Last Friday we got a taste of what the future is likely to be like as we make our way further into the belly of the second great depression. The Fed rushed to bail out a venerable Wall Street institution, which was rumored to be insolvent. Sunday evening, that rumor was confirmed to be true, as Bear Stearns agreed to sell itself to JP Morgan for a paltry $2 per share. Two dollars! This for a firm that was trading at $170 just over a year ago, and was as high as $54 just Friday! If Bear Stearns is only worth $2 per share, how can we possibly say with any confidence what other "investment banks" are worth?

While this bankruptcy comes as a shock to nearly everyone, it should be a surprise to no one. The global financial system has been teetering on a precipice for years if not decades, pumped up by unsustainable amounts of debt at every level of the economy, and is primed for a crash. That the crash has been postponed countless times by even easier money lent to yet poorer credit risks has served only to instill a false sense of confidence in markets and to magnify the impending calamity that seems finally to be at hand. Warnings that have been sounded on websites such as this one appear finally to be coming true, as confirmed by none-other than the venerable Wall Street Journal in a front page article titled, "Debt Reckoning: US Receives a Margin Call."

The US is at the receiving end of a massive margin call: Across the economy, wary lenders are demanding that borrowers put up more collateral or sell assets to reduce debts.

The unfolding financial crisis - one that began with bad bets on securities backed by subprime mortgages, then sparked a tightening of credit between big banks - appears to be broadening further. For years, the US economy has been borrowing from cash rich lenders from Asia to the Middle East. American firms and household have enjoyed readily available credit at easy terms, even for risky bets. No longer.

Did you ever think news like that would ever make it off the internet and into the pages of the Wall Street J? Even I was beginning to have my doubts. But the news is seeping even further into the mainstream. This week's Time Magazine has an article titled "10 Ideas that are Changing the World." Idea #8 is "The New Austerity:"

Americans simply don't have enough money to pay back the mortgage and credit-card debt they've run up. That reality is forcing banks to retrench as loans gone bad shrink their capital bases and falling house prices shrink the collateral that homeowners can borrow against. And it will presumably force chastened consumers to change their ways as well.

Americans simply don't have enough money... What does it mean? It means defaults, economic loss and a spiral of fear and more loss. It means more Bear Stearns. Time's article quotes David Rosenberg, an economist at Merrill Lynch: "I'm not saying we're going back to our parents' level of frugality, but what we have witnessed in the past 20 to 30 years - and especially the parabolic credit growth of the last five years - is going to be bursting in the next decade." If not back to our parents' level of frugality, then what? To our grandparents' level? How can anything less be avoided, in an era when most people are already working full speed, maxed-out and yet still need credit to survive? And now they're cutting off the credit!? The result for households will be the same as for Bear - massive liquidation. And the Fed is in no position to do anything about it. The Fed is currently operating in triage mode - desperately trying to aid the banks and save the global financial system as we know it. But what ammunition does the Fed have to save the average American working stiff, who is up to his eyeballs in debt?

In 2002, Bernanke - concerned with the possibility of deflation - concluded that "under a paper-money system, a determined government can always generate higher spending and hence positive inflation" simply by creating more money. But so far it appears that only half of this equation is correct. Positive inflation, definitely. But by lowering nominal interest rates below inflation, the Fed has made it irrational for individuals to save. Why keep money in a savings account that pays 0.5%, or even in a money market at 3% when the "official" B(L)S inflation rate is 4% and reality-based inflation is closer to 10%? The Fed assumes rational people will simply spend the money instead of saving it, thereby generating increased economic activity. But there is in fact a third alternative that Bernanke did not address, and that is that citizens might choose - Gasp! - to pay off their debts. Time goes on to say that debt is the new four-letter word, and that citizens are catching on to the predatory ways of consumer lending. "Several polls have shown that large majorities are planning to use the tax rebate coming later this year to pay off debt rather than buy new stuff," it says.

Deflation was the scourge of the first great depression, and it is what Bernanke was hired to prevent. With his years of study and deep knowledge of the Great Depression Bernanke is one of the world's foremost academic experts on the Depression. It would be a supreme irony if the second great depression were to unfold on his watch. But as I write this - 10pm on Sunday night - news across the wire is that the Fed has cut the discount rate another .25%, effective immediately, and is offering more ways for financial institutions to borrow money to help prevent another institutional bank run Monday Morning. All this on a Sunday night. This is unprecedented, and shows just how panicked the Fed is to soften the crisis. Meanwhile, Asian markets are down 2-3%, as are US futures indices. So Far, the Fed has proven powerless.

Meanwhile, take a look at these charts of the debt insurers MBIA and Amabac from the latest Elliott Wave Theorist (subscription required). Notice how quickly the reversals came. The report states:

When optimisim toward a market continues unrestrained despite deteriorating conditions, the only possible resolution is a "light-switch" type of reversal. When bulls have committed capital to a market and borrowed more to keep investing, and when the rising prices fund even more borrowing to keep them going, there is simply no cushion when the trend reverses. There is no cash on the sidelines waiting to scoop up bargains; it has all gone into investments and the loans that back them. Additionally, there is no contingent of bears waiting for an entry point, and there are no short positions to cover. So there is nothing to stem a free fall.

The report goes on to state that Moody's & Standard and Poors' still has AAA ratings on both of these firms. And if you believe that, there are plenty of banksters and brokers out there that would love to talk with you.

If these charts say anything it is how ephemeral confidence is and how quickly wealth can evaporate when that confidence is destroyed. The same pattern will likely play out for any number of securities, companies and even households in the weeks and months ahead: Everything appears fine until suddenly it isn't.

The question now becomes - how far will the Dow itself fall before this is all over? What is fascinating is that in spite of Friday's panic, the Dow still managed to close within its range and above its lows for the week. Perhaps traders felt optimistic that the Fed would get everything sorted out over the weekend. That didn't quite happen.

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