But the trading day was not all about mere rumors. It was also about hearsay, hype and giddy optimism…

Meredith Whitney, “The Woman Who Called Wall Street’s Meltdown,” according to the Fortune Magazine cover of August 18, 2008, upgraded the shares of Goldman Sachs to a “Buy,” and predicted the stock would rise 30% from current levels. “Goldman has all the benefits of the capital markets in general,” said Whitney, “Without the ‘junk in the trunk’ as I like to call it.” Goldman shares jumped 5.3%.

Based on Whitney’s upgrade, and the subsequent market action, gullible investors could have deduced that the credit crisis has ended. The rest of us could have deduced that the credit crisis took a day off.

Lost in the celebration of Whitney’s upgrade was a smattering of bad news “below the fold.” For starters, Whitney did NOT upgrade any of the other seven banks she analyses. To the contrary, Whitney damned the other seven banks – and the economy in general – with her faint praise for Goldman.

“Our more bullish outlook on Goldman Sachs shares is deeply rooted in our sustained bearish stance on the U.S. economy and the state of U.S. financials at large,” said the influential analyst. “Specifically, we expect a tsunami of debt issuance from federal/sovereign, state, and local governments to fund woefully underfunded budget gaps. In addition, we expect corporate debt issuance to be at least 60% as strong as peak cycle levels, reflecting sizable debt maturity rolls. What’s more, given fewer players in the market, not only is GS benefiting from market share gains on these products but more widely in the derivatives products.

“To be clear, our reasons for liking GS stock today are drastically different from any we have had recommending the stock on and off over the past decade. In the past, GS shares were a great play on equity markets and expansive global gross domestic product. While that may still hold true down the line, our thesis today is that we expect GS to be the key competitor in some of the most unpredictable markets: government, corporate, and municipal debt.”

As if on cue, the U.S. Treasury disclosed yesterday that the U.S. federal deficit has already topped $1 trillion for 2009…and the year is barely half over! Sure, that might seem like bad news. But it’s actually GOOD news…for Goldman Sachs. More debts mean more Treasury bonds, which mean more trading profits for Treasury bond dealers like Goldman.

Whitney, who probably possesses more intellectual honesty than most equity analysts, probably possesses legitimate reasons to fancy the shares of Goldman. But a relatively promising outlook of one company is hardly a reason for investors to chase after all the other stocks in the market.

We would be surprised to discover any correlation whatsoever between the fortunes of Goldman Sachs and the fortunes of a bakery in Des Moines or a florist in Fargo. On the other hand, we have no trouble whatsoever imagining that Goldman might flourish while bakeries and florists are going out of business from coast to coast.

The only essential point here is that Goldman, circa 2009, is hardly General Motors, circa 1954. What happens in Goldman stays in Goldman. This company is not a bellwether for the economy at large.

“We’d suggest that whatever Goldman did to goose earnings is probably not going to be possible for the rest of corporate America,” observes Dan Denning, our insightful colleague at the Australian Daily Reckoning. Furthermore, Denning points out, most other American financial institutions are continuing to play “hide the bad asset.”

“A New York Times story from yesterday,” Denning remarks, “suggests that government capital injections and loan guarantees, along with new equity offerings, have allowed banks to evade the inevitable consequences of the popped credit bubble.

“‘The capital provided by the government through TARP, etc. has allowed the banks to continue holding deteriorated assets at values far in excess of their true market value,’ says Daniel Alpert of Westwood Capital in a note to clients, according to the Times. ‘It is unrealistic to believe that home or commercial real estate values are destined to recover any meaningful portion of bubble-era pricing.’

“This means all the new equity raised by banks after the stress-tests has merely papered over capital adequacy and solvency issues for now,” Denning continues. “The banks have simply refused to revalue loans on their books and continue to carry them at unrealistically high valuations. If they sold them, they’d got a lot less for them, forcing them to raise more capital (or wiping out their capital and revealing them to be insolvent)…

“The default and foreclosure data coming out of the U.S. housing market suggest the banks are kidding themselves, or misleading shareholders, or both!” says Denning. “It’s the sort of calculated mis-truth that can cause a short-term crisis to last years and years. The correction is postponed through phony accounting. It leads to an ‘Ushinwareta Junene,’ or ‘lost decade,’ as the Japanese say.”

While Goldman is busy kicking butt, everyone else is busy kicking the can down the road – hoping that if they keep kicking the can long and far enough, the crisis will end without further incident.

In a CNBC interview last week, Bryan Marsal, CEO of Lehman Brothers Holdings, remarked, “One of my partners said yesterday that we are going to call this phase the ‘extend and pretend’ phase in our economy. Which is you extend someone’s maturity – because they are going to default – and you pretend that business will come back…Then we’ll enter phase two, which he said is the request to extend or ‘amend.’ Then ‘send.’ In other words, send the keys.

“Those are the phases we are in right now.” Marsal concluded. “Everyone is trying to buy time, as opposed to dealing with the leverage, they are trying to buy time. Whether you are a banker or a company, they are all trying to buy time.”

Maybe all of this can-kicking will produce the desired outcome. But the more likely scenario is that the U.S. government will continue to throw newly printed dollars bills at the problem until eventually something that looks like a lot like a recovery will appear. Shortly thereafter, the recovery will yield to something that looks a lot like debilitating hyperinflation.

Source:  Gold…if Not Now, When?

It’s enough to make you succumb to the Two Minutes’ Hate.

But let’s face the truth. As egregious as salary escalation seems – coming as it does on the tail of the worst U.S. banking crisis since the Great Depression – the reality is that this is the U.S. government’s fault. After all, it was the U.S. Federal Reserve and the Obama administration that created all the bailouts and the special-loan-subsidy schemes for banks that would otherwise have been on their last legs.

In a truly free market, ex-Citibankers (NYSE: C) would be on every street corner of Manhattan – selling apples – and that would properly hold down the pay of those bankers still lucky enough to have a job.

The sudden rebound in demand for bankers is a symptom of overall market conditions right now. The U.S. stock market is way up from its lows, there are three Chinese initial public offerings (IPOs) due to come to market this week (one of them for a company with no earnings), the volume of home mortgage refinancing has been running at record levels, the FHA index of home prices has dropped only 0.3% this year and the volume of new corporate debt issuance is also high. Commodity prices are well off their lows, and oil prices are again close to $70 a barrel, which would have been considered an excessively high level only three years ago. That’s not a picture of a financial market – or a global economy – in deep recession.

Far from it.

To some extent, this is good news. A revival of the financial system and its ability to finance businesses and home purchases is exactly what the huge monetary and fiscal stimulus was meant to produce. A modest revival in world trade, as inventories cease being wound down and Chinese production ramps up again, is also a necessary precondition for economic recovery.

As the banking bonus news suggests, however, much of the activity is coming in some pretty funny places, where the excesses of the past decade were concentrated and where you wouldn’t expect to see such a quick revival.

That gives us a clear indication of just what the problem is. Because bankruptcies weren’t allowed to happen back in September and October – as they would have in a free market – there are more institutions in the market than there should be, Citigroup and Merrill Lynch most notable among them.

Moreover, in a true free market, the entire credit-default-swap (CDS) business – a product that caused $180 billion of losses to the financial system through American International Group Inc. (NYSE: AIG) – would be nothing but a smoking ruin. But in the market we are living in, those $180 billion worth of losses have been transferred to the tab of the taxpayers of America.

With Citigroup and Merrill Lynch bankers mooching around on street corners, financial sector salaries would be forced down to a more reasonable level.  As it is, the few unemployed unfortunates who worked at Lehman Brothers are not enough to depress the market. Likewise, credit default swaps have caused huge pain to the unfortunate employees of Abitibi-Bowater Inc. (NYSE: ABH), General Growth Properties (OTC: GGWPQ), and Six Flags Inc. (OTC: SIXFQ), each of which went bust partly because their creditors were playing in the CDS market and had no incentive to find an alternative to bankruptcy. Had CDS caused the pain they should have to financiers, the product would no longer exist, to the considerable benefit of the rest of us.

Inevitably, we are going to have to pay the price for all the bailouts. The financial sector will eventually shrink to its proper size, as will its members’ earnings. CDS will eventually be sharply restricted, to prevent their holders from forcing random companies into Chapter 11. Interest rates will have to rise, to accommodate the huge debt-funding needs the government has incurred. Money will have to be kept tight, to pay for the indulgences that Fed Chairman Ben S. Bernanke granted during the bubble, as well as for the even greater-indulgences of the bust.

Which is probably why you don’t want to hold U.S. stocks right now.

[Click here to check out a related Money Morning story on the salary increases some banks are offering in order to retain key employees.]

Source: Who’s Really to Blame for the Crooked Financial System

This from Sovereign Society:

Several segments of the credit markets have come back to life in December after crushing losses recorded in September and October. Though it’s too early to celebrate a broad-based credit revival, the largest issuers of investment grade debt surged this month as yields plunged. Mortgage-backed bonds, or agency debt, have also rallied sharply in December on the heels of government guarantees and the Fed’s plan to spend $500 billion dollars to shore up the sector.

With the United States and other governments amassing a truckload of debt to finance state sponsored bailouts of financial services and fiscal spending plans, it is conceivable that investors will increasingly swap low-yielding T-bonds for high quality corporate debt in 2009.

Since hitting a post-crisis peak of 4.88% in October, three-month LIBOR (London Interbank Offered Rate) has plunged to 1.52% on December 19. On December 1, LIBOR stood at 2.22%. A lower LIBOR rate is the first indicator to finally emerge from stress amid the credit crisis. Banks are still largely hoarding cash but several large institutions have started to lend in overnight markets this month for the first time since late 2007.

The Growing Yield Dilemma

The Federal Reserve’s latest interest rate cut to effectively 0% on December 16 has laid the foundations for more trouble at money-market funds where yields for 30-day and 90-day Treasury bills continues to fetch just 0.01% – the lowest in more than six decades. Earlier in December, 30-day bills actually turned negative for the first time since 1940. That means investors are paying the government to park cash.

Money market funds are now sitting on potential losses as management fees erode the yield generated by Treasury bills and other short-term paper. Though other debt securities yield more than T-bills, investors might be embracing more credit risk as fund companies look to boost yield.

A better alternative to money market funds include one-year term deposits (CDs), short-term investment grade bonds and even intermediate-term corporate debt. Term deposits should be held only at the nation’s biggest banks, including J.P. Morgan Chase, Wells Fargo and Bank of America.

Yield Hungry? Here’s a Free Lunch

The Fed’s latest moves to spur lending in a massively credit-inflicted bear market since 2007 is forcing many investors to turn to distressed corporate investment-grade bonds. The effective yield on the benchmark Dow Jones Corporate Bond Index is 7.23%, down from a record high of 8.88% just a few months ago and down from 8.06% on November 30. A lower yield means corporate bond prices are rising in value.

In September, investment grade bonds were hammered following the collapse of Lehman Brothers Holdings and posted their single worst month of performance since February 1981. Many bonds plunged more than 15% in September alone.

More than half of the investment grade bond sector is comprised of financial services debt or bonds issued by some of the largest banks in the United States and Europe. With the Fed’s implicit guarantee on the largest issuers of such debt, investors can now tap into bank issued bonds trading at a 5.16% premium to expensive Treasury bonds.

For a portion of an investor’s liquidity, corporate high quality debt is literally a “free lunch.” The largest issuers of corporate paper have started to return to the market since November, including IBM and other large cap companies. In Europe, some banks without government guarantees have managed to raise sizable offerings – a positive development.

Corporate Debt: The New Safe-Haven?

Since October, governments in the United States and Europe have swapped government paper for toxic mortgage-backed assets previously held at banks. Despite these efforts, most banks are still laced with all sorts of other clogged credits like leverage loans, auction rate securities and repo credits.

The credit crisis has not disappeared because of aggressive government and central bank action; rather, swaths of credit risk has been transferred from bank balance sheets to government balance sheets, effectively polluting central bank coffers with largely illiquid and near worthless paper. Since August, the Fed’s balance sheet has mushroomed from $850 billion dollars to more than $1.5 trillion dollars – and still rising.

Indeed, credit default swap rates since October have risen sharply on government paper while swap rates have decreased for the highest quality companies. This suggests investors are starting to place a risk premium on government issued bonds.

Are we at the cusp of a major transition in the credit markets whereby investors might increasingly purchase investment grade debt as a hedge against rising yields on government bonds? After all, outside of the financial sector many industries harbour their highest net cash levels in more than a decade. For some companies, especially the food and beverages and fast-food companies, cash flow is largely generated internally and, in most cases, these companies don’t need to raise cash to finance operations. I would argue that companies like Kraft Foods (NYSE:KFT), General Mills (NYSE:GIS) and McDonald’s (NYSE:MCD) are a better long-term credit risk than most sovereign borrowers.

Failed Auctions Rising

To confirm the above theory that perhaps investors are starting to embrace riskier bonds like investment grade debt because of bulging government deficits, consider the trend in Europe since October whereby several governments have scrapped bond auctions.

Over the last sixty days, Germany, the Netherlands, Italy, Spain, Austria and the United Kingdom have either scrapped bond auctions or reduced their planned offerings because of tepid investor interest. These governments, including Germany, the largest and most liquid, are paying higher yields to draw institutional buyers. This could mark the beginning of a bear market for government bonds at some point later in 2009, once credit markets stabilize and risk taking is resumed.

In the United States, demand for Treasury’s remains strong because of fears of deflation. The current environment – a disaster for just about every asset class except T-bonds – has supported the dollar to an extent. Foreigners are chasing Treasury securities as they scramble for safe havens. Yet even Treasury is not immune to the deluge of supply coming our way in 2009.

Over the next 12 months Treasury estimates it will have to raise about $1.5 trillion dollars to fund gargantuan fiscal spending plans, bailouts, and possible tax cuts. Treasury will re-introduce one-year, three-year and five-year T-bonds in 2009 to finance part of this spending spree. At some point, investors will force long-term rates higher. The Fed will try to influence the long end of the yield curve but will ultimately be unsuccessful. The Fed can only control short-term lending rates.

Investment grade bonds shouldn’t supplement T-bills. The risk spectrum is normally quite significant in a normal economic environment. Yet these are anything but normal economic times. It is possible that as 2009 progresses and, assuming credit markets continue to grudgingly normalize, the new safe haven in bonds will be high quality investment grade bonds at the expense of super low-yielding Treasury debt.

Source: Is Investment Grade Corporate Debt Safer Than Government Bonds?

More from the Sovereign Society:

Are investment-grade corporate bonds the new “safe-haven” for investors?

You certainly wouldn’t think so following their worst monthly drubbing since 1980 in October. September and October sliced and diced investment-grade debt to levels unseen in more than two decades, with effective yields now at 8% compared to 3.7% for ten-year U.S. T-bonds.

Short-term Treasury bonds have been a magnet since the onset of the credit crisis. They’ve been drawing safe-haven flows from nervous investors worldwide ahead of redemptions, fund closures and panic selling since mid-September when Lehman Brothers failed. At the same time, investment-grade debt has been smashed.

The spread, or difference, between the Dow Jones Corporate Bond Index compared to ten-year Treasury bonds is 431 basis points; prior to the subprime blowup in August 2007 that spread was under 80 basis points.

But do corporate bonds really deserve this discount, even in the midst of asset deflation?

Judging by several poor auctions last week of government bonds – including a failure in Germany of a benchmark ten-year issue – investors might want to look at intermediate and short-term investment grade corporate bonds instead. Though companies can’t print money like governments, the majority of these AA and A credits harbor balance sheets far superior to global governments in late 2008.

Through September 30, U.S. companies held $675 billion in cash – the highest level in more than 15 years.

In many ways, U.S. companies are better credits than government agencies, states and municipalities. Large cap companies in the S&P 500 Index have already refinanced or financed new loans prior to August 2007 when rates were near record lows and, in most cases, don’t have high debt-to-equity ratios like financial companies and the Federal government.

Kraft Foods (NYSE:KFT), for example, funds most of its ongoing debt commitments organically through revenues, unlike the government, states and municipalities. Personally, I’d much rather own credits issued by Kraft Foods, Nestle, General Mills (NYSE:GIS), McDonald’s (NYSE:MCD) or YUM Brands (NYSE:YUM).

Even financial company debt, like American Express (NYSE:AXP) and J.P. Morgan Chase (NYSE:JPM) remains highly attractive because of government backstops initiated in October to guarantee interest payments. If that’s the case, why would someone buy a U.S. T-bond paying 3.7% compared to 7% for an American Express bond when the latter’s promise to repay is now fully guaranteed by the U.S. government?

In Europe, a slew of governments will increasingly have trouble raising fresh capital as auctions saturate the market. It’s the same in the United States whereby weekly auctions will accelerate next year to fund the explosive cost of TARP and other bailouts as the economy continues to deteriorate. At some point, the world will tire of Treasury debt, especially long-term T-bonds, and, ultimately, the dollar. That’s when I expect Treasury yields to start climbing.

Meanwhile, deflation remains mired across the industrialized world this fall. Declining asset prices are causing all sorts of dislocations for governments, companies, individuals and especially those seeking to refinance debt. Credit is indeed hard to obtain.

Treasuries will remain well-bid for now. But I suspect a big bear market to unfold for Treasury debt once this panic ends.

Source: Investment-Grade Corporate Bonds Deserve a Premium

And it gets worse. That increase in borrowing costs will spread to other parts of the global debt market, representing an across-the board threat to corporate, institutional and sovereign borrowers. If interest rates remain high and interbank lending remains tight, the credit crisis is not likely to recede.

This raises two key questions. Are desperate times prompting desperate measures? Is LIBOR being manipulated by banks that are trying to make their financial positions appear better than they really are?

If that’s the case, it’s one more reason the credit crisis will fester and spread undetected: The artificially low interbank lending rates removed a key “early warning” indicator, leading investors to believe the credit market was healthy when it actually wasn’t.

The Lowdown on LIBOR

LIBOR, or the London Interbank Offered Rate, is arguably the most important interest rate in the world. It is used to calculate the interest rates on hundreds of billions of dollars of corporate debt, mortgages and innumerable other loan products – including hundreds of trillions of dollars of derivatives.

It is important to understand that LIBOR is a “reference” rate, meaning it isn’t imposed on a borrower by any regulation or law. Developed in the middle 1980s, LIBOR is the benchmark rate banks use when they offer to lend unsecured money to other banks in the London wholesale money market.

LIBOR was created to make sure that banks that offer loans with “floating” – or adjustable – interest rates know just what their constantly changing cost-to-borrow actually is.

Lenders offering floating or adjustable rate loans typically charge borrowers a “spread” above LIBOR. When you hear: “Your cost on this loan is three-month LIBOR plus 5,” it means the lender is charging you the three-month LIBOR rate – plus an additional five percentage points. If three-month LIBOR is 4%, your actual rate is 9% (4% + 5% = 9%). If your loan re-sets in the future, it will do so based on the LIBOR rate that day – plus an additional five percentage points.

LIBOR is calculated for 15 different loan durations, ranging from overnight to a year, and is listed in 10 different currencies. For this discussion, we are focusing on only the dollar LIBOR rate, which is the rate, in terms of dollar borrowings, that banks theoretically charge each other when buying and selling dollars in the London market.

Each morning, “panels” of banks submit loan data to Thomson Reuters PLC (ADR: TRIN) in London, usually by 11:10 a.m. London time, and Reuters (a news, information, data and market quoting service corporation) calculates LIBOR, which is subsequently published each day by the British Bankers’ Association (BBA).

Subverting the System

That brings us to the current problem in the LIBOR market: As Money Morning has previously reported, there’s substantial evidence that LIBOR is being “managed.” This has been happening and the BBA is actively looking into it. In fact, several months ago, when the BBA announced it was speeding up its probe, LIBOR jumped.

The dollar LIBOR rate, or “fixing,” as it is known, is calculated based on the submission of quotes from 16 major world banks. The banks send in data as to what they paid, or could pay, to borrow from other banks at each maturity level. Reuters throws out the four highest and four lowest quotes, and calculates the average of the eight that remain to come up with the dollar LIBOR fixing.

If banks are seeking to charge one another higher rates, that’s telling us one of two things. Either:

• Banks don’t have excess cash to lend.
• Or they are unwilling to lend freely to other banks, which they fear are facing potential troubles because of bad loans, defaulted mortgages, and other pending hits to their capital and threats to their solvency. [Pending hits to capital could include anticipated higher foreclosure rates brought on by mortgage re-sets].

No bank wants to admit it is being charged a premium to borrow: That sends a bad signal. If a reporting bank submits data that shows its own borrowing costs are higher than average, it will very likely raise questions about that institution’s financial strength and stability – the kind of uncertainty that recently brought down such financial institutions as The Bear Stearns Cos. [now part of JP Morgan Chase & Co. (JPM)], and Lehman Brothers Holdings Inc. (LEHMQ).

So what might that bank do? Since the submitting banks providing data to Reuters are on the “honor system,” maybe this institution has an incentive to not submit its actual borrowing costs? Maybe this bank submits rates at which it could borrow – which it is permitted to do, by definition, under the submitting rules – if those rates are lower by virtue of only being a quote it received?

Maybe this bank – and the rest of its brethren – would like to keep LIBOR lower than the interbank rate should actually be, realizing that if rates rise, bad-loan exposure increases. And if bad-loan exposure increases, derivative exposure will escalate, too. What if U.S. ARM re-sets (based on LIBOR) bump up the interest-rate charges that already-strapped homeowners have to pay? What will more foreclosures do to already-battered bank balance sheets?

We already know the answers to those questions.

Since the interbank-lending markets here in the United States have not been freed up, the U.S. Treasury Department and the U.S. Federal Reserve have gone to extraordinary lengths to thaw out the frozen markets and get credit flowing across the economy. Included in their buckshot-pattern arsenal of misguided turnaround initiatives is one that forces the largest U.S. banks to borrow directly from the government. That initiative hasn’t helped because banks are simply afraid to lend to other banks because of the problem of toxic balance sheets and future loan-loss probabilities. Worst of all, no bank’s balance sheet has become a single bit more transparent. Nor will that ever happen if we do away with fair-value, mark-to-market accounting.

But, last Friday, at the same time Citigroup Inc. (C) reported November re-sets on adjustable rate mortgages will exceed $24 billion – which can only lead to further mortgage defaults – it was also revealed that some of the banks our government gave money to actually lent it to banks in London. Strange? Not really.

When JP Morgan, Citigroup and other big U.S. banks place money with London banks, specifically banks that submit borrowing cost statistics to Reuters that ultimately determines the LIBOR fixing, could it be that there’s more than free-flowing lending going on? Did the London banks lend any of the pittances that the U.S. banks lent across the pond?

By simple virtue of actually having more money to lend, and without any lending between themselves, London banks have the cover to say: “There’s money available to borrow, but we didn’t borrow any, but we could have borrowed and the cost to us would have been lower than it has been.”

So, they submit to Reuters the lower cost at which they could have borrowed and, presto, the LIBOR fixing is lowered.

Blueprint for a Turnaround

Desperate times, it has been said, require desperate measures.

While it is imperative that credit flows freely here and around the world, the desperate and manipulative measures that banks, the Treasury Department and the Federal Reserve are employing are the equivalent of the Air Force using a carpet-bombing campaign when it’s clear that a couple of smart bombs would do a better job. As a result, U.S. taxpayers are being bombed into a deeper, wider and steeper crater from which it will be very difficult – if not impossible – to climb out of.

There’s just not enough dirt to fill in the craters created by the repeated pounding of the errant policy bombs, as well as the disinterested and abetting regulation, unencumbered Wall Street greed and the profligate orgy of spending that’s come to define Main Street.

Fixing this massive problem – of which LIBOR is just an element – will take time. But we can start by taking all the lobbyists, ex-legislators and ex-regulators and their former staff members (and perhaps some current legislators who are serial enablers of such problems, and who enrichen themselves each time along the way) and burying them in the craters as we fill the holes in.

That rant aside, devising an actual fix for our problems starts by understanding just what it was that caused them. We can assign blame later. For now it’s far more important to stop the flood of red ink that’s washing down Main Street.

Understanding LIBOR and what’s really going on is critical to understanding the motivation and maneuvering of the players that have us headed for a worldwide financial Armageddon.

Source: Fears of Mortgage Rate Re-Sets May Fuel LIBOR Manipulation and Mask Deeper Banking System Problems

Editors Note: This is the ninth installment of an ongoing series in which retired hedge-fund manager R. Shah Gilani breaks down the credit crisis for readers.

The losses among banks, insurers and money managers may spark the next round of writedowns on CDOs after $660 billion in subprime-related losses. They may force lenders to post more reserves against losses after governments worldwide announced $3 trillion in financial-industry rescue packages since last month, according to Barclays Capital.

– Meanwhile, Reuters reports that U.S. banks will need more $700 billion in government cash injections to stay afloat because “banks cannot predict how many of their loans will sour because they do not know how much the economy will shrink, and forecasts of their future losses would only spook investors.”

– The numbers are certainly worrying:

By the numbers, the outlook for banks is troubling. U.S. commercial banks had about $1 trillion of capital as of the end of the second quarter.

That may sound like a lot, but Alpert estimates that banks globally could have a total of $1.25 trillion to $1.5 trillion of writedowns and losses from mortgages, of which perhaps $600 billion have already been recorded.

– Earnings season is upon us. Investors are reacting to the prospect of corporate losses. This from MarketWatch:

U.S. stock futures pointed to a second straight drop on Wednesday on concerns for earnings in a rocky economy, though Apple looked set to buck the trend after the consumer electronics giant was able to sell far more iPhones than expected.

S&P 500 futures fell 20.1 points to 939.20 and Dow industrial futures tumbled 166 points. Futures on the tech-concentrated Nasdaq 100 fell a more modest 15.5 points to 1,277.00.

– Global stock indexes also fell. This from Bloomberg:

The MSCI World Index lost 2.9 percent to 944.07 at 12:02 p.m. in London. The index has lost 40 percent this year and oil has tumbled more than 50 percent from its peak in July as concern deepened government bailouts to save the global banking system won’t avert a recession.

– In the currency markets, the British pound hit a five-year low against the dollar. The euro plumbed a 20-month low against the buck.

– Crude oil prices fell below $70 a barrel on growing fears of a global economic slowdown. OPEC’s scheduled meeting on Friday to discuss output cuts has so far failed to stem oil’s slide.

– A lot of investors are calling a bottom — at least a tentative bottom — in stocks.

– Addison Wiggan and Ian Mathias in The 5 Min. Forecast note that Jeremy Grantham, self-proclaimed “perma-bear” is turning bullish.

Grantham says the time has come for “hesitant and careful buying” of equities. Grantham, who also correctly called a global bubble among all asset classes last year, told his $120 billion worth of clients that this is the quarter to start buying.

“On Oct. 10, we can say that, with the S&P at 900, stocks are cheap in the U.S. and cheaper still overseas. We will, therefore, be steady buyers at these prices. Not necessarily rapid buyers — in fact, probably not — but steady buyers…

“History warns, though, that new lows are more likely than not.

“Fixed income has wide areas of very attractive, aberrant pricing. The dollar and the yen look OK for now, but the pound does not. Don’t worry at all about inflation. We can all save up our worries there for a couple of years from now and then really worry!

“Commodities may have big rallies, but the fundamentals of the next 18 months should wear them down to new two-year lows. As for us in asset allocation, we have made our choice: hesitant and careful buying at these prices and lower.”

After witnessing a major rally following the Bear Stearns Cos. bailout in mid-March, investment grade corporate credit spreads have risen to multi-decade highs this summer.

If you’re a long-term investor, I would consider nibbling at these levels because interest rates for many bonds in the non-financial sector now pay attractive inflation adjusted yields.

But I’d avoid most financial company debt instruments because these securities will remain distressed much longer amid ongoing balance sheet erosion and high risk premiums to fund borrowing obligations.

The corporate debt market now yields an effective 3.11% above risk-free Treasury bonds compared to 3.05% at their pre-Bear Stearns‘ peak in March, according to Merrill Lynch (NYSE:MER).

The Dow Jones Corporate Bond Index now yields an effective rate of 6.04% or 2.20% above ten year Treasury bonds. That’s also at a multi-year high.

One of the cheapest ways to invest in investment-grade corporate debt is to buy low-cost exchange traded funds (ETFs). These products are listed in the United States and offer daily liquidity. You can also find similar products traded in Frankfurt, Germany and denominated in euro.

Another segment of the credit markets also offering high value is the mortgage-backed securities market or the MBS sector.

The investment-grade corporate debt market and mortgage-backed securities are cheap. These products provide a low correlation to common stocks AND they pay attractive inflation adjusted yields. Plus, non-financial corporate bonds offer strong balance sheet management.

In fact, I prefer to own the corporate debt of, say, Coca-Cola (NYSE:KO) or Exxon-Mobil Co. (NYSE:XOM) than the U.S. federal government or the state of California. These and other S&P 500 Index non-financial companies have far healthier balance sheets.

As the U.S. and global economy continues to slow this year, inflationary pressures should also cool. This should open the door to higher bond prices, especially in the high grade investment sector and mortgage-backed securities.

But I would still avoid junk bonds or high yield debt because the corporate default rate for risky issuers continues to rise and won’t peak over the next 12-18 months.

Source: Time to Start Bargain Hunting: Where I’m Looking

• Crude oil for July delivery rose $4.33 to $133.38 a barrel yesterday (Wednesday) after U.S. stockpiles showed an unexpected decline. Supplies fell 5.32 million barrels to 320.4 million last week, the biggest drop in four months, according to the Energy Department.

• Time Warner Inc. (TWC) announced yesterday (Wednesday) that it plans to spin off its cable-television unit and receive a $9.25 billion windfall in the transaction, Bloomberg reported. The move will let the company focus on its cable network, entertainment, and publishing operations rather than distribution – something investors have been clamoring for.

• The Boeing Co. (BA) said yesterday (Wednesday) that it would lay off 750 Southern California employees after losing a lucrative military satellite contract and seeing a dip in demand for the technology, the Associated Press reported. The cuts involve engineering staff at plants in El Segundo and Seal Beach.

• Swiss bank UBS AG (UBS) yesterday (Wednesday) sold subprime and other mortgage-based securities to a newly created investment fund run by U.S. asset manager BlackRock Inc. (BLK) for $15 billion, the Associated Press reported. The securities had a nominal value of $22 billion but have been listed with a book value of $15 billion as of March, according to UBS.

• American Airlines, a subsidiary of AMR Corp. (AMR), announced yesterday (Wednesday) that it was taking drastic measures in the face of escalating oil and fuel prices, Reuters reported. The world’s largest airline will cut thousands of jobs, reducing capacity by 12%. American will also charge $15 for passengers’ first checked bag. AMR stock dropped 25% with a $1.98 decline to close at $6.22.

• Shares of corporate debt rating agency Moody’s Corp. (MCO) dropped over 15% yesterday (Wednesday) after a computer glitch mistakenly issued “Aaa” ratings for Constant Proportion Debt Obligations, commonly referred to as CPDOs, Reuters reported. Moody’s stock lost $6.99 to close at $36.91 yesterday (Wednesday).

• The U.S. House of Representatives passed legislation yesterday (Wednesday) that would allow the Department of Justice to sue the Organization of Petroleum Exporting Countries (OPEC) for limiting oil supply and price-fixing, Reuters reported. The measure still needs to be approved by the Senate, but President Bush has already threatened to veto the bill.

• Inflation fears were blamed for the Bank of England’s 8-to-1 decision to hold interest rates steady yesterday (Wednesday), MarketWatch reported. “For most members, a reduction in Bank Rate this month would make it more difficult to keep inflation expectations in line with the target,” the minutes said. For April, consumer inflation clocked in at 3%, above the BOE’s preferred 2% target.

Source: Global Investing Roundups:Thursday, May 22nd, 2008

“I’ve already called this credit crunch, ‘the worst financial crisis since the Great Depression’…and unfortunately, we’re not through it yet” says Eric Roseman.

It’s true the worst of this credit storm has probably passed. But banks, companies and individual investors are still facing funding pressures. That tells me the absolute bottom of this crisis has yet to arrive.

The highest estimates I’ve heard say it will take US$1.7 trillion to clean-up this credit crisis. The more conservative projections allude to a US$500 billion cleaning bill (remember when half a trillion dollars seemed like a lot of money?).

Either way, it’s not time to buy aggressively into stocks.

But investment-grade bonds are starting to look increasingly attractive – particularly as credit spreads start to stabilize among highly-rated corporate debt instruments and Treasury bonds. But it’s still too early for bargain-hunting in equities and riskier debt markets.

The Smart Money Isn’t Following the
Sucker Stock Rallies

This morning’s edition of the Wall Street Journal points to lingering concerns in debt markets. According to the Journal, credit spreads for higher risk bonds, short-term inter-bank lending rates and investment-grade corporate financing remain under severe pressure.

Stocks might have mustered a big rally yesterday, but the smart money in credit markets is showing a very different picture on the state of the American economy.

How will investors know it’s time to load-up on distressed common stocks again? Is there a set of indicators that allow you to measure credit stress?

As the bottom of this bear market eventually arrives, look to credit markets for signals that it’s time to resume your buying. Bonds and credit spreads will provide a far more accurate gauge to global investors than stocks, which tend to harbor false recoveries or “sucker” rallies.

Yield-Curve Inversion Warning in 2006-2007

Back in 2006, the Treasury yield curve turned negative, and accurately forecast an economic recession. Back then, I was writing about it - warning about this dangerous anomaly.

Today, it’s still my opinion that bonds represent the “smart money” in the financial markets. Historically, bonds have accurately predicted economic recessions more often than not.

An inverted or negative yield-curve occurs when short-term interest rates yield more than long-term rates. That’s an anomaly in fixed-income markets that has historically preceded a slowdown or an economic recession about 12 months later.

At the time, most analysts refuted this price action, but it still proved incredibly accurate. By July 2007, the credit markets had begun to unwind and stocks tanked, finally hitting bear market territory for the first time since 2002.

While Treasury bond inversion accurately forecasted trouble ahead, that wasn’t the case for the Dow or the S&P 500 Index.

In stark contrast, the S&P 500 Index in mid-2006 was still in bull market mode, defying the repeated warnings from the Treasury market as yield inversion grew louder. And most high-risk credit markets, namely high-yield or junk bonds, also continued to race higher even as the Treasury market began predicting trouble.

The Credit Crisis Check-List

I thought I’d give you a little insight to how I gauge the markets. These are the indicators I’ve been watching like a hawk for years. And today, I’m using this checklist to predict when the current credit crisis will bottom. More importantly, I’ve got my eye on these indicators so I know exactly when I can re-enter the stock market. You can do the same.

I’ll elaborate on each of these indicators so you can better identify what to follow and eventually, call your broker and start loading-up on equities again!

• LIBOR and SWAP rates
• Credit spreads
• Mortgage-backed securities
• Junk bond defaults
• Credit hedge fund failures

LIBOR and EURO LIBOR are important short-term overnight lending rates. LIBOR or the London Interbank Offered Rate has historically traded slightly above the official Federal Funds rate. Euro LIBOR has also historically traded just above the European Central Bank’s official base rate since the currency was introduced in 1999.

The SWAP Rate -
A Sign That Banks Aren’t Confident to Lend

The difference between LIBOR and overnight interest rates set by central banks is called the SWAP rate. This spread number must relax or narrow before credit markets get a “green” light to unclog and start lending as usual again.

But since last summer when sub-prime began to boil, overnight lending rates have skyrocketed. Despite the Federal Reserve’s best efforts to lubricate the wheels of the funding markets since last summer, inter-bank lending rates remain high. And institutions are reluctant to commit overnight funds to one another.

This lack of confidence among banks in the United States, Canada and Europe, is spreading to Asia. As banks grow wary of lending to one another and question inter-bank collateral, the cost of funds increases exponentially. And that slows economic growth.

LIBOR Rates Say Banks Are Holding onto Their Cash -
A Sign the Credit Crisis Is Still With Us

From its high last fall, U.S. dollar LIBOR SWAP rates managed to decline before Christmas. That was after the Fed and other central banks injected gobs of credit to stabilize the financial system.

But since March, LIBOR SWAPS and its European counterpart, Euro LIBOR SWAPS, have jumped. This is an important signal that the credit crisis is not over. Until LIBOR SWAP rates decline and return to normal spreads above central bank monetary targets, the crisis continues.

CREDIT SPREADS are another indicator worth watching. The spread between risk-free Treasury debt and other bonds like corporate debt and junk bonds is called a “credit spread.”

When the economy is strong and deal-flow is rampant, credit spreads will narrow. That happened as we headed into 2007 last year. Junk bonds, which are below investment-grade credits, saw their yields hit historic lows versus Treasury bonds last spring. That was just ahead of the July sub-prime blow-up. At the time, high-yield bonds paid under two hundred basis points (2%) above T-bonds – unbelievably low.

Today, that spread is just below 10%. And it’s likely it will rise further as default rates climb in a recessionary economy. Until credit spreads for riskier bonds begin to tighten or narrow significantly, the economy remains on the rocks.

Those Mortgage-Backed Securities
We’re All So Fond Of

MORTGAGE-BACKED SECURITIES encompass a wide spectrum of instruments ranging from synthetic illiquid CDOs or collateralized debt obligations to bonds issued by government agencies like Fannie Mae (FNMA) and Freddie Mac (FHLMC).

You’ll be able to tell when stability returns to the mortgage-backed area by watching the mortgage-backed derivatives and the more conservative mortgage bonds guaranteed by FNMA. When both of these numbers bottom, that’s a sign this credit crunch is easing.

The good news is that PIMCO’s Bill Gross, the world’s savviest bond investor, has loaded-up on 30-year mortgage bonds guaranteed by Fannie Mae. These bonds yield almost 2% more than Treasury bonds. That’s a bullish sign that investors are returning to the safest segment of the tattered mortgage market.

However, the mortgage-backed market still has a long way to recover. In all likelihood, the CDO market and other synthetics tied to mortgages will probably never trade at par-value again. But at some point, deep value investors will start buying some of the more liquid CDOs, and that will point to a bottom in this market.

Sometimes It Pays to Watch the Junk

JUNK BOND DEFAULTS typically hit a high in excess of 5% of outstanding instruments during a recession.

At the moment, the junk bond default rate is under 2%. That suggests many more financially leveraged and indebted companies will head into bankruptcy or credit default. I would have to see a much higher default rate among American high-yield or junk bond companies before turning bullish on the stock market.

CREDIT HEDGE FUNDS represent the largest segment of total hedge fund assets, now an estimated US$2 trillion. Combined with leverage, credit hedge funds are the dangerous pariahs of the investment world in 2008 as more of their investors scramble to redeem assets.

Many credit hedge funds have already collapsed or have been liquidated since 2007. As assets are liquidated to meet growing redemptions, hedge funds must unwind leverage and ultimately, abandon many positions in the credit markets that are illiquid. This will snowball into a major disaster for leveraged hedge funds in asset-backed, distressed and event-driven hedge fund strategies.

The end of the credit crisis will likely coincide with a major blow-up at one of the largest credit hedge funds in the world. To date, the failures have mostly represented second-tier or smaller industry players.

Hang In There, This Will Pass

The above credit market check list is by no means absolute. But if you’re looking for a bottom in stocks, these numbers can help you gauge when it’s time to buy again. And of course, I’ll continue to watch all these indicators for signs of a bottom. And I’ll let you know the moment I see it coming here in the A-Letter.

This credit crisis will eventually pass. The worst is probably behind us for most segments of the debt markets but danger still lurks for equity investors. Tread carefully and heed the signs of credit, not stocks, for a true bear market bottom.

ERIC ROSEMAN, Investment Director

EDITOR’S NOTE: As Eric watches for signs this credit crunch is easing, a related crisis is emerging worldwide. It’s a dangerous cocktail of worldwide food and fuel inflation. This disastrous combination has already sent commodity prices sky-high and sparked protests, hoarding, strikes and deadly riots the globe over. Today is your last day to find out FREE of charge exactly why these record-high food prices will continue to rise – and how to use that information to make up to 910% on these soaring commodities. You have until MIDNIGHT tonight. Click here.