Sinking Rapidly Into Depression

This is the crisis that will change the course of history.

Even before ivory-tower theorists have gotten around to officially calling it a “recession,” the U.S. economy is already sinking rapidly into depression.

And even as the government has vowed to embark on a $700 billion spending spree to avert financial panic, over $1 trillion in wealth has been wiped out in just five days of stock and bond market declines.

Cheap credit, the lifeblood of the U.S. economy, has nearly vanished from the scene.

Borrowing from Peter to pay Paul — the norm for decades in the consumer and corporate world — is becoming next to impossible.

Greed has been replaced by fear; euphoria, by panic; trust, by suspicion.

Everywhere, we see vicious cycles of mutual financial destruction:

• Falling prices driving homeowners to abandon their homes … and fire sales on foreclosed homes driving prices into a steeper tailspin.

• Strangled consumers falling behind on their credit cards … and credit card losses compelling banks to choke the available credit for consumers.

• Wall Street panic smashing Main Street business … and Main Street business sowing the seeds for more Wall Street panic.

The probable consequences: Astronomical unemployment rates and intense hardship for millions of Americans; devastating losses for investors in almost every asset class; and, ultimately, deep depression and deflation (falling prices).

I wish that, somehow, this crisis could have been averted. But now that the bombs have been dropped, there’s not much chance we can avoid the explosions that typically follow.

The U.S. government’s giant bailout may buy some time and buffer some pain. But no matter how hard it may try, it cannot force banks to make risky loans or compel investors to buy sinking bonds. No government can repeal the law of gravity. No force can turn back the clock.

But you and I will get through this — together.

My team and I have everything we need to continue our operations in any foreseeable disaster. We will be here to guide you through thick and thin. And when it’s all over, we will be ready to start anew, hopefully on a steadier, more wholesome path.

This Is Not the End of the World;
It’s Just the End of a Crazy Era.

Our country has a cornucopia of resources and a wealth of knowledge. Even after a great fall, we will still have the elements for a great recovery.

Inevitably, this decline will deliver severe financial losses to most of those who endure it. But it can also deliver long-lasting benefits to all those who survive it.

If I’m right about the ultimate outcome, burdensome debts will be liquidated. Wild spending will be replaced with prudent saving. Unaffordable luxuries could give way to affordable bargains. And after the worst is over, thousands of new, innovative companies will burst onto the scene with clean balance sheets and a new vision.

Therefore, throughout our journey together — regardless of how dark the tunnel may appear — always remember the benefits. Relax your reactive impulses. Breathe what we trust will be a new atmosphere of collective sacrifice. Let time work its wonders.

But Don’t Expect a Recovery To Come Easily or Quickly.
The Deepest Declines of All Are Still Dead Ahead.

A recovery certainly won’t come from Washington’s $700 billion bailout boondoggle. It’s too little, too late to avert a debt collapse. At the same time, it’s too much, too soon for all those who will be asked to pay for it.

For the evidence, see our white paper submitted to Congress on September 25. The highlights:

1. The FDIC’s list of problem banks includes only 117 U.S. institutions with assets of $78 billion. But the list has a fatal deficiency:
   • It did not include any of the large banks that have failed or been forced to merge this year.

   • Our list did. And that list shows there are 1,479 U.S. banks and 258 thrifts at risk of failure with total assets of $3.2 trillion, 41 times more than estimated by the FDIC. This number alone illustrates the shock and awe ahead for anyone expecting the new bailout law to bring about a real recovery.

2. The government seems to assume that our debt problems can be resolved by focusing on banks with financial assets gone bad. But the reality is that bad debts are everywhere:
   • At Fannie Mae, Freddie Mac, Ginnie Mae and other government agencies, $5.4 trillion in residential mortgages continue to rot.

   • Beyond residential mortgages, there are $2.6 trillion in commercial mortgages.

   • And beyond all mortgages, there are another $20.4 trillion in consumer and corporate debts — all subject to the same kind of surging delinquency rates we saw in subprime mortgages.

3. The government’s bailout plan is designed to help clean up debts that have gone bad so far. But what about debts that turn sour from this point forward? Do our leaders assume the economic decline is going to stop on a dime? Don’t they see that the decline is actually gaining momentum?

4. The bailout plan does nothing to address the $182 trillion maze of bets called derivatives. Nor does it take into consideration the fact that our nation’s three largest banks — Citibank, JPMorgan Chase and Bank of America — are exposed to far more credit risk on their derivatives than they have in capital.

5. In sum, even after committing $200 billion for Fannie-Freddie, $85 billion for AIG, $25 billion for the auto industry, $700 billion for the Wall Street bailout, another $150 billion tacked on to the plan for pork and tax cuts, plus hundreds of billions in emergency loans from the Fed … the government’s rescue is still too small to cope with the tens of trillions of souring debts and bets in a sinking economy.

6. At the same time, the government’s bailout commitments made so far — now exceeding $1.5 trillion — are already too much for those who will be asked to foot the bill or lend the money:
   • Even before these bailouts, the Office of Management and Budget (OMB) projected the 2009 federal deficit would rise to $482 billion.

   • Now, in just three weeks, the government has effectively chartered a course to triple that deficit.

7. In practice, the only way the government can try to raise that much money is by borrowing it. And to the degree that it does so, the only possible outcome is huge upward pressure on the interest rates that consumers, corporations and local governments have to pay for mortgages and loans. That can’t make the debt crisis go away. It can only make it many times worse.

The Day of Reckoning Is Today —
Monday, October 6, 2008

Today is the day we’ll learn whether the global financial markets will welcome the giant bailout plan with open arms … or reject it with grim disdain.

If the latest events are any indication, it will be the latter, and the markets will crash like never before. Look at what’s happened in just the past 72 hours:

First, immediately after the great bailout plan was signed by the president on Friday, the Dow plunged 474 points from peak to close. Not exactly a welcome reception!

Second, on Saturday, the previously agreed-to bailout of Germany’s second biggest property lender, Hypo, fell apart at the seams, sending government officials scurrying to come up with an alternative deal. But the amounts needed are huge: 20 billion euros by the end of next week, 50 billion euros by the end of the year, and as much as 100 billion euros by the end of 2009.

Third, UniCredit — the biggest bank in Italy, whose shares have been plunging lately — is trying to raise $9 billion in capital to stay afloat.

Over the weekend, even the country of Iceland has been shopping for a bailout.

Yes, stock markets can sometimes behave in perverse ways — plunging on good news, rallying on bad news and confusing the pundits on virtually any news.

But the world’s vast credit markets rarely lie. These are the markets where corporations and governments sell their bonds, notes and short-term paper to investors in exchange for cash.

These markets are far larger than the stock markets. And they are driven by traders who typically are among the first to see through the hype and fluff that pours daily out of Washington or Wall Street.

Join me for a sprint on my time machine — this time, going back just three weeks. Then follow along through each major turning point, and you’ll see what I mean …

New York City, September 15. Officials from the Federal Reserve and the Treasury Department have called together the heads of the biggest financial companies over the weekend. Their mission: To avert the inevitable meltdown that would ensue if two of Wall Street’s largest firms — Lehman Brothers and Merrill Lynch — went down.

Merrill has a buyer; Lehman doesn’t. So a Lehman bailout is on the table, following the pattern of the Bear Stearns bailout six months earlier.

But after back-to-back handouts week after week, some officials are fed up; they’re losing their appetite for more of the same. Instead of a Bear Stearns-type rescue, a vocal minority is arguing forcefully to make an example of Lehman, to let the firm fail.

“Let’s teach ’em a lesson,” they say. “Let’s send the message to complacent investors that risk in the marketplace is not dead after all.”

They assume the financial system is strong enough to withstand the shock. But they assume wrong …

September 16. It’s Monday morning. In one fell swoop, 158 years of Lehman Brothers’ history has been extinguished. Employees are saying their farewells. On 7th Avenue, dozens are carting off boxes of personal belongings.

As these images are transmitted via the Internet and the wire services to the far corners of the financial world, there’s a vague sense that something different is happening: For decades, an invisible glass shield called “trust” has protected global financial markets. But on this day, that shield has been shattered.

Suddenly, we have crossed into a new world of mistrust. Instantly, lenders have lost respect for borrowers, banks have lost confidence in fellow banks, and buyers are suspicious of nearly all sellers.

Several pivotal debt markets — already weakened by the on-again, off-again credit crunch that began over a year ago — are now plunging into a new, more acute phase of panic.

The market for commercial paper, the primary source of quick cash for thousands of corporations, is going into convulsions. A giant money market fund is “breaking the buck” — falling below $1 per share, due to huge losses in its Lehman Brothers’ commercial paper.

Libor, the international standard for interest rates that banks pay each other for short-term loans, is surging. The cost of credit default swaps, a type of insurance against big company failures, is skyrocketing.

While world credit markets are in turmoil, U.S. government officials are in shock. Their “let’s-teach-’em-a-lesson” theory is dead at birth … and in its place, and a new “Mother of All Bailouts” is in gestation.

White House Rose Garden, September 19. In 1930, even on the brink of the Great Depression, America’s highest officials dared not warn the public of a financial panic.

But today, appearing before the press in the Rose Garden, the nation’s three most powerful economic decision-makers — President Bush, Treasury Secretary Paulson and Fed Chairman Bernanke — are doing just that: They’re warning of a financial meltdown.

They’re deliberately taking a monumental risk with the public psyche, and they’re doing so for a single-minded reason — to help justify the greatest government rescue of all time: $700 billion, or nearly five times more than the entire economic stimulus package that came — and went — earlier this year.

Why are they doing it today of all days? Why are they in such a great hurry? Because they can see, with their own eyes, the seizures in the credit markets. By announcing a mega-bailout, with all the fanfare and theatre they can muster, they hope they can restore confidence in the credit markets and stem the flood of panicky selling.

But despite the high drama, and despite knee-jerk euphoria in the stock market, the credit markets barely blink. The credit convulsions continue unabated. Trust is not restored. Confidence continues to sink.

Capitol Hill, Sunday, September 28. After a long weekend burning the midnight oil, Congressional leaders of both parties are announcing a “done deal” with “solid bipartisan support.”

New York, September 29, 11 AM. Despite the “near certainty” of a deal in Congress, credit market investors are still not impressed. The Libor rate is still rising. The cost of credit default swaps is still surging. Commercial paper buyers are still in hiding.

Same day, 1:15 PM. Just a few minutes ago, in stunning defiance of President Bush, the House of Representatives has rejected the bailout package by a vote of 228 to 205. The news is exploding on the floor of the New York Stock Exchange like a neutron bomb, sending the Dow into a 778-point tailspin for the day and throwing credit markets into virtual cardiac arrest.

Thursday, October 2. While Congress scrambles to recover, Fed Chairman Bernanke — along with his counterparts at foreign central banks across the globe — have jumped in to try to fill the gaping hole left by the U.S. Congress’ failure to pass the bailout legislation. In just a few short days, they’ve injected an astounding $1 trillion into the global financial system, doubling, tripling and quadrupling their already-extraordinary prior infusions during previous bouts of the 13-month-old credit crisis.

But even these huge amounts aren’t enough. Several foreign banks are falling by the wayside. Trust continues to erode. Credit continues to vanish from the marketplace. More seizures sweep through the global credit markets.

Washington, Friday, October 3. Congress has stuffed the rescue bill with pork … Republicans and Democrats who opposed the legislation on Monday have caved in … the House has voted “aye” … and the President has rushed to sign it into law.

“Now, finally,” they say with a great sigh of relief, “the markets will give us their blessing. Now, finally, we can put this debt crisis behind us.”

Ironically, however, even after all the political arm-twisting and even after all the added billions, the package still doesn’t seem to be enough to calm credit markets. Quite the contrary, the Libor rate has risen even further. The cost of credit default swaps continues to make new highs. Commercial paper buyers continue to recoil in horror.

Surprising as it may seem, despite the greatest central bank money infusions ever … despite the largest government bailout package of all time … the credit crisis is not ending.

Back To the Present

You read these words on your screen or in a printout. And you say: “All this is unbelievable. Give me proof.” OK. Here it is …

Proof #1. Bloomberg, October 3: “The market for commercial paper plummeted the most on record as banks and insurers were unable to find buyers for the short-term debt amid the worst U.S. financial crisis since the Great Depression. Commercial paper outstanding tumbled $94.9 billion.”

Proof #2. Bloomberg, also October 3: “Leveraged loan prices plunged to all-time lows … and even the safest company bonds suffered the worst losses in at least two decades as investors flocked to Treasuries. Credit markets have frozen and money-market rates keep rising even after central banks pumped an unprecedented $1 trillion into the financial system.”

Proof #3. Citigroup is in danger:

• TheStreet.com Ratings has just downgraded the Financial Strength Rating of Citi’s main banking unit from C- (fair) to D+ (weak).

• Separately, Weiss Research finds that Citigroup’s global credit card portfolio — 185 million accounts with $201 billion — is in jeopardy with credit losses mounting. And nearly every single category of consumer loans is suffering dramatic increases in delinquency rates (Citigroup’s June 30 Quarterly Financial Data Supplement, pages 10 and 15).

Proof #4. Silent bank runs — mass withdrawals by institutional investors — are hitting some major banks, accelerating the credit crisis even more:

• At Washington Mutual, the biggest bank failure in history, the Office of Thrift Supervision (OTS) reports $16.7 billion in cash withdrawals in just nine business days (MarketWatch).

• At Wachovia, when the bank opened on Monday, it’s reported that it would have had no other source of liquidity if the FDIC had not stepped in to arrange a shotgun marriage with another major bank (Charlotte Observer). But which is the groom — Citigroup or Wells Fargo? Based on a judge’s decision this weekend, the answer is now up in the air, another source of uncertainty for investors and depositors.

Proof #5. In a thinly veiled attempt to stem the bank runs, the FDIC is changing its rules: The new bailout law now includes a jump from $100,000 to $250,000 in FDIC coverage limits for depositors.

But it’s unlikely this will be enough to significantly slow the outflows from banks. Reason: Too many banks may be relying too heavily on large, uninsured deposits that are not affected by the change. (For the data, see Weiss Research’s latest press release and report, “Many Banks and Thrifts Overly Reliant on ‘Hot Money’ Deposits.”)

All this evidence leads you to a single obvious conclusion: The crisis is gaining momentum and worsening at an even more rapid pace.

Perhaps not so obvious is whether the long-term outcome might be …

Inflation or Deflation?

Clearly, ours is a debt-addicted society.

Without debt, U.S. consumers, corporations, local governments and, ultimately, even the federal government must cut spending drastically, driving down demand.

And without demand, most prices for goods and services are bound to plummet.

That’s deflation … unless, of course, the government can somehow end the debt crisis … unless the Fed can print money in unlimited amounts … and unless that money turns the threat of deflation into the specter of hyperinflation.

Which will it be? Watch the credit markets. As long as they continue to contract, they’re telling you that …

This collapse is bigger than any government: Despite the inflationary spending and bailouts, ultimately, DEFLATION is the more likely outcome.

If so, that implies the real possibility of further declines in some of the markets that previously were among the biggest winners, including foreign currencies, foreign stock markets and industrial commodities.

Nearly two months ago, in his August Real Wealth Report, Larry Edelson explained it this way: “The U.S. economy is dealing with a pricing collapse. It’s a deflationary spiral in a global recession that will lead to depression” — all in the broader context of major, long-term bull markets in commodities.

Regardless of inflation or deflation, however, there’s always money to be made in a great crisis like this one — on the way up since the early part of the century … on the way down in a period of deflation … and on the way up again once the deflationary period has passed.

And no matter happens in the months ahead, your number one priority right now must be safety and liquidity.

Move most of your money into the safest, most liquid investment on the planet — 3-month T-bills bought directly from the Treasury or a Treasury-only money market fund.

For specific instructions on how to buy short-term Treasuries, see my September 30 report, “Your Last Chance to Act.”

Good luck and God bless!

Martin

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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Christina Kern, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau and Leslie Underwood.

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