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September 23, 2008

The Reality of the Bailout World
by Boris Sobolev

September of 2008 will go down in financial history as the most dramatic moment since 1929 and 1987. Unprecedented recent actions by the government and monetary authorities will be studied for years to come.

Today, nobody fully understands what really happened in the past few weeks. These events will be analyzed and re-analyzed in the future and a greater understanding will be gained.

But for now, we can schematically draw out the September financial tsunami as follows.

The Ripple Effect

In our September 7 newsletter, we wrote:

"The financial crisis that started in August 2007 has now entered into a third phase - a de facto nationalization of Fannie Mae and Freddie Mac, Government Sponsored Agencies (GSEs) who own or back over 50% of home mortgages in the United States. The third phase of the financial crisis ... [will] witness what is likely to become the biggest bailout in the US history".

The nationalization of Fannie Mae and Freddie Mac caused a ripple effect and led to what is likely to be a culmination of this financial crisis. Within days, Lehman Brothers stock sold off as investors increasingly began to doubt Lehman's ability to raise capital and fulfill its short term liquidity needs.

Central bankers and the Treasury worked frantically to convince stronger players on Wall Street to invest in or merge with Lehman but every firm pulled out of negotiations as the government absolutely refused to provide any taxpayer funded support. Lehman was not in Fed's and Treasury's opinion, too big to fail. Next few days showed that this was a fatal error.

As Lehman declared bankruptcy the following business day, the stock market, led by American International Group (AIG), went into a downward spiral. The Credit Default Swap (CDS) market was in serious crisis as panic on Wall Street spread. Goldman Sachs and Morgan Stanley bonds traded at junk bonds level. Spreads between government bonds (IEF) and corporate bonds (LQD) skyrocketed, dwarfing the panic created by Bear Stearns failure earlier in the year.

On the money markets, some funds had to freeze their assets to avoid redemptions, which reached a record of $89 billion in just one day. Panic was everywhere and the existence of Wall Street as the world financial center was under question.

This was the time for the authorities to panic. The Fed changed its tone, provided an $85 billion high interest rate loan to AIG in exchange for an 80% stake the company and made it implicit that no more major bankruptcies would be allowed to occur. It also agreed to accept equities as collateral for cash loans at one of its special credit facilities, the first time that the Fed has done so in its nearly 95-year history.

The question remained: how is the Fed going to finance these new measures especially when its balance sheet was deteriorating as rapidly as the balance sheets of many of the Wall Street investment banks. Answer. The Treasury announced $200 billion in special bill sales to help the Fed expand its balance sheet from $800 billion to $1 trillion. We are confident more sales on behalf of the debt are likely to follow.

New debt sales meant that the Fed and Treasury are willing to create money out of nothing, beef up their finances and then infuse this extra cash into the faltering financial system. No measure would be spared and bad debts created by years of excess money supply will once again be monetized by newly borrowed funds.

While this was nothing new to us or to many of our readers, it was enough for the speculators to drive the gold price by $90 per ounce in just one day.

But the broad market was still falling, with the Dow down about 1,000 points in just a few days. Finally, the Fed and Treasury broke down and announced a proposal for a government fund (similar to Resolution Trust Corporation of late 80s, early 90s), which would buy up banks' toxic debt and be financed with gigantic sales of new treasuries. The upfront cost of the rescue proposal could easily be $700 billion, and outside experts predicted that it could reach $2.0 trillion or more.

As an additional measure, the SEC temporarily banned short-selling of financial companies' shares until Oct. 2, while the U.K. and Germany took similar steps. Additionally, the feds also proposed to guarantee up to $2 trillion in money market funds by infusing $400 billion into FDIC to prevent further flight from the nation's money markets.

The bazooka plan that Paulson threatened in July, but hoped would never have to be put into action, now emerged more powerful than ever.

The authorities of our newly founded socialistic republic also decided to intervene in the gold market. The Comex division of the New York Mercantile Exchange raised margin payments on gold futures by as much as 47 percent after price swings accelerated. Clearly, the $90 rise in gold did not fit very well into their agenda.

So who is getting blamed for the mess in the financial markets? The short sellers, of course. The people who correctly forecasted the financial storm are now getting brutally punished as they are forced to rush through the closing doors and cover their short positions. Have those who are so quick to blame bothered to check the short ratios on the major financial stocks? These ratios average 3.5% for the entire financial sector. Can 3.5% of shares be responsible for the collapse of Wall Street?

Have we seen any lawsuits being filed against the execs of the greedy Wall Street firms? Few have blamed the Fed or the SEC, but let's remember that it was they who in 2003 allowed the leverage ratios for Bear, Lehman, Merrill, Morgan and Goldman to be increased from 12 to 1 to as high as 40 to 1 thus encouraging further outrageous risk taking.

What's Next? The Feddie Pay Corporation

What can we anticipate next? This weekend the finance and banking committees, leaders of both major political parties, the Fed and the Treasury are scrambling to come up with a mutually acceptable plan that would include forming the giant government waste dump of toxic securities.

The Bush administration is now asking Congress to let the government buy $700 billion in illiquid mortgage backed securities. The plan would give the government broad power to buy the bad debt of any U.S. financial institution for the next two years. It would raise the statutory limit on the national debt from $10.6 trillion to $11.3 trillion to make room for the massive rescue. The proposal does not specify what the government would get in return from financial companies for the federal assistance.

In the end, the Congress will rubber stamp this bill, just like they voted for the Iraq war. What has now been sarcastically dubbed as the Feddie Pay Corporation will probably be managed by Bill Gross, one of a few people from Wall Street who saw this financial storm coming as much as a year ago.

Dollars that will finance Feddie Pay do not exist on the Fed's balance sheet or the Treasury. Foreigners already own over $5 trillion in US dollars and are looking for every opportunity to unload these huge holdings. When an extra $1 trillion plus (a realistic figure required to diffuse the situation in the financial markets) is offered by a nation with a practically bankrupt financial sector, are buyers going to be found? Sure, but at a much lower price, i.e. higher interest rates.

Current low interest rates in the treasuries over the entire spectrum of maturities are unrealistic and simply reflect recent flight to safety as shown in the collapse of the 3-Month T-Bills rates ($IRX), which virtually reached 0% last week. We believe that in the past weeks, bonds have topped and interest rates have bottomed as we experienced the culmination of the deflation scare.

As deflation will be avoided at all costs, inflation expectations (as approximated by the ration between Treasury Inflation-Protected Securities {TIPS} and 7-10 government bonds) are bound to rise.

As a result, gold will enter into a new phase. While in 2007 and 2008, gold rose due to uncertainty and as a safe haven investment, now it will rally due to growing inflation expectations, negative real interest rates and reflationary central banks' stance around the globe.

We believe that the foreign exchange rates will play a minor role in gold's next move up. Gold will rise in all currencies as competitive currency devaluation begins. As major central banks try to fight the world economic slowdown, inflation will be the least of their worries and gold will shine once again.

Detailed analysis of the Broad Markets, Gold, Silver and PM Stocks follows in the Resource Stock Guide Newsletter.

Boris Sobolev
Denver, Colorado
www.ResourceStockGuide.com

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