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January 31, 2008

Pandemonium!
by Alex Wallenwein

Markets in Uproar After Fed Loses All Traction

From Merriam Webster's Online Dictionary:

Pandemonium. noun; Etymology: New Latin, from Greek pan- + daimo-n evil spirit -- more at demon. Date: 1667. 1: the capital of Hell in Milton's "Paradise Lost." 2: the infernal regions: hell. 3: not capitalized : a wild uproar : tumult.

Today, Wednesday January 30, 2008, the last stops to a total collapse of the US financial structure were pulled out. The elevator cable is now cut, with the elevator carriage at the 45th floor of a 50-floor skyscraper. If you believe you can "jump" to avoid getting crushed when the carriage hits the concrete floor below - good luck!

The "puller" of the last stop was none other than "Chopper Bernie" Ben Bernanke.

On January 22, he pulled an unannounced 75 bp emergency cut. Today, he followed suit, trying to give the markets what they were screaming for all along: another whopping 50 bp cut.

It didn't work.

After the announcement, the Dow had a fairly lame bump of about 170 points to the north - but I guess it got too cold up there. By closing time, the Dow ended up 36 points back down south on the day. The reason? Three words:

Bond * insurance * disaster.

Ambac and MBIA (and to an even greater extent Security Capital Assurance, Ltd.) are two bond insurance companies whose credit ratings were infamously downgraded in recent weeks. Moody's cut Ambac's credit rating from AAA to AA. Just today, CNBC reported that further ratings cuts are in the works for these companies as the problems associated with the bond insurance business appear to be "much worse" than previously thought.

A bond insurer's primary line of business is to insure bond issues by municipal and other local governments. The insurer guarantees to the buyers of the bonds that the governmental entity in question will timely make its interest and principal payments. That way, the municipalities get to take advantage of lower borrowing costs (interest) as such guarantees make their bonds more attractive in the open markets.

The reason Ambac, MBIA (and to an even greater extent Security Capital) have suffered these downgrades is that their cash positions became shaky when large portions of their reserves had to be used for payouts on their various policies.

That means their customers - municipalities and other local governments - were defaulting on their scheduled payments to bond investors. The point in time when this started happening strangely but meticulously coincided with the implosion of the subprime lending market and the metastasis of the subslime cancer to other parts of the global body economic: June-July of 2007.

Now, what could make municipal governments unable to make their scheduled interest payments on issued bonds? What is their major source of income?

Property taxes.

When people default on their mortgages en masse, the collection of property taxes naturally becomes just a bit more difficult, wouldn't you agree?

The World Bank has this to say on the subject:

"4.05 Taxes on land and buildings are the most common form of direct revenue for local municipal governments. The ad valorem tax, or the property tax, is usually local government's largest single revenue source. Property tax revenues are normally general purpose revenues contributing to a broad range of municipal services, particularly physical infrastructure such as roads and drainage."

Since we now know that the travails of Ambac and MBIA are much worse than originally thought (and they were already thought to be worse" before), what does that tell us about the real default rate of subslime and other mortgage debt? Could that also be "much worse" than officially reported?

You bet!

Conclusion: We have very likely been lied to about the true extent of the mortgage default crisis. What else is new?

And since that very mortgage debt was leveraged up to about the fifth layer of the earth's stratosphere, if there are that many, or maybe even as far as the outer reaches of our solar system, the problems that arise out of the US subslime morass will soon make Godzilla look like a toy puppet in comparison.

A lot of city governments also listened to the "expert advice" of professional financial analysts and started hedging their liabilities by investing in derivatives of the interest-rate kind. Guess what those hedges were built on? More mortgage-morass from hell!

As the true dimensions of the subslime monster in all of its horrific splendor become vaguely discernible to the naked eye - and vaguely conceivable by the human brain - Godzilla quickly fades into nothingness.

So, not to be left behind, Bernie has begun to empty his magazine on this monster - with mostly negative actual effect. A few more rounds, and the chamber will be completely empty. Unfortunately, he has nothing to fall back on since he must have been pumping out printed money to buy up the long term treasuries everybody else was selling for quite a while - with equally negative effect, as it seems.

In the end, if a 125 bp rate cut by the Fed in an eight-day period doesn't light a serious fire under the stock market, then the "wood" in the furnace must be seriously wet - as in under water.

At the same time, long term rates have bottomed out and are now on the way back up, as can be seen on this chart:

And that means whatever clandestine long term treasuries-buying Bernie has been guilty of as of late appears to be in the process of being hopelessly overwhelmed by precipitous selling from other sources.

And you k now what that means!

When massive amounts of money are exiting long term US treasuries and do not appear to be finding their way to the US stock markets, then where do you think thy are going? When the traditional, much-touted "safe haven" instruments no longer promise to be safe and appear to be a "haven" only for shipwrecks in the making (i.e., guaranteed future losses due to inflation), then only one kind of safe haven remains:

Gold. Silver. Platinum. Precious metals ETFs, and hopefully soon ... PM stocks!

The time for that is not yet, though - but we are getting very, very close. Until recently, I was bearish on gold and other PM stocks because I did not know how close the reversal in treasury prices was. That appears to have already happened, now.

A little more time is needed for confirmation, just to be sure. Monitor subscribers will know when that time comes.

Got gold?

Alex Wallenwein
Editor, Publisher
The Euro vs Dollar Monitor

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is your golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!

Copyright © 2003-2008 Alex Wallenwein

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