At The Intersection of Wall Street and Washington

Just in case you are still confused by what is going on at the intersection of Washington and Wall Street, Matt Taibbi at Rollingstone.com has written one of the best explanations of the financial destruction the United States now faces.  He points out, as I believe, that the solutions the Fed and Treasury are now implementing are going to be far worse than the problems that would have occurred.  And he points the finger squarely at Congress, which was in Wall Street's back pocket, for allowing the financial services industry to deregulate in the late 1990s.  In its greed, Congress forgot the lessons of the 1930s, when all the original regulations were implemented.  Now, the same people that got us into this mess are trying to get us out, and, most likely, it will end badly.  

Matt Taibbi explains…   

It's over — we're officially, royally fucked. No empire can survive being rendered a permanent laughingstock, which is what happened as of a few weeks ago, when the buffoons who have been running things in this country finally went one step too far. It happened when Treasury Secretary Timothy Geithner was forced to admit that he was once again going to have to stuff billions of taxpayer dollars into a dying insurance giant called AIG, itself a profound symbol of our national decline — a corporation that got rich insuring the concrete and steel of American industry in the country's heyday, only to destroy itself chasing phantom fortunes at the Wall Street card tables, like a dissolute nobleman gambling away the family estate in the waning days of the British Empire.

The latest bailout came as AIG admitted to having just posted the largest quarterly loss in American corporate history — some $61.7 billion. In the final three months of last year, the company lost more than $27 million every hour. That's $465,000 a minute, a yearly income for a median American household every six seconds, roughly $7,750 a second. And all this happened at the end of eight straight years that America devoted to frantically chasing the shadow of a terrorist threat to no avail, eight years spent stopping every citizen at every airport to search every purse, bag, crotch and briefcase for juice boxes and explosive tubes of toothpaste. Yet in the end, our government had no mechanism for searching the balance sheets of companies that held life-or-death power over our society and was unable to spot holes in the national economy the size of Libya (whose entire GDP last year was smaller than AIG's 2008 losses).

So it's time to admit it: We're fools, protagonists in a kind of gruesome comedy about the marriage of greed and stupidity. And the worst part about it is that we're still in denial — we still think this is some kind of unfortunate accident, not something that was created by the group of psychopaths on Wall Street whom we allowed to gang-rape the American Dream. When Geithner announced the new $30 billion bailout, the party line was that poor AIG was just a victim of a lot of shitty luck — bad year for business, you know, what with the financial crisis and all. Edward Liddy, the company's CEO, actually compared it to catching a cold: "The marketplace is a pretty crummy place to be right now," he said. "When the world catches pneumonia, we get it too." In a pathetic attempt at name-dropping, he even whined that AIG was being "consumed by the same issues that are driving house prices down and 401K statements down and Warren Buffet's investment portfolio down."

Read the rest of the article here.

Current Market A Mirror Image Of 2002 Bottom

Over the last couple months, I've seen more historical market overlays than ever.  The current market has been compared to everything from the 1970s market to the 1930s, from the 1987 crash to the 1990s financial crisis.  But you don't have to go back very far to find an analogue to the current bottoming formation.  The current market looks a lot like the bottom formed between July and October of 2002. 

2002 vs 2009 Market Bottoms 

After the October bottom and surge, the market drifted higher for two months before rolling over to make a final bottom in March 2003.

SPX 2003 Bottom

The current market could certainly move higher into the Summer before rolling over again.  A plausible scenario is that the current rally turns into a trading range between 840 and 940 on the S&P 500, which was an area of consolidation prior to the most recent decline.  After a consolidation, the market could get spooked lower again by poor first quarter earnings which will begin to hit in late April and early May. 

Whether the next retest of the bottom holds at that point would depend on whether earnings estimates have bottomed and whether the financials begin to stabilize.   In March 2003, earnings estimates for many companies were already moving higher and fundamentals were already improving.  The only issue weighing on the market in March of 2003 was the upcoming Iraq war.   

This time, if earnings estimates begin rising after the first quarter is reported because investors have gotten too pessimistic, then I think we could see a similar bottom play out.  However, if another crisis hits or earnings estimates continue to fall then I think the bottoming scenario won't play out like in 2002-2003.  The next three months will be key in determining the longer term outlook.

Martin Armstrong: Is It Time To Turn Out The Lights?

(Note: I accidentally published a prior edit of the essay on Sunday March 8th.  The following is the final edit.)

The following is an essay from Martin Armstrong dated February 19th, 2009.  I have taken the liberty to edit the essay.  Martin Armstrong occasionally throws complex ideas into his essays almost as a sidenote.  I have edited the essay to make it more direct and accessible for all readers and have done my best not to alter any of the content or ideas.  If you would like to read the essay in its full form, I have provided a link to it at the bottom of the essay.  

Is It Time To Turn Out The Lights? 

By Martin Armstrong

Please Register Your Email Address For Any Update News – ArmstrongEconomics@GMail.com.

Since the beginning of the year, everyone has expected either one of two outcomes: (1) The election of Barack Obama would spark a recovery and the economy would be saved by his stimulus package, or (2) we would see a major wave of rising interest rates to pay for the Obama spending-spree that would spark serious inflation. But there is a much darker side to these shallow views. To put it mildly, it may just be a far more complex outcome than anyone has dared to guess. We may be in the midst of a "Waterfall Effect" that could undermine the very structure of Western Civilization. Historically, it has always been the debt crisis that destroys the greatest plans of men and dictators.  This could be phase two of the collapse of Marxism.  After phase one reshaped Russia and China, phase two may mean that it is the United States' turn. 

Is it the Time to Turn out the Lights?

This Economic Depression is far more complex than meets the eye. I believe that the Investment Bankers, in their own greed, used the final days of the Bush Administration to try to grab as much as they could while there was an ex-Goldman Sachs boss in the driver seat. I believe they needed to scare Bush into giving them everything that they dreamed of, and Congress was stupid enough to hand-over a pile of cash with no strings attached. This scare tactic worked. The bankers got what they wanted and even settled scores by getting rid of their competition like Lehman. But in the process, they pricked the bubble in which everyone lived. They set in motion a collapse in confidence that is the critical key to a contraction.  Once people lose confidence, they get depressed which is why we call such events a “Depression."

This Depression has centered on the most vulnerable of markets – real estate. It is the least economic force of production, yet it is the most visible sign of wealth in the minds of the average person. People will hoard cash whenever they feel that wealth is impaired.

States are in crisis and their way of doing business is also facing a new reality. As the real estate base collapses, so does the tax base.  Unlike the Federal Government, the states cannot print cash without limit. What use to be safe like Muni-Bonds is no more. The end of borrowing for everything is now here.
 
Yet we are also reverting to the age old problem of Regional Capital Flows and disparities within each nation. This is a critical issue that is tearing Europe apart placing the Euro at risk. At the same time, the disparity among regions in the United states is percolating beneath the surface and is about ready to split the nation asunder.

The Disaster of One Size Fits All

Just prior to the formation of the Euro, I was giving numerous seminars on the subject and warning that the one-size-fits-all policy will not work and may be the undoing of the European Union. Some people believed that just because I was an American I was naturally pro-America. But that was certainly not true. The key warning I was illustrating at that time is starting to come to the surface. Let me make this perfectly clear. I believe Europe can survive and reverse the trend if it listens to reason!

Politicians have no long-term view because their self-interest is to merely win the next election. No one will run for office on a claim that they prevented a disaster. You just don’t know what could have happened! Just as President Obama is taking every possible wrong step that will ensure that this global economic disaster gets far worse, his advisers truly know nothing about history, trends or have any practical real world experience from the private sector to draw upon. How can we expect them to understand when such people have only lived within the bubble of government and convince themselves they have all the answers?

Call Money Rates 1870 Before there were central banks, the perpetual swings in the economies of the world rose and fell not in unity, but diversity according to the local economic mix. In the United states, these regional capital flows  created localized booms and busts. For example during the Gold Rush of California, inflation in that region was running at multiples of that on the East coast. There were even $50 gold coins being privately minted in California whereas the largest denomination in the east was $20. When the San Francisco 1906 Earthquake hit, the insurance companies were in the East and the claims were in the West. The flow of capital left cash shortages in the East that contributed to the Panic of 1907 causing call rates to rise to 125% on the NYSE. 

The analysis that followed the Panic of 1907 came to the realization that there had been a capital flow problem. The answer led to the creation of the Federal Reserve Bank in 1913 with its 12 branches. Why were there so many branches? What is not widely known today is that each branch operated independently. In other words, there could be 12 different interest rates. If cash was tight in California, that branch could raise rates by 1% and that would attract capital flows for investment.

The mistake of the Euro that is now starting to pull apart the entire system, is that the model used was that of the United states post-World War II. Because of Franklin Roosevelt and World War II, central power seemed to be the main goal. The independent status of the 12 branches was usurped into Washington and never given back. This usurpation of power completely altered the ability to manage the economy and thus, the Europeans based their model upon the mistakes of the United States. Just as there were regional distinctions in the United States, the same exists in Europe. The Euro is being torn apart by the ignorance of economic history.

The way to save the Euro before it is too late is to allow interest rates to float independently within each nation. This is necessary to allow capital to flow naturally to the regions that need it the most. Unless the Euro is fundamentally restructured, it is following the path of destruction that has been tearing apart the US economy not to mention many others.  For example, in Canada, the central bank was raising rates to fight real estate speculation in Toronto. At the same time, it was putting farmers and miners into bankruptcy in Vancouver. There can be no one-size fits-all economic policy. 

Outlook for the Euro

The Euro Monthly 2006The highest monthly closing for the Euro came in March 2008. The April high was exceeded slightly on July 15th, 2008 when the high was established at 1.5988 US. This is a clear double top that could yet be exceeded. The March 2008 highest monthly closing was in line with 2008.225, which was the first minor 'turning point after 2007.15 on the Economic Confidence Model where the US real estate peaked and made a major high that may last for several decades to come.

From the high in the Euro on July 15th, 2008, there was a bold collapse that, so far, constitutes a reaction amounting to a 3 month decline. While the Euro penetrated the low of 2007, it did hold its major closing support that remains at $1.26. A monthly closing in the Euro beneath this area would signal the end is near. For now, the Euro could still survive if the right steps are taken and Russia keeps its weapons harnessed. The greatest problem for the Euro long-term remains the geopolitical problems on the horizon in Russia, which still lives in the world of empire, rather than the age of production.

In order for the Euro to show some sign of strength, it must first accomplish a monthly closing back above $1.4215. This is the minimum threshold level from a technical perspective to show same sign of survivability. The next level of key monthly closing resistance will be at $1.4315. As long as the Euro remains below this level on a monthly closing basis, then a test of the major long-term support is still possible at $1. 1680. A monthly closing below that area and it will be very unlikely that the Euro will survive in its current form.

Currency Is Still The Key

British Pound 1919 - 1933We must understand that currency values may still prove to be the key. Often forgotten is the international and regional capital flows that dictate the overall trend and the outcome of what we face. The Free Market will always prevail. It even forced the collapse of Communism.  No matter how much politicians may want to bury it or call it a Republican dream, it cannot be suppressed. The chart to the right shows the British Pound between 1919 and 1934.  The currency clearly shows the decline of British power.  It fell from $7.50 in the 19th Century to about $5 for the start of the 20th and it has flirted with $1-$2 going into the 21st. No matter what system, the Free Markets always prevail as this now shows even during the Gold standard. This is a safety-valve that the currency absorbs economic stress in a complex relationship with interest rates. This is a dynamic between capital concentration and capital flow internationally.
 
Today, we have the same interesting trend emerging. Despite the fact that the Debt Crisis has emerged from the United States, or more correctly, the London office of AIG, capital is still fleeing to the dollar in this flight to quality. But how can there be a flight to the dollar that is a flight to quality in a rational world?

The underlying strength of the dollar is also geopolitical. From a conventional perspective, the United States is still a very difficult place to land troops. There is also the maturity factor. The dollar is one currency that has remained intact. If you have a note printed in 1934 or 1864, it is still legal tender. That cannot be said even for the British Pound.

Yet there is something more profound. So far, the United States remains the key Super Power and the largest economy. Hence, what we are really looking at is the similar effect that Rome had in ancient times followed by Constantinople. When the Roman Empire in the West fell in 476AD, the Byzantine Empire of the East became the leading world economy. Its gold coin the "solidus" became the world currency even in Western Europe when no other states existed with the economic power to issue gold coinage. The coin began to be called the "'byzant" much the way the dollar is called the "buck" or "greenback" in slang terms.

For better or worse, the dollar is still the reserve currency of the world. It may not deserve that status, but that is another story. There is only one primary world currency at a time.  The dollar may be humbled by internal stress and the political split of the nation and when that day comes, we will see it fall. For now, the world currencies have been few and far between. 
Reserve Currencies  

Silver Denarius of Julius Caesar Currency has always been a safety valve to relieve economic stress. This is not always understood, yet it is a vital component of global economics. When an economy comes under great stress where confidence collapses, people then hoard their cash. This is why Roosevelt confiscated gold, and it is why there was a Dark Age after the fall of Rome for there was no real capital flow nor banking, leverage, or borrowing – just hoarding. This drives the purchasing power of the currency higher (deflation) and when it declines, it does so against tangible assets (land, etc). The decline in the value of a currency is in reality a Free Market tax taking away wealth that is overstated. So currency can also be an indirect tax to compensate for the poor management of the state.

To illustrate the difference that capital concentration and capital flows will have on an economy, we need only look at the discount rate at the NY Federal Reserve between 1915-1933. Note that the worse economic decline was surely the 1929 Great Depression. Yet when we look at the real world effects, we come up with a different perspective.

NY Federal Reserve Discount Rate 1915The high at the NY Federal Reserve on the Discount Rate came during the Panic of 1919s aftermath – not the Panic of 1929. We can see the earlier high was 7%, yet in the Great Depression, the peak was only 6%. If we refer back to the Call Money chart from the NYSE, the peak was 1899 and in 1919 the high was 30% compared to 20% for the so called Roaring 1920s in 1929.

If the 1929 Crash was the worst in history and it was sparked by even shoe-shine boys speculating in stocks, then why did the Call Money rate reach the lowest level compared with every other crash going back to 1882? The answer is simple. Show me the Money!

The key to understanding the Great Depression is not speculation and Wall Street any more than what is going on today. There was currency crisis in 1931 that you can see illustrated by the British pound.  And England was the least European-nation affected. Yet the pound crashed and burned from $4.86 dropping to about $3.15.  It cannot be emphasized enough that the contagion spread then like today. All of Europe defaulted on its debt except Switzerland.  Britain went into a moratorium and eventually honored its debt. This created an intensive capital outflow from Europe to America. We can see that the Fed lowered interest rates (discount rate) from 6% to 1.5% very rapidly. It did not matter, for capital was still pouring into the US seeking a flight to quality driving US rates down, but driving the dollar to record highs. We can see that the British pound had fallen in the Panic of 1919 to $3.40, and recovered going into 1925. Therefore, despite lower interest rates in the US during the Great Depression compared to the Panic of 1919, the dollar rose to higher highs. So we can see that there is no linear direct relationship that can be drawn. This is a complex dynamic interrelationship that must be understood.

England Cuts Rate to Historic Low

One would have expected interest rates to rise where there is a Debt Crisis. Yet interest rates even in England have collapsed to new historical lows going back to 1694.  Indeed, most are now expecting interest rates in the United states to rise sharply in the face of Obama’s stimulus package. This is a rather simplistic view that we may not see unfold as many expect. This one-dimensional aspect of the problem is counter-balanced by the massive contraction in leverage at the core of the Great Depression of the 21st century.

It would appear that adding $1 trillion in spending would be inflationary and send interest rates higher. But this assumes that there is an alternative to investment not just domestically, but also internationally. We are also looking at a counter-trend causing the collapse in the avenues for capital to seek shelter. As I mentioned earlier, what use to be regarded as the safest bet – Municipal Bonds – for they were seen as backed by revenues, collapsed during the Great Depression. The City of Detroit defaulted on its bonds, but to be precise, it did eventually pay them off with much cheaper dollars in 1963.

Total Bonds Listed At Par Value on NYSE 1930s Another aspect of the Great Depression that has been lost in the details was that foreign nations, who defaulted on their debt, resulted in a collapse of the money supply in the United States. Back then, the investment banks sold these Bonds in small denominations to the average people. The irony of the Great Depression has been often hurried in history. Those who lost the most, tended to be the most conservative. Those who stayed away from the "risky" stock market, were still wiped out by the bond markets. For decades, there were groups of women who ware children whose family fortunes were wiped out by the collapse in the bond markets. Corp And Treasury Spread 1930s We can see from the above chart, the total amount of debt listed on the New York Stock Exchange exploded in 1928 and collapsed at the end of 1932. Another detail lost in history, the Fed lowered interest rates in 1925 in order to steer the capital flows to Europe. It was then presumed that lowering interest rates in the US would shift the capital flows and  relieve the crisis building in Europe. Yet the defaults in 1931 wiped out conservative investors who stayed away from stocks contributing to a collapse in US money supply by one-third.  We can see that the premium of AAA corporate debt over federal even reached a peak of more than 1.3% in 1932. The state and Municipal Debt also collapsed so the Flight To Quality did not subside until after 1932 and took place both domestically and internationally, not unlike what we are seeing again today.

The Waterfall Effect

The Waterfall Effect There are two primary different patterns of how markets collapse. The first kind is the speculative bubble.  Typical speculative bubbles end with a spike whereby a sharp rise goes exponential, followed by a sharp and steep decline.  The chart pattern appears like a heart-beat. This short-term panic typically does not lead to ruin. The spike formation is dramatic and highly volatile.

The far more dangerous pattern is the rolling over of an economy that is less dramatic, but does far more damage.  Suddenly you just wake-up and everything is changed.  This happened in China and Russia during 1989. There was no spike, just what I call the ''Waterfall Effect" that appears to be how a political state simply dies with no flare nor big bang. 

The greatest concern that we should have is the degree of volatility is off the charts. We are looking at nearly an outside reversal to the downside of the Euro on an annual basis! This degree of volatility is truly amazing on an annual level and has not been seen since 1933. Just look at the previous chart of the Pound. Note that in 1933, the Pound fell to new lows, but then reversed and even exceeded the $5 level, due to Roosevelt’s 60% devaluation of the dollar and the confiscation of gold domestically. The sheer level of volatility is clearly back to the days of the Great Depression.

The Rise of Volatility

I cannot stress enough that the level of volatility that we are experiencing during this financial crisis is just well beyond even that experienced during the early stages of the Great Depression and is more akin to the collapse of Rome. That is a stark comparison tells me this decline is nothing to fool around with.  However, the likelihood of either Europe or America following prudent economic policy to save our free economies is about as likely as me running for President.

Dow Industrials 1897 - 1937As we can easily see from the annual chart of the Dow covering the Crash of 1929, the decline does not reflect even an outside reversal in the first year of the decline. We can see that 1929 formed a spike high but it did not penetrate the low of 1928. The Dow Industrials did close lower than 1928, but it held the 1928 low

In 1930, the high remained below that of 1928, and it did penetrate that low and closed well below it. This provided a major annual sell signal and indeed we find the low 3 years from the 1929 high in line with the reaction rule duration of a maximum duration of 2 to 3 years.

When we look at the Dow Jones Industrials between 1897 and 1937, we actually do not find a single annual outside reversal to the downside until 1931. There was the Rich Man's Panic of 1903, the famous Panic of 1907, the Panic of 1919-21, the Panic of 1929 and then the Panic of 1937. Notice that none of these financial chaotic periods took place with the degree of volatility we have seen today, except 1937. The rise from the 1932 low into a 1937 high came with rising unemployment. Primarily, as gold was confiscated, capital was attracted back to stocks insofar as this afforded some tangible value for cash. The stock market became a hedge against the deliberate inflation that Roosevelt was creating. But keep in mind, Europe was still quite unstable economically and don’t forget that this economic instability also brought to power Adolf Hitler at the same time as Roosevelt. Change was the battle cry of politics in 1933.

Public/Private Confidence Wave

For years, I have warned that the greatest degree of volatility comes during a 51.6 year Private Confidence wave. This is a period that government, fearing losing power becomes most aggressive. For example, the Public Wave that peaked in 1671.75 was followed by a Private wave that was marked by tremendous upheaval including very serious spreading wars that included the early stages of revolution both in Britain that spilled over to Russia during 1689. This is the period of Oliver Cromwell, the beheading of Charles I, that all culminated in the South Sea. Bubble as well as the Mississippi Bubble both in 1720. This gives way to a Public Confidence wave that began in 1727.65. This wave reaches its peak in 1774.95 and that began the great period of revolution that overturned the idea of monarchy both in America and France. So we can see, we are now in a Private Confidence wave and the degree of volatility is certainly extremely high.

Call Money Rates 1870Looking at the call Money Chart, we can see that the pre-1913 period displays a much greater period of volatility. The end of the previous Public Confidence Wave peaked in 1878.15 and it bottomed in 1882.45. This is precisely the year we see the first spike to the upside with call Money Rates reaching the 30% level.

The Private Confidence wave marked the near bankruptcy of the US Treasury in 1896 and we can see that the major high in interest rates actually takes place in 1899 at nearly 200%. It is this Private Confidence Wave that peaked in 1929 that ended with the Great Depression.

The high degree of instability in 1937 was due to the fresh memories of the Great Depression. The press was filled with negative comments and the fear was that there would be another Depression. The fact that we can see the reflection of that degree of instability in 1937, illustrates that there was a deeply seated lack of confidence. This is the beginning of a Public wave where the Private wave peaked with 1929. Therefore, the growing lack of confidence in the private sector is reflected in the sharp volatility seen in 1937 compared to the previous panics.

The next 51.6 year cycle reached its peak 1981.35 marking the high in interest rates once again as the Government began to battle inflation due to its collapse of the Gold Standard in 1971. Hence, that Public Confidence wave peaked in 1981 giving rise to a new Private Wave.

Dow Jones Industrials Weekly 1929 - 1932Even when we look at a weekly chart of the decline and fall of the Dow Jones Industrials during the Great Depression, although this was about a 90% decline in three years, it was still very orderly from a technical analysis perspective. From the initial low that was made from the September 1929 high, there was about a 50% recovery as the Dow rose from about 200 to about 300. We do not see even this degree of strength in the current trend. To match that reaction rally, the Dow would have had to rally to 11,000. The first decline from the 1929 high was about 48%. So far, the decline from 14,198 to about 7,400 was also about 47.8%. Yet the recovery is nowhere in sight. Even the election of Obama has had virtually no impact upon the whole world economy.

Waterfall Effect Dow JonesIf we look at the current monthly chart of the Dow Jones Industrials, we see a very different sort of pattern from 1929. The main panic decline in 1929 took place in 3 months from the major high, with a 5 month reaction recovery from about 200 to 300. What we are confronted with currently, is what I have throughout the years defined as the "Waterfall Effect" that is a complete type of collapse from what you might call Exhaustion following a curved decline. Penetrating the Nov. low, could lead to a drop to 4,000 by June 2009 or September 2009.

Throughout the years of research covering all major economies and civilizations back to the beginning of recorded time, what has always distinguished the end of an era is how the decline unfolds. Sharp spike drops are indicative of corrections within a long-term trend that ultimately survives. When we see the “Waterfall Effect" the decline tends to mark the end of that organized state as we once knew it. 

We are confronted with a major shift that could lead to the same mistakes that caused the fall of Byzantium and destroyed individual liberty and capitalism. We are in a battle that may be far greater than anyone dares to think. The fall of China and Russia was phase one of the collapse of Marxism. We may be facing the fall of Socialism in a battle to the end.

In building databases of all civilizations and using computers to correlate both global interactions and domestic trends, there are certainties that do emerge. It is clear that civilization emerges time and again because mankind is a social animal and seeks the benefit of banning together in sort of a tribe of nations. But there is also the downside, and that is that civilization creates leaders and the self-interest of those in power always is pitted against its own people to exercise and extend its own powers.

Civilization is destroyed by the inability of all governments no matter the form it may assume, to spend only what it earns. Every state in history has fallen into a Debt Crisis and that has always led ultimately to higher taxes. In the Byzantine Empire, the taxes became so outrageous, they forced the average person to become serfs seeking shelter and to retain a portion of their crops for protection from the state. It was taxation that created feudalism, drove people from the cities to the suburbs, and just led to the Waterfall Effect whereby the state became so weak, it could no longer defend itself or sustain its economy. Taxation destroyed civilization and capitalism.

This "Waterfall Effect" was evident also in the Roman economy going into the full collapse that took place between 253 and 266 AD in just 13 years out of 1,000. The economic decline that changes the face of society forever, takes place in the shortest amount of time. The likelihood of Western Society listening before it is too late, is nil!

The End Of Real Estate

This economy peaked with real estate precisely at 2007.15. The stock market made a brief tally thereafter, but it was not sustained. However, American real estate has been an unrealistic market funded purely by debt that strangely produces no real national wealth. Purchasing a house creates dead capital. It does not create jobs after its construction, yet consumes capital through financing. Because mortgages have been available for 30 years, the price of a home is significantly higher than in other nations where there is no such a deep market available for borrowing.

Real Estate has been hailed as the greatest investment of all time – at least post-World War II. But the wealth created by real estate is mainly an illusion created by currency movements.  During the 1970s, a Porsche 924 cost as little as $10,000. By 1980, a Porsche was going for more than $50,000. People saw foreign cars as a good "investment” because you could drive them around for two years, and still get your money back. The same thing took place in England in 1985. A Ferrari that was $50,000 in the US, could suddenly be purchased for $30,000 in Britain when the Pound fell nearly to par with the dollar – $1.03. Because Ferrari could not afford to sell their cars in England at a substantial discount, they raised the price of the car to 40,000 pounds. However, the pound then rallied back to nearly $2 as the G-5, formed in 1985, manipulated the dollar lower by 40% to increase trade. Suddenly, that same Ferrari was now selling for nearly $80,000.

The point I am illustrating with the European sports car example is that the fluctuations in currency of 30-40% in a short time period, created the illusion that the cars were the real investment. However, the value of the car was related to the indirect swings in the value of currency. The rise in foreign car values throughout the 1978 instilled the image in American minds that a good German car held its value and was thus better than an American car. This image, created by the decline in the dollar after 1971, produced the age of inflation added to by OPEC. This period in time also created the "brand" image for foreign cars.  This did more to destroy the American car industry than any other event.

What we must also come face-to-face with, is that the same source of capital appreciation in foreign cars caused by the decline in the value of the dollar, has been the steadfast momentum behind Real Estate. A home purchased in 1955 for $14,000 at the peak in 2007 rose to $300,000 on average.  The question becomes, after excessive property taxes, does real estate really provide a good long-term investment? Most would just answer yes. But you are being paid with dollars that have far less in purchasing value. Add up the taxes paid, and you find out in real net terms, the same fluctuations in currency that make cars appear to be investments, do the same to housing.

Of course, there are segments of the real estate market which outperform the drop in currency and exceed other areas by 50% or more in "capital appreciation."  This is the natural business cycle that takes place. You will notice that the rise in real estate after a setback, starts typically in the City. It spreads from that center to the less central portions of the city, and then to the suburbs. As the suburbs are still rising, you will begin to see the core city district peak. That will be the first sign that the cycle is over. This manner in how real estate rises and falls was something that emerged from our studies at Princeton Economics monitoring real estate trend from Europe, America, Asia, and Australia. It always was the same pattern.

But what if the current economic decline is running much deeper and is along the lines of the Great Depression insofar as the total collapse in real estate values? Today, the cycle is far more volatile because of the widespread loans on real estate that did not exist during the Great Depression. The length of debt on mortgages post-World war II is far greater than what existed in anytime during the past. As banks were willing to lend for 30 years, it drove the price of housing up to meet the available cash. If there were no mortgages and property could trade only for cash, the value would drop substantially. So it has been the availability of money that has also accelerated the rise and fall in the value of real estate.

It was the S&P Real Estate Index that peaked with the Economic Confidence Model on 2007.15. This is the target market that will see the greatest fall. We are now facing a very serious possibility that the decline in real estate may not be over for at least 4.3 years into 2011, but the more likely scenario of a minimum of 10 years with the outside shot it will never again be an "investment" as we know it.

How could real estate decline for so long? The two contracting factors that are conspiring against real estate are (1) the Debt Crisis cutting off available capital to keep the bubble expanding, and more importantly, (2) the collapse in state revenues. The states and municipal districts rely upon property taxes. The greater the mortgage crisis, the greater the foreclosures, and that suspends the tax revenues as well. This causes the collapse in state and local revenues forcing states to raise taxes even higher and this is precisely the combination of a debt crisis that ends societies and has been the destroyer of civilization. When it goes to extremes as it did in Byzantium, it even destroyed capitalism reducing the average worker into a peasant who was forced to sell himself, his family, and future children into servitude just to survive.

Is Gold Trying To Speak?

Gold Monthly 2009 Gold has been the best performing investment on the board. It has continued to make new highs in all currencies but the dollar, but even there it is holding on like a politician in his right to control the lives of others. While production of gold was expanding dramatically going into the 1980 high of $875, today, South African production has been dropping like a stone. South Africa is no longer the leading producer in gold and just as demand is rising, the production is falling.  

From a pure technical view, the breakout line from the 1999 low stood precisely at $718 last October, and provided the closing support. Once exceeded, it was penetrated 601 y during Sept/Oct of 2006 on a monthly closing basis and has held nicely for this '08 reaction low. This technical line moves up to about $810 by the end of 2010. Near-term, if we see a real Waterfall Effect in the Dow Jones Industrials going into June 2009 where a collapse takes place back to the 4,000 area, we may see a corresponding high or a major key turning point in gold also for June 2009. This does not appear to be the major or high, but we may see a shocking punch upward with a next thrust. If gold breaks out to new highs going into June 2009 as the now makes a major low, there could be a 5 month reaction low forming by November 2009, with a rally thereafter into about April 2011 for the intraday high, but leaving 2010 as the highest close annually. Gold would then reverse perhaps, but this may be due to Government intervention at that point in time.

Gold still appears to be headed to at least the $2,500 level by 2011. Exceeding that area before the end of 2009, would open the door to a potential rally even up to the $5,000 level. Please keep in mind, this is a relative forecast. That means the dollar would be little of its former self. What we are honestly talking about is the collapse of our Governmental infrastructure not so different from Russia. In plain words, Russia could no longer sustain its control of the economy because it was broke. We are approaching the same problem. Just because we have been always able to borrow and never worry about what would happen when the day comes that the well is dry, does not mean we have bottomless pit. A very minor technical projection shows resistance for gold scaling in from the 1 ,100 to 1,200 level for 2009. Breaking through this technical resistance area will signal that we are in a very serious economic implosion.

The United States' Turn

The reverse side of the Seal of the United States has an interesting Latin saving that was part of our inheritance from the Founding Fathers. They recorded their belief in the history of man – Novus ordo seclorum. What they recorded there was what they believed they were creating – a new cycle of the ages. The men who had the courage to stand against the tyranny of Government, believed that the American Revolution was a dawn of a new age where the cycle of fortune had completed its revolution and it was now Just time to establish a new world order without kings. And what was the saying that more than any other reflected their wisdom?

No Taxation Without Representation!

Thomas Jefferson believed in cycles. He doubted that the United States would even survive beyond 100 years. He was correct. The dream the Founding Fathers created fell with the passage of the Income Tax in 1909 that required amending the Constitution to say, Jefferson, we disagree and it shall no longer be in our people and God that we believe, but in the self-interest of Government and Karl Marx. The prohibition against direct taxation was eliminated in 1913. With that came uncontrollable borrowing, spending that always exceeded revenues, and interest paid to foreign lands no different that Spain to its Italian bankers that wiped out both nations and shifted the core economy in Europe to the North, eagerly seized by the Dutch.  

Jefferson even believed that revolution was a necessary part of the long-term cycle for he wrote that the Tree of Liberty required to be fed with the blood of tyrants and patriots. We have so far avoided that outcome. But the cycle is still very young.

I am not trying to yell "fire" in a crowded theatre. I believe that our future remains ours. History repeats because we ignore the lessons it offers. If we understand the possibilities and how things fall apart, we can exercise a choice and correct them. To look into the flame and know that its power to burn exists, does not mean we have to stick our finger into it just to see.

We are standing on the edge of a cliff in the middle of nowhere. The hatred that spilled out of the mouth of Karl Marx has led to this battle between freedom and the control of individuals that is capitalism vs. Communism/Socialism. We must ask our politicians a very important question – Quo Vadis? (Where are you going?) To date, the answers have been more of a riddle, or in Latin – lucus a non lucendo. In other words, we get a paradoxical explanation that is of something that is the opposite of what it suggests. What we must fear the most, is also what the Romans called – lex talionis – the law of retribution. We must now also ask, quis eustodiet ipos custdes? (who shall guard the guardians?)

Laissez faire (doctrine that opposes government intervention) is dead in the current political discussion. We will not hear this again until Western Civilization collapses. The idea of smaller government and the dream of Thomas Jefferson, Benjamin Franklin, James Madison and others, has expired and vanished into the night suffering what Horace called – Pallida Moors – the pale death. Any solution that somehow excludes government, will never be even attempted. What Marx failed to realize was there was never a dramatic battle between the classes.  It has always been a battle between Government and the people. No matter what happens, Government will always blame the private sector and never admit mistakes. Out of self-interest, it will hunt down those in the private sector to sacrifice in the public square.

This Economic Depression is unstoppable, regardless what Government says. I remain nil admirari – unimpressed with the nonsense of the stimulus package. Even if it did work, by the time it had any effect, it would be election time. Jobs are not created out of thin air. It requires something different than the private sector working for government. It requires a demand and confidence that increasing production will find a willing buyer. Government policy is to hire, but the quality of the work means nothing.

Unless we start to get sane people with real live experience outside of the governmental bubbles, we may see the total meltdown of western civilization. Everyone will then blame the next guy which will lead to war. Already both Russia and China blame the global meltdown on the United States. This is perhaps rightly so since the legal system is so corrupt, regulators like the SEC and CFTC can be bought easily since the people they were to regulate, can hire them as well. No politician can act in such an unethical manner. Yet this is why we have the problems we do now because those Investment Bankers, not Wall Street brokers, have been manipulating the system. It worked so long, we forgot what real "free" market was all about. Just look back at how many Secretaries of the Treasury were ex-Goldman Sachs chairmen.

Unless we restructure the taxes and restore our international competitiveness, jobs will continue to leave. Unless tort reform is imposed, there will never be an affordable national healthcare service. Even corporations can no longer afford to pay the benefits. States and cities are starting to implode because they have promised much to workers, but always ran their own Ponzi schemes taking money currently to pay past obligations. We are facing a harsh reality that governments have expanded assuming resources would always be there, but that day has now arrived. Horace also once said:

naturam expellas furca, tamen usque recurret
(Horace 65-8 BCe)

Horace said though you may drive nature out with a pitchfork, she will keep caning back. The same can be said of the nature of mankind. We can cling to Marxism for it points the fingers at the so called rich who are always defined as the neighbors who just have a little more than me. Socialism is a form of Marxism that Western politicians have used to further their own power.  Socialism created the illusion that we can create the benefits of civilization and cooperative alliances without destroying our liberty.

We are on the edge where the way of life may be altered forever. We must open the door to all solutions and judge our future without bias and prejudice. It is time we recognize Marxism for what it is – the most dangerous theory of all time that may destroy now western Civilization. The more Byzantium could not cover its debts, the more it became aggressive against its own people that in the end, destroyed capitalism and freedom itself. Marx gave us the only alternative to capitalism, and that he called Communism that was just a false dream of Utopia - everyone works for the government, the government takes care of everyone, and in the process, you not merely sell your soul, you give up your right to be an individual. The Western culture has flirted with Marxism because politicians see the power belongs to them. Socialism is no different, for it is trying to be just a little-bit pregnant. It still involves centralized planning of the economy that cannot be done by people who have never worked in the real world.

We must stop the bullshit!  We must open our minds and understand the nature of mankind cannot be altered by passing laws. Marx is dead, and his ideas have to be allowed to die. The class-warfare must stop.

Ironically, China has no debt, nor does it have an income tax. Yet China has been exploding in economic growth rising to the second largest economy faster that the United states ever did. This is part of the cycle of volatility. The very design of the Founding Fathers is by default alive and well. All China has to do, is pay attention on domestic growth and expansion, and it is ready to replace the West and assume its historic moment to emerge as the center of the world economy. China has rejected Marx. It is now our turn to learn the same lesson.

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BAC and WFC Have No Equity After Accounting For Bad Loans

I have always had the suspicion that Wells Fargo's (WFC) loan values were inflated and wrote as much in January.  Wells sits at ground zero of the housing implosion and the fact that their numbers held up so well was a mystery…unless they were very slow to take write downs for bad loans.   The company's own 10-K reveals that my suspicion was correct.  Numerous banks are equity deficient which explains the continued weakness in the stocks.   

According to Jonathan Weil at Bloomberg "Perhaps never before have so many banks’ balance sheets been so patently full of hot air. Bank of America Corp. last week disclosed that its loans at the end of 2008 were worth $44.6 billion less than what its balance sheet said." 

Investors may be placing too much faith in bank's capital ratios.  If the bank's own estimates of fair value were applied to the company's balance sheet the banks would be technically insolvent.  Weil continues:

Bank of America, for instance, had $35.8 billion of tangible common equity as of Dec. 31, before it completed its government-aided acquisition of Merrill Lynch & Co. That figure falls to negative $1.7 billion once it’s adjusted so that all financial assets and liabilities are measured at fair value, using the numbers BofA disclosed in its footnote. The fair-value version shows BofA needs lots more common equity — badly.

Wells Fargo’s tangible common equity was $13.5 billion as of Dec. 31. On a fair-value basis, it was negative $133 million. That makes the bank’s $40.9 billion stock-market capitalization look awfully rich.

In total, eight of the 24 banks in the KBW Bank Index had negative tangible common equity on a fair-value basis, including SunTrust, KeyCorp, Fifth Third Bancorp, Huntington Bancshares Inc., Marshall & Ilsley Corp. and Regions Financial Corp.

This indicates to me that these companies will soon be back at the government's teat to get more capital injections, further diluting current shareholders.   

If You’re Bearish: Time Has Run Out For A Rally Edition

The time has run out for a rally on the S&P 500, according to James Flanagan, head of Gann Global Financial.  Flanagan uses a historical database of stock and commodity prices to analyze current moves in prices.  His knowledge of market history is unsurpassed and he has been superb in calling the decline in all market since 2007. 

His current database indicates the only historical precedent for the current stock market decline is the 1930 – 1932 time period.  And according to all five legs down during that time period, the current market has run out of time and is due for the next leg down.  Based on a similar analogy, the S&P 500 could decline to between 420 – 700.  The following chart shows the various scenarios from that time period. 

According to Flanagan, "If we are to replicate the velocity of the leg down which occurred into the November 21st low, an the 6 legs down during the "great Depression", there is a high probability we are at a breakaway point where the market can move down very quickly."

"If the Stock Market moves higher from here, it will divorce itself from the market geometry of the declines during the Great Depression.  As you are aware, I do not expect this to happen although for the sake of America I hope it does," adds Flanagan.  

Yes, lets hope it does. 

Gann Global 021709  

Source: Gann Global Financial

If You’re Bullish: Time For A 70’s Party Edition

Many traders have been following the 1974 analogy to the current market.  The Dow Industrials have traded in a remarkably similar pattern to the Dow in the 1973 – 1974 time period. 


According to the analogy, the market is now due for a major advance of 50% – 70%.  In the chart below, the current Dow Jones Industrial Average is pictured in blue, while the 1973 – 1974 Dow is a black line.


Dow today vs 1974  


 Source: Bloomberg


The following chart is a closeup of the current market versus the market in 1974.  The comparison basically shows that the market should not make a new low.  In fact, it should begin a rather strong advance within the next several days, otherwise the overlay will disengage.  


Dow today vs 1974 closeup


 Source: Bloomberg

Credit Thaw Foreshadows Equity Rally

So the bottom line is we're making loans. We want everybody to know it. I mean, we even have banners hanging on the outside of our branches, saying we're making loans. And so if you see somebody that says, they can't get a loan, give them my number.

— Kelly King, CEO of BB&T

Thawing Despite the horrendous news on employment and corporate profits there is some good news from the markets.  Overall, the credit markets have unfrozen for all but the worst credits.  I pointed some of these indicators out in September of last year after Lehman Brothers went bankrupt.  At that time, the indicators correctly warned of the vicious beat down that stocks were about to receive.  Right now, they are showing the exact opposite.  Things are generally returning to normal in the credit markets.  Five months after the Lehman debacle, trust is slowly being restored.  Stocks should be beneficiaries of this improvement in the credit markets.  

Some market observers might miss this improvement. Most of the measures of short term liquidity in the credit markets use short term Treasury securities to measure the "spread."  The spread is the difference between the debt instrument, such as corporate bonds, and the "risk-free" rate, or US Government T-Bills.  T-Bill rates are trading at, what I believe, are unsustainably low interest rates because of the flight to safety.  In January, short term treasuries actually had a negative yield when you account for transaction costs because investors were so scared, they were happy to lock in a guaranteed loss rather than risk money in other credit instruments.  The point being, if you look at any debt instrument versus Treasuries, the spread will still be indicating financial stress.  But that's only because treasury securities are trading at unsustainable levels.  With that in mind, let's look at some of the indicators of credit market health.

TED Spread 

The TED spread is a money market spread that measures the difference between the three month T-bill interest rate and three month LIBOR (the interest rate at which banks lend money to each other without posting collateral). The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another. 

The TED spread has returned to 1.0 or 100 basis points, which is the level at which it was trading before Lehman Brothers went bankrupt.  Yet this level is still higher than pre-credit crisis, when the TED spread (the blue line in the chart below) routinely hovered at 50 basis points or below.  However, it you look at the actual yield of LIBOR (the brown line in the chart below), it has returned to 2002 and 2003 levels, indicating that banks are not charging an outrageous premium to lend to one another. 

TED 020609

Click To Enlarge Image

Source: Bloomberg

Commercial Paper

The commercial paper market shows a similar development.  The commercial paper to US treasury bill spread has returned to pre-Leman Brothers levels.  However, corporations that access the commercial paper market are now paying the same low interest rate as they did in 2002 and 2003.  While the spread is still elevated, the yield on commercial paper has returned to all time lows.  That indicates investors are willing to accept a "normal" interest rate for the risk they are taking on.  Granted, only the highest quality companies are accessing the commercial paper market but the trends are still encouraging.

Commercial Paper T Bill Spread_1020609

Click To Enlarge Image

Source: Bloomberg

Industrial Corporate Bonds

The corporate bond market finally perked up last week with several large deals that were well received.  You can see a similar trend as in the commercial paper market.  While the spread is still elevated, the interest rates for AAA corporate bonds is hovering near all time lows.  Investors are willing to accept a relatively low yield for the highest quality paper.  This indicates that investors are willing to pay up for high quality corporate bonds to earn a higher yield. 

Corporate A Yield 020609

Click To Enlarge Image

Source: Bloomberg

Single A corporate bonds show a similar trend although as you might expect, the yields have not dropped as sharply as with AAA rated bonds.  Investors are sill willing to pay a premium for safety.

Corporate A Yield 020609

Click To Enlarge Image

Source: Bloomberg

The most interesting chart in corporate bonds is the yield of the lowest quality credits.  While interest rates have dropped for both AAA and A rated bonds since the beginning of the year, the rates for BBB rated bonds have actually continued to increase.  So while investors are flocking back to high quality credits, they are still shunning lower quality bonds.  That would be normal investor behavior in a recession. 

B Corp Yield 020609

Click To Enlarge Image

Source: Bloomberg

If you believe that the collapse in the credit markets last September lead to the carnage in the stock market, then the current improvement in the credit markets has to make you bullish.  The trends from the credit markets indicate that trust is returning and credit is flowing for all but the worst credits.  The damage from the credit markets has obviously done serious collateral damage to the real economy, which might well continue to weigh on corporate earnings.  However, the environment has improved which should provide a support for stocks.  A rally back to October highs of 1,000 in the S&P 500 and of S&P 1,000 and 9,500 on the Dow seem achievable.  

GDP Deflator Actually Deflates

After a brief bout of enthusiasm this morning, when GDP came in at -3.8% vs estimates of -5.5%, investors quickly realized that the majority of the "beat" came because of an inventory adjustment.  Inventories grew $6 bil vs. a decline of $28 bil last quarter.  That artificially "lifted" GDP by 1.2%.  In essence, companies were stuck with more inventories than the end market demanded.  In a quirk of GDP reporting, this inventory build gets counted as growth.   

Not as widely discussed were the import/export component of GDP.  Net exports added to the GDP calculation, which is good.  However, that's only because imports fell even more drastically than exports fell.  And that's not particularly good for world growth.  Demand all over the world is falling off a cliff.  Therefore, statistically, Q4 may NOT be the low for the economy, as some are hoping. 

However, that's not the most alarming and significant part of the GDP report.  The headline numbers that are reported are typically "Real" GDP numbers, which are adjusted for inflation.  Normally, inflation reduces "Nominal" GDP (GDP not including the inflation adjustment) yielding a lower Real GDP number.  This adjustment is known as the GDP Deflator.  However, nominal GDP declined significantly for the first time since 1960 and at a larger rate since 1958.  In fact, this report was the first since 1952 when deflation actually added to the "real" GDP number.  In other words, this is the first time the GDP Deflator has actually deflated in 60 years.  This is deflation showing up in official government statistics for the first time.  

GDP Deflator 013009

Source: Bloomberg

Click Image to Enlarge

It's no wonder that companies can't cut expenses fast enough.  Corporate profits are shrinking even if management does a great job on costs because sales are falling even faster.   

Deflation is taking a wicked hold of the United States economy.  So even though the Treasury is pumping money into the system like mad, they aren't pumping fast enough. 

The Communists Lecture Us

French TauntingI don't want to talk to you, no more, you empty-headed animal, food trough wiper. I fart in your general direction. You mother was a hamster and your father smelt of elderberries.

French Guard, Monty Python and the Holy Grail

So it's come down to this.  The United States is being lectured by Communists about economic policy.  From the Financial Times:

Wen Jiabao, the Chinese premier, and Vladimir Putin, Russia’s prime minister, used the World Economic Forum in Davos to argue that the two rising powers must play a bigger role in a new economic order.

Mr Wen made scathing comments about the “inappropriate macroeconomic policies” of some unnamed countries and the “unsustainable model of development characterised by prolonged low savings and high consumption”.

He attacked financial institutions’ “blind pursuit of profit” and their “lack of self-discipline”.

The two men’s self-confident speeches contrasted with the gloomy mood hanging over the annual gathering of the world’s political, financial and social leaders. “This is Davos under the Russian flag,” Dmitry Peskov, Mr Putin’s spokesman, told reporters on Tuesday.

Their speeches came as a senior adviser to Dmitry Medvedev, Russian president, criticised the scale of the new US administration’s economic rescue package and projected budget deficit, saying it would suck liquidity from other global markets.

“What is discouraging is [Barack] Obama’s statement that he is going to run a $1 trillion deficit for years to come. For us, that means that all the free liquidity in the world will run into American Treasury bills,” said Igor Yurgens, who heads a think tank advising Mr Medvedev.

Mr Yurgens likened the policy to the “beggar thy neighbour” protectionist policies of the 1930s. “Of course, [Mr Obama] expects the Chinese or Russians to buy US Treasury bills. That is pretty selfish and philosophically it is protectionism,” he said.

Mr Wen also voiced concern about protectionism as he called for the establishment of “a new world economic order that is just, equitable, sound and stable”.

The Russian and Chinese leaders are pretty brazen, given the fact that their own economies are facing very difficult circumstances.  It's becoming fairly clear that unless the world economy miraculously turns around, the Chinese government will have a difficult time finding a purpose for the myriad of workers now returning home after their factories closed.  You can get a sense of it from the poignant article on the "reverse migration" of Chinese workers in Der Spiegel

At least Xiaoju's boss did not simply abandon the factory, escaping at night, like the owners of other bankrupt factories in the neighborhood. Xiaoju heard how angry workers seized the machines in those factories. And in some factories, she says, the workers even organized gangs of thugs to collect their outstanding wages.

But these have been isolated cases so far. Most of the laid-off workers take the crisis personally, not politically. For "Little Chrysanthemum," too, the government in Beijing is far away. She has few expectations of the country's leaders, nor does she blame them for anything. "No one can be held responsible for the crisis," she says, as if she were talking about a natural disaster. "It strikes everyone in the same way."

Yet Steven Keen on his blog, Debtwatch, indicates that this might be too benign a view.  China's Providences have a history of rebellion when the Central Government's dictates go awry at the local level.  

But its current serious decline is sending probably millions of once-were-peasants back from their coastal manufacturing jobs to the countryside, where they are likely to be unemployed and seriously disaffected.

If they emulate their parents, they may well rise up against the local Party officials; the demure acquiescence to Party authority will go out the window when the Party’s policy fails them.

When it does, there will be a political shift in China at the top as well–not necessarily an overthrow of the Western, development orientation, but certainly a strengthening of those who believe, for example, that the provinces should be developed rather than throwing all the resources at the coastal manufacturing cities.

Likewise, Vladimir Putin seems unaware of the political problems that arise in Russia when commodity prices fall.  In my view, the sustained low price of oil did as much to bankrupt Russia in the 1980s and cause the fall of Communism as did President Ronald Reagan's Cold War military buildup.  The political ramifications of an economic recession are not always so severe.  However, Putin is tempting fate by lecturing the United States at a time when his own country will be facing a severe economic downturn.

China's and Russia's lectures show that the move to protectionism is starting.  The retoric is being turned up and it will only shortly follow with actual policy.  Enacting protectionist policies will do more to extend this economic contraction than any bank failure could ever do. 

 

The Devil Is In The Details

Bank stocks are rallying sharply this morning on the news that the administration and Treasury are developing a "good bank/bad bank" concept.  However, whether this rally is justified is all in the details of the plan, which no one knows yet.  For many banks, the concept of a good bank/bad bank scenario involves a binary outcome.  Either the shareholders get screwed or the tax payers get screwed. 
 
For instance, if the government just buys the assets from the banks and leave existing management in place, then the shareholders win. The government will essentially be buying toxic assets at an above market value and putting the burden on working out the problems and taking the losses on the government.
 
However, if the government takes over Citigroup because the company management teams have been incompetent, then the shareholders get nothing.  It would be a repeat of Fannie Mae and Freddie Mac.  The banks get put into conservatorship until all the assets get worked out.  Bill Siedman, CNBC commentator who ran the original Resolution Trust Company, explained the concept in a recent interview on Fast Money

Seidman said he basically nationalized many banks.  He even states that the RTC would have nationalized Citigroup if the company hadn't gotten "saved" by Prince Al-Waleed.   Siedman nationalized insolvent banks, fired and replaced management, sold off the bad assets and returned a "good" bank to the market.  The problem with this method is that it takes guts, resolve and toughness.  The government is basically taking the bank away from the shareholders and current management.  Those parties will scream bloody murder. 
 
In one scenario many bank stocks go to zero.  In the other scenario, many bank stocks double.  However, in either scenario, the overall tone of the market should improve as a huge overhand gets dealt with one way or the other.   
 
I would guess that with the current administration the tax payers won't be the ones that will bear the brunt of the cost.  President Obama doesn't seem to have the shareholder's or management's interest at heart.  However, many Taft Hartley (union) and state pension plans have big exposure large cap bank stocks.  Those plans would be badly hurt if shareholders were wiped out.   In addition, buying the toxic assets gives the Administration a way to help homeowners and banks, but not look as much like they are coddling Wall Street.  At this point, I think it is still a toss up which way the Administration will eventually lean.