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Sun

26

Oct

2008

Keyser Soze Heists Main Street Out of $700 Billion
Sunday, 26 October 2008 02:08
by Nadeem Walayat

The greatest heist in history took place on Friday when congress was CONNED into signing away $700 billion accompanied by SOME $120 billion of pork.

The Usual Suspects, Paulson, Bernanke and Cox (the Chair of SEC) over the last 10 days have proceeded to spin their verbal scare story to both the Democrats and Republicans into joining forces to hand over a ransom of $700 billion in the form of a blank check to the aid bankrupt banks to off load losses onto the US tax payer.

The bailout plan will not make any difference to main street, none, there will still be a recession starting this year, there will still be soaring unemployment and many more foreclosures. The banks that are bankrupt will still go bankrupt or be taken over, the only difference now is that some banks will profit hugely as they like vultures dive down onto the carcasses of dead banks picking the profitable parts whilst the US tax payer gets saddled with the toxic debt.

The bankrupt banks should be allowed to go bankrupt as that is what a free market economy should allow to happen so that all off the bad debt can be written down in short order, and the banks assets distributed amongst the creditors which may or may not mean that the bank actually closes. Yes it means a crash of sorts, but that is inevitable anyway in the short-run given the scale of the bad debts as the market seeks to punish those that took on excessive risks, but it would also result in a far faster economic recovery than what we are in for. All the bailout does is use tax payers money to reward bad investment decisions, when instead the $700 billion could have been used far more effectively to support the US housing market.

Being an active trader that participates in the markets in real-time, gives one tells as to what is actually going on rather than what the politicians and mainstream financial commentators theoretically surmise should be happening. This happened last Monday as the article Dow Jones Stock Market 777 Point 7% Crash explained and the below graph illustrates.



Chart courtesy of Bigcharts.com

The morning sell off to down 350 on the Dow Jones left market commentators and politicians dumbfounded as the expectations were for a strong rally ahead of a YES vote, well that was not what the market was saying, instead the price action suggested a great deal of skepticism about the vote outcome, which had been reported on as a foregone conclusion by virtually every news outlet.

For a moment there on Monday the politicians reeling from voter anger blinked and actually saw through wall streets subprime illusion created for main street politicians. As what the banks officers were actually engaged in was fraud on a monumental scale for self benefit in the form of huge bonuses which in many cases ran to the tune of hundreds of millions of dollars a year, which has left for the public, open facades of rock solid banks which in reality are mere hollow shells that should anyone venture inside and open the ledger marked off balance sheet positions would soon realise.

Now we have Senators and wannabe senators fish away $700 billion on Friday, accompanied by spin about oversight and more regulation when in actual fact the REGULATORS FAILED to do their duty and are just as culpable as those responsible for turning the banks into hollow shells. It was known by everyone who dared to peep beneath the bonnet, that the banks were running huge positions off the balance sheets hidden away, you only need to traverse over to the Bank of International Settlements (BIS) to see the extent of the growing OTC unregulated derivatives bubble. What were the regulators doing ? It clearly seems that the regulators as usual failed to understand the system they were meant to be regulating and thus swallowed the spoonful of medicine marked the market knows best. The situation we had was of building derivatives positions for the sake of artificially boosting bank balance sheets so as to bank huge bonuses, the positions were valued based on complex models constantly tweaked to further inflate valuations that did not reflect the REAL value of the underlying securities against which they were valued, i.e. the subprime mortgages and prime mortgages on which the US and other housing markets were inflated.

The greatest trick the devil ever pulled was to make you think he does not exist, and poof before you know it he's gone and so is your $700 billion. As President Obama will wonder as he stares into the gaping $1 trillion+ hole in the federal budget.

Friday the market again spoke, though this time it was relatively easy for the financial press to use the get out of jail card of "buy on the rumour sell on the news" as stocks fell sharply following the Yes vote, reversing a strong early day rally with a large 500 point intra-day down swing for the Dow Jones into the close.

Clearly the market wanted the bailout cash as a short-term free lunch at tax payers expense but it was also saying that its NOT going to make ANY difference to the economy, all that the $700 billion has bought is perhaps a few days, what a price for $700 billion! which does not change any of the fundamentals which are that corporate earnings are fast contracting as the US and much of the west heads towards a recession which portends for much lower stock prices, and with the tendency for stocks bear markets to revert to below the mean in price to earnings terms, thus stocks have much further to fall and there is NO Bailout bottom, instead we have extremely high volatility, the sort of volatility amidst which crashes are born!

The whole financial sectors over the counter derivatives bubble has been built up on a complex house of cards based on the premise that holdings were complex to value given the nature of the packages and hence ever inflated computer valuations were assigned to feed the perpetual boom fuelled by short-term greed. Back at the start 2007 many knew something was seriously wrong and it was linked to derivatives and the US housing market, defaulting subprime mortgages and the carry trade were at the core of the problem, in February 2007 the stock markets plunged led by China which implied that maybe things were now coming to a head and the OTC derivatives bubble will crack led by the unwinding of the carry trade. But nothing happened, instead China recovered and again roared ahead to a new all time high way past the previous peak and picking up plenty of newbie small chinese stock investors and western late comers along the way, that will by now have experienced loses's in excess of 50%. Those months following February were clearly the last hurrah, the final spike of the derivatives bubble.

The two Bear Stearns hedge funds going bust in June 2007 was the first open sign of the potential crisis that was about to unfold. It was only in August following the freezing of the credit markets that actually the financial world changed and embarked up on the steady trend of hollow shell banks announcing every larger quarterly losses that proceeded to destroy shareholder capital all the way to bankruptcy and nationalisation.

Some commentators are looking to the crash of 1987 and 1929 for clues and answers, my take is that it is different this time. It is completely different to 1987, I cannot see any real comparisons there. However there are many comparisons to 1929 but the sequence of events is out of order. Yes stock markets in the west have slumped by more than 20% into a bear market encompassing a few crashette's along the way. But the western stock markets were never overly inflated unlike at the dot com bubble peak or 1929. Therefore the current financial crisis is NOT a stock market crisis as both 1987 and 1929 were. This is a banking system bad debts crisis that that fuelled the housing bull and now bear market, so it is different to both 1929 and 1987, as in 1987 the powers that be were able to isolate the real economy from the stock market crash which allowed the stock market to recover to new highs within a few years. Similarly governments were able to isolate much of the impact of the dot com crash during 2000.

This time the banking system is in collapse, one could argue that the current crisis is a delayed reaction to the measures taken following the dot com crash so may yet have its roots in the stock market after all as the actions taken following the dot com crash led to the inflating of the credible bubbles that fed the housing bubbles.

What does this mean ?

It means that the current outcome will be worse than either of the two recent crashes of 2000 and 1987. It also means that western stock markets are being driven lower by worsening fundamentals rather than from speculative bubbles.

Now its NOT all gloom and doom ! For as the bear market in stocks progresses and valuations on corporations that are destined to survive the coming recession start dipping below a P/E of 10, then we will literally have the buying opportunity of a life time to pick up long-term investments at bargain basement prices, where there is more than a 95% probability of long-term profits as against say buying when the market is in the latter stages of a bull market when everyone is piling in when the actual probability for long-term profits is less than 40%. Recessions are also a good mechanism for clearing out the trash and leaving behind a strong lean economy and corporate and banking sectors that are able to grow at a sustainable rate, off course it also sets the scene for another boom later on and a subsequent bust, but by that time the savvy investors who got in when no one was buying and 'should' have banked their profits before the shoe shine boys start buying.

But first we need to get through much of the current crisis where the economies are only just starting tip into recessions that could last another 2 years. A lot now depends on what actions the governments take, will their solutions as evidenced by the recent $700 bailout and flood of liquidity result in a more favourable outcome i.e. from the expectations of a recession or something far worse ?

One things for sure, many more banks will go bust or be nationalised over the next few months regardless of the bailout, therefore we will observe a great deal of market volatility as witnessed by the Dow Jones wild daily gyrations last week.

For more on the credit crisis see the recent articles below, also the following 10 page report gives valuable insight into the governments actions Visit EWI to download the full report.

Your credit chaos exhausted analyst, aiming to get back to analysing and forecasting inflation, interest rates and house prices this coming week.



Nadeem Walayat has over 20 years experience of trading derivatives, portfolio management and analysing the financial markets, including one of few who both anticipated and Beat the 1987 Crash. Nadeem is the Editor of The Market Oracle, a FREEDaily Financial Markets Analysis & Forecasting online publication. We present in-depth analysis from over 150 experienced analysts on a range of views of the probable direction of the financial markets. Thus enabling our readers to arrive at an informed opinion on future market direction.
 
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