Thursday, August 16, 2007

Global Financial Instability Returns!!

This is an apt description of the global financial system in a fiat currency and credit world, where money and credit are being created at a breakneck pace (Average Global growth rate of 14% year over year according to the economist magazine) by every Ce ntral Bank in the world. As the worlds government authorities pile dollar after dollar, yen after yen, British pound after British pound, euro after euro, Yuan after Yuan, Ruble after Ruble, Rupee after Rupee, etc. on the global economic pile, selected “Bubble” investment areas of the world economies will grow and then collapse, as we are now seeing in US housing and sub prime lending markets. They must keep the game going in other asset classes and create “emerging bubbles” so these “STRONG HANDS” can step into the dog pile and take out the losers in that particular bubble collapse and keep the overall game going. I have also seen this referred to serial “BUBBLE BLOWING”. Many analysts wondered where the next bubble would emerge. Now we know, and this situation has now moved beyond the shores of America , and is practiced everywhere In the G7.

The next part of the Sandpile it is the money being created by the Big Institutional Banks and Brokerages (that's what they used to be called, now they are poorly disguised hedge funds, look at sources of their earnings) when they “INVENT” Derivative products that literally allow them to print money. Slicing and dicing things like commercial and residential mortgages, into instruments where the “devils” in the details. Most of these newly invented financial products are part and parcel of the holdings of every institutional and pension fund investor in the world. There are trillions of dollars in these investment vehicles/products. They know not what they hold, and have only the financial institutions mathematical models to inspire confidence in the underlying investment instrument and its creditworthiness.

These “credit ratings” used to underpin the issuance of these products come from the likes of Standard and Poor's, Moody's and Fitch and are bought and paid for by the Issuing Institution, and facilitated by enormous amounts of quantitative and probability analysis which is newly invented in the last 15 years. Many of the assumptions in these models are based on data from history, a history where bankers were not as irresponsible as the ones who currently lead the world's economies. We will see these mathematical models be tested in the securitized mortgage markets in the not to distant future and I bet you they are not as “ROBUST” and predictive as they have been presented to be. Its going to be interesting who they “pin the tail on the donkey” this time, as the players involved are also powerful investment interests pitted against one another!!! Of course it will be the little guy!!!

The next part of the sandpile is created the emerging world's central banks, and their money printing is a self defence mechanism , as they have developed fiercely competitive manufacturing and supply chains and their export industries have blossomed. When they get paid this puts a HUGE bid under their currencies as the sheer size of the money flowing into their economies when they get paid is Trillions of dollars in purchasing power from the G7. This money printing is a super charger to their economies allowing them to invest in businesses, plants, equipment, infrastructure and create jobs for their emerging middle classes. The virtuous circle of Austrian economics at work in these emerging powerhouses.

The size of their domestic currencies is Dwarfed by the size of the G7's. So as they receive payment for their products and services they must STERILIZE the income or risk having their currencies SKYROCKET against those of their customers in the G7. An example of “Sterilization” is where they receive a dollar or Euro in payment for something (manufactured goods, raw materials, energy resources, services, etc.) and rather then go to the currency market to exchange it for their domestic currency they print their domestic currency, put it into their central bank reserves (rather than convert them in the currency markets) and pay the domestic businessmen out of the money they printed in the domestic currency. They then must recycle much of this back into the financial systems of their customers to prevent the deflationary effects of the customers borrowing requirements to overwhelm their customer's ability to borrow.

It is clear that words have little meaning to G7 central bankers and government financial officials bent on “NOMINAL” growth at any cost, sacrificing the futures of later generations, for the votes of today's citizens. With runaway money and credit growth the appearance of a healthy, growing economies is in the headlines, while the seeds of collapse are being sowed on a wider and wider scale. The reckless expansion of G7 credit and money is winked and nodded at by Pop ulous Politicians around the globe as the honey pot of a “growing economy” is worth any price to them, as it provides the fuels for the next “RE”election cycle and government inspired idiocy that fools their citizens into thinking there is growth. Look no further than ethanol for an example of a government inspired Di saster in the making, distorting every market that is related to it (we will revisit the “ethanol” finger of instability from the original “FINGERS OF INSTABILITY” as it is illuminating what has unfolded, and the monster it is continuing to morph into).

You have to learn to invest in the direction the wind is blowing and learn to take advantage of these fingers of instability as they emerge. Bubbles forming, driving asset prices higher as good fundamentals combine with TOO MUCH LIQUIDITY to drive the asset class to unbelievable heights, and then implode as the fundamentals no longer support the mania prices in the underlying asset class . It will happen over and over and over again, as rising asset prices, and nominal growth (growth from inflation) underpins everything in the G7 financial systems . As they no longer have policies that are conducive to and supportive of “WEALTH CREATION”. Substituting an ever growing welfare state and the relentless expansion of government while the private sectors suffer death from a thousand cuts. As relentless regulatory expansion, uncompetitive tax structures and the relentless expansion of the welfare state “EAT THEM ALIVE”.

You need to learn to make money in up, down and sideways conditions. As this experiment has a long way to go before the endgame emerges. Make money now, and do your homework, when the final explosions are on the near horizon, know where the exits are, be in liquid investments that will allow you to exit, and then initiate capital preservation and income strategies. In the wrong instruments and you will be killed, in the right ones and the opportunities are limitless.

What can you Bank on? You can bank on the G7 global money printing and credit creation continuing. Asset based banking and economic management strategies such as those that evolved under Greenspan, are now the economic models that are in place around the globe. Widely employed by the developed and emerging world alike. Around the world politicians and central bankers liked what Greenspan did so much that they now are challenging even him for supremacy in recklessness. He has left the scene and the public is quite good at blaming those left holding the bag!!! And he has passed the hot potatoes to others. But because they are putting a super charger to his previous efforts, what was an anticipated “ US collapse” because of these reckless policies are now postponed far into the future! As all these new participants send their economies on the path to wealth creation through asset appreciation rather than growing economies and industries.

Globalization is the canvass, and the Global economic and financial system is the “Sandpile”. As money moves around the globe with ease, seeking out returns. The smart holders of fiat money seek to own the “means of production”, move out of paper currencies and move into assets that can withstand the relentless debasing the sovereign currencies are undergoing at the hands of G7 Ce ntral Bankers and Politicians. The assets the smart money holds and buys just reprice in the debased currencies.

The money and credit machines are generating the constant theft of purchasing power of currencies in deposits, wherever they may be held, (savings accounts, money market accounts, Bonds, interest rate instruments of all stripes, etc.). The dollar is a good example of fiat currency over time; as one dollar now buys what 4 cents bought when the Federal Reserve was unconstitutionally mid-wifed in 1913, only now the process has accelerated. (Sound money was a central theme of the founding fathers of the United States ; they prohibited the creation of a “fiat” faith based money system, they had seen numerous failed experiments with this throughout history and new these lessons well). In 1913 US politicians forgot these lessons with the creation of a foreign owned central bank (US Federal Reserve) and changed this forever.

Now “GUSHERS” of hot money roll of the central bank presses or are created by the big banks and brokerages when they spin new products such as CDO's (collateralized debt obligations and CMO's (collateralized mortgage obligations), but there is one common element to all of these instruments and that is the are like bonds, and they are sold based on the underlying “ASSET” value, and if the asset value declines or the income streams off them cease they become ‘BOMBS' to balance sheets.

Remember Japan, it was just 16 short years ago when we witnessed an asset based economy come off the rails; it is now just barely emerging from its deflationary debacle

(During Bernanke's academic career he developed intimate knowledge of Japan and the great depression, both times where credit availability for even qualified borrowers evaporated: mean the sub prime mortgage debacle “must not” be allowed spread to other parts of the lending system). US and EU politicians are totally ignoring this recent lesson of history (as they attack the Yen and by extension the yen carry trade).

Think of what would happen if this Japanese type of deflation and a liquidity crunch were to unfold on a Global scale, that's what teeing up if the central banks don't keep the international money and credit creation trains humming. If feeble-minded protectionist politicians or weak kneed central bankers in the United States and the European Union precipitate the choking off of these money flows we all will enter a deflationary depression of unprecedented scale. A Kondratieff winter! Hopefully someone will explain this to them before it is too late. We are now in a world of inflate or die. I promise you they will inflate. So it's going to be fire hoses of HOT money right off the printing presses for as far as the eye can see.

Enough already? Ready for some fingers of instability? Also known as bubble opportunities? And potential pitfalls!!!


This week a fire emerged across the banking systems of the G7, as CMO/CDO's markets started to implode. Approximately 300 billion dollars was PRINTED during the week to rescue the banks and the prime brokers from “ARM”ageddon. The overnight lending windows froze as banks REFUSED to lend to other banks as the value of their counterparties collateral suddenly was in question. The overnight commercial paper market suffered many disruptions as well. So the authorities did as they must to keep the game going: they printed the money and said “COME and GET IT” to supply the short term liquidity requirements of the G7 financial systems. It was enormous as every G7 central bank opened the lending windows. These episodes are set to continue as the financial authorities DO NOT know where the problems are, and on whose balance sheets they reside so they must wait for them to emerge then address them one at a time.

Most people think the problems were contained by these injections, but the important event was not the injection into the overnight banking systems which HAD to be done. The important event is that the US “FEDERAL RESERVE” went to the heart of the problem on Friday and took the “MORTGAGE BACKED SECURITIES” as collateral. They took over 20 billion dollars worth of them into inventory. NEVER has any central bank taken these over the counter “DERIVATIVES” as collateral. By putting a price on them now they can mark the models to the market, and the G7 central banks have the purchasing power to dictate the bid price, therefore now the balance sheets can be defined. However to this point it is only the US Federal Reserve that has done so. The Bundesbank did a rescue as well of IKB bank, but only by guaranteeing the banks in question, they didn't take the notes.

The seeds of this unfolding debacle are trillions of dollars of Mortgage backed securities which up to this point has been completely an over the counter affair between big banks, prime brokers and their clients such as hedge funds, institutions and pension funds (the investors in these products). The blow up is happening because the quality of the mortgages in these securities varies wildly and has come into question, some are backed by “good borrowers” and others by “liar loans” and “ninja” (no income, no job or asset) loans. They are PANDORA's box investments . Open them up and you don't know what will fly out of them. So as more and more investors decide the risk is a little more than they can be comfortable with and decide to sell the market was turning into a black hole. No bidders will put a price on them, so effectively they were worth very little, maybe as low as twenty cents on the dollar or as high as 90 cents, as NO ONE will buy something if they can't understand the value of that something.

Another shoe just dropped as we go to press, banks are WITHDRAWING their credit lines to hedge funds that hold this paper, and they are revoking credit lines predicated on this type of collateral. Another negative.

Now the interesting part starts as to effectively address this problem the G7 central banks must wait for bank after bank, institution after institution, hedge fund after hedge fund, pension fund after pension fund to try and exit their positions. The cockroaches must be identified as they as are flushed out by the mob of investors in PANIC liquidation mode. LOL. Some will be allowed to survive and others will be allowed to die as a lesson to others. The G7 central banks will HAVE TOO be the market maker of last resort. To not do so spells doom for the G7 financial system as the “ALWAYS” inflating value of the assets are the underpinnings of their financial systems.

Did you notice there wasn't one central bank in the emerging world which had to inject liquidity? Why? Because they have savings, and their economies are not dependent on monetary and asset inflation for growth like the G7's is. The emerging world does not depend on financial magic, inflation through currency and credit creation, and smoke and mirrors to create the illusion of growth. They are becoming wealth creating machines, courtesy of unrestrained capitalism and the Austrian economic models they employ and the money the G7 prints and sends to them provides the seeds they need to emerge into the modern economies they wish to create.

This week looks to be interesting as the selling abated somewhat after the fed took the MBS (mortgage backed securities), but you can be sure that meeting between G7 central bankers and financial authorities occurred all weekend long to discuss the next step of containment strategies. But there is one containment strategy you can bank on: “THEY WILL PRINT THE MONEY"! Otherwise this is the big Kahuna for the G7 financial systems, and I don't believe they are ready to throw in the towel! They won't throw in the towel until they are dead and buried or the markets don't let them get away with it!

In conclusion, we will be covering the unfolding drama for the next several months in the “FINGERS OF INSTABILITY” series. As the worlds government financial authorities pile dollar after dollar, yen after yen, British pound after British pound, Euro after Euro, Yuan after Yuan, Ruble after Ruble, Rupee after Rupee, etc. on the global economic pile, selected “Bubble” investment areas of the world economies will grow and then collapse, as we are now seeing in US housing and sub prime lending markets. As we watch financial authorities and public servants WORLDWIDE battle the markets as they attempt to control them. It figures to cause stock market indigestion as the credit needed to underpin them is temporarily interrupted until they get the fires under control and restore confidence to the G7 financial systems and their participants.

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