fsu editorials

PUT YOUR FINGERS IN YOUR EARS
by Ed Steer
August 5, 2007

"Government is a disease masquerading as its own cure."

Last week the Italian government announced that they might consider selling some of their gold in order to bring their huge deficit under control. The gold market yawned.

I believe that it was Rob Kirby that commented that this might just be the Italian Central Bank�s way of writing off the gold it allegedly lost during the LTCM crisis. The rumour swirling around at the time was that LTCM went under with a 3-400 tonne gold short position and was one of the reasons that the Fed stepped in to organize a bailout. Since then, the talk has been that it was the Italian Central Bank�s gold. It now appears that LTCM had been working directly with the Italian government and/or its Central Bank to do some work for them in the Italian bond market so that they could smooth things out for Italy�s entrance into the European Union/Euro. It's not too much of a stretch (at least for me) to think that Italy might have to put some of its gold to work to get this done.

The possible Italian gold sale was big news and was sent out in a couple of GATA dispatches. The stories are hyperlinked here...and here.

My comments to Chris Powell, GATA�s Secretary Treasurer on this issue, were posted in Bill Murphy�s MIDAS commentary for August 1, 2007�and were as follows�

Hi Chris,

Your comment about the central banks of the world being scared white...is right on the money. We're talking about global systemic risk that has become so large so fast that there is no way for the West's banking system to cope with it. It matters not what they do, or do not do, with interest rates anywhere in the world now. The banks have become bystanders in this crisis. Anything they attempt now will be a band-aid solution at best...and their "cure" could end up being worse than the disease.

The situation is deteriorating in leaps and bounds by the day, and with another $40 billion in ARM resets occurring (in the U.S.) every month from now until November 2008, the situation is totally out of control to the down-side. This financial swamp the boys have created over the last thirty-six years is 50 miles across but only 6" deep...and it doesn't take much draining to start uncovering all the creepy-crawlies that have been swimming in it since 1971. And the more liquidity that is drained out of this swamp...the more of these creatures get exposed and die.

Even if they lower rates in an attempt to save the mortgage holders, the psychology of the market is now such that it makes no difference...the damage has been done...and of course there are the usual negative ramifications for the dollar and all world currencies, which is why they are collectively sitting on the PM prices...especially in New York.

If/when that dam breaks; the fiat currency system will fail spectacularly almost overnight. The political, economic and financial ramifications of that are incalculable. I doubt the European Union or its currency would survive�unless they back their currency with their considerable? gold reserves. This is financial Star Trek of the 21st century.

I don't know if the boys are working on a new Plaza Accord or not, but current financial events are far outrunning anything they could come up with even if they tried. Bob Landis could very well be right. One of these days we're going to wake up and the entire system has just stopped working.

It's my opinion that the essay on gold as an alternative currency by that CFR guy was a straw in the wind. I was enthusiastic about his article, but even more enthusiastic about the audio interview with him on the same subject...it was on C-Span I believe. This guy sounded like an old-time evangelist. The only thing missing was a brass band and the bunting. James Turk must have been ecstatic!

And the Italians selling their gold�give me a break! With conditions being what they are right now, even they aren't that stupid.

Nope, this time the boys are screwed, blued and tattooed...and it looks good on 'em.

Let's just hope there's something left of this world when this is all over. END

My above attempt at describing what I see coming down the pipe are pretty feeble, as I have only scratched the surface�and with a very blunt instrument at best.

I now turn to the Master of the Credit Markets to lay it out for all of us. For years he's been a lonely voice in the credit wilderness. His weekly examination of the entrails of the biggest credit bubble the world has ever experienced, are well know in Internet financial circles. I speak, of course, of Mr. Doug Noland over at www.prudentbear.com. I have cut and paste the most salient paragraphs from his latest Credit Bubble Bulletin entitled �Credit Market Dislocation�.

He has no peer in reporting the credit markets, and in this commentary he lays it out chapter and verse. My advice to you is to read this very very carefully�more than once.

I'm never comfortable with the idea of �yelling �fire� in a crowded theater.� But Jim Cramer already did as much late this afternoon on CNBC. His �we're in Armageddon� tirade was made moments after Bear Stearns� CFO Samuel Molinaro offered a disconcerting assessment of market conditions during the company�s hastily called conference call: �I've been out here for 22 years, and this is as bad as I've seen it in the fixed-income markets.� A highly-aroused Mr. Cramer, volunteering to speak on behalf of Wall Street, called for the Fed to aggressively cut rates and �open the discount window.�

The Credit Market has dislocated, liquidity has evaporated, and our academically-inclined new Fed chairman is in store for a historically challenging real world first test. Wall Street has been conditioned over the years to expect �bailouts.� Only months on the job, Alan Greenspan stepped up and assured the markets that the Fed was ready to add liquidity after the �87 stock market crash. The Greenspan Fed acted aggressively during the LTCM crisis and, later, Dr. (�Helicopter�) Bernanke played an instrumental role in the Fed talking the risk markets higher in late 2002. To be sure, Fed �re-liquefactions� played a conspicuous role in fostering ever greater and more unwieldy Bubbles - and this will remain in the back of FOMC members� minds. The Bernanke Fed today would likely prefer to maintain a �hands off� approach for as long as possible � which has already been too long for an acutely fragile �Wall Street.�

And let's not forget the (unsung hero) GSE �backstop bid.� The GSE�s ballooned their balance sheets $150bn to absorb speculative de-leveraging during the 1994 de-leveraging and bond market rout � about double 1993�s at the time record asset expansion. GSE balance sheets (chiefly holdings of mortgages and MBS) ballooned $305bn during tumultuous 1998, $317bn during 1999, $238bn in 2000, and $344bn during liquidity challenged 2001. Agency balance sheets mustered growth of $37bn last year. Importantly, the GSE�s are definitely in no position these days to aggressively create marketplace liquidity by expanding their (money-like) liabilities to aggressively purchase MBS - in the process stabilizing market prices (especially for the leveraged speculators). Wall Street must all of the sudden feel short of friends.

Appearing this evening with Larry Kudlow, Larry Lindsey called upon Fannie and Freddie to loosen lending standards to help ameliorate the rapidly accelerating Mortgage Credit Crunch. I was immediately reminded of how Washington nurtured the $200bn (or so) S&L bailout from what should have been resolved years earlier at a fraction of the cost to taxpayers. The GSE tab is today running out of control. Keep in mind that Fannie and Freddie already have combined �Books of Business� (MBS holdings and guarantees) of almost $4.0 TN supported (in the best case) by stockholders� equity in the neighborhood of $60bn (current financial statements not available!). The thinly-capitalized Federal Home Loan Bank System has another $1.0 TN of assets. Before all is said and done, taxpayer GSE exposure will likely reach the trillions � to add to other untenable ballooning federal contingent liabilities.

This week, the unfolding financial crisis reached a problematic stage on several fronts. For one, illiquidity hit the gigantic �AAA� market for �private-label mortgage-backed securities.� The booming market for non-agency MBS has played an instrumental role in ensuring abundant cheap mortgage Credit � on the one hand filling the liquidity void created by the constrained GSEs (balance sheets) and, on the other, providing virtually unlimited inexpensive �jumbo� mortgage finance to inflate upper-end housing Bubbles in California and the most desirable locations and neighborhoods across the country.

While the sub prime implosion was a major marketplace development, in reality only a small segment of the mortgage marketplace was actually impacted by significantly tighter Credit conditions. Today, we are in the throes of a dramatic, broad-based and momentous tightening of mortgage Credit. Importantly, key players and sectors throughout the mortgage risk intermediation process are increasingly impaired and now in full retreat. This includes entities such as the mortgage insurers, MGIC�s and Radian�s faltering C-BASS securitization unit, REITs such as failed American Home Mortgage and others, hedge funds such those that failed at Bears Stearns and many more, the broker/dealer community and the expansive mortgage derivatives market generally. There is also the issue of exposed mutual funds, money market funds, pension funds and the banking system in general. Just like NASDAQ went to unimaginable extremes than then doubled during a fateful �blow-off� � total mortgage Credit doubled subsequent to the Greenspan Fed's reckless post-tech Bubble �reflation.� Risky mortgage exposure now permeates the (global) system and is highly susceptible to �Ponzi Finance� dynamics.

The process of transforming risky mortgage loans into coveted perceived safe and liquid (�money�-like) Credit instruments has broken down on several fronts. Not only is the risk intermediation community impaired, marketplace confidence and trust in the quality, safety, and liquidity of mortgage (and mortgage-related) securities is being shattered. There are apparently serious problems developing throughout the massive marketplace for (�repo�) financing MBS. And it is precisely the market for financing the top-rated mortgage securitizations � where the perceived risk was minimal � where I suspect the greatest abuses of leverage occurred. The marketplace is now experiencing forced de-leveraging and a liquidity Dislocation - with major systemic ramifications.

I mostly downplayed the marketplace liquidity and economic impact of the housing downturn last fall and the sub prime implosion this past February. For the system as a whole, the Credit spigot remained wide open. My view of current developments is markedly different. I cannot this evening overstate the dire ramifications for the unfolding Credit Market Dislocation. There is today serious risk of U.S. financial markets - distorted by years of accumulated leverage and derivative-related risk distortions - of �seizing up.� A system so highly leveraged is acutely vulnerable to speculative de-leveraging and a catastrophic �run� from risk markets. At the same time, the Bubble Economy and inflated asset markets � by their nature � require uninterrupted abundant liquidity. The backdrop could not be more conducive to a historic crisis, yet most maintain unwavering confidence that underlying fundamentals are sound.

I am this evening unclear how the enormous ongoing demand for new California mortgage Credit will be financed going forward. With the market having lost all appetite for �jumbo� MBS, mortgages must now be priced generally in accordance with the standards of increasingly cautious loan officers willing to live with these loans on their banks� balance sheets (a radical departure from pricing set by originators selling loans immediately in an overheated MBS market). And, let there be no doubt, the prospective Credit tightening will hit grossly inflated and highly susceptible �Golden State� housing prices hard � a scenario that will force lenders to incorporate significantly higher Credit losses into their loan pricing terms (perhaps Cramer was speaking to CA homeowners when he jingled house keys in front of the camera during Wednesday�s show and suggested it was perfectly rational to mail your keys to the bank). Furthermore, I expect the pricing and availability of Credit required to refinance millions of rate-reset mortgages in California and elsewhere to turn prohibitive for many. And the home equity well is about to run dry � from a combination of sharply tightened Credit conditions and accelerating home price declines.

A severe tightening in mortgage Credit is in itself sufficient to pierce a vulnerable U.S. Bubble Economy. But there is as well an abruptly brutal tightening in corporate Credit. The junk bond market has basically closed for business. The leveraged loan marketplace is in turmoil and scores of debt deals have been pulled. And, more ominously, the previously booming ABS and CDO markets have slowed to a crawl. Perhaps not immediately, but it will not be long before the economy succumbs to recession.

Credit Market Dislocation now dictates the assumption that Federal Reserve liquidity assurances and rates cuts are on the near horizon. And while they will likely incite the expected knee jerk response in the equities market, I don't expect they will have much lasting effect on our impaired Credit system. Current issues are much more complex and serious than �87, �98, 2000, or 2002. The dilemma today is that confidence in �Wall Street finance� has been shattered. The manic Bubble in Credit insurance, derivatives, and guarantees is bursting. The manic Bubble in leveraged speculation is in serious jeopardy. The currency markets are a derivative accident in waiting. Fed rates cuts risk a dollar dislocation and/or a further destabilizing (for spreads) Treasury melt-up.

A focal point of my Macro Credit Analysis has for some time been the grave risks posed to markets and economies commanded by the seductive elixir of speculative liquidity. I have compared the current backdrop to that of 1929. For too long our Bubble Economy and Bubble Asset Markets have luxuriated in liquidity created in the process of leveraging speculative securities positions... (especially in the Credit market). We are now witnessing how abruptly euphoric boom-time liquidity abundance can transform to a liquidity crisis.

I apologize for appearing overly dramatic. But this evening I have nagging feelings that for me recall the disturbing emotions following the terrible 9/11 tragedy. I know the world has changed and changed for the worse � yet I recognize that I don't know how and to what extent. I fear for our markets, our economy, our currency and our system. I received an email this week on my Bloomberg that said something to the effect, �You all must be happy in Dallas.� I can tell you we're instead sickened by what has transpired during the late-stages of this senseless Credit and speculative orgy. The Great Credit Bubble has been pierced, and there will now be a very, very heavy price to pay. And, as always, I hope I am proved absolutely wrong. END

Noland�s entire August 3rd commentary is hyperlinked here...

So, unless the Fed�and all the world's central banks�are prepared to flood the world with liquidity by lowering interest rates on a world-wide basis�I think Doug�s call is 100% on the money.

It will be interesting to see how the �powers that be� react to this systemic crisis (of their own making) that's now threatening to bury them. Will they fight it tooth and nail, or will they allow the inevitable to happen?

Next week�s markets will certainly be interesting.

© 2007 Ed Steer
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Ed Steer, Director
Gold Anti-Trust Action Committee, Inc.
Edmonton, Alberta
Canada
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