How do we fix this?

Instead of trying to be right, as I am just as wanting to be right as any of you guys, we need to get involved in how to come in with some kind of fix that could change the picture. I don't think the country gets off without some kind of deep recession, but to continue the policy of feeding Wall Street fat pitches so they can bilk America out of its economic base along with the rest of the world isn't going to do anything. The rich need to recapitalize the banks, not the customers who got stuck with the deposits created out of this mess or the guy on the bottom who is beyond even having a dog in this fight. I read something where the top 400 richest people in the US gained $600+ billion in net worth over the past 8 years, just enough to restore this lost capital. You can bet 95% of this increase was traced to banking transactions of some sort. The bailout cements this amount into permanent debt that will burden the country and all that don't hold the debt. We are looking at a swap of treasuries for debt the holders don't even dare mark down to its true value. I would exclude all Wall Street firms including GS, JPM, MS, MER, Citi and others up there from receiving a dime, as they were the group that facilitated the creation of this mess and bankrolled many a hedge fund which leveraged this stuff into trillions for themselves. The entities that need to be restored are those that can show that they were bilked by this group into buying this crap. This doesn't include FNM or FRE, who for all practical purposes, should only be indemnified to the extent that their holdings were encouraged by Congress. If any of these firms do participate, their loans should be limited to 80% of face of what is bought and to what can be determined to be FMV of these products deducted from this amount and the balance loaned to them as preferred stock at rates around the rate charged by Warren Buffett, with a 20% call premium. This way, we don't see wholesale dumping of crap that the holder doesn't need to get off their books merely to restore them to par. I am sure most of us would like the value of our SUV's and pickups restored to pre high gas price times that were in essense created out of this mess as well, but none of us outside of the lenders are going to get a dime.
I heard Mish Shedlock on the Overnight radio show just long enough to hear he had some stuff on his website about this. I think we should take action here and follow his lead in sending crap to Congress. My mother wants me to send an email to McCain to the extent that anything derived out of this mess is used to pay down the debt, not to be put into the general fund to be thrown around as if it was a windfall. That is a good concern to be addressed. My concern is that these are generally companies that in the broadest sense serve and are held by multi-hundred millionaires and up and these guys should bail out their own firms. I would rather the government have to bail out the depositors than to allow these outfits to sit back and wait a few years then fleece the country one more time. They need to pay the fiddler. Also, if short selling can be outlawed, intercompany stock transactions, like buybacks and to some extent sizable bonuses and dividends need to be limited and in the case of stock buybacks, done away with entirely for a period of 5 years. The banks need to lend around their capital, not pay screw the shareholder, smoke up the scene of performance with borrowed funds to buy back stock and pay out valuable capital in the form of dividends. The stock needs to reveal reality and not some wishful thinking of some welfare queen. All these firms are trading well above zero, some having 12 figure cap values, despite the term beaten down being used on CNBC over and over again and most of them need a capital infusion. Now how can an outfit need a capital infusion and be trading at such huge cap values?
Here are the links from Shedlocks website; We should all either back up what we can agree with on this site or offer our own opinions.
http://globaleconomicanalysis.blogspot.com/] Mish Shedlocks home page

http://globaleconomicanalysis.blogspot.com/2008/09/senator-sanders-petition-against.html Representative Sanders petition against Paulson

http://globaleconomicanalysis.blogspot.com/2008/09/fate-may-rest-with-shelby.html
Fate may rest with Shelby
http://globaleconomicanalysis.blogspot.com/2008/09/take-back-america.html Take back America

http://faculty.chicagogsb.edu/john.cochrane/research/Papers/mortgage_protest.htm
Protest letter by economists

http://www.hussmanfunds.com/wmc/wmc080922.htm
John Hussman letter to congress

I think many of us realize that we have reached a point in history where it might better to lose all and go through a depression than to bow one more time to international entities in need of a bailout so they can continue to hold and increase bondage over us. I propose that this is nothing more than a treasury swap, where instead of these guys owing us, we are going to owe them. The FDR gold seizure was a similar transaction where all is now owed back to the Federal reserve and the Federal reserve owes you nothing for your paper except debt that is held against all Americans. I hate to get regional, but this is one more NY swindle of Americans, that has been going on since this Republic was founded. The Texas banks were wiped out in the 1980's along with the S&L's. The shareholders weren't bailed out and the local banks were given to east coast concerns. Except for a few freewheeling S&L guys, none of the employees were enriched in the manner that those working for these NY concerns were. We are now beginning to see that emperor Paulson has no clothes, though he was compensated at Goldman as if he were royalty. His salary is equivalent to paying Mario Mendoza Arod money in baseball (for those that don't know, 200 batting average is kindly referred to as the Mendoza line). There are some things about Paulson and his efforts I appreciate, but this is one more attempt to remove his pals from reality and to attempt to allow the American public to not face what is really going on. We can't afford another bailout of these guys and I don't believe we can afford to see another Fed chairman in the vein of bernanke or Greenspan nor can we afford another Goldman Sachs Secretary of the Treasury in the vein of Paulson or Rubin, who did more his share of veiled Wall Street bailouts.

No helicopter drops?

What the government did in the spring was a clear and simple helicopeter drop. Bernanke sat in front of congress and told them about $160 billion should do the trick. It went right into a black hole, as it bulled Walmart stock a little and was gone in a few weeks. This move isn't a helicopter drop and if they go through with it, most likely it will prevent the stimulus helicopter drops needed to get the economy going, the way it has been done in the past, because this bailout weakens the US financial position. To go further and roll out more spending or as far as that goes, more tax cuts would likely be counter productive, as over consumption got us here in the first place and it can be directly traced to government and Wall Street financing.

This, on the other hand is a swap. If the Congress holds the banks feet to the fire, we are actually talking about a program to reduce bank capital or thin it out, not replace it. The plan Bernanke and Paulson put out was a flat gift, which is probably what is needed for the short term as much as I hate to say it. What I would like is that the bad banks just went broke and the government then acquired the assets and liquidated them over time. Something tells me there are too many default swaps out there to let the group go insolvent and shit would fly around the world until everything was brown. Thus, attempting to maintain the status quo with some strings attached was probably a good idea, even though it was also borderline criminal.

The reason I don't believe this does much over the short term is the economy is 2 or 3 steps slow now in credit creation. I won't go into details here, except to say that the system has failed to create enough credit to keep the ball rolling and the system has had too many losses to start the pump again very quickly. Thus we are looking at a swap here, much like the RTC did in 1990. Does anyone recall an inflationary spiral in 1990 besides one in the stock market and one associated with the Gulf War? There was actually a downtick in inflation that followed this mess, to the shock of everyone.

There are a couple of things different now than in 1990. For one, we didn't have the next step in credit creation to take, which was all this crap that they are now stuck with from the CDO's to FNM/FRE. I don't think the financial postion of the US was in better shape in 1990 from a government standpoint either. But, they had an interest rate spead in 1990 that could be lowered and widened on the assets provided. Where do you go from a 2% short term/ 3.8% 10 year spread? Not too far, especially if they have to support the dollar next. I think the t-bill is sending a signal that we are going back to 1% soon and the dollar will be supported short term because the rest of the world is about to join us there.

First of all, we are looking at one of the great farces in history, a blackmail that we are going to be forced to swallow. As much as most of us bears would like to see these bull bastards get zero for their stock, the problem is the problem is so big that the Fed is out of funds and the whole system probably fails, not only in the US, but around the world. It is almost like playing Russian roulette where if the gun doesn't fire, the house is going to fall in on you. The vast marjority of us don't want to lose our money and I wouldn't snicker if you are a gold bug either because police with no paychecks in chaos don't show up for work as we saw in New Orleans, but instead join the looters.

There is absolutely no way out of this. If we prop the banks, this solves the immediate problem, ala putting our finger in the dike. The system is still going to have to deleverage. If there was sufficient capital, sufficient good credit, this mess wouldn't have happened in the first place and it is clear that the higher income people in the US are going to pay for this mess longer term. We are going to see a restriction in credit, which is going to really piss a lot of people off, but what else can come out of this? There cannot be a return to subprime, blindfolded lending and I find it highly doubtful that there is much toxic junk marketed for a long time to come under the guise of top rated credit. This means lower demand from all circles.

What is a depression? I think it is a collapse in capital goods demand. What do we have here? Clearly a capital shortage. You can devalue the dollar, up value the dollar or whatever, but it won't increase the flow to the US from China to fill up Walmarts. The most visible capital spending crazes are going on in China and much of Asia and I would venture that most of their massive growth has been coming from their capital spending craze, not their other output. The whole thing has been fed by a speculative inflow of hot money chasing return, as was demonstrated by their stock market boom and following bust, not exports as supposed. They are buying oil just like we are, iron ore, coking coal, copper, you name it. Then there is the boom in Arabia, where a major world skyline has appeared overnight. I doubt this stuff goes on, as the fuel for it all has been exported American credit. They could replace the dollar, but what would continue the flow of credit? I say all this goes into the box and the price of commodities that go into capital expansion go into the crapper.

I know a guy that I talk about this stuff to quite often. He has a brother that is a street guy in California. His brother got a credit card for $3000, maxed it out and now don't know what to do. The guy lives in a homeless shelter and got a credit card with a pretty nice line of credit. This is what built Asia and broke the banks. The recent string of Presidents, Congressmen and others hasn't been too anxious to end this as it kept the game going.

When I grew up , we had recessions every 3 to 4 years and they were planned and usually not so bad. Then LBJ launched the Great society, fought the Viet Nam war and flooded the world with credit. Inside of 9 years, the dollar was pushed off the gold standard and the business cycle was in ruins. Devalued dollar meant leverage was less forceful in doing anything and the recessions got to be something to be avoided at all costs, as President after President went to slaughter in the 1970's. There were 2 problems that were fixed by Reagan(I know I am going to be debated here), spiraling government spending and tax bracket creep. If Reagan had dropped the tax brackets 10% instead of 20%, maybe capped unearned income at 60% instead of 50% and indexed for inflation, his plan might have worked perfectly or at least much better, but I think he also knew the tax bracket creep game had been allowed to run too long. Politics is beside the point, as what Reagan did worked to the point that it created an expansion that lasted most of his term, most likely becaused he wiped out the shot of speed the Congress typically gave the economy and replaced it with requests for spending cuts and a military expansion. The fact that the trend for interest rates turned down was another factor and maybe a bigger factor than anything else but it too was traced to the political scene. That and the creation of a market for some new financial products, derivatives.

Bush I lost in 1992 because he was probably 6 months early in his term, meaning he was 6 months early in running for election. Had the election been in May 1993 instead of November 1992, I doubt the economy stupid would have played. Bush I had to fade the first deflation game and part of it was probably taking a tax increase. Clinton walked into a new game, new derivatives, cleaned out banking system, the GSE's deciding they could write all the mortgages in the world and a Treasury secretary who could sell anything, fresh from sucking all the money out of Mexico for Goldman Sachs. Rubin knew the prosperity game came out of leverage and I believe his aim was to create a bubble and a favorable view of Wall Street (by the end if the 1990's, everyone loved Wall Street in politics). If you read Greenies book, you realize that Rubin convinced Greenie, who always worked on the fringe of Wall Street that there were no such things as bubbles. I believe Greenie wanted to prove the central bank could fix anything and went along(had he not tried, some idiot would think for the rest of time this could be done). Because the credit machine was so big, the distribution of money(balances belonged to one group to the extreme, debts to another group) in the bank so poor, the game ran on. When it bursted, Greenie came with a new money game called the carry trade and Bush with tax cuts and a war. Anything but to come face to face with the dreaded recession(probably depression by 2001) word. Things weren't getting better for the guys on the bottom, but they did have a job and credit cards came in the mail.

So here we are, at the end of a long economic cycle. There has been almost 30 years since we have had a recession worse than the previous one. Some say 1990 to 1992 was the worst economy since the depression, but I think credit was just tougher, not the real economy worse. The rebound was weak, but the depth of that recession was much less than the 1980 recession that they called a double dip (that was a political lie made up over years, as that one started in 1979) which was worse than the 1975, which was worse than the 1971 or whatever year it was. The 2000 one wasn't as bad as the 1990 one and this one is going to be worse.

One has to look at the string of artificial demand that has circled the world to realize that to deleverage means a collapse in that demand. The 1930's was a capital goods collapse. People can drive the cars on the street in the US for another 20 years before they had to have a new car and maybe car sales go to 12 or 13 million instead of the bubble level. That is 4 or 5 million cars less in capital goods needed. China's exports drop, the financial burden of a bubble economy hits and their building boom stops or slows. That is a massive decline in capital spending. The capital spending to do capital spending also declines, whether it be mine production or machine tools to make machine tools. Who needs the latest PC to run their business? Best guess is very few can't go another year or 2 without one.

Here is the question. I think the economy moves to survival mode, which means that gasoline and food take over the concern of most people, followed by a roof over their head with the desire to get the latest TV or cellphone and service moving to the rear. This crisis has probably thrown the election to Obama, who will attempt helicopter drops at the expense of the rich then have to address the other problem, which is the deficit. The government is going to have to prepare for war, which means that the stream of money paid out for goodies is going to decline. My guess is the near term goal is that something be done to weaken the economies of our likely foes and piling up payments to give them leverage over us isn't going to solve the problem. We have been leveraging up for 70 years or more and the leveraging game is over.

Maybe the gold bugs are correct and this results in hyperinflation, but I think we are going to see a deep recession worldwide that is going to reveal a massive liquidity squeeze due to the fact the punchbowl has been drained. It hasn't been taken away, the host is just flat out of punch. In that vein, I think we deflate and the world joins us.

What the real problem is

I need to write something where I am not responding to questions or debating, so I am here. To spend an hour writing something for the PB board as to have it gone in a matter of minutes under the senseless stuff that is quite often posted there is a waste of time for any well thought out post, correct or in error. I know my writing always contains some erroneous conclusion, but amidst the errors is a basic point that is true to the point you can write it in stone.

The first point is that there is nothing new under the sun. FDR started this emergency procedure and it has never stopped since March 4, 1933. The day it stops will be the day that the phrase, "this note is legal tender for all debts, pubic and private", quits showing up on our money. I am not going to write 12USC95a and 12USC95b on this page, as it only consumes time, but I would get a copy of it and read it every time something like this happens. Rubin used it to send $40 billion to Mexico. Not one peep out of Congress. The Fed posted what it was going to do in assisting money market funds and banks in keeping that system liquid, saying there was no debate and they were going to start immediately. What was posted on PB was the press release, but somewhere there was an actual order issued by the Secretary or the President that quoted 48 stat 1 as its authority or 12USC95a and 95b. This is war ladies and gentleman.

I will start out by saying that the net result of what the government is doing in the money markets and capital markets will add up to about nothing. For the most part, what they are doing is assisting in liquidation. This is pretty much all the government does other than finance hot checks and put the balances in some of our accounts. The money market emergency allows the movement of deposits from money market accounts to other accounts by providing temporary liquidity. It allows for banks to deal with their off balance sheet subsidiaries that violate rule 23A or 23B, which deal in size in relation to capital reserves. We are looking at another SIV model in the money market accounts, something that seems to elude a lot of people and little if any insurance, only commercial paper, which is generally very high quality.

FNM, FRE and AIG were taken over in order to keep assets and liabilities that permeate the entire world financial system from collapsing. It appears that they either should have done nothing and let the chips fall or they should have taken in LEH as well. I am not going to get into any of this other than to say that the system is already illiquid and that for the short term, the mistake would be to allow any of these operations with assets and liabilities this large to cease to function. The mistakes made in taking them in can be rectified, as the businesses can be operated and liquidated in some kind of orderly fashion instead of falling into chaos, as is the case for Lehman. We will never know if such action would stop a depression until we do it, but to let them fail in a world system that has so much debt would be certain deflation and depression. If this doesn't work, which I don't expect it to work to the point that it is declared an immediate success, then we will find out about it and speculation that it should be done might end. If it does work, it adds an important tool. On an individual basis, this might be a moral hazard, but company wide, it is definitely a total loss for most involved in ownership of these companies. In the case of FRE, FNM and AIG, the shareholders are left with a maximum of 20% of what comes out of this mess, which probably isn't going to be much. The government stands to lose big or profit big, but the losses that hit the system had these operations failed would have made the government losses that much bigger. They were all headed for bankruptcy by the end of September and the GSE's would have probably been operated at that time under a rule of emergency, as the entire financial system would have seized up.

Here is the problem as I see it and why it can't be solved. I asked last night where were the deposits coming out of all these socalled printing press actions? There aren't any because assets of the system are being bought to liquidate debt and accounts. The actions to support the money market accounts is nothing more than allowing for liquidation of balance sheet assets to move balances. There isn't going to be a 1 cent increase in the balances of the new accounts from the old accounts because the Fed provided the liquidity. There was a reduction of $169 billion in MM accounts last week according to statistics posted by Doug Nolands Credit bubble bulletin. There was no corresponding increase in m1 and m2 to reflect this. Maybe we are dealing with a lag. This isn't the long term problem though

Before all this mess became public, what were the big financials doing with their profits? Well, they were buying back stock and paying huge bonuses. This capital position money was pretty much being put into accounts that became liabilities of the system. To understand banking, one must realize that the balance sheets of the banks reverse mirror the balance sheets of their customers. This is why my deposit is a debit on my account and a credit on theirs. That term used to drive me crazy. Their balance sheet has all their loans on one side of the sheet, the debit side and all their liabilities and owners equity on the other side. Now they have the new games, the SIV's and MM companies that are off balance sheet and most likely have no capital requirements. But that is another matter. The problem with this layout is the net worth of the banks. As you might see, their loan balances and other assets are generally stated to be higher than their deposit liabilities. The paradox here is that the deposits are the only thing in the system as a whole that can pay the liabilities, meaning the capital account or the owners equity if you prefer is an illusion. This works well as long as money circulates in general, but once the imbalance gets large, it no longer works. This is why the rich become poor or much less rich as well in a depression, as their bank balances are required to disappear in order for the system to heal itself.

All the actions I have seen so far have done nothing to change the balance between assets and liabilities in the financial system. The new proposal is to create a super fund, now $700 billion to buy mortgages in the system. What is this going to do? My guess is the government is going to have to sell bonds, which means that all the mone spent to buy the mortgages is going to go back to the government or fed to buy the bonds. The government is going to counterbalance its costs of funds with the income off these mortgages and maybe redeem the mortgages over time. I have heard they are going to pay fair market value for them, maybe sell them off and maybe let some of them pay off on their own. If the bulls are correct, the government will make out like a bandit if they pay something close to FMV for these assets and not just set up a fund to buy bad assets. They say the problem is liquidity. I say it is capital position.

Why is it capital position? As I brought up, this time around, the banks didn't keep their earnings, but instead used them to buy back stock and pay large bonuses to their employees. What does this do? It converts capital to bank liabilities. Not bank assets, but bank liabilities. How? It converts bank capital, the earnings left after operation into money that now exists in the accounts of those that sold the stock. This served to inflate the value of the stock market temporarily as did the leveraging of the balance sheet of banks into more credit. Thus, the net worth of the banks were converted from net worth to liabilities. Pretty amazing fact. Do the transaction if you don't believe me.

Now what kind of deal did the banks make in this matter? Well, I doubt one of them can sell stock at anywhere near what they bought it back for. Also, they are now caught short capital and any capital raised now reverses the transaction I mentioned in the previous paragraph, increasing net worth and decreasing liabilities. But, it also decreases the amount of deposits in the system to pay the assets on the bank balance sheet, something that few understand. The entire cash movement in banks is a reduction or increase of liabilities and a reduction or increase in owners equity and there isn't a cash account per se on the debit side of the account other than cash held as an asset, as in Federal Reserve cash or credit balances of the Federal reserve. The exchange of check is all done on the other side of the equation and against assets,but rarely against cash to a significant degree with the public.

So here is the real problem. If we start out with a bank that has lets say $1 billion and it represents the entire game of credit. If it earns a net 3% on its business after expenses, its net worth will be $2 billion at the end of 24 years. It will owe $1 billion and have $3 billion or it will owe $2 billion and have $2 billion. Thus it will now have assets, mostly loans and cash of $4 billion and liabilities of $2 billion. This could be more extreme in that it might have assets of $10 billion and liabilities of $8 billion and owners equity of $2 billion. This works well as long as the bank is still acquiring physical assets or collateral as part of its net worth and the balances it owes to customers is circulating around the community as medium of exchange.

But, what happens once the system becomes highly collateralized and the bank no longer can expand its assets and liabilities against existing assets? Well, it still might work as long as the balances are circulating, but in time something is going to happen. The bank is going to make a mistake in sector lending, thus lend too much against real estate or stocks or new business or inventory. Second is the mathematical equation that money won't circulate evenly and the liabilities of the banks will become concentrated in one group of hands and the assets will be claims against another group of people. Thus, in either case, what started out as a bank having $1 billion morphed into the bank having $2 billion and the people having a billion to pay back the banks $3 billion or whatever.

One thing is clear and that is once systematic imbalances do occur, the problem of debt increase moves from being shown in price inflation to asset inflation, as the balances that increase over time become concentrated in the hands of few who now spend their money to enhance returns rather than to buy Cadillacs. They leave these acts to the welfare queens and the general public, who continue spending and increasing their pile of cash assets. Thus the bank balance sheet becomes a picture of liabilities it owes to a group that is entirely different than the group in general that owes its assets. A prime example would be a guy that bought a nice real estate project with 20% down for $1 billion. This guy is rich, but the loan proceeds went into the accounts of a group of 25 partners who now have $40 million each to draw interest off of and bid for other assets. Most will look to buy some stock of some other rich guy who will maintain the cash in his account. The money might filter down, but it won't filter down to the guys it needs to filter down to and it probably won't make it back long term to the guy that just borrowed the $800 million. That guy is going depend on the little guys continuing to get cash to go shopping and once that don't occur, the bank is going to get the project back. The entire value of the project then becomes the availability of credit for the middle class guy to go shopping and the next rich guy to buy the project. If credit for either disappears, the bank becomes dependent on the previous sellers or their assigns to come back and buy the property, hopefully at a price of at least $800 million. In the procedure, the $200 million put up for the purchase appears to have disappeared, but in reality, it exists now as a bank liability to the previous sellers or their assigns as well. Thus we have entered a period where the assets can't support the liabilities and the liabilities can't support the assets and the net worth must be adjusted downward. (if this appears to be out of order, I added it later so the flow to the next paragraph is going to look a little jerky)

So lets see what is happening today? First of all, this thing operates in a loop. The Fed doesn't print money and give it out without acquiring interest bearing assets in return. So, the more the Fed puts out, the more it takes back in the form of interest, thus its activities are always a net drain over time. Second, the banks give up their good assets and the Fed is taking even less good assets, but lending less money against them if this is necessary. But, they aren't printing money, but temporarily liquidating the assets of the banking system to supply cash equivalents to settle the liabilities of the system. They are not making these loans to allow the banks to loan money, only to settle their balances between themselves created out of prior loan activity. An example is the money market mess that erupted this week out of the LEH bankruptcy and most likely has been brewing for 20 years. The Fed opened a special window to allow for liquidation of commercial paper to facilitate the relocation of these liabilities. Lets say the head organization is Chase. If Chase is faced with a run on its off balance sheet MM fund, it can face a liability of huge amounts that it can't liquidate in the current market. If all the money merely moved from Chase MM account to Chase bank, the bank could merely buy the assets of the MM fund with the deposits moved, a trade. But lets say that Chase MM account has $10 billion that moves to another bank. Chase has no way of moving that money save an around the block liquidation of commercial paper in an unstable market. There was $90 billion moved in one day, so you might grasp the problem. There wasn't any new money created here, only a facilitation of liquidation of high qualilty, short term paper. The balances remain the same, only the collateral rests with another bank. There is no more money to lend, as the liability exists and has not been extinguished. Only the holder of the collateral and how draws the interest on it has changed.

The FNM, FRE and AIG take overs are another game. That said, has the government done anything different than KKR did with AIG? The government has backstopped these crucial organizations, not monetized them. The corporate takeover boom of the past 5 years was much more inflationary and dangerous than these moves. Credit contraction and squeezes were the problems with these firms along with maybe insufficient capital to exist as financial intermediaries. This doesn't mean they had negative worth on the market though. In the case of AIG, it had one side that was a mess and the other side which was probably worth more than the bad side was negative. But, it had to operate as an ongoing financial entity and it wasn't going to operate as such under the current financial conditions. Thus it was not going to match its cost of doing business with its income. Neither were FNM and FRE and all of them were woven throughout the world financial system. The government didn't even write a check to buy these operations in the sense that KKR, Blackstone, Cerebus and the other raiders would have. The idea at which end the government was going to get the bill for these failures was really a choice of whether they wanted to go through the worldwide financial failure or not. I don't think there is going to be a choice, as the whole thing is going to deflate, but this buys time.

For the inflationists, where is the capital? The financial system needs capital, not Fed funds injections to expand. They need fed funds injections to meet the liabilities and imbalances in the system, not to make new loans. What about the GSE's and AIG? AIG sold for roughly $100 a share in 2000. That means their top worth was well in excess of $200 billion. FRE sold for roughly $70 per share in December of 2004. This talllies to $45 billion. FNM brought $86.75 in January of 2001. With roughly 1 billion shares, that is $86 billion. So conservatively we are talking about 3 institutions that had a worth of well over $330 at their combined peaks and now the private side of these 3 are worth less than $12 billion, over $10 billion still accorded to AIG. I highly doubt that at this fire sale time that the enterprise liquidation value of AIG is going to come anywhere near $50 billion, which is what it would have to bring in order for the current price to hold true. Chances are that by the time it pays the government its financing fees, buys its way out of its derivative positions that the whole thing might produce $5 billion. AIG stock is a dead short, which is why shorting has been banned.

The brokers are another animal. The Government didn't take over any brokers because the brokers depend on keeping their large customers. What customers would stay with a broker should the company be taken over by the government? Well, I think we all know the answer to that, which means that there wouldn't be a enterprise value at all for these guys because their business was gone the day the government would have stepped in. AIG and the GSE's have a potential enterprise value and I suspect that the GSE's might be significantly undervalued in the current environment, but then again might not be worth anything. But, it appears that the government is going to have to cut these guys into what they sell the next time around the block, regardless of how much money they have to put in. I don't believe this is true of AIG, which is being propped by a loan in exchange for high interest and 80% of the equity. The LIBOR plus 8% is going to force time to be of essense in this matter and the assets will probably be moved at less than attractive to AIG prices. The good side of AIG is a Cadillac in a stable of Fords, while the bad side is the sludge at the bottom of the feedlot pit.

No one has explained to me where the capital is coming from? All these transactions involve giving up good assets for liquidity that is already owed. The best the Fed can do is keep the price of assets up by preventing the system from freezing up. The now $700 billion bailout involves selling mortgages that to this point are illiquid. If they are bad paper, they won't bring much, so the entity selling them is going to have to take a writedown. Maybe this will allow some writing up of assets as some of the poor value has to do more with the fact that there isn't a market for them, but it won't make the assets good nor will it allow for capital appreciation. This is basically allowing companies to move their assets to liquidate their liabilities. It will speed deflation rather than prevent it.

Lets say that they do put up $700 billion? How are they going to finance this? My guess is a swap of treasuries for the mortgages. That was how the RTC was handled, but this has a problem attached to it. The government is limited in how much they can pay for this crap and if it is indeed toxic waste, this will be very little. In fact, there is a lot of level 3 assets that I suspect fit this category that have been marked to some kind of fiction that may be bought here. If the market price is what many of us expect, there will no longer be a mark to model or some other kind of fiction to support the fiction on the balance sheet of GS, MS, BAC, MER and others. The problem for all these assets holders is the fiction will no longer be the fact. There will be more hell raised than can be spoken generally over the next century in the next year if they end up paying a massive subsidy to the failed financial system. So, the best the system can do is sell these assets in return for treasuries. This won't be rolled off the press cash and the treasury and these sellers now exposes themselves to an interest rate risk and to a need to move interest rates on the short term higher to protect the dollar.

My points are that buying the assets of the banking system don't do anything to remove the liabilities of the banking system. They can support the liabilities of the banking system, but they can't make the assets good because the assets are owed by an entirely different group of people. They can tax away the liabilies and give the money to the other side of the equation if they close Walmart and do away with the game over a period of years, but they can't make the assets good or keep the liabilities intact over time. The problem is that credit has expanded to maximum potential and now has to implode. Banning short selling, the government purchasing assets at FMV, the government buying treasuries, etc., none of this extinguishes the liabilities in the system or creates a dime of capital. The losses or the bill is now coming due.

Whats next

I wrote this August 20, 2008. It never made post status, but what has transpired since, it becomes an interesting read October 26, 2008

Meanwhile, back at bear chat, the debate rages about inflation and deflation, gold and silver shortages and all kinds of wacko stuff. But, what is really happening? I think it is everything contrary to what the news says, that we are actually deflating, that the dollar is getting stronger because there is not only a shortage of them to continue the rest of the world on its merry way, but that they are going to get even shorter in supply. The US political scene is really getting messy and whomever wins the next election is going to prolong this agony any way they can, because government draws its power out of agony and not out of prosperity. Here in the US, they just get us to rubber stamp that what they are doing is agreed to because we voted for it. None of us would vote and I don't because I never agree to what they are doing.



The biggest shoes are about to drop, FNM and FRE. They will either languish for awhile or they will agree to something with the US in return for dropping all suits and prosecutions. Thirdly, the US will at least figure out that FNM and FRE weren't all at fault and were only doing what HUD and Congress told them to do and throw them a bone. The third case would allow them to begin to transact business like they should have all along and shut down the loose lending standards that have been increasingly applied since 1995.



For those on the inflation side, no one has shown me how the big spending consumers are going to get the money to keep the party going. Inflation going forward depends on money or credit to keep the bust going big time. In the 1970's, people went out and hoarded stuff to get a jump on the next price increase. This time they just aren't buying what is going up any more than they have to. Why is clear, they don't have the money or the capacity to ask the boss for more money this time.



The wacko gold bug bears think the dollar is going to nothing. I give them some credit in foresight, but I don't believe we are at that point nor do I believe they are going to be young men when it occurs, as in under 70. The US is still the economic powerhouse of the world and most of the rest of the world merely acts as suppliers to the US economic machine. Today I saw a comparison with Japan, the 1930's and with Argentina, and the comparison was the US was mostly like Argentina. There is a lot to the world besides adding up money flows, as they happen for more reasons than one side getting rich and the other going broke. In the case of the US, its debt is dollars and the financial assets of the world are dollars, mostly by choice. As I have written before, the exporting countries to the US have been exporting for a purpose, namely to acquire dollars. Their machinery over there is geared to produce goods in exchange for dollars and thus if the US fails to purchase the production, their business models fail.



The comparison to Japan is really deep. In todays society, savings and debt are bedroom cousins of each other. I am not sure what savings is, but to say that according to statistics, the corporations in the US made record profits in comparison to the GDP, the highest since 1929. Debt in the US is well over 300% of GDP, yet we owe foreigners an amount in the area of 50% of GDP. The other roughly 300% came from somewhere. Someone saves that money to create the loan and the more saved, the more debt accumulated.



If I had to make a guess right now, we are going to a short period of inflation talk followed by some bankruptcies, followed by a collapse in consumer spending. Consumer spending crashes won't be pleasant for the developing world or for parts of Europe. It is the US consumer floating China, not the relending of money to the US that is floating the US consumer. The consumer stops spending and expanding the economies of Asia as soon as the US consumer has no more credit. Then the money supply implodes in on itself, causing a scramble for market share in a variety of world commodity producers. Those that are liquid and poised to pick up some bargains in commodities will make a lot of money, while those caught speculating long are going to be crushed by the debt deflation.



Here is the problem with calling for deflation. The current mess created by the bailout of the financial system under the guise of floating bad funds under the auspices of the international banking community, we have the appearance of run away prices. The big point here is that the dollar recyclers are also commodity consumers on a grand scale for the first time and rather than lend the money back, they went shopping. Thus the prices for commodities everywhere are being pushed by demand from areas not seen since the 1970's. The 1970's commodity price spirals were also created by the third world being loaned money at that time to consume, together with a large war, the launching of social programs in the US and the removal of gold backing from the dollar. Throw in the maturing of the baby boom generation born between 1945 and the early 1960's and we have a huge demand for everything. People don't remember deflation because deflation is something avoided at all costs and the ones that saw it are dead. The people that saw the last gas crunch are the ones running the money now and they recall that very well. Thus, we have dead people that remember the deflation and a huge generation that remembers the inflation. Thus, we will eventually move to fight inflation, not even having a clue as to what deflation is.



But, it is deflation that will win. Everyone scoffs at it and I am a contrarian and I believe it will happen. They won't lower prices until their warehouses are so piled with crap that their bankers are calling the loans if they don't liquidate. People don't know how to make money and they understand losing it even less. Once they start holding out for their money, they are going to find that debt is consuming money so fast that yesterdays rock bottom price is a sellers bonanza today. In many cases selling is going to mean bankruptcy and not selling is going to mean bankruptcy. We are already seeing this in the financial circles, as you can't sell your CDO's at this price so wait. Wait and you keep taking lower prices, as word gets out this stuff is mainly toxic. The car business is more than just gasoline, as the sales apparently started to dive last July, not after the price run up in gasoline. It is just that the automakers are all trying to sell what brung them, not what they can't make presently. We won't see that demand return when the price of gasoline falls because people just won't have the money this time around. It is one thing to wait around for a deal, but it is another to have your money or credit disappear in the meantime. There is going to be a lot of this.



The problem cannot be solved in the conventional sense that a normal recession happens. It can't be solved because it is a debt problem that must be wiped out in a liquidation. They don't wipe it out and either the economy drags into a long term down cycle or the deflation pressures are worse next time.

Now We Have Been Rescued-NOT!

I carry on a continual debate with other bears about whether we are in an inflationary environment or a deflationary one. It appears for the moment that we are hung between the two, but it is my contention we end up with deflation, at least until recovery starts anew. I will go into details what I mean later in this post.

The stock market bottomed again on July 15. I had been expecting a bottom because July always provides turns in markets or I should usually. In fact, if one would trade just 4 months, they would probably make more money than trying to force the markets for the entire year, the first months of quarters. Almost all the strong moves I have seen originated in January, April, July and October with April and July usually providing signals of direction. I won't go into details here because I don't have a load of statistics, merely observations. But, the point is that in bears, an up means a correction of a down move in July, in bulls an up means get on board, at least from what I have seen. A down in a bull means all hell is going to break loose and a big correction is ahead, ala 1987, 1997 and 1998 and to some extent 2000 to name a few. This correction looks like the ones we had in 2001 and 2002, where we had big falls into July, a strong rally for a month then a turn down. The true nature of the 2000-2002 bear was obscured by its aliabi, the 9/11 event, which was a smoke screen (A $30 billion event causes a recession and a $500 billion real loss is supposed to be a walk in the park? I will get to this later as well), but the bottom in July was taken out in August and we were headed strongly down when 9/11 hit. an

So I think this is a seasonal event that has appeared in the last 2 strong bear moves down and nothing but a bear correction. The bulls are rejoycing in some things, namely that the Fed won't have to raise interest rates because of the oil markets being in decline. There is too much reflection on the 1970's going on when in fact this is nothing like the 1970's. The 1970's were a period of strong worldwide demand colliding with a required change in the US money and strong generational demographics in the US coming into play. This one is a long and pure financial bubble, aka, 1914 to 1930. There is a world of difference.

The bulls are celebrating a strong reversal in the dollar as well. So they celebrate the fall in the dollar and then the rise in the dollar like both are Johnny on the spot to rescue them. There is the thought that the dollar is making oil go down and the thought that oil is making the dollar go up. I have to believe neither of them are true and that if anything, the dollar price in oil is a supporting feature of the dollar, not a depressing feature of it. The true culprit is liquidity and it might be liquidity in a lot of places.

Doug Noland, whose inflation outlook is much polar to mine, speculates that the pair trades on Wall Street are in a mess and that is what is causing the fall in commodities, the rally in the dollar and maybe the stock market rally as well. I give him an angle on this because I am still pretty naive to what the pair trades are at this time and I would venture Doug, being where he is has a clue. Truth be known, the banks could very well be running the markets against their customers to make some money of their own. What Wall Street and its financiers will do to their customers for money is as close to fraud and a violation of some kind of fudiciary duty as can be imagined, as they know where the players are most of the time. This means they know how much retail money is short in the stock market and can influence moves overnight by moving the market parameters and they know the pair trades, thus force the hands of the players to carry the trade in their favor. Plus they have all the free money anyone could imagine, as they only have to mark to market.

The bulls speculation is that the price of oil is the entire problem, that the subprime losses didn't really happen and that what did happen is easily absorbable. This is all bullish nonsense and those that spout it really can't believe it. There is a lot of difference between a $500 billion loss in the bond market and a $500 billion loss in the stock market. For one, the bonds are expected to be there, while it is accepted that stocks are play money. In public institutions few are based on stock in their portfolio that depend on it for their net worth. Most is in trusts and the vulnerable are the pension trusts which have been swept under the rug for years anyhow. Bonds, on the other hand, come out of the net worth of highly leveraged financial institutions and not only have to be recognized, but greatly impair the capacity of these institutions to make more loans. Stocks might have a wealth effect and in some cases force corporations to pay more attention to their pension liabilities, but bonds make companies go to zero and destroy the capacity for further financial growth. I don't believe most of these losses are temporary, as the companies taking them are having to make bargain basement deals for more capital and would otherwise find a legal way around imaginary losses. They aren't taking these losses to get ahead of the curve in other words, but only out of necessity. There are more to come.

I believe this is the real game behind the dollar rally, the decline in the price of oil and the decline in business in general. I also believe it will lead to deflation. I will introduce what I call my theory of pressure just to coin a phrase. I think it applies in all systems where you can deal with excess for awhile, but you can't deal with shortage for very long at all and shortage includes a reduction in the former excess. Thus if we are getting 12 units when we need 10, whether it be oil or money, we can play with that for awhile. Once the market pretends we have 12 units when we need 10, in money, we have inflation expectations and an accomodation that we are going to continue to need 12 units, we are going to price like we have 12 units and so on. But, let the market drop to 11 units and one might realize after awhile that Old Joe didn't have as much inventory last time and we are using just in time inventory systems so we have better stock up a little. On the other side, demand is falling for oil in the US. What does that mean? Even though the price is up, the pressure to acquire more oil has dropped and in fact, the inventories can be reduced by a factor of maybe 20 times the drop in demand, because that is how many days of inventory are being held. This is probably fallacious because so much of the inventory is used to fill the system and not really in surplus (ie in pipelines and other places). Thus mere changes in pressure, even if pressure is still in excess or in sufficient are enough to produce a swing in the opposite direction.

There is a lot of talk about there being too many dollars in the world. Are there? The oil markets have created a pile in the Middle East and in Russia. The export markets have created a pile in east Asia and even in South America in places. But, is the pile growing fast enough? The typical inflation bear seems to think it is growing so fast that in a matter of days the dollar is going to zero. But, ask the banker in London who is borrowing against a rising or high TED spread if there are enough dollars? He will probably tell you differently.

The point being that outside of OPEC, the flow of dollars has changed dramatically. In OPEC, we have seen the run in oil prices maybe come to an end and demand begin to drop so the flow may change there as well. The stated US trade deficit isn't rising despite massive increases in oil prices and the bill for oil. This means there is $200 billion of international income missing from the exporters to the US. There are other problems as well, namely massive losses in bank capital.

Though we may have a stock market crash, my idea here is that we are more likely going to have a long grind down. Bulls point to factors that have no real bearing on what is going to happen going forward and look back at a time when credit was easier, cheaper and more widespread than we will have going forward. They point to a bottom in housing that seems to never come and is threatened by further financial impairment in the GSE's and other sources of home financing. Mostly they point to a fall in oil prices, which were caused to start by the solution to the credit mess sought by banks and now are falling most likely due to even tighter funds. They look back at the amazing growth in China and think it will carry us through, when in fact the Chinese have in total assets about 25% of the GDP of the US and if they have to spend those, they are out of business.

I don't believe the real impact of the credit crunch is upon us yet. Using the unwritten theory of pressure, what we are seeing right now is the impact of diminished pressure. The banks wrote a hot check to cover their SIV's then after awhile the Fed covered it then the different wealth funds around the world took the money out of circulation by injecting capital into the banks. Thus we had a sudden blow up in pressure that probably peaked in March and now we are seeing the pressure diminish into May and probably level out now. The point of the leveling out only has to do with the stock market, which is enjoying a temporary increase in pressure due to less money being needed to trade the oil market. But, the supply of pressure creating money is declining and the stock market will only last so long.

In this vein, I think we are moving to a bear in all markets and the action to the upside is only due to the idea that most traders have lived their entire lives in asset inflation times and are continually trying to buy the bottom. Robert Prechter, someone that many try to discredit, said in his books that once the supercycle top was reached, the previous bull action would have been so long that the market would be bought all the way down. I see here that people are speculating in housing, despite the fact that the financing for housing has been impaired not only on a national level, but an international level as well. They have no clue that 75% of the demand for housing is based on financing and much of the rest of it is based on the idea that prices will go up. We are going to get a time where neither prevail, neither easily available financing or the expectation the price will go up. Existing home sales are still well above 4 million, which used to be the speculative peak of home sales, which tells me there is plenty of speculating going on.

Look what is going on in China. Now we have a dollar reversal and maybe it is short term and maybe it isn't, due to the level of interest rates worldwide and the use of dollars for banking liquidity worldwide. Hot money going into China with its high growth and appreciating currency (appreciating while inflation rages over there as they have overpaid for everything) is likely to reverse and it won't find a wide exit. The Shanghai was off 5% last night, a level that constitutes a crash over 1 day (the list of 5% down days in US history is pretty short) and this in itself might be a signal the door isn't too wide. The entire world is on the short dollar trade and the banks may have all speculators where they want them, as bankers might just want to take delivery on all these dollars.

As of right now, bears are cheering in the commodity markets and crying in the stock markets. But, the cash flow that was generated by commodities was an important factor in supporting the economys of the world, as it created the pressure in dollar assets to keep the supply of dollars sufficient. Some say the oil market went up because of a weak dollar, but it is all possible that the oil markets kept the supply of dollars on the international markets up, mainly because so many Americans had to put the purchase of gasoline on their credit cards. I doubt the US consumer is alone in this matter. Now with the peak in oil demand, oil prices, the incoming pressure of dollars is weakened and thus the supply pressure of dollars has declined or even turned negative.

I have been posting that the market would rally for a month, retrace 5/8th roughly of the decline since May and roll over. A month would be August 15. This has been the pattern going into and coming out of July in the past 2 bear market moves. The lone bullish exception was 1996, which in fact was a sideways market that took off out of a sudden decline in July and reversal. Thus the sideways, which bulls consider down market, turned up in July. This wasn't a sideways market, but a steady sell down. In fact, this wasn't a classic turn off the bottom as we have seen in the past. Past turns have made a 1000 points in a week, well beyond the moves we have seen so far.

When and how do we know this thing is over?

I think we are in a watershed event that is going to lead to depression around the world, but even that situation will have an end. The Great Depression lasted 20 years, even though historians seem to gloss this fact over with nonsense about the New Deal and other socialist programs that basically were make work, survival programs and little else. But, even in that vein, one of the great bull markets in history occurred between 1932 and 1937, where gains were in the area of 400% on the Dow. What followed was a bear market that was also one of the worst. There was a difference then in the sense that they at least could debase the local currencies and leave gold for international settlement. That end of the game is over and the only thing left to do is move the currencies to zero as a solution. I doubt TPTB will allow that to occur, as it would mean everyone was bankrupt. Also, the impact of intentional deficit spending isn't new any more and won't have the impact it might have had then. the only solutions so far are to sustain prices and demand at unsustainable levels and massive resistance to let the situation finish adjusting and put the problems behind us, thus the heartburn might just turn into a heart attack.
The US is the demand for the world. Robert Rubin undertook this path in the late 90's in order to attempt to finish the Asian crisis and we forgot to stop it. Trade deficits exploded with the stock bubble, then florished with the housing bubble. It hasn't seemed to sink into the average Joe's head or the average analyst what impact this trade deficit going away is going to have on the rest of the world. This is demand fueled by credit from the US. It might be money loaned back by other countries, but the credit is made in the US and that system is reversing itself fast. I believe this mess has the capacity to balance the US trade deficit and there isn't 5 countries combined in the world that could replace the $600 billion or so in excessive demand that the US brought to the table and if there are, it is only due to the fact that the US is running deficits with them right now. This amount of credit would suck China dry in about 2 years. They won't be able to expand or maintain trade by shrinking the value of the medium of trade.
The idea of Peak Oil might turn out correct not because potential production has peaked, but because consumption has peaked. I think people now will be shocked to see how much less gasoline is used, how much less paper towel is used and so on and so on. Take away pricing pressure and you will soon see the shitcan the Arabs have put themselves into with all their financial commitments. India implodes and the financial backing in China disintegrates. Commodities collapse and the commodity exporting contries go with it.
It will be worldwide and the signs are already showing worldwide. One of signs of this will be oil and what is right now being viewed as a bullish development, the price coming down, is either a temporary respite or a sign that what I am illustrating is starting to occur. The price of oil in this area has been there too short a time to have caused much of the economic grief that has shown up on the scene and much lower prices would have to appear before there was any impact on the current conditions. Bullish or not, oil is a limiting factor on economic expansion due not to price but to supply.
If demand for oil is indeed falling and price follows, then at some price there will be a need to sell more oil, not less oil due to financial necessity. At what price does this occur? I am guessing under $70 and maybe under $55. Remember if you were there, that in 1980, we were never going to see oil at $13 again and yet we did on and off for the next 19 years. I think $55 is a much more substantial price than $13 was 25 years ago, due to the direction other assets are headed and the relative financial position of the exporters. It is also substantial in that instead of allowing consumers to keep there cash and pay down debt, it keeps the money in circulation and in bank accounts. The main reason oil prices are inflationary at this time is they keep the money coming, but the consumer can only send out so much before they are tapped.
I would guess the best way to tell that my prognosis is wrong is if the bull win enough rounds to keep this from occuring is that home prices quit falling and home starts tick up(this is probably a nonsense sentence, but I didn't know how else to write it and I hope you know what I mean in the form of demand). As long as these are inclusive of each other, this game is going to go on and it isn't a housing crisis to start, but a housing bubble. Without price increases, construction increases only prolong and make the problem worse. I think the other thing is that oil demand remains high. As long as the demand and price for oil are high, the bulls are still in the game, contrary to the news. The most bearish news right now is if oil keeps coming down. The bulls didn't need lower prices, they just needed a price where it would stop going up. I believe that if China isn't in full financial crisis by this time next year or apparently headed for it, depression will probably be avoided. I would watch to see how much it slips. A legitimate boom continuing in China probably precludes a depression, but I have to believe for the time being that China is booming toward over expansion that won't be profitable. There is a lot of money from around the world chasing Chinese assets that outsiders really cannot own. The return will be zero.
Now if you followed me closely, I might have made sense. But, if you got lost by your follow the press logic, you might be more confused than before I wrote this. I think most of us bears believe the US credit system has run its course and this will take down the world economy, but at the same time, we have our eyes on 2002. This time is different, as all the financial companies have impaired financial positions and there isn't any home equity left to leverage. The hedges are fully leveraged and before long there won't be a counter party to buy what they have to liquidate.

Is the bubble done?

I have speculated for about 2 years that the oil rally would eventually end at a fibonacci number, $89 or $144 as it has appeared for the past couple of years. For one, I had an idea that the rally had fallen short in 2006 and that the low 80's figure was going to be the high. That was until the financial crisis left huge amounts of money unattached worldwide and the market ran past $89 to about $100. That too was a potential top, but once oil ran past $110, it was clear it was going to the $144 area, where for the time being it has stopped.

In such a market, the high of $147 or whatever it was interday was about as close to $144 as one could expect. The next move, if we do in fact go higher will be $233.

I have become attached to these fib numbers due to my knowledge of the movement of oil over time. For a long time it was $3 a barrel, even when $3 was a lot of money. In the 1970's, it moved first to $5, then to $8, then to $13 where it stayed for about 5 years. When the Iranian revolution broke out, oil then moved to $21 and then in a 2 price system to $28 and $34, with the Saudi's maintaining the lower price. When oil broke, it always settled in the $13 range before rallying back to $21 for about 2 decades, with some runs to $34 during times like the first Gulf War and early in the 2000's. Thus we saw moves to $5, $8, $13, $21 and $34, making 5 total moves. This time we saw moves to $21, $34, $55, $89 and $144 for 5 moves. Does this mean we are done? I think there is a real good chance we are, as there is coming something that few will understand, the fact that inflation causes deflation.

Here is what I believe and I will maybe change this, but for now I am going to stick to what I believe is happening. For one, the bust in the CDO market created a situation where $400 billion wasn't recycled to from one account to another and instead was funded by the banks writing what amounted to hot checks, leaving the money to circulate. Of course, the Fed had no alternative but to cover these checks, as word got out in the Fed funds market that maybe lending to XYZ bank might be a bad idea. Everyone knew about banks like Citi, which clearly had worldwide influence as was probably too big to fail, but much of this is still out there. There was the run on Northern Rock and the implosion of hedge funds, including some run by Bear Stearns, but this was lost money. The bank of England covered the funds drawn from NR with $100 billion. All this money was left to follow the only game left, commodities.

What has happened in the last year is quite interesting. For one thing, much of the $400 billion has been absorbed by deflation. I will elaborate here to the point that hopefully you can follow what I am talking about instead of reading the headline inflation numbers, primarily because inflation and deflation are lagging and not forward. First, much of this extra money went to buy oil because the demand for oil was burgeoning and it was something that would clearly store and play down the road. Second, much of this money ended up or was already in SWF (sovereign wealth funds) and much of this money went to recapitalize many of the weak financials. In this case, money kind of disappears. They say we have written off $400 billion worldwide, so that pretty much accounts for the $400 billion that didn't get recycled.

We are now seeing a pretty violent reaction on the oil price run up. The bulls think this is good news, but oil is a huge market. If this is indeed a speculator driven price hike, then it is clear that there are some huge speculators stuck in positions. There is only one way that speculators could have driven this market higher for this long and that is to roll their own contracts. In order to get out of the current months contracts, they would have had to have taken delivery or rolled sufficient enough long positions forward to entice the hedgers to move their short positions forward instead of making delivery at a loss, thus both moving their liabilities forward. Now that the shorts might have the upper hand here, it is quite possible they are going to force delivery of product the longs aren't prepared to take. I don't know where this oil may be hidden, but I woudn't be surprised to see it suddenly appear in inventory either here in the US or overseas. The point is that if speculators are indeed responsible for this bubble, then there is oil somewhere unaccounted for and if it is hidden by the longs, then it is financed and it and the borrowed money must be liquidated. This is a financial disaster awaiting the hedge funds and you can bet that OPEC itself has forward shorts in this market.

Amaranth supposedly lost $6 billion on their failed gas corner. To understand the size of their position, one must realize that gas declined about $8 from peak to bottom and that Amaranth probably paid around $10 for most of it on average. Realizing they got out at between $6 and $8 and that 1 trillion feet of gas sells for $1 billion a dollar then one might realize how huge their position was. Figuring they lost $3 per MCF, they had 2 trillion of the roughly 3 trillion in storage. I was wondering for some time how gas was staying as high as it was in light of how large the supplies in storage were. There just isn't a lot of places you can hide natural gas. This may not be true for oil, as I suspect there are storage facilities around the world that could hold a billion barrels or more and it not be inventoried. Imagine if there were 1 billion barrels of oil out there that suddenly needed to be liquidated? Even if the figure were 200 million barrels, we would be looking at the US supply of crude sitting out there somewhere. The large exporting countries have to have massive storage facilities for no other reason than to be able to manage production and demand over time. Countries like Indonesia where there used to be sizable exports could have large storage facilities that they could rent to allow the hiding of oil. The Japanese trader who ran the copper corner in the 1990's supposedly had copper in warehouses in LA and other areas that was bought on the LME.

In any case, the market could actually have been true rather than rigged as I suppose and there isn't a hidden surplus. I find that highly doubtful, having watched the oil market for decades. But, it has to be either a rolled contract game or an actual taken delivery and hidden game where continued pressure is put on the market by very sizable excess contracts being taken to delivery points over and over again. If a corner has enough long contracts over what could be provided to the market, they can always exercise a few deliveries and the shorts have to buy their way out of the rest of them. This gives the appearance of making a huge profit, which is really nothing more than postponement of a liquidation of long positions. All buyers have to become sellers in speculation and visa versa.

Where I part company with the bulls is I believe this to be highly deflationary. For one, the bulls think the consumer game will go back to normal while I believe that those that could still spend kept spending while those that couldn't used the rest of their credit just to survive this oil price run up. Thus, they won't be spending any time soon, if forever. Thus we have had a forced inflation in the short run out of this speculation which will cease and now the world will run without the credit inputs of high oil prices. You can consume for as long as you have room on your credit card, which could be as long as they keep raising the limit or the payments exceed income.

I am watching the money supply figures and they have weakened over the past 90 days. Not a decline in M-2, but a very weak growth, which in light of $160 billion in stimulous checks and the extra money that has been injected into some account by the credit used to buy gasoline is pretty sorry. Where would we stand without the stimulous checks? Bernanke was making light of this situation and the bulls seemed to take it as a signal of the bottom. I take it as the first true recognition that we are in recession and that we went into recession with Santa Claus gifts from Uncle Sam, huge booms in exports and 2% interest rates.

What I see now is maybe another huge short opportunity for the financials. There are again statements to the effect that the bottom is in on housing. It is going to be a damn flat bottom if that is the case. Suddenly Europe is slowing down and China is clearly going to be next, as it is paying massive premiums on everything it imports and its exports are losing traction with its customers economies on the slide. I sense the financials get a good month of reprive and then are back in the dumps again, just as we saw back in March. In fact, we really got to June before the financials started getting the truth out once more. First time it was C getting new capital, then it was Bear being bailed out along with MBIA and Ambac and now it is the implicit being made explicit in regard to FNMA and FHLMC paper. This won't in any way fix the problem.

I would watch the money supply figures going into the fall. I have to believe that we are going to see poor retail results as the stimulous money dries up and the price of oil dries up credit card spending. If inflation indeed turns to deflation, the entire world game is up.