By Chris Carey, Bailout Sleuth

Regulators closed three banks in the Eastern
United States on Friday, one in New York, one in Florida and one in Louisiana.

The institutions that failed were Park Avenue
Bank in New York City, Old Southern Bank in Orlando and Statewide Bank in
Covington, La. In all three cases, the Federal Deposit Insurance Corp. was appointed
receiver, and arranged for other banks to take over the branches, deposits and
assets.

Valley National Bank acquired Park Avenue’s four
branches, along with its $494.5 million in deposits and $520.1 million in
assets. Valley National, which has headquarters in Wayne, N.J., took over
another failed New York bank on Thursday.

Valley National agreed to pay a 0.15 percent
premium for Park Avenue’s deposits. It entered into a loss-sharing deal with
the FDIC on $379.8 million of the failed bank’s assets.

New York regulators and the FDIC issued
cease-and-desist orders against Park Avenue last month. The orders required it
to take immediate action to correct what state officials called “apparent
violations of federal laws and regulations.”

According to news accounts, Park Avenue and real estate investor David Lichtenstein, one of its major shareholders, have been targeted by lawsuits alleging a number of questionable financial moves.

Centennial Bank, based in Conway Ark., took over
the remains of Old Southern, which had been operating under an FDIC
cease-and-desist order since September.

The acquisition included seven branches, $319.7
million in deposits and $315.6 million in assets. It paid a 1 percent premium
for the deposit, and the FDIC will share in the losses on $282.7 million of the
assets.

Home Bank, of Lafayette, La., took over Statewide
Bank’s six branches, $208.8 million in deposits and $243.2 million in assets. Home
Bank and the FDIC entered into a loss-sharing deal on $163.5 million of those
assets.

Statewide also was the subject of an FDIC
cease-and-desist order, issued last April.

The three banks brought the total number of
failures so far this year to 30. The FDIC said the closings would cost its
deposit insurance fund an estimated $183.4 million.

More articles from the Bailout Sleuth….

By Chris Carey, Bailout Sleuth

Regulators seized a New York bank on Thursday, in
a rare departure from the usual carefully coordinated Friday night closings.

The New York State Banking Department took over
LibertyPointe Bank and appointed the Federal Deposit Insurance Corp. as
receiver. The FDIC arranged for Valley National Bank to take over LibertyPointe’s
three branches, its $209.5 million in deposits and its $209.7 million in
assets.

Valley National paid a 0.5 percent premium for
the deposits, and entered into a loss-sharing deal with the government on $181.5
million of the assets.

LibertyPointe was based in New York City and was controlled by real estate
developer Shaya Boymelgreen. It had long been on the FDIC’s list of troubled
institutions.

Regulators issued a cease-and-desist order against the bank last
July, citing a high concentration of commercial real estate loans, excessive
delinquencies and inadequate provisions for loan losses.

Last October, the bank was given 30 days to
raise additional capital to strengthen its financial position.

The FDIC estimated that LibertyPointe’s failure would
cost its deposit insurance fund $24.8 million.

LibertyPointe was the 27th bank to fail so far this year.

More articles from the Bailout Sleuth….

By Karl Denninger, The Market Ticker

The Lehman Report on which I wrote last night regarding deeply troubling issues surrounding the Lehman Bankruptcy, has laid bare some very ugly facts relating to our financial system, corporate governance, and our government’s active complicity not only in the Lehman collapse, but in ongoing balance sheet shenanigans and the current investment picture.

The conclusions I am forced to reach, after much reflection and sleeping on this article overnight, are not pretty.

They compel me to advise that, in my opinion, the market is now trading both technically and on a fundamental basis, exactly as the Nasdaq was in 1999.

I recognize this is a serious charge and has implications that are most unpleasant, in that it implies a probable detonation ahead at some time in the next year – one that will not only destroy all of the gains made since March of last year but go beyond that – indeed, perhaps as far as the banner on The Market Ticker has for the major indices.

The technicals of the last month leave no doubt what’s going on – the market is moving in a parabolic upward fashion, exactly as was the case for the Nasdaq in ‘99, and indeed, we are approaching the sort of gains in the broad market that Nasdaq saw in 1999.

For those who need a refresher, here it is:

Now let’s look at the S&P 500 since the March lows:

And if you need a refresher on what happened to the Nasdaq after it topped in early 2000, here’s that unfortunate reality:

Not only did the entire ramp in 1999 disappear, more than another 50% was lost beyond that.

The seriousness of this cannot be overstated.  Anyone who bought into the start of the decline in 2000 was wiped out by doubling into a decline that took a literal 85% off the NDX from the peak.  Worse, today, nearly a decade later, we remain more than 50% below the peak valuation that the NDX reached.

The Nasdaq is not alone in this behavior.  The Nikkei 225 reached 38.957 in 1989.  Today it trades around 10,000 – a nearly 75% loss from it’s all-time highs, and despite 20 years it has not healed.

An analytical look at history says that when markets rise on fraudulent accounting and false claims - that is, the booking of asset values that is fictional, the claim of profits that were never really made, the hiding of losses off-balance sheet – the losses, when they come, are not recovered for a generation or more.

When this happens to individual companies, they go bankrupt.

When it happens on a broad basis in a market index, the result is utter destruction.

Such happened in the 1930s as well.  The DOW’s high of 1929 was not recovered until more than 20 years later, and due to FDR’s devaluation of the currency it was another decade before, on a purchasing-power basis, your original values were seen again.

So the seminal question for this alleged recovery has been whether or not the recovery is real – that is, whether the asset class at the core of the original problem, the banking system, now has clean balance sheets and it can be reasonably assumed that what is reported in terms of assets, liabilities and earnings is in fact real.

If you cannot be reasonably certain of this then you simply cannot, as an investor, be in this market.  The reason for this is clear on its face – we will, at some point in the not-distant future, have a point where the insolvency of these institutions rises to public consciousness.

When (not if) that happens the market will collapse. 

This is not conjecture.

It has occurred in each case through history where markets have been pumped through fraudulent balance sheets and similar game-playing, and when it happens the typical losses are in the 75-80% range.  Those losses are maintained even a decade or more later.

Now let’s examine the evidence on whether the core of the reason for the collapse – bogus accounting that led to the failure of Bear Stearns and Lehman Brothers – is in fact resolved and no longer present.

Tim Geithner and the Obama Administration understand this risk.  That much was made clear last year when they ran their so-called “Stress Tests.”  The market understood this too, in that the promulgation of those “results” was a large part of the underpinning for the rally in the markets that has followed.

Is that reliance reasonable?

The evidence says it is not.

As was made clear in the article I wrote last night, Lehman failed multiple stress tests internally, and yet they were repeated with ever-looser standards until an internally-conducted test passed – at which point Tim Geithner’s NY Fed proclaimed them healthy:

After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank.5753 The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.”5754 Lehman failed both tests.5755 The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.5756 However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.5757 It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

Unfortunately the precise same practice took place with all of the other major institutions when Geithner ran the famous “stress tests” that were hung out in front of investors to “bring them confidence.” 

It was physically impossible for The Federal Reserve to actually perform the testing on its own – so instead, they provided metrics to the firms and asked them to run them.

This is the precise same process that was used to produce a “passing” grade by Lehman after the Bear Stearns failure and that process was administered by the same person who was responsible for the false Lehman outcome.

Now add to this that Diane Olick of CNBC has confirmed what I’ve been saying since the crisis began: If the banks really accounted for all the losses in the home loan market, they’d all be insolvent.

Wait a second.  If the “stress tests” were valid, then the capital raises that were done were sufficient and none of the banks are insolvent. 

Indeed, Diane Olick called this exactly as I have:

That’s why the Obama Administration has created this kind of shell game in the first place.

Shell game?

Further, the fact that these loans have no economic value isn’t just mine.  It’s also Barney Frank’s, who is the lead guy in Congress on the House Financial Services Committee.  He said:

Many second liens have little value because of the plunge in home prices, Rep. Frank wrote, adding: “Yet because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans.”

Accounting rules that Congress caused FASB to modify by literally pointing a gun at them.

I’m sorry folks, but the weight of the evidence is overwhelming on this point.

Whatever gains you think you’re chasing in the stock market at this point in time, you’re doing so against a risk of an 85% loss.  The idea that Government can prevent this sort of collapse if it initiates is fanciful – remember that in the summer of 2008 the common belief was that we’d never see a crash right in front of an election, as “they” would not allow it to happen.  If you bought into that belief, you lost half your money.

The risk here is even more severe.  If, in point of fact, those “Stress Tests” provided false confidence (and I believe the evidence is strong that they have) then it is simply a matter of when the market comes to realize that these losses in the large banks are still present but being hidden.

If we apply the FDIC’s own metrics to the expected losses from such a revelation that would “immediately appear” we get a number between $2 and $3.5 trillion that would have to be paid to depositors of the failed institutions - equal to somewhere around one full year’s Federal Budget and dramatically exceeding what the FDIC and Treasury could cover – by more than 10 times.

The consequence of such an event would be literally catastrophic. Having squandered over $3 trillion in the last two years in new borrowing by The Federal Government to prop up the economy (instead of clearing this bad debt through resolving the bankrupt financial institutions) it is highly unlikely that The Government would be able to, on short notice, raise another $3 trillion.

I’m out of all long positional trades as of this morning and will not be back in them until this issue is resolved.  Even if there is a potential 10 or 20% advance that I will miss by doing so, the downside risk of 85% is so extreme and the facts that we now have available strongly suggest that not only are all the large banks insolvent but that the government has been and is complicit in covering it up – not just temporarily, but as an ongoing practice, just as occurred with Lehman.

I’m sure many will call me crazy for this analysis. 

We will see if you still think so in a year or two.

More articles from the Market Ticker….

By Karl Denninger, The Market Ticker

Sarbanes-Oxley was supposed to prevent crap like this:

From the paper:

Lehman employed off-balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.2847

Oh yeah, that’s legal?  It’s not supposed to be!

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.2850  Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851  Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.

Isn’t that special?

It gets better, as you might expect.

The Examiner concludes that colorable claims of breach of fiduciary duty exist against Richard Fuld, Chris O’Meara, Erin Callan, and Ian Lowitt, and that a colorable claim of professional malpractice exists against Arthur Anderson Ernst & Young.2915  (strikethrough mine, not in the original)

It is stated that Government Regulators (FRBNY and The SEC) had “no knowledge” of these practices.  Perhaps true.  But this calls into question why we’re hearing of this just now, and whether other firms have or are at present doing the same sort of thing.

There also appears to be a colorable claim that Lehman Management was fully-aware of what was going on:

Although interview statements given to the Examiner were inconsistent at times, no reasonable dispute exists that each of Lehman’s Chief Financial Officers from late 2007 to September 2008 possessed some knowledge of and/or involvement with multiple aspects of Lehman’s Repo 105 program, including the existence of firm-wide Repo 105 limits, the volume of Repo 105 activity Lehman engaged in at quarter‐end, and Lehman’s efforts to manage its balance sheet using Repo 105 transactions.

Well that’s special.

But we’re just getting warmed up.

Remember, The Feral Reserve is supposed to by the “uber-regulator” and the “safety and soundness” manager for the financial system.

They did a great job, right?  Well…

For example, when

the Examiner questioned Lehman executives and other witnesses about Lehman’s financial health and reporting, a recurrent theme in their responses was that Lehman gave full and complete financial information to Government agencies, and that the Government never raised significant objections or directed that Lehman take any corrective action.

True?  Let’s see what the Examiner had to say:

Although various Government agencies had information that raised serious questions about Lehman’s reported liquidity and about the sufficiency of its capital and liquidity to withstand stress scenarios, the agencies generally limited their activities to collecting data and monitoring.

Oh.  They looked but didn’t act.  I see.

Indeed, they looked pretty closely….

After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank.5753 The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.”5754 Lehman failed both tests.5755 The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.5756 However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.5757 It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

So let’s see what we got here.  They ran two sets of stress tests and the firm failed both.  Not satisfied with the results they then designed a third set, which the firm also failed (we can reasonably presume the third had less stringent requirements than the other two!)

Instead of applying any of these three, FRBNY, which was run by one MR. TIMOTHY GEITHNER, NOW OUR TREASURY SECRETARY WHO REPORTED TO ONE BEN BERNANKE, instead took Lehman’s word that all was ok and did nothing.

Nor did it end there.

The SEC inspection revealed significant problems at Lehman. The SEC found that Lehman’s Price Valuation Group was understaffed; and it found that Lehman’s asset pricing function was overly “process driven.”5761 But the SEC did not release its findings or formally present them to Lehman prior to Lehman’s demise.

So The SEC knew, and they too did nothing.

It’s worse.  While Geithner is implicated as being “concerned” about Lehman in the paper, the most-troubling part the narrative is here:

The challenge for the Government, and for troubled firms like Lehman, was to reduce risk exposure, and the act of reducing risk by selling assets could result in “collateral damage” by demonstrating weakness and exposing “air” in the marks.5823

Air?

Uh, that’s an apparent admission that FRBNY and Tim Geithner specifically knew that the marks that these banks were taking on their assets was materially and intentionally false.

Where have we seen this of late?  Oh yeah – in all those banks that have failed of late, with 25-40% discounts to their claimed balance sheet values when the marks are actually reduced to losses to the deposit fund by the FDIC!

So let’s see here.  We now have:

1. Geithner, and presumably everyone under him, knew the marks on these assets were fictions months before Lehman failed, yet they intentionally concealed this fact from the market and took no action (nor did the SEC) to disclose this intentional misdirection.

2. The misdirection and false claims in this regard are almost certainly continuing today, as evidenced by the FDIC seizures literally on an every-week basis.

How about Bernanke?  While he maintains (as did Geithner) that primary responsibility lay with the SEC, he also said:

Our concern was about the financial system, and we knew the implications for the greater financial system would be catastrophic, and it was.”

What does all this say about the stability of things now?

Yeah, I know, everyone’s “too big to fail.” 

But what if the truth is that they’re “too big to bail“, for instance, if one of the “big four” was to get in trouble today due to a recognition in the marketplace that not only is this what blew up Bear Stearns and Lehman Brothers, but that the same chicanery with “asset values” is continuing even today, and as such one cannot be reasonably certain that liquidity provided today will be repaid tomorrow?

Why is it that if the implications would be catastrophic (and they were), both the SEC and FRBNY knew that Lehman had insufficient liquidity long before the collapse (and they did) neither the SEC, The Federal Reserve or FRBNY did a damn thing to blow the whistle on this crap and put a stop to it?

This report sets out a damning case against the pseudo-government and government actors, who it is alleged were well-aware of critical weaknesses in Lehman’s risk controls and liquidity months before it collapsed, yet none of them did a damn thing about it until days before the bankruptcy filing.

Why should any of the clown-car riders who clearly knew that this situation existed for literal months before it blew up, yet did nothing, still retain their jobs and, in Geithner’s case, obtain a promotion?  These people are unqualified for supervisory positions involving anything more complicated than handing out towels in the men’s room.

The key question facing the nation this evening is not, however, the past.  It is the future.  We have over 100 literal instances in which banks have been seized by the FDIC since Lehman blew up in which their balance sheet “asset values” have been shown by the FDIC’s own DIF loss projections to be abject fictions, yet none of these institutions have been flagged to investors or the public, no indictments or civil complaints have been brought by the SEC or Department of Justice, and they have remained operating for months with these bogus values exhibited for bank examiners and regulators to see.

IF – and I stress IF – these fictions are also present in our large banking institutions, and there is NO REASON TO BELIEVE THEY ARE NOT, it is simply a matter of time before one or more of them detonates in a similar if not identical fashion.  Since these firms are all much larger than Lehman and neither the FDIC or Treasury has a spare $500 billion laying around for the potential payout to depositors that might be necessary in such an instance, we cannot reasonably assume that the risk of financial Armageddon has in fact passed until we know for a fact that all fictional balance sheets are excised and all off-sheet exposures accounted for.

More articles from the Market Ticker….

“Federal Deposit Insurance Corporation Chairman Sheila Bair came close to the third rail of tax policies Monday, citing the federal tax deduction for mortgage interest as one of the causes of the nation’s banking crisis.”

Read more….

Zero Hedge

Earlier today political corpse Chris Dodd said that he would proceed with unveiling a financial reform bill on Monday without Republican participation, in a humiliating blow to Bob Corker, who was most recently seen doing all he could to help his Wall Street colleagues make sure the Volcker plan would never see the light of day. Yet with recent rumors out of Washington that not only is the Volcker plan alive and well, the double whammy for Corker may be coming any day. So what does the Tennessee Senator do? He joins the Fed bashing brigade. Among his remarks from his conference given today after his was “fired” by Dodd, was the observation that the “Fed will, no dobut, will have its wings clipped in reform” and that the Fed “likes their marble buildings” as the Fed is actively lobbying on regulatory reform, with a material amount of turf protection in play. No doubt Senator: it is people like you who make Fed (and broader Wall Street) lobbying efforts quite easy. We hope that you and all your other bought and paid for colleagues in the Senate can learn from Senator Kaufman, whose speech on financial reform we already posted earlier, but which needs to be read and understood by all who are serious about regulatory reform, instead of puppets like Chris Dodd who huff and puff, yet only want to secure a friendly donation paycheck from his core Wall Street constituency, well into his retirement days.

Here are the key Kaufman speech highlights as selected by Shahien Nasiripour of the HuffPo:

Kaufman on the need for fundamental reform:

I start by asking a simple question: Given that
deregulation caused the crisis, why don’t we go back to the statutory
and regulatory frameworks of the past that were proven successes in
ensuring financial stability?…

Mind you, this is a financial crisis that necessitated a $2.5
trillion bailout. And that amount includes neither the many trillions
of dollars more that were committed as guarantees for toxic debt nor
the de facto bailout that banks received through the Federal Reserve’s
easing of monetary policy…

Given the high costs of our policy and regulatory failures, as well
as the reckless behavior on Wall Street, why should those of us who
propose going back to the proven statutory and regulatory ideas of the
past bear the burden of proof? The burden of proof should be upon those
who would only tinker at the edges of our current system of financial
regulation…

Congress needs to draw hard lines that provide fundamental systemic
reforms, the very kind of protections we had under Glass-Steagall. We
need to rebuild the wall between the government-guaranteed part of the
financial system and those financial entities that remain free to take
on greater risk…

The notion that the most recent crisis was a “once in a century”
event is a fiction. Former Treasury Secretary Paulson, National
Economic Council Chairman Larry Summers, and JP Morgan CEO Jamie Dimon
all concede that financial crises occur every five years or so.

Kaufman on the growth of megabanks:

Most of the largest banks are products of serial mergers.
For example, J.P. Morgan Chase is a product of J.P. Morgan, Chase Bank,
Chemical Bank, Manufacturers Hanover, Banc One, Bear Stearns, and
Washington Mutual. Meanwhile, Bank of America is an amalgam of that
predecessor bank, Nation’s Bank, Barnett Banks, Continental Illinois,
MBNA, Fleet Bank, and finally Merrill Lynch.

Kaufman on the failure of regulators:

Regulatory neglect, however, permitted a good model to mutate and grow into a sad farce…

In fact, one of the primary purposes behind the securitization
market was to arbitrage bank capital standards. Banks that could show
regulators that they could offload risks through asset securitizations
or through guarantees on their assets in the form of derivatives called
credit default swaps (CDS) received more favorable regulatory capital
treatment, allowing them to build their balance sheets to more and more
stratospheric levels.

While this was a recipe for disaster, it reflected in part the
extent to which the and complexity of this new era of quantitative
finance exceeded the regulators’ own comprehension…

In the brief history I outlined earlier, the regulators sat idly by
as our financial institutions bulked up on short-term debt to finance
large inventories of collateralized debt obligations backed by subprime
loans and leveraged loans that financed speculative buyouts in the
corporate sector.

They could have sounded the alarm bells and restricted this
behavior, but they did not. They could have raised capital
requirements, but instead farmed out this function to credit rating
agencies and the banks themselves. They could have imposed
consumer-related protections sooner and to a greater degree, but they
did not. The sad reality is that regulators had substantial powers, but
chose to abdicate their responsibilities.

Kaufman on Too Big To Fail and the government’s response during the crisis:

This provided them with permanent borrowing privileges at
the Federal Reserve’s discount window – without having to dispose of
risky assets. In a sense, it was an official confirmation that they
were covered by the government safety net because they were literally
“too big to fail”…

We haven’t seen such concentration of financial power since the days of Morgan, Rockefeller and Carnegie…

By expanding the safety net — as we did in response to the last
crisis — to cover ever larger and more complex institutions heavily
engaged in speculative activities, I fear that we may be sowing the
seeds for an even bigger crisis in only a few years or a decade…

Because of their implicit guarantee, “too big to fail” banks enjoy a
major funding advantage – and leverage caps by themselves do not
address that. Our biggest banks and financial institutions have to
become significantly smaller if we are to make any progress at all.

Kaufman on current financial reform proposals:

Unfortunately, the current reform proposals focus more on
reorganizing and consolidating our regulatory infrastructure, which
does nothing to address the most basic issue in the banking industry:
that we still have gigantic banks capable of causing the very financial
shocks that they themselves cannot withstand…

While no doubt necessary, [resolution authority] is no panacea. No
matter how well Congress crafts a resolution mechanism, there can never
be an orderly wind-down, particularly during periods of serious stress,
of a $2-trillion institution like Citigroup that had hundreds of
billions of off-balance-sheet assets, relies heavily on wholesale
funding, and has more than a toehold in over 100 countries.

There is no cross-border resolution authority now, nor will there be for the foreseeable future…

Yet experts in the private sector and governments agree – national
interests make any viable international agreement on how financial
failures are resolved difficult to achieve. A resolution authority
based on U.S. law will do precisely nothing to address this issue…

While I support having a systemic risk council and a consolidated
bank regulator, these are necessary but not sufficient reforms – the
President’s Working Group on Financial Markets has actually played a
role in the past similar to that of the proposed council, but to no
discernible effect. I do not see how these proposals alone will address
the key issue of “too big to fail.”

Kaufman on separating Main Street banking from Wall Street trading:

Massive institutions that combine traditional commercial
banking and investment banking are rife with conflicts and are too
large and complex to be effectively managed…

To those who say “repealing Glass-Steagall did not cause the
crisis, that it began at Bear Stearns, Lehman Brothers and AIG,” I say
that the large commercial banks were engaged in exactly the same
behavior as Bear Stearns, Lehman and AIG – and would have collapsed had
the federal government not stepped in and taken extraordinary
measures…

By statutorily splitting apart massive financial institutions that
house both banking and securities operations, we will both cut these
firms down to more reasonable and manageable s and rightfully limit the
safety net only to traditional banks. President of the Federal Reserve
Bank of Dallas Richard Fisher recently stated: “I think the
disagreeable but sound thing to do regarding institutions that are
['too big to fail'] is to dismantle them over time into institutions
that can be prudently managed and regulated across borders. And this
should be done before the next financial crisis, because it surely
cannot be done in the middle of a crisis.”

A growing number of people are calling for this change. They include
former FDIC Chairman Bill Isaac, former Citigroup Chairman John Reed,
famed investor George Soros, Nobel-Prize-winning-economist Joseph
Stiglitz, President of the Federal Reserve Bank of Kansas City Thomas
Hoenig, and Bank of England Governor Mervyn King, among others. A
chastened Alan Greenspan also adds to that chorus, noting: “If they’re
too big to fail, they’re too big. In 1911 we broke up Standard Oil –
so what happened? The individual parts became more valuable than the
whole. Maybe that’s what we need to do.”

More articles from Zero Hedge….

The Daily Reckoning

Since we have little interest in joining the speculative party going on in the stock market at the moment – other than in the precious metals and “positive black swan” type of stocks we mentioned yesterday – the task of today’s Daily Reckoning is to prove why the coming collapse of the shadow banking system is not deflationary by inflationary and, among other things, bullish for gold.

If that’s not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we’re wading through. So we’ll do our best to clear them up for you. But it’s probably going to take two days. Today, we’ll look at the case against deflation. Tomorrow, we’ll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we’ll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He’s written about it for years. But for a short course on what he’s predicting and why, check out this video.

In the video Prechter says, “The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back….The scramble will be for dollars not for things.”

The investment outcome of Prechter’s scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, “the chances of default are low.” Prechter’s argument is based on the idea – which we happen to believe – that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter’s reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that’s trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren’t unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that’s not in anyone’s model might be the sort of thing that precipitates the next crisis. After all, that’s the way these things generally begin.

You could make the argument that it shouldn’t really matter to the real economy if a bunch of global institutions find out they can’t settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can’t we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today’s funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are “danger” banks. The reason is that these banks own mostly commercial real estate. It’s their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren’t going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We’re going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It’s easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it’s hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people’s preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We’ll assume for the moment the regular banks won’t do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit…to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it’s monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can’t have inflation if there’s no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won’t this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we’re going out on a limb. But what we’re arguing is that as the private sector is less able or willing to dole out credit into the economy, we’re entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It’s done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won’t do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it’s possible to receive 99 weeks of unemployment benefits. This doesn’t mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments…well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it’s true for the Euro, the Yen, and the Dollar. It’s true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed’s ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar…mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you’ll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and “jobs” programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it’s possible – likely even – that you’re going to see across the board falls in stocks, real estate, bonds, and commodities….AND inflation. Whether we got the proper sequence right, we’re not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Credit Markets Threaten Retail Banking, Bank Runs Next?
• Nationalised Banking System Will Come from Global Market Rout
• Bankers Take Money From the Government and Use it to Speculate
• The Single Best Trade for 2010
• World Economy Faces Hyperinflation or Deflation?

More articles from The Daily Reckoning….

Yesterday’s price action in the currencies versus the dollar was a drag, man… We did, however, see the higher yielding currencies begin to move away from the pack of currencies led by the euro (EUR). That move higher by the likes of Australia (AUD), Brazil (BRL), South Africa (ZAR), and others, carried over through the overnight sessions, so, as we start today, they are stronger versus the dollar… In fact, the Aussie dollar is near a 7-week high this morning.

Another thing helping to boost the Aussie this morning was the news overnight that China reported that exports had increased the most in three years, last month… For those of you keeping score at home… That’s a 46% increase in exports during February for China! Now… I can hear some of the new readers saying, what in the world do China’s exports have to do with the Aussie dollar rising? Ahhh grasshopper, come sit…

You see, Australia is a raw materials (commodities) rich country, which supplies China with all the raw materials they need to build their infrastructure. When China slowed down, it caused a chain reaction to Australia… But… As we’ve seen in the past nine months, China was the first to come out of the economic slowdown, and this report confirms that they are hitting on all 8 cylinders right now… So, as the old saying goes… What’s good for the goose is good for the gander… And what’s good for China is good for Australia!

That can be carried over to the commodities, too… What’s good for China is good for commodities… And looky here, copper, for instance rose $24 on the Chinese news!

The Reserve Bank of New Zealand (RBNZ) meets this afternoon to discuss rates… I would be very surprised to hear that the RBNZ hiked rates this afternoon… Like I said the other day, I think that they will wait another month… But, does this present us with a buying opportunity before the hike? You bet your sweet bippie it does!

The news from Germany this morning wasn’t helping the beleaguered euro any… German exports fell in January according to a report printed this morning. You may recall about a month or so ago, I told you how China had replaced Germany as the #1 exporter… Well, that difference between the two must be widening, given Germany’s slumping exports, and China’s 46% increase last month!

Hey! The rate hike campers here in the US had to lower their flags yesterday, after Chicago Fed President, Evans, said that he “expects the central bank to hold its target rate (Fed Funds) at a record low for the next ‘three or four meetings’”… OK… The Fed Reserve meets every six weeks… So… Given this news, it means the Fed is at least 4-5 months away from moving rates higher.

Now… I know that the markets are always looking forward… But, these are uncharted waters, folks… There’s no guarantee that the Fed will look to raise rates even in 4-5 months! So… The looking forward thing is treading water carefully, watching for those sharks that live on the land!

The Canadian dollar/loonie (CAD), has backed off the lofty level of 0.9770 it reached yesterday… Things are looking good for the loonie… I mean, Canada doesn’t have the subprime mess to deal with… Their housing boom was never even close to that in the US or the UK… And the list goes on… But let’s not leave out rising oil prices, and commodities remaining in their bull market… It’s all good for the loonie these days.

Speaking of the commodity bull market… I’ve not gone on here for some time, and believe that, since I mentioned it, we could discuss it today… OK… Well… Long time friend, Jim Rogers (yes that famous Jim Rogers) wrote in his book on commodities, that for the past 400 years, commodity bull markets run between 17-22 years in length of time… Well… Lets see… This commodity bull market began about nine years ago, right? So, that means we’re only about half way through the “normal” or “historical” bull commodity market.

Now… This is where it would be good to discuss trends… Trends begin for a fundamental reason, and normally do not end until that fundamental reason has been corrected… However, a trend is not a ONE-WAY street. There can be volatility within a trend that will fool or trick people into believing the trend has reversed… Only to find later that they were wrong…

This current weak dollar trend is a good example… You see, we’re experiencing dollar strength right now… But does that mean the weak dollar trend is over? Not in my book! For the fundamental reason, that deficits being too high, has not only not corrected, it’s gotten worse! So, mark this down, and the same can be said for the commodities, as one of those periods of volatility within a trend…

Then there was this… Did you see the news that the FDIC is encouraging public pension funds to invest/inject capital into failing banks? If you just screamed really loud “WHAT?” then you joined me, because that’s exactly what I did when I read that headline in a NY Times article that was sent to me… Why in the world would public pension funds want to inject capital into these failing banks? And even more important than that question, why is the FDIC “encouraging” these public pension funds to do so?

Well… I can come up with a number of reasons for the FDIC to be “encouraging” that this be done… But, what I’m sitting here banging on the typewriter keys about this morning is the fact that this uses “real dollars”… Not ones that were printed out of thin air, like the Treasury gives to the Fed to use… They aren’t future guarantees either… They are “real dollars” that are about to be thrown at failing banks that have already had money thrown at them and they still can’t make it!

I shake my head in disgust at this attempt to get these bad loans off the government’s books and onto the public balance sheet…

None of the bailouts should have ever been done, and we wouldn’t be still messing with all of this! It’s like telling a lie… Once you tell it, you have to keep adding on to the lie, until it gets so big that it explodes in your face… We started this bailout mess, and it just keeps growing and getting bigger and bigger all the time.

To recap… The currencies traded in a tight range versus the dollar for most of yesterday. The higher yielding currencies did gain ground versus the dollar, and that carried over throughout the night as China posted a 46% rise in exports! German exports slumped in January, and the Canadian dollar backed off its lofty level from yesterday, which means it’s cheaper today… Wink, wink…

As I begin to head to the Big Finish, the currencies are mounting a mini-rally versus the dollar, with the euro trading higher to 1.36, which has seemed to be the real hurdle for the single unit… Every time the euro begins to trade above 1.36, it gets smacked right back down again… Makes you wonder if there’s something going on here, eh?

Chuck Butler
for The Daily Reckoning

Strong Chinese Exports Cause Aussie Dollar to Soar originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today’s markets. Its been called “the most entertaining read of the day.”

Read more….

So what happens when government steps in to revitalize neighborhoods and make more people homeowners? Sometimes neighborhoods are hurt and homeowners go into foreclosure. Example number one is from Buffalo, NY where the city decided to subsidize new homes:

"Foreclosures weakened the effort, but overall, not all the housing that was put up was well thought out," said Michael K. Clarke, head of the Buffalo office for Local Initiatives Support Corp., a nonprofit agency that promotes community development. "There was insufficient coordination with the need for rental housing, and not enough emphasis on target areas that might demonstrate a more stable return. You can't sell new homes next to vacant ones, or sell houses to people who only qualify for financing by the skin of their teeth, and expect to have much success."

 

"We played musical houses with the housing in Buffalo," added Joseph E. Ryan, the former strategic planning director under former Mayor Anthony M. Masiello. "We have more houses than we need. People are coming from existing neighborhoods. It's not like they've been coming from out of town. It helps to destabilize neighborhoods."

It's not only communities that are hurt, but the taxpayers that end up paying for these mistakes: [Thanks John!]

Home ownership in the United States ranks up there with motherhood and apple pie. The government has championed it for decades through tax breaks, mortgage guarantees and, most recently, the herculean task of keeping Americans in their homes after the housing market collapse. But government subsidies of the American Dream also have a darker side: when things head south, taxpayers end up stuck with the costs.

The government-run mortgage finance agencies Fannie Mae and Freddie Mac owned more than 131,000 properties between them at the end of 2009, according to recent annual filings. That’s roughly the equivalent of San Francisco’s owner-occupied housing stock. The two companies sold off nearly 200,000 units last year that they took over after owners defaulted. But despite those efforts, Fannie and Freddie owned substantially more units at the end of 2009 than they did a year earlier.

And things are set to get worse. Barclays Capital estimates the pipeline of severely troubled loans at around five million across the United States. Modification programs, which should help some borrowers stay in their homes, have also delayed the inevitable forfeiture of many others.

Fannie and Freddie end up owning properties because they provided guarantees for the benefit of mortgage investors. Between them, they back around $5 trillion of American home loans. Such support — once implicitly and now explicitly backstopped by the Treasury — has handed borrowers relatively low financing costs for years.

Now, though, the result is that aside from the huge financial burden they place on taxpayers, the two companies have been amassing foreclosed properties and, in a few cases, have become landlords.

But the Treasury wants to intervene in the effects of all this intervention:

Today we are providing a program update, including additional details on Foreclosure Alternatives and Home Price Decline Protection Incentives. Foreclosure Alternatives will help to prevent costly foreclosures by providing incentives for servicers and borrowers to pursue short sales and deeds-in-lieu of foreclosure in cases where a borrower is eligible for a MHA modification but unable to complete the modification process. This program will assist homeowners who cannot afford to stay in their homes by helping them to avoid foreclosure and relocate to a home they can afford. Building on insights developed by the FDIC, Home Price Decline Protection Incentives will provide additional payments based on recent home price declines, and therefore will incentivize additional modifications in areas where home prices have been falling. By increasing MHA modifications and the use of alternatives to foreclosure, we will reduce the negative impact of foreclosure, minimizing damaging costs for financial institutions, borrowers and communities.

This is to be accomplished by:

-Servicers may receive incentive compensation of up to $1,000 for successful completion of a short sale or DIL.

-Borrowers may receive incentive compensation of up to $1,500 to assist with relocation expenses.

-Treasury will also share the cost of paying junior lien holders to release their claims, matching $1 for every $2 paid by the investors, up to a total contribution of $1,000 by Treasury.

Question: If this program is such a great deal for servicers, borrowers and lien holders, why does everyone have to be bribed to do it? The claim has been that these programs are to keep homeowners in their homes, but this is paying them to leave. Have we hit the point that the government is merely intervening now for interventions sake?

Read more….

The Daily Reckoning

Since we have little interest in joining the speculative party going on in the stock market at the moment – other than in the precious metals and “positive black swan” type of stocks we mentioned yesterday – the task of today’s Daily Reckoning is to prove why the coming collapse of the shadow banking system is not deflationary by inflationary and, among other things, bullish for gold.

If that’s not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we’re wading through. So we’ll do our best to clear them up for you. But it’s probably going to take two days. Today, we’ll look at the case against deflation. Tomorrow, we’ll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we’ll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He’s written about it for years. But for a short course on what he’s predicting and why, check out this video.

In the video Prechter says, “The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back….The scramble will be for dollars not for things.”

The investment outcome of Prechter’s scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, “the chances of default are low.” Prechter’s argument is based on the idea – which we happen to believe – that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter’s reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that’s trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren’t unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that’s not in anyone’s model might be the sort of thing that precipitates the next crisis. After all, that’s the way these things generally begin.

You could make the argument that it shouldn’t really matter to the real economy if a bunch of global institutions find out they can’t settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can’t we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today’s funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are “danger” banks. The reason is that these banks own mostly commercial real estate. It’s their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren’t going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We’re going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It’s easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it’s hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people’s preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We’ll assume for the moment the regular banks won’t do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit…to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it’s monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can’t have inflation if there’s no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won’t this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we’re going out on a limb. But what we’re arguing is that as the private sector is less able or willing to dole out credit into the economy, we’re entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It’s done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won’t do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it’s possible to receive 99 weeks of unemployment benefits. This doesn’t mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments…well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it’s true for the Euro, the Yen, and the Dollar. It’s true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed’s ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar…mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you’ll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and “jobs” programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it’s possible – likely even – that you’re going to see across the board falls in stocks, real estate, bonds, and commodities….AND inflation. Whether we got the proper sequence right, we’re not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Credit Markets Threaten Retail Banking, Bank Runs Next?
• Nationalised Banking System Will Come from Global Market Rout
• Bankers Take Money From the Government and Use it to Speculate
• The Single Best Trade for 2010
• World Economy Faces Hyperinflation or Deflation?

More articles from The Daily Reckoning….