Full article here. Well, somebody finally blinked on lousy mortgage valuations. Now it’s hard to pretend what “market value” is after someone says it’s 90% less than what you have on your balance sheet.

“Monday’s trading on the New York Stock Exchange (NYSE) was a real humdinger. It started off with the White House announcing that this year’s fiscal deficit would soar to a new record of nearly $500 billion. That was followed by news of rising oil prices, weak quarterly earnings and a slowdown in consumer spending. By mid-morning the markets were in full retreat. That’s when investment giant Merrill Lynch announced that it would notch a $4.6 billion second-quarter loss and write-downs of $9.4 billion on collateralized debt obligations (CDOs) and other mortgage-related assets. Stocks quickly went verticle and the rout was on. By the closing bell the Dow was down 240 points. Traders staggered from floor of the exchange slumped-over and bedraggled, looking like they just got a missive from the draft board.And, yet, on Tuesday, the market staged a valiant comeback, surging 260 points in a matter of hours. It was enough to give the fund managers a bit of a lift and hope that things are finally turning around. But the market’s woes are far from over. The International Monetary Fund summed it up in warning they issued earlier in the week:

“Global financial markets are ‘fragile’ and indicators of systemic risk remain ‘elevated’…Credit quality ‘across many loan classes has begun to deteriorate with declining house prices and slowing economic growth.’ Bank balance sheets are under ‘renewed stress’ and the decline in bank share prices has made it more difficult to raise new capital. (There is an) ‘increased likelihood of a negative interaction between banking system adjustment and the real economy.’ (Financial Times)

The IMF also stuck by its earlier prediction that total losses to financial institutions from the credit crisis would reach $1 trillion ($945 billion) a sum that will have savage consequences for industry, consumers and the global economy.Over at Nouriel Roubini’s blog, Dr. Doom made this observation about the Merrill Lynch’s troubles:

“Merrill Lynch’s decision to ’sell’ a good chunk of its remaining CDOs at 22 cents to the dollar has been widely praised as the firm finally recognizing the full extent of its losses on these toxic instruments. This batch of $30.6 billion of CDOs was already marked down to $11.1 billion. Now with the ’sale’ of it to Lone Star at a price of $6.7 billion Merrill Lynch is taking another $4.4 billion write-down and ’selling’ it at 22% of the original face value. But is this a market-based ’sale’? No way, calling this transaction a ’sale’ is a joke.” (Nouriel Roubini’s Global EconoMonitor)

Indeed. This isn’t a “sale”; it’s more like abandoning a sinking ship. The investment chieftains are getting scorched by their downgraded assets and have started dumping them at any cost. There’s no market for mortgage-backed anything now, and there won’t be until housing finds a bottom.The Merrill Lynch deal illustrates just how crazy things have gotten. Merrill said it “will provide financing to the purchaser for approximately 75 per cent of the purchase price.” Whoa. In other words, the banks are so anxious to off-load their junk-paper, they’re almost paying people to take it off their hands. Now that’s desperation! The problems haunting the financial markets have cross-pollinated with the real economy and are spreading misery everywhere. Unemployment is rising, growth is slowing, inflation is up, the dollar is down. We’ve heard it many times before, but it’s still jarring to see General Motors stock fall below Bed & Bath, or Starbucks shut down 600 stores, or million dollar McMansions sell for $425,000.

“The National Australia Bank’s decision to write off 90 per cent of its US conduit loans will have dramatic repercussions around the world. Wall Street will be deeply shocked when they understand the repercussions of what NAB has done. It is clear global banks have nowhere near provided for their exposures to US housing loans which in the words of John Stewart are experiencing a ‘meltdown’.

“We are now way beyond sub-prime. NAB says that it is suffering a 55 per cent loss on American housing loans – an event that has never happened in the history of a developed country in recent memory. This is an unprecedented event and means that the cost of bailing out the US financial system is now far beyond the highest estimates. A US recession is now locked in, but more alarmingly, 55 per cent loan losses point to the possibility of a depression.“It means the cost of bailing out housing exposures to the two mortgage insurers will be so great that it will leave no room to bail out anything else and there are several US banks that are now in big trouble. NAB says that the dislocation in the residential market is separate from the corporate market, but the flow on is inevitable.” ( The Business Spectator,”NAB will shock Wall Street”)

The conduits are off-balance sheets operations run by the banks which contain hundreds of billions of dollars of bonds which are now essentially worthless. So far, many of the banks have not accurately reported the losses from these operations hoping that the housing market will stabilize and the value of the bonds will rebound. The action taken by the National Australia Bank is a “game-changer”.
Gottliebsen again:

“The global banks have been marking to market the assets they held on their balance sheet, but the vast amounts held in so called ‘conduit trust accounts’ have not been written down because they were not marketable. NAB wrote them down when they saw the bad mortgages….US banks have written down $450 billion in bad housing loans. The revelation from NAB means that they will now certainly need to take provisions to $1,000 billion. But write-downs of $1,300 billion and perhaps even more are on the cards.”(Business Spectator.)”

I got this from my mole in the banking industry:

“<generic bank> has been informed by the Federal Deposit Insurance Corporation (FDIC) that it has released funds to The Depository Trust & Clearing Corporation (DTCC) today, July 30, 2008 to pay all holders of IndyMac Bank, F.S.B., Pasadena, CA, (IndyMac Bank) certificates of deposit (CDs) at 100%. This includes the amounts exceeding the insured limits.

FDIC informed <generic bank> that this is a one-time deal only that will NOT apply to any other bank failures. <generic bank> anticipates that DTCC will begin to release the funds today, July 30, 2008, and we will allocate the funds when received…”

Wow, I didn’t know the FDIC could overstep its bounds and pay out more insurance than is covered. I wish Allstate were so generous! “One time deal” sounds like something you get at a used car dealership, not a federal agency. Who’s money got covered by this “one time deal”? I can’t believe that the FDIC was worried about little old ladies getting gyped.

Full story here. Another article from economist Henry CK Liu. I always thought history and finance were boring. Little did I know how much fun they were when applied in real time.

Use ShadowTraders to have fun playing, and not getting played.

“The vast expansion of US-led globalized trade since the Cold War ended in 1991 had been fueled by unsustainable serial debt bubbles built on dollar hegemony, which came into existence on a global scale with the emergence of deregulated global financial markets that made cross-border flow of funds routine since the 1990s.

Dollar hegemony is a geopolitically constructed peculiarity through which critical commodities, the most notable being oil, are denominated in fiat dollars, not backed by gold or other species since then president Richard Nixon took the US dollar off gold in 1971. The recycling of petro-dollars into other dollar assets is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973. After that, everyone accepts dollars because dollars can buy oil, and every economy needs oil. Dollar hegemony separates the trade value of every currency from direct connection to the productivity of the issuing economy to link it directly to the size of dollar reserves held by the issuing central bank. Dollar hegemony enables the US to own indirectly but essentially the entire global economy by requiring its wealth to be denominated in fiat dollars that the US can print at will with little in the way of monetary penalties.

World trade is now a game in which the US produces fiat dollars of uncertain exchange value and zero intrinsic value, and the rest of the world produces goods and services that fiat dollars can buy at “market prices” quoted in dollars. Such market prices are no longer based on mark-ups over production costs set by socio-economic conditions in the producing countries. They are kept artificially low to compensate for the effect of overcapacity in the global economy created by a combination of overinvestment and weak demand due to low wages in every economy.

Such low market prices in turn push further down already low wages to further cut cost in an unending race to the bottom. The higher the production volume above market demand, the lower the unit market price of a product must go in order to increase sales volume to keep revenue from falling. Lower market prices require lower production costs which in turn push wages lower. Lower wages in turn further reduce demand.

To prevent loss of revenue from falling prices, producers must produce at still higher volume, thus further lowering market prices and wages in a downward spiral. Export economies are forced to compete for market share in the global market by lowering both domestic wages and the exchange rate of their currencies. Lower exchange rates push up the market price of commodities which must be compensated for by even lower wages. The adverse effects of dollar hegemony on wages apply not only to the emerging export economies but also to the importing US economy. Workers all over the world are oppressed victims of dollar hegemony, which turns the labor theory of value up-side-down.

In a global market operating under dollar hegemony, the world’s interlinked economies no longer trade to capture Ricardian comparative advantage. The theory of comparative advantage as espoused by British economist David Ricardo (1772-1823) asserts that trade can benefit all participating nations, even those that command no absolute advantage, because such nations can still benefit from specializing in producing products with the lowest opportunity cost, which is measured by how much production of another good needs to be reduced to increase production by one additional unit of that good.

This theory reflected British national opinion at the 19th century when free trade benefited Britain more than its trade partners. However, in today’s globalized trade when factors of production such as capital, credit, technology, management, information, branding, distribution and sales are mobile across national borders and can generate profit much greater than manufacturing, the theory of comparative advantage has a hard time holding up against measurable data.

Under dollar hegemony, exporting nations compete in the global market to capture needed dollars to service dollar-denominated foreign capital and debt, to pay for imported energy, raw material and capital goods, to pay intellectual property fees and information technology fees. Moreover, their central banks must accumulate dollar reserves to ward off speculative attacks on the value of their currencies in world currency markets. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. Only the Federal Reserve, the US central bank, is exempt from this pressure to accumulate dollars because it can issue theoretically unlimited additional dollars at will with monetary immunity. The dollar is merely a Federal Reserve note, no more, no less.

Dollar hegemony has created a built-in support for a strong dollar that in turn forces the world’s other central banks to acquire and hold more dollar reserves, making the dollar stronger, fueling a massive global debt bubble denominated in dollars as the US becomes the world’s largest debtor nation. Yet a strong dollar, while viewed by US authorities as in the US national interest, in reality drives the defacement of all fiat currencies that operate as derivative currencies of the dollar, in turn driving the current commodity-led inflation. When the dollar falls against the euro, it does not mean the euro is rising in purchasing power. It only means the dollar is losing purchasing power faster than the euro. A strong dollar does not always mean high dollar exchange rates. It means only that the dollars will stay firmly anchored as the prime reserve currency for international trade even as it falls in exchange value against other trading currencies.

In recent decades, central banks of all governments, led by the US Federal Reserve during Alan Greenspan’s watch, had bought economic growth with loose money to feed debt bubbles and to contain inflation with “structural unemployment”, which has been defined as up to 6% of the workforce, to keep the labor market from being inflationary. Central banking has mutated from being an institution to safeguard the value of money so as to ensure wages from full employment do not lose purchasing power into one with a perverted mandate to promote and preserve dollar hegemony by releasing debt bubbles denominated in fiat dollars. (See Critique of Central Banking, Asia Times Online, November 6, 2002.) …”

We almost had an up-week…almost! But the Market was hit with a double whammy on Thursday…34,000 initial claims, existing home sales sank to 17 year low. And earnings have not been helpful. Google and Microsoft have hurt the Nasdaq. Learn to trade futures and stay out of the stock market. Read the rest of this entry »

Found this little morsel here.

Here’s an updated version of the Voight-Kampff test from Ridley Scott’s “Blade Runner” movie. Instead of identifying Replicants, however, these questions sort the financial optimists from the reali…I mean, pessimists.

1. A Tale of Two Economies You see a line of badly dressed people snaking along the sidewalk, seemingly oblivious to the wind and rain. A guy with a beard is pouring himself a steaming cup of something from a thermos. You conclude that they are:
   1. outside a bank, desperately trying to get their savings out because they have heard a rumor that the financial system is on the brink of meltdown and there’s no way they trust the deposit insurance plan to protect them.
   2. outside an Apple Inc. store, desperately trying to get their hands on a 3G iPhone. And, no, they don’t want a white one, or 8 gigabytes of memory; they want a black one with 16 gigabytes. (What they REALLY want is a red iPhone with 32 gigabytes; Apple will introduce that five minutes after everyone has the current model.)
2. I Have Seen the Future and It Smirks The price of a tank of gasoline has gone through the roof. Your response is to:
   1. buy a Toyota Prius with smugness fitted as standard, pretending not to notice how darned ugly the thing is and trying not to worry about what happens when it breaks down and your local mechanic has to work out how to fix it.
   2. hand over a $5,000 deposit and join the waiting list for a $109,000 battery-powered Tesla Roadster. The makers claim zero to 60 miles (97 kilometers) per hour in 3.9 seconds, at less than 2 cents per mile. Hey, if it’s good enough for the guys at Google Inc.
   3. slap a bumper sticker on your Ford Behemoth that reads “How Did Our Oil Get Underneath Their Sand?”
3. Scapegoats and Witch Hunts Surging oil and energy prices threaten to wreck your economy. You, a U.S. legislator, decide to:
   1. propose lucrative tax breaks to companies that invest in alternative-energy sources such as wind and wave power, excluding ethanol.
   2. propose lucrative tax breaks to drivers who trade in their Chevy Mastodons for more fuel-efficient vehicles.
   3. cry “speculators!” Your solution is new legislation to ban trading in parts of the futures market because “Americans are being taken advantage of not only by OPEC but by speculators right here in our own country,” as Senator Ted Stevens, an Alaska Republican, put it. Hey, I believe in free markets, but there has to be a limit.
4. Cover-Up The mortgage-backed bond market is dead, murdered by lax lending standards that destroyed investor faith in the quality of home loans. As U.S. Treasury secretary, you decide that:
   1. this is a disaster. We need rules to ensure unscrupulous lenders can’t finagle people into buying houses they can’t afford by offering introductory teaser rates that reset two years later. That will help to restore confidence.
   2. this is a disaster. We need rules to stop unqualified home buyers lying about their incomes and suckering the mortgage companies into granting loans that will never get repaid. That will help to restore confidence.
   3. this is a disaster. How are my Wall Street pals supposed to generate bonus-boosting fees without an asset-backed bond market to play in? Maybe we could rebrand it? I know, let’s create a covered bond market. Completely different! Hey, if it works in Europe.
5. Naked Cheerleading The collapse in the share prices of financial institutions, driving both the U.S. S&P 500 Financials Index and the Bloomberg Europe Banks and Financial Services Index down about 40 percent in the past year, is attributable to:
   1. prudent investors who are tired of hearing the worst is over, concerned that there are more huge writedowns to come, and planning to pass the hat around to build a statue of Oppenheimer & Co.’s Meredith Whitney for daring to speak truth to power.
   2. naked short sellers, who are a stain on the integrity of global capital markets and spend their days propagating scurrilous rumors to make money. They must be stopped. What’s that? What about the cheerleaders who relentlessly talk stocks higher? I’m sorry, we’re busy trying to prosecute the authors of e-mails about the liquidity situation at Bear Stearns Cos.
6. Tough Love The housing markets and construction industries in Spain and Ireland are in meltdown. Consumer and business confidence is plummeting everywhere you look in the euro region. The failure to find agreement on the Lisbon treaty threatens political chaos. As a policy maker at the European Central Bank, you decide to:
   1. cut interest rates, recognizing that the economy is staring into the abyss.
   2. leave interest rates unchanged, hoping to calm the euro’s increase against the dollar and give exporters a break.
   3. raise interest rates by a quarter-point. We have only one needle in our Bundesbank-designed compass, and it points perpetually skyward.
7. Shiny, Happy People Gold is:
   1. a barbarous relic, and has been ever since John Maynard Keynes coined the phrase.
   2. the erstwhile and future money. We need to get back on the gold standard RIGHT NOW and abandon fiat currencies. We wouldn’t be in this mess if you had listened to me and kept your tinfoil hat on. Hey, is that a tiny black helicopter I can hear whirring away next to my ear? “

Full data here. Just caught this excerpt from a blog I frequent:

“The housing bill in Congress — which has now morphed into a housing-and-Fannie/Freddie-rescue bill — appears likely to become law within days.

The president has dropped his objection to $3.9 billion in largesse to city and state governments to dole out to favored constituencies in exchange for the assurance of a blank check for Fannie and Freddie.  So everybody wins — except the taxpayer/dollar holder.

But wait — it gets worse.  It’s not only a boondoggle, it’s a major-league privacy threat. 

Two egregious provisions of the bill haven’t gotten a lot of coverage, especially since Fannie and Freddie got thrown into the mix, but I assume they’ll end up in the final version of the bill: 1) Nearly all credit-card transactions will be tracked and reported to the IRS and 2) Many people in the mortgage and real estate industries must submit to a mandatory fingerprint registry.

Let’s start with the credit card (and debit card) provision first.   Former Congressman Dick Armey’s Freedomworks organization has led a feeble opposition.  As he explains it:

This is a provision with astonishing reach… Not only does it affect nearly every credit card transaction in America, such as Visa, MasterCard, Discover, and American Express, but the bill specifically targets payment systems like eBay’s PayPal, Amazon, and Google Checkout that are used by many small online businesses. The privacy implications for America’s small businesses are breathtaking.

To say nothing of America’s consumers.   The aim is to curb underreporting of income by businesses to the IRS.  It sure seems odd that this would turn up in a bill championed by Sen. Chris Dodd (D-Connecticut) who poses as a champion of civil liberties, and indeed who took the lead fighting the warrantless wiretapping bill that retroactively cleared the phone companies of breaking the law.

But when it comes to reporting all our credit card transactions to the IRS, Dodd’s office says nope, nothing to worry about.

This is not a controversial provision or a new one.  Republicans and Democrats on the Senate Finance Committee have supported it for months, and it has been included in the Administration’s budget proposal for years.  This provision simply requires banks–not small businesses–to report sales transactions to the IRS each year and to merchants at the end of each day.  It makes the tax system fair for everyone, without burdening small businesses and without putting consumers’ privacy rights at risk.

I guess PayPal, et. al. now qualify as “banks” in Washington.  You can read the official summary of the amendment [.pdf file] and decide for yourself:

The proposal requires information reporting on payment card and third party network transactions. Payment settlement entities, including merchant acquiring banks and third party settlement organizations, or third party payment facilitators acting on their behalf, will be required to report the annual gross amount of reportable transactions to the IRS and to the participating payee. Reportable transactions include any payment card transaction and any third party network transaction. Participating payees include persons who accept a payment card as payment and third party networks who accept payment from a third party settlement organization in settlement of transactions. A payment card means any card issued pursuant to an agreement or arrangement which provides for standards and mechanisms for settling the transactions. Use of an account number or other indicia associated with a payment card will be treated in the same manner as a payment card. A de minimis exception for transactions of $10,000 or less and 200 transactions or less applies to payments by third party settlement organizations. The proposal applies to returns for calendar years beginning after December 31, 2010. Back-up withholding provisions apply to amounts paid after December 31, 2011.

Then there’s the fingerprint provision.  As explained by the Competitive Enterprise Institute’s John Berlau:

The provision says that “an individual may not engage in the business of a loan originator without first . . . obtaining a unique identifier.” To obtain this “identifier,” an individual is required to “furnish” to the newly created Nationwide Mortgage Licensing System and Registry “information concerning the applicant’s identity, including fingerprints,” that will be sent to the FBI and other government agencies.

The bill’s definition of “loan originator” could cover a broad swath of employees working for mortgage lenders and brokers and real estate firms, including clerical employees, part-time and seasonal workers. An “originator” is defined as anyone who “takes a residential loan application; and offers or negotiates terms of a residential mortgage loan for compensation or gain.” Real estate agents are also covered if they receive any type of compensation from “originators.”

The rationale for this new fingerprint registry is thin. Were a significant number of bad loans made by ex-convicts? And how would the targeting of lower-level employees – rather than executives like Countrywide Financial CEO Angelo Mozilo – stem the creation of problematic mortgages?

And so, Congress and the President are about to perform favors for their contributors and constituencies, while ordinary people foot the bill and have their privacy stripped in the process.  Just swell…”

Full story here. Guess which phase we’re in right now…Use ShadowTraders now, because you can’t say we didn’t warn you.

“THE INNOVATOR, THE IMITATOR AND THE IDIOT
by Chris Mayer

While in Vienna last week, I grabbed hold of the international edition of The Wall Street Journal. Over a classic Viennese breakfast of coffee, a boiled egg and pastry, I stumbled across an interview with Ted Forstmann, titled, “The Credit Crisis Is Going to Get Worse.”

I hadn’t seen Forstmann’s name in years. He once lorded over one of the world’s most famous private equity firms, Forstmann Little. For a time, it was, as the Journal notes, “the most successful private equity firm in the world, renowned for both its outsized returns and its caution.” When things got a little too crazy, Forstmann chose not to play. For two years, he sat on $2 billion of uninvested funds. That’s discipline you don’t find often, in any era.

Ted Forstmann’s caution saved his firm a lot of pain when the private equity market collapsed later. As the interview made plain, old Forstmann has that bad feeling again. “Buffett once told me,” he said, “there are thee ‘I’s’ in every cycle. The ‘innovator,’ that’s the first ‘I.’ After the innovator comes the ‘imitator.’ And after the imitator in the cycle comes the ‘idiot.’” We’re in the idiot phase now, he says.

The idiot phase is when financial disasters strike. It’s when the market reveals all the mistakes of the prior boom. It’s when all these supposedly smart people running billion-dollar financial firms get their heads handed to them. “The creation of much too much money caused all of this excess,” he says.

…

Dr. Andre Homberg, a friend, reader and the organizer of the event, laid it out as the 5 “D”s:

- Delusions - the notion that “the welfare state can provide everyone with a free lunch and a reliable pension and health care”
- Deficits and Debts - the accumulation of enormous fiscal imbalances, particularly in the public sector
- Dollars - the debasement of the dollar and reckless credit expansion
- Derivatives - Dr. Homberg pointed out that the notional value of derivatives topped $1,000 trillion, as per a recent IBS report. “This excessive leverage could implode anytime and make the U.S. subprime debacle look like a day at the beach,” he said.

The end result of all this? Dr. Homberg happily explained: “The prices of everything that you must have will escalate at a speed that you will not believe. The prices of energy and fuel will continue to spiral higher. Food and water prices will accelerate upward and will result in a lower standard of living for yourself, your family and your loved ones.”

…

There are plenty of reasons to feel gloomy. But even Dr. Homberg allowed that there would be great opportunities to make a lot of money. “At least for the ones that understand the forces involved,” he added, “and have the courage to grab the opportunities that this process will create.” Homberg is financially independent, in large part owing to his deft investing since 2000. I’m proud to count him as a loyal reader.

Going forward, I think it will be important to stick with real assets during these inflationary times. I’ve got two very interesting ideas I’m researching now. Both of them are quirky oddball opportunities rich in tangible inflation-beating assets.

Also, in thinking back to the “I” cycle, the idiots eventually make way for the innovators, the winners in the next up cycle. Among the innovators in this cycle will be those who solve or ease the high cost of oil.

I’m currently reading an interesting book, Engines That Move Markets by Alasdair Nairn. It’s all about the history-making shifts of various innovations - canals, railroads, telephones, etc. In particular, the book focuses on their impacts on markets and investing. One early lesson is how people misread key events and missed great investments in the process.

One early quote stands out. The Quarterly Review in March 1825, noted: “What could be more palpably absurd than the prospect held of locomotives traveling twice as fast as stagecoaches?” Stagecoach and canal investors who doubted the power of the trains lost a lot of money. While the losers are easy to spot in retrospect, they’re not usually so obvious to investors at the time, as The Quarterly Review comment shows.

As far as identifying the winners of this process, that was also not obvious. The railroads proved poor investments for most. By the mid-1870s, 40% of American railroad bonds were in default. The real winners were the people who enjoyed the lower cost of freight - traders and merchants expanding into new markets. So, too, the winners in this crisis might not be so obvious.

Regards,

Chris Mayer
for The Daily Reckoning

Editor’s Note: This essay was taken from a recent issue of Capital & Crisis. To read more of Chris’s expert analysis, click here.

Chris is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital & Crisis - formerly the Fleet Street Letter.”

Full story here. Once again the mantra of “Look, don’t think” holds true. Whilst holders of 401(k)s, SIVs and other “assets” keep trying to see the bright side, smart ShadowTraders are making real money– and keeping it– every day.

“The financial crisis continues to create victims. Not only people but also some of our most cherished ideas risk falling by the wayside. Take the hugely influential idea that financial markets are efficient. Its proponents told us that when financial markets were left free, they would work miracles. Savings would be channelled to the most promising investment projects, thereby boosting economic growth and welfare. In addition, these financial markets would spread risk around over a large number of participants, thereby lowering the risk of doing business, again boosting growth and welfare. In order to achieve these wonders, financial markets had to be freed from the shackles of government control.

The country that embodied these principles most was the US. Helped by the missionary zeal of successive American administrations and pushed by international financial institutions, country after country freed their financial markets from pernicious government controls, hoping to share in these economic wonders.

The credit crisis has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects. Millions of US citizens took on unsustainable debts, pushed around by bankers and other “debt merchants” who made a quick buck by disregarding risks. While this happened, the US monetary authorities marvelled at the creativity of financial capitalism. When the bust came, a large number of Americans who had been promised a new life in their beautiful homes were told to move out. This boom and bust cycle cannot have been an example of efficient channelling of savings into the most promising investment projects.

The fact that unregulated financial markets fail to deliver the wonders of efficiency does not mean that governments should take over. That would be worse. What it does mean is that a new equilibrium must be found in which tighter regulation is reintroduced, aimed at reducing the propensities of too many in the markets to take on excessive risks. The need to re-regulate financial markets is enhanced by the fact that central banks, backed by governments, provide an insurance against liquidity risks. Such insurance inevitably leads to moral hazard and excessive risk-taking. The insurer cannot avoid monitoring and regulating the be­haviour of those who obtain this ­insurance.

There is a second idea that is likely to become the victim of the financial crisis. This is the idea found in macro­economic models, that individuals are supremely well-informed creatures. In these models that are now being used in central banks and universities, individuals understand the most complex intricacies of the world in which they live and they have no disagreement about this. All these individuals understand the same “truth”.

If we have learnt one thing from the credit crisis it is that individuals did not understand the “truth” and, it must be admitted, neither did economists. Individuals who sold the new financial instruments did not understand the risk embedded in these instruments, nor did the buyers. When the bubble started many interpreted the happy turn of affairs as permanent and took on massive levels of debt that turned out to be unsustainable. When the bubble burst, they did not understand what had happened and nor did most experts. Our world is one of a fundamental lack of understanding of the “truth”.

But that is not the world of the macro­­economic models that are now in use in central banks. The world of these models is one of supernatural and God-like creatures for which the world has few secrets. These creatures can perfectly compute the risks they take and estimate with great precision how an oil price shock will affect their present and future production and consumption plans. They may not be able to predict each shock, but they know the probability distribution of these shocks. Thus the risk involved in financial instruments is correctly evaluated by individuals populating these models.

These superbly informed individuals want the central bank to keep prices stable so that as consumers they can optimally set their consumption plans with minimal uncertainty, and as producers they can set prices equal to marginal costs (plus a mark-up). If the central banks keep prices stable, these individuals, helped by well-functioning markets, will take care of all the rest and ensure that the outcome is the best possible one. This is a world in which free and unfettered markets are always efficient.

This is also a world where individual agents cannot make systematic mistakes. Their consumption and production plans are optimal. They will never build up unsustainable debts. In the world of these macroeconomic models financial crises should not occur. And if they do, it cannot be because of malfunctioning markets. Governments that impose silly constraints on rational individuals are messing things up, and central banks that do not keep their promises to maintain price stability are the source of macroeconomic ­instability.

This intellectual framework helps to explain the single-minded focus of many central bankers on inflation. Clearly, inflation is important and maintaining price stability is an important task of the central bank. It is not the only task, though. Financial stability is equally important. But this dimension is completely absent from the macroeconomic models now in use. In addition, since financial stability these days also depends on avoiding deep recessions, stabilising the business cycle should also be of the concern of the central bank.

Inflation in the euro area stood at 4 per cent in June. That is a problem. But is it an acute problem, compared with the disequilibria in the financial markets and the banking sector? When the European Central Bank raised the interest rate two weeks ago it took the view that inflation is the most important problem we face. No wonder the intellectual frame imposed on one’s mind by current macroeconomic models said that inflation is the number one enemy.

There is a danger that the macro­economic models now in use in central banks operate like a Maginot line. They have been constructed in the past as part of the war against inflation. The central banks are prepared to fight the last war. But are they prepared to fight the new one against financial upheavals and recession? The macroeconomic models they have today certainly do not provide them with the right tools to be successful.

They will have to use other intellectual constructs to succeed. “

Full article here. A timely piece, further revealing that the emperor has no clothes…

“…With US housing prices continuing to fall, it was evident, contrary to government assurances, that Fannie Mae and Freddie Mac did not have the requisite capital needed to meet future obligations. The sudden decline in the value of their shares forced US authorities to come to their rescue; but, it will not be the last time the US will be forced to act in such a manner. The systemic distress set in motion by last August’s credit contraction is still continuing and the recent collapse of Bear Stearns and now Fannie Mae and Freddie Mac are witness to that fact. We are only one year into the contraction and although the liquidity provided by central banks has gone beyond all previous levels, financial institutions are continuing to falter and collapse.
It is possible that the FDIC, the insurer of America’s savings deposits, may be next. The capital of Fannie Mae and Freddie Mac equaled 1.6 % of the sums they guaranteed. Prior to last week, the FDIC had only 1.2 % of the funds necessary to cover the accounts they insure. It is now estimated the bank failure of IndyMac last week cost the FDIC 10 % of its capital, leaving the FDIC with even less than its previous 1.2 % to cover additional bank defaults. As it is, $1 billion approximately 5 % of IndyMac’s deposits were not covered by the FDIC and it is estimated 37 % or $7.07 trillion of US deposits are also similarly exposed to bank failures. As financial institutions continue to fail, bank failures will increase. As usual, government regulators at the FDIC maintain there is no problem. Believe them and you might soon have problems of you own…
 We are at the end of an era. Capitalism, itself, is a misnomer. It should instead be called or referred to by its subsequent state, debtism, for capital de facto is credit, not money. This does not mean credit is not important. Credit is an integral part of functioning economies but its use should be constrained within gold and silver based monetary systems in order to prevent its abuse.
But in its present form where credit-based money (fiat money) completely replaced gold and silver based currencies (savings-based money), central bank originated credit has led to today’s unsustainable levels of debt Trillions of dollars of that debt are now beginning to default and, as a consequence, credit is being withdrawn by banks, the intermediaries of credit in today’s system. It will soon begin to appear that money is becoming scarce. But that’s an illusion. The money was never there in the first place. It was only credit…”

Full story here. The biggest $64 question yet.

“…Economic policymakers in the United States took swaggering pride in the cutthroat but lucrative form of capitalism that was supposedly indigenous to their frontier nation.

Through this uniquely American lens, saving businesses from collapse was the sort of thing that happened on other shores, where sentimental commitments to social welfare trumped sharp-edged competition. Weak-kneed European and Asian leaders were too frightened to endure the animal instincts of a real market, the story went. So they intervened time and again, using government largess to lift inefficient firms to safety, sparing jobs and limiting pain but keeping their economies from reaching full potential.

There have been recent interventions in America, of course - the taxpayer-backed bailout of Chrysler in 1979, and the savings and loan rescue of 1989. But the first happened under Jimmy Carter, a year before Americans embraced Ronald Reagan and his passion for unfettered markets. And the second was under George H.W. Bush, who did not share that passion.

So it made for a strange spectacle last weekend as the current Bush administration, which does cast itself in the Reagan mold, hastily prepared a bailout package to offer the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. The reasoning behind this rescue effort - like the reasoning behind the government-induced takeover of Bear Stearns by JPMorgan Chase just a month before - sounded no different from that offered in defense of many a bailout in Japan and Europe:

The mortgage giants were too big to be allowed to fail.

Big indeed. Together, Fannie and Freddie own or guarantee nearly half of the nation’s $12 trillion worth of home mortgages. If they collapse, so may the whole system of finance for American housing, threatening a most unfortunate string of events: First, an already plummeting real estate market might crater. Then the banks that have sunk capital into American homes would slip deeper into trouble. And the virus might spread globally.

The central banks of China and Japan are on the hook for hundreds of billions of dollars worth of Fannie’s and Freddie’s bonds - debts they took on assuming that the two companies enjoyed the backing of the American government, argues Brad Setser, an economist at the Council on Foreign Relations.

Commercial banks from South Korea to Sweden hold investments linked to American mortgages. Their losses would mount if American homeowners suddenly couldn’t borrow. The global financial system could find itself short of capital and paralyzed by fear, hobbling economic growth in many lands.

Nobody with a meaningful office in Washington was in the mood for any of that, so the rescue nets were readied. The U.S. Treasury secretary, Henry Paulson Jr., announced that the government was willing to use taxpayer funds to buy shares in Fannie and Freddie. The chairman of the Federal Reserve, Ben Bernanke, said the central bank would lend them money.

The details were up in the air as the week ended, but some sort of bailout offer was on the table - one that could ultimately cost hundreds of billions of dollars. Whatever the dent to national bravado, or to the free-enterprise ideology, the phrase “too big to fail” suddenly carried an American accent.

“Some institutions really are too big to fail, and that’s the way it is,” said Douglas Elmendorf, a former Treasury and Federal Reserve economist who is now at the Brookings Institution in Washington. “There are no good options.”

Still, there are ironies. Since World War II, the United States has been the center of global finance, and it has used that position to virtually dictate the conditions under which many other nations - particularly developing countries - can get access to capital. Letting weak companies fail has been high on the list.

Paulson, who announced the bailout, made his name as chief executive of Goldman Sachs, the Wall Street investment giant, where he pried open new markets to foreign investment. As Treasury secretary, he has served as chief proselytizer for American-style capitalism, counseling the tough love of laissez-faire. In particular, he has leaned on China to let the value of its currency float freely, and has criticized its banks for shoveling money to companies favored by the Communist Party in order to limit joblessness and social instability.

All through Japan’s lost decade of the 1990s and afterward, American officials chided Tokyo for its unwillingness to let the forces of creative destruction take down the country’s bloated banks and the zombie companies they nurtured. The best way out of stagnation, Americans counseled, was to let weak companies die, freeing up capital for a new crop of leaner entrants.

But as Japan’s leaders engaged in bailouts and bookkeeping fictions to keep banks and companies breathing, they offered those words of justification now heard here: The companies were too big to fail.

In 2002, the government engineered the rescue of Daiei, a huge, debt-laden grocery chain. In 2003, it injected some $17 billion into Resona Bank to keep it upright. Each time, Japan’s leaders said failure was not an option. It would pull too many others into a downward spiral.

Today, among strict adherents of laissez-faire economics, the offer to bail out Fannie and Freddie is already being criticized as a trip down the Japanese path of putting off immediate pain while loading up the costs further along.

For one thing, this argument goes, taxpayers - who now confront plunging house prices, a drop on Wall Street and soaring costs for food and fuel - will ultimately pay the costs. To finance a bailout, the government can either pull more money from citizens directly, or the Fed can print more money - a step that encourages further inflation.

“They are going to raise the cost of living fo