objectives and how they think to best achieve their goals.

The current predicament exposes several issues. First, interest rates are insufficient as a solution in the current economy. The housing market is in the dumps because the rules have reverted from free money to normal credit standards. After 10+ years of conditioning home buyers that they could afford $250k homes with no down payment on two $15/hour salaries the sudden change in inertia has been painful. The housing market is at the very beginning of a new paradigm. The rules have changed and not everyone knows what the new rules are. This is especially true of new home buyers. As a result the market is in the tank. I spoke with a friend who is a Real Estate agent with 30 years of experience. She told me there is no spring market right now. Why? Because the buyers cannot secure financing. Why can't they? Because the lenders have to cover themselves from previous abandonment of sound lending practices. They will only take on extremely low risk debt. The result: The rules of the game have changed. Now buyers need down payments and strong credit. This means spending less money and paying down obligations.

The FED fears a population that does not use debt. The current unstable equilibrium of the economy depends in part on the FED's ability to reflate (issue more money/fuel spending) when deflationary pressures arise. A public that is willing to spend money and take on debt is essential to that reflation. If the public does not spend money, but instead saves it or pays down debt, then it adds deflationary pressure to the economy. This is where I believe we are headed. People that need credit must first clean up their credit to get credit. That means not spending money, but instead saving it and paying down debt. This is why I said earlier that interest rates are insufficient. Interest rate movements indirectly effect credit standards and can be, as they were in housing, usurped by asset price inflation. If the population does not play ball the FED will not be left with any other tools in the tool box. This foretells a choppy year economically, but as people adjust to the new rules things will eventually start to level out. Whether that leveling is permanent or temporary I cannot say.

The history of the past 20 years has been paying it forward. We have paid it forward on government spending, debt, and national security issues such as terrorism. We have paid it forward on the economy as well. First we had excess capacity from the 90s following a bubble market in not just tech, but stocks as a whole. Then we had twin bubbles of housing and credit that were already growing when the capacity and stock market bubbles popped. We are seeing companies pay it forward to their employees by using bankruptcy laws to break pension liabilities. Are we going to pay it forward to the next generation through currency devaluation?"

The Red and White D also wrote:

"$2 for a $160 share. That is some kind of inflation!

$1,000,000 for a once upon a time $100,000 house in a San Francisco suburb in '04....same house today 20 to 30 percent off it's peak price and no end in sight.

Which way is the pendulum actually swinging, inflation or deflation, and which is really worse?

Yes, the FED can print money ad infinitum, but could they be pumping it into a financial black hole. Yes commodities are soaring in price but commodities will eventually run into the price elasticity brick wall and fall back. They always do.

One, like me for instance, might ask if the current situation is somehow different from all the other financial emergencies in the last 75 or so years. Did housing become such a staple foundation of finance that its collapse in value has become the equivalent of yelling fire in a theatre.

What central banks do or don't do may be irrelevant if and when a genuine financial panic sets in, and people start cashing in their 401 ks and hoarding the cash.

Perhaps you are right. Perhaps central banks can inflate the currency and keep the psychology of the market under control by throwing cash at it. It has worked before. 'Start the machine'.

But, like positioning firemen with firehoses in the aisles of a burning theatre, I'm not sure this tactic will produce the desired results....by that I mean calm patrons. If there is a perception out there, real or imagined that folks will only have $2 left for every $160 they used to have in investments they are going to head for the exits in droves.

Like a famous fellow once said:

'Let me assert my firm belief that the only thing we have to fear is fear itself.'

Like the folks at Minyanville, I am struck by a universal harkening back to the Great Depression. Red and White D uses an FDR quote. The FED uses techniques not used since the 30s.

Here are links to two articles at Minyanville.com.

'Spring Cleaning For Free Market', by Andrew Jeffery.

'Main Street Feels What Wall Street Has Yet to Acknowledge', by Kevin Depew.

March 16, 2008

There is no inflation, this I know
For Bush and Paulson tell me so
The dollar's weak, but the economy's strong
Get into the markets and go long

Recent headlines on the front page of my local newspaper included the price of flour trippling and the bailout of Bear Stearns. When my local newspaper takes note of these things, the concern has to be pretty universal, because my local newspaper is absolutely the last to catch on.

A very large number of the stocks in my system are now 4 to 6 months from their 52-week highs, actually 38 of the 61 stocks in my system are in that range. That does not bode well for the markets in the long term.

The Bear Stearns bailout is of interest to me. I tried to warn my readers that the big banks and banks in general would be in the jaws of the foreclosure crunch for a period of at least 15 months. During that time forclosures will keep happening, wounding our financial institutions and seriously compromising their ability to make new loans. We are only half way through the third month of this period and a bailout of a major financial institution is taking place. That is a bad omen. I see more big hogs having to belly up to the Fed trough in months ahead. Really folks, it does not require a crystal ball to foretell the future.

And inflation, what inflation, and what could be the cause of that inflation that the Feds say does not exist? My back- of-the-envelope calculations say that even as the Feds have reported 2 percent inflation year after year it really was moving along at 7 to 8 percent. That is how we got 1,400 square foot houses to be worth a cool half mil. A rule of thumb here would be to take whatever inflation figure the Feds will admit to and multiply that by 4 to get the real number. Hey, we can call this the Bender 4 factor!

The cause of the inflation is our governments, state, local, and Federal spending more than they take in along with the average joe American consumer doing exactly the same thing. The average American household owes $12,000 in credit card debt. Ouch!

Housing is not the only place where inflation 'went'. It went to the central banks of developing nations. Those foreign central banks 'absorbed' our inflation and stored it for us. At the time our currency was more stable than theirs. That is why Paulson and his predecessor kept up all the brave talk about the soundness and stability of the dollar. Now, the dollar is not as stable as it was then.

We, collectively, have had too much exposure to credit. We have become far too comfortable with it. I think we need to return to a time when government budgets are balanced. The problem with that is that there is no hope of that happening any time in the next 4 years. Congress is not in the 'zone' on this and neither are the three major candidates for President. So what I see is more devaluation of the dollar in our mutual future, accompanied by some really serious inflation. That is how debt gets paid in these kinds of situations, with currency that is not nearly as valuable as that which was loaned in the first place.

And now the question that you should have been asking yourself as you read this: How does this really affect me? Well for one, your paycheck already does not go as far as it did a year ago or even a month ago. And if you think that is bad wait until you hear the really bad news. Your savings don't go as far either, and your savings include your retirement funds.

Sure, your retirement plan will probably deliver to you the exact dollars it promised. But what will those dollars buy when you get them? You'll be alright though as long as your house is paid for by the time you retire, you don't need to buy gasoline or fuel to heat the house, and you can grow your own food. If that will not be the case, maybe you should be concerned.

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Here are two links sent by Red and White D. He and I and the boys were having coffee when a long missing fellow Bender showed up, one Paul Goedicke, who stated that he was moving back to God's country, and that IBM had agreed to keep paying him money and he had agreed to keep working for them, but from a Casper location. It will be good to see him again.

'Dubai aims new fund at the West' , by Louise Armitstead and James Hall of The Telegraph.

Real Clear Markets

March 9, 2008

Richard Kolon watches the FED pretty closely. He notes that futures recently died when it was learned that the FED announced it is increasing its Term Auction Facility (TAF) to $100 billion, thus dashing speculation of a rate cut between meetings.

Rich's analysis: "Complete credit collapse."

March 2, 2008

Yes, I still list the top ten longs in my personal system above on this page. Am I buying them? No. Look here for strong hints about what I am doing with my personal money right now. When you do, you will see that I am into gold right now and into SKF, which is a fund that shorts the financials. I just closed out my shorts on the home builders because it looks like some fools are going to ballyhoo them up to higher levels before they get some rain on that parade.

The past 13 months were in one way, the winter of my discontent. I was out of a job and worked only part time. But in other ways the time off was well spent. My daughter needed my help and advise as never before and I was able to give her a lot of my time, thought, and energy.

I began a serious writing project, a book, that is now 35 chapters complete. The project was challenging on more than one level. The main character is a composer. I have always been good at composing music, but lyrics were my weakness. To write this book I had to develop my lyric-writing abilities, had to grow and stretch. I just finished what I call my super chapter in which the main character's music is being played all over town. It is an explosion of music and I had to write the songs as I wrote the chapter.

The other good thing that has happened is that I now have a job that I love. It is richly fulfilling in personal way. I get to watch and promote personal growth in others, who desperately need to turn their lives around. I work at a work-release program for felons. I never dreamed I'd do this kind of work. But I love it.

I hope all my readers are well and happy.

The Bender, Fred Jacquot.

February 29, 2008

I have several links here from Richard Kolon.

In this first link Jim Rogers talks about inflation: 'Quantum's Jim Rogers says US 'out of control'', on TimesOnline.Com. I quote it below.

"The dollar may have declined recently, he added, "but you ain't seen nothing yet'.

Talking to a room almost exclusively populated with Japan- focused equity investors, Mr Rogers recommended an immediate language course in Mandarin and a switch into commodities - the second-biggest market in the world behind foreign exchange.

Mr Rogers said that historic drains on wheat, corn and other soft commodity inventories have created market dynamics that could lead to severe food shortages."

The price of flour for bakers has risen 100 percent in the past year, but the FED keeps telling us that inflation is benign, and idiots like Larry Kudlow keep repeating that drivel in hopes we'll all believe it. Boy, that sure makes me feel better. It's a good thing none us actually eat flour (he said, tongue in bagel).

Rich sends along to 'Borrowers Abandon Mortgages as Prices Drop', by Ruth Simon and Scott Patterson of the Wall Street Journal. I quote it below.

"Sgt. First Class Nicklaus Skaggs is among those looking to walk way. Mr. Skaggs bought his home in April 2005 shortly after returning to California from a one-year tour of duty in Baghdad.

The $455,000 three-bedroom home he and his wife purchased in Vacaville, about one hour northeast of San Francisco, is worth an estimated $285,000 today, well below the $453,000 he owes on his mortgage. The monthly mortgage payment, which jumped after its interest rate increased, is now $4,000, up from $2,980 when he bought the house."

Did you catch that? This guy only put down $2,000.00 and walked into $453,000 loan on a First Class Seargent's salary. The house has depreciated 37 percent in thee years (or less). This is what was going on all over folks. As this unravels, it is going to be really messy.

Here is the third link from Rich titled 'The Early Innings of a Gold Boom',by John Rubino of FinancialSense.Com. I quote it below.

"A smaller economy never would have been able to accumulate debt equivalent to more than 300% of its GDP, as we have today; its currency would have collapsed, as has happened dozens of times in emerging markets in just the last twenty years.

...Currency collapses are always caused by excessive debt, and no nation has ever accumulated more than we have. Our debt is larger than global GDP, and that is without including the tens of billions in unfunded federal liabilities.

...I think gold will have peaked when the rewards offered for holding traditional assets are sufficient to compensate us for surging risks. If we consider that gold peaked when an ounce of the precious metal was near the value of the Dow Industrials index, then perhaps gold needs to rise at least ten-fold or the Dow needs to fall quite a bit."

February 25, 2008

Here are are some good links:

'Five things you need to know', by Kevin Depew of Minyanville.Com. I quote below.

"What is extraordinary is not merely the fact these agencies are being proposed in the first place, but that no one seems to bat an eye about advocating a return to economic policies last implemented during the Great Depression! Are we the only ones who find this stunning?"

'The Un-Credible Fed', by William Fleckenstein. I quote it below.

"It takes many years for a certain psychological mindset to plant roots, and generally that state of mind is resistant to change. But it does appear that psychology regarding inflation has changed, and that the Fed is in the process of losing the bond market. One has only to look at the explosive rise in 30-year fixed-rate mortgages to see that the Fed' campaign of easing has backfired. A knowledgeable friend in that business tells me this is one of the worst periods ever, as those rates have just rocketed higher, even as the Fed has eased.

Greenspan and the Fed created this mess by picking the wrong interest rate -- and by continually bailing out every problem created by excess money-printing with more excess money-printing. But we're finally at the moment in time where the problems are too big to bail out (periodic upside flurries in stocks and belief in magic wands notwithstanding)."

From Rich Kolon, an interesting nugget.

'THIS WEEK: GRADING THE MACROTRADING CHALLENGE', from FinancialSense.Com.

February 24, 2008

The Red and White D send along this link to 'HSH Nordbank sues UBS over exposure to sub-prime danger', by Christine Seib of The Times. I quote below.

"HSH accused UBS of putting risky American mortgages instead of low-risk assets into a CDO that it sold to the German bank in 2002. The bank has engaged Quinn Emanuel, a US law firm, to sue UBS for breaching its contractual obligations and fiduciary responsibilities."

When you read this article please note that the securities were sold in 2002. How about all those sold in later years? Just as the first of the really heavy foreclosures occurred in January, and will go on for over a year; the sueing season is just now underway and it will go on for many many years.

In line with a note that Richard Kolon sent this weekend, here is a link to 'Market Manipulation Afoot', by Mr Practical of Minyanville.Com. I quote below.

"I ask you, why would any fiduciary enter an order like this other than to signal to the market that it is going up? Why would any fiduciary want to pay an artificially high price for his investors? Logic dictates that this is either manipulation by a non-economic entity (infinite capital) or someone really, really stupid.

I can't rule out the latter, but after a while you would think fiduciaries like this would be out of a job. Regardless. It tells us one thing: there is very little information in the market right now...there is only volatility. That volatility is a function of the ever decreasing liquidity from deflationary pressures (the lower the liquidity, the higher the volatility) and the fact that this market has now become a 'news' market. There is so much happening, mainly from the stain of imbalances and too much debt, market participants change their minds with every new piece of news and every rumor."

There is an incredible amount of volitility in the markets right now.

When I was 19 I took micro and macro economics from an old hand teacher in college. He used to give us the one question that would be the final test two weeks in advance. On the scheduled day we would march into his classroom and write into blank blue books the answer which never took less than four blue books. One of his questions was this:

"Using what you have learned in this class this semester, describe how it is possible to have both inflation and recession at the same time."

Of course it is one of those questions you can never answer completely, but you sure can write a lot about it. I believe we are in precisely that situation now. And yes, Virginia, you can have both at the same time. With Helicopter Ben at the wheel, we are damned likely to have both recession and inflation.

What else is likely is that we will see some sectors shine over the next 12 months even as other sectors get creamed. Another possibility is that we will see inflation in some sectors of our economy, particularly those linked tightly to comodities, and deflation in others, particularly those linked to housing. But Ultimately, the housing/subprime/bundling mess is going to drag the whole economy down.

The markets seem particularly out of step with the economy right now. DJIA is way too high. Stop and do the math. GM's most recent quartly loss is more than all the other 29's profits. So then, how can DJIA still be in the 12,000s? Perhaps it is that same invisible hand that Mr Practical keeps noticing at work. It is not unusual for markets to bear no relation to the economy. That, as we have seen in the past, can go on for years.

February 16, 2008

Jay Steele still sees the silver lining and thinks the markets are set up for a nice run up here. He sees that the NASDAQ 100 has just put in a double bottom.

The Orange Section writes. I include his note here.

"Bender,

I read your comments, great as always. I wouldn't be surprised if you put me in the camp of your 'free enterprise friends who will get upset.' However, I'm not all that upset at what you said, although I do have a differing view on the solution.

What you are ultimately referring to is the boom bust cylce. Academics and other ego maniacs have written all sorts of idiotic treatises on why it happens, but as with many things in life, I believe occum's razor applies. What comes up must come down. I would argue that our current crisis can be attributed to a wide range of regulatory and cultural phenomena. I would like to focus on the nanny state and this concept of feeling bad and covering for people who make mistakes.

A central hallmark of capitalism and free enterpise is that they both reward success AND punish failure. This means that when someone does something ultimately stupid they will be swiftly punished. The whole point of capital destruction is to correct the wrongs of the market. The reason our economy is at this point can traced to a long series of dodges and preventative measures by a politically and ego motivated Federal Reserve. Things need to be allowed to break. If you prolong inevitability you just allow it to get worse. It might sound un-American but this country needs a good solid dose of financial reality."

Here is a link to 'Fed's Fix', by Mr. Practical on Minyanville.Com. I quote it below.

"The banking system and the relationship it has with central bank borrowing is not operating normally; one should not expect the Fed to operate or communicate in a normal fashion. We will be seeing various 'nationalization' and 'socialization' remedies over the next year that will be desperate and unconventional. You have to start thinking outside of the box to keep up with what the Fed is doing.

...But the banking system is broken so the Fed is going to very unusual lengths, such as TAF auctions and, I suspect, continuous rollovers (thus not increasing the size of balance sheets when you take a snapshot, but in the shadows is massively increasing risk to the Fed) to try to keep the banking system afloat by lending it money that we don't see on its balance sheet.

Of course, none of this ultimately will affect the larger deflationary credit contraction picture: As the senior loan officer survey last week illustrated very clearly, the debt deflation is occurring outside of the Fed's control at the world's money center banks, where supply and demand for credit has undergone a rapid and significant decline.

...Deflation will be ugly but it has some ultimately good results. It wipes out debt (which is painful), but ultimately realigns the world's economies for future growth: it will over time re-distribute wealth from the rich to the poor (which is why those in power hate it so much and love inflation)."

I was having coffee with the Red and White D this morning when a mutual friend, whom I shall call Lars, offered another possible solution to the mess I ranted about last week, and to which the Orange Section refers above.

Lars reminded me that I currently work in a beaurocracy and that I should know better than to suggest that what the world needs is more regulation. More regulation, suggests Lars, just gives beaurocrats more opportunity to malfease.

What Lars suggests for the subprime loan problem is that in future, if you make a loan that no reasonable person would expect could be paid back, you go to prison for 3 years for each offense, no parole, no time off. If a realtor was involved, he gets a year and a half as a co-conspirator. It is Lars' contention that the courts are better equipped to handle this situation than any beaurocracy.

February 9, 2008

I have some good reads here. Red and White D, who has taken to calling me Dr. Doom, sends along this link to '91 Billion pound Northern Rock debt is public liability', by Christine Seib, Grainne Gilmore and Greg Hurst of The Times. It seems the British government is going to buy Northern Rock. I think our Fed could do the same with most of our big banks right now. I don't think it wants to.

Here is a link to 'Bubble Economy Endgame', by Mike Mish Shedlock of Minyanville.Com.

Here is a link to 'Ugly retail sales on tap, and more from Bernanke', by Rex Nutting of MarketWatch.Com.

Rich Kolon sends along this link to 'The Financial Tsunami Part IV:', by F. William Engdah. It pretty much describes how we got into this mess.

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Now I am going to say something that is really going to enrage the really die-hard conservative free-enterprise friends of mine. Oh well, here goes.

• We don't live in a pure free-enterprise system. If we did, we would live in a very different place. Five guys would own everything, absolutely everything, including the clothes on your back (which you would lease) and the air you breathe (for which you would be charged a user fee). That is what unrestricted free enterprise leads to, and it would only take about one generation for that to happen. And innovation would be strictly forbidden, because innovation would be a threat to the status quo.

• We thrive in a 'free enterprise' economy only because we recognize the need to rein in the excesses of that very freedom. Innovation only thrives in an environment where there is fair play, a 'level playing field'. We don't play football without the rules and the refs, do we? So why would it be a good idea to do away with the rules and the refs? Why was it a good idea in the Financial Industry?

• Some elements in our society are so important to our mutual welfare that we need to regulate them. One element that springs to mind is the production, distribution, and sale of electrical power. Some people in history lived in the Bronze Age, some lived in the Iron Age. Our age is the Electron Age. Without electrical power nothing gets produced, nothing moves. It is simply too critical to both economy and the larger society to go unregulated. Attempts to deregulate that industry only led us to the Enron situation and related messes.

• If an element in our economy/society proves to be so critical to our mutual welfare that its demise, or even partial paralysis, threatens our mutual welfare then it will have to be regulated. Ah, but you say, the Banks and Mortgage Companies ARE regulated. Well, yes and no. While I was not a fan of the Glass-Steagall Act. It's repeal in 1999 has brought about the conditions for the creation of a huge financial crisis, the likes of which we have never before faced. A huge amount of debt lies out there to be unwound. It may be as large as two and a half times our GDP. This unwinding will be a process that encompasses many years, perhaps a decade. The huge 'shaddow banking system' that became an unregulated wealth creation system, has rolled over onto its back and now we see the other side of it: a huge wealth destruction machine.

• Banks and Mortgage Companies will have to be reregulated. For me, it could not happen soon enough. We need to stamp out the 'shaddow banking system'. We need to treat it like the cockroach it really is. Before the repeal of Glass-Steagall we had banks and mortgages and everything, really we did. And it was a system that worked, really it did. We need to take two corporations out to the woodshed and administer some reminders. The two I am thinking of are Moodys and Standard and Poor. If I had the power I would kill these companies altogether, or at least forbid them from doing any more rating for the next ten years. That would get the attention of the rest of the Financial Industry.

• We have to get over the idea that all deregulation is good. It isn't. If you think it is, then deregulate the Water Industry and allow me to buy it up and run it any old way I please. You'll get good water to drink, I promise. I won't maximize profit by leaving out the filtering and the chlorine. I'll create my monopoly by issuing bonds with AAA ratings from Moodys and Standard and Poor. You'd buy those bonds now, wouldn't you? After that I want you to deregulate traffic signals. I'll monopolize that industry and I promise the lights will work some of the time. Then we can set our sights on Air Traffic Control.

• Besides wealth destruction, the unwinding, the sorting out of this huge amount of debt is going to give us another unforseen bonus: the destruction of trust. We had situations where people with monthly incomes of $1500 were given loans whose normal payments would have been $1800 per month. They only had to pay $600 per month for the first two years, and then the payments ballooned out to $3600 per month. The borrowers walked away from the loans. Now we have a whole class of borrowers who will never trust a bank or mortgage company again. We have banks who don't trust the borrowers. And because these subprime loans were bundled and bonded out in a hugely intricate and confusing way, the foreign and domestic holders of the bonds that financed these transactions will never be able to trust any AAA rated U.S. bond again. What a sweet deal.

February 5, 2008

The Orange Section sent me a note. I will share it with you.

"Here are some thoughts on the Derivatives end of things.

All derivative contracts have expiration dates. Typically these expirations are under 12 months. However, it can be wide ranging. SWAPS can go out for literally years, it just depends on the terms of what you buy. A critical attribute of having an expiration date is that if contracts are not exercised they are worthless. So, for the Derivatives to have the effects that Rich is talking about they must be exercised. So if a Financial company were looking to mitigate the strain on it's capital it might play a stalling game in order to run out any negative exposure they have. Of course, this assumes they are not rolling their contracts. Without internal access to these institution's private portfolios it is really quite impossible to know.

However, we are not without tools that we can use to get an idea of the big picture. Somethings I would consider investigating:

• Net Outstanding Derivative Liability (both long and short) vs. Real Money Supply (I suspect this will be fairly frightening).

• Another interesting piece of information would be the average Duration of the Derivatives Exposure among Banks (again probably scary).

• Finally, the Net balance of Derivatives outsanding. This, to me, is the real kicker. We might have trillions in contracts, but what is the net balance? If this is a low number the monetary 'risk' is not directly born by the banks. It is being shouldered by the broker/counterparty. Thanks to the repeal of Glass Stegall, this could be another bank!

If I were to guess I think we are on the cusp of a revealing the necessity for a revolution in monetary policy. The old definition of money supply and money creation is dead. As Bill Gross has pointed out the Credit Derivatives world can now create and destroy money at will in what he calls a "shadow banking" system. This creation/destruction process is external to the traditional regulatory power of the Federal Reserve. It also currently has no regulation and no policing body. It is literally running amuck, wreaking havoc on our financial system.

My guess is that we will see the heavy hand of regulation eventually fall on this aspect of finance. There is just the question of how and when. For the current situation, are these numbers current? Do they include the infusions that many of the big New York banks took from foreign investors in the past month?

On a more theoretical level I think we are seeing the need for some kind of limit to be placed on the issuance of Derivatives and the hedging they provide. The current market hedges risk on the basis of a simple model. You are long X, so to hedge X you go long the opposite of X or -X. The problem is that this is not a zero sum game. The hedge has the potential to create dollars in the market instead of allowing them to be destroyed. Due to leverage, this creation may far exceed the original act of capital destruction. The opposite is also true in terms of capital destruction."

"It is literally running amuck, wreaking havoc on our financial system." Did you ever notice that we never get the heavy hand of regulation until after some process has run amuck? We never get it before. We always get it post-muck, when perhaps we needed it pre-muck.

Here is a link to a great article: 'Everybody, Back Into the Woods!', by Kevin Depew of Minyanville.Com. This one has lots of graphs to back up what he is saying.

February 3, 2008

Here is another really grim article: 'America's Teetering Banking System: "Where did all our deposits go?"', by Mike Whitney of SmirkingChimp.com. I quote this ugly thing below.

"A careful review of these graphs should convince even the most hardened skeptic that the banking system is basically underwater and insolvent. We are entering uncharted waters. The sudden and shocking depletion of bank reserves is due to the huge losses inflicted by the meltdown in subprime loans and other similar structured investments."

A few points I have been trying to make in my comments are these:

• Banks are extremely stressed right now and the year has only begun.

• We will have more than a year of heavy defaults from this point, and we've only experienced about a month of the really heavy tide of defaults so far. That this was going to happen in 2008 was known far in advance.

• Most of these early losses have not even been reported yet. When they are, most investors will begin, I say again, begin to become concerned.

• This early response by the markets will be negative, but not nearly negative enough to be appropriate to what this nation is facing.

• We are facing the most serious banking crisis since the Great Depression.

Now, here are some more quotes from 'America's Teetering Banking System: "Where did all our deposits go?"'.

"The debt-securitization process is in a state of collapse. The market for structured investments-MBSs, CDOs, and Commercial Paper---has evaporated leaving the banks with astronomical losses. They are incapable of rolling over their their short-term debt or finding new revenue streams to buoy them through the hard times ahead. As the foreclosure-avalanche intensifies; bank collateral continues to be down-graded which is likely to trigger a wave of bank failures.

...The pace at which money is currently being destroyed will greatly accelerate as trillions of dollars in derivatives are consumed in the flames of a falling market. As GDP shrinks from diminishing liquidity, the Fed will have to create more credit and the government will have to provide more fiscal stimulus. But in a deflationary environment; public attitudes towards spending quickly change and the pool of worthy loan applicants dries up. Even at 0% interest rates, Bernanke will be stymied by the unwillingness of under-capitalized banks to lend or over-extended consumers to borrow. He'll be frustrated in his effort to restart the sluggish consumer economy or stop the downward spiral. In fact, the slowdown has already begun and the trend is probably irreversible."

Please note dear readers that not only are trillions of dollars in derivatives going to be lost, but so are trillions of dollars in mortgage foreclosures. For the banks, it's going to be a kind of double whammy.

While I have my crystal ball out I may as well point out some other things I think will happen as 2008 plays out.

• As I stated above, investors and markets will react negatively to the early bad news, but even then, their reactions will be seen, later in hindsight, to not have been negative enough.

• The banks themselves are already reacting far more negatively than the market system that values their stocks.

• The banks will continue to tighten credit throughout 2008 and this will harm them even more. Banks always tend to over-react. Their own actions, later in hindsight, will be seen by many to have caused a lot of the banks' own distress.

• Even though the rest of the economy may be doing fine just now, the banking crisis will drag down the whole economy.

• Whatever you do now, do not go long on housing or financial institutions.

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