The Bear Stearns news hit the market early and hard today. Gold passed $1000 and Oil continued its march about $110. Rumors are now the Fed cuts 1% and the latest CPI was unchanged, despite high oil and food prices. The dots are not being connected yet, but it is clear the banking sector doesn't have enough funds to transact business, even though the market has been flooded with dollars.
The problem of course is where the dollars are, not how many there are. It appears the banks screwed up the credit system so badly that the last round of fundings they did are still out there, now chasing commodities around the world. The dollar is falling against all currencies because the only mechanism the Fed has to fix things is hope that interest rates will stimulate borrowing. Borrowing to whom and for what? It appears the only borrowing that is even attempted is for speculation and for keeping mistakes afloat. The liquidations of investment firms recently that had been speculating on securities bought with huge leverage pulled into question the solvency of some of the banks that financed these transactions and Bear is the one that had the run on it. I suspect there are plenty more of them and I wouldn't be surprised if there isn't some favored fund out there with positions many times the size of Carlyle Capitals $21 billion and for that matter even more under water.
It is clear the Fed took the action of swapping treasuries for mortgage backed securities of the FNMA, GNMA type. You would think by the talk that they paid par for CDO's backed by sub-prime mortgages. If the FNMA paper isn't any good, the US is probably cooked for good as it is indirect ownership in the majority of homes financed in the US. Some people say this is risky, but I am quite sure the Fed has margin requirements on these funds and will settle up every so many days and hopefully reverse the transaction. In any case, the Fed is taking risks, but the deeds of houses is a lot more than just paper. It was clear the market wasn't going to digest the sale of $200 billion in mortgage backed securities at this time and such a sale would have called into question more leveraged funds.
There are many points here. For one, I think the big point is that the banking system is near broke. They might have pretty balance sheets, but the debts are noncollectable in a lot of ways. The economy won't be bailed out by low interest rates because the banks won't lend at these rates and people that need to borrow now in this high cash balance system are high risks. I think the speculators of the world are trying to knock over the dollar, which is actually next to impossible and the next big loss is going to be the rampant rebound as the real issues start to hit home. What are the real issues?
The number one issue that is just starting to sink in is that leverage is getting more and more dangerous and at the same time, there are more and more people engaged in it. It isn't just the United States, as the world has been awash in leveraged credit. We found out the CDO's were done on leverage and now the banks are in trouble from having to fund what they were previously borrowing from or laying off on other entities. I believe this is the source of the excess credit that is now going to speculation, also leveraged, instead of coming back to take the assets funded by this money off the books of the banks. So, the CDO pipeline is clogged, the corporate takeover finance pipeline is clogged and the GSE backed paper pipeline is also getting stopped up. There is rampant speculation on the futures market and the longs are winning for the time being. But the prices have reached levels that I am sure the shorts are going to be content in making delivery, another margin call and wipe out in the making.
I had a sort of dream where the government was promoting our dollar as being backed by our debts. The pieces of papers we call dollars are so tied to possession of literally everything in America and most world trade that few that doubt it realize how important it is. Much of this debt is going bad and what is going on is the wipe out of leveraged lender capital. The monetary base in the US has been leveraged about 12 times, 50 if you count all debt, but 12 if you go to M-3. The difference between the base and the 12 times is leverage. These losses are coming out of the leverage. To wit, look at the Carlyle deal or the Peloton deal. These are 2 leveraged players that aren't playing any more. Their capital was used by the banks to create over $30 per dollar put up by them. Indirectly, there was over $20 billion on what should be capital created out of thin air. Now that the risk is there, I highly doubt the banks want to put up the $3 billion or more that should be behind these instrument and may sell them into the market. Result? It would by itself result in a decline in the money supply of $21 billion.
In any case, I don't recall all of this dream, but it seems I was getting the message the government was egging the people on to pay their debts to keep their money. What bad debts do is wipe out the capital necessary to make more money to service more debt. The idea isn't that the debts are ever going to be paid, only that they can be serviced with nice income coming to the bankers, depositor and those drawing interest. The bankers may be broke and if so, the manufacture of extra funds in the system will cease, Federal reserve or no Federal reserve.
We are going to deflate. The inflationists are misreading what is going on because they don't understand the math involved in debt and why it was necessary to expand the debt exponentially. We are at a fork in the road where the next event is going to be a default by someone like a GMAC, an entity that makes Bear Stearns look like a pimple on an elephants butt. We are already seeing auction after auction of municipal paper fail every week. What happens when the commercial paper auctions start failing and the money market funds freeze up? Well in short order, there goes most peoples stock trading accounts right out the window. The inflationists don't really understand how this is linked and instead keep focusing on what in the end will cause deflation, not inflation, the supposed level of M-3. The supposed increase of M-3 is inflation that has already happened, not inflation that will happen. It in the end will reflect the point reached that there is nothing to be added to the inflation and now the game is over.
There isn't anything left for the game to do but deflate. The inflationists are screaming about the Fed trading what they call worthless credit for worthless mortgages. If the homes of the US are going to zero, why the hell own anything Just move out into the street. The idea that we have hyperinflaion and houses go to zero is flat stupid. It is people making statements that are contradictory. In any case, why would a bank give up its best assets for Fed cash when it can create the stuff itself on its won books by making additional loans? The additional loans are the real question. Additional loans to whom? Subprime borrowers? People with millions in their accounts? Carlyle Capital so they can burn them for more when hyperinflation blows out the value of the collateral? I hate to say it, but the gig is up.
What is the direction? For one, all involved need more money and it won't be coming from the banking system pretty soon. China and India are going to soon find the flow of dollars inadequate and have to cut back themselves. The Arabs are going to find themselves over extended. Oil might be $110 a barrel, but the supplies are piling up. Supply could drop 10% and they could cut their production 10% and maintain the price, but most likely the price would have to collapse first and it then takes a shortage to put the price back up. What if it is 10% less oil at 50% less price, well within the realm of possibility. The US trade deficit vanishes and that sucking sound is the US debt service sucking dollars right down the drain. It might take a year, 2 years, but I wouldn't gauge it on what happens in the oil markets day to day, the gold market day to day or any market day to day, as the world is still playing bubble games when game is over.