Like Japan did in the 1990s to get itself out of its own economic morass, China is splurging on massive public infrastructure programs. China’s banks are lending like crazy to fund these projects. In the first six months of this year, they loaned Rmb7.4 trillion (just over $1 trillion). That’s over three times the amount loaned out in 2008 and the biggest six-month lending surge on record.

Is China’s spending spree setting the global economy up for another leg down? China’s surging investment accounted for an unprecedented 88% of Chinese GDP growth in the first half of 2009.If that’s not a dangerous bubble in the making, we don’t know what is.

What we do know is that the quality of Chinese bank lending will suffer. And as Stephen Roach recently pointed out in the Financial Times, this is a trend that “could sow the seeds for a new wave of non-performing bank loans.”

We’re not economists, dear reader. And nor do we want to be. But that doesn’t mean we can’t spot a bubble in the making. This week, investors paid 40 times earnings for China State Construction Engineering Corporation. As Will’s father, Bill, points out in the Daily Reckoning , these investors have learned nothing from the crash of 2007-08.

As Bill says, it’s a secret of the underground that this kind of hyped investing rarely works out.

The rest of the world seems unaware of how the investment markets work…and they think credit is Miracle-Gro for the economy.But markets are not mathematical… nor mechanical; they’re moral. Their purpose is not to make people wealthy, but to make them wise. And then… only for a while.

It they were mathematical you might make people richer by adding zeros. But it’s not that simple. Zimbabwe tried it; it doesn’t work. A Dear Reader gave us a $10 TRILLION dollar bill – real money printed by the Zimbabwean Treasury. That – and about $5 US dollars – will buy you a cup of coffee in Harare… if they have any.

If they were purely mathematical, you might be able to anticipate price movements with computers and PhDs in math. Many have tried it. As far as we know, none has ever really succeeded.

It’s not a mechanical system either. When prices go down, there are no screws you can tighten…no levers you can pull… Nor can you add more fuel or slather on more grease. It’s not that simple.

What Bill understands better than most is that you’ve got to learn to take your lumps if you want to make money in the markets. And no matter how hard government tries to avoid what’s coming… the market will eventually give us what we deserve…

Instead, markets are complex natural systems. Like mistresses, they can be jiggled and jived… but they can never really be controlled or predicted. That’s what makes them so interesting, of course.

The markets are always teaching us… always correcting us… always giving us a kick in the pants. These are moral lessons…in the broad sense. That is, if you do the wrong thing you get punished for it. Step on a rake; it hits you in the face.

The purpose of a bear market is to correct the errors of the preceding boom. Most prominent among those errors is to think you can make money by speculating in the stock market. When this idea takes hold, good sense goes out the window. People will buy dotcoms with no business plans…and house builders at 40 times earnings!

But that’s how we’ll know when the correction is over – when people give up on the stock market… when they want nothing more to do with it. Judging by today’s news… we’re still a long way from there.

The banks have gotten themselves into a heck of a bind, as we have seen, and Taipan readers have made good money going short. (Just yesterday, in-house options guru Adam Lass reminded us of his not-too-shabby 652% gains.)

Today, though, Andrew Mickey of Fear & Greed offers another angle on the story. Because the bankers went wild with foolish loans at the height of the housing frenzy, they are now left with empty pockets just when the getting is good.

That’s bad news for anyone who needs a bank loan… but potentially good news for investors like you and me. Read on to find out how Andrew plans to make a mint following the “profiteers” of the banking crisis — and how you can, too.

Have a great weekend,

JL

Revealed: The Biggest Profiteers of the Banking Crisis
by Andrew Mickey, Editor, Fear & Greed

I can tell you right now, I might get into trouble for telling this to you. But you know what, it’s the truth.

Over the past few months, the banking crisis has ebbed and flowed. Some months we’re told the banking crisis will send us back to the economic dark ages (a.k.a. the Carter administration). Other months we’re told in soothing tones that it won’t be so bad.

Now, I’m not going to tell you the banking crisis is over. I’m also not going to tell you there is another shoe to drop.

Frankly, I don’t know.

As far as I can tell, expectations are already pretty low for the economy and banking stocks, and most of the easy money has been made.

More importantly, I know that as we speak, a small group of investors will be able to turn the banking crisis into more wealth than most of us can imagine… all with a surprisingly little amount of risk.

How are they doing it? Well, they’re doing what the banks won’t. And they are set to make an absolute killing in the process. Let me explain how they’re turning the banks’ mistakes into their own profits… and how you can join them.

“Easy Money” Spigot Shut Off

The current situation in the banking sector is a bad one.

Years of aggressive lending, overleveraging and shouldering undue risk have created a situation that is going to take a long time and quite a few big cash infusions from our oil-rich friends to fix. But everyone has realized that. It’s “priced in,” as they say.

We’ve got to find the opportunities that everyone hasn’t quite figured out yet. That’s how you win as an investor, and that’s why I’m writing you today.

You see, in response to the current crisis, banks have tightened their purse strings. They’re not lending any money to anyone that can’t already afford it.

Picture this: Someone wants a loan to buy a house. He goes into his bank and applies for a mortgage. The banker is not asking about his current salary or credit rating; instead, the banker is concerned primarily with the potential borrower’s assets.

If they have enough to pay for the loan — in other words, if they don’t really need the loan — then the banker can say “done.” The deal is closed and loan is issued. If the borrower isn’t flush with cash and assets, on the other hand… no loan. The bank can’t afford to take on any risk right now. The easy money spigot has been shut off.

And that is what’s creating an investment opportunity that only comes along every couple of decades. One that is surprisingly low-risk… yet offers huge rewards.

The Smart Money’s Smart Move

While the banks are battening down the hatches, the smart money is making its move. If a bank is unwilling to make loans with a 20% down payment and a house as collateral, it’s certainly not going to make loans to small businesses.

Banks don’t consider track record of growth or future growth prospects when they consider funding the growth of a proven medium-sized business. They look at the worst-case scenario and the value of the businesses assets in the event of liquidation.

That’s where the smart money comes in. They don’t make loans in hopes of getting paid with a ho-hum interest rate. They take an equity stake in the company. And if the investment pans out, the financial rewards can be absolutely massive.

Right now, the smart money is funding everything worth funding. The banks aren’t about to take on the risk.

The smart money — those willing to take on the risk of funding a growing business — has the cash, and they are making investments with a time horizon from six months to five years. It’s a buyers’ market for the venture capitalists (VC), and they’re not passing up on too many opportunities.

Banks’ Pain, Venture Capitalists’ Gain

The lack of bank financing is creating a big opportunity for VCs.

You see, there are a lot of small- and medium-sized businesses that have already proven successful and are now looking for capital to expand. Because of the banking crisis, these businesses can no longer turn to the banks for the growth capital they need.

The economy is tough, and the risks (or the perceived risks, at least) are pretty big. Banks won’t touch these small, aggressively growing businesses. They’re often too busy borrowing money themselves just to stay afloat. But the entrepreneurial VCs of the world are happy to step in.

The VCs are in a great position. They know that many companies worth investing in have no place to turn. The VCs get to lay out the conditions of the investment and take a larger equity stake than they normally would.

They’re the only game in town; it’s a buyers’ market for them. And they know it.

But, of course, I realize that most of us just don’t have $5 million or $10 million available to put in a single investment like a VC fund does.

The great news is, I’ve found a way to put in as little as $500 and come along for the ride.

When Billionaires Bet, the Rich Get Richer

Don’t sit around trying to figure out how bad it’s going to be. It’s much more fun (and profitable) to see what the smart money is up to.

The latest opportunity I’ve come across has two billionaires, who recently cut seven-figure checks to get one start-up off the ground. I like the industry, have been covering it for years, and see plenty of growth ahead.

But in this case, what does it really matter what I think? There is a reason why these guys are billionaires: They choose their investments very carefully.

Learn more about my latest pick here and, more importantly, how you can go along for the ride without having to lay out what the average person would consider a fortune.

Andrew Mickey

Editor, Fear & Greed

Source:Revealed: The Biggest Profiteers of the Banking Crisis

Good day… And a Happy Friday to one and all! A Fantastico Friday in my books, as we had a day without rain yesterday, and… Mr. Trichet did jawbone the euro back to life, as I hoped he would do yesterday… After all that craziness from Big Ben this week, things sort-a got back to the awful fundamentals of the U.S….

OK front and center this morning, I’ve got to tell you that European Central Bank (ECB) President Trichet set the record straight yesterday, and reminded the world’s traders that U.S. rates are low… But Eurozone rates could be going higher, and increasing the already wide interest rate differential that exists between the dollar and euro.

Trichet warned that inflation was high, and probably going higher, and then reminded everyone that the ECB’s mandate is to maintain price stability… There’s two ways to go about that… Turn the money supply spigot off, or raise rates… With the economy slowing in the Eurozone, he can keep the money supply spigot trickling as to not completely kill the economy, but raise rates… The ECB might not get around to raising rates in this cycle, but the threat to do so is there, and the markets have to take that seriously…

So… In taking that threat seriously, the markets sold dollars and bought euros for the first time in two days… And the euro’s rise was something to behold… The single unit sat at 1.5385 when Trichet began to talk… And soon afterward, it was well into the 1.55 handle!

It wasn’t all Trichet though… The Fed’s Vice Chairman, Kohn, had some very strong words about the lending landscape… Let’s go to the tape…

Kohn noted that bank loan quality would worsen, bank write downs would increase, and expressed concern that loan losses might spread. Now before I go on, let me say that the “banks” he’s talking about are all those that participated in the mortgage Ollie, Ollie oxen free the past few years… Let me say also that EverBank did NOT, participate in the sub-prime, fancy free mortgage loan business… We stayed the course with our tried and true principals… Yes, we didn’t make as much money as the “other” guys the past couple of years, but then, we don’t have the losses to book now either!

Anyway… Kohn, sounded like he was a Pfennig reader… I just get a kick out of others that finally come around to my way of thinking that we may have averted a major meltdown, but the problems aren’t going away… And… We’ll have another “Bear Stearns” from all of this…

To follow up what Kohn had to say… 1st QTR mortgage delinquencies were reported by the Mortgage Bankers Association, showing a rise to 6.35%, a record high in data back to 1979. These delinquencies threaten the banking system folks… And on top of that the economy as a whole.

So… We saw a huge turn around in the currencies on our Thundering Thursday… If you had sailed around on the ocean and was gone for a week, and just came back, you would think that nothing had happened, except a stronger bias to sell dollars…

OK… Continental announced job cuts of 3,00 yesterday… And… A BIG home builder here in St. Louis, Taylor, Morley Simon closed their doors! It’s a sign of the times… I saw a funny sign yesterday that was titled: A sign of the times… “Beer costs less than gas” Drink Beer, Don’t drive! That’s funny!

Under the heading of: That’s NOT so funny, is the news that the SEC is going to investigate AIG on their accounting of sub prime mortgage contracts… Here’s where my thoughts are headed on all of this… Recall about 7 years ago, when one Corporate Scandal hit the news after another? I have the feeling that we’re heading right back to that awful time… It just all depends on how many rocks the investigators want to turn over…

Another Fed Head, Lacker chimed in yesterday and struck a nerve… Let’s go to the tape here… In a striking insider’s critique, Lacker said lending programs the central bank has created to combat the credit crisis distort private markets, encourage risky behavior and could endanger the Fed’s independence. Federal Reserve Bank of Richmond President Jeffrey Lacker’s remarks show that concerns that outsiders have raised about the Fed’s actions — in particular its rescue of the investment bank Bear Stearns — are shared by some inside the Fed.

Whoa there partner! Those are some harsh words… But… Sounds like Lacker has become a Pfennig reader!

The weaker dollar yesterday sent Oil prices climbing to the tune of $6 on the day! I looked at some stuff last night and saw that our friend, Jim Rogers, was speaking again, and said that the Bull Market in Oil has “years to go”… I agree… The demand has amped! I know that some will point to the U.S. and say that there aren’t lines at gas stations, etc. but… The slack in demand here is being taken up and more so by India and China…

Speaking of China… A former colleague at the old Mark Twain Bank, brought at thought to me attention yesterday and that is… With the election period on its way, the guys with the bats that are always beating on China to allow greater appreciation with their currency, will be tied up, and focusing on getting re-elected rather than beating on China… Therefore, China gets a “get out of jail free card” and therefore, I suspect the appreciation to slow for the rest of this year…

And if the The Institute for International Finance Inc.’s new proposal on “mark-to-market” accounting is implemented, Wall Street will have achieved this objective.

Needless to say, that would be bad news for shareholders.

Once upon a time, asset valuation was easy, even for banks. Whatever you paid for it was the value at which you carried it in the books. In the years of inflation, shysters would wander round the country looking for companies that carried their Head Office at its value when built in 1926.

The only exception was in the few cases such as dud bank loans. If the asset was clearly worth far less than you paid for it, then you would write it down to a new lower value. More often than not, you wrote it off altogether and forgot about it. However, if you wanted credit for an asset’s increase in value, you had to sell it – simple as that.

The only exception to this methodology arose in a few trading operations, such as the investment banks – at the time, much smaller – and commodities traders, where positions were written up or down, or in other words, “marked-to-market” at the end of each day, according to that day’s closing prices. By and large, the only assets marked to market in this way were actively traded shares and bonds.

The advantage of this system for shareholders is that it was difficult for management to play games. There was no possibility of management declaring a higher value for an asset while the company still owned it and paying itself a bonus based on the increase. That’s a big protection, because unless the asset is very liquid or actively traded, it is impossible to be really sure of its value until it is sold.

Banks began to move to mark-to-market accounting in the 1980s. They quickly discovered that it could prove a bonanza for management if there was any kind of profit sharing bonus arrangement, even more so if stock options were involved. In a bull market, it was no longer necessary to sell a building or an equity position to record a profit on it; you could record profits and pay yourselves bonuses as you went along. The technique became particularly profitable when there wasn’t a true market for an asset; in that case management was free to make up a value, using some internal mathematical model.

Naturally, if a bear market occurred, mark-to-market accounting resulted in much larger losses than traditional accounting. First, the value of assets had been marked up to the absolute maximum bull market peak, so they had to be written down that much further than they would have under historic cost accounting. Second, under historic cost accounting an asset whose value was temporarily diminished but was still fundamentally sound did not have to be marked down. Thus share positions, or bonds whose credit rating had become impaired, could still be held at book value.

However, under mark-to-market accounting, those positions had to be marked down to their new value and a loss taken. In theory, mark-to-market accounting was more precise in a bear market. In practice, it allowed management to pay themselves bonuses for year after year, and then declare one utter disaster year, in which everything would be written off and most of the profits of the preceding decade would disappear in smoke (without, however, management having to repay the bonuses from the boon years).

Of course in some cases, most notoriously Enron Corp. (OTC: ECSPQ), it was taken too far and the company went bust, but hey, that’s capitalism.

The new FAS157 that came into effect last December did not change much in principle, but codified some of the nastiness. Under it, assets were now classified into three “levels” according to how much of a market there was. “Level 1″ assets had a liquid market – no problem. “Level 2″ assets could be valued by reference to a liquid market in a related asset. “Level 3″ assets had no easily relatable market, and therefore had to be valued by internal mathematical models.

Unfortunately for Wall Street, the new system, which had appeared to offer opportunities for endless bonus-creating mark-ups, was put in place right in the middle of the subprime mortgage crisis. All the collateralized debt obligations with subprime mortgages underlying them became a problem, because the very thin asset-backed securities index or “ABX” market for them collapsed, with AAA-rated bonds being quoted at less than 50 cents on the dollar. That paper, which had all been recorded in Wall Street’s books as “Level 2″ had to be quickly shifted to “Level 3″ – otherwise huge losses would have been taken (huge losses WERE taken; but these would have been even larger).

Fortunately for Wall Street, astute lobbying had ensured there was a loophole in FAS157 – if the market for an asset was a “distress” market without willing buyers or sellers, the asset no longer needed to be counted as Level 2 but could be shifted to Level 3. Naturally the ABX market was a “distress” market – nobody wanted to sell at those prices, and it was highly distressing to management how far prices had fallen. So the subprime mortgage-backed paper was duly shifted to Level 3, increasing those assets by over $30 billion in one quarter at Goldman Sachs Group Inc. (GS), for example, giving Goldman $96 billion in Level 3 assets, nearly 3 times its capital.

Nevertheless, the idea that prices might have to be marked down sharply in a bear market was unpleasant. What’s more, bear markets could last for years, in which write-down after write-down could occur, wiping out profits year after year and preventing bonuses from being paid. Wall Street lifestyles were seriously threatened!

Now the Institute of International Finance, Wall Street’s tame think-tank, has come up with a solution. Prices should still be marked UP to market, but in difficult times they should no longer have to be marked DOWN to market. In the long run, this would turn Wall Street balance sheets into gigantic collections of waste paper. In the short run, it would preserve profitability and bonuses. And if it all goes wrong in the end, well, as The Bear Stearns Cos. Inc. (BSC) rescue showed, what are taxpayers for?