Market Observations with Rob Kirby

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Hank’s House of Horrors

by Rob Kirby, Kirby Analytics. October 22, 2007

U.S. Treasury Secretary Hank Paulson recently proposed the establishment of a $75bn-plus "superfund" to buy unwanted asset backed commercial paper in hopes of accelerating the return of "liquidity" to the marketplace.

Mr. Paulson's proposal has been endorsed by financial market heavy-weights J.P. Morgan Chase, Citibank and Bank of America.

I'd like to examine how we got here in the first place.

As evidenced in the charts of U.S. money supply growth below, Central Banks around the world have been creating money at a blistering pace for better than 10 years:

Compliments of Jesse's Café Américain

Folks should understand that the act of printing new money dilutes the existing monetary stock.

When monetary authorities who are responsible for the world's reserve currency [the Federal Reserve] undertake such action – the results are unpleasant and ruinous but predictable.

Actions like this undermine global confidence or willingness to hold the currency being debased.

When this scenario plays out, historically [and predictably], the price of gold begins to rise on world markets.

Gold is and always has been the world's ultimate currency.

That is, of course, unless the offending party – in attempt to trick everyone - declares that they are actually pursuing a "strong dollar policy" and rigs the price of gold.

M3 supply
chart compliments of

In very simple terms – all money created or loaned into existence, IS spent on something.

In response; during the 1990s we witnessed the rise in price of equities in general and technology stocks in particular.

Rising interest rates in or about the year 2000 served to "prick" the bubble in tech stocks but, as we can clearly see in the charts above, money creation continued unabated.

Next up was real estate.

Real estate prices began to rise meteorically – frankly – because SOMETHING had to sop up the money – the printing presses were still running!

Maintenance of a rising real estate market began to encounter some serious problems in or around the year 2003; there simply weren't enough qualified buyers.

Something had to be done.

To enable new buyers – to continue inflating the real estate bubble – exotic mortgages were introduced with "gimmicks" like teaser rates. These exotic mortgages effectively created a whole new class of buyers; namely, ones that had no business buying real estate in the first place.

The Exploding Pumpkin

If you've followed along this far, you might be wondering why banks would want to lend money to folks that had no business owning a house in the first place?

The answer to that: They don't.

Nowadays, banks tend to originate loans from their storefronts. Then the loans are taken to the back office and bundled into esoteric products called derivatives [securitized]. Then with the aid of a respected ratings agency, the newly created derivative paper securities [which are in reality bad credits] are rated triple-A [AAA] and sold to trusting counterparties.

This ponzi-scheme works very well for those running the show until real estate prices stop going up [or fall] and introductory teaser rates begin resetting at elevated market rates of interest.

Then mortgage defaults begin in earnest.

As mortgage defaults accelerate, the price of the bonds they act as collateral for declines rapidly or gets written-off altogether.

Folks need to appreciate that Triple-A rated bonds VIRTUALLY NEVER get written off in one fell swoop.

But this is exactly what has occurred to a great many foreign institutions; they were left holding the bag – so to speak.

In aggregate, this has all served to undermine foreign confidence in American financial prowess. Just look at the dollar:

So this brings us full circle as we ponder whether or not Mr. Paulson's latest proposal – the superfund – will win the day and restore foreign confidence in the U.S. Dollar centric financial system?

Whether or not this comes to pass is the 64 million dollar question?

In the mean time, everyone would be well advised to remember that the printing presses are still running.

Today's Market

Overseas equity markets began the week on sour note with Japan's Nikkei Index falling 375 points to 16,438. North American markets fared better with the DOW ahead 45.0 to 13,567.10, the NASDAQ up 28.77 to 2,753.93 and the S & P up 5.70 to 1,506.35. NYMEX crude oil futures lost 1.04 to close at 87.56 per barrel.

Interest rates rose with the benchmark 10 yr. government bond yield moving up 3 basis points to 4.41 % while the 5 yr. note was up 7 basis points to 4.08 %.

On foreign exchange markets the U.S. Dollar Index gained .64 to 78.01.

Precious metals were hit hard with COMEX gold futures losing 10.70 to 753.70 per ounce while COMEX silver futures lost .03 to 13.56 per ounce. The XAU gave up 4.15 to 169.75 and the HUI was drubbed 10.27 to 394.55.

Wishing you all a pleasant evening, light hearted tricks and the best of treats!

Rob Kirby

© 2007 Rob Kirby

Contact Information

Rob Kirby | Proprietor, Kirby Analytics Newsletter - Proprietary Macroeconomic Research
Toronto, Ontario, Canada | Observations | FSU Editorials | E-mail

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