This is no ordinary downturn. After the biggest credit bubble in history, we face a correction on an unimaginable scale. Make no mistake about it: This is a credit-cycle bust that the government cannot stop. The losses are already catastrophic. And the massive unwinding is nowhere near finished yet…

The following is an excerpt from Bill Bonner and James Davidson’s crisis report, How to Survive and Prosper in the Coming Global Depression.

To read the full report, simply enter your e-mail address below. You’ll also begin receiving critical updates to the report via e-mail.

Contrarian Profits readers are probably familiar will Bill’s commentary from his Daily Reckoning column. But here is some information about James Davidson:

Davidson is a self-made multi-millionaire, venture capitalist and best-selling author.

His books include Blood in the Streets, Financial Reckoning Day and The Sovereign Individual.

As an author and editor of private financial advisory service Strategic Investment, Davidson has made a number of bull’s-eye crisis predictions.

He is the founder and chairman of the National Tax Payers Union, the largest and oldest grassroots taxpayer organization in US.

His forecasts and his war against taxes and deficits have earned him frequent invitations on programs such as Good Morning America, The Tonight Show and MacNeil-Lehrer.

Read on…

This Is a ‘Credit Cycle’ Bust

One of the saddest lessons of history is this: If we’ve been bamboozled long enough, we tend to reject any evidence of the bamboozle. We’re no longer interested in finding out the truth. The bamboozle has captured us. It is simply too painful to acknowledge — even to ourselves — that we’ve been so credulous.

We turn here to the words of American astronomer Carl Sagan because they so aptly describe our current economic predicament.

Americans have come to believe the particular bamboozle that we can get rich by spending…that we can get something for nothing.

As Bill put it in Financial Day of Reckoning, “Americans can no more retreat from this dream than Napoleon could have brought his troops back from Germany, Italy and Spain and renounced his empire.”

And here’s where our story gets really interesting.

Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.

- John Stuart Mill

Because what becomes clear is that this is no ordinary collapse.

Let us explain…

When left to themselves, the markets are natural phenomena. There is a wonderful simplicity about them.

Failure follows success. What goes up eventually comes down. Like a tree, they cannot continue to grow forever.

We can easily illustrate this by describing the pattern of pig farmers.

When the price of pigs rises, pig farmers naturally raise new pigs to increase production. About 18 months later, these new creatures arrive on the market. This increase in supply causes prices to fall. Farmers decide to cut back, which caused prices to rise again.

This is nothing more than the cyclical boom-and-bust cycle that defined the US economy from the end of World War II to 2001.

Then something changed radically. The Fed, under eager-to-please chairman Alan Greenspan, decided it could avoid the bust part of the cycle altogether.

The result is a different beast from your garden-variety downturn. You get a “credit cycle” bust instead.

This is exactly what we are experiencing now. And it’s more like the post-bubble depression of the 1930s than the downturn of 1973 to 1974 or 1981 to 1982…

‘Catastrophic Acceleration’ of Losses

Here’s the big worry.

The severity of this kind of bust depends on the magnitude of the bubble that preceded it. And the bubble that came before this bust was the biggest ever in history.

In fact, it wasn’t really a bubble at all. It was a “hyper-bubble.”

Now this hyper-bubble has popped, and the losses are catastrophic.

Billionaire investor George Soros recently explained just how dangerous the unwinding of these kinds of bubbles can be.

The typical sequence of boom and bust has an asymmetric shape. The boom develops slowly and accelerates gradually. The bust, when it occurs, tends to be short and sharp.

The asymmetry is due to the role that credit plays. As prices rise, the same collateral can support a greater amount of credit. Rising prices also tend to generate optimism and encourage a greater use of leverage — borrowing for investment purposes.

At the peak of the boom both the value of the collateral and the degree of leverage reach a peak.

When the price trend is reversed, participants are vulnerable to margin calls and, as we’ve seen in 2008, the forced liquidation of collateral leads to a catastrophic acceleration on the downside.

Of course, all this was inevitable.

Bill repeatedly warned the more than half a million subscribers of his newsletter, The Daily Reckoning.

No doubt, many got tired of hearing his warnings. But all he was doing was pointing out the obvious.

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Audio Commentary from Resource Investor Rick Rule

Click to play with Media Player

Key points summary:

* The crisis is not limited to mortgages… Financial institutions are over leveraged
* There is a wipe out of shareholder equity in financial services
* Financial service companies don’t know what their derivatives are worth
* They are keeping liquidity for themselves because they don’t know value of derivatives of others banks
* The US is the leading edge of a worldwide trend of over-leveraged financial services
* An extreme example of over-leverage is Iceland

Rick Rule is chairman of Global Resource Investments. He has dedicated his life to all aspects of the natural resource industry. His contacts and knowledge of this market are unmatched.

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A Monster of Deleveraging

Instead of getting a typical bear market in 2001, we now face a monster of deleveraging as the biggest credit boom in history unwinds.

Deleveraging is simply the cutting back on the amount of money borrowed compared to equity.

In the case of this crisis, financial institutions sell off assets to recoup losses inflicted on their balance sheets by toxic mortgage-related securities.

These forced sales push down asset prices, hurting the balance sheets of other investors, forcing more asset sales and so on.

Nothing can stop this process. It’s a necessary cure for the credit bubble that Greenspan puffed up.

The problem is it is devastating the wider economy.

As The Economist magazine puts it, “What hurts finance affects the rest of the economy in spades.”

Because of leverage, a shortfall of bank capital of around $100 billion may reduce the potential supply of credit by $1 trillion.

This assumes banking system leveraging of around ten times…the geniuses running Lehman Brothers leveraged 25 times to equity.

But let’s assume that leverage of ten times to equity is about right.

So far, financial institutions have admitted to about $600 billion in credit-related losses and writedowns (net of re-capitalization via new equity issues).

This means cuts of $4 to $6 trillion to the potential supply of credit.

This, in turn, leads to higher cost and lower availability of credit to the real economy. And it forces consumers to reduce debt and consumption, most of which was based on borrowing in the first place.

This is bad enough. But it doesn’t end there…

So-called “negative feedback loops” mean the reductions in consumer spending and investment further hurt the economy. This puts further financial stress on corporations and individuals and triggers more debt defaults and more losses for the financial system. These then reduce lending capacity.

And so on…

Like a giant forest fire, the deleveraging process can’t be extinguished.

And although the government believes it can put the fire out with bonehead bailouts, at the very best all it can do is create firebreaks that limit the damage until the fire burns itself out.

Right now, the bailouts are stopping companies such AIG and Citigroup from going under. But banks are still refusing to lend to each other despite all the money the government is giving them.

The bottom line?

This massive unwinding is nowhere near finished.

Remember, Wall Street has only admitted to a small fraction of its mortgage-related losses and writedowns.

And the very, very bad news is total losses are estimated to clock in at $2.5 to $3 trillion…

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