The Yellow Brick Road to Armageddon

Both the Economy and Stock Markets are unfolding, almost as if on cue to the play I have been writing during the last year or so. I am not sure whether to be happy or sad as more and more analysts begin to see the dangers that lie beneath the surface and recognize the far reaching effects of the problems You may recall that I was always kind of hoping that this time I would be completely wrong. While it’s nice to get a little company after standing alone; I am sure we would all rather be wrong than have to bear witness to what’s coming.

Why did Bernanke cut the Fed Funds rate by an unprecedented inter-meeting 75bps, followed two weeks later by another 50bps? The flow of bad news in December to mid-January did not, by itself, justify such radical action. In order to understand these moves, one has to read between the lines and ignore the Pollyannish babbling of our Media, Politicians and Financial pundits and look instead at the rising probability of a"Catastrophic" financial and economic collapse (1930’s type depression). It now looks like the Fed is seriously worried about the risks, the likes of which have not been seen since the 1930’s. After a year in which the FED and the Treasury were underplaying the economic and financial risks – The FED has been pressured into taking a very aggressive, wrong headed, Keynesian(Socialist) approach to risk management. To understand the risks that the financial system is facing, let us examine the "nightmare" scenario that financial officials around the world have suddenly become aware of and which can no longer be swept under the rug. To begin with let us assume that the recession, which we will soon discover, started in the last quarter of 2007, will be much worse than those that occurred in 1990-91 and 2001-02 for several reasons. First, we have the biggest housing bubble/bust in US history with some home prices likely to eventually fall 30% to 50% or more. Second, because of deregulation and the elimination of Glass Steagall and a host of other protections put in place (after the last financial debacle) by the Securities Act of 1933-34, a massive credit bubble/crunch was created that has now gone far beyond just sub-prime mortgages. Third, deregulation has caused reckless financial innovation and securitization, causing the FED to lose complete control of the money supply, leading to the worst credit crunches in American history. Fourth, US household consumption which now accounts for more than 70% of GDP have spent well beyond their means for 15 years, piling up massive amounts of debt. Now that home prices are falling and a severe credit crunch is emerging, the retrenchment of private consumption will be serious, longer lasting and far reaching.

The Ten Steps to Financial Armageddon

1. The worst housing recession in US history and there is no sign that it will bottom out any time soon. US home prices will fall between 30% and 50% from their blow-off peaks which would wipe out between $5 and $10 trillion of equity, making the 1987 and 2001-2002 equity destruction look like chump change. While a 20% home price drop will translate into a sub-prime meltdown of about 2.2 million foreclosures, a 50% fall in home values will result in over 13 to 18 million households ending up with negative equity in their homes. What will that do to consumer spending? It won’t be long before a few large home builders go bankrupt, leading to another free fall in home builders' banks and related stock prices. The perennial Bulls, looking at last years earnings began bottom fishing and rallied these stocks in spite of the worsening housing recession, thus giving us a perfect opportunity to short the Home Builders and Banks.

2. The financial system losses from the sub-prime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be restricted to sub-prime mortgages and their related CMOs and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices, i.e. LIAR loans (no down-payment, no income verification interest rate only, negative amortization, teaser rates), were occurring across the entire spectrum of mortgages. All of which were being pushed by Greenspan and the Government promoting the American Dream. Instead, what they have created will be the Great American Nightmare. 60% of all mortgage origination between 2005-2007 had these suicidal features. What happened to risk underwriting? Goldman Sachs now estimates total mortgage credit losses of about $400 billion, but that is based on home prices falling only 20%. The markets for securitization of mortgages - already dead for sub-prime and practically frozen for other mortgages – further reduces the ability of banks to originate mortgages and as their risk tolerance is ever increasing, so are the minimum down-payments and credit score requirements. The huge losses have forced banks to bring back on to their balance sheet all types of toxic off-balance sheet investments and loans turning them into financial Time Bombs. Because of securitization, the toxic waste has spread from the major banks and brokers to their Investors, Pension Funds, Insurance Companies and Money Market Funds in both the US and abroad; increasing rather than reducing systemic risk as well as globalizing the credit crunch. The rest of the world will not be growing fast enough to pull the US out of recession.

3. The recession will cause a sharp increase in defaults in all other forms of unsecured consumer debt such as credit cards, auto loans, student loans, etc. As the Fed Loan Officers Survey suggests, the credit crunch is spreading from mortgages to consumer credit, and from large banks to smaller banks, it is becoming clear that the losses are much higher than the $10-$15 billion rescue package that regulators are trying to put together. The Monolines are actually borderline insolvent if not out and out bankrupt and none of them deserves a AAA rating regardless of how much recapitalization is provided. Any business that requires an AAA rating just to stay in business is a business that does not warrant an AAA rating. However, any downgrade of the Monolines will lead to another $150 to $250 billion of write-downs since it will also lead to huge losses on their portfolio of Muni Bonds. Just their downgrade will spillover into large losses and potential runs on the Money Market Funds that have relied on those AAA ratings. The Money Market Funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run, but such a rescue will exacerbate the capital and liquidity problems of their underwriters. Any Monolines' downgrade would lead to another sharp drop in US equity markets already shaken by the risk of a severe recession and large losses in the financial system but worst of all, to a general loss in overall CONFIDENCE. NOTE: The current Monoline rescue talk and/or plans is providing yet another short selling opportunity.

5. As I have been warning you, the commercial real estate loan market will sooner or later enter into a meltdown similar to that of the sub-prime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The recession led by the housing crisis will lead, with a lag, to a bust in non-residential construction. The CMBX index is already pricing in massive increases in credit spreads for non-residential mortgages/loans.

6. It is highly probable that some large regional or even national banks will go bankrupt in the near future. This, like in the case of Northern Rock, will lead to a depositors' panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks as well as Fannie and Freddie are too big to fail as well as the FDIC’s Deposit Guarantees. The bank’s losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans - a good chunk of which were issued to finance very risky and reckless LBOs - is now or soon will be frozen as another prop to the stock market goes into the DEEP FREEZE. Hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar, but soon to be much lower). Add to this the many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the LBO, Pvt. equity bubble) have now been postponed, restructured or cancelled. The problem worsens by the fact that some large LBOs will end up in bankruptcy as some of those corporations that were taken private will go bankrupt in a recession and given the re-pricing of risk, convenant-lite and PIK toggles may only postpone - not avoid - such bankruptcies and make them uglier when they do eventually occur. The leveraged loan mess has already frozen the LBO market leading not only to growing losses, but the elimination of a very lucrative source of income for financial institutions.

7. Once a severe recession is underway, a wave of corporate defaults will take place. In a typical year, US corporate default rates average about 3.8% (for 1971-2006); in 2006 and 2007 this figure was a puny 0.6%. This was due to the lax lending requirements and ultra low interest rates. In a typical US recession, such default rates surge above 10%. Also, during such distressed periods, the recovery given default (RGD) rates are much lower, adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with Junk Bond yields being only 260bps above Treasuries until mid June 2007). But now the re-pricing of risk has been massive and Junk Bond spreads are close to 700bps, while the Junk Bond market is now practically frozen.

While on average the US and European corporations are in better shape in terms of profitability and debt burden than in 2001, there is a great many corporations with very low profitability that have piled up a mass of Junk Bond debt that will soon require refinancing at much higher spreads: Corporate default rates will then surge well above the recession average of 10%. Once both defaults and credit spreads are higher, massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Losses on CDS’s do not represent only a transfer of wealth from those who sold protection to those who bought it. If some of the counterparties selling protection, i.e. banks, hedge funds and large broker dealers go bankrupt, even greater systemic risk results as those who bought protection face counterparties who cannot pay.

8. Unlike banks, non-bank financial institutions such as GE Credit and GMAC etc. don't have direct or even indirect access to the central bank's lender of last resort facility, as they are not depository institutions. In the event of financial distress, they may go bankrupt not because of insolvency, but for lack of liquidity and their inability to roll over or refinance their short term debt, especially since they cannot be directly rescued by the central banks in the same way banks can.

9. Soon, perhaps after one last wishful thinking, short-covering rally, stock markets around the world will begin pricing in a severe US recession as well as a global economic slowdown. The drop in stock markets around the world will then resume with a vengeance as investors begin to realize that the economic downturn is much worse than they ever imagined. Long equity hedge funds will go belly up as large margin calls are triggered leading to a cascading fall in equity prices as a Bear Market is recognized. While a typical US recession causes the S&P 500 to fall by about 28%, this Recession/Depression will not be typical and I am looking for losses in the 50% plus range.

10. Using Economics 101, $200 billion in losses in the Banking system, given a reserve requirement of 10%, leads to a contraction of credit of $2 trillion. Even the recapitalization of banks by sovereign wealth funds (SWF) - about $80 billion so far - will be unable to stop this credit (money supply) contraction. A contagious and cascading spiral of credit contraction, sharp fall in asset prices and widening credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction even more severe and the economic recession will become deeper and more protracted. A global economic recession will follow as the credit crunch spreads around the world. A cascading fall in asset prices will cause panic, fire sales and exacerbate the real economic distress as a number of financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic. Monetary and fiscal easing, as I have previously explained, will no longer work and will not be able to prevent a systemic financial meltdown. The lack of trust in counterparties driven by the lack of transparency in financial markets and uncertainty about the size of the losses and exactly who is holding the toxic waste securities, will add to the impotence of monetary policy and lead to massive hoarding of liquidity. In this meltdown scenario, the US and global financial markets will experience their worst crisis since the 1930’s.

HOW SAFE ARE WE?

The great false hope.

Ambac had, at one time, a capitalization of $US 5.7 billion, with which it guaranteed bonds of $US 550 billion! REALLY! A 1% misstep wipes out its entire capital. How safe will we be even after some back room engineered re-capitalized bail-out designed primarily to help maintain the dubious AAA ratings. And we call this insurance?

What about the general and much broader US Insurance System which covers

everything from life insurance to fire and accident all the way to hurricanes, tornados and floods? All the US insurance companies will be reporting their financial status by the end of February, but only as of the end of 2007. Being so big, they hold enormous investments in all forms of US financial paper from stocks to commercial bonds, CDOs, CMOs etc. and US Treasuries. Their losses on these investments are certain to be huge, but their report will not reflect their true status because the realization of the damage took place in 2008. Since they do not have to mark to the market every day, their true losses will be even bigger after the market falls further, later this year. The issue now becomes: How “safe” are they?

WHAT CAN BE DONE?

One thing for sure, obfuscation, misinformation and politicizing every problem, large or small, will only make it worse. A recession is inevitable, a depression is not. If Bernanke and the Government can work together to control the recession but allow the economy and the securities markets to heal themselves, while mitigating the harmful effects of the recession, then we may avoid a depression. But if an all out effort is undertaken to stop the recession from running its course, as Wall St is demanding, then matters will get a lot worse instead of better. Can our politicians, the Fed and other financial officials come together and avoid this nightmare scenario? Probably not, unless they all hand in their Keynesian credentials and suddenly read and adopt Austrian Economics, recognize the real problems and are able to differentiate cause from effect. Nevertheless, the answer to this question will depend on whether the policy responses (monetary, fiscal, regulatory and financial) are coherent, timely and credible.

I would not bet on it! My philosophy always remains the same regardless of the situation: “HOPE FOR THE BEST, EXPECT AND PREPARE FOR THE WORST, YOU WILL NEVER BE DISAPOINTED”.

WHAT TO DO NOW?

SELL, SELL, SELL: We are in a BEAR MARKET for BONDS and STOCKS. Get out of all your bonds and money markets NOW! Short Term Treasuries and CDs are ok. Although the FED may try to continue to cut rates, because of our weak dollar they may not be able to. But regardless if they do or not, long term rates will be increasing as sanity finally returns to the marketplace and risk once again becomes part of the cost of borrowing.

The 64.2 % reading was high enough to set the stage for the substantial Pull-Back rally into the Bernanke trip to Washington.

Sell and go short into any 450 to 750 point (38%) DJII retrenchment rally. You can now buy Puts on the ETF’s that you think are the most vulnerable such as the XLF (Financials) or you can buy the pro ETF’s that go up when their related indexes go down (i.e QID represents double down the QQQ’s) AND/OR you can just accumulate more GOLD and SILVER stocks and Bullion.

NOTE: This is not a handholding Day Trading Letter, so don’t expect specific option or stock trading recommendations. I only name buy and hold LT positions.

GOLD

The Selling Of IMF Gold: Calls Attention To The REAL Problems.

Ever since its beginnings in the late 1940s, IMF Gold sales have always coincided with a last ditch emergency act in response to a global monetary crisis. Only Gold stands as a valid alternative to failing Fiat monetary systems. IS IT CRISIS TIME AGAIN? Every time the IMF has sold “official” Gold, it soared. In the late 1970s, as US consumer prices were soaring, both the IMF and US Treasury were selling Gold out of their respective inventories. The response to that was Gold gapped up $20 to $40 at every auction. So instead of with dread or fear, I welcome IMF Gold sales.

RIDING THE GOLDEN BULL

The early 1970’s saw Gold go from $35/oz to $200/oz., a 570% increase in less than three years which, at the time, marked the end of Wave I only. A similar move today since we are now in the final stages of Wave I , just like we were back in 1975, would give us a target of ($250 X 5.7) $1425 and that would only complete a 7 year Wave I of an ongoing 5 wave, 16 to 20 year Bull Market for Gold. Do I have to spell it out for you what you should be investing in?

SENIORS vs JUNIORS

Both the Juniors and to a lesser extent the Seniors and Mid Caps have been lagging the rise in the Gold price, instead of leading it as they usually do. Let us now all complain and keep looking a gift horse in the mouth instead of slowly and quietly doing our homework and accumulating the once in a lifetime bargains that are staring us all in the face.

Usually it is “hurry up and buy before the bargains run away”. My crystal ball is a little cloudy, but I am convinced that in the not to distant future, they will catch up and surpass Gold and Silver Bullion. I am running out of time and space, so if you want to know why this abnormal occurrence is happening, you will have to wait for my next letter or go to Gold-Eagle.com where you will find a good number of knowledgeable Gold and Silver people. In the meantime, my TUNE has not changed for the last SIX years: BUY - DO NOT TRADE. Buy more on dips and retrenchments and hang on for dear life as the GOLDEN BULL will definitely try its best to buck you off.

NEW POSITIONS

Bought Miranda Gold (MRDDF) at $0.58 and looking to Buy March in the money Puts today on C, JPM, LEN and LOW

GOOD LUCK AND GOD BLESS

February 27, 2008,

MY SUBSCRIPTION LETTER, “UNCOMMON COMMON SENSE” was started Feb. 1st. We are now living in the type of times in which you will definitely want to be kept abreast as to what is really happening on a regular bi-weekly basis. A 3 month trial subscription is only $55. One Year $199: Call for more info.

Aubie Baltin CFA, CTA, CFP, PhD.

2078 Bonisle Circle

Palm Beach Gardens FL. 33418

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561-840-9767