GoldMoney Alert - 12 December 2007

There is a lot of uncertainty at present about the monetary crisis that has been unfolding over the past several months. Many people are saying that the crisis is over. Don't believe it, and the following essay by Doug Casey that appeared in the latest issue of his newsletter, International Speculator, explains why.

The Continuing Crisis: It's Not Over Yet
Doug Casey
Chairman, Casey Research

While we have already dedicated a lot of ink to the continuing crisis, a recent quieting of the markets has caused many of you to wonder if the turbulence that resulted from the credit bubble hitting the subprime pin in August represents the worst of the economic storm, or if a greater crisis is still ahead.

In order to address that question, we need to quickly review what has happened to date, then try to project what the future may hold.

The Bubble and the Pin

To understand the loud popping noise heard in August, you have to understand the simple truth that over the past decade, the U.S. has imported far more than it has exported, leaving the rest of the world with large quantities of U.S. dollars to invest on an unprecedented scale. Depending on how you slice the data, the total pile now adds up to between $7 and $8 trillion.

The trade deficit isn't just the result of American gluttony. Much of the imbalance results from foreign governments intervening to keep their currencies from appreciating against the dollar. Cheaper currencies, of course, make foreign-made products less expensive and, therefore, more attractive to U.S. consumers. Consider it a gift. But as many are now learning, it's a gift that falls into the same category as the Trojan Horse.

The cycle is exacerbated by foreigners deciding to invest their freshly minted U.S. dollars back into U.S. bonds, treasuries, agencies and stocks. As we have detailed in prior articles, that constant stepping up to the buying window for U.S. paper has provided a large infusion of cash to U.S. institutions, including the Treasury, keeping the credit channels well greased and U.S. interest rates surprisingly low.

Big party - everybody's happy!

And that's how things stood until subprime defaults triggered the August credit crisis, crashing the party and stealing all the silver (figuratively speaking, of course, because there was nothing nearly as tangible as silver to be stolen). That changed things, and in a fundamental and serious way.

Slapped awake to the risk, instead of reinvesting their surplus dollars back into the U.S., foreigners began selling. In fact, August was the worst month for foreign investment in the U.S. since tracking of that data began in 1978.

Chart A shows the latest data, published October 16, 2007, for transactions in August. As you can see, there was a one-month outflow of $163 billion - quite a shocker when you consider that foreigners typically invest $100 billion a month in the U.S. So, we're talking a $263 billion shift in the flow of money.

And now you know why the Fed and European Central Bank intervened so quickly, throwing $300 billion into the hat in order to shore up the system.

Chart B shows purchases of U.S. equities by foreigners. This signal is so far off historical levels, it underscores just how serious the August crisis was.

The same dramatic negative spikes can be seen in charts for corporate bonds and combined long-term investments.

It's hard to overstate the importance of this reversal... a reversal we have been warning readers about for the past couple of years. Correctly, it rang alarm bells all over the world.

Consider that market action as a preview of the sort of monumental dislocations that could occur if all the king's men - central banks, big banks, small banks, financial institutions, hedge funds, etc., etc. - fail to keep Mr. Dumpty from falling off the wall.

Back to Normal?

That was August. Things have settled down since then.

In order to get an updated picture, our own Chief Economist Bud Conrad developed a weekly indicator of foreign purchases of U.S. debt from an important subset of foreign investment data supplied by the Fed. As you can see in Chart C, these purchases have returned to their normal range.

So, is it over? Hardly.

As you can see in Chart D, year after year of U.S. trade deficits have resulted in a massive amount of accumulated foreign investment in U.S. dollar-denominated instruments. This is a far bigger swamp than can be drained in a single month.

Government's Response to the First Wave of Crisis

With the stakes so high, it's no surprise that a number of governments stepped in with drastic measures as the crisis emerged, even taking actions they said they would not. On that score, none has been more notable than the Bank of England which, after harrumphing about Northern Rock looking to its own affairs, went into full-on bailout mode. The tab from this single troubled financial institution is already over $36 billion, and there are plenty more like it that have been stuck with the worst of the subprime paper.

No matter what your frame of reference, that's real money.

Since the crisis kicked off, we have heard about banks needing bailouts around the globe... England, Spain, Italy, Germany, etc. For reasons we'll discuss momentarily, there are more bailouts to come. And it won't be just banks.

Which brings us to the topic of Structured Investment Vehicles (SIVs).

These are a special kind of institution set up to play the role of credit intermediary. Investment banks package up mortgages into Collateralized Debt Obligations (CDOs) and sell them to SIVs. The chain of events includes breaking the mortgage pools into slices called tranches and obtaining credit ratings. Then the SIVs use the CDOs as backing for issuing Asset-Backed Commercial Paper (ABCP). The final purchaser may not realize that the original mortgages were to relatively risky homeowners who may default.

Think of it like making sausage. You take a lot of rather unsavory cuts of leftover pig parts, mush it all together, then add a few spices before stuffing the mixture into a somewhat attractive casing and selling it off as a delectable. SIVs perform that function for portfolios of high-risk debt.

Given the nature of their products, SIVs are formed as off-balance sheet entities, often with no formal legal relationship to the banks that set them up. That avoids oversight by the Federal Reserve System, but also means that losses are not covered by FDIC or SIPC insurance. The banks like them because they don't have to show SIV debt on their books and don't have to set aside capital in reserve to cover such debt.

The problem comes in when investors smell risk. Then the SIV hits the fan, or to be less colloquial, SIVs find themselves short on available credit.

That is what occurred in August, when investors lost confidence in the quality of the mortgages held by the SIVs and stopped buying their securities. In the absence of buyers, prices of these securities plummeted, casting doubt on the same brand of securities already sold into the portfolios of investors and institutions worldwide.

Financial markets were roiled. For the simple reason that if institutions acknowledged that the billions of dollars in SIV-generated paper they held was worth considerably less than previously recorded, it would result in reporting large losses.

Even more troubling was the fact that, because the SIV securities are based on formulas and assumptions (for example, guesses on the number of subprime borrowers that would actually continue to pay on their loans) and these assumptions proved to be way off the mark, holders of SIV paper were unable to determine the actual value of what they held.

There is much more to it than that, of course, because to fully appreciate the problem, we'd have to get into a discussion of ratings agencies and of derivatives and other hocus pocus created by modern money magicians. Suffice to say, the very foundations of modern finance were shaken.

Treasury Department to the Rescue!

Even though not part of the Federal Reserve System, in recent talks with Citigroup Inc., Bank of America Corp., JPMorgan Chase & Co. and others, the Treasury Department proposed establishing a fund to be used to bail out troubled SIVs. The funny thing is, the plan revolves around selling shares of this sausage-gone-bad fund to the investment community.

While no one knows for sure, there are reports that the amount of money to be raised for this bailout fund could be between $80 billion and $100 billion. The banks said they hope to have the fund, to be called the Master Liquidity Enhancement Conduit or MLEC, ready ASAP to head off a possible collapse.

Citigroup has the most to gain from the new fund, considering that an estimated 25% of the total $400 billion SIV universe comes from Citigroup-affiliated SIV funds that have already sold off $20 billion in assets in an attempt to remain liquid. At this point, it's unclear how the paper issued to start up the MLEC will be priced or whether there will even be a market for it.

What happens if the market shuns the new MLEC fund and in the end, the banks are stuck with the paper? Not to get overly deep into this single aspect of the multi-faceted crisis, but bank balance sheets would have to be reconstructed, resulting in a contraction in lending activity. Those SIVs no longer able to issue commercial paper will be seeking bank lines of credit at the same time when banks will be cutting those very lines. That would mean a call for another Fed rate cut.

All obviously bad for the U.S. dollar, which is to say, bullish for gold.

MLEC has been incorrectly explained in the press. It really stands for: "More Loans, Easy Credit." Credit derivatives innovator Charles Ponzi could not be reached for comment.

Consequences

One of the sources of credit that got squeezed in August was loans made between banks. That's because once bankers realized how weak some of their own structures were, they lost confidence in lending to each other and the availability of credit to keep these structured vehicles afloat collapsed.

As you can see from Chart E, since the depths of the August crisis, lending has gone back to normal too.

As has been widely cheered by the money honeys on MSNBC, the sense of panic has ebbed in recent weeks, largely because the obvious distortions of August have largely subsided.

But It's Not Over Yet ...

We have been forecasting a housing slowdown for more than a year, and the related subprime defaults have appeared on cue.

The linkage through unexpected defaults of packages of paper sold to foreign banks was the tipping point of loss of confidence in the CDO and Collateralized Loan Obligation (CLO) paper that rocked the world and caused the collapse.

Whether the problems are fixed and markets are now returning to some semblance of normalcy revolves around the question of whether the housing market is recovering. As you can see in Chart F, it isn't.

More evidence: Chart G shows that the number of foreclosures is continuing to rise. It's akin to a slow-motion tsunami of margin calls, the result of flat or falling home prices, anemic sales and a market struggling with the excesses of the 2004-2005 home-buying frenzy.

A key cause of this bubble bursting was overlending to people who couldn't afford payments on mortgages once their variable interest rates reset. Some 170 firms supplying mortgage money to the underqualified subprime borrowers have collapsed and gone out of business.

There are still more resets coming - major ones - as you can see in Chart H. The money just isn't there for these subprime borrowers to refinance. And many more of these borrowers are going to default. Because of the way their loans were packaged up and sold off, their problems will continue to overhang global credit markets for years to come.

And neither is the damage. Chart I, from JPMorgan Chase & Co, shows just how seriously the market has deteriorated for the lower-rated subprime CDOs. As you can see, the AAA-rated issues were down but have recovered, while the BBB never recovered much and look like they are getting even worse. This is further strong evidence that the credit crisis is not yet over.

What's Next?

While the situation has pulled back somewhat from the imminent crisis level, we are a long way from being out of the proverbial woods.

That's because, as detailed in our October 2006 lead article "Can the Fed Save the U.S. Economy?", the Fed and other central banks of the world have only limited tools available to them for "managing" the economy. Those tools are mostly limited to the relatively small sphere of overnight lending between banks and influencing short-term interest rates. Unless you count dumping dollars from helicopters. And, of course, central banks are extremely important in the psychology of markets.

But real power to set the important interest rates, for example those associated with long-term bonds and mortgages, is beyond their reach. Consequently, the Fed has no tools at its disposal that will move the economy to lasting stability without first going through a recession, a recession it will try to stave off by inflating the currency.

Another way to look at the magnitude of the problem - and why the extinction of a few subprime lenders and a couple highly leveraged banks is just a drop in the bucket of the correction heading towards the U.S. - is to look at the dollar itself.

The money supply figure in the U.S. most closely associated with the ability of people to buy things is called "Money of Zero Maturity" (MZM). This new measure from the Fed attempts to estimate the supply of currency and checking deposits at banks traditionally found in M1, but also includes newer inventions of near-money like money market funds.

As you can see in Chart J, the amount of money being pumped into the system is still growing. In fact, the money supply is currently growing at 12%-obviously a level that should cause higher inflation than the government now reports.

This rapid growth in money shows clearly that the government is already in the process of sacrificing the dollar in an attempt to shore up the sagging economy. On that front, Chart K shows that the dollar is still weakening. It is far from over: as we prepared to go to press, the Fed announced another 25 basis point cut.

There is a high cost to this approach - price inflation - that cannot be put off indefinitely. And that sets up a classic "stagflation" scenario, with a faltering economy and higher inflation at the same time.

Final Thoughts

Summing it up, the massive bubble has only let off a little air, not exploded. That leaves us with the strong possibility of further convulsions and volatility in financial markets.

The continuing fall of the dollar and the continuing fall of the housing market, which has been responsible for so much consumer spending since 2000, means our frequently alluded-to rock and hard place will soon come together, and probably with even greater force than in August.

Unfortunately, the potential now exists for things to get even worse, setting into motion trends such as those previewed in August that could become epidemic. That's because while the economic scenario makes a major adjustment all but inevitable, we may soon find that politics will trump economics.

What happens, for instance, if the U.S. decides to actually bomb Iran? Or another 9/11-type attack occurs? Or Hillary Clinton is elected and decides to try to beat the Bush Administration's abysmal record on government spending?

It's anyone's guess... but none of it will be good for the already wounded U.S. economy.

And it won't be good for those who fail to prepare for what's next.

DOUG CASEY is the author of Crisis Investing, which spent 26 weeks as #1 on the New York Times Best-Seller list. He is also editor and publisher of the International Speculator, one of the nation's most highly respected publications on gold, silver and other natural resource investments.

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