Hell, Meet Handbasket, Part II

The bad news is that no one completely understands what’s going on; the good news is that, yes, a measure of sense can be made of the madness. Being armed with that bit of understanding should enable us to survive the tsunami…even prosper.

When capital is allocated in a free market, it moves toward the productive, and the economy tends to prosper. By the same token, when it is misallocated, an economy can hit the skids.

We’ve had decades of misallocated capital in the U.S. Instead of saving, we’ve been spending… way beyond our means. Rather than investing in something productive, we’ve been gambling, taking on ever greater risks in the hope of the big payoff. Instead of creating the clean balance sheets that support stability – at all levels, personal, corporate, and governmental – we’ve piled up mountains of unsustainable debt.

The tragedy is that the prudent will suffer right along with the reckless. Misallocations of capital must be unwound, one way or another, before an economy can get back on its feet. It will be no simple task, and it’s made even more difficult by those who put themselves in charge of the clean-up: certain residents of Washington, D.C.

At the center of the storm are two men who propose to save the nation, and they could hardly be more different.

Secretary of the Treasury Henry Paulson is the Street’s guy. The former CEO of Goldman Sachs, the most powerful and successful investment bank, he brings a Wall Street insider’s perspective to the table. However committed to public service he may be, he cannot be expected to act against the interests of his friends in the banking community.

And then there’s Fed Chairman Ben Bernanke, a pure academician. For better or worse, Bernanke’s specialty is America’s Great Depression, and he considers himself an expert on the subject. Above all else, he wants to be remembered as the guy who understood how to steer the country away from the shoals of a Second Great Depression.

There is no question that Big Ben and Hammerin’ Hank are trying to navigate in unfamiliar waters. Today’s economy hardly mirrors that of a decade ago, much less the conditions of the 1930s.

Back in the spring of 2007, as the initial cracks in the structure began to appear, few were expecting the broken-levee crisis that has since unfolded. Savants such as our own Doug Casey and Bud Conrad saw it coming and said so, but no one in the mainstream was listening.

What was actually happening was that the first dominoes – subprime borrowers who should never have been approved – had begun to fall. In and of themselves, they would have been little more than straws in the wind. But because of the multiplier effect of the derivatives market, their influence reached far beyond a few blown mortgages. As more and more debtors were unable to pay, mortgage-backed securities lost value. And then the securities based on the MBSs lost value. And then…

Here’s where CDSs were supposed to ride to the rescue. They didn’t, for the simple reason that they had long since strayed far from their original insurance intent and become primarily an instrument that gave derivatives market players access to an asset class (mortgages) without having to actually own the asset.

As MBS values were hammered by defaults on the underlying loans, buyers of CDS protection began trying to collect. That hit CDS sellers, who were being drained of cash. Further out, derivatives speculators who had bet the wrong way defaulted or went bankrupt, sending shockwaves back down the line. Slowly at first, and then with increasing speed, the capital necessary to keep the system alive started drying up.

Everyone is familiar by now with the institutions that have collapsed or been bought out or taken over by the government. The list of names is stunning: Bear Stearns, Countrywide Credit, MBIA, Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Washington Mutual, Merrill Lynch, Wachovia. Wall Street has undergone a transformation unimaginable a year ago. The big investment banks are gone – bankrupted or swallowed up by someone else. Even the two that remain standing, Goldman and JP Morgan, have had to reinvent themselves as bank holding companies to save their own hides.

The movement of capital among financial institutions is based not only on integrity but on confidence. Right now, that confidence has evaporated. Banks are carrying so much paper of indeterminate value that it’s impossible to price in the risk of making a loan. So they aren’t lending to each other, out of fear that they’ll never get their money back.

The credit market, upon which our economy depends, has seized up.

When the government finally got around to admitting that there was a problem, it was already too late for any simple fix. So Washington had only two options: stand back and let the market sort things out or take drastic, emergency action.

No one knows quite what to make of Washington’s response to the credit crisis. Some are howling that it’s socialism, others that it’s fascism or, at best, corporatism, an unholy alliance of private enterprise and the state.

Whatever the name, there is no question that the government is boldly going where none has gone before, helping to bail out some financial institutions and seizing control of others.

The Treasury Department now has $700 billion – albeit with some strings attached – with which it can buy up toxic waste paper through the Troubled Asset Relief Program (TARP). Taking this direction, instead of making direct loans, allows the "assets" they buy to be resold somewhere down the road. And perhaps, the plan’s defenders say, even at a profit. Like that’s gonna happen.

Proceeding in ways never before tried, in early October the Fed announced it was opening the Commercial Paper Funding Facility. For the first time, it will buy unsecured paper. To facilitate this and to cover potential losses, the Treasury will deposit an unspecified amount at the Fed. This is in addition to the Treasury’s own buying spree, and the Fannie Freddie conservatorship, and the expansion of the FDIC to cover deposits up to $250,000, a move likely to send that agency back to the Treasury for another fill-up.

All the government’s actions to date have accomplished… well, precious little. For the time being, credit remains frozen. Banks are still making overnight loans to other banks, but only very selectively. The stock market, despite coming off its lows, is extremely volatile after enduring its worst crash ever. Commodities have sold off. States and municipalities are facing severe budget cuts and, in some cases, bankruptcy. Money markets are in trouble. Pensions and retirement funds are at risk. And recession, or worse, looms increasingly large on the horizon.

Nor is the crisis purely an American problem. Much of the U.S. bad paper was sold to gullible Europeans, and world economies and markets are so interconnected that if one sneezes, someone else catches a cold. Already there have been big bailouts in Germany and England. The Irish government recently announced it was guaranteeing all bank deposits, which attracted a flood of money from elsewhere in the European Union, enraged other members of the EU, and raised questions of how long that shaky confederation can endure as each country charts its own path through the economic minefield.

This is a once-in-a-lifetime event, a train to nowhere, and it will cause no end of suffering.

Since we can’t stop it, we’ll do the next best thing, which is to protect ourselves. That means assessing the likely fallout from the government’s meddling in the market, and developing guidelines for the best way to ride out the hurricane.

Some consequences are already baked in the cake. Casey Research Chief Economist Bud Conrad has been studying the unfolding crisis for years. Based on his work, this is what we foresee:

? More financial institutions will collapse. So will many hedge funds. Money market funds are also shaky; although the government will do all it can to keep them solvent, those that invest in anything but Treasury bills are at risk.

? The economy will fall into recession. By most lights, it’s already here. It won’t be brief, and there is even a chance that despite all the Fed’s pump priming, we could drop into a depression. For however long credit remains tight, business will be unable to function normally, and the consumer-driven economy will grind to a halt.

? The whole structured finance model under which we’ve been operating is broken. The packaging of mortgages and other forms of consumer debt is impossible when no one will buy the packages. The trillions of dollars of outstanding mortgage derivatives will have to be unwound somehow.

? Without debt leverage, private equity financing is dead. Raising money for business start-ups or expansion will be extremely challenging. IPOs will be few and far between. Leveraged buyouts are gone. Mergers and acquisitions will mostly be limited to distress sales.

? At best, the government will succeed at what it’s trying to do, i.e., stave off a depression, by sacrificing the dollar and allowing a fairly high level of inflation. If we’re lucky, it won’t turn into hyperinflation.

? Interest rates are going up. On the day of the coordinated, worldwide rate cut, the Fed lowered its discount rate by 50 basis points, yet the yield on the 10-year Treasuries rose from 3.5 to 3.7%. The Fed’s credibility is about shot, as it has debased its own balance sheet by swapping good debt for bad. With more than half of its reserves gone, it could itself become the subject of a Treasury Department bailout.

? It is highly likely that the era of U.S. economic dominance, when the almighty dollar served as the reserve currency of the world, is drawing to a close.

But on the bright side… Well, there is no bright side. The hole that we’ve dug for ourselves will take a while to climb out of, and it won’t be easy. But at least you can protect yourself.

Regards,

Doug Hornig
for The Daily Reckoning
November 13, 2008

Protecting your assets is not just a buzzword anymore, it’s mandatory if you want to keep yourself and your family financially safe in these tough times… which will only get tougher in the near future.

O! Bama! Where is thy bounce!

Yesterday, stocks got whacked again – the Dow was down 411 points, bringing the loss for the year to more than 4,000 points.

Oil fell to $56 a barrel; investors feared that the world’s drivers would leave their cars in the garage and the world’s teenagers would begin turning off the lights when they left their rooms.

And they seem to be right.

"Buying binge slams to a halt," reports the New York Times. It is a "crisis of confidence" among consumers, the paper explains.

Crisis of confidence? No…it is more like an attack of good sense…a bout of sanity…a brush with sobriety. This is a ‘balance sheet recession,’ remember. Consumers, businesses and speculators are all acting perfectly reasonably. They haven’t lost their senses, in other words, they’ve come back to them. They finally realize that they need cash…savings…money in the bank "for a rainy day."

The weather forecasters on Wall Street and in the press said it would never rain again. But here it is – pouring down!

Even gold is running for shelter. The price of an ounce of gold fell $22 yesterday.

A hard rain is gonna fall. No doubt about it, it’s falling already.

And now, the whole world turns its weary eyes to America’s president-elect – Barack Hussein Obama:

"Mr. Obama, please…do something!" they beg. "Save me! Spare me! I promise I will never do stupid things with my money again. "

Will Obama be able to restore consumers’ confidence? Will consumers recover from their bout of sobriety? Will the feds be able to lure them off the wagon with more cheap booze?

And so…those questions before us…the world moves closer to its first trillion-dollar deficit. Wait…did we say ‘trillion dollar?’ Make that $2 trillion.

There is now no doubt about the general direction of the markets and the economy – they’re going down. That’s not to say we can’t have a nice rally. We’d be disappointed if we don’t get one. Following the crash of ’29, for example, the Dow rallied back to within 60 points of its all time high. The rally took 6 months and gave investors plenty of time to get out.

Instead, many concluded that the good times were rolling again. Alas, it wasn’t so. The good times were over…and wouldn’t really come back until the 1950s – 20 years later.

What we had in the ’30s…in Japan in the ’90s…and now worldwide… was a massive destruction of wealth. Well, wealth…such as it was. In all three cases, a huge, credit-led boom led to a huge build-up in speculative debt. Then, when asset prices fell…balance sheets looked terrible. People had to pay down debt and build up savings. That takes many years. And while it is going on, spending, investing and living it up are depressed. Obviously; people need the money for other things. Just look at Starbucks – the stock is down 75%. And Coach (maker of expensive leather handbags) – down two thirds. Tiffany has been cut in half.

Yes…the hard rain is falling on everyone, rich and poor alike.

*** Central banks lower interest rates to try to gin up some activity. They set up another round of drinks, hoping the party will get going again. The Fed cut rates decisively (if a bit slowly) in the ’30s. Japan’s central bank went further – taking rates down to near-zero and leaving them at that level for years. The U.S. Fed, meanwhile, has already hacked its key rate down to 1%. It’s ready to cut more…if need be.

But the central bankers are missing the point. They’re like a liquor salesman at an AA meeting. Everyone is desperately trying to sober up – not go on another bender. Of course, the feds will get a few people to take up the bottle again…but these poor saps will be even worse off.

In this type of correction, people need to correct the mistakes of the late bubble. That means getting balance sheets back in balance. And that means spending less and saving more.

Economists describe this problem as "pushing on a string"…or a "liquidity trap." The central bank can make more credit more readily available, but it can’t force people to borrow.

Yesterday’s news headlines included one that went to the heart of the matter; "Government to force banks to lend." But the problem is not so much the banks – it’s the economy itself. Banks would be happy to lend – if they could be reasonably assured of getting their money back. But in a crumbling economy…who knows?

This is the tough financial situation that President Obama will face.

While monetary policy won’t do much good, fiscal policy might. At least, there’s plenty of temptation in fiscal policy…so much that powerful, ambitious and/or corrupt politicians – forgive us for repeating ourselves – always find it irresistible.

The principle is simple. If businesses won’t spend…and consumers won’t spend…the government will do the spending. This is the idea made popular by Keynes and known today as "Keynesian" economics.

"We are all Keynesians now," said Richard Nixon back in the ’70s. As we said, the idea was irresistible.

Keynesian spending doesn’t really make people better off, but it has three things going for it:

1) It gives politicians an excuse to spend more money
2) It looks like things are getting better…and at least government is "doing something"
3) It tends to keep the lights on

In the coming U.S. downturn, (we say "coming" because the worst of it is still in the future) consumers are likely to pull hard on their belts and send the rate of saving soaring. Maybe not the 20%-30% you see in Japan and China, but at least back to the 10% we saw before the 1990s. That will remove more than $1 trillion from the economy. Directly. Indirectly, it will remove a lot more.

And here we bring bad tidings of Christmas.

"Balloon bursts on festive parties in tough times," is a headline at the Financial Times. Companies are cutting back sharply on their holiday celebrations. We know that from personal experience. A memo just received from corporate headquarters in Baltimore tells us that the annual Christmas party will be greatly scaled down. "Employees only," is the word.

Well, the grinches in our own little company are generous compared to those in other firms. The big Wall Street firms "have scrapped extravagant parties," comes the word from the street. "What’s there to celebrate?" asked one executive. "It’s the year from Hell."

Certainly a "glass is half empty" way of looking at it. It’s a correction. And in corrections, spending goes down as people correct the errors of the past.

In Detroit, GM and Chrysler have cancelled their big holiday bashes, too. Oh, the poor caterers! It’s not as if there were a lot of upper-end work in Detroit these days. The caterers probably waited all year to put on a big do at Christmas for the carmakers. Then, wham, they cut off the juice…the party lights go out…and it’s a cold, cold winter in Detroit. As if it weren’t cold enough already!

The automakers are trying to cut costs as rapidly as they can. But revenues fall faster. Vehicle sales fell again in October – for the 12th straight month. This is the longest losing stretch in 17 years.

A writer for Britain’s Spectator Business took a drive to Detroit to check on the state of things. Spotting a live human being in a huge parking lot…apparently guarding an abandoned factory…he stopped to chat.

"Ten years ago, this place was booming," said the guard. "Hard to believe isn’t it? Back in ’85 I used to work for General Motors fitting radios and cruise-control switches to the dashboards of cars. But they moved the factory somewhere else and that was that. Now I do security. Although what they’re guarding this for, I do not know. There’s nothing here."

Behind him was the apocalyptic scene we associate with Detroit. Then, referring to the American Dream, the guard took up his reflection:

"I thought it was the auto industry…with jobs and pension and health insurance and what not, but that went pop. Now they say they are building condos everywhere down here, but I don’t know who they think is going to buy them. I guess that’s another type of dream."

"It’s time to wake up, America," continues the reporter, "this dream has become a nightmare."

So, in addition to the $1 trillion taken out by the savers…there’s also the effect of less spending magnified all through the economy. The caterer doesn’t get to serve up a holiday party…the baker doesn’t get to bake…the liquor bottles begin to collect dust…from the guys who park cars to the babysitters to the hairdresser…the whole economy spins fewer dollars…people earn less…and they pay less tax. Then, at the far back of the income bus, the most marginal workers fall off altogether. The jobs they could get anytime before can’t be gotten at all now. McDonald’s begins to get choosey. It wants someone with a master’s degree in fluid mechanics doing its deep-frying. And over at the Bright Nails shop, heck, they’re looking for someone who used to be a chemist!

So the guys with few skills and spotty employment records can’t get jobs at all. They should do like those fellows in Latin America and South Africa. They stand out on the roadsides, waiting for anyone to pick them up and put them to work…a day at a time…one hour after the other. They get paid at the end of the day – in cash. They should reduce the cost of their labor to the point where they’re worth hiring, in other words. But this is the United States of America we’re talking about. This is a democracy. And there are a lot of votes in the greater Detroit area…and a lot of Democrats who are going to be really cheesed off if their man in the White House doesn’t do something to protect the voters from reality.

So what’s Obama going to do? Simple, he’s going to do what his most persuasive advisors tell him to do…he’s going to borrow all those savings and put them to work. Everyone wants the safety of Treasury paper. Fortunately, the Obama Administration is going to give them plenty of it. They’ll absorb the trillion or so in U.S. savings…and then everything else they can get their hands on – including much of the rest of the world’s savings too. The U.S. deficit will soar – along with the national debt. Rates will rise.

And then…maybe 18 months from now…maybe 10 years from now…it will get really interesting…

More to come…

Until tomorrow,

Bill Bonner
The Daily Reckoning