Goldilocks! the Bears are Coming Home (Uncommon Common Sense)

Berenanke's hands are tied, he cannot lower rates for fear of a US $ collapse. On the other hand, the money out of thin air creation machine cannot work while lending standards are being tightened. Risk is in the process of being re-priced and what's worse, there are very few good deals around that warrant financing, at anything like a fair risk, adjusted interest rate./p>

You can lead a horse to water, but you can't make him drink. The worst FEAR is that the inevitable Debt Collapse that I have been warning you all about is about to take place and it works something like this: On the way up, the FED deposits $100 in the Banking system which is then able to lend up to (assuming a 10% reserve requirement) $1,000, thus creating $900 out of thin air (all the while creating an illusion that real money was being created). Now here comes the problem: Eventually something happens that wakes everyone up to the illusion that the Emperor Has No Clothes. When a borrower defaults on $100, it is the same as the FED taking back their initial $100 thus forcing the Banking system to call in $900 worth of loans. The money supply has now shrunk by $1,000, not just by the $100 default. This is highly simplified, but do you get it. During an upswing, a default is rare and any shortfall in Bank reserves is made up by the FED. However, the last 20 year build-up of "out of thin air creation of money and credit" is about to come home to roost. It will shake the world's financial system to its core. And you can bet that you have only seen the beginning of the Sub-Prime debacle as it will spread as house prices drop by 30 to 50% over the next 3 to 5 years. If you want to know what an overblown real estate bubble burst looks like, just take a look at Japan since 1990. Real Estate is just beginning to recover after 17 years.

THE BIG PICTURE

If you want to understand what is really going on, you must remember to always keep the big picture in mind. If Junk Bonds suddenly have NO BIDS, it does not mean that they have no value, it just means that there is no market at the present time. But there are margin calls and they have to be met so they sell whatever they can (anything that is liquid) in an attempt to stay solvent. Once the margin calls begin to hit, much more is sold than is initially required because everyone knows that the flood gates are now open and all excess money finds its way to Treasuries, hence the decline in rates. I've warned you more than a year ago that the FED has lost control of the money supply.

THERE IS A TIME AND A PLACE

When there is a shortage of money in the system and the economy is mired in recession (which has always been caused by the FED tightening the money supply by raising Interest Rates) that is the time to lower interest rates and increase the money supply. However, lowering rates when not only our banking system but the whole world's is awash in money is not the solution. With our currency on the verge of collapse and the economy growing at a near record pace after five consecutive years of expansion, now is certainly not the time to lower interest rates because it will only make matters worse. It will tank the US $ and because of the tightened lending standards, injecting liquidity into the banking system which is already awash in excess reserves, will no longer increase the money supply, but the defaulting debt will shrink it.

SHOULD THE FED CUT THE DISCOUNT RATE?

Short Term Interest Rates are already as much as 75 basis points below the Discount Rate, so cutting rates will accomplish absolutely nothing positive. In fact, it could cause a lot of harm as it will signal to the world that the FED is worried about the Economy and as you all know, perception is everything. Just because Wall Street wants a rate cute, that doesn't mean it's the right thing to do. They are just grasping at straws because they know that the Bubble has burst and, as has always been the case, they have been caught with their pants down.

CAN THE FED BAILOUT THE SUB-PRIME VICTIMS?

LTCM : To understand both the Sub-Prime and mortgage crisis by comparing the solution to what Greenspan did with LTCM, we must first analyze what the problem with LTCM was. LTCM was just one company run by a couple of Math and Financial geniuses who forgot about the NATURAL Laws of Limits and Liquidity. They got caught owning a position in Treasuries that was so huge and so highly leveraged that it became illiquid. So, when the market went against them and they were called for margin, they could not come up with the margin nor could they liquidate. Greenspan came to the rescue by forcing the major brokerages to buy them out while lending the company enough money to meet its margin calls. The FED forced the brokerages involved in the bailout to make a fortune even though they acted against their better judgment at the time. Had LTCM been a Bank, the Fed could have lent them the money to meet their short term liquidity crisis, which is exactly what the FED was set up to do from the start. Two things that must be kept in mind: They were buying US Treasuries (not junk bonds) and it was only ONE Hedge Fund. The whole problem was less than one tenth the size of the sub-prime debacle. I had warned you all in my letter titled DENIAL ( March 4) that the virus will be spreading not only to Alt-A1 mortgages, but to the rest of the world's over leveraged financial system as well, especially the buyout and takeover craze.

HAS "IT" BEGUN?

What is IT? and When will "IT" happen?
"IT" is a major financial melt down followed by an economic contraction. "IT" is sudden and sharp downward financial spiral that takes everything down with it. "IT" will be started by a catalyst, a spark that will get everybody's attention. But "IT" is already built into the system by 20 years of accumulated excess credit creation, just lying, there like a pile of oily rags, just waiting for spontaneous combustion or a match or a spark to ignite "IT". Some of the candidates for the catalyst include the following:

• Crash of the Dollar
• Stock Market Crash
• Derivative meltdown at a major bank
• Nuclear terrorist attack
• Major terrorist attack on the US ( Bio or Chemical)
• Major Corporate Debt Default
• Major Municipal or State Default
• Foreign Dumping or perhaps simply a refusal by our major creditors to continue buying US Treasuries
• A major takeover fall through because of the inability to get financing
• And last but far from least, A Blow-up of the Sub- Prime Mortgage Market

This an excerpt from my February 2007 Letter.
There is no question that the oily rags have begun to simmer and it's only a matter of time before they burst into a major conflagration.

CAN ANYTHING BE DONE TO STOP "IT" FROM BURSTING INTO FLAMES?

The die has been cast, but that doesn't mean that Berenanke won't try. The Greenspan put worked before, maybe it's time for a Berenanke put. NOW IS A DIFFERENT TIME AND A DIFFERENT PLACE. Cutting interest rates and injecting more reserves into an already bloated system may work for a day or two, maybe even a month or two, but at best it can only delay the inevitable.

HISTORY REPEATS

If you go back and review the actions of the Government during the 30's to halt the Depression, you will discover an eerie similarity between then and the Bills that are working their way through Congress now. A Recession will bring about protectionist policies and an end to any free trade talks (Smooth Holly).

Increased Union strength, increased taxes, Government manipulation of the economy and CARBON CREDITS, which in reality will be the biggest hidden tax increase combined with the most shackles on industry that the world has ever seen will result in turning a needed recession to re-balance the economy, into a world-wide Depression (along the lines of the 30's). I wrote about this more than two years ago when I called for history to repeat by electing Hillary to become the FDR of the 21st Century.

IS THERE ANYTHING THAT CAN BE DONE?

Not unless you believe that we can change History from repeating and thus change our destiny. But you can act now to protect yourself. First of all, if we are lucky and my analysis is correct; we have a good chance for a short term reversal with the Market breaking out to new all time highs. The Berenanke put will be perceived has having worked and bullish sentiment will skyrocket. SELL into this last rally and go short, especially the financials. Can you just imagine all the lawsuits that will be flying around as the blame game comes to the forefront? What a great time to be a Wall Street trial lawyer.

And last but far from least, BUY GOLD on any weakness. Although I don't think the correction in Gold is over, it's possible that financial conditions will shorten its consolidation. My maximum downside target is $520, which would mark the end of Wave II and start a WAVE III explosion with an objective of $1,000 points plus. BUT, I firmly believe that Gold's correction will be truncated both as to time and price. So continue to buy weakness until Gold breaks above $730. If you're not fully invested by then, just back up the truck and load up.

Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL
[email protected]
561-840-9767